Financial History of the United States from the Subprime Crisis to the Great Recession (2006-2009)

A Financial History of the United States From the Subprime Crisis to the Great Recession (2006-2009)

Jerry W. Markham

M.E.Sharpe Armonk, New York London, England

Library of Congress Cataloging-in-Publication Data

Markham, Jerry W. A financial history of the United States : from Enron-era scandals to the subprime crisis (2004–2006) : from the subprime crisis to the Great Recession (2006–2009) / Jerry W. Markham. v. ; cm. Includes bibliographical references and index. Contents: Enron and its aftermath—Other Enron era scandals—Corporate governance reforms— Securities, banking, and insurance—Commodity markets—The rise of the hedge funds and private equity—The mortgage market—A critical look at the reformers. ISBN 978-0-7656-2431-4 (cloth : alk. paper) 1. Financial crises—United States—History—21st century. 2. Corporations—Corrupt practices—United States—History—21st century. 3. Enron Corp—Corrupt practices—History. 4. Investment banking—United States—21st century. 5. United States—Economic policy—21st century. I. Title.

HB3722.M375 2010 332.0973’090511—dc22 201000775

Printed in the United States of America

The paper used in this publication meets the minimum requirements of American National Standard for Information Sciences Permanence of Paper for Printed Library Materials, ANSI Z 39.48-1984.

EB (c) 10 9 8 7 6 5 4 3 2 1

Gertrude Stein

This is the sixth volume of a financial history of the United States. The first three volumes trace the development of finance in America from the colonial period to the beginning of this century. They are entitled A Financial His- tory of the United States: From Christopher Columbus to the Robber Barons (1492–1900); A Financial History of the United States: From J.P. Morgan to the Institutional Investor (1900–1970); A Financial History of the United States: From the Age of Derivatives into the New Millennium (1970–2001). The fourth volume describes the Enron-era financial scandals and other developments in finance during the period 2001 to 2005 and is entitledA Financial History of Modern U.S. Corporate Scandals: From Enron to Reform. The fifth volume covers the aftermath of the Enron-era reforms and the developments in the securities, derivative and mortgage markets that promoted subprime lending and is entitled A Financial History of the United States: From Enron-Era Scandals to the Subprime Crisis (2004–2006). This volume describes the worldwide subprime crisis that occurred between 2007 and 2009. As a prelude to that crisis, this history examines the development of the securitized mortgage products that came to be known as collateralized debt obligations (CDOs) and their attendant credit support in the form of credit-default swaps (CDS) and monoline insurance. It next turns to the factors that led up to the subprime crisis and then describes events during that worldwide crisis as they unfolded, including the Great Panic that followed the bankruptcy of Lehman Brothers. The massive government bailout programs for financial services firms and automakers are addressed, and the regulatory reforms enacted by President Barack Obama’s administration to prevent such systemic failures in the future are considered.

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The author thanks Beth Peiffer for her research assistance, her reading and correcting the manuscript, and her diligence in preparing the bibliography and index. George Sullivan and Rigers Giyshi, my research associates, provided invaluable assistance in responding, always promptly, to my numerous and persistent research requests. I am also, once again, grateful for the support of the Florida International University College of Law.

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Even while the government was in the midst of prosecuting executives involved in the Enron-era scandals, another disaster was in the making in the form of a residential real estate bubble. As housing prices soared, the practice of “flipping” houses and condos for a quick profit became a popular Ameri- can pastime. The real estate bubble was fueled, sometimes irresponsibly, by liberal credit extensions at quite low “teaser” interest rates to “subprime” borrowers. These borrowers had credit problems that disqualified them from obtaining a conventional mortgage. Nevertheless, subprime loans were made to individuals with poor or no credit histories on terms that assured they would eventually default. Fueling this subprime lending boom were mortgage brokers promoting “no-doc” or “low-doc” loans that did not require the normal documentation of the borrower’s creditworthiness. Credit quality was of no concern to the mortgage brokers and lenders making those loans because the loans were immediately resold by securitizing them in a pool, which was then sold to investors as collateralized debt obligations (CDO). The CDOs often had complex payment streams, and they were frequently insured against default by “monoline” insurance companies with little capital or hedged by a new financial instrument in the form of credit-default swaps. Those protections allowed the “super-senior” tranches in subprime securitizations to obtain a triple-A credit ratings from the leading rating agencies, making them highly marketable in the United States and Europe. However, there was a major hidden flaw in the ratings process. The rating agencies used risk models for awarding the triple-A rating that did not take into account the possibility of a major downturn in the real estate market. Subprime mortgages were sometimes pooled to fund off-balance-sheet commercial paper borrowings called “structured investment vehicles” (SIVs) or “asset-backed commercial paper” (ABCP). Banks, such as Citigroup, used short-term commercial paper borrowings to purchase mortgages held in their SIVs. Those commercial paper borrowings funded the mortgages and provided a profit through the spread between the higher rates paid by mortgages and the lower rates then existing in the commercial paper market. These carry-trade

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(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. xxii introduction programs had a flaw. In the event that commercial paper borrowers refused to roll over their loans, SIVs would have to liquidate their mortgages. That rollover might not be possible in a credit crunch or major market downturn. Another danger was that short-term rates could rise faster than long-term rates, erasing the spread or even inverting the payment stream. The Fed funds rate (the interest rate for overnight funds among banks) was 6.50 percent in 2000 and fell to 1 percent in June 2003. This triggered a housing mania in the United States. In order to burst the real estate bubble inflated by those low rates, Alan Greenspan, the chairman of the Federal Reserve (the Fed), set the first of a series of what eventually were seventeen consecutive interest rate increases, beginning on June 30, 2004. Ben Bernanke, who succeeded him in that post on February 1, 2006, put in place still more interest rate increases. The effects of those actions were already becoming evident as Bernanke assumed office. Indeed, the housing market experienced the largest decline in new home sales in nine years in the month after Bernanke took office. Undeterred by that rather ominous news, Bernanke imposed another rate increase on March 28, 2006, pushing short-term rates to 4.75 percent, the fifteenth straight interest rate increase. Bernanke suggested that more rate increases would be forthcoming. The sixteenth straight rate increase followed on May 10, 2006, pushing short-term rates to 5 percent, and the seventeenth consecutive increase came on June 29, 2006, increasing short-term rates to 5.25 percent. The effect of this onslaught on the real estate market turned into a financial crisis in 2007. Home sales and new residential construction slowed dramatically, and the market became glutted with unsold homes. Construction firms, such as Toll Brothers, cut back their building programs, and the housing construction industry experienced its worst slump in forty years. Speculators who had been earning unprecedented profits by buying and quickly reselling properties, often after only a cosmetic touchup, found that they could no longer flip their properties for a quick profit, so they were left holding highly depreciated properties. “Short” sales, in which foreclosed homes were sold for less than their outstanding mortgage, became common as speculators defaulted, and as homeowners who did not have fixed-rate mortgages could no longer meet their payments due to the rising interest rates. Subprime homeowners, in many instances, simply walked away from their homes and mortgages when the value of their home dropped below the amount of the mortgage, a condition known as being “underwater.” The growing crisis in the real estate market caused banks to tighten credit requirements and to cut back on credit, creating a credit crunch in the summer of 2007. In response to that concern, on August 17, 2007, the Fed issued a statement encouraging banks to access its discount window more freely, but the crisis only deepened. The Fed then cut interest rates by a surprisingly large fifty basis points on September 18, 2007. That was the first rate cut in four years. The size of it was surprising, nevertheless it had little effect in restoring liquidity in the credit markets.

The Fed reduced rates by a further twenty-five basis points on October 31, 2007, pushing the Fed funds rate down to 4.5 percent. It warned that this cut was likely the last because of inflation risks, which it then viewed as equal to the risk of a recession stemming from the housing crisis. However, this cut, too, had little effect, and failed to mitigate the continuing liquidity crisis. The Fed responded with yet another twenty-five-basis-point cut on December 11, 2007, which was disappointingly small and could not prop up faltering market confidence. The Fed then broadened bank access to its lending window in order to provide more liquidity in the system, but that too had little effect. Other problems abounded in financial markets. Traders in energy markets, which were booming as crude oil prices increased to over $145 per barrel, became the subject of attention as regulators and populist members of Congress looked for a scapegoat for the high gas prices faced by consumers. In addition, foreclosures continued to mount and the number of defaults on subprime mortgages skyrocketed. This caused a crisis in financial markets when SIVs were unable to roll over their commercial paper. Large financial institutions, including Citigroup, Merrill Lynch, Bear Stearns, and UBS, had to write off billions of dollars in losses from SIVs and CDOs. Several of those institutions fired their CEOs and sought capital to shore up their finances from a new, and, to some, foreboding source:sovereign wealth funds of foreign governments. As the crisis continued to spiral, some SIVs tried to sell their mortgage collateral, but they could do so only at steep discounts. Concerned over losses from SIVs and CDOs, banks cut back further on lending, worsening the credit crunch that was causing funding problems throughout the economy. Subprime problems spread to Canada, where a large number of ABCPs were frozen and a rescue operation was mounted to protect banks that had exposure from those vehicles. European investors had also become deeply involved in the subprime market, and some financial institutions there faced massive losses. Customers began a run on Northern Rock in England in September 2007, after they became worried about its mortgage exposure—the first bank run in England in more than a hundred years. Depositors withdrew $2 billion before the run was stopped by a $28 billion cash infusion from the Bank of England. The British government later nationalized Northern Rock as well as the Royal Bank of Scotland which was facing massive losses. The Bank of England and the European Central Bank (ECB) also worked in tandem with the Fed to make unlimited funds available to their banks for borrowing in order to ease the credit crunch. “Teaser” loan rates offered to subprime borrowers in the United States reset at much higher rates and foreclosures skyrocketed. Though retired, Greenspan voiced his support of the use of public funds to bail out those homeowners. However, the administration of George W. Bush wanted the banks to simply freeze existing rates on those mortgages. This touched off a debate over whether individuals and institutions that made bad credit decisions should be bailed out

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. xxiv introduction by the government or disciplined by the market. Those concerns were muted as the subprime crisis worsened. Citigroup and Merrill Lynch announced billions of dollars in losses from subprime loans as 2007 ended, causing the removal of their CEOs and the injection of billions of dollars obtained from sovereign wealth funds to shore up their capital. Other financial institutions, including Morgan Stanley, also announced billions of dollars in losses from subprime loans. Just as it seemed that things could get no worse, a rogue trader, Jérôme Kerviel, a midlevel employee at France’s Société Générale, was discovered in early January 2008 to have racked up $7.2 billion in trading losses on index futures contracts. The bank liquidated Kerviel’s trades over the weekend of January 15 in the United States. That liquidation was thought to have contributed to a worldwide selloff in financial markets that, in turn, unsettled the Fed and led to a reduction in Fed funds interest rate of seventy-five basis points. Congress and the Bush administration panicked and quickly passed a $160 billion stimulus package, in the form of tax refunds of $1,200 for jointly filing taxpayers and half that amount for single filers. The action had little immediate effect. The Fed then had to arrange a dramatic takeover of Bear Stearns by JPMorgan Chase in March 2008. Bear Stearns was brought down by a liquidity crisis that arose after traders declined to roll over Bear Stearns’ positions in the money market. Assets of clients were pulled from the firm in large amounts, and counterparties refused to trade with Bear Stearns because of concern that it would fail, which it did. In order to close the deal, the Fed agreed to guarantee some $30 billion in Bear Stearns assets. The Fed also threw open its lending window to investment banks, as well as to the commercial banks, and accepted as good collateral mortgage-backed securities, the very instruments that led to the crisis. Some other giants on Wall Street were forced to merge as a result of massive losses from subprime mortgage exposure. The venerable Merrill Lynch was taken over by Bank of America. Wachovia Bank was folded into Wells Fargo. JPMorgan Chase took over Washington Mutual, the largest savings and loan association in the country. Still, the situation worsened, becoming a full-scale panic, after Lehman Brothers failed in September 2008. A money market fund then “broke the buck” (traded below the amount invested) and touched off an investor run on money market funds, in which over $500 billion was withdrawn before the government stepped in to guarantee the funds. The giant insurance firm American International Group (AIG) had to be rescued by the federal government at a cost of over $170 billion. A $700 billion bailout package passed by Congress, called the Troubled Asset Relief Program, (TARP), failed to halt the ensuing stock market panic. The Treasury Department used TARP funds to inject capital into the largest financial institutions, including $25 billion into Citigroup, but then paused. That pause further destabilized an already volatile market. The value of Citi- corp’s stock fell 60 percent in a single week, and the bank’s existence was

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. introduction xxv threatened until the government stepped in to guarantee some $250 billion of its mortgage holdings and to inject the bank with another $20 billion in capital. General Motors and Chrysler were given funds for a bailout, and they were later partly nationalized. The Fed introduced various new lending programs in order to restart the credit markets. The newly elected president, Barack Obama, stepped into the crisis with an $838 billion stimulus package that he was able to persuade Con- gress to pass just after his inauguration. The crisis was exacerbated, however, when Chrysler was forced into bankruptcy in April 2009. General Motors met the same fate shortly afterward and both were bailed out by the federal government. Still, some incipient signs of recovery (“green shoots” in the words of Fed chairman Bernanke) were evident in the housing and credit markets in mid-2009. It then appeared that the subprime crisis had actually bottomed out in March 2009 but economic uncertainy remained late in 2010. Congress and the still new administration began considering a near complete revamping of the existing financial regulatory structure. That work was completed with the passage of a 2,300 page bill called the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.that intruded the government deeply into nearly every aspect of finance. Oddly, the legislation left untouched any reform of the subprime lending by Fannie Mae and Freddie Mac, who were at the center of the crisis. This book describes these events and attempts to address the flaws in the financial system that gave rise to the subprime crisis. It also considers the various “reform” proposals that are being floated in response to this crisis.

Government-Sponsored Enterprises

GSEs

About 43 percent of Americans owned their own homes in 1940. That number rose to 64 percent in 1968. Gains thereafter were incremental, rising to 69 percent in 2004 and falling back to 68 percent in 2007. Between 1968 and 1996, the value of home mortgages outstanding rose from $264 billion to $3.7 trillion. A lot of that growth was the result of activities by the government-sponsored enterprises (GSEs) for the mortgage market: the Federal Home Loan Mortgage Corporation (Freddie Mac), the Federal National Mortgage Association (Fannie Mae), and the Government National Mortgage Association (GNMA, or Ginnie Mae). Freddie Mac was initially supervised by the Federal Home Loan Bank Board (FHLBB), and its stock was held by the banks in that system. However, Freddie Mac was privatized and became a public company in 1989, and its stock was listed on the New York Stock Exchange (NYSE). Fannie Mae was privatized even earlier, in 1968, and it was listed on NYSE. However, both Freddie Mac and Fannie Mae remained GSEs. The president appointed five of the eighteen directors of each of these GSEs, and they were allowed to issue their securities through the Federal Reserve’s electronic book entry system. Both Fannie Mae and Freddie Mac had access to a line of credit from the federal government, and both were exempted from state taxes, except real estate taxes. They were also exempted from the registration requirements of the federal securities laws, but the Treasury Department was required to approve their borrowings. Another group of GSEs, the Farm Credit System lenders, sustained large losses during the 1980s. The federal government then intervened to relieve the farming crisis that caused those losses by providing backup support to the Farm Credit System. This bailout was justified on the theory that they were “too big to fail,” a theory that would be widely applied during the subprime crisis. Other GSEs were also affected by that crisis. Fannie Mae had been borrowing at short-term interest rates to fund its long-term fixed rate

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(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 378 The Growth of the Mortgage Market mortgage obligations, which worked well as long as short-term rates did not increase. Fannie Mae was quite profitable until the S&L crisis in the 1980s, when short-term interest rates did increase, causing Fannie Mae to reach a point of a negative net worth of a $10.8 billion, which was reversed when interest rates began to fall. Congress became concerned over the financial stability of Fannie Mae and Freddie Mac during the savings and loan (S&L) crisis. It directed the Trea- sury Department and the Government Accountability Office (GAO) to make an evaluation of the financial condition of those two GSEs. They found that Fannie and Freddie had grown rapidly in the 1980s and concluded that these GSE’s posed systemic risk that could not be avoided through diversification or market discipline. The Treasury Department recommended that strong regulatory supervision be imposed over these entities. If that were not possible, the department believed that Congress should cut all governmental ties with these entities. After considering those reports, Congress passed the Federal Housing Enterprises Financial Safety and Soundness Act of 1992. That legislation added additional regulation over Fannie Mae and Freddie Mac. Their regulation was assigned to the Office of Federal Housing Enterprise Oversight (OFHEO), an independent entity within the Department of Housing and Urban Development (HUD). OFHEO was headed by a director who was appointed by the president for a five-year term. The government was also given authority to appoint a conservator for the GSEs should they become dangerously undercapitalized, a event that occurred during the subprime crisis. This was the same sort of power given to the bank regulators for the resolution of failed banks. OFHEO was directed by its authorizing legislation to stress test the portfolios of the GSEs and set risk-based capital requirements based on a ten-year scenario of an economic downturn in the housing and financial markets. The GSEs were to be stress tested by shocking both interest rates and default rates at the same time, and severely, in order to measure possible risk exposures. Credit loss assumptions were based on the region with the highest default rate, historically defaults were uneven across the country, and that loss assumption was carried out over the ten-year test period. The stress test–based capital requirement went into effect in 2002. Fannie Mae was then required to have capital of $21.4 billion, while it claimed capital of $27.3 billion. The 1992 legislation stated that the government did not guarantee the debt of Fannie Mae and Freddie Mac. However, the market continued to value the debt securities that they issued and their guarantees as having an implied guarantee from the federal government. That assessment proved correct during the subprime crisis, which had an advantage for consumers. The implicit guarantee effectively subsidized loans for homeowners through lower interest payments and reduced down payments.

Securitization

The GSEs became a central part of the residential mortgage market as the result of their securitization programs. The securitization concept is not a new one. The process essentially involves the sale of a future stream of payments, or some other asset, whose value will be realized in the future. An early example of securitization was found in Amsterdam in the seventeenth century. There, a corps of women recruited sailors for the Dutch East India Company by luring them off the streets with promises of food, shelter, drink, and sex. The women were paid a portion of the future wages of their recruits. The right to receive those payments was guaranteed by a marketable security called a transport- brief issued by the company. Those securities were purchased by zielkoopers (buyers of souls) at a discount that reflected the high death rate of the sailors. By pooling the securities, the zielkoopers were able to diversify their risks. However, a rising mortality rate among sailors bankrupted many of these merchants. Subprime lenders had a similar experience in this century. This concept of selling the right to a future payment was applied to mortgages by the GSEs. They created a secondary market for mortgages by placing them in a pool. Interests in the pool were sold to investors, who thereafter received the principal and interest payments from the mortgages. The mortgages placed in the pools were initially required to all be of the same type, such as a single-family house, and the interest rates on those mortgages were all the same. To further streamline this process, the terms of mortgages being pooled were standardized so that their payment streams could be valued uniformly. Fannie Mae and Freddie Mac spearheaded the effort to create uniform documentation after the passage of the Emergency Home Finance Act of 1970.1 Ginnie Mae pioneered the sale of these pooled mortgages in the form of “pass-through certificates” that gave an investor a pro-rated portion of the principal and interest payments received from mortgages placed in the pool. This process allowed lenders to originate loans, to sell the loans through Ginnie Mae, and then to use the proceeds of that sale to originate more loans. This process increased the amount of credit available to homeowners and helped lower interest rates. Ginnie Mae issued its first mortgage-backed security in 1970. Since then, it has guaranteed over $2 trillion in mortgage-backed securities. The interest rate paid on Ginnie Mae pass-through certificates was slightly less than that on the underlying mortgages, the difference being used to pay servicing and guarantee fees. The service fees were usually paid to the issuing institution, which was responsible for collecting mortgage loan payments and passing the principal and interest through two certificate holders. Ginnie Mae charged issuers a guarantee fee, which was typically six basis points for securities backed by loans for single-family residences, the majority of its business. Notwithstanding those fees, the yield on Ginnie Mae pass-through certificates was usually higher than that on other government-guaranteed securities with

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 380 The Growth of the Mortgage Market comparable maturities, such as Treasury bonds. The Ginnie Mae guarantee greatly enhanced the marketability of these pass-through securities. Ginnie Mae mortgages have generally been untroubled. In November 2002, however, executives at First Beneficial Mortgage Corporation were convicted of engaging in fraudulent practices in connection with Ginnie Mae pools. The defendants used forged documents to create pools that were collateralized with nonexistent properties and that were not insured by a federal agency, as was required by Ginnie Mae’s rules. Ginnie Mae suffered a loss of $20 million as a result of that fraud. There was also a signal in this market that subprime residences posed risks. Many low-cost pre-fabricated homes were repossessed between 2000 after 2002, after a downturn in the economy. The certificates guaranteed by Ginnie Mae were called “pass-through” because they simply passed the monthly mortgage payments on the mortgages held in the pool on to the certificate holders. This meant that the certificate holder received monthly interest payments plus an amortized portion of the principal on the mortgage. During the initial stages, the principal payments were only a small portion of the monthly payment but, as the principal on the mortgage shrank over time, the portion of the payment attributable to principal grew each month. This payment stream raised some complex yield issues and reinvestment concerns. Many mortgages are paid off before maturity because as their income grows homeowners move or purchase a more expensive home. Many homeowners also refinance their mortgages when interest rates drop. This results in a return of principal on that mortgage, which is then passed through to the holders of Ginnie Mae certificates. The holder of the certificate then had to reinvest those funds. If interest rates had fallen since the purchase of the pass-through certificate, that reinvestment would have to be made at the then-existing lower interest rate, which displeased the certificate holder. This created a reinvestment risk. In order to allow investors to make a more informed investment decision, the issuer of mortgage-backed securities modeled the expected rate of repayment based on past experience. This gave the pass-through certificate holder a general idea of what to expect in terms of repayment. However, those models were not always accurate, as when unusual interest rate changes occurred that might accelerate or slow home sales and refinancing. This created a “repayment” risk that funds from the mortgages would be paid back more quickly or more slowly than predicted by the models. Because of this repayment feature, pass-through securities did not react in the same manner as corporate bond prices when interest rates fell. Bond prices generally increase when interest rates fall because the holder is now receiving a higher interest rate than is available in the market. In contrast, pass-through certificates may not increase at the same rate because there will be a greater prepayment of principal from accelerated refinancing that must be reinvested at lower market rates.

Collateralized Mortgage Obligations

Freddie Mac sought to address the investment concerns associated with the pass-through securities developed by Ginnie Mae. Initially, Freddie Mac sold something called Freddie Mac MCs, or “motorcycles,” as they were nicknamed, which guaranteed the timing of the cash flow from the certificates, as well as the principal and interest. However, that simply shifted the risk to Freddie Mac. In order to avoid that result, Freddie Mac began offering “collateralized mortgage obligations” (CMOs), also known as “real estate mortgage investment conduits” (REMICs). CMOs were a product created for Freddie Mac, in 1983, by Larry Fink, who was then working at First Boston. Fink later headed BlackRock, the giant asset manager, and played a prominent role in managing distressed pooled mortgage assets during the subprime crisis. CMOs divided principal and interest payments from the mortgages placed in the pool into different payment streams. Unlike investors in pass-through securities, CMO investors did not have pro-rated principal and interest payments passed through to them. Instead, the CMO mortgage payments were divided into separate tranches with varying payment streams and with differing maturities, seniority, subordination, or other characteristics. This allowed investors to choose between investments with a longer-term investment and with a shorter term. The long-term investor was given some protection from prepayment risks by a requirement that principal repayments first be directed to the short-term investors. Only after they were completely paid off would the longer-term tranches start receiving principal payments. The CMO concept was designed to guard against prepayment risk. How- ever, investors lost sight of a different risk posed by such securities. There is an “extension” risk, which is the opposite of the prepayment risk. Extension risk occurs in the event of an unusual increase in interest rates. In such a case, homeowners will be reluctant to sell their homes or to refinance them because they will have to pay a higher interest rate on a new mortgage. This means that the certificate holder will be locked in for a longer than predicted period of time, which will cause a drop in the value of the certificate because the certificate holder will be receiving a lower rate than the one prevailing in the market for a longer than predicted time. CMOs often contained exotic tranches, including inverse floaters and inverse interest-only strips that converted fixed-rate mortgages into floating-rate tranches.2 Inverse floaters had a set principal amount and earned interest at a rate that moved inversely to a specified floating index rate. The principal amount on which that interest rate was calculated was determined by reference to the outstanding principal amount of another tranche. As the reference tranche was paid off, the principal on which the inverse interest-only strip earned interest decreased. A rate increase reduced the inverse interest-only floating rate but also extended its maturity and, thereby, increased total interest payments. These tranches were deemed necessary in order to cover the effects of increases in

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 382 The Growth of the Mortgage Market interest rates, which caused their maturity date to lengthen. Inverse floaters could receive high returns if interest rates declined or remained constant but suffer large losses if interest rates decreased. Inverse interest-only strips did not receive principal payments. These floaters were leveraged, so a small increase in interest rates would cause a dramatic decrease in the inverse floating rate. Inverse floaters and inverse interest-only strips were popular after they were introduced in 1986 and 1987, during a period of decreasing or stable interest rates. That situation changed on February 4, 1994, when the Federal Reserve (the Fed) increased short-term interest rates for the first time in five years. The Fed then embarked on a series of rate increases that had some disastrous effects on the bond markets. CMOs were crushed by these increases because they virtually stopped mortgage repayments, extending the average maturity of CMOs, and hammering their inverse-floater tranches. As a result, the market in CMOs collapsed and large losses were suffered. A valuation problem surfaced during the collapse of the CMO market. Some of the CMO tranches were so complex that Goldman Sachs had to use multiple supercomputers to run simulations of cash flows under different interest-rate scenarios. That problem presaged the valuation issues that emerged during the subprime crisis in 2007. Among those hurt by the CMO market was Merrill Lynch, after one of its traders, Howard Rubin, lost over $370 million, in 1987, through unauthorized CMO transactions. Rubin was fired by Merrill Lynch and was quickly hired by Bear Stearns, where he became a star in its mortgage trading department. JPMorgan lost $50 million from CMO investments in 1992. This was only a temporary setback. Mortgage-backed securities guaranteed by GSEs increased in value from $200 million in the 1980s to $2 trillion in 2007.

Mortgage Market Growth

Secondary Market

The secondary market involved sales of mortgages after they are originated. This market brought in investors who purchased the loans either directly or indirectly from their originators. The investors purchasing these mortgages might hold them on their own books or they could be pooled and sold to investors in bond-sized units. By 2005, almost 60 percent of home mortgages originated in that year were securitized in such a manner. The secondary mortgage market had essentially two tiers, securitized offerings that had a government or GSE guarantee and private offerings that did not have such a guarantee. Borrowers taking out mortgages that were not guaranteed by a GSE were usually required to purchase expensive private mortgage insurance when their loan-to-value ratio exceeded 80 percent, that is, when the borrower’s down payment was less than 20 percent of the purchase price of the home. That mortgage insurance usually covered 20 to 30 percent of the mortgage

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. Securitization 383 balance. In contrast, borrowers insured by the Federal Housing Administra- tion (FHA) could make very low down payments (as low as 3 percent) and usually pay interest rates competitive with prime mortgages because of the FHA guarantee. FHA borrowers could also finance their mortgage insurance premiums and some closing costs. The FHA backed its mortgage insurance program through its Mutual Mortgage Insurance Fund, which was funded by the insurance premiums paid by borrowers. As a result of losses from mortgages that went bad in the 1980s, Congress increased the premiums payable by homeowners receiving FHA insurance. The amount of those premiums was set at 1.5 percent of the mortgage balance upon origination of the mortgage and annual premiums of 0.5 percent. Congress also set limits on the size of FHA-guaranteed loans. Those limits were based on local median house prices in 2007, which varied from about $200,000 to $360,000. Those loan limits would rise during the subprime market when lending for higher-value homes froze. Congress sought to enhance the attractiveness of mortgage-backed securities to investors through passage of the Secondary Mortgage Market Enhancement Act of 1984, which exempted such securities from Fed margin requirements and allowed banks and fiduciary investors to invest in these obligations. They proved to be popular investments. By 1986, GSEs were able to buy or guarantee more than $1 trillion in residential real estate loans, much of which was securitized. By 1990, Fannie Mae had $103 billion in assets and had issued $300 billion in mortgage-backed securities. Freddie Mac had $41 billion in assets and had issued $316 billion in mortgage-backed securities. In 1988, Congress created another GSE, the Federal Agricultural Mortgage Corporation (Farmer Mac), tasked with creating a secondary market for agricultural loans. Farmer Mac was authorized to guarantee mortgage-backed securities issued by private lenders and pools of agricultural mortgages. Com- mercial rural lenders and other private bodies that utilized its services owned Farmer Mac. Its board of directors had fifteen members, five of whom are appointed by the president. The Federal Home Loan Banks (FHLBs) also created programs, first authorized 1998, in which they purchased pools of conventional and federally insured mortgage loans from member banks. They purchased $12.7 billion in FHA and Veterans Administration (VA) loans in 2000, taking a significant portion of Ginnie Mae’s market share. Ginnie Mae’s overall market share of mortgage-backed securities dropped from 42 percent in 1985 to 7 percent in 2004. However, it still retained a large market share of FHA-insured and VA-guaranteed loans. The result of these programs was that the government had become the largest financial intermediary in credit markets. The size of these programs began to raise concerns. Critics wanted user fees to cover the cost of government- sponsored loans. Concerns were also raised that mortgages held by GSEs and their guarantees were a liability that could become massive in the event

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 384 The Growth of the Mortgage Market of a collapse of the residential mortgage market. Critics wanted the federal government to sell off existing loan assets and include all federal loans in the government’s budget.3 They were ignored.

Private Securitizations

Commercial banks entered the mortgage-backed securities market. They were at somewhat of a disadvantage because they did not have the implicit government guarantee of Fannie Mae and Freddie Mac or the explicit guarantee of Ginnie Mae. In order to address investor concerns, private banks enhanced their private pools through credit support arrangements such as by overcollateral- izing the pool. Some banks also provided letters of credit that would support the pool up to a specified percentage of loss, say, 10 percent. The high rate of return on these assets attracted investors and allowed these securitizations to be marketed without recourse to the bank that pooled the assets. As was the case for CMOs, these instruments could be structured to provide flexibility for investors in the type of payment stream that they would receive. In the event of defaults, the pool of assets being securitized were bankruptcy- remote from the issuer, which meant that general creditors of the issuing bank could not make claims on the assets. Another advantage was that it allowed the issuer to “monetize” assets in advance of their own self-liquidation as well as allowed the assets to be taken off the issuer’s balance sheet. Of course, such off-balance-sheet structures could be abused, as occurred at Enron. The FHA competed with private mortgage lenders in loan origination. The latter could provide mortgage products with flexible payment and interest options. Because of that competition, and FHA product restrictions, the market share of home mortgages insured by the FHA fell from 19 percent in 1996 to 6 percent in 2005. The use of these non-GSE mortgage-backed securities grew rapidly, even though they did not contain an explicit or implicit government guarantee against default. It was estimated that more than $2 trillion in mortgages was securitized. The market share of private-label mortgage-backed securities doubled between 2003 in 2005, reaching 29 percent of all outstanding mortgage-backed securities in the latter year. Alarmingly, two-thirds of the privately issued mortgage-backed securities were for nonprime mortgage loans in 2006, compared with 46 percent in 2003. As the Federal Deposit Insurance Corporation (FDIC) noted in 2006: “[I]n- vestors appear willing to assume greater risk in their search for the yield.”4 This was a dangerous phenomenon in the banking business. As Robert Rubin, a leader at Citigroup during its subprime difficulties, concluded while he was secretary of the treasury under the Clinton administration, the prevailing mentality of investors is to downplay or ignore risks in order to “reach for yield.”5 Securitization could be abused in other ways. Patrick D. Quinlan, Sr., pleaded guilty to charges that his company, MCA Financial, misrepresented the risk and returns from $71 million in securitized mortgage loan pools that it

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. Securitization 385 sold between 1994 and 1999. Investors lost some $50 million in that scheme. Quinlan was sentenced to ten years in prison. Mortgage scoring and automated underwriting systems for mortgage loans aided private lenders. These underwriting systems used algorithms called a “scorecard” that measured the risk of default. The scorecard analyzed data relating to the borrowers’ credit history and credit scores, as well as their cash reserves and credit requirements, in order to predict the likelihood of a default. FHA lenders used their own scorecard. If that scoring system indicated that the loan application should be rejected, the application would be reviewed manually before a final rejection decision was made. This system worked well until its requirements and scoring methodology were abandoned for subprime loans that did not meet its criteria.

Asset-Backed Commercial Paper

The securitization concept spread to other instruments. Commercial banks began securitizing consumer automobile loans in 1985. In the following year, credit card receivables were used to securitize commercial paper. These asset- backed commercial paper (ABCP) programs spread to other assets, including consumer loans, leases, trade receivables, and, later, subprime mortgages.6 The ABCP programs used a special-purpose vehicle (SPV) to buy the credit card receivable or other income-generating asset from the sponsoring bank or financial institution—which removed that asset from the balance sheet. SPVs sold commercial paper in order to buy those assets. The assets in the SPV pool, in turn, secured that commercial paper. SPVs were an off-balance-sheet instrument that was not subject to the more restrictive Basel II bank regulatory capital requirements used for on-balance-sheet instruments. These off- balance-sheet instruments joined the “shadow banking” created by nonbanks through CDOs. These securitization devices also included “structured investment vehicles” (SIVs, or perhaps, as some wags suggested during the subprime crisis, “sieves”). SIVs were ABCP programs used by Citigroup, starting in 1988, to arbitrage short- and long-term interest rates by acquiring highly rated, medium- and long-term fixed income assets and placing them in an SPV. Those purchases were funded with short-term highly rated commercial paper and medium-term notes. These structures were initially given high ratings by credit agencies. However, those ratings were cut sharply during the subprime crisis, making these securities illiquid and slashing their value. These instruments caused large losses for Citigroup in particular. As Citigroup discovered, such an arrangement entailed a serious risk. Com- mercial paper is a short-term instrument, while the assets in an ABCP pool that funded the commercial paper were longer term. This mismatch required the commercial paper issued by the pool to be continually rolled over until the pool self-liquidated as mortgages were paid off or, in the case of SIVs,

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 386 The Growth of the Mortgage Market refunded with additional long- or medium-term assets. In the event of a crisis in the money markets, however, such a rollover might not be possible. In that case, the issuer would be faced with the problem of selling the assets, which might be illiquid or sold at fire-sale prices. To guard against such an event, banks provided a loan facility to pay off the commercial paper holders. This left the bank holding the bag should the assets decline in value below the amount extended under that credit facility or in excess of any credit protection. ABCPs provided advantages to issuers, including access to funds at interest rates lower than that charged by commercial banks. ABCP programs became popular because the commercial paper market was usually quite liquid, and issuers had a great deal of flexibility in the timing and duration of their offerings in that market. Those offerings were also exempt from registration requirements of the Securities and Exchange Commission (SEC). The commercial paper market grew from $1.5 trillion in 2005 to $2.25 trillion in August 2007. The ABCP market comprised about $1.2 trillion of that amount at the time of the credit crunch, a market that shrank to a little over $800 million by December 2007 when many programs were frozen and caused massive losses.

Student Loans

Securitization spread beyond commercial banks. One popular securitization payment stream involved the government-guaranteed student loan program that flowed from the policies expressed in the National Defense Education Act of 1958. That legislation was passed in response to concerns that, as a result of the Sputnik satellite launch by the Soviet Union in 1957, the United States was falling behind in mathematics education and science. Congress decreed in that legislation that the national defense required loans and fellowships that would encourage students to study science and technology. That program proved popular and drew demands for expansion into other fields of study. The student loan program that began in 1965 broadened the government’s encouragement of education to all other postsecondary education programs. That program guaranteed private loans to undergraduate students up to specific amounts annually and with a cumulative limit. It provided those students with a large interest rate subsidy that paid lenders an amount sufficient to guarantee a rate of return of 3.5 percent above the yield on ninety-day Treasury bills. The government also paid all interest costs during the period that the student was enrolled in college. Students did not have to begin repayment until six months after graduation and had from five to ten years to pay off the loan. In 1983, some 3 million students received government-guaranteed loans, about 30 percent of all students in postsecondary educational schools. These subsidized loan programs also increased college enrollment. The student loan subsidies were justified on grounds that the government would recover their cost from higher tax payments, which would be paid by better-educated citizens with higher-paying jobs than those without such education. However, as

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. Securitization 387 the Chicago economist Milton Friedman noted, the prediction of a particular rate of return on such an investment was most uncertain and subject to much variation. Critics also charged that the program encouraged unqualified individuals to enter postsecondary education programs. Many student borrowers were unable to complete their degrees and were left saddled with large debts that they had difficulty paying off because they were qualified only for low- paying jobs. In the event, as in the mortgage market, private lenders needed a secondary market where they could sell the loans that they originated. To that end, the Student Loan Marketing Association (Sallie Mae) was created in 1972, as a federally chartered, stockholder-owned corporation, charged with creating a secondary market in student loans. Like Fannie Mae and Freddie Mac, the president of the United States was entitled to appoint a portion of its board of directors. Those appointments tended to be driven by politics rather than financial acumen. As a GSE, Sallie Mae was exempt from state and local taxes, other than real estate taxes. As with Fannie Mae and Freddie Mac, its debt offerings were exempt from SEC registration requirements. Sallie Mae was also given access to the Federal Financing Bank, which could provide it with low-interest rate borrowings. However, Sallie Mae used that facility only once, when it borrowed seed money to commence operations. In addition to purchasing student loans from originating banks, and, like Ginnie Mae, Fannie Mae, and Freddie Mac, securitizing them, Sallie Mae also originated loans of its own. The securitization generated fees, but it initially provided another monetary advantage to Sallie Mae. The Omnibus Budget Rec- onciliation Act of 1993 required Sallie Mae to pay a 0.3 percent “offset fee” to the Department of Education (DOE), created in 1980, on the principal amount of each student loan held on Sallie Mae’s books. However, an appeals court held in 1997 that the fee did not apply to loans securitized by Sallie Mae. Government aid to students expanded with the creation of the DOE, which provided more than $65 billion in student loans in 2005. DOE programs included Pell grants, Stafford loans, PLUS loans, Federal Work-Study program funding, and Perkins loans. Government-guaranteed student loans were insured by the Student Loan Insurance Fund (SLIF), which protected borrowers in the event of a default on a guaranteed loan. SLIF was supported by insurance premiums paid by borrowers and supplemented by congressional appropria- tions when there was a shortfall. To better assure repayment, student loans were not dischargeable in bankruptcy, except upon a special showing of undue hardship. The private student loan market, which was nearly nonexistent in the 1990s, had grown to $17 billion by 2006. In contrast, the federally guaranteed student loan market was almost $60 billion in 2006. Because privately issued student loans were not guaranteed by the federal government, they charged higher interest rates, sometimes as much as three percentage points more than federally guaranteed loans.

Sallie Mae’s founding legislation required it to become a private company by 2008, taking it down the same path as Fannie Mae and Freddie Mac. Sallie Mae began privatizing its operations in 1997 and became a fully private entity in December 2004, severing all ties to the federal government. It then began operating as SLM Corporation. No small entity, it had some 10 million student loans outstanding when it was privatized. After privatization, Sallie Mae’s loan programs consisted primarily of originating and holding student loans through its participation in the Federal Family Education Loan Program and its own non-federally guaranteed private education loan programs. Sallie Mae marketed its loans through on-campus financial aid offices and direct marketing. The student loan market was roiled in 2007 by scandals involving improper incentives being given by lenders, including Sallie Mae, to college financial aid officers. Those incentives were inducements for promoting the lender’s business to students by listing the lender at the top of their preferred lender lists. Some aid officials were paid to sit on lender advisory committees, and lenders, in turn, were allowed to answer telephones at the university financial aid centers. The University of Texas rated student lenders on the amount of “treats” that they provided to loan officials at the university. The university fired the director of financial aid at its Austin campus for recommending Stu- dent Loan Xpress to students, after he bought stock in its parent company, CIT Group, a commercial lender that was later devastated by the subprime crisis. Financial aid officers at Johns Hopkins University and two other prominent schools received $160,000 in gratuities from Student Loan Xpress. Three managers at Student Loan Xpress were suspended for making such payments. Several college financial aid officials were fired at other schools. In May 2007 Congress reacted to these scandals with the Student Loan Sunshine Act, which banned gifts and regulated student loan marketing efforts by lenders. New York attorney general Andrew Cuomo began an investigation of these practices, discovering that a number of schools had “revenue-sharing” agreements with student lenders, pursuant to which the lenders paid the schools a percentage of the loans generated at the school. Cuomo found that student loan companies had provided all-expense-paid trips, entertainment, and other perks to financial aid officials, in exchange for being placed on their preferred lender lists. Lenders on those preferred lender lists typically received up to 90 percent of the loans generated by the school. Sallie Mae was one of the targets of the Cuomo probe. It agreed in April 2007 to stop making payments to school officials as an incentive for recommending its loans and paid $2 million to settle charges over that conduct. Sallie Mae also agreed to adhere to a code of conduct created by Cuomo, which became a favorite tool in his investigations of financial services firms. David Charlow, the financial aid director for Columbia University’s undergraduate college and engineering school, was fired after it was discovered that he had received $100,000 in profits from stock of a company that owned Student Loan Xpress

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. Securitization 389 before it was acquired by the CIT Group. Charlow had placed Student Loan Xpress on Columbia’s preferred lender list. The university agreed to pay $1.1 million to a Cuomo-created fund to educate students about loans. Columbia further agreed to have its financial aid office monitored by state officials for five years. It was unclear what the legal basis was for this intrusion of government into private business. Student loan provider Education Finance was another target of Cuomo’s because of its practice of paying kickbacks to schools that promoted its loans to their students. A group of financial aid officers agreed to a ban on the receipt of gratuities from lenders, and lenders agreed to be monitored by Cuomo, thereby creating his own special student loan regulatory organization. Goal Financial, which had been using mailings that looked like they had come from the federal government to solicit loans, entered into a settlement with Cuomo. The firm also offered iPods, gift cards, and other goodies in order to attract student borrowers. It agreed to adopt the Cuomo code of conduct and to pay $350,000 into a financial aid education fund established by Cuomo. Seven student loan companies agreed to change their marketing practices in a settlement with Cuomo in September 2008, and they, as well as twenty-six schools that had student loan programs, agreed to adopt his code of ethics, which was later included in legislation in New York. Cuomo was more low- key than his predecessor as attorney general, Eliot Spitzer, but blasted the DOE for not discovering and stopping these student-lending practices. Cuomo also began an investigation of universities, including Columbia, Cornell, and Georgetown, to determine whether they were improperly receiving any benefits from their relationships with companies providing health insurance for students. Lenders had benefited greatly from government subsidies under the Federal Family Education Loan (FFEL) program that provided federal subsidies and performance guarantees for privately issued student loans. However, the passage of the College Cost Reduction and Access Act of 2007 reduced interest rates that student borrowers paid on their loans, creating a further subsidy for those students (rather than the lenders), valued at $7 billion over the subsequent five years. The legislation also reduced yields on student loans, making student loans unprofitable for the banks. Within a few months, more than one-third of the larger banks in this market suspended further student loan activities. Among the lenders terminating participation in the program was the Brazos Higher Education Service Corporation, which had some $15 billion in student loans outstanding. Bank of America stopped making loans in the private student loan market. The Pennsylvania Higher Education Assistance Agency, one of the largest student lenders, also exited the market in federally guaranteed student loans. By April 2008, forty-six lenders, including NorthStar Education and CIT Group, had stopped making student loans. Another problem was that student loan default rates were approaching 7 percent in 2007, compared with 4.6

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 390 The Growth of the Mortgage Market percent in 2005. Hard-hit by this upsurge in defaults and reduced lending was Education Resources Institute, a firm that was ensuring more than $17 billion in private student loans but declared bankruptcy on April 7, 2008. Several colleges tried to fill the gap left by the private lenders that had quit the student loan market by having their students obtain direct loans from the federal government. Some of the better-endowed colleges provided free tuition in various forms, but the subprime crisis decimated those endowments. In order to provide some relief to students seeking loans, the DOE announced on November 20, 2008, that it would purchase as much as $6.5 billion in federally guaranteed loans made during the 2007–8 academic year. This action was intended to add liquidity to the FFEL program for private sector student loans. In 2007, in the midst of the student loan scandals, Sallie Mae was the target of a $25 billion buyout proposal from a consortium composed of private equity investors J.C. Flowers and Freidman, Fleischer & Lowe, as well as Bank of America and JPMorgan Chase. However, after the passage of the College Cost Reduction and Access Act of 2007, Sallie Mae expressed concern that higher financing costs might eliminate its profitability. Sallie Mae soon concluded that it could no longer make a profitable student loan based on the reductions in subsidies, and it decided to reduce its involvement in the student loan market. This considerably undercut the value of Sallie Mae’s franchise, and the private equity buyout fell apart. On top of these problems, Sallie Mae was hit with a $2.5 billion bill for a buyback of its own stock that had been hedged with a forward purchase agreement with Citigroup. Sallie Mae had thought that the hedge would protect it from an expected increase in its stock price during a buyback program, but the problems in the student loan market caused the price of its stock to plunge instead. As a result, Sallie Mae lost $1.6 billion in the fourth quarter of 2007. Sallie Mae increased its loss reserves by $575 million, but reported another loss in the first quarter of 2008 in the amount of $104 million. Company officials again warned that Sallie Mae was unable to make profitable loans under existing conditions. Sallie Mae wrote off 3.4 percent of its student loans in 2008 and issued another profit warning for its projected 2008 earnings, which turned out to be lower than expected. Sallie Mae faced increased funding costs caused by the credit squeeze and lower credit ratings during the subprime crisis. In a reprise of Jeffrey Skilling’s famous cursing of a questioner during a financial analysts’ conference call, Sallie Mae’s chief executive officer, Albert L. Lord, became frustrated and let loose with an expletive that shocked the audience listening in on an earnings conference call report. The SEC also investigated whether Sallie Mae executives had sold a large number of shares on the basis of inside information. Sallie Mae’s stock fell by almost 56 percent in 2008. It was able to borrow $1.5 billion from Goldman Sachs for student loans in January 2009, but that did not rally its shares. Still, Sallie Mae continued to be the largest private lender in the $85 billion student loan market. It made $6.3 billion in student

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. Securitization 391 loans in 2008. Citigroup made a much smaller $1.8 billion in such loans that year, while JPMorgan Chase only made $1.1 billion. The student loan market continued to falter as the subprime crisis worsened. The newly installed Obama administration dealt Sallie Mae a further blow by announcing that it would seek to sideline private lenders in the student loan market by further reducing their profit on the spread between borrowing costs and lending rates. This effectively constituted nationalization of much of the student loan business. There was some residual business left for Sallie Mae in the servicing of student loans. Sallie Mae announced in March 2009 that it would make private student loans requiring students to pay interest while still attending school. Repayment terms were also shortened from fifteen to thirty years to five to fifteen years. Sallie Mae estimated that private student loan volumes would fall by 30 percent but that these changes would make it easier to securitize its loans. As 2009 began, the DOE was planning to buy some $60 billion of student loans in order to assure the availability of funds for students. The Obama administration announced after taking office that it intended to increase the DOE’s share of the student loan market from 20 to 80 percent by July 2010, an increase that would require a commitment of some $100 billion in taxpayer funds. To assist that effort, the House of Representatives passed a bill that would shut out private lenders from the student loan market. During the subprime crisis the Fed also created a Term Asset-Backed Securities Loan Facility, which allowed the Federal Reserve Bank of New York to purchase newly issued, highly rated, asset-backed securities collateralized by student loans as well as other receivables. In the meantime, students borrowed more, increasing the value of educational loans taken out by 25 percent for the academic year 2008–9.

Subprime Lending

Subprime Loans

No uniform standards have been established for classifying loans as subprime, but they are generally viewed as loans extended to borrowers who fall into one of three categories: (1) those with a poor credit history; (2) those with no credit history; and (3) those who have existing credit but are overextended (some subprime borrowers were “house rich” but “cash poor” because of equity built up in their house7).8 Factors considered in classifying a loan as subprime include credit history, household debt-to-income ratio, and combined loan-to-value ratio for home equity loans and other mortgage debt. FICO credit scores are also used to identify subprime borrowers. Named for its creator, the Fair Isaac Corporation, FICO is a method of calculating a borrower’s creditworthiness based on information gathered by credit bureaus, credit card usage, payment history for debts, previous bankruptcy, judgments, and liens.

FICO uses a scale ranging from 300 to 800. The higher the FICO score, the more creditworthy the borrower is in the eyes of a lender. The median FICO score in the United States is about 720. Generally, a FICO score below 660 is viewed as subprime, although many lenders accepted a lower number during the subprime crisis. About 27 percent of Americans have a FICO score below 650, and 15 percent have a score below 600.9 In contrast to subprime borrowers, “prime,” or “A credit,” borrowers, as they are known in the trade, have strong credit scores, allowing them to obtain the most competitive interest rates and mortgage terms. Like other lenders, the subprime lender makes profits based on the spread between the funds it borrows and those that it lends borrowers. Because of the high risk of default among subprime borrowers, interest rates on subprime loans are much higher than those charged to more creditworthy borrowers— differences of three or four percentage points between prime and subprime borrowers were common. Those differences, and the high origination and other fees charged for subprime loans, tempted lenders to originate large amounts of subprime loans.

Consumer Protection Legislation

Congress passed several consumer protection statutes related to consumer lending and residential mortgages. The Truth in Lending Act passed in 1968 sought to ensure SEC-style full disclosure of all loan terms to consumers. Lenders were required to disclose the full cost of the mortgages that they issued and in a uniform manner so that consumers could, presumably, comparison shop for better terms. However, the formula required for those disclosures was so complicated that it became burdensome and unworkable. Congress was then forced to adopt the Truth in Lending Simplification and Reform Act to simplify those disclosures. Another consumer protection measure was the Fair Credit Reporting Act, which allowed consumers to examine their credit reports and to correct inaccu- racies. This was important for consumers because most lenders relied on those reports in making credit decisions on mortgages. The Equal Credit Opportunity Act was passed in 1974 to prohibit discrimination in credit extensions on the basis of sex or marital status, race, religion, or national origin. Among other things, this meant that the incomes of unmarried persons applying jointly for credit had to be combined for credit purposes. The Real Estate Settlement Procedures Act of 1974 (RESPA) required disclosure to consumers of the costs associated with real estate mortgage closings. This allowed borrowers to assess their settlement charges, which sometimes were inordinately high. The disclosures were required in every settlement involving a federally insured mortgage loan. Unfortunately, these and other disclosure requirements turned residential real estate settlements into a marathon, requiring the signing of dozens of documents filled with legalese

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. Securitization 393 so dense that no one but a real estate lawyer could understand it. Many states also required disclosures for environmental problems, termites, radon, and other defects, laying the groundwork for lawsuits by dissatisfied homebuyers.

Predatory Lending Practices

Because subprime borrowers were desperate for credit, they were targets for predatory lending practices that state and federal governments tried to curb. The Office of the Comptroller of the Currency (OCC) identified several practices deemed predatory: loan “flipping,” which involved frequent refinancings in order to generate additional fees; hidden financing fees; unreasonable loan terms, such as negative amortization, which made it impossible for the borrower to repay the loan; balloon payments to force early refinancing; and inadequate disclosures of the risks and costs of financing transactions. Another abuse was the offering of a single premium credit life insurance, rather than monthly premiums over the life of the loan. This was disadvantageous to the borrowers because they often refinanced or sold the house before paying off the mortgage, and they had already invested money in what then turned out to be unneeded insurance. Third-party mortgage brokers also presented the OCC with concerns over loan origination practices. Mortgage brokers were paid a fee for each loan that they originated. Consequently, they had a strong incentive to overlook any flaws in the credit history of borrowers. Federal bank regulators warned that banks should ensure that they had properly documented subprime loans and that reduced documentation loans should be extended only where there were mitigating factors, such as prior favorable history with the borrower. State regulators also issued warnings to state-regulated lenders concerning “no doc” and “low doc” subprime loans, which were followed by NINJA (no income, no job, no assets) loans. More than 75 percent of subprime loans had an adjustable rate. Their initial “teaser” interest rates were often below existing market rates. This allowed borrowers to leverage the amount that they could borrow because loan amounts were set by the amount of interest payments that their income could support. However, the teaser rate could increase by three to six percentage points in as little as two years. Moreover, some two-thirds of subprime mortgages had prepayment penalties that deterred refinancing into lower-cost mortgages. Federal banking regulators issued a warning in June 2007 that expressed concern over particular adjustable-rate mortgages (ARMs), including loans with teaser rates that were adjusted after a short period into a variable index interest rate plus an additional number of points. For example, the “2/28 ARM” had a fixed rate for two years and then adjusted to a large premium over some existing rate index for the remaining twenty-eight years of the loan. The spread over the index rate used to set the adjustable rate usually ranged from 300 to 600 basis points, called “payment shock” in the business.

Nontraditional mortgages began to appear in greater numbers in the form of interest-only mortgages (with no or delayed principal payments) and payment option ARMs (“pick-a-pay”), in which the borrower could choose from a number of payment options. One option allowed the borrower to make a minimum payment that was less than the declared interest rate, resulting in negative amortization. After a specified period, the borrower’s payments were increased to an amount that would allow full amortization of the loan balance over the remaining loan term. That increase could be substantial, as the regulators pointed out using an illustration with a 41 percent increase in a borrower’s monthly mortgage payment at the conclusion of the initial two-year period. These payment option ARMs were sold to some 2 million homeowners, and they became known as the “Typhoid Mary” of mortgages during the subprime crisis. Nearly $750 billion in these mortgages were issued between 2004 and 2007. The World Savings Bank in California, a part of the Golden West Financial Corporation, heavily marketed the pick-a-pay loans. Its founders, Marion and Herbert Sandler, sold those operations to Wachovia for $26 billion in 2006. After Wachovia failed and was taken over by Wells Fargo during the subprime crisis, losses on loans from Golden West mortgages were estimated to be as much as $36 billion.10 Another type of ARM that concerned regulators was that in which the payment amounts on the reset date were not capped, which could result in payment shock. More innovations followed in the form of debt consolida- tions secured by a home mortgage, on which interest payments were tax deductible. “Reverse mortgages,” which allowed elderly homeowners to take drawdowns on the equity accumulated in their homes over the years, were widely sold to seniors by retired actors. Such payments assured participating seniors a guaranteed source of income. Reverse-mortgage payments were not taxable, and repayment did not have to be made until the senior died or sold the residence. Still another matter of concern in the subprime market was the “piggyback” loans, in which the borrower was allowed to borrow 80 percent of the value of the home being mortgaged. A separate loan would give the borrower the additional 20 percent needed for the down payment. This, of course, meant that the borrower had no “skin in the game” and could simply walk away from the mortgage if the value of the house dropped—which was no deterrent to the mortgage lenders. The head of Countrywide Financial Group even asserted in 2003 that low-income borrowers should no longer be required to make any down payments on their home mortgages. This would make piggyback loans unnecessary, but left the borrower with no capital at risk in the event of a market downturn. Concern was also raised over “no money down” mortgages because of their high default rate. Some of those mortgages were made possible by nonprofit organizations, which were funded by home builders and homeowners seeking to sell a property. The sellers were thereby able to provide enough money for the borrower to obtain a loan from the FHA,

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. Securitization 395 which required a minimum down payment of 3 percent. The FHA sought to eliminate such programs in 2008 because of their high default rate. The Home Ownership and Equity Protection Act of 1994 (HOEPA) tried to limit some predatory lending practices. It applied to residential mortgages with interest rates in excess of 8 percent over that of Treasury securities of comparable maturity or a spread of 10 percent for second mortgages. The statute applied to mortgages in which fees (including credit insurance premiums) and points payable by the borrower totaled more than $510 (adjusted annually for inflation) or 8 percent of the total loan amount. This legislation provided for a cooling-off period of three days, during which the borrower could rescind the loan. HOEPA also required various disclosures by the lender to the borrower for covered loans, some of which were rather elementary. For example, the lender was required to disclose that it would have a mortgage on the home and that the borrower could lose the residence, and any money put into it, if mortgage payments were not made. HOEPA banned some predatory practices for covered loans, including balloon payments, negative amortization (which involves monthly payments that do not fully pay off the loan over its life and that cause an increase in total principal debt), most prepayment penalties, and due-on-demand clauses. The law prohibited lenders from making loans based on the collateral value of a residence property without regard to the borrower’s ability to repay the loan. It prohibited refinancing within twelve months of origination of a loan, unless the new loan was in the borrower’s best interest. The OCC also prohibited national banks from making consumer loans that were supported predominantly by the expected sales price in foreclosure and that were issued without regard to the borrower’s ability to repay the loan. States began to pass laws that sought to prohibit predatory lending practices. North Carolina was the first to pass such a statute in 1999, one that prohibited “flipping,” a practice in which mortgages were repeatedly refinanced, each with new upfront fees. The North Carolina legislation required counseling for loans with high fees or interest rates and forbade balloon payments and negative amortization. The statute prohibited lenders from requiring upfront lump-sum premium payments for credit insurance, allowing monthly payments instead. It also required lenders to consider the borrower’s ability to repay before making a home loan. The North Carolina statute caused a drop in lending in that state, touching off a debate over whether the statute was denying credit to the needy or doing what it was intended to do by prohibiting predatory loans that consumers could not afford. In 2001 Georgia passed a Fair Lending Act, requiring lenders to be able to prove that all home refinancing of mortgages of less than five years in duration provided a “tangible net benefit” to the homeowner. In other words, the refinancing had to have some beneficial purpose, and not be just a way to generate fees for mortgage brokers and lenders. New Jersey passed a similar requirement in 2003, called the Home Ownership Security Act. Other state

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 396 The Growth of the Mortgage Market legislation was directed at particular predatory lending practices. Some states sought to regulate mortgage brokers, who were the ones most frequently engaging in predatory lending activities. By 2004, thirty-two states and the District of Columbia had enacted some form of legislation regulating predatory lending practices. A massive lobbying effort was carried out by the mortgage financing industry to stop the advance of other state anti–predatory practice laws that threatened to curb subprime lending. A study by the Center for Public Integrity reported that the top twenty-five mortgage originators had spent some $370 million to fend off regulation between 1999 and 2009. One of the largest subprime lenders, Ameriquest Mortgage Company, spend $20 million on campaign donations and other lobbying efforts that resulted in the easing of predatory practice laws in New Jersey and Georgia. It was aided in that effort by Countrywide Financial, Citigroup, and the Mortgage Bankers Association.

Federal Preemption

Concerns over the penalties in the Georgia Fair Lending Act, which included criminal punishment, caused many lenders to withdraw from the subprime market in that state. The OCC and the Office of Thrift Supervision then preempted the Georgia statute—which meant that the federal government was preventing the states from exercising jurisdiction over federally regulated banks on this issue. The state then ruled that state banks would also be exempted from its reach, but nonbank mortgage lenders and finance companies were still subject to its provisions. To prove that it was a tough enforcer, and that state regulation was unnecessary, the OCC filed an enforcement action in 2000 against the National Bank in Tilton, New Hampshire, for engaging in predatory lending practices. The bank agreed to refund $300 million to clients and was subject to several restrictions on its future lending practices. In another case brought in 2003, the OCC entered into a consent decree with the Clear Lake National Bank that required it to pay more than $100,000 to thirty of its borrowers because of abusive home equity loans. The FDIC suffered some embarrassment when it was reported that a bank it had taken over after a highly publicized failure had continued making predatory subprime mortgages totaling more than $550 million. The bank that failed was the Superior Bank in Illinois. Those loans were originated while the FDIC was winding down its operations and were sold to another bank. Some of those loans had interest rates of more than 12 percent and were defaulting in large numbers. The FDIC settled a case brought by Beal Bank, which bought those faulty mortgages, for $90 million. The Federal Trade Commission (FTC) jumped into the predatory lending fray and charged that First Alliance Mortgage Corporation had engaged in predatory lending practices by concealing high fees and interest rates from

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. Securitization 397 borrowers. The company paid $60 million to settle those charges. In September 2002, the FTC announced a settlement with Citigroup that required the bank to reimburse borrowers $240 million as a result of predatory lending practices by a firm acquired by Citigroup, Associates First Capital Corporation, which was selling overpriced credit insurance. This was the largest settlement in FTC history. Citigroup also agreed to lower its cap on lending fees from 5 percent to 3 percent of the loan value. Thereafter, in 2004, the Justice Department and the Fed entered into a settlement with Citigroup over predatory lending practices by one of its affiliates. The bank agreed to pay $70 million and became subject to a cease-and-desist order. In that case, the Baltimore-based CitiFinancial Credit Company, a unit of Citigroup, had required loan applicants to have cosigners and had required both the applicant and cosigner to purchase expensive credit insurance. CitiFinancial was also charged with making loans without considering the borrower’s ability to repay. Compounding these violations was the fact that CitiFinancial employees tried to conceal these practices from investigators. Citigroup also agreed to a $20 million settlement with the North Carolina attorney general over charges that some 9,000 borrowers were deceived into purchasing expensive credit insurance. ABN Amro agreed to pay $41.3 million in a joint settlement with the Justice Department, the OCC, and HUD to settle charges that it had falsified mortgage loan documentation by submitting 28,000 falsified insurance certificates to the FHA. The SEC brought charges against Los Angeles area brokers who persuaded their customers to refinance their homes with subprime mortgages. The brokers then invested the loan proceeds in high-risk securities that were not suitable for those investors. The states continued their attacks on predatory lending practices. In 2002, Household International, the parent company of Household Finance, which was not subject to the OCC preemption order, entered into an $844 million settlement with state attorneys general and banking regulators from all fifty states, as a result of its predatory lending practices. Later, in January 2006, Ameriquest agreed to pay $325 million to attorneys general and banking regulators in forty-nine states to settle predatory lending charges. Democratic members of Congress had long been seeking to adopt predatory lending laws, copying the statute passed in North Carolina. However, the Bush administration and Alan Greenspan, the Fed chairman at the time, resisted those efforts. Greenspan also pushed back against efforts to impose such restrictions by regulations on banks under the Fed’s regulatory umbrella. Legislation was introduced in Congress to overrule the OCC preemptive order, but the subprime lobby assured that it did not pass. The states were still seething over the OCC’s preemption order, though it won support from a Supreme Court ruling in 2007 that held that the mortgage lending business of a national bank, whether conducted through the bank itself or through a subsidiary, was subject to OCC control and not that of the

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 398 The Growth of the Mortgage Market states.11 Regulatory officials from all fifty states opposed that position. North Carolina’s attorney general, Roy Cooper, remarked that the Supreme Court’s decision “took fifty sheriffs off the beat at a time when lending was becoming a wild west.”12 Ironically, that case had been brought by Wachovia, which was headquartered in North Carolina. Wachovia had brought the case against Michigan regulators, who were seeking to regulate a subsidiary of Wachovia, the Wachovia Mortgage Corporation. Not long after the Supreme Court’s decision, Wachovia suffered massive and destructive losses from its subprime lending activities, and it was taken over by Wells Fargo. New York attorney general Eliot Spitzer separately challenged the preemptive order of the OCC. He had been able to bulldoze other federal regulators out of his way, including the SEC, but the OCC was another matter. Spitzer challenged the OCC by suing First Horizon, a subsidiary of a national bank, charging predatory practices. He sought only a nominal fine, bringing the case only as a test of the OCC’s preemptive powers. Spitzer also demanded that the New York Clearing House, which handled clearing for eight large banks, turn over information on credit scores and other lending data. The SEC had wilted from Spitzer’s attacks on its competence, but one federal regulator, the OCC, rejected Spitzer’s rhetoric. Julie L. Williams, the acting comptroller of the currency, had Spitzer permanently enjoined by a federal court from investigating low-income lending practices by national banks. Of course, the OCC’s action now raises the question of whether lax bank regulation led to the subprime crisis and whether Spitzer could have exposed those problems earlier. In the event, the Supreme Court decided to review the issue of whether the injunction was appropriate and ruled that it was not insofar as it prevented Spitzer from bringing an enforcement action against a national bank for violation of state law. Nevertheless, the New York attorney general was not allowed to visit or demand the books and records of banks, limiting his ability to bring such actions. The ruling in the Spitzer case was not handed down until June 29, 2009. By then the subprime crisis had swept aside any concern for consistency or duplicative regulation, but Spitzer was unable to savor the victory because he had already been driven from office in disgrace. Ironically, Spitzer’s last act as a crusader, before his resignation, was the publication of an op-ed piece in the Washington Post, in which he decried the OCC’s preemption order, asserting that state attorneys general had observed a large spike in predatory lending, but that they were prevented by the OCC from attacking such practices. The OCC published a rather tart response, claiming that most of the predatory lending problems emanate from state-regulated institutions over which it had no control and to which its preemption order did not apply. The Dodd-Frank Act that was passed by Congress in July 2010 imposed some restrictions on the OCC’s preemption authority. The states persisted in their efforts to regulate subprime lending. Bank of America settled predatory lending charges in the third quarter of 2008 involving Countrywide, which it had acquired during the subprime crisis.

That case was brought by attorneys general from fifteen states. In settling that case, Bank of America agreed to modify as many as 400,000 mortgages by refinancing them at lower interest rates and through a reduction of principal. However, Bank of America encountered some difficulties in carrying out that agreement because some of the loans had been securitized, and some of the investors who had purchased those obligations objected to any modifications that reduced their returns. Vermont was taking a victory lap as the subprime crisis wound down in August 2009. A front-page article in the Wall Street Journal noted that this state had one of the lowest default rates on home mortgages in the country—3 per 100,000 homes versus Nevada, number one with 396 defaults per 100,000 residences. That success was attributed to a state statute that required lenders to tell borrowers if their rates were substantially higher than those at other lenders and that imposed fiduciary duties on mortgage brokers in favor of the home buyer. Vermont banks also rarely securitized the loans that they originated, giving them a stake in ensuring the quality of the credit.13

Fannie Mae and Freddie Mac

Fannie Mae purchased or guaranteed $270 billion in subprime loans between 2005 and 2008. It was noted at the time that Fannie Mae was taking on considerably more risk through that activity. Even earlier, an article in the New York Times on September 30, 1999, presciently pointed out that an economic downturn could cause those loans to default and could require a government rescue of Fannie Mae.14 Peter Wallison, a fellow at the American Enterprise Institute, and a longtime and frequent critic of Fannie Mae and Freddie Mac, also cautioned that this subprime exposure at Fannie Mae and Freddie Mac would set the stage for another government bailout like the one that occurred during the savings and loan crisis in the 1980s. That prophecy turned out to be correct. By 2004, Fannie Mae and Freddie Mac accounted for $2.65 trillion of the outstanding $4.1 trillion in mortgage-backed securities. Concerns continued to be raised that these two GSEs were not managing their risks properly. In 2003, Freddie Mac announced that it was restating its earnings for the prior three years. That announcement seemed innocuous at the time because the company stated that it was making those restatements in order to reflect higher earnings from its derivatives operations. However, a few months later, Freddie Mac fired three executives because of their involvement in previously undis- closed accounting irregularities. That caused Freddie Mac’s stock to drop by 16 percent in one day. Freddie Mac understated its earnings by $5 billion for 2000 to 2002, in order to smooth its earnings and meet financial analysts’ consensus estimates. The agency fired its president, David Glenn, and its chairman and CEO, Leland Brendsel, and its chief financial officer (CFO), Vaughn Clarke, were forced

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 400 The Growth of the Mortgage Market to resign. Brendsel also agreed to a settlement with OFHEO over his role in that scandal. This included the return of $10.5 million in compensation that Brendsel received while he worked at Freddie Mac. He also agreed to waive claims for an additional $3.4 million in compensation. Freddie Mac paid a record $125 million fine to OFHEO, which blamed management misconduct for the faulty accounting. Freddie Mac paid another $50 million to settle SEC charges over its accounting misstatements. In the meantime, Fannie Mae asserted that it did not have any mortgage- related accounting problems like those at Freddie Mac. However, late in 2003, Fannie Mae disclosed that, in fact, it had its own accounting problems and that it had made some computational errors. That proved to be a giant understatement. Fannie Mae had voluntarily registered its securities with the SEC and, coincidentally, filed its first annual financial report with that agency in March 2003. This allowed the SEC to charge that Fannie Mae had misstated earnings over a four-year period, requiring a restatement of $9 billion—which would eliminate 40 percent of the GSE’s profits between 2001 and 2004. Fan- nie Mae agreed to pay $400 million to settle SEC and OFHEO charges over that conduct, but OFHEO was still criticized for not responding in a timely fashion to those announcements. Critics also complained that OFHEO was too small and understaffed to regulate these two giant GSEs, having only 140 employees and an insufficient budget of $30 million. Fannie Mae disclosed additional accounting problems in March 2006, and OFHEO issued a report on Fannie Mae in May 2006. That report concluded that Fannie Mae’s CEO, Franklin Raines, and other executives at Fannie Mae had acted in a manner that “was inconsistent with the values of responsibility, accountability, and integrity.”15 The OFHEO report found that Fannie Mae’s accounting was motivated by a desire to portray the company as a consistent and stable generator of earnings, and it was also encouraged by an executive compensation scheme that rewarded management for meeting earnings per share goals, a “metric” that could be manipulated by management. OFHEO concluded that Fannie Mae had a “dysfunctional” accounting policy, and it strongly condemned Raines’s management, noting that he benefited greatly from the accounting manipulations.16 Franklin Raines had been a highly paid executive at Fannie Mae. His earnings rose from $4.5 million in 2000 to $11.6 million in 2003. Those earnings were based on the inflated profits reported as a result of the accounting manipulations. Raines was raised in poverty in Seattle, and he fought his way up to attend Harvard and receive a Rhodes scholarship. Raines served as the White House budget director during the Clinton administration. Fannie Mae became a dumping ground for Democratic politicians, and Raines was given a lucrative post there. He and two other senior executives agreed to pay OF- HEO $31.4 million to settle charges over his responsibility for the accounting problems at Fannie Mae. Raines agreed to pay $24.7 million of that amount, but the payment was to be made mostly by forgoing the exercise of vested

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. Securitization 401 stock options and other benefits that turned out to have little, if any, value after Fannie Mae failed. The taxpayers also had to foot the legal bills, which totaled over $6 million, of Raines and other Fannie Mae executives who were targets of lawsuits over the accounting irregularities at the firm. A massive report was prepared for the Fannie Mae board of directors by War- ren Rudman, the former senator from New Hampshire, on Fannie Mae’s past accounting abuses. Although it found that most of Fannie Mae’s accounting practices had not been in accordance with generally accepted accounting principles, the Rudman report largely exonerated Raines of any wrongdoing. However, it did accuse him of creating a “culture” that allowed improper activities. Blame for the accounting problems focused on Fannie Mae’s CFO, J. Timothy Howard, and the controller, Leanne Spencer. The accounting manipulations were said by a Treasury official to be the result of an “earnings at any cost” culture.17 Raines later became an adviser to Barack Obama during his presidential campaign and was the target of attack ads by the campaign of his Republican opponent, Arizona senator John McCain. Raines was embarrassed by disclosures that Angelo Mozilo, the head of Countrywide, had made personal efforts to arrange mortgages for Raines and James Johnson, Raines’s predecessor at Fannie Mae and another Democratic politician who was paid a substantial salary there, $21 million in his last year of employment. The Raines and Johnson loans were arranged through a “friends of Mozilo” lending program at Countrywide that made mortgage loans on favorable terms to members of Congress and other prominent individuals. Raines denied any favored treatment on the loans, but congressional investigators claim to have discovered documents indicating that the loans were made on preferential terms. After the subprime crisis peaked in September 2008, it was revealed that two other Fannie Mae executives received loans from Countrywide. One was Daniel Mudd, who was ousted from his position as CEO when Fannie Mae was taken over by the federal government. The other Fannie Mae executive receiving a loan from Countrywide was Jamie Gorelick, another former Clinton administration official at Fannie Mae, who received a bonus of almost $800,000 from Fannie Mae in 2003. It is unclear how Gorelick qualified for her position at Fannie Mae as she had no financial experience. A congressional investigation in 2010 revealed that, in total, Countrywide gave “VIP” mortgage loans on favorable terms unavailable to the general public to over 150 individuals working at Fannie Mae. They included several directors, executives and lower level employees. Several of those loans were made about one year before Fan- nie Mae agreed to buy large amounts of Countrywide loans. In 2004, Treasury Secretary John Snow urged that the size of the mortgage portfolios of Fannie Mae and Freddie Mac be reduced because interest rate changes could cause large losses at those GSEs and unhinge markets. That effort got nowhere. Efforts by the Bush administration to regulate Fannie and Freddie like banks were blocked by the strong opposition of Democratic Senator Chris Dodd, Senator Chuck Schumer, and Representative Barney Frank.

Accounting problems continued at the GSEs. Freddie Mac announced that it was delaying its 2005 results because it was having difficulty valuing its assets. Fannie Mae disclosed more accounting problems in March and May 2006, and then it announced that it would not be filing financial statements until 2007. Fannie Mae paid $800 million to its accountants in 2006 for their work on straightening out its records. In 2008, OFHEO warned Fannie Mae and Freddie Mac that they were improperly applying accounting rules to value their portfolios for earnings purposes. The GSEs and their regulation were further criticized by Greenspan for not imposing higher capital requirements on Fannie Mae and Freddie Mac in order to cushion their creditors from any losses that might occur in the event of a mortgage market crisis. Congress set those capital limits at very low levels. However, both firms contended that they were properly managing their risks through hedging and other activities and that, therefore, their capital was adequate.18 Legislation was introduced in 2004 to transfer OFHEO to the Treasury Department, but that legislation was not enacted before both Fannie Mae and Freddie Mac failed at the height of the subprime crisis.

Collateralized Debt Obligations

One popular form of securitization for subprime mortgages was collateralized debt obligations (CDOs). These were simply packaged subprime mortgage pools that were securitized and sold off to investors who bought participation certificates entitling them to some portion of the proceeds from the pooled mortgages. Those participation certificates were sold to those investors in underwritings conducted by investment banking firms such as Lehman Brothers, Bear Stearns, and Merrill Lynch. A trustee was appointed to manage the pool for investors, and a servicing agent collected and distributed the mortgage payments. This process of packaging subprime loans and securitizing them became almost mechanized. Complicating these instruments even more were “CDO squared” instruments, which were pools of CDOs, rather than the underlying mortgages, which were securitized. They were followed by “CDO cubed,” which were pools of CDOs squared. The financial engineers also developed synthetic CDOs. These instruments do not contain mortgages or CDOs. Rather, they were credit protection devices that protected against loss from a CDO instrument. The return on a synthetic CDO is determined by reference to the performance of a portfolio of loans. The CDO is synthetic in that the issuer does not actually have to own the loans. The credit exposure is synthetically created by entering into a credit-default swap, in which one party pays a periodic fee, and the other pays any losses in principal on the nominal loans. As described in Chapter 7, a synthetic CDO was the subject of a sensational case brought by the SEC against Goldman Sachs.

Monoline Insurers

Another credit enhancement for subprime mortgage securitizations was financial guarantee insurance policies issued by “monoline” insurance companies.19 These insurance companies initially insured state and municipal bond offerings against default. That insurance allowed municipalities to issue triple-A-rated bonds, which lowered their funding costs because they could not otherwise obtain such a rating. This business was successful for the insurer because the default rate on municipal securities was less than 1 percent of the outstanding issues each year. The monoline insurers branched into guaranteeing subprime mortgage securitizations when those instruments became a popular product, a decision that they would later regret. Like the rating agencies, monolines used mathematical models to predict the expected rate of defaults on the subprime securitizations as the actuarial basis for setting premium payments. Those loss rates were quite low in the rising housing market before the subprime crisis because of low teaser interest rates that had not reset, and a rising residential market allowed frequent refinancing that could be used to defer defaults. As a result, the monoline models proved inadequate in predicting the losses that would be experienced during the subprime crisis. One of the larger monoline insurance companies was MBIA, which was based in Armonk, New York, and had offices around the world. MBIA’s revenues increased by 140 percent between 2001 and 2006 as its structured finance business grew. Another large monoline insurer was Ambac Financial Corporation, based in New York City. Both companies started as insurers of municipal bonds, which still accounted for much of their business. However, they fatefully sought to expand their business into CDOs involving subprime mortgages. That business, initially, appeared to be lucrative and to pose little risk to the insurance companies because of their modeling abilities. As the subprime crisis began to bloom, Ambac was insuring some $40 billion in debt linked to subprime mortgages. However, it had too little capital to cover its exposures when the subprime crisis fully blossomed. It tried to ease that situation by reinsuring about 5 percent of its portfolio, transferring that risk to another company, Assured Guaranty. Ambac also reached an agreement with Citigroup that took Ambac off the hook for most of the insurance that it had issued for some mortgage-backed securities held by Citigroup. Ambac agreed to pay $850 million in settlement of $1.4 billion in claims held by Citigroup. Ambac gave a profit warning that it would be experiencing large losses in the fourth quarter of 2007. The company’s CEO, Robert J. Genader, was removed, and the company cut its dividend by 67 percent. Ambac later announced a $3.26 billion loss in the fourth quarter of 2007 as the result of a $9.21 billion writedown on its credit-related insurance activities in subprime

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 404 The Growth of the Mortgage Market securities. The company had been downgraded from triple-A status by the rating agencies after Ambac concluded that the market would not absorb a $1 billion issue that was needed to increase the company’s capital. The situation at Ambac continued to deteriorate. It reported a loss of $1.66 billion in the first quarter of 2008, causing the value of its shares to fall by 43 percent. In March 2008, Ambac sought to recapitalize through an injection of more than $2 billion from eight banks, including Citigroup and UBS. New York governor Eliot Spitzer had been involved in pressuring the banks to assist Ambac because the failure of a monoline insurer would raise financing costs for municipalities that used its insurance to boost their credit ratings. That effort resulted in only a $1.5 billion equity financing by Ambac in March 2008, rather than the $2 billion it sought, and which was about half what many thought was needed. Ambac announced the declaration of a six-month moratorium on writing insurance for structured finance instruments. The value of Ambac’s shares fell by 20 percent after its capital-raising effort fell short. It had some $140 billion outstanding in structured finance exposures. Ambac stopped its dividend payments in 2008, and it reported a loss of $5.6 billon for the year. Ambac then set off howls of outrage when it announced in January 2009 that it was paying four executives bonuses totaling $3 million, even though the value of the company’s shares had fallen by 96 percent during 2008. MBIA’s capital was also badly damaged by losses from defaulting mortgages. The company’s stock price was down 70 percent in 2007, and it was in danger of losing its AAA credit rating. The loss of that rating would harm its ability to continue to act as an insurer. MBIA announced a six-month self- imposed sabbatical from insuring further structured finance instruments. In order to shore up its capital base, MBIA obtained an investment from a private equity group, Warburg Pincus, which purchased $500 million in MBIA stock in December 2007 for $31 a share. That was not a good investment. The price of MBIA’s stock dropped to $13.61 a share in early April 2008. MBIA was able to preserve its credit rating as 2008 began through a $1 billion issue of “surplus notes” with a 12 percent yield in January 2008. MBIA also reduced its quarterly dividend by 62 percent. Those efforts did not stop the hemor- rhaging. MBIA reported a first-quarter loss in 2008 of $2.41 billion. Strangely, that was considered good news by the market because traders thought that the company would be able to retain its AAA credit rating. However, Moody’s announced a review of MBIA’s credit rating, and as losses mounted in June 2008, MBIA lost its triple-A rating. MBIA and Ambac were both downgraded to AA, and Standard & Poor’s warned of further downgrades. Moody’s cut MBIA’s ratings again on Novem- ber 7, 2008, dropping its debt rating to junk bond status and pushing its insurance business rating down from A2 to Ba1. That downgrade set off triggers in some of its contracts, which placed more pressure on the firm’s liquidity resources. MBIA asked Fitch Ratings, one of the smaller rating agencies, to stop rating some of its securitized debt because of MBIA’s disagreement over

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. Securitization 405 the capital requirements imposed by Fitch. MBIA thought those requirements were too high. MBIA’s losses increased in the third quarter of 2008, and Am- bac received a further ratings downgrade. MBIA lost $806 million in the third quarter and posted a loss of $2.7 billion for the year. MBIA announced in February 2009 that it was dividing itself into two arms, one for municipal bond insurance and the second for structured investments and other nonmunicipal business. It denied that this was an effort to create a “good bank–bad bank” structure. A group of eighteen banks sued MBIA over this division of assets, claiming that it defrauded them of coverage. Third Avenue Management also sued MBIA, claiming that the split was “asset stripping” that harmed bond holders. MBIA kept the CDO guarantees, and the National Public Finance Guarantee Corp. took the state bond insurance business. MBIA posted a first-quarter loss in 2010 of $1.48 billion. Monoline problems spread. In March 2008 Wilbur L. Ross invested $1 billion in Assured Guaranty, the fifth-largest bond insurer, which had taken over the insurance on some of Ambac’s subprime underwriting. Its triple-A rating was put on a credit watch by Moody’s Investors Services in July 2008, as was Financial Security Assurance. Another monoline insurer, Syncora (formerly known as SCA), was in trouble over its guarantees for $140 billion in bonds covering municipal debt and structured finance. It was ordered by insurance regulators in April 2009 to stop making payments on claims. That action then triggered $18 billion in credit-default swaps written on Syncora’s debt. How- ever, the net exposure on those swaps was only $1 billion. Another bond insurer, ACA Capital Holdings, reported a third-quarter loss in 2007 of $1 billion and was facing a ratings downgrade that would destroy its ability to meet collateral requirements. In that event, banks that insured SIVs and ABCP investments with that company would have to move those investments back onto their books. ACA Capital Holdings reached a settlement with clients covering $69 billion of its coverage for subprime mortgage defaults. The company agreed to turn over control of itself to those creditors and continued to underwrite insurance on municipal bonds. ACA Financial Guarantee Corporation had more than $60 billion of credit-default swaps that it had underwritten but was unable to pay, including a large amount held by Merrill Lynch to cover its exposure from subprime instruments. Merrill Lynch, which was itself in extremis during the subprime crisis, had other problems with subprime insurance. It sued Security Capital Assurance, a bond insurer, claiming that it had reneged on credit-default swaps covering $3.1 billion in mortgages. Insurance claims for individual mortgages were also rising. The largest of those insurers, MGIC Investment Corp., lost hundreds of millions of dollars during the crisis, including $340 million in the second quarter of 2009. It posted twelve straight quarterly losses and did not return to profitability until the second quarter of 2010. In October 2008, Fed chairman Ben Bernanke proposed the creation of a

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 406 The Growth of the Mortgage Market government bond insurer that would insure securitized mortgages, but that program was not pursued. Warren Buffett announced that he was entering the bond insurance business and would use his strong capital base to compete with the faltering bond insurers. Buffett made that announcement at the request of Eric R. Dinallo, the New York State superintendent of insurance. Buffett’s new monoline insurance company, Berkshire Hathaway Assurance, raked in $400 million in premiums in the first quarter of 2008, making his new company the largest in the industry. The market for new municipal bond offerings was frozen because of concerns over the stability of MBIA and other municipal bond insurers. Suspicions were raised that the monolines would be unable to meet their obligations in the event that municipal bond defaults increased. Such defaults were expected to increase because of declining municipal revenues caused by the economic downturn accompanying the subprime crisis. The value of many municipal bonds dropped sharply, and many municipalities were unable to borrow in the municipal bond market because of a lack of viable insurance. This put a further squeeze on municipal finances, which were already suffering as the recession bit into their revenue streams. In July 2009, the State of California was reduced to writing IOUs to pay its bills. The state budget deficit in Cali- fornia had grown to $19 billion in 2010. Another part of the mortgage insurance business continued to be affected by the subprime crisis. Mortgage insurers that provided private mortgage life insurance for homeowners were in a panic as the third quarter of 2008 began. They tightened insurance standards for mortgages to such an extent that many potential borrowers were excluded. Commercial credit insurers were also facing difficulties. Their products included credit insurance for accounts receivables, accounts receivable puts, single buyer credit protection, and credit-default swaps.

Credit-Default Swaps

The higher interest rates charged to subprime borrowers made those loans attractive to lenders, but they still had to contend with the embedded risk of high default rates. This required some credit enhancement to make them marketable, such as a credit-default insurance or a credit-default swap (CDS) that would serve the same purpose. One scholar gave the following description of a CDS in which Bank A is trying to hedge its exposure from a $10 million loan to company B “by going to C, a dealer in these swaps, who agrees to pay the $10 million to A if B defaults, in exchange for paying an annual premium to C for the protection. A will want collateral from C to be sure it’s good for the debt.”20 The CDS proved a popular instrument. Outstanding notional value of the CDS market hit $45 trillion in the first half of 2007. That market grew to cover $65 trillion in debt at year-end 2007. The actual net exposure was estimated to be a much smaller, but still hefty, $2.3 trillion.

Indexes were created to track and trade the value of mortgaged-backed securities based on CDS. In 2001, JPMorgan Chase created the High Yield Debt Index composed of 100 high-yield single name corporate debt instruments. That index was followed in 2004 by the Dow Jones CDX Indexes across several areas covered by CDS, including everything from investment grade to junk bonds. IBOXX and Trac-X were providing debt basket quotes and other debt indexes included CMBX prepared by Markit Partners and the ABX, which referenced fifteen to twenty debt instruments. The ABX became known as the “fear” index because it reacted to adverse subprime events. In 2007 the Chicago Board Options Exchange (CBOE) began trading credit-default options that were automatically exercised upon the occurrence of specified credit events. Another CBOE product was credit-default basket options, which were cash- settled options based on a basket of at least two reference entities. Futures on CDS were also traded on the Chicago Board of Trade (CBOT). An issue had arisen in prior years over whether CDS and similar instruments were insurance that was subject to state insurance laws and reserve requirements. The state insurance regulators, specifically in New York, concluded that such instruments were not insurance. In order to be insurance there must be, in insurance parlance, an “insurable interest” on the part of the beneficiary. In the case of a CDS, there need be no insurable interest because the CDS was not tied to any specific casualty event directly affecting the party receiving the protection. Rather, payment was made on the CDS even if there was no injury to the protected party. Dinallo, the New York State superintendent of insurance, testified in Congress in October 2008 that only about 10 percent of CDSs were used for protection. The rest were speculative bets. Legislation passed in 2010 prohibited CDSs to be treated as insurance.

Mortgage Brokers

Mortgage brokers comprised a large part of the mortgage origination process in the run-up to the subprime crisis. They were paid a fee by banks for originating mortgages, which were usually based on the payment of a yield spread premium (YSP) above the “par” rate otherwise offered by the lending bank to consumers, who make their loan application directly to the bank. Some 90 percent of all mortgages originated by mortgage brokers carried a YSP, and it was estimated that, leading up to the subprime crisis, some 60 percent of all mortgages were arranged by a mortgage broker. There were some early warning signs that mortgage brokers might be more motivated by fees than sound lending practices. Citigroup announced in August 2001 that it was suspending its relationships with 4,000 mortgage brokers because of integrity concerns. Those concerns grew during the subprime crisis. Senator Charles Schumer from New York charged that Countrywide, the nation’s largest home mortgage lender, was providing inappropriate incentives to mortgage brokers to steer borrowers to take out high-cost mortgage

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 408 The Growth of the Mortgage Market products. Mortgage brokers were being given 1 percent of the value of a subprime loan containing a three-year term for prepayment penalties and an additional incentive for subprime loans with a high reset rate after the teaser rate expired on an ARM. JPMorgan Chase announced in January 2009 that it was discontinuing the use of third-party brokers to originate even prime mortgages. Instead, it would use its own employees to originate loans. In light of the then-ongoing subprime crisis, the Treasury Department recommended, in March 2008, the creation of a regulatory scheme for mortgage brokers. That program would be administered by the states, but would be overseen by a federal agency called the Mortgage Origination Commission (MOC). MOC would set licensing standards for mortgage brokers and review state implementation of those licensing standards and regulation of mortgage brokers. Such a program was established through legislation passed in 2010. Another flaw in the securitization process was due diligence on the quality of the mortgages placed in the CDOs. The investment bankers outsourced this task to various firms, including Clayton Holdings, the Bohan Group, and Opus Capital Markets. Those firms only sampled the documentation and reviews were, by necessity, only cursory. However, Clayton claimed it warned the rating agencies that many loans had deficiencies.

Nonbank Subprime Lenders

Traditionally conventional mortgage lenders—banks and thrifts—avoided the subprime market because of the risks it posed. Instead, nonbank lenders serviced that market. Subprime lending had historically been limited to the local loan shark, pawnshops, and personal loan companies. One of the latter, Beneficial Finance, began to make second mortgages available to subprime lenders in the 1960s. Beneficial carefully expanded that portfolio and within a decade was making profits of $100 million a year, with a loss rate of just 1 percent on defaults.21 In 2003 HSBC, one of the world’s largest banks, acquired Beneficial for $14 billion as well as the Household International finance company. Those acquisitions made HSBC the second-largest consumer lending company in the United States, with almost a thousand branches in forty-six states. However, those acquisitions proved almost fatally costly. HSBC wrote off $11 billion in losses from that unit in 2007 and announced in February 2009 as losses continued to mount that it was cutting back its U.S. consumer finance operations. A principal source of subprime lending in the 1990s were the mortgage banks, financial institutions that focused their business on residential loans, particularly subprime loans, whose fees and rate spreads were the greatest.22 These mortgage lenders were “nonbank banks” that were able to escape regulation because the regulatory definition of a bank is that it is an institution that both accepts demand deposits and makes commercial loans. The nonbanks did

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. Securitization 409 not take deposits and made only residential loans and, therefore, fell outside the definition of a bank.23 In the 1980s, regulators had to contend with a number of nonbank banks that offered services similar to those of regulated banks but that were not techni- cally considered banks because they did not accept “demand” deposits that could be immediately withdrawn on the demand of the depositor. Rather, those nonbank banks offered NOW (negotiable order of withdrawal) accounts with a technical notice requirement that meant that the deposits could not be legally withdrawn on demand, although in practice they were. Other nonbank banks avoided regulation as banks in the 1980s under the second prong of the bank definition because they took deposits but did not make commercial loans. The Fed tried to regulate these nonbank banks in 1984 by adopting rules defining NOW accounts as demand deposits and broadened the definition of a commercial loan to include commercial paper and other money market instruments bought by nonbank banks, but excluded personal, family, and household loans.24 The Supreme Court ruled in 1986 that the Fed did not have the power to extend the statutory definition of a bank in such a manner.25 Congress then passed legislation that included NOW accounts as a form of demand deposit. However, that change did not extend to mortgage lenders that were not accepting deposits in any form or did not make commercial loans. The mortgage companies were able to exploit that loophole by funding their residential mortgage loans from their own borrowings from banks and other commercial lenders. Those unregulated institutions would be at the heart of the subprime crisis. The nonbank mortgage lenders included the likes of First Plus, Cityscape Mortgage, Ameriquest, Long Beach Mortgage, Option One Mortgage, and the Money Store. Eight of the top subprime lenders were nonbanks based in southern California. This was a fiercely competitive market and an appealing one for those entrepreneurs because of the spreads. Little regard was given to risk. Between 1993 and 1997, the volume of new home-equity loans raised by subprime nonbank companies increased tenfold, to $64 billion. A Wall Street Journal article reported in 1998 that many of those loans were made to “borrowers without a prayer of getting money from a bank.” A financial analyst “remembers visiting the companies and ‘I’d sit there and watch the underwriters approve a credit: You’d look on the credit report and the guy would have two prior bankruptcies.’”26 DiTech Funding Corporation of Irvine, California, made high-fee loans of up to 125 percent of the resident’s value of a home. These subprime mortgage lenders had a financing problem. They could not take deposits to fund the mortgages. Rather, they were dependent on loans from firms willing to finance their operations, and that is what led to the perfect storm that became the subprime crisis. Prudential Securities led the way into this nonbank “warehouse” financing. Other investment banks soon found it to their liking because they could charge high rates to the nonbanks, which could still profit from the even higher interest on the subprime mortgages that they originated or purchased.

This “warehouse” financing also provided access on the part of the investment banks to the mortgages being generated by the nonbank mortgage lenders, which could then be securitized by the investment banks for more fees. The result was a giant, and ever-growing, merry-go-round of warehouse loans by investment banks, followed by loan originations by the mortgage lenders, which were then sold to the investment banks, which was followed by their securitization, which generated funds for a new round of originations. The subprime mortgage market experienced a boomlet in the mid-1990s due to these securitizations, but it encountered a crisis between 1998 and 1999 when the bottom fell out of the market. It then became difficult to securitize subprime loans, and that funding source dried up, for a time, for the nonbank lenders. The securitization certificates sold to investors in the securitizations also became highly illiquid. That event bankrupted dozens of subprime lenders, many of which had become public companies. Firms suffering during this first subprime crisis included Southern Pacific Funding Corporation, Aames Financial Corporation, First Plus, AmerCredit, IMC Mortgage, PacificAmerica Money Center, and Unites Cos Financial Corporation. As one report noted:

A number of factors have contributed to the recent decline in the health of the subprime industry. Increased competition is one of the most important factors. In 1994, there were only ten companies in the subprime lending business. By March of 1998, that figure had grown to fifty. Increased competition in the subprime market caused deterioration in overall credit quality. The proliferation of subprime lenders forced companies to go deeper into the credit pool to find customers. This reduction in credit quality has increased the risk of default. Moreover, consumer defaults have been on the rise as the average American has taken on an increasing amount of debt. The industry was also hurt by the entrance of inexperienced subprime lenders who incorrectly evaluated customers’ credit ratings and thereby made bad loan decisions. As the stock prices of subprime lenders dropped because of financial difficulties, institutions were less willing to provide the capital to subprime companies to finance further loans.27

In the wake of this first subprime crisis, the SEC warned accounting firms that they should more carefully scrutinize the way subprime lenders booked profits from loans that were being securitized. The SEC was particularly concerned with “gain-on-sale” accounting for booking profits from securitizations. That accounting treatment recognized the gain on the transaction immediately even though the gains would be actually realized over several years. The Fi- nancial Accounting Standards Board (FASB) then proposed tougher accounting treatment for such transactions. No other lessons appear to have been learned from that event, perhaps because the press mostly ignored it, focusing instead on the then-ongoing Asian financial crisis that had spread from Thailand to Russia and caused the

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. Securitization 411 collapse of the Long-Term Capital Management hedge fund. Another factor limiting coverage was the then-small size of the subprime mortgage market. At that time only about 10 percent of outstanding mortgages were subprime. Even so, the big investment banks should have learned a lesson from the first subprime crisis. First Union, the giant North Carolina bank that later merged with Wachovia, purchased the Money Store in 1998 for $2.1 billion. Just two years later, it was forced to take a $1.8 billion charge as a result of losses from that operation. Wachovia, Merrill Lynch, and others afterward purchased nonbank subprime lenders that destroyed their businesses during the subprime crisis that emerged in 2007. First Alliance, a California subprime lender, was able to secure a $150 million warehouse credit facility from Lehman Brothers Holdings as 1999 began. Lehman also invested in two subprime loan originators, Aurora Loan Services in Littleton, Colorado (in 1997), and BNC Mortgage (in 2000) in Irvine, California. Bear Stearns was also committed to the subprime nonbanks, providing large amounts of warehouse financing, and it created its own subprime lender, EMC Mortgage, which survived the first subprime market panic with little damage. The first subprime crisis was written off as an accounting problem and a hundred-year storm in the financial markets that was not likely to be repeated. The larger investment banks believed that they could assess the risks of the market and structure their securitizations in a way that would make them highly marketable. The investment banks came to believe that their more sophisticated risk management techniques would shield them from the losses suffered by the pioneer nonbank subprime lenders that failed in that first crisis. They were horribly wrong.

Panics and Bubbles

Some History

Periodic market bubbles, panics, recessions, and depressions have long plagued the world. The Tulip mania in the Netherlands in 1636 and the South Seas bubble in England in 1720 are well-known examples. Similar economic dis- turbances also erupted in the New World, with ten depressions there between 1762 and 1837. The Panic of 1792 (due to the speculation of William Duer and Alexander Macomb against stock held by the Bank of New York) and recessions in 1796, 1802, 1807, and 1837 were particularly troubling to the new American republic. They were followed by panics in 1857, 1873, 1884, and 1893—the last of which resulted in an economic downturn that lasted until 1897 and was called the “Great Depression” until that title was claimed by the depression of the 1930s. These panics were usually attended by a loosening of credit and an economic boom that ends with a high-profile business failure, a process recognized by Hyman Minsky and thus known as the “Minsky Moment.”1 A boom in Western land sales preceded the Panic of 1837. President Andrew Jackson tried to dampen that land speculation with his 1836 Specie Circular, which required public land purchases to be paid for in specie. That was a shock to the economy, but the panic itself was triggered in 1837 by the failure of two large cotton firms. Their demise reverberated throughout the economy. Over 250 firms failed in New York, and real estate values fell by the then-considerable $40 million. The Panic of 1857 followed an economic boom that was reflected in a high volume of trading in stocks and bonds. The precipitating events in that panic were the sinking of the SS Central America, which was carrying gold stocks from California, and the failure of the Ohio Life Insurance and Trust Com- pany, which was caused by embezzlement by its cashier. The Panic of 1873 followed a boom in railroad financing. The precipitating event was the failure of Jay Cooke & Company, a brokerage firm named after its founder, who had financed much of the Union’s expenses in the Civil War. The Panic of 1884

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(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. Prelude to a Crisis 413 was preceded by speculative operations in the stock markets and a Florida land boom. Its precipitating event was the failure of Grant & Ward, a brokerage firm in which the former Union general Ulysses S. Grant was a partner. The Panic of 1893 followed the failure of the National Cordage Company. The nation experienced thirteen banking panics between 1814 and 1914, but the worst during that period was the Panic of 1907, a seminal event in American financial history.2 It was triggered by a stock manipulation in copper that failed and brought down the Knickerbocker Trust Company. The manipulation was an attempted “bear squeeze” of naked (uncovered) short-sellers in the stock of the United Copper Company. This meant that the conspirators were selling stock that they did not own in the hope that the stock would decline in value so that they could buy it back for less than the price at which they had sold it. The short-sellers prevailed in that contest, and they would reappear to play a role in the subprime crisis in 2008. The failure of the Knickerbocker Trust Company endangered other trust companies and led to a panic. J.P. Morgan, who had just rescued New York City after it was unable to place a bond offering, took charge of the chaos that followed Knickerbocker’s downfall. He famously locked a group of bankers in his library until they devised a rescue plan and, with more of Morgan’s firm leadership, order was restored. The sudden and unexpected nature of the 1907 panic and its severity led to a lengthy congressional investigation that eventually resulted in the creation of the Federal Reserve (Fed) several years later.

The Stock Market Crash of 1929

Until the subprime crisis, the country’s most horrifying financial experience came in the wake of the stock market crash of 1929, followed by the Great De- pression. Stock prices on the New York Stock Exchange (NYSE) had doubled in the 1920s, and volume exploded. Securities prices increased by more than 37 percent in 1927 and grew another 43 percent in 1928. The crash of the stock market in 1929 was unexpected, despite some warning signs, like the failure of the Credit Anstalt in Austria on May 8, which had been involved in the carry trade of borrowing short and lending long. Yet the market seemed unconcerned, though there were a few naysayers. Paul Warburg, a well-known financier, and one of the founders of the Fed, warned on March 8, 1929, that the speculative mania in the stock market would result in a market collapse that would be followed by a nationwide depression. On September 5, 1929, Roger Babson, a popular investment adviser, predicted that the stock market would soon crash. That caused a brief sell-off, but the market did not begin to react sharply until October 1929, culminating in “Black Thursday,” when millions of shares were thrown on the market and panic gripped the nation. Efforts by bankers to per- form a 1907 J.P. Morgan–style rescue by supporting the market failed. The Dow Jones Industrial Average fell 23 percent on October 28–29, 1929. A decline of that magnitude would not be repeated until 1987 and 2008.

Unlike in earlier panics, it is difficult to isolate any one event that could be said to have caused the Great Depression. Economists have generally agreed that the 1929 crash was but one of many factors leading to that depression. Certainly, the Fed failed to fulfill its mission before and after the crash. It had raised rates in order to slow the market, pushing the call market rate (the rate at which brokers obtained loans for their customer’s margin positions) to 20 percent for this short-term money. However, those high rates only brought more money into the call market. After the market crashed, the Fed injected $500 million into the banking system and, in a series of eleven cuts, reduced interest rates from 6 percent to 1.5 percent between 1929 and 1931. It shocked the economy by raising interest rates from 1.5 percent to 3.5 percent in October 1931, before reducing them to 2.5 percent in 1932. The Fed also required banks to increase their reserves in 1936, just as the country appeared to be recovering. That action, and President Franklin D. Roosevelt’s continued attacks on business managers, including a “soak the rich” tax bill, helped send the economy into another tailspin in 1937. The country was saved not by government intervention but by the outbreak of World War II.

Inflation

The country experienced one of its greatest economic expansions in the 1960s. The result was a high rate of inflation, and the economy went into recession in 1969. By May 1970, the value of stocks listed on NYSE had been cut nearly in half. Later in the 1970s, the country was confronted with “stagflation,” a unique combination of low growth and high inflation, for which the government had no cure. The stock market continued to lag, and Time magazine published a cover story titled “The Death of Equities: How Inflation Is Destroying the Stock Market.” A new Fed chairman, Paul Volcker, finally stepped in to apply some harsh medicine in the form of interest rate increases that were unprecedented in magnitude. Volcker’s actions sent the economy into a recession that was one of the worst since the Great Depression of the 1930s. Unemployment reached 10 percent nationwide in 1982, but the unemployment rate in Detroit was an astounding 25 percent. Nevertheless, the economy did recover and a new era of prosperity began. Future Fed chairmen ever after adopted Volcker’s method to combat inflation by raising interest rates to punitive levels, even at the expense of a recession. His success persuaded the Fed that it could use interest rate hikes to dampen inflation or burst bubbles and interest rate cuts to boost the economy when it appeared headed toward recession. In the post-Volcker era, interest rate manipulations, good in theory or not, proved too blunt an instrument and only served on more than one occasion to exacerbate market bubbles when rates were too low and to nearly wreck the economy when too high.

The Stock Market Crash of 1987

Another seminal event in American financial history was the stock market crash of 1987. As in the Panic of 1907 and the Crash of 1929, the sell-off that began on October 14, 1987, had no forewarning. On that day, the stock market began its worst-ever one-week decline until the subprime crisis. The market continued to plunge on October 15 and 16. On October 19, 1987, the Dow experienced a new historical record for a one-day decline in percentage and absolute numbers; the Dow fell by 508 points, more than 20 percent of its market value. Over $500 billion in stock value evaporated. Until events in 2008 required a reconsideration, October 19, 1987, was considered by many to be the worst day ever on Wall Street. The actual cause of the 1987 crash is uncertain. The Fed had raised short- term interest rates from 5.5 to 6 percent in September; some claimed that a merchandise deficit was the cause, while others thought that a proposal to eliminate tax benefits for corporate takeovers was the culprit. A presidential commission headed by Nicholas Brady, a future secretary of the treasury, was created to conduct a study of the 1987 crash. The Brady Commission’s report concluded that the development of financial futures contracts and related trading strategies had resulted in a convergence of the futures and stock markets. The Brady Commission believed that the two markets had become disconnected during the October sell-off, exacerbating price declines and destabilizing the market. The Brady Commission recommended several steps to prevent such panics in the future, but the only action actually implemented was the imposition of trading collars or “circuit breakers,” as they were called, which caused trading to be stopped when certain levels of volatility were reached. The circuit breakers proved unpopular, and NYSE announced its intention to discard them in 2007, almost twenty years to the day from when they were first proposed. They were no longer needed to allow orderly trade processing because NYSE had massively increased its capacity to deal with the sort of large-volume trading that might trigger those limits. In 1987, NYSE could handle only about 95 electronic messages per second, but by 2007 it was able to handle 38,000 messages per second, as a result of computer enhancements. However, the extreme price volatility that occurred during the subprime crisis halted the elimination of those circuit breakers. NYSE announced new circuit breaker limits on December 31, 2008. Among other things, those limits would halt trading for an hour in the event of an 850-point decline in the Dow Jones Industrial Average before 2 p.m. Eastern Standard Time. Collars were also placed on “program” traders, large traders responding to computer-generated trading signals. Such trading was thought to have disrupted the market during the 1987 crash. However, NYSE discarded those program trading restrictions after twenty years, just as the subprime crisis was getting under way. The October 1987 crash had few long-term effects on the economy. It

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 416 The Growth of the Mortgage Market took the stock market two years to recover its pre-October 1987 levels, but not before a minicrash that occurred on October 13, 1989. On that day, the stock market lost $190 billion in value, of which $160 billion was lost in the last ninety minutes of trading. However, this plunge appeared to be merely a random event, and the market shrugged it off. Another matter for Brady to attend to when he became treasury secretary was the Latin American sovereign defaults of the 1980s. Loans by U.S. banks to those countries had paid high returns, but the ten largest banks in the United States had made loans totaling $50 billion to countries that were about to default in 1982. About half of those loans were made to Mexico. Bank of America was among those suffering from doubtful debts in Latin America and other underdeveloped countries. It had reserved $1.1 billion for loan losses on those debts. That was not a good thing because the bank had written off over $5 billion in bad loans over the previous five years. Citigroup reserved $3 billion and Chase Manhattan $1.7 billion for their bad loans. Those amounts seem small in light of the massive writedowns during the subprime crisis, but concern was raised at the time that the entire U.S. banking system might implode. The banks resolved the Latin American loan crisis by restructuring the defaulted loans, which included extending maturity dates, reducing interest rates, and even allowing some forgiveness of principal. Secretary Brady then began a program of securitizing these loans off the banks’ books through so-called Brady bonds that packaged the loans for sale to investors, and the crisis passed. In response to those problems, Congress passed the International Lending Supervision Act of 1983, requiring banks to increase their loss reserves for loans to countries that were delinquent or in default. The legislation stated somewhat ironically it now appears that it “is the policy of the Congress to assure that the economic health and stability of the United States and the other nations of the world shall not be adversely affected or threatened in the future by imprudent lending practices or inadequate supervision.”3 It was lack of supervision and imprudent lending practices that became the watchwords for Congress and regulators in the wake of the subprime crisis

Trouble Abroad

In the early 1990s, except for a brief recession in the United States, economic concerns were focused abroad. The Mexican peso collapsed in 1994, setting off a financial crisis that had worldwide effects. The 1994 crisis was touched off by the Mexican government’s effort to gradually devalue the peso without panicking investors. That effort failed, and the Mexican economy suffered a severe slump. That crisis spread to other countries in Latin America. The International Monetary Fund (IMF) put together a rescue package for several countries, and the crisis gradually subsided. By then, the IMF had become an international emergency lender of last resort for defaulting countries.

However, it was unpopular in many of the countries that it rescued because the IMF imposed conditions (“conditionality”) on its loans, which were intended to make the borrowing government more fiscally responsible. These conditions ranged from cutting government spending on social programs to increasing taxes—conditions viewed as impinging on the borrowing nation’s sovereignty and sometimes leading to violent protests. Another economic crisis broke out in Thailand in 1997, after that country experienced an unprecedented economic boom financed through borrowings that could not be supported. The panic spread quickly to Indonesia and then to South Korea. That situation was remedied by a $40 billion IMF rescue effort that sought to stabilize the currencies of the affected countries. However, the effects of that crisis continued to reverberate around the world for more than a year. This “Asian flu” spread to Russia in 1998, where the economy nearly collapsed as a result of flaws in its financial system and a drop in oil prices. Those problems in turn touched off a near crisis in the United States. In August 1998, the Dow Jones Industrial Average fell by 1,000 points over a few days. The Russian crisis had caused a worldwide “financial freeze, as one asset class after another became highly illiquid, and investors piled into the treasury market.”4 Fed chairman Alan Greenspan, Treasury Secretary Robert Rubin, and Deputy Treasury Secretary Larry Summers appeared on the cover of Time magazine and were lionized as the “Committee to Save the World” for their efforts in containing the Asian flu. The accompanying article stated:

In late-night phone calls, in marathon meetings and over bagels, orange juice and quiche, these three men—Robert Rubin, Alan Greenspan and Larry Summers—are working to stop what has become a plague of economic panic. Their biggest shield is an astonishingly robust U.S. economy. Growth at year’s end was north of 5%—double what economists had expected—and unemployment is at a 28-year low. By fighting off one collapse after another—and defending their economic policy from political meddling—the three men have so far protected American growth, making investors deliriously, perhaps delusionally, happy in the process.5

The members of the Committee to Save the World would also be front and center during the subprime crisis. Long Term Capital Management (LTCM), the highly leveraged hedge fund, lost nearly 90 percent of its $4.8 billion in capital, largely from losses stemming from a default on Russian government bonds. The Fed helped arrange a rescue of LTCM. Although that bailout did not involve any government funds, it was highly controversial because it was thought that the Fed was adding liquidity to the market and signaling that it would rescue any large investor caught in a liquidity trap or faced with unexpected losses. This infusion of liquidity was called the “Greenspan Put.”6 Another bit of fallout from the LTCM rescue was that Bear Stearns was the only major investment bank invited by the Federal Reserve Bank of New York to participate in the rescue that refused that request. This refusal created a lot of lingering resentment and animosity on Wall Street

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 418 The Growth of the Mortgage Market against Bear Stearns, which did not stand it in good stead when it was failing during the subprime crisis. The government has adopted a “too big to fail” approach at other times in history. Government loan guarantees for Lockheed in the 1970s and Chrysler in the 1980s are two prominent examples. The government also stepped in to save the depositors of the Continental Illinois Bank in the 1980s, extending deposit protection beyond the normal limits of the Federal Deposit Insurance Corporation (FDIC) and effectively nationalizing that bank. Those actions were based on a belief in some financial quarters that some firms were “too big to fail” because their demise would set off a market panic, cause the failure of other firms, and do severe damage to the economy. Those views were supported by prior panics in which a single failure or small group of failures resulted in panics, recessions, and depressions. An opposing school of thought argued that such interventions were improper and created a “moral hazard” that would encourage irresponsible actions by large firms because of their belief that the government would step in and save them. It also relieved shareholders and creditors of the obligation to monitor management to protect their investments.

Run-Up to the Real Estate Bubble

Breaking the Dot.Com Bubble

In the 1990s a bull market developed that lasted almost ten years. During that boom, stock market indexes exploded in value and reached heights undreamed of in earlier years. The Dow Jones Industrial Average doubled and then doubled again, reaching a record high of 11722 on January 14, 2000. Trading volume on the exchanges also ballooned. Average daily trading on NYSE was more than 800 million shares per day in 1999. NASDAQ average daily trading volume exceeded a billion shares. This market bubble was spurred by the growth of the high-tech “dot.com” companies that sprang up as computer technology and use of the Internet expanded. Many of the initial public offerings (IPOs) by these often-untested start-up companies were “hot issues” that traded up rapidly in secondary markets immediately after their issuance. More than 250 Internet-related IPOs took place in 1999, with an average 84 percent increase in price on the first day of trading. The stock market run-up caused Fed chairman Alan Greenspan great concern. He warned of a bubble in the stock market in 1994, but his concerns were largely ignored. In 1996, Greenspan again warned that the stock market was overinflated and asserted that this bubble was the result of “irrational exuberance.” Greenspan was a bit premature in his predictions (by three years), but he later began to act on his concern that a sudden bursting of the bubble would send the country’s economy into a recession. Actually, he made

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. Prelude to a Crisis 419 sure that his warnings became a self-fulfilling prophecy. Greenspan broke the market single-handedly through a series of punitive interest rate increases that began on June 30, 1999. Although the market resisted those attacks for a time, it began its decent in April 2000. Over $8 trillion in stock values evaporated in the ensuing downturn. Greenspan claimed that his interest rate increases would assure a “soft landing” for the economy after the bubble was eventually burst. In actuality, the Fed’s actions helped push the country into a near recession. Realizing his error, Greenspan reversed course and started cutting interest rates, starting on January 3, 2001. That action was too little, too late, and was compounded by the terrorist attacks on September 11, 2001, which not only brought down the World Trade Center but also nearly emptied the financial district in New York and sent stock market prices plunging. The NASDAQ Composite Index fell 25 percent during one week in April 2000, declining from a high of 5048 on March 24, 2000, to a low of 1114 after the market crash. The Dow Jones Industrial Average fell to 7286 in 2002, and the S&P 500 from its high of 1527 in 2000 to 777 in 2002. The Fed’s interest rate hikes were responsible for reversing the market’s course, but the economy was also suffering from the effects of those increases. The economic decline in 2002 did not meet the official definition of a recession because there were not two quarters of decline in a row, but there were two quarters of decline separated by a quarter of low growth. The catastrophic terrorist attacks on September 11, followed by the Enron-era scandals, further undermined confidence in the economy. Greenspan testified before Congress in July 2002 that “infectious greed” had invaded corporate America.

Interest Rates

Greenspan’s reductions in interest rates eventually pushed them down to levels unseen in forty-five years. The Fed also announced on January 30, 2002, that it planned to maintain its low-interest-rate policy for the near future. The stock market was bolstered by this change in direction by the Fed on interest rates as well as by the large tax cuts that the newly inaugurated president, George W. Bush, was able to pass in Congress. The NASDAQ index increased by 50 percent in 2003, and the Dow rose 25.3 percent during the year. Gold prices reached $414 an ounce in December 2003, the highest level in eight years (gold prices exceeded $1,200 per ounce in the wake of the subprime crisis). The NASDAQ index reached a thirty-year high on January 12, 2004. The national unemployment rate was 5.6 percent in March 2004, and retail sales climbed by 3 percent. The gross domestic product (GDP) increased at an annual rate of 6.1 percent in the first half of 2004. Manufacturing activity was at a twenty-year high. The economy gave every appearance of having entered a new period of prosperity. The law of unintended consequences then asserted itself. The Fed’s low-

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 420 The Growth of the Mortgage Market interest-rate policy set off a residential housing market boom, during which housing construction mushroomed and home prices climbed sharply. New home construction in 2000 increased at the fastest rate since 1986. In 2000, total mortgages outstanding in the United States were valued at $5.2 trillion, and nearly 10 million new loans were originated, with a value of $1.6 trillion. About half those originations were sold into the secondary market. More than 40 percent of mortgages originated with Fannie Mae, Freddie Mac, and Ginnie Mae. In March 2001, housing prices were 8.8 percent higher than the year before. Fannie Mae, Freddie Mac, Ginnie Mae, and the Federal Home Loan Banks (FHLBs) increased their mortgage business by almost $85 billion in the first quarter of 2001. New mortgage originations in 2001 increased to $1.5 trillion, of which about $900 billion was for new mortgages and the rest was for refinancing. On average, homeowners owed about 45 percent of the value of their homes to a mortgage lender, an increase over 32 percent in 1985; in 2008 it rose to 54 percent.7 In his testimony before Congress in July 2001, Greenspan stated that rising housing prices had created “a buffer of unrealized capital gains” that were being captured through mortgage refinancing and home sales. He asserted that this capital was protecting the economy even while the stock market was in a slump. Low interest rates were also spurring subprime lending. New home sales set a record in 2002, when the average interest rate on a thirty-year residential mortgage fell to 6.07 percent. Mortgage refinancing continued its boom as interest rates fell even lower and housing prices continued to rise, freeing up cash for consumers. The dollar value of second mortgages increased by 20 percent in 2002. Interest-only mortgages were growing in popularity. Washington Mutual lent about $1 billion per month in 2002 for such mortgages, which usually paid a monthly spread over LIBOR (the London Interbank Offered Rate), which is a popular benchmark of current interest rates used as a guide by many banks to set loan rates and to reset rates on loans with floating interest rates. In 2002, the interest rate payments on such mortgages were as low as 3.25 percent. Interest-only mortgage payments dropped to 2.8 percent as LIBOR fell from 6.37 percent in 2001 and then to 1.625 percent in 2003. Washington Mutual increased the percentage of its option ARMs from 5 percent in 2003 to 40 percent in 2004. In 2004, the amount of outstanding interest-only, negative amortization, and similar exotic mortgages totaled about $800 billion. Merrill Lynch urged investors to take out an interest-only mortgage in order to free up funds that could be invested elsewhere.8 Other interest-only advocates pointed out that there was not much amortization in the early years of a thirty-year mortgage anyway, so why worry about the absence of any amortization in an interest- only mortgage that simply deferred amortization? Between September 2002 and September 2003, new mortgage originations

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. Prelude to a Crisis 421 totaled $1.2 trillion and refinancing totaled about $3 trillion. The percentage of American families that owned their own homes reached 69.2 percent in 2003. Sales of existing homes set a record in both 2002 and 2003. More than 7 million homes were sold in 2003, including 1.09 million new homes, which was another new record. Lower interest rates meant that consumers could borrow more and pay more for their residences, which they did. The average price of a new home increased by 5.8 percent in 2002, reaching a new high of $218,900. Home prices climbed at a rate of 7.4 percent in 2003. In June 2004 sales of existing housing set an all-time record and new home starts were the second most numerous in history. Housing prices more than doubled in California and Florida between 2001 and 2006. The number of homes valued at over $1 million grew, reaching 0.6 percent of the housing market in 2003, about half of them in California, New York, and Florida. “Flip- ping” real estate became a national pastime as speculators from every walk of life tried to cash in on the bubble by purchasing and reselling residential property. Reality television shows were devoted to showing how to buy and quickly fix up existing properties for flipping. Banks and other lenders jumped in to assist by refinancing mortgages on a massive scale as interest rates dropped, generating large fees for those financial institutions. Banks, online firms, and mortgage brokers pushed consumers to take out loans by offering quick application processes, often online, with reduced documentation requirements. As one book related, Americans had developed a “house lust” that was becoming an obsession dominating everyday life.9 Although critics were concerned that a real estate bubble was growing, Greenspan discounted that possibility for some time. It was not until June 30, 2004, that he seems to have awakened and began raising interest rates. On that date, the Fed funds rate was raised from 1 percent to 1.25 percent. This deflated the stock markets, but they were able to recover. Greenspan raised interest rates by another 0.25 percent on August 10, 2004. The Dow Jones Industrial Average surged after the rate hike, but then began drifting and became volatile. The pace of growth in the housing market temporarily slowed. The rate of sales of existing homes fell in July 2004 by 6.4 percent over the previous month, and median home prices did not rise. Ignoring that signal of a downturn, the Fed responded with another rate hike of 0.25 percent on September 21, 2004. At this point, the interest rate on a fifteen-year residential mortgage averaged 5 percent. GDP grew 4.4 percent in 2004, the fastest rate in five years. Corporate profits were up and growing at the strongest rate since 1992. However, there was a disconnect in the money markets, where long-term interest rates were not rising in tandem with short-term rates. Bank loans in default reached a six-year low in December 2004. A slightly bullish stock market was twenty-seven months old as 2005 began. Housing starts hit a twenty-one-year high in January 2005, giving rise to more specula-

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 422 The Growth of the Mortgage Market tion in the press that a residential real estate bubble was beginning to inflate. Greenspan joined the chorus of concern over a bubble, stating that there was “froth” in the real estate market and that the boom was not sustainable. He would not go so far as to admit the existence of a national real estate bubble, but he did recognize several localized bubbles. His statements had no immediate effect on the real estate bubble. The Fed continued to raise interest rates, lifting the Fed funds rate to 2.75 percent on March 22, 2005, but the market continued its boom. The chairman of the president’s Council of Economic Advisers, Ben Bernanke, opined in 2005 that while housing prices had risen by some 25 percent during the preceding two years, “these price increases largely reflect strong economic fundamentals.”10 Sales of new homes set another new record in April 2005. The Fed announced that it planned to continue to increase interest rates and did so on May 3, 2005, by 0.25 percent. Inflation was low, except in the energy markets. Natural gas prices were rising. Crude oil prices reached $58 per barrel in April 2005 and continued to climb, reaching $70 per barrel in August, after Hurricane Katrina shut down drilling rigs in the Gulf of Mexico. Rising gasoline prices, which reached $3 per gallon, shocked consumers. The oil companies brought much disfavor upon themselves by announcing record profits afterward. By May 2005 outstanding home mortgages in the United States totaled $7 trillion. About 25 percent of those mortgages were adjustable rate. Sales of existing homes set another record in June 2005. The Economist made a dire, but prescient, warning that, after the real estate bubble burst, it would wreck the economy. Greenspan also warned that investors were unrealistically assuming that the economy was permanently less risky. He noted that consumers were borrowing against their home equity to increase their spending by $600 billion. The Fed made its tenth straight interest rate increase in August. The Fed fund rate was then 3.5 percent, a 2.5-percentage-point increase over the level of the previous year. The Fed raised rates once again on September 20, 2005. By then its assault on the real estate market seemed to have an effect. Economists estimated that the dollar value of mortgages to be issued in 2005 would be only $2.78 trillion, down from $4 trillion in 2003. By September, it was clear that the housing market was slowing. At this point, the Fed began hinting that it might slow its interest rate increases. The savings rate for Americans turned negative in 2005 for the first time since 1933, and savings rates divided along racial lines. A survey found that African Americans were leaving the stock market. Their participation in the stock market had risen from 57 percent in 1998 to 74 percent in 2002, but declined to 57 percent by 2007. In contrast, 76 percent of whites were invested in the stock market. African Americans saved about 50 percent less than their white counterparts—$48,000 versus $100,000. Retirement account figures were also troubling, with average savings of $73,000 for blacks versus $210,000 for whites. Whites saved on average $260 per month while blacks saved $180.

There was some good news. Consumer debt shrank in November for the second straight month. Household wealth in the United States also reached a new record level in the fourth quarter of 2005. However, that was due largely to increases in home prices. The increase in value created a “wealth effect” in the economy, meaning that increasing home prices made homeowners feel wealthier—and that feeling encouraged their spending. The year 2005 was the first year since the Great Depression that Americans spent more than they earned. Eastman Kodak lost $52 million in the fourth quarter of 2005. The company reported an even bigger loss in the first quarter of 2006—$298 million. General Motors sustained a loss of $8.6 billion in 2005. It was also having accounting problems, and the company’s CEO apologized to shareholders for those failures. GM announced in March 2006 that it was offering a buyout of union employees. The value of the buyouts ranged from $35,000 to $140,000. Ford Motor Company reported a $1.19 billion loss in the first quarter of 2006. However, ExxonMobil had a world-record profit of $10.71 billion in that quarter. The trade deficit grew by 17.5 percent in 2005 to a record $725.75 billion, and fourth-quarter growth in 2005 slowed to 3 percent on an annualized basis. Housing construction also slowed, declining by 8.9 percent in December, and building permits fell by 4.4 percent. Pending home sales slowed, the number of new home sales fell by 5 percent, and sales of existing homes shrank by 5.7 percent in December. Residential renovations also slowed as a result of increased interest rates. More ominously, housing inventories were at their highest level in ten years. Although jobless claims were at the lowest rate in six years, that happy situation would change dramatically in future months. Banks continued to expand their business. Regulators allowed the Bank of America and PNC to build hotel and office properties, further exposing them to the vagaries of the real estate markets. Nevertheless, the banks had some good results to show for the fourth quarter of 2005. Citigroup posted a 30 percent gain, mostly as the result of a sale of an asset management group. Charles Prince, the Citigroup CEO, was rewarded with the additional title of chairman in anticipation of the retirement of Sandy Weil. UBS earnings tripled, but they too were boosted by a sale of assets. Wachovia, Wells Fargo, US Bancorp, and Fifth Third Bancorp all reported increased earnings. However, Bank of America reported its first loss since 2001, as the result of trading losses and increased consumer bankruptcies. Barclays’s net rose by 5.9 percent, but it announced that its bad debt charges had increased by 44 percent. On an unrelated note, Bill Miller at Legg Mason Value Trust Fund beat the S&P 500 for the fifteenth straight year in 2005, but that streak was about to end.

More Interest Rate Increases

As 2006 began, the Wall Street Journal predicted that, despite a softening of the housing market, the economy should continue to grow. In the first two

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 424 The Growth of the Mortgage Market weeks of January the bond market thrived with issues valued at some $50 billion. The Fed signaled that it was less concerned about inflation, which gave rise to a rally in the stock market. On January 6, 2006, the S&P 500 index was at a four-and-a-half-year high. The Dow Jones Industrial Average closed above 11000 on January 9, 2006, for the first time since June 2001. The market showed some volatility. The Dow dropped to 10667.39 on January 20 as a result of concerns over relations with Iran and energy prices, which were rising. Oil prices were high, but financial analysts predicted that crude oil would stabilize at about $60 per barrel. However, some contrarians forecast that prices could go as high as $100 per barrel. By February 2006 crude oil was trading in the range of $65 per barrel. The unemployment rate was at 4.7 percent, and retail sales jumped sharply in that month. Personal income and spending both increased during January, and auto sales were up. The NASDAQ market reached a five-year high on March 29, 2006. The Dow reached a six-year high on April 20, 2006, climbing to 11342.89. Public companies bought their own stock in record amounts. In the one-year period ending March 31, 2006, such purchases totaled $367 billion, enough to pay for the Medicare budget. Those purchases were useful in boosting per share income and causing a rise in the company’s stock to the benefit of those executives holding stock options. Housing starts jumped by 14.5 percent in January 2006, but that was considered a seasonal aberration, as was an increase in existing home sales in February. More telling, sales of new homes fell by 10.5 percent in February. That was the largest decline in new home sales in nine years. One large builder, Toll Brothers, reported a 29 percent drop in new orders, and its home inventories were increasing. Another national home builder, KB Homes, which had been in the business for more than fifty years, reported a sharp increase in order cancellations and a decline in new orders. A report published in February 2006 criticized Fannie Mae for falling short of its subprime lending targets. However, subprime lenders like Countrywide Financial Group, one of the largest subprime lenders, were experiencing a sharp decline in loan applications as interest rates rose. As one Countrywide employee put it: “We knew that showing a compellingly low rate was the most powerful motivator for a prospect to respond. Duh,” and when interest rates increased “we saw all call volume precipitously drop.”11 Nevertheless, more than 20 percent of residential mortgages written in 2006 were subprime. As a Fed official testified before Congress in March 2007, “the subprime sector grew rapidly over the past three years and accounted for an outsized share of originations in 2006. The roots of this increase can be traced back to the low levels of market interest rates that existed in the early part of this decade which, in turn, spurred significant volumes of mortgage refinancing, as well as new originations.”12 The originations in 2006 were garnered in many instances by reduced credit quality. The Fed’s longest-serving chairman, Greenspan announced in October 2005 that he was leaving at the end of his term in January 2006, which he did. After

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. Prelude to a Crisis 425 a reign lasting for eighteen years under four presidents, he retired at the top of his game, achieving legendary status as Fed chairman and reverential treatment by much of the world as the leading guru on financial matters. In retirement, Greenspan became a pundit on all matters economic. Even though he was a Republican, Greenspan’s autobiography attacked the deficit spending of the George W. Bush administration, drawing headlines in the press. However, the subprime crisis shattered Greenspan’s reputation, as he was blamed for not curtailing the housing market before it turned into a bubble.

Changing of the Guard

Ben Bernanke succeeded Greenspan as the Fed chairman on February 1, 2006. He was an economics professor from Princeton University, where he had displayed an intense interest in the economics of the Great Depression, background that would prove useful during his tenure at the Fed. Bernanke had previously served on the Fed’s Board of Governors. At the time of his appointment to the Fed, Bernanke was serving as the chairman of the president’s Council of Economic Advisers. Greenspan used his last meeting at the Fed to raise interest rates once again. It was then clear that the Greenspan interest rate increases crippled the real estate market, but his successor would have to finish the job. The hope that it would be “one and done” for Bernanke, meaning that he would raise interest rates one more time and then pause, was not realized.13 Bernanke continued Greenspan’s attack on the real estate market with three more consecutive interest rate increases. The Wall Street Journal published a front-page report in the first week of March 2006 describing how the property management business was gearing up for an increase in home foreclosures. That newspaper warned on March 11 that homeowners faced higher mortgage payments as the low rates in their adjustable mortgages reset. Home-equity borrowing also slowed with the rise in interest rates. Bernanke shrugged off those concerns, but warned Congress on March 14 that federal budget deficits were too large and should be reduced. The budget deficit was declining in 2006 but was expected to expand in 2007 and would explode in the wake of the subprime crisis. Bernanke also opined in March that short-term rates might have to be held to a lower level if a glut of long-term savings pushed down long-term rates any further. Undeterred by the increasingly alarming signals that the housing market was broken, Bernanke announced another rate increase on March 28, 2006, pushing short-term rates to 4.75 percent.

First-Quarter Results

First-quarter results for financial firms were strong. Lehman Brothers reported record results. Profits at Bear Stearns rose by 36 percent, and those for

Morgan Stanley were up 17 percent. Citigroup, Wachovia, and Wells Fargo all had good results. Citigroup had other purportedly good news. Corporate governance firms publicly announced in March that it had improved its regulatory controls. The Fed also allowed Citigroup to renew acquisitions in April 2006, removing a restriction that it had imposed as a result of Citigroup’s involvement in the Enron-era scandals. Bank of America’s profits were up 14 percent, and JPMorgan’s net income rose by 36 percent. SunTrust reported higher profits, but warned that it would face problems in its loan portfolio in the future. Washington Mutual (WaMu) had a good quarter, and it purchased Commercial Capital for $983 million in April 2006. S&P 500 companies bought more than $100 billion of their own stock in the first quarter of 2006. Corporate profits were up overall, but auto sales were dropping. Office vacancies were at their lowest level in five years. Payrolls jumped sharply in March. Existing home sales increased in that month, and consumer confidence was at a four-year high. Although home prices increased by only 2 percent on an annual basis in March, the slowest rate of growth in two years, the U.S. economy grew at an annual rate of 4.8 percent in the first quarter. This largely rosy picture carried over into April, as retail sales rose. Tax receipts were up by 13.5 percent, mostly as a result of increased tax payments by the wealthy. However, the auto industry was clearly in a slump. GM sales dropped by more than 10 percent in April 2006. There was other uncertainty in the air. Gold prices rose to more than $600 per ounce in April, and crude oil traded at $70 per barrel. Florida home sales were noticeably cooling, and foreclosures around the country were increasing. The Dow Jones Industrial Average hit a six-year high on May 2, 2006, reaching 11416.45. Gold traded at $700 per ounce on May 10, 2006. The Dow closed at 11639.77 that day. Brokerage firm stock prices were rising rapidly, and insiders were cashing in on that upswing, which, in retrospect, turned out to be a provident thing for them.

Paulson Arrives

The Bush administration allowed the dollar to decline in value against the euro and other currencies in the hope that this would make U.S. products cheaper abroad and thereby help shrink a ballooning trade deficit. That strategy was not immediately successful. The Fed made its fifteenth straight interest rate increase in March, and Bernanke suggested that more would be forthcoming. However, in mid-April the Fed signaled that it was considering a pause on further interest rate increases. Nevertheless, a sixteenth straight rate increase was announced on May 10, 2006, pushing short-term rates to 5 percent. Minutes from the Fed meeting on May 10 showed some uncertainty over how long the rate increases should continue. Fed members seemed to be balanced between a pause and further increases. Bernanke then signaled that the

Fed might pause in increasing rates, but that statement turned out to be a head fake. Because of continuing concerns over inflation, the Fed raised interest rates for the seventeenth consecutive time on June 29, 2006, pushing short- term rates to 5.25 percent. By then, short-term interest rates were higher than long-term rates. This was troubling, since an analysis by the Federal Reserve Bank of San Francisco in 2003 had found that all of the previous six recessions were preceded by an inverted yield curve. Bernanke discounted the possibility that the interest rate inversion signaled a recession because both long- and short-term rates were relatively lower than had been the case in prior recessions. An inverted or flat yield curve posed other concerns because it would place stress on institutions that borrowed short term and lent long term in “carry trades.” Compounding the situation was the return to the market of the thirty-year “long” Treasury bond in February 2006. In May 2006, President Bush appointed Henry M. Paulson, Jr., to serve as his treasury secretary, succeeding John Snow. Paulson had been the CEO and chairman of Goldman Sachs, where political correctness on splitting those two roles did not reign.14 Lloyd Blankfein followed Paulson as Goldman’s CEO and chairman. Blankfein would play a prominent role during the subprime crisis. Paulson was paid $29.8 million at Goldman in 2004, but his personal fortune from Goldman stock was rumored to be as much as $700 million. As a result of government conflict of interest rules, Paulson sold his remaining Goldman stock at $485 million for $142 per share when he became secretary. Government regulations provided a tax break for such sales, saving Paulson some $100 million in taxes. Paulson had been an All-Ivy, All-East linemen at Dartmouth and was a graduate of the Harvard Business School. He served on the White House Domestic Council and as a staff assistant to President Richard Nixon. He had also served at the Defense Department as a staff assistant. Paulson worked his way up through the ranks at Goldman Sachs and played a key role in ousting NYSE head Richard Grasso, turning that institution into a mostly electronic market.

Interest Rate Effects

The subprime market, which was boiling in 2005, continued to percolate in 2006, centered in California. More than 600,000 subprime loans were originated in that state in each of those years, nearly 25 percent of all subprime originations during that period. Delinquency rates rose in May 2006 for home mortgages issued a year earlier, a harbinger of a decline in credit quality. However, housing starts rose 5 percent in May over those in April. Home prices rose by 1.17 percent in the second quarter of 2006, but housing inventories hit a nine-year high in June, and pending new home sales dropped in both June and July. The overall economy was still strong, with an unemployment rate in June 2006 of only 4.6 percent. However, a consensus

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 428 The Growth of the Mortgage Market of economists expressed concern that the Fed would raise rates too much and send the country into a recession. Inflation concerns remained, due in part to crude oil prices, which exceeded $72 per barrel in the first week of June. Wheat and corn prices were also up. Wages were rising, but payroll growth had slowed. Toll Brothers orders for residential housing fell by 47 percent in the second quarter, and it reported a 19 percent decline in earnings. Fannie Mae had some good news: The Justice Department concluded a criminal investigation of its accounting manipulations without filing charges. However, the Bush administration sought, unsuccessfully, greater regulation for both Fannie Mae and Freddie Mac. Large public companies bought $116 billion of their own shares in the second quarter. Overall corporate profits were up in that quarter by 3.2 percent over the previous quarter and 20.5 percent over the previous year. Investment and commercial banks had a banner quarter: Bank of America posted an 18 percent increase in net income, JPMorgan Chase tripled its earnings, Lehman Broth- ers’ earnings increased by 47 percent, Goldman Sachs and Morgan Stanley doubled their earnings, and Bear Stearns had a record profit of $539 million. Citigroup’s net was up 3.8 percent, with profits of $5.27 billion, but it was struggling and was pushed out of its position as the world’s largest bank by HSBC. Citigroup CEO Charles Prince rejected a cost-cutting program even though such discipline was needed to boost the bank’s lagging share price. The amalgamation of financial services at Citigroup had proved a regulatory disaster for the bank. Starting with Enron and the financial analyst scandals, and before plunging into the subprime crisis, Citigroup had been forced to pay billions of dollars in fines and settlements.

Third Quarter

In the second week of July 2006 the stock market began experiencing volatility, attributed to confusion over the Fed’s interest rate policies and outlook on inflation. On July 19, Fed chairman Bernanke stated that an ongoing economic slowdown should cool inflation and cause the stock market to rise. This was perceived as a signal that the Fed would slow its interest rate increases. By August, ten of the twelve federal reserve banks were opposed to any further interest rate increases. Inflation was still a concern, but later evidence revealed that the rate of inflation was slowing. Hiring weakened in July, but retail sales were strong. Consumer spending rose that month, but housing starts were down almost 20 percent over the same period the previous year. Sales of existing houses fell by 11.2 percent in July. Sales of new homes were also down. Housing inventories rose by 4.7 percent in August, and the number of existing home sales declined again in August. Median home prices also fell for the first time since 1995.

Japan raised its discount rate from 0.00 percent to 0.25 percent, which seemed to signal a recovery in that country after a decades-long recession. The European Central Bank (ECB) and the Bank of England also raised interest rates 0.25 percent in August. However, the Fed left rates unchanged in a close vote among the governors at its meeting on August 8, 2006. This was its first pause in raising interest rates in over two years.

The First Cracks Appear

The Dow Rises

The Fed left interest rates alone once again at its meeting on September 20, 2006. Short-term rates remained at 5.25 percent. The jobless rate fell to 4.4 percent in September 2006. On October 3, the Dow Jones Industrial Average set a new record, at 11727.34. Bank regulators tightened restrictions on low- down-payment mortgages in September. Those mortgages resulted in increased costs to the borrower at later periods of repayment. Bernanke finally seemed to awaken to the problems in the housing market in the first week of October 2006, when he warned that declines in that market could affect overall growth. Economic signals were inconsistent, however. The budget deficit narrowed in October, and the Dow closed above 12000 on October 19, 2006. JPMorgan reported that its net rose by 30 percent in the third quarter. However, WaMu, the giant mortgage lender, had a 9 percent decline in earnings in that quarter, while Citigroup had a 23 percent drop. Citigroup issued a profit warning on October 1 related to writedowns for securities backed by subprime mortgages and loans tied to corporate takeovers. UBS, the largest bank in Europe, also warned of an unexpected loss in the third quarter because of a $3.42 billion writedown on mortgage-backed securities. Still concerned with inflation, Bernanke held interest rates steady at 5.25 percent at the Fed’s October 25, 2006, meeting. The Fed also announced that it was placing a stronger focus on the housing market, predicting a severe slowdown in that sector. Even so, it seemed tone-deaf to the possibility of a severe crisis approaching. Construction slowed by 14.6 percent in October. Home sales fell by 3.2 percent over the previous month, 25.4 percent lower year on year. Toll Brothers experienced a 56 percent drop in orders in the third quarter of 2006, and completed sales declined by 10 percent. A Wall Street Journal survey of economists in November 2006 produced a consensus estimate that, while the worst of the housing slump had passed, housing prices would continue to decline. This seemed to refocus the Fed on inflation. Bernanke announced on November 28, 2006, that inflation was “uncomfortably high” and that the Fed’s bias was to raise, rather than lower, interest rates. As it turned out, the Fed’s concerns over inflation were inflated, and that concern stopped it from taking the drastic action needed to halt the slide in the housing market.

False Hopes

New home sales rose by 3.4 percent in November, and existing home sales increased, leading to further predictions that the housing slump was over. Mortgage applications increased between August and December 2006, but the number of listings for homes in eighteen major metropolitan areas declined in December. Although delinquencies on subprime loans were at their highest level in ten years as December 2006 began, a Wall Street Journal survey of economists concluded that those delinquencies should cause no significant damage to the financial structure. The Fed rejected rising demands for an interest rate cut, announcing that the economy was in better shape than it had been in 2002, when it began slashing rates. The Fed decided to leave rates as they were at its meeting on December 12, 2006, stating that it was still concerned with inflation. Some institutions tried to reduce their exposure to the mortgage market. ABN Amro hired Lehman Brothers to sell its mortgage lending assets. The severity of the downturn in the market was becoming more apparent. Two subprime lenders failed in December, and KB Homes announced an asset write-off of as much as $285 million that month. Adding to KB Homes’ problems was an investigation by the Securities and Exchange Commission (SEC) over options backdating. Profits at financial institutions were good for all of 2006. Goldman Sachs set a Wall Street record after its net for the year rose by 93 percent. Bear Stearns’s profits rose 38 percent for the year. Lehman Brothers’ profits were up 22 percent. Its CEO, Richard Fuld, was given a ten-year compensation package valued at $186 million in company stock. The firm’s top three executives made $92.3 million in 2006. Both Lehman Brothers and Bear Stearns would fail during the subprime crisis. Bank of America had a good year, and its CEO, Kenneth Lewis, was paid $27.9 million plus $77 million in stock options. At the time it would have been hard to imagine that the bank would be facing failure during the impending subprime crisis and that Lewis would become a widely reviled executive. Revenues at Citigroup for the fourth quarter of 2006 set a record, up 15 percent to $23.8 billion. It bought back $1 billion worth of stock in the fourth quarter and $7 billion for the full year and paid out $9.8 billion in dividends as well as announcing a 10 percent increase in dividends after its fourth-quarter results were posted, though these turned out to be false profits. American International Group (AIG), the world’s largest insurance company, posted fourth-quarter earnings nearly eight times higher than those for the previous year. AIG then announced plans to repurchase $5 billion of its common shares during 2007 and to increase its dividend by 20 percent. AIG profits were up a spectacular 700 percent in 2006 over the previous year. Nothing indicted that AIG would have to be rescued by the federal government when the subprime crisis peaked because of concern that its failure would undermine the entire U.S. economy.

In December 2006, Fannie Mae restated its earnings, cutting them by $6.3 billion, and its income fell 36 percent over the previous year. Freddie Mac reported an earnings increase of 3.8 percent in 2006 compared with 2005. A Wall Street Journal article asserted that it could profit from the burgeoning turmoil in the subprime markets. Actually, both Fannie Mae and Freddie Mac would fail as a result of their subprime exposures. Goldman Sachs had been a major underwriter of subprime mortgage securities, but in December 2006, its CFO, David Viniar, pushed the firm toward a negative position on those securities. Viniar ordered Goldman traders to sell 10 percent of their positions, which were somewhat illiquid, in order to value them for the purpose of hedging their risks. He also had the firm cancel further underwritings, sell inventory, and go short on subprime securities. Those acts saved Goldman Sachs from massive losses, or worse, in the subprime crisis.15 Existing home sales dropped by 8.4 percent during 2006, the worst record in seventeen years. However, average income in United States grew in 2006 for the first time in six years. Average adjusted gross income was then just over $58,000. The average tax rate of the richest 1 percent of Americans in 2006 declined, and that group increased its share of adjusted gross income.

The New Year—2007

Mixed Signals

Yet another survey of economists by the Wall Street Journal, this time on Janu- ary 2, 2007, found a consensus that the United States was about to shake off the ongoing housing slump. Treasury Secretary Paulson stated a few weeks later that the housing market appeared to have stabilized. Although minutes from the previous Fed meeting expressed doubt about the strength of the economy, a Fed official stated that inflation remained a concern and that no rate cuts should be expected. The Fed was then in the midst of a debate over whether it should have a “hard” or a “soft” inflation target. At its next meeting, on Janu- ary 31, 2007, it decided to leave rates unchanged, at 5.25 percent. There was, however, good news on the inflation front. Crude oil prices declined to $56.31 a barrel on January 5, 2007, and to $50.48 a few days later. Oil consumption actually slowed in developed countries during 2006. The bond market signaled concern over subprime defaults, and it was right to do so. Mortgage lender share prices were falling rapidly as subprime mortgage defaults increased. The market value of the seven biggest mortgage lenders fell by $3.7 billion. The Independent National Mortgage Corporation, universally known as IndyMac, the largest savings and loan association in the Los Angeles area and seventh-largest mortgage originator in the United States, issued a profit warning in January 2007. Centex, a home builder, also issued a profit warning. Toll Brothers, the giant luxury home builder, saw its

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 432 The Growth of the Mortgage Market orders shrink by 33 percent in January 2007, and it experienced a 67 percent decline in profits. Mortgage delinquencies rose to a five-year high in January 2007. Hous- ing starts fell 14.3 percent in January over those in December 2006. Defaults on piggyback mortgages—which allowed the borrower to borrow the down payment for the house—had increased, and some lenders curbed their offerings for such loans. Commercial banks and investment bankers dumped their mortgage investments as delinquencies continued to increase. However, bank reserves for bad loans were at the lowest level since 1990. Zions Banccorporation, which operated in several Western states, purchased $840 million in off-balance-sheet investments held by an affiliate, an action necessitated by a “liquidity agreement” requiring Zions to purchase those securities if they became nonperforming. The securities were mortgage-backed and appeared to be part of an asset-backed commercial paper (ABCP) program. The affiliate was unable to raise money in the commercial paper market to support those investments. The Dow Jones Industrial Average closed at a record of 12741.86 on Febru- ary 14, 2007, but the dollar continued to weaken. The stock market also took a hit in the last week of February 2007, when vacant homes for sale reached a forty-year high, at 2.7 percent of all homes. Freddie Mac announced at the end of February that it was curbing its subprime purchases. HSBC Holdings disclosed that it was reserving $1.76 billion for bad debts associated with subprime mortgage lending, much more than HSBC’s original estimates. The report heightened concerns over the subprime market. The U.S. mortgage unit of HSBC experienced a 5.26 percent delinquency rate for the first quarter of 2007 and subsequently appointed a new head for its U.S. subprime business. Share prices for subprime lenders continued to drop sharply. H&R Block was among those facing large losses from subprime loans. Bank and other regulators began to crack down on loose subprime lending practices. Among others, Beazer Homes was under investigation for its mortgage lending practices. John Paulson, a hedge fund manager, doubled the value of $1 billion in investments that shorted the subprime market in the first quarter. That bet would become the basis for a sensational suit brought by the government against Goldman Sachs that is described in Chapter 7.

New Century Financial

New Century Financial Corporation, headquartered in Irvine, California, faced bankruptcy in March 2007. The nation’s second-largest subprime mortgage lender, it was experiencing a large number of defaults. Its lenders cut off further funding, and the company filed for bankruptcy in April 2007. New Century was also under criminal investigation. The company originated over $56 billion in mortgages in 2005 alone. After its failure, Ellington, a hedge fund, purchased New Century’s mortgage portfolio for a mere $58 million.

The New York Times accused New Century’s auditor, KPMG, of failing to detect the company’s problems before the bankruptcy. The State of California audited New Century in August 2006 and found no problems, even though the company declared bankruptcy just seven months later. An “independent” report on KPMG’s role as auditor of New Century was commissioned in connection with the firm’s bankruptcy proceedings and was made public in March 2008. The conclusions in the report were predictable because the “independent” examiner preparing the report was Michael J. Missal, formerly an attorney in the SEC’s enforcement division, who had been involved in the WorldCom investigation. Missal compared KPMG’s auditing practices with those of Arthur Andersen in the Enron debacle. A bankruptcy examiner also charged that KPMG had aided New Century in manipulating its accounts, and the examiner urged investors to sue the accounting firm. New Century’s trustee did sue KPMG in April 2009. The trustee claimed that the accounting firm had been grossly negligent in its audit and that a super- vising partner had rejected warnings from a subordinate regarding the fact that New Century was not properly accounting for its operations. By then, accounting manipulations were so common as to be unremarkable, and the scandal was not heavily covered in the press. In December 2009, over two and a half years after the company became bankrupt, the SEC filed suit against New Century and three of its executives. The SEC charged that the defendants had publicly touted New Century’s “responsible” lending practices, which were actually irresponsible, and claimed that the company was outperforming its peers. However, the defendants had received dire warnings in September 2006, through internal “Storm Watch” reports, that New Century’s mortgage portfolio was deteriorating sharply in value. The defendants were also charged with overstating the company’s revenues. Morgan Stanley agreed to pay the State of Massachusetts $102 million to settle charges that it loaned money to New Century that was used to provide mortgages to unqualified borrowers. Morgan Stanley then securitized those loans and sold them to investors who sustained significant losses.

More Losses

The inventory of foreclosed homes grew, and banks tightened their lending standards for subprime loans. On March 22, 2007, KB Homes announced an 84 percent decline in earnings. Countrywide Financial Group and IndyMac also suffered sharp declines in their first-quarter earnings. Washington Mutual had a first-quarter decrease in earnings of 20 percent as a result of subprime losses. Home Depot’s net income dropped 30 percent in the quarter, attributed to the slumping housing market. Citigroup, already under criticism for a drop in profits due to higher expenses, appeared to have growing problems. The firm’s first-quarter earnings fell 11 percent as the result of a $1 billion charge to cover a massive, but belated, restructuring that sought to cut costs and increase earnings. The restructuring

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 434 The Growth of the Mortgage Market included the elimination of 17,000 jobs. Edward Lampert’s hedge fund bought a cumulative $800 million in Citigroup stock, possibly signaling an attack on management, but it turned into a very bad investment. Wells Fargo’s net was up 11 percent for the quarter. JPMorgan was up 55 percent, while Bank of America experienced a much more modest increase of 5.4 percent. Lehman Brothers’ profits rose 27 percent, but that firm announced that it was issuing $3 billion of preferred shares in order to shore up its capital position. That announcement seemed out of line with Lehman’s profit reports, and turned out to be a first warning that Lehman might have some large exposures on its books. Global mergers in the first quarter of 2007 were valued at $1.1 trillion, a record, of which mergers and acquisitions in the United States comprised $439 billion. The unemployment rate fell to 4.4 percent in March, the lowest level in six years. Personal income was also up, but the housing market continued its slump. Existing home sales shrank 8.4 percent in March, the largest monthly decline since 1989. In April, new building permits dropped to their lowest level in almost ten years. Productivity, manufacturing, and service-sector growth weakened. The U.S. economy grew at an annual rate of only 1.3 percent in the first quarter, the lowest rate in four years. The Fed reported on March 5, 2007, that liquidity was not in short supply, but its earlier interest rate changes laid the groundwork for another financial crisis. Home sales and new residential construction had slowed dramatically, and the housing market became glutted with unsold homes. Toll Brothers continued to cut back its construction programs, as that company experienced its worst slump in forty years. Toll Brothers announced a first-quarter drop in revenue of 19 percent and a reduction in orders of 24 percent. At its meeting on March 21, 2007, the Fed left the Fed fund rate unchanged. Bernanke was increasingly criticized for placing too much emphasis on inflation expectations. The Fed shrugged off those critics; citing concern over inflation, it indicated that another rate increase might be in order in future months. A Fed official again warned of inflation risks in April. A survey of economists in March 2007 reflected a consensus view that despite subprime concerns no recession would develop. Another study undertaken in March forecast that 1.1 million foreclosures would occur over the next year as a result of ARM resets, but predicted that this would not damage the economy.

On to the Second Quarter

The Dow Jones Industrial Average set a new record on April 4, 2007, and exceeded 13000 for the first time on April 26, 2007. But bad news continued to trickle out. Same-store sales (those that had been in operation for at least one year) were falling. Wal-Mart had its steepest-ever decline in such sales. Consumer spending also declined. New home sales increased in April 2007 because of discounts, but existing home sales declined, and inventory was at

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. Prelude to a Crisis 435 a fifteen-year high. KB Homes reported a $148.7 million loss in the second quarter. Speculators holding properties found that they could no longer flip them for an assured profit, as had been the case while the housing market bubble was growing. In Naples, Florida, one of the hottest markets during the boom, one speculator tried to sell her portfolio of properties through an auction held at a local hotel, without much success. The number of foreclosures hit a record high in Collier County, Florida, which included Naples and its environs. The nearby Ft. Myers/Cape Coral area had the highest rate of mortgage foreclosures in the country as the second quarter of 2007 began, reaching 24.1 percent. The New York City area had an 11.6 percent foreclosure rate for subprime mortgages. Another national leader in the number of foreclosures was Stockton, California, where one in seventy-five homes was in foreclosure. “Short” sales, in which a foreclosed home is sold for less than the amount of its outstanding mortgage, became common as homeowners found themselves unable to meet their payments due to the rising interest rates. The slump spread to condominiums and private residences that had been bought by speculators in anticipation of rising prices. Many speculators who bought preconstruction units sought to renegotiate with builders in order to avoid their purchase price obligations, which were at prices well above the present market value of the property under contract. Moody’s downgraded more than 30 highly rated subprime offerings in May 2007 and subsequently another 131 downgrades in June. This raised a concern as to why so many highly rated securities were downgraded so quickly. Had they been correctly rated in the first place? Whatever the answer to those questions, this was only the beginning of a mass of downgrades for subprime- related securitizations. ACC Capital Holding (ACCH), a California institution that created one of the largest subprime lenders, was in trouble and would fail. Roland Arnall, the founder of ACCH, became U.S. ambassador to the Netherlands under the administration of George W. Bush. His family had escaped the Holocaust during World War II and immigrated to the United States, where Arnall began his career selling flowers on the street. Arnall founded the Long Beach Savings & Loan in 1979, which entered the business of selling subprime mortgages to Wall Street investment banks in the 1990s for securitization. Long Beach surrendered its federal S&L charter in 1994 to become a private mortgage lender. In 1997, Long Beach split itself into Ameriquest Mortgage Company, a private company owned by ACCH, and a publicly traded subsidiary, Long Beach Mortgage Company. The latter was bought by Washington Mutual in 1999 and became the basis for Washington Mutual’s subprime operations. ACCH owned Argent Mortgage in addition to Ameriquest, one of the nation’s largest subprime lenders. Ameriquest spread its operations nationwide through television advertisements that featured the slogan: “Proud Sponsor of

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 436 The Growth of the Mortgage Market the American Dream.” Like Enron, Ameriquest had a baseball stadium named after itself—the Texas Rangers stadium—and even sponsored the halftime show at the Super Bowl in 2005. The firm was also somewhat infamous for the $325 million it paid to settle predatory lending charges. Ameriquest was among the first of the subprime lenders to experience the effects of the downturn in the subprime mortgage market. It announced in May 2006 that it was cutting 3,800 jobs and closing its 229 branch offices as a result of the downturn in real estate sales and increased interest rates. On September 10, 2007, Ameriquest stopped making loans entirely. To its regret, Citigroup bought what was left of ACCH’s assets, renaming those operations Citi Residential Lending, a company that lasted only a few months before it was shut down with significant losses. The Fed left interest rates unchanged at 5.25 percent at its meeting on May 9, 2007, and again expressed concern over inflation. It seemed oblivious to the effects of rising interest rates on the housing market and perhaps was blinded by other favorable data. Consumer confidence was up despite the housing slump. The number of new jobs added in May doubled over that in the previous month. Still, news from the housing sector continued to be negative. Housing starts fell by 24.2 percent in May over a year earlier. The number of houses for sale rose 5 percent, and new home sales declined by 1.6 percent over the level in April. Housing prices fell once again in the second quarter. The next month was no better. New home listings rose in June 2007, while existing home sales fell by 3.8 percent. The economy grew at an annual rate of 4 percent in the second quarter of 2007, and the Fed reported that the economy was stronger than it looked. The stock market dropped after Bernanke stated on June 5, 2007, that he was still worried about inflation. He warned, incorrectly as it turned out, that the burgeoning problems in the subprime market were unlikely to spill over into the broader economy or the financial system. Unemployment was still a low 4.5 percent in June 2007, and retail sales were up. The Fed left rates unchanged at its meeting on June 28, 2007, and appeared to reject any rate cuts in the immediate future. Yields on five-year Treasury securities reached a five-year high in June 2007. Some investment banks had a banner second quarter. JPMorgan’s net rose by 20 percent, Bank of America experienced a 5.2 percent rise, Citigroup was up 18 percent, and Morgan Stanley announced a 40 percent increase in profits for the second quarter. UBS reshuffled its management as it warned of large losses. IndyMac experienced a 51 percent decline in earnings. Although economists predicted that the housing slump would continue at least until the end of the year, IndyMac optimistically hired more than 600 employees in order to increase its mortgage lending. Despite a loss by Freddie Mac of $211 million in the second quarter, Fan- nie Mae and Freddie Mac announced the creation of a program for delinquent subprime borrowers that would allow them to avoid foreclosures. Oblivious

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. Prelude to a Crisis 437 to the gathering storm, these government-sponsored enterprises (GSEs) also stated that they would be buying billions of dollars in prime loans in order to support the mortgage market. James B. Lockhart III, director of the Office of Federal Housing Enterprise Oversight (OFHEO), which was responsible for the safety and soundness of Fannie Mae and Freddie Mac, classified them as adequately capitalized as of June 30, 2007. However, OFHEO also reported that Fannie Mae and Fred- die Mac’s risk controls were still inadequate and that a number of safety and soundness issues were not yet resolved. In addition, Fannie Mae was not yet current in filing its financial reports, and significant work remained before Freddie Mac could become a timely filer of financial statements. Although OFHEO appeared to be a most gentle regulator, Freddie Mac president Eugene McQuade turned down the post of CEO at that GSE because of what he called onerous regulatory oversight. Other regulators seemed to be awakening to the fact that the subprime mortgage market might be in a meltdown and issued guidelines for strengthening subprime underwriting standards. The Office of Thrift Supervision also explored the possibility of imposing restrictions on predatory lending practices.

Bear Stearns—The Struggle Begins

Bear Stearns was a Wall Street icon, known for its aggressive trading and investment bank activities. Joseph Bear, Robert Stearns, and Harold Mayer founded the firm as a partnership in 1923. Bear Stearns initially dealt in equities but soon expanded into government securities. The firm prospered in the 1920s and was able to survive the Great Depression without discharging any employees. It survived by selling New Deal–era government bonds to banks that had large amounts of accumulated cash and no safe place to put it. Salim “Cy” Lewis was hired in 1933 to direct Bear Stearns’s institutional bond business. Lewis became a partner five years later and rose to lead the firm in the 1950s. His aggressive style established the culture of the firm, which had a highly competitive culture of “PSDs”: “poor,” “smart” traders with a “desire” to get rich. Another forceful leader arrived at the firm in the form of Alan “Ace” Greenberg, who became chairman of Bear Stearns in 1978. Green- berg started out at the firm as a clerk, and, true to the culture of Bear Stearns, he became renowned for his aggressive trading style. Under Greenberg, Bear Stearns grew rapidly and expanded its activities into nearly every niche of investment banking, and it became a public company in 1985. James E. Cayne succeeded Greenberg as CEO in 1993, but Greenberg remained chairman until 2001. They guided the firm through some turbulent years and through a scandal involving their clearing business for small broker- dealers. One of its customers, A.R. Baron, a small broker-dealer, declared bankruptcy in 1996 after defrauding its customers of $75 million. Courts had

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 438 The Growth of the Mortgage Market generally ruled that clearing firms, such as Bear Stearns, were not responsible for the fraud of introducing brokers, like Baron, for which they cleared. However, the government charged that Bear Stearns had received numerous warning signals of widespread fraud at Baron, and Bear Stearns agreed to pay the SEC and the Justice Department $42 million to settle charges relating to its clearing activities for that firm. In another case, Bear Stearns was able to convince an appeals court to set aside a $164 million jury award for damages claimed by a wealthy currency trader, Henryk de Kwiatkowski. He had traded through an account at Bear Stearns and made profits of over $200 million in 1994–95, before he made a series of bad trades that resulted in net losses of $215 million. De Kwiat- kowski claimed that Bear Stearns had provided bad advice, but the appeals court ruled that he was a sophisticated trader and was responsible for his own trading decisions.16 After the market slump at the beginning of this century, Bear Stearns laid off about 7 percent of its staff. Jamie Dimon, the CEO at Bank One in Chicago, sought to acquire Bear Stearns on favorable terms, but that offer was rejected. Bear Stearns was looking for its own business opportunities and instead became a large player in the prime brokerage business of servicing hedge funds by providing them with financing, stock borrowing for short-selling operations, and custody arrangements, as well as clearing their trades. Bear Stearns was also an early participant in the subprime mortgage market. It created EMC Mortgage in the 1990s to act as its own subprime lender. Initially, that firm bought mortgages from the Resolution Trust Corporation, the government entity that was selling off assets from failed S&Ls after the crisis in that market in the 1980s. As that business tapered off in the mid- 1990s, ECM switched to subprime lending originations. Initially it used loan brokers to originate the loans, but it later began purchasing subprime loans from nonbank subprime mortgage originators. Bear Stearns was an aggressive participant in this market. In 2008 Bear Stearns and EMC agreed to pay $28 million to settle Federal Trade Commis- sion (FTC) charges that they had engaged in unlawful practices in servicing consumers’ home mortgage loans. Among other things, EMC was claimed to have misrepresented the amounts that borrowers owed and to have charged unauthorized fees, including late fees, property inspection fees, and loan modification fees. The firms were also charged with engaging in abusive collection practices. EMC avoided the worst of the problems that arose during the first subprime crisis in 1998–99. Bear Stearns not only remained in the market but began a massive expansion of its role through securitizations of subprime loans. It also acquired another subprime originator, Encore Credit, a rather strange investment to make because Encore had been selling to Bear Stearns mortgages of low quality, many of which Bear Stearns returned. In all events, the mortgage business at Bear Stearns reported massive profits in 2006. Bear Stearns’s profits

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. Prelude to a Crisis 439 rose by 36 percent in the first quarter of 2006 and had a record profit of $539 million in the second quarter, with overall profits up by 38 percent year on year. That happy situation changed with the subprime crisis. Bear Stearns reported an 8 percent gain in revenues in the first quarter of 2007, but advised that earnings had been hurt by losses from subprime exposures. In June 2007, Bear Stearns experienced severe problems with two of its hedge funds invested in subprime loans. One of these hedge funds bought highly rated long-term collateralized debt obligations (CDOs) that it funded with short-term borrowings in the repurchase (repo) market, profiting from the yield spreads. That fund was profitable for forty consecutive months, and a second fund was created that used similar strategies. Problems surfaced after some other hedge funds accused Bear Stearns of manipulating the market for subprime loans. The net asset value of the two Bear Stearns hedge funds fell by 23 percent shortly after those accusations were made. The Bear Stearns hedge funds had liquidity problems and tried to sell mortgage-backed instruments worth $4 billion. Those sales underlay the claims that Bear Stearns was trying to manipulate the market in order to increase the value of those instruments. Concerned that the Bear Stearns hedge funds might default, Merrill Lynch grabbed $850 million of Bear Stearns assets (subprime mortgages) that were being held to collateralize its credit obligations to Merrill. In order to stop this run on the hedge funds’ assets, Bear Stearns lent the hedge funds $3.2 billion on June 22, 2007. However, the hedge funds continued to drop in value until they were virtually worthless. On July 17, 2007, Bear Stearns reported that these hedge funds had experienced massive losses. The Bear Stearns High-Grade Structured Credit Fund had lost more than 90 percent of its value, and the Bear Stearns High-Grade Structured Credit Enhanced Leveraged Fund had lost nearly all of its investor capital. Bear Stearns fired Richard Marin, the head of its money management unit. The hedge fund assets remained illiquid. An effort to auction off their mortgage-related assets by JPMorgan was canceled for lack of buyers. Bear Stearns’s Alt-A mortgages (those just above the subprime grade) carried a delinquency rate (i.e., those delinquent more than sixty days) of 15 percent, while the industry average was a much smaller (although still quite significant) 8.4 percent. This disparity suggested a significant lack of quality control on the part of Bear Stearns. The Justice Department indicted two Bear Stearns hedge fund managers, Matthew Tannin and Ralph Cioffi, charging that they had misrepresented their personal investments in the hedge funds to investors in order to bolster investor confidence. Cioffi moved $2 million of the $6 million of his own funds out of one of the hedge funds, without disclosing that fact to investors. He was charged with insider trading as a result of that withdrawal. In an effort to discourage an investor from withdrawing funds, Cioffi also told him that he personally had $8 million invested in the fund. The indictment further charged that the two men had told investors that the funds were invested in low-risk,

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 440 The Growth of the Mortgage Market high-grade debt securities that were mostly AAA- or AA-rated tranches of subprime and other mortgages. Investors were told that they could expect a modest, safe, and steady source of returns with only slightly higher risk than that of a money market fund. Actually, until the subprime crisis such tranches had been highly rated. One of them provided a return of almost 47 percent between 2003 and early 2007, but used a great deal of leverage and some exotic investments to achieve those returns. The government charged that the hedge fund managers had discussed the deteriorating condition of the two hedge funds four days before they told investors that they were quite comfortable with the hedge fund investments. In one e-mail, Cioffi stated that it was either a meltdown situation or was the greatest buying opportunity ever, but that he was leaning toward the meltdown scenario. He also asserted that the subprime market was looking “pretty damn ugly.” In another e-mail, Tannin stated that the subprime market was “toast.” However, the two men discussed the e-mail, brought it to the attention of a supervisor, and concluded that Tannin was wrong. In the end, the government’s prosecution failed, as both were acquitted of all charges by a jury in November 2009. This was a highly embarrassing setback for the government, which had been threatening widespread prosecutions of executives managing subprime portfolios or instruments that caused large losses to investors. James E. Cayne, Bear Stearns’s chairman and CEO, sought to reassure Wall Street that these problems had not damaged the viability of the firm. He pointed out that it had $11.4 billion in cash holdings and had strong credit lines that allowed for longer-term borrowings. Nevertheless, Bear Stearns shares hit a twelve-month low of $106.55 in August 2007. Confidence in the firm was further undermined after Warren Spector, head of stock and bond trading at Bear Stearns and heir apparent to Cayne, was fired. The hedge funds that had collapsed were under his supervision. Nonetheless, he received a $23 million severance package. Bear Stearns was a significant force in the mortgage markets as a trader and underwriter of mortgages and related products. As a result, the subprime crisis had a severe effect on its business. Losses continued to mount, resulting in a third-quarter loss of $854 million—the first quarterly loss in the eighty-four- year history of the firm. Bear Stearns also suffered a loss of its prime brokerage business as a result of concerns over its stability, and it sought outside investors to boost its capital. The firm was on the ropes, and its demise would shake Wall Street to its core.

The Credit Crunch and Private Equity

The first cracks in the private equity market began appearing in June 2007, when Kohlberg Kravis & Roberts (KKR) encountered difficulties in raising financing on the leveraged loan market. Many private equity deals were announced on Mondays, coining the term “Merger Monday.” On Monday, June

25, 2007, however, only seven private equity acquisitions were announced, down from forty-three the previous week and eighty-four deals announced on June 4. Somewhat ominously, Bank of America CEO Kenneth Lewis stated publicly that his bank was turning down private equity deals that it might have previously financed. Those words presaged one of the worst credit crunches ever experienced in the United States. The last major credit crunch occurred between 1989 and 1992. Especially hard-hit during that crunch was commercial real estate lending, a problem that spread to business loans. The credit crunch that began in mid-2007 hit the private equity firms first but soon spread to medium-size business loans and even small businesses. The growing crisis in the real estate market in 2007 caused the banks to tighten credit requirements and cut back on credit, creating a credit crunch for private equity and other businesses. The private equity buyout binge peaked in July 2007 as the credit crunch tightened. Leveraged loans to private equity groups were an early victim of that credit crunch. Banks that were willing to underwrite syndicated loans for billions of dollars shut down much of that lending because of concerns that losses could spread throughout the credit markets. Private equity deals virtually stopped in August 2007 as the credit crunch further tightened. Thomson Learning was sold to Apax Partners and the Ontario employees pension fund for $7.75 billion, but Apax had to scale back its bond sales to finance that acquisition, in the face of a declining appetite for such offerings and rising interest rates. They also had to eliminate a “pay-in-kind” provision that had been used in the KKR takeover of RJR Nabisco and which allowed interest to be paid in cash or bonds. Another effect of the credit crunch was to disrupt closings of acquisitions agreed to before the credit crunch. Cerberus Capital Management walked away from a $6.6 billion takeover of United Rentals, an equipment leasing company; a suit against Cerberus over that failed transaction was dismissed. Cerberus also took a pounding from large investments in Chrysler and GMAC, the auto financing arm of General Motors. Its $7.4 billion investment in Chrysler in 2007 was worth only $1.4 billion as 2008 ended. In another aborted deal, KKR and Goldman Sachs backed out of an agreement to purchase Harman International for $8 billion because of a material adverse change in the market that could be used to invoke a walk-away clause in the purchase agreement: Harman’s business was deteriorating. Previously walking away from a deal was practically unheard of on Wall Street, but the credit crunch had changed the rules. The breakup fee for the transaction was $225 million plus expenses, a total of $400 million. Thomas H. Lee Partners and Bain Capital withdrew from an agreed $19 billion purchase of Clear Channel Communications. A consortium of six banks, including Citigroup, Deutsche Bank, and Wachovia, reneged on their deal to provide nearly $20 billion in financing to those two private equity firms. A misdirected e-mail disclosed that the banks formulated a plan to evade their

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 442 The Growth of the Mortgage Market commitment as the credit crunch worsened. The banks confronted the prospect of immediately losing $2.65 billion, the amount that such debt was being discounted for in the markets. Agreement was reached in May 2008 allowing the buyout to be completed in July. Two equity investment funds managed by Thomas H. Lee Partners suffered losses of about 40 percent during the first eleven months of 2008. The firm, founded in 1974, became famous after it purchased the Snapple juice company for $135 million in 1992 and sold it two years later to Quaker Oats for $1.7 billion. In another deal, in which Thomas H. Lee Partners partnered with Bain Capital, the information systems of TRW were purchased for $1.01 billion in 1997 and sold a few weeks later for $1.7 billion. Those salad days were gone. Thomas H. Lee Partners’ $500 million investment in Refco, a large commodity brokerage firm, suffered a major hit when Refco went bankrupt shortly after it made its initial public offering (IPO) in 2005. Refco failed after it was discovered that the company had been concealing massive losses on its books. Thomas H. Lee left his namesake firm in 2006 and started another equity group called Lee Equity Partners. He planned to take one of his hedge funds public in 2006 but dropped the idea as the market became unsettled. Other private equity firms withdrew from agreed acquisitions in 2007. One such pullout required the payment of breakup fees in the case of the SLM Cor- poration totaling $900 million. These breakups were due to the withdrawal of financing commitments from banks and investment bankers, includingLehman Brothers Holdings and JPMorgan Chase. J.C. Flowers lost $1.35 billion in a vain effort to rescue Washington Mutual, the giant mortgage lender. Flowers nearly sustained another large loss when it appeared that Hypo Real Estate Holdings in Germany, in which it had invested $1.7 billion, was about to fail. However, the German government came to the rescue and put up $68 billion to keep the firm from failing. Home Depot reduced the price of a supply business that it was trying to sell to private equity investors by 18 percent from what had been agreed to just a few months earlier. Penn National Gaming announced in July 2008 the breakup of a proposed $6.1 billion sale of itself to two private equity firms, Fortress Investment Group and Centerbridge Partners. Instead of a buyout, Penn National was given a $225 million breakup fee and a $1.25 billion minority investment. Previously, private equity had eschewed minority investments, preferring instead leveraged buyouts (LBO) of the entire company. David Bonderman of TPG, who had previously rejected such minority positions, was among those who decided that it was not such a bad idea, after all. Blackstone Group and General Electric withdrew from a previously agreed purchase of PHH. Blackstone was unable to obtain the $1.7 billion needed to fund the acquisition because of the ongoing credit crunch. Alliance Data Systems sued the Blackstone Group after it pulled out of a $6.4 billion buyout of that firm. This was the second such suit filed by Alliance. A group of banks tried to salvage a private equity deal involving the buyout of BCE, a Canadian

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. Prelude to a Crisis 443 telecommunications company. That acquisition had been announced in June 2007, at the very height of the private equity acquisition binge, and was approved by BCE shareholders. The $52 billion transaction would have been the world’s largest ever LBO. The purchasers included the Ontario Teachers’ Pension Plan and affiliates, Madison Dearborn Partners, and Merrill Lynch Global Private Equity. However, that deal fell apart because BCE auditors could not render a solvency opinion for the business, which was required as a condition of completion for the buyout. The leveraged loan market was disrupted further by the inability of Deutsche Bank and Bank of America to syndicate a $14 billion debt offering that was needed to finance the $20 billion buyout of Harrah’s Entertainment by two private equity groups, Apollo Management and Texas Pacific Group. Apollo Management was also suing Huntsman Corporation in an effort to withdraw from its precredit crunch agreement to purchase Huntsman for $6.5 billion and to assume $4.1 billion of its debt. Apollo claimed that Huntsman’s financial condition had deteriorated and that a merger would render both companies insolvent. The parties finally agreed on a breakup fee of $1 billion, $675 million of which was to be paid by Apollo, and the rest by some of the banks that had agreed to finance the deal. Apollo was given rights that would allow it to recover at least some of its payment. Huntsman sued Credit Suisse Group and Deutsche Bank for their role in the breakup, seeking $4.65 billion in damages. The case went to trial in Texas in June 2009, but was settled by the banks before a verdict was rendered. They agreed to pay Huntsman $632 million in damages and an additional $1.1 billion in financing. In the meantime, Apollo announced a public offering through NYSE, but it continued to experience problems. The firm lost its entire $365 million investment in Linens ’n Things when that company went bankrupt. Apollo’s investment in the retailer Claire’s and a large real estate brokerage firm also suffered. Before the subprime crisis, Apollo had averaged an annual return of 27 percent, after fees, which exceeded the 19 percent track record of Blackstone and the 20 percent reported for KKR. Apollo was headed by Leon Black, the son of Eli M. Black, who had committed suicide in 1975 by jumping from the 44th floor of the Pan Am (now MetLife) building in New York because of his anxiety over an SEC investigation into payments made by his company, United Brands, to a foreign government official in Central America. Leon Black got his start on Wall Street at Drexel Burnham Lambert, where he rose to head the Mergers and Acquisitions Department. The younger Black started Apollo in 1990, after Drexel Burnham collapsed. The investor René-Thierry Magon de la Villehuchet had been instrumental in obtaining financing for the start-up of Apollo while employed as a senior executive at Crédit Lyonnais; he committed suicide in 2008 after he lost large sums for his clients at Access International Advisors (AIA Group) in the Ponzi scheme of Bernard Madoff (see also Chapter 5).

KKR continued its ambitious acquisition program into the fourth quarter of 2007 despite the ongoing credit crunch. It had planned deals on its books totaling $400 billion in September 2007. However, it had to renegotiate the terms of bank loans for a $26 billion acquisition of First Data Corp. in the fourth quarter as a result of the credit crunch.

Third-Quarter Problems

On July 18, 2007, a still-clueless Bernanke stated that inflation remained the Fed’s main concern. He asserted that the jobless rate would have to rise and excess capacity utilization would have to be reduced before concerns over inflation could be quieted. Bernanke predicted that the U.S. economy would expand at a moderate pace during the second half of 2007, with growth increasing in 2008. In the meantime, mortgage lenders cut back their underwriting and raised interest rates in recognition of increased risks in mortgage lending. Mortgage foreclosures increased 58 percent in the first six months of 2007 over the same period in 2006. By July 2007, 13 percent of subprime mortgages were in, or approaching, foreclosure. Housing inventories expanded again in July 2007, and the problems in the subprime mortgage market were referred to as a “crisis” in newspapers. However, Treasury Secretary Paulson stated to the press that the situation was containable. The stock market plunged on July 26, 2007, over concerns with increased interest rates and lower corporate earnings. By the end of the month, the Dow was still up 8 percent for the year, but the market showed increasing volatility. The Dow rose to 13907.52 on July 13, 2007, but fell back a few days later after oil prices hit $73.93 a barrel. Sales of light trucks plunged in the United States as gas prices skyrocketed. Pushed by stock buybacks, the Dow passed 14000 on July 19, 2007, but a market sell-off occurred during the week of July 27. Paulson sought to reassure the market on August 16, 2007, with some words that would come back to haunt him. He blithely stated that, while the problems in the credit markets would slow growth in the United States, he did not expect a recession. Paulson also cautioned, in another incautious statement, that the federal government would not seek to protect borrowers or lenders against losses. However, the seriousness of the situation had filtered into the corridors of government. The Fed, at long last, announced concern over the volatility in financial markets and its effects on the economy. Subsequently, the Fed cut its interbank discount rate by twenty-five basis points on August 18, 2007, reducing that rate to 5.75 percent. However, it declined to reduce its more widely followed, and lower, Fed funds rate, and the interbank discount rate cut seemed to have little effect on credit markets. Investors fled securities, pushing down Treasury security yields. On August 21, 2007, Treasury security yields had their largest drop in almost nineteen years, suggesting a flight to quality. The Fed also found that a sharp contraction of credit extensions by banks had occurred in August 2007. In fact, the

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. Prelude to a Crisis 445 private equity market was coming unglued as a result of the credit crunch, which had stopped forty-six acquisitions between June 22, 2007, and August 1, 2007, that involved $60 billion in credit. Bernanke, nevertheless, opined that, while a credit crunch and subprime problems could hurt the economy, the Fed’s principal concern still remained inflation. Toll Brothers announced a decline in earnings of 85 percent in the third quarter. American Home Mortgage Investment Corporation, a large real estate investment trust (REIT) that invested in mortgage-backed securities, stopped operations in August and filed for bankruptcy. Impac, a residential REIT, stopped funding Alt-A mortgages (those just above subprime) in August 2007. Capital One shut down its Green Point mortgage operation and took an $860 million charge. Lehman Brothers closed its BNC Mortgage unit in Irvine, California. HSBC Holdings shuttered its U.S. subprime lending operations, though it continued other consumer finance activities in the United States through its Household and Beneficial acquisitions, until it shut them down entirely in 2009. Accredited Home Lenders Holdings, a San Diego–based subprime lender, announced the closing of its subprime mortgage origination business and layoff of much of its workforce. The Canadian Imperial Bank of Commerce (CIBC) fired two executives who were responsible for its nearly $10 billion in subprime loan exposure. CIBC wrote down $2 billion to cover subprime losses from loans made in the United States. The firm was no stranger to defaulting debtors. It had financed some questionable Enron transactions before its collapse, and the bank paid $2.4 billion to settle Enron shareholder class-action claims. BNP Paribas, the giant French bank, froze the assets of three hedge funds on August 9, 2007, because the bank could not “fairly value” their subprime-related investments. The value of the hedge funds’ assets had been about $2.6 billion, before declining about 20 percent in two weeks. A German bank, the IKB Deutsche Industriebank, had to be bailed out by the German financial regulator and a group of German banks because of losses from subprime investments in the United States. The bailout totaled $4.7 billion, plus backup facilities of over $15 billion that were put in place to keep that bank stable. The commercial paper market was reeling, which awakened Bernanke to the increasingly alarming indication of a serious liquidity crisis. The Fed injected $24 billion of cash into the money markets on August 9, 2007. On August 17, the Fed issued a statement encouraging banks to access the Fed discount window more freely. That borrowing facility was normally used only to cover overnight or short-term cash shortfalls and not as a funding source, for which it was now being made available. The ECB also responded to the effects of a growing credit crunch in Europe. It injected $210 billion into its financial markets on August 10 and 11 in order to provide liquidity. New home construction in the United States was at its lowest level in a decade. Existing home sales contracted by 4.3 percent in August, new home sales fell by 8.3 percent, and housing inventories were at an eighteen-year

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 446 The Growth of the Mortgage Market high. Foreclosures and delinquencies were increasing. The Senate passed a bill to allow the Federal Housing Administration (FHA) to insure refinanced loans for borrowers who were delinquent on payments because they could not afford the much higher interest rates that resulted after their “teaser” rate periods. That legislation was not signed into law until July 2008. Some mortgage lenders were easing payment terms for homeowners. Adjustments were made to more than 370,000 subprime loans in the second half of 2007, but loan adjustments became a controversial practice when they were attempted for securitized mortgages because many investors objected to the loss they would experience from such adjustments. H&R Block faced large losses and had trouble selling its subprime mortgage business at Options One. The firm took charges totaling $200 million and laid off 620 employees. Its CEO, Mark A. Ernst, was dismissed with a $2.55 million severance package and stock options on 760,000 shares. The firm’s CFO, William Trubeck, followed Ernst out the door with a $900,000 severance package. Later, billionaire investor Wilbur Ross, known for his investments in distressed companies in the steel and automotive industries, announced the purchase of H&R Block’s mortgage servicing business for $1.1 billion. H&R Block shareholders elected three directors to its board proposed by Richard Breeden, the former SEC chairman and corporate monitor-turned-corporate gadfly. Breeden opposed ongoing efforts to reduce the regulation of financial services in the United States. He wanted more regulation, not less- or more- coherent regulation. His reform efforts were also directed at Zales, the jewelry chain, where his hedge fund became the largest shareholder and a member of its board. Breeden had been given $500 million by California Public Employ- ees Retirement System (CalPERS) to invest in a politically correct manner. Zales was foundering after the subprime crisis struck, and Breeden was being criticized for withholding information from the Zales board about potential buyers. Breeden’s politically correct investment strategy was substantially underperforming other investment funds. In the event, H&R Block’s troubles continued. It settled a suit with the state of California for $4.85 million, in which the firm was charged with having engaged in deceptive marketing of “refund-anticipation loans” that were made to clients awaiting tax refunds. H&R Block did become profitable again in 2009. Moody’s cut ratings on 691 subprime mortgage offerings in August, placing further pressure on the balance sheets of financial services firms. Washington Mutual warned of increased bad loans on its books and later reported the loss of 1,000 jobs. Citigroup investment funds sold $5.3 billion in assets in August 2007, another sign of trouble at that bank. Countrywide Financial Group pulled down its entire $11 billion line of credit. The SEC demanded to examine the books of Bear Stearns, Goldman Sachs, and Merrill Lynch to determine whether they were hiding subprime losses. The agency discovered nothing of interest even though both Merrill and Bear Stearns later failed. Shortly after that visit, Goldman Sachs found itself facing

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. Prelude to a Crisis 447 its first major crisis as a public company. Goldman pumped $2 billion into its floundering $3.6 billion Global Equity Opportunities (GEO) fund, which had lost more than 30 percent of its value during the week of August 9, 2007. Other investors in that fund, including Hank Greenberg, the former head of AIG, and the billionaire property magnate Eli Broad, contributed another $1 billion. The Goldman Sachs Global Alpha Fund also fell by 22.7 percent in August, the worst-ever performance by that hedge fund. These two Goldman Sachs funds lost a total of $4.7 billion in value. Wheat prices soared, hitting a record $7.54 per bushel on August 7, but the stock market was plunging. Stocks of financial service firms were under attack from short-sellers who had been relieved of the obligation not to sell stock except on a price increase by a change in SEC rules. As the turmoil mounted, President Bush attempted to assuage concerns over the economy and the market with a speech from the Rose Garden on August 31, 2007. He proposed that the FHA aid homeowners facing foreclosure and expressed concern over subprime mortgages with teaser rates that would reset at levels that would create “payment shock.” Yet Paulson continued to state that the United States should be able to avoid a recession. The Fed suggested that the worst of the problems in the mortgage markets was over. Bernanke sought to reassure the financial community, stating in late August that the Fed would “act as needed” to protect credit markets. Stock markets rallied on the expectation of a rate cut. The Fed became less sanguine on the housing market, declaring that recovery in that market was uncertain because of tightened lending standards and higher interest rates. It also stated that the downturn in the housing market was threatening the broader economy. In the meantime, Moody’s downgraded another 149 subprime investment vehicles. As September 2007 began, the Bank for International Settlements (BIS) predicted that the mortgage market turmoil was receding and normality could be expected to return. A sharp market sell-off followed that prediction. The ECB pumped $104 billion into the European money market on September 12, 2007. The Bush administration wanted Fannie Mae and Freddie Mac to be given expanded powers in order to allow them to provide support in the ongoing mortgage crisis. Instead of acting as rescuers, however, it appeared that these GSEs were themselves in trouble. Freddie Mac announced a third-quarter loss of $2 billion. Fair-value accounting took its toll at Freddie Mac, which reported a decrease in the fair value of net assets of $8.1 billion for the third quarter of 2007, compared with an increase of approximately $300 million for the same period in 2006. Fannie Mae lost $1.39 billion in the third quarter. A $2.24 billion decline in the value of derivative contracts and $1.2 billion in credit losses contributed to that quarterly loss. Fannie Mae also published accounting statements for the first two quarters of the year, bringing it up to date on its financial reports. The news in those reports was not good. It was reported that the fair value of its assets fell by $8.7 billion in the first three quarters of 2007.

Fair-Value Accounting

A problem that was bedeviling the burgeoning subprime crisis was the concept of fair-value accounting for financial instruments, standards for which are set in the United States by the Financial Accounting Standards Board (FASB), a private body.

The foundational ideas associated with fair value accounting were adopted by FASB in Statement of Financial Accounting Standards (FAS) 115 [in 1993]. The rule divided financial assets into three categories—those held “to maturity,” those held “for trading purposes,” and those “available for sale.” Each of these categories is treated slightly differently. Assets held to maturity are valued at amortized cost; assets held for trading are marked to market, with unrealized gains or losses included in earnings; and assets deemed available for sale are marked to market, with unrealized gains or losses excluded from earnings but included in shareholders’ equity.17

That concept was further advanced with FASB’s SFAS 157, adopted in 2006, just as the subprime market peaked, and became effective for fiscal years beginning after November 15, 2007, just as the subprime crisis was in full bloom. SFAS 157 specified conditions on how fair value was to be determined, but placed the greatest emphasis on the use of market prices. This requirement meant that financial assets whose value was being determined using these standards were subject to having their stated value reduced, or “written down,” if they were negatively affected by market conditions. The FASB also announced on September 6, 2006, that it was repealing a ban on using the “mark-to-market” valuation method for financial instruments whose value was not known. Many subprime mortgage instruments were not actively traded and were difficult to value, particularly as foreclosures mounted and mortgage-backed securities were downgraded. Accounting firms, badly stung by the overvalu- ations at Enron and elsewhere, were taking a hard line on marking down the value of subprime securities. Because the valuation of these instruments was difficult, and any overstatement could be prosecuted, this meant that those securities had to be marked down to levels well below their actual value. The result was to further undermine subprime securitizations, creating more uncertainty, which resulted in more markdowns, which created more uncertainty and so on, touching off a cascade effect that that would eventually undermine the entire economy. Fair-value pricing led to a downward spiral of writedowns that bore no relation to actual value. As Peter Wallison, an American Enterprise Institute fellow, noted in the midst of the subprime crisis:

As losses mounted in subprime mortgage portfolios in mid-2007, lenders demanded more collateral. If the companies holding the assets did not have additional collateral to supply, they were compelled to sell the assets. These sales depressed the market for mortgage-backed securities (MBS) and also raised questions about the quality of the ratings these securities had previously received. Doubts about the quality of

ratings for MBS raised questions about the quality of ratings for other asset-backed securities (ABS). Because of the complexity of many of the instruments out in the market, it also became difficult to determine where the real losses on MBS and ABS actually resided. As a result, trading in MBS and ABS came virtually to a halt and has remained at a standstill for almost a year. Meanwhile, continued withdrawal of financing sources has compelled the holders of ABS to sell them at distressed or liquidation prices, even though the underlying cash flows of these portfolios have not necessarily been seriously diminished. As more and more distress or liquidation sales occurred, asset prices declined further, and these declines created more lender demands for additional collateral, resulting in more distress or liquidation sales and more declines in asset values as measured on a mark-to-market basis. A downward spiral developed and is still operating.18

The effort to ease fair-value accounting developed into trench warfare between corporate activists who wanted the requirement continued and much of the business community, which wanted it suspended. Robert Hearst, the head of the FASB, asserted in December 2007 that the United States was losing credibility in the financial markets because of the subprime crisis. He lamented the fact that it had only been five years since the Enron-era scandals had created so much turmoil in the financial markets. Hearst’s comments seemed a bit out of place considering that his organization’s fair-value ruling was responsible for much of the stress in the market.

The Fed Acts on Rates

After pausing for over a year since the last time it raised rates, the Fed on September 18, 2007, cut its Fed fund rate by a surprisingly large fifty basis points, or double what was expected. The first Fed funds rate cut in four years, this cut pushed rates down to 4.75 percent. One economist called it “shock therapy,” but the reduction had little success in restoring faith in the credit markets. Existing home sales contracted by 19 percent in September. Losses from the subprime crisis continued to mount. The Impac Companies, a financial services firm that specialized in nonconventional residential and multifamily mortgage originations and warehouse lending operations, stopped mortgage lending and suspended the distribution of dividends. Also suspending dividends was NovaStar Financial, based in Kansas City, Missouri, which originated, invested in, and serviced subprime loans that were securitized. NovaStar sold its mortgage-servicing business to Saxon Mortgage for $155 million, as well as its loan portfolio, stopped the origination of new loans, and cut about 1,600 jobs. Beazer Homes, a national home builder headquartered in Atlanta, Georgia, which built in more than forty markets in the United States, announced that 68 percent of its homebuyers had canceled their orders in the third quarter of 2007, an increase of 36 percent over the number of cancellations in the second quarter. The company was in default on its Senior Notes. General Motors had a third-quarter loss of $39 billion, after having reported

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 450 The Growth of the Mortgage Market a loss of $38.7 billion for 2007 in the largest annual loss ever reported by an automobile company. That year for the first time Toyota tied with GM in automobile sales—the first time in more than seventy-five years that GM had not been the world’s leader in total automobile sales. American automakers were clearly struggling and would be the subject of a government rescue as the financial crisis worsened. In the third quarter of 2007, JPMorgan’s earnings rose to a record $3.37 billion, about the only financial services firm reporting good results. The halcyon days of outsize earnings from the mortgage market were finished for the rest of the financial services industry. Freddie Mac, which handled about 20 percent of all U.S. home mortgages, experienced a third-quarter loss in 2007 of $2 billion. It faced losses of as much as $12 billion on its portfolio of mortgages. Freddie Mac cut its dividend in half in order to shore up its capital base. The GSE also issued $6 billion in preferred stock in November 2007 to investors who would soon come to regret that investment choice. Fannie Mae had a third-quarter loss of $1.39 billion. It was then holding or guarantying $2.7 trillion in mortgages. Washington Mutual issued a profit warning and reported a 70 percent decline in profitability for the third quarter. At Bank of America earnings fell by 32 percent, and it cut 3,000 jobs. General Electric (GE) announced that it was taking a $300 million to $400 million charge from mortgage-related investments and was quitting the subprime market. The firm also shut down all its residential mortgage operations in Canada. State Street Securities was being sued by its investors and was under investigation by various state attorneys general in connection with mounting losses from subprime investments. Bernanke stated on October 8, 2007, that the housing slump would continue to be a “significant drag” on the economy through early 2008. Nevertheless, the stock market continued to rise. The Dow Jones Industrial Average hit a new record high on October 1, 2007, reaching 14087.55, but fell by 366 points on October 19, 2007, as a result of weak earnings reports. The dollar was at a record low against the euro. Oil prices surpassed $80 a barrel for the first time in September 2007 and $90 a barrel on October 25, 2007. The number of home sales in October 2007 was the lowest since 1999. Of- ferings of mortgage-backed securities declined from over $38 billion in March 2007 to just over $6 billion in October of that year. Aided by lower interest rates, November home sales rose by 0.4 percent but were still far below their peak, and were 20 percent lower year on year. The median sales price of a residence dropped in November 2007 to $210,200, down 3.3 percent from the previous year. Migration to the sunbelt states of Florida, Arizona, and Nevada slowed. Florida home sales were down 30 percent in November 2007 over the previous year, and the median sales price fell by 10 percent. Home prices fell by a collective 6.1 percent between October 2006 and October 2007, as revealed in an index surveying twenty cities. Some cities experienced even greater losses. Miami home prices fell by 12.4 percent and

Detroit by 11.2 percent. New York fared better, experiencing a loss of only 4.1 percent, while Los Angeles prices fell by 8.8 percent. Interestingly, Charlotte, North Carolina, Seattle, Washington, and Portland, Oregon, all experienced gains. Another, narrower index showed a collective drop of 6.7 percent in home prices in the month of October 2007—the twenty-third month that this index had shown a slowing or decline in residential home prices. Despite rising signs of an impending economic crisis, some members of the Fed were reluctant to make further rate cuts because of continuing inflation concerns. However, Bernanke persuaded them to make a cut of twenty-five basis points on October 31, 2007, pushing the Fed funds rate down to 4.5 percent. The Fed warned that this cut was likely its last cut because of its continuing concern over inflation, which it then viewed as equal to the risk of a recession stemming from the mounting housing crisis. That forecast proved well wide of the mark, and the rate cut had little effect; the downturn only deepened. The Fed’s concern over inflation, though it may seem out of place in retrospect, was not completely unjustified at the time. Crude oil prices were skyrocketing, and commodity prices reached an all-time high on the Chicago Mercantile Exchange. Soybean and corn prices attained levels not seen in decades. A jump in wholesale producer prices in November 2007 was the highest in thirty-four years. Diesel fuel prices set a record in November 2007 of nearly $3.50 per gallon. The Bush administration began to stir on the housing front. In October 2007 the president announced the creation of Project Hope Now, an alliance between the Department of Housing and Urban Development (HUD) and mortgage lenders and loan counselors. The program was supposed to provide voluntary assistance and counseling to homeowners having trouble paying their mortgage. Within a few months, some 4,500 homeowners called the Hope Now hotline every day, but complained that they received little assistance.

Subprime Problems Travel Abroad

The subprime crisis spread abroad, as exemplified in the failure of Northern Rock, a British mortgage bank that had to be rescued by the British government after it collapsed. The Northern Rock crisis began when it sought emergency funding from the Bank of England in September 2007. The bank needed that funding because it could not access the short-term money markets, which were frozen due to the ongoing credit crunch. Northern Rock was borrowing short term and lending long term on mortgages that it had securitized. That request raised concern over Northern Rock’s liquidity, and those concerns turned into a panic as depositors began a run on the bank, in the first bank run in England in more than a hundred years. Customers withdrew $2 billion in deposits from Northern Rock before the run was halted by the announcement, on September 14, 2007, that the Bank of England, the country’s central bank, would provide

$28 billion in funding to prevent a liquidity squeeze, a rescue arranged by Alistair Darling, the British chancellor of the exchequer. Northern Rock agreed to sell a portion of its mortgage portfolio to JPMor- gan Chase, and the British government announced on January 21, 2008, that it planned to guarantee some $58 billion in bonds to be issued by Northern Rock. This was intended to be an alternative to nationalizing Northern Rock and would have replaced the $28 billion lent to Northern Rock by the Bank of England. However, the British government decided to nationalize Northern Rock in February 2008, after efforts to keep it in the private sector failed. In carrying out this nationalization, the British government provided $48.7 billion in funds and guaranteed more than $50 billion of the bank’s obligations. Two Northern Rock executives were later fined several hundred thousand dollars and banned from holding senior posts in the banking industry. Paul Tucker, a Bank of England official, warned in December 2007 of a “vicious circle in which tighter liquidity conditions, lower asset values, impaired capital resources, reduced credit supply and slower aggregate demand feed back on each other.”19 The British government considered increasing its regulatory oversight of the mortgage market after the Northern Rock failure. The European Union also examined its regulatory structure to determine whether greater coordination was needed. The House of Commons Treasury Committee subsequently issued a report criticizing the Financial Services Authority (FSA), the UK’s financial regulator, for its laxness in regulating Northern Rock. The report asserted that the FSA had failed to allocate sufficient resources to monitor the bank, whose “business model was so clearly an outlier.”20 The committee recommended that the Bank of England, rather than the FSA, be designated as the lead regulator when banks face financial difficulties. That recommendation was an apparent effort to turn back the clock on the single-regulator concept in Britain, which had given the Bank of England’s regulatory authority to the FSA because of perceived inadequacies in the central bank’s regulatory abilities. FSA regulations appeared to have other weaknesses. Some 20 percent of merger transactions in Britain in 2007 were preceded by unusual trading activity in the stock of the companies involved, suggesting that inside information was at play. The FSA promised more stringent regulation in the wake of the Northern Rock crisis. Its head, Hector Sants, stated that the days of financial services–friendly regulation in London were over and that he intended to take strong action to ensure that the business community would be “frightened” of the FSA.21 The problems in the United Kingdom only mounted after the Northern Rock bank rescue. Barclays, a significant player in the questionable bank funding given to Enron, took a $2.56 billion writedown in November 2007 as a result of losses from its subprime activities. This led to a management shakeup at the bank. A co-president of the bank, Grant Kvalheim, resigned, but troubles at the bank continued. The Royal Bank of Scotland announced that it had lost

$5.8 billion in 2007 as a result of credit-related problems. The London Scottish Bank experienced subprime losses in 2007 that impaired its capital. The bank agreed with the FSA to shore up its capital by early 2008. HSBC Holdings announced losses from bad debts of $7.4 billion in the first three quarters of 2007. It sought a capital infusion from a Singapore-based sovereign wealth fund, Temasek Holdings. In Australia, Centro Properties defaulted on $1.1 billion in debt. Centro was a shopping mall owner that had expanded into the United States through the acquisition of two large REITs. It planned to refinance the short-term debt used to acquire those properties through commercial mortgage-backed security underwriting in the United States. However, that market was effectively shut down as a result of the credit crunch and growing subprime crisis. Lehman Brothers was sued by an Australian township for losses suffered from CDOs marketed by the brokerage firm, whose value had declined by 84 percent. Terra Securities, a Norwegian financial institution, declared bankruptcy in November 2007 and was forced out of business by regulators as a result of its sale of subprime instruments sold by Citigroup to eight small towns near the Arctic Circle. Those towns experienced large losses as a result of those investments.

The Crisis at Citigroup

Citigroup’s third-quarter earnings fell by 57 percent as a result of a $5.9 billion writedown related mostly to subprime mortgage investments. The firm tried to allay fears in the market over its continued viability by declaring that it had $80 billion in funding for its subprime investments. However, continuing concerns over Citigroup’s exposure to subprime instruments sent its stock plunging by 40 percent after that announcement. In fact, Citigroup faced the very real danger of failure, a notion that had seemed inconceivable only a few months earlier. One of America’s premier and largest financial services firms, Citigroup traces its origins to the City Bank of New York formed in 1812 by Revolu- tionary War colonel Samuel Osgood. Osgood took over the New York branch of the first Bank of the United States and reorganized it as City Bank of New York. City Bank nearly failed in 1814 as a result of some bad loans made to bank insiders. It also nearly failed during the Panic of 1837, but was saved by John Jacob Astor. It exchanged its New York charter for a national one in 1865, becoming National City Bank. By 1893, it was New York’s largest bank, with deposits of more than $100 million. National City Bank grew even more after a merger with the Third National Bank in 1897. In 1919, National City Bank became the first U.S. bank to reach $1 billion in assets. National City Bank entered the securities business through the creation of an affiliate called the National City Company, which was formed to evade a 1902 ruling of the comptroller of the currency that prohibited national banks

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 454 The Growth of the Mortgage Market from engaging in investment banking activities, such as acting as an underwriter of securities offerings. National City Bank ignored an opinion by the U.S. solicitor general that formation of this affiliate was illegal. National City Company became somewhat infamous for the high-pressure sales tactics and other abuses that it employed to exploit the rising stock market in the 1920s. Charles E. Mitchell, the head of National City Company, later became the head of the bank. In that role, he defied the Fed’s efforts to cool the stock market in 1929. After the market crashed that year, Congress responded to concerns over commercial bank participation in investment banking by banning them from such activity through the passage of the Glass-Steagall Act in 1933. The National City Bank acquired the First National Bank of New York in 1955 and changed its name to First National City Bank of New York. The name of the bank was shortened to First National City Bank in 1962. A one- bank holding company, First National City Corporation was created in 1968 to become the parent of the bank in order to expand its business activities. The name of the holding company was changed to Citicorp in 1974. Two years later, its subsidiary, First National City Bank, was renamed Citibank. In the 1980s Citicorp led U.S. banks in massive lending to Latin American countries that became nonperforming. Citicorp worked its way out of the crisis by rescheduling loans with the assistance of the Treasury Department, which introduced a plan to securitize Latin American debt and otherwise restructure loans. Citicorp encountered more problems in 1991 after a restructuring and other charges resulted in an $885 million loss for the third quarter. The firm then eliminated its quarterly dividend for the first time since 1813. The Federal Reserve Bank of New York placed Citicorp under special regulatory supervision in 1992 and as a part of that supervision limited its ability to make new loans. In order to raise the capital needed to shore up its business, Citicorp solicited an investment by Saudi prince Al-Waleed bin Talal, who provided approximately $400 million of the $2.6 billion Citicorp raised in 1991 and 1992. Citicorp also suffered losses from its real estate holdings. It initially decided to hold nonperforming properties until the economy recovered. However, Citicorp lost its nerve and sold some 60 percent of its holdings in 1993 at a loss. By two years later the 40 percent that it continued to hold had recovered their value. Citicorp merged with Travelers Group to form Citigroup in 1998. That megamerger conflicted with the Glass-Steagall Act, but the following year it was repealed with passage of the Gramm-Leach-Bliley Act, retroactively permitting the merger. As a result of that merger, Citigroup became the largest financial services company in the world, with assets of more than $1 trillion. Citigroup then had 200 million customer accounts in more than a hundred countries, and it was also the world’s largest issuer of credit cards. John Reed, chairman of Citicorp, and Sanford (Sandy) Weill, chairman of Travelers Group, agreed to run Citigroup as co-CEOs. That friendly arrangement soon turned into a battle between Weill and Reed over control of

Citigroup, a battle that Weill won. After Citigroup was caught up in the Enron and financial analysts’ scandals, Weill began planning his retirement. The heir apparent was Jamie Dimon, but Weill and Dimon had a falling out over the promotion of Weill’s daughter, and Weill appointed as his successor Charles (Chuck) O. Prince III, Weill’s long-time corporate lawyer. Prince became CEO in 2003 and gained the additional title of chairman when Weill retired in 2006. Two other attorneys who were appointed to be vice chairmen of Citigroup joined Prince. The appointment of lawyers, rather than bankers, to lead Citigroup appears to have been a reaction to the aggressive attacks of Spitzer and other regulators that were causing companies to put compliance ahead of what should have been the primary goal: building and protecting their businesses from economic downturns. Unfortunately, the subprime crisis demonstrated that Prince was no businessman. Indeed, his leadership nearly cost Citigroup its franchise. Certainly, Citigroup had not learned its lesson from the Enron debacle and seems to have shrugged off regulatory concerns that had at one point led to an order prohibiting the bank from expanding its business through additional mergers. Indeed, it appeared that those restrictions were what pushed Citigroup to expand into subprime mortgages so that it could build its business internally. In a July 2007 interview with the Financial Times, which questioned him on whether he had any concerns over the then-nascent credit crunch, Prince stated that: “When the music stops, in terms of liquidity, things will get complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” That blasé remark came back to haunt him when Citigroup announced its third-quarter results in 2007. The firm reported a profit of $2.38 billion for that quarter, some 57 percent less than that for the same period of the previous year. Those diminished earnings were caused by writedowns totaling about $6 billion, consisting of $1.35 billion for leveraged loan activities, $1.56 billion for problems associated with subprime securitizations, and $2.98 billion for increased consumer credit costs. Citigroup had over $40 billion of subprime exposure on its books. Prince had to deal with the embarrassment of not only the size of these write downs but also the fact that the bank’s initial announcement had understated their amounts. The writedowns for the third quarter were later increased to a total of $16 billion. Citigroup’s former chairman, John Reed, publicly rejoiced over Citigroup’s woes. He even called the merger with Travelers a mistake, even though he had approved it. Weill responded that the merger had been a success, but that management after he left had been “very poor.” However, Weill himself had put in place that management, led by Prince. In the event, Prince lost Weill’s confidence after he fumbled the announcement of the bank’s subprime losses and was forced to resign. However, Prince was given several perks, including a car and driver and an office, as well as vested stock holdings of $94 million, plus $53 million that he was paid while serving as CEO. He would also receive a pension of $1.74 million per year.

Robert Rubin, the former co-head of Goldman Sachs and former treasury secretary, became the interim Citigroup chairman until Vikram S. Pandit, who had not long before been appointed head of Citigroup’s institutional businesses, was selected to replace Prince. Pandit had been a senior executive at Morgan Stanley but was ousted in an internal struggle for control of that company between Philip Purcell and John Mack. After Pandit left Morgan Stanley, he formed a hedge fund called Old Lane Partners, which Citigroup acquired for $800 million when it hired Pandit, and received $165 million as his share of the Old Lane buyout. The other co-founder of that hedge fund, John Havens, was hired by Pandit to become the head of Citigroup’s investment bank and alternative investment division. This was not a great deal for Citigroup. Old Lane Partners soon ran into difficulty and had to be closed in June 2008. Pandit quickly removed several Citigroup executives who had worked under Prince and put his own management team in place. In order to bolster the subprime mortgage market, Citibank announced that it was seeking to form a consortium of large banks that would create a pool of $100 billion, to be used to support the price of mortgage securities in order to prevent them from being sold at fire-sale prices as dictated by fair-value accounting requirements. JPMorgan Chase and Bank of America joined in this proposal, which was dubbed the Master Liquidity Enhancement Conduit (MLEC). The MLEC proposal received support from the Treasury Department because Secretary Paulson wanted an orderly liquidation of those securities. That effort never got off the ground and was scrapped in December 2007 because of a lack of interest among other banks. Instead, Citigroup and other banks began to move distressed assets onto their balance sheets, where they could be supported by the bank’s other assets and liquidated in an orderly fashion. In addition to Citigroup, HSBC Holdings, Société Générale, and WestLB took similar actions to rescue their structured investment vehicles (SIVs) from forced fire sales of assets in an illiquid market. Citigroup had created a massive SIV program during the heyday of the housing boom that used long-term subprime obligations to fund commercial paper borrowings. However, the commercial paper market was frozen and would no longer accept the credit of SIVs. This put Citigroup in a bind because it had sold “liquidity puts” on $25 billion of its SIVs that entitled their investors to sell the notes back to Citigroup at par value. The largest of the Citigroup SIVs were based in the Cayman Islands and included Centauri, with $20 billion in assets, Beta Finance, Dorada, Five Finance, Sedna Finance, Vetra Finance, and Zela Finance. Citigroup initially provided $7.6 billion in funding to these SIVs through commercial paper purchases. It later moved some $50 billion in SIVs onto its balance sheet, but that action only created more unneeded pressure on Citigroup’s capital. Citigroup turned for help from a sovereign wealth fund, the Abu Dhabi Investment Authority, which invested $7.5 billion, giving it a 4.5 percent ownership of Citigroup and entitling it to an annual payment of 11 percent.

The firm already had another large Middle Eastern investor, Prince Al-Waleed bin Talal, who held a stake of similar size, which gave him great influence at Citibank. The prince was the nephew of the Saudi king Abdullah and had a net worth estimated at more than $20 billion. Citigroup also considered selling assets, but Weill urged Pandit not to break up the combination of financial services that he had put together as Citigroup. Citigroup reported a fourth-quarter 2007 loss of $9.83 billion—the largest quarterly loss in the bank’s 196-year history—having written down its assets by an additional $18.1 billion. Even after that writedown, Citigroup still had $37.3 billion in CDOs on its books. For the year, Citigroup’s net income was $3.62 billion.

UBS

UBS, a venerable Swiss financial institution that traced its origins back to 1854, was a leading global wealth manager, investment banking and securities firm, and one of the world’s largest asset managers. Its merger with Swiss Bancorp in 1997 created what was then the second-largest bank in the world. In addition to operating in more than fifty countries and employ- ing more than 75,000 people around the world, UBS also had large operations in the United States, having acquired Paine Webber, one of America’s larger broker-dealers, in 2000. The bank became heavily involved in the U.S. subprime mortgage market through Dillon Read Capital Management (Dillon Read), which Swiss Bancorp had acquired for $600 million before its merger with UBS. Clarence Dillon and William A. Read formed Dillon Read in 1922. That investment banking firm was known for its creation of a giant investment trust during the 1920s that suffered massive losses. However, it managed to survive and become a leading investment bank under the guidance of Dillon’s son, C. Douglas Dillon, who became treasury secretary in the Kennedy and Johnson administrations. Dillon Read was used as the base for a large UBS hedge fund, which had reported in March 2007 that it would have $50 million in writedowns on subprime securities. That loss grew to $124 million in May, and UBS then announced the closure of Dillon Read and takeover of its assets. UBS’s CEO, Peter Wuffli, left the bank as a result of the Dillon Read losses and was replaced by Marcel Rohner. UBS issued a profit warning on August 14, 2007. By the end of September 2007, the losses from the Dillon Read positions ballooned to over $3 billion, and UBS took a total writedown on assets of $3.42 billion and reported its first quarterly loss in nine years. The bank also announced the elimination of 1,500 jobs. An additional $10 billion in writedowns was announced on December 10, 2007. UBS losses were associated with U.S. residential mortgages, mostly from CDOs, and grew to $18.7 billion for all of 2007. In order to shore up its capital, UBS sold a 12.4 percent stake in itself to Singapore Investment

Corporation, a sovereign wealth fund, and an unnamed Middle Eastern investor for $11.3 billion. The UBS subprime operations mimicked the “warehouse” financing operations made popular by other investment banks for securitization programs. In a report to its shareholders, UBS described its CDO warehouse facility as follows:

In the initial stage of a CDO securitization, the [CDO] desk would typically enter into an agreement with a collateral manager. UBS sourced residential mortgage backed securities (“RMBS”) and other securities on behalf of the manager. These positions were held in a CDO Warehouse in anticipation of securitization into CDOs. Generally, while in the Warehouse, these positions would be on UBS’s books with exposure to market risk. Upon completion of the Warehouse, the securities were transferred to a CDO special-purpose vehicle, and structured into tranches. The CDO desk received structuring fees on the notional value of the deal, and focused on Mez- zanine (“Mezz”) CDOs, which generated fees of approximately 125 to 150 bp [basis points](compared with high-grade CDOs, which generated fees of approximately 30 to 50 bp). Key to the growth of the CDO structuring business was the development of the credit default swap (“CDS”) on ABS [asset-backed securities] in June 2005 (when ISDA published its CDS on ABS credit definitions). This permitted simple referencing of ABS through a CDS. Prior to this, cash ABS had to be sourced for inclusion in the CDO Warehouse. Under normal market conditions, there would be a rise and fall in positions held in the CDO Warehouse line as assets were accumulated (“ramped up”) and then sold as CDOs. There was typically a lag of between 1 and 4 months between initial agreement with a collateral manager to buy assets, and the full ramping of a CDO Warehouse.22

After the CDO process was completed, UBS generally sold the lower-rated, subordinate CDO tranches to outside investors. It retained the AAA-rated “super-senior” tranches on its own books because their triple-A rating made them appear to be a safe investment. UBS also purchased super-seniors from third parties. UBS’s inventory in mortgage-backed assets grew from a non- substantial amount in February 2006 to $50 billion in September 2007. Bank regulators in the United States had allowed reduced, favorable capital treatment of super-seniors when carried on bank balance sheets, provided that the super-senior had a triple-A credit rating.23 This regulatory blessing removed any residual concerns of undue risk normally associated with subprime debt. However, losses on the super-seniors caused about half of UBS’s total losses in 2007. A large portion of those positions had been hedged, but only for 4 percent or less of their value, which was thought to be the maximum amount of the value at risk. Because of market chaos, those positions were written down in amounts far in excess of that coverage. Other super-seniors were not hedged at all. The bank also engaged in “carry trades,” in which it was using cheaper, short-term funding to invest in higher-yielding, long-term subprime mortgages. UBS chairman Marcel Ospel publicly admitted that the bank had not understood the risks posed by its subprime exposures. UBS also had other problems. Michael Guttenberg, an executive direc-

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. Prelude to a Crisis 459 tor at UBS Securities, pleaded guilty to securities fraud and other charges in connection with an insider-trading scheme. Guttenberg sold information about planned changes in analyst recommendations at UBS to David Tavdy, a trader who then used the information to make trades that generated some $25 million in profit. Tavdy was sentenced to five years in prison. Paul Risoli, a trader at Bank of America, who was a part of this large insider-trading ring, also pleaded guilty and was sentenced to seven months in jail. In total, thirteen individuals, including employees from Bear Stearns, Morgan Stanley, and Bank of America, pleaded guilty to charges stemming from that trading. Even more seriously, as discussed in a prior volume, UBS became embroiled in a messy dispute with the Justice Department in 2008 over the bank’s offshore tax shelter programs for Americans.

Money Market Fund Problems

State officials froze the Florida Local Government Investment Pool (LGIP) at the end of November 2007, after a run on its assets was touched off by concerns over subprime-related investments. The pool was a state-sponsored entity that invested the funds of 1,000 municipal government units in Florida, including school boards, that had come from bond sales, tax revenue and fees, and held in the pool until needed by the municipalities for their operations. LGIP was the largest of the pools of this type, which are common across the country. It had been previously embarrassed by a $280 million loss on Enron stock purchased while Enron was in the midst of its death throes. A prior investment disaster had occurred in another municipal investment fund in Orange County, California, which had invested heavily in collateralized mortgage obligations. That fund lost $1.5 billion, bankrupting Orange County, and the Orange County treasurer, Robert Citron, was sent to jail. LGIP promised municipalities a higher rate of return than was available from short-term U.S. government securities. However, in order to generate that higher return, LGIP had to invest in securities with higher risk profiles, including subprime mortgage obligations. LGIP held some $2 billion in subprime-related securities that were under stress, some of which had been purchased after the problems in the subprime market had already surfaced. As the subprime crisis started to blossom, some municipalities began a wholesale withdrawal of their funds from LGIP. Before the run began, LGIP held $32 billion in funds, but this sum had shrunk to $14 billion before the Florida governor froze the fund. Florida hired BlackRock as interim manager of LGIP. Withdrawals were then allowed from the pool but only up to an amount equal to 15 percent of a municipality’s investment. Any additional withdrawals were subject to a 2 percent penalty. After the pool was reopened, another $1.8 billion was withdrawn, but then the situation stabilized. BlackRock had troubles of its own, even while seeking to rescue the Florida state fund. Moody’s downgraded a

BlackRock fund for institutional cash strategies to junk bond status at year- end 2007. However, BlackRock announced that its fourth-quarter earnings in 2007 were up by 40 percent. Other money market funds were suffering. US Bancorp announced in De- cember 2007 that it was writing down $110 million in securities that it had purchased from its own money market funds at face value in order to avoid any losses to customers. SunTrust injected $1.4 billion into its money market funds that had suffered losses from SIVs. Legg Mason injected $1.1 billion into two of its money market funds as a result of losses from ABCP. That action was taken in order to avoid any loss of customer confidence. Among those rescuing their money market funds was Janus, which put $109 million into its funds. By year-end 2007, twenty financial institutions managing money market funds had injected some $12 billion into those funds in order to cover losses from subprime-related investments. This was designed to prevent those money markets funds from “breaking the buck,” that is, returning less than $1 for each $1 invested, an event that had occurred only once before, in 1994. Despite those problems, the sums held in money market funds increased by 30 percent as customers sought liquidity.

Asset-Backed Commercial Paper (ABCP) Problems

The subprime crisis accelerated with refunding failures of ABCP. In November 2007, ABCPs in the United States paid 4.75 percent on commercial paper, but those rates rose to 6.16 percent in December, thereby reducing their spread. The ABCPs were a $1.2 trillion market by August 2007, but by December of that year they had declined by a third. At the same time, the value of non-ABCP financial commercial paper outstanding rose to $863 billion, increasing by $9 billion in just one week in December 2007, as commercial borrowers increased the issuance of their own paper directly rather than through an ABCP. An ABCP crisis broke out in Canada. Canada’s fifth-largest bank, CIBC, wrote down $3 billion from subprime losses. Twenty-one Canadian nonbank trusts, including Coventree, were frozen in August 2007 after they were unable to roll over the commercial paper issued by ABCPs that they sponsored. They had more than $30 billion in ABCPs outstanding. Resurrecting J.P. Morgan’s rescue of the New York trusts after the Panic of 1907, Purdy Crawford, a prominent corporate director in Canada, headed a committee of banks that tried to restructure the ABCPs. Some investors agreed to defer their claims pending that rescue effort. However, the trusts were later placed in bankruptcy in order to facilitate a restructuring that required the ABCPs to be converted from short-term to long-term funding. Small investors were bought out. Interestingly, despite these problems, the Canadian banks had not jumped into subprime paper to a degree comparable to their American and European counterparts and were spared the worst of the crisis.

Fed Policy

In order to pump liquidity into an increasingly cash-starved financial system, the Fed created a term auction facility in December 2007 that conducted biweekly auctions of $20 billion in twenty-eight-day loans to the banks. The banks were allowed to include residential mortgages as collateral for such loans. The money auction conducted by the Fed in December 2007 under this facility attracted bids from ninety-three financial institutions. Concern had been raised that participation in this facility would be low because such borrowing might reflect or show weakness to the market. Similar concerns had kept banks from borrowing through the Reconstruction Finance Corporation during the Great Depression. There was no reason to worry. The bids submit- ted were three times the amount of funds being auctioned off by the Fed. The Fed’s subprime crisis auction resulted in loans paying an interest rate of 4.65 percent, lower than the existing discount rate of 4.75 percent. On December 12, 2007, after a meeting in Cape Town, South Africa, the Fed, the ECB in the European Union, the Bank of England, the Bank of Canada, and the Swiss National Bank announced that they would coordinate efforts to provide their banks with liquidity. The Bank of Japan also voiced its support for that effort. The ECB and the Fed diverged in their approach to interest rates. The ECB still signaled that it would not reduce interest rates further, while the Fed indicated that rates would be cut significantly. On December 18, 2007, however, the ECB announced that it would offer unlimited amounts of funds to its member banks at bargain interest rates. It stunned the financial community by disclosing that it had already pumped more than $500 billion into 390 eurozone private banks, twice the amount expected. The Bank of England also conducted auctions, like those of the Fed, in order to inject funds into the banks. As for the Fed, it lent almost $5 billion a day from the Fed discount window at the end of December 2007, in addition to the biweekly auctions. The interbank rate charged by banks to one another was in a disconnect at year-end 2007. The spread between that rate and the Fed funds rate widened to over 1 percent, whereas normally it was less than twenty basis points or 0.2 percent. The money market faced concerns because of the rolling over of some $300 billion in commercial paper. That market was contracting, shrink- ing to $748 billion in December 2007, down from its high in August of that year of $1.2 trillion. The commercial bond market also suffered from the credit crunch. The prices of several corporate bond issues fell sharply as a result of fears of subprime lending exposure. Concern welled up that $600 billion in corporate bonds that would come due in 2008 might be difficult to refinance. The spread between the interest rates of junk bonds and Treasury securities set a record low in the first half of 2007, but that spread more than doubled in the second half of that year. The inflation rate in the United States reached 4.3 percent on an annualized

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 462 The Growth of the Mortgage Market basis in November 2007. This placed the Fed between a rock and a hard place in setting interest rate policy. On the one hand, the Fed had viewed its principal role as preventing inflation, which would mandate that it increase, or at least not decrease, interest rates. On the other hand, lower rates were needed to rescue homeowners facing large mortgage payment increases after their loan rates reset. Lower rates were also needed to revive the moribund real estate market, which was threatening the viability of many financial institutions. On top of all that were concerns that the economy was slowing. After weighing these factors, the Fed cut interest rates again on December 12, 2007, by twenty-five basis points—but to no apparent effect. A debate arose over how to deal with the burgeoning credit crisis and what could be done to reduce foreclosures. President Bush advised Wall Street on December 20, 2007, that it should take any writedowns from mortgage losses before the end of the year. Apparently, he proposed that they take a “big bath” so they could put their troubles behind them in the new year. Such accounting tactics were common when new management came into a company. The losses could be blamed on the old management, and the new management would essentially start with a fresh balance sheet. Such tactics had been frowned on by the SEC for years, but the growing severity of the subprime crisis seemed to justify a little accounting manipulation. The Bush administration also pressured banks to freeze interest rates on a massive amount of subprime mortgages whose interest rates would reset in early 2008, causing many defaults by borrowers. That proposal was criticized as rewarding bad credit judgments by those borrowers. It also removed flexibility for banks to work out their own arrangements with defaulting debtors, while keeping the rewards of higher rates from nondefaulters. After all, it was argued, the banks had incurred the risks, and they should be the ones to decide how to work things out, not the government. Alan Greenspan, the former Fed chairman, was among those criticizing the Bush proposal. He advocated direct government aid to defaulting homeowners, not a big government bailout. But the plan to freeze mortgage rates on variable rate mortgages or other mortgages with reset features ran into a large roadblock: Bank computer systems were unable to deal with those changes, and banks were unable to comply with accounting rule requirements for this kind of restructuring. Other regulatory threats loomed. The Democratic-controlled Congress was considering more regulation of bank lending activities. The Fed also amended its regulations for subprime mortgages, which it defined as those charging interest rates of more than three percentage points over that of government securities with similar terms. The Fed tightened loan documentation requirements, which had been essentially waived by many banks during the real estate boom. It required taxes and insurance to be placed in escrow and banned deceptive advertising, as well as loans described as having a fixed rate that in reality would reset. Restrictions were also levied on mortgage broker fees.

Fourth-Quarter Results

As 2007 ended Bear Stearns announced the first quarterly loss in its eighty- four-year history. The loss was largely attributable to a decline in the value of the firm’s subprime mortgage portfolio. Investors worried that the problems at Bear Stearns might be worsening. Pimco, a leading global investment management firm, with more than $747 billion in assets under management, advised Bear Stearns in December 2007 that it wanted to unwind several billion dollars of trades in which Bear Stearns was a counterparty. Bear Stearns was able to push off that request, but it caused a great deal of concern at the firm. Lehman Brothers had reported income of $807 million in the third quarter of 2007, a decline of 3.2 percent over the previous year due to mortgage writedowns. Although it had written off $3.5 billion as a result of its mortgage activities, the firm still exceeded analysts’ expectations, reporting $886 million in earnings for the fourth quarter in 2007. That was a decline of 12 percent over the previous year, but Lehman’s earnings for the year nonetheless set a record for the firm for the fourth straight year. JPMorgan Chase reported record profits in the third quarter of 2007, but its fourth-quarter income was down 34 percent—the first decline in quarterly profits since Jamie Dimon had taken the helm in 2005. Goldman Sachs had hedged its bets in the subprime market and, as a result, had a good year in 2007. The firm had only “modest” mortgage-related losses, but offsetting positions more than covered them. Goldman’s fourth-quarter results handily beat analysts’ predictions. Year-end bonuses for Goldman employees were reported to average $360,000. The head of the firm, Lloyd Blankfein, was given a pay increase bringing him up to $70 million per year. Gary Cohn and Jon Winkelried, co- presidents of Goldman Sachs, were each paid $67.5 million for their work in 2007. Those outlays suggested that Goldman Sachs had escaped the worst of the credit crisis. However, a Goldman Sachs spokesman cautioned that 2008 might be less favorable. He was right. Capital One Financial Corporation reported that its fourth-quarter 2007 profit fell by 42 percent over the previous year because of a rise in bad debts. General Electric (GE) was hurt by the credit crunch. Although viewed by many as an industrial firm, GE was heavily involved in finance. Its GECapital unit made loans to small to medium-size businesses and invested in commercial real estate. GE issued a profit warning in December 2007 and announced plans to sell at least a portion of its once highly profitable credit card unit, which was hit by the liquidity squeeze. Merrill Lynch reported that it had $15 billion in subprime exposure in the third quarter, but increased that number at year-end to $46 billion as the result of off-balance-sheet exposures from subprime CDOs called such things as Pyxis. State Street, the manager of $2 trillion of pension and other funds, reserved $618 million at the end of its fourth quarter in 2007 to cover losses

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 464 The Growth of the Mortgage Market from subprime investments. One of its managed funds lost 28 percent of its value as a result of subprime investments. Sovereign Bancorp took $1.61 billion in write-offs in the fourth quarter of 2007. That bank also announced the closure of its automobile lending operations in several states. The Bank of New York Mellon reported that its fourth-quarter 2007 profits had fallen by 68 percent, largely due to a $118 million writedown of CDOs. The Jeffries Group, a brokerage firm that got its start in the “third market” in off-exchange transactions in New York Stock Exchange–listed stocks back in the 1970s, announced a $24 million fourth-quarter loss for 2007, after experiencing large gains in the first three quarters of that year. However, its losses owed to the large bonuses it had paid employees.

Fannie and Freddie

Freddie Mac reported a fourth-quarter 2007 loss of $2.5 billion, a record for that entity, but seemed unfazed by that setback. Indeed, it boasted of the purchase of $43 billion in mortgages to help some 47,000 families avoid foreclosure. In announcing its fourth-quarter results, Freddie Mac CEO and chairman Richard F. Syron stated: “Today’s economy represents one of the most severe housing downturns in American history, and our results reflect that difficult environment as well as Freddie Mac’s steadfast commitment to its important mission of providing liquidity, stability and affordability to the U.S. housing finance system.”24 Fannie Mae reported a loss of $2.1 billion for 2007, which did not compare favorably to profits of $4.1 billion in 2006. Losses in the fourth quarter of 2007 totaled $3.6 billion. Those losses were driven by fair-value writedowns of derivatives totaling $3.2 billion in the fourth quarter and $4.1 billion for the full year. Those writedowns were due mostly to the effects of falling yields on interest rate swaps used as hedges. This seems curious considering that hedges are supposed to protect asset values and thereby prevent such losses. The FHLBs were keeping the mortgage market open by lending hundreds of billions of dollars to holders of residential mortgages, who were allowed to use their mortgages as collateral for those loans. That lending by the FHLBs far exceeded the amount of funds injected into the financial system by the Fed. The FHLB Board lending facility was needed to offset the $500 billion decline in mortgage securitizations by SIVs and ABCPs. Those services came at a cost. The FHLBs reported a fourth-quarter loss of $672 million. The FHA announced a $4.6 billion loss for 2007. At the time that announcement was made, Congress was considering a proposal to have the FHA purchase $300 billion in subprime loans. Corporate earnings were considerably lower in the fourth quarter of 2007 as compared to the year before. Sprint Nextel survived the telecom shakeout that took down WorldCom and others but still struggled in 2007. It lost wireless customers to its competitors and eliminated 4,000 jobs as 2007 ended. Top

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. Prelude to a Crisis 465 management was replaced. Sprint announced a $30 billion loss in 2007 and warned of more difficulties in the following months. AOL shifted its marketing strategy, making its Internet service free, and sought to gain revenue from advertising, but that effort showed little sign of success. Revenue in 2007 was 33 percent lower than in 2006. ExxonMobil had a profit of $40 billion in 2007, the largest annual profit ever reported by a U.S. company. That profit caused much resentment because consumers believed it had been earned by charging them exorbitant gasoline prices. Southwest Airlines was feeling the benefits of derivatives. That air- line had hedged its fuel oil costs, allowing it to double its profit in the fourth quarter of 2007. In contrast, Delta Air Lines suffered a large loss because of increased fuel costs. Berkshire Hathaway had a very good year in 2007. In December it bought 60 percent of Marmon Holdings from the Pritzker family in Chicago for $4.5 billion. Marmon was the holding structure for the Pritzker’s industrial enterprises. Berkshire Hathaway’s head, Warren Buffett, planned to buy the remainder of Marmon over the next several years as the Pritzkers carried out their plan to liquidate the family’s enterprises. Berkshire Hathaway’s stock was up almost 30 percent at year-end. That happy condition would change in 2008. The Conference Board’s index of leading economic indicators trended downward in the last quarter of 2007. Several economists predicted a recession. The number of unemployed in December 2007 was more than a million higher than it had been at the same time the year before, an increase of 30 percent. Gold prices jumped by over 31 percent in 2007. The dollar’s exchange rate against other currencies was sinking. Between 1999 and 2001, the euro had lost almost 20 percent of its value against the dollar. However, the dollar then began faltering and fell below parity with the euro in 2002. The euro gained 10.6 percent over the dollar in 2007. The year 2007 turned out to be a hot one for IPOs in the largest such market in seven years. Offerings were led by foreign and technology companies, but the bulk of them took place in the first half of the year. The largest IPOs included the Blackstone Group, MF Global, Interactive Brokers, and Och-Ziff Capital Management. In March 2007 Goldman Sachs joined the increasingly popular IPOs for blank check offerings, or special acquisition companies (SPACs) that sought funds but did not disclose what the funds would be used for. Rather, these blind pools would look for opportunities. If they made an acquisition, they typically were given 20 percent of that company. Goldman Sachs insisted that the sponsors take less than the usual 20 percent fees in their offerings. The Dow Jones Industrial Average had its worst fourth quarter in twenty years, and it had several days with triple-digit losses, including a decline of 101 points on the last day of trading in 2007. The Dow finished up 6.43 percent for the year, but that gained paled beside the 2006 rise of 16.29 percent. Still, it was better than the small loss experienced in 2005. The S&P 500 index ended 2007 up 3.5 percent over the previous year, which was less than the

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 466 The Growth of the Mortgage Market inflation rate and lower than the yield on government securities. The Harvard endowment fund reported a gain of more than 7 percent in 2007, a remarkable performance in light of the losses sustained in almost all financial sectors. However, that situation would be reversed in 2008. Bank stocks were hammered by their subprime problems. The Dow Jones Wilshire Banks Index was down 26 percent in 2007. Wall Street firms cut 35,000 jobs during 2007. However, the investment banks did not slow their bonus payouts simply because of losses experienced in 2007. The amount of bonuses rose to $40 billion in 2007, up from $36 billion in 2006. Predictions were made that the total asset write-offs by financial institutions could exceed $300 billion for mortgage-backed securities. Even some conservative banks, like Wells Fargo, were damaged by bad credit decisions. In its case, home equity mortgage defaults and debt consolidation loans were the cause. Wells Fargo experienced a 38 percent decline in earnings in the fourth quarter of 2007, its smallest quarterly profit in six years. That drop was driven by a $1.4 billion increase in loan loss reserves. Liquidity woes spread abroad. Eurozone banks held more than $350 billion in off-balance-sheet asset-backed structures and leveraged loans. Nearly a million subprime loans were overdue by thirty days or more at the end of the third quarter of 2007. Late mortgage payments hit a twenty-one-year high at year-end. Balances on home equity lines of credit totaled $1.1 trillion as 2007 ended, and 5.7 percent of those credit lines were delinquent in repayment. Lenders cut back on home equity loans because the rate of delinquencies had nearly doubled in 2007. Homeowners seeking to refinance their mortgages encountered difficulty in having the holders of their home equity lines agree to subordinate their claims to the new first mortgage, permission that was granted almost automatically in the past. Some homeowners were asked to reduce their credit lines before receiving approval. The percentage of foreclosures and loans past due reached 7.9 percent of all loans outstanding in the fourth quarter of 2007, the highest rate since those figures began to be compiled in 1979. Some struggling homeowners refinanced their unaffordable subprime loans with reverse mortgages. The Bush administration sought to assist them by proposing a five-year freeze on subprime mortgage interest rates. Housing starts increased by an average annual rate of 8.5 percent between January 2003 and December 2005. However, housing starts fell by an annual rate of 21.8 percent between January 2006 and December 2007. Housing prices dropped by an annualized rate of 23 percent between November 2007 and Janu- ary 2008. During 2007, existing home sales dropped at a rate greater than had been seen in the prior twenty-five years. Pending housing sales fell to the lowest level in 2007 since such statistics began to be kept. Sales of existing homes dropped in December 2007 by 2.2 percent. The median price also declined, falling to $217,000, in the first such decline in price since the 1930s. The decline in real estate prices was not uniform across the country. In California, which led the nation in subprime mortgage originations, home sale

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. Prelude to a Crisis 467 prices fell on average by 36 percent in 2007, and Florida saw a decline of 30 percent. This was much higher than the national average of 20 percent. The vacancy rate for homes in the United States in the fourth quarter of 2007 rose to 2.8 percent, tying a record set earlier in the year. The National Association of Realtors reported that its index for pending home sales was down almost 20 percent in 2007. Housing starts hit a sixteen-year low as 2007 ended. New construction contracted by 14.2 percent in December 2007. Merger volume slowed dramatically in the second half of 2007. The commercial real estate market also suffered in 2007. Commercial lending set a record of $515 billion that year, mostly in the first six months of the year. Very little lending occurred in that market during the last six months of 2007. The national vacancy rate for commercial office buildings increased in the last quarter of 2007—the first such increase in four years. Corporate bankruptcies jumped by 40 percent in 2007. Among others, ResMAE Mortgage Corporation and American Home Investment Mortgage Corporation went bankrupt as a result of the credit crunch. Levitt & Sons, a unit of the giant Levitt housing construction company, declared bankruptcy in November 2007. The company halted ongoing construction, including homes on which families had made deposits and awaited construction to be completed. KB Homes reported a $772 million loss for its fourth quarter in 2007. The price of that company’s stock fell by 9 percent after that announcement. CIT Group, a New York–based finance company, issued a profit warning for 2007 and boosted its loan loss reserves. The company suffered losses on its student loan business as well as home mortgages.

Payday Lending

The House of Representatives approved legislation in November 2007 that would have made loan packagers for securitization and other secondary-market resales liable for predatory lending practices even if they did not originate the loan. That bill would require the SEC and bank regulators to set due diligence standards that would have to be met before banks could make mortgage loans. The measure was sponsored by Representative Barney Frank (D-MA). A bill sponsored by then–presidential candidate Senator Christopher J. Dodd (D- CT) would have gone further and allowed class-action lawsuits for failures by banks to exercise due diligence in assuring that loans could be repaid. Such legislation was not passed until 2010, and it softened these requirements but did impose some due diligence obligations. In the meantime, subprime borrowers looked for other sources of credit. The number of people living in the country who were “unbanked” (that is, who did not participate in the banking system) was estimated at more than 28 million in 2008. More than 50 million American citizens had no credit score. Payday lenders were supplanting, or replacing, commercial banks in many poor neighborhoods and were becoming an industry unto themselves. Some

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 468 The Growth of the Mortgage Market of the larger such firms were Ace Cash Express, Advance America, Check ’n Go, and Nix, as well as numerous local operations. Their fees ranged from about 2 to 4 percent for a two- to four-week advance. Because of such exorbitant charges and other abuses, Congress effectively banned payday loans to military personnel in 2006. Some states tried to regulate fees charged by payday lenders.25 The bankruptcy laws were amended in 2005 to make it more difficult for individuals to avoid repaying their debts. Homeowners in foreclosure did not find it as easy to declare bankruptcy as it had been before, but sometimes had few other options; thus bankruptcy filings were on the increase. The Fed announced in March 2008 that household wealth in the United States shrank by $533 billion in the fourth quarter of 2007, in the first such decline in five years. The number of new jobs was lower than expected for 2007. Other signs of slowing in the economy appeared. The number of people working part- time increased. According to one poll, consumer confidence had plunged to a fifteen-year low by the end of the year. Auto loans turned into another problem for financial institutions. Lending standards had been loosened, and delinquencies increased in number on such loans at the end of 2007. Retail sales declined in December by 0.4 percent. This performance was the worst in six months and was especially disappointing because it came during the holiday shopping season, on which retailers are dependent for a substantial portion of their annual sales. Despite a doubling of expected retail sales in November, Christmas in-store shopping was lackluster. Retail sales weakened at the end of December 2007, and several companies issued profit warnings. Even high-end jewelry stores experienced a downturn in Christmas sales. Tiffany’s issued a profit warning after the holiday season ended. Sales of other luxury goods also declined. Internet-based holiday sales increased by 19 percent, but that growth rate was well below the over 25 percent growth rate in prior years. Outstanding credit card debt totaled about $950 billion and grew by $20 billion in the fourth quarter of 2007.

Executive Compensation

The level of executive compensation continued to be high at financial services firms, which reported record profits before the subprime crisis hit. In fact, the pay was so good that one enterprising company hired an attractive model to stand in front of Goldman Sachs’ offices and hand out $1,000 discount coupons on corporate jet leases. A shortage of $250,000 Ferraris was also reported in the New York area. Among the winners was Charles Schwab, who took home more than $800 million over a five-year period. Another executive receiving generous packages was Lloyd C. Blankfein, the CEO at Goldman Sachs, with payouts of $54 million payout in 2006 and $69 million in 2007, which set a new record for Wall Street CEOs. Richard Fuld, CEO of Lehman Brothers

Holdings, was given a ten-year package valued at $180 million. He was paid more than $40 million for his work in 2007. John Mack, the head of Morgan Stanley, received $40 million in 2006, but his pay was cut to $1.5 million in 2007, after his firm suffered subprime-related losses. James Cayne, the head of Bear Stearns, received $163 million before 2008 began. Martin J. Sullivan at AIG was paid nearly $14 million in 2007. During the six years he served as Merrill Lynch’s CEO, E. Stanley O’Neal was paid a total of $157.7 million. The top five executives at Merrill Lynch received a total of $172 million in compensation for 2006. Even while these bonuses were being paid out, those executives were in the process of exposing Merrill Lynch to massive losses from the subprime market.

A Crumbling Landscape

The New Year

As 2008 began, some hope existed that the worst of the subprime crisis was past, but a number of troubling signs suggested otherwise. Some 2.1 million houses were for sale in the United States as the new year dawned, 2.6 percent of all existing homes—a figure exceeding by far the peak of 1.9 percent experienced during market downturns over the previous twenty-five years. About 25 percent of subprime home mortgage loans were delinquent or in default as 2007 ended, a rate that was likely to grow. Approximately 1.8 million subprime loans were scheduled to reset during 2008 and 2009 at interest rates well above their initial teaser rates. By January 2008, Wall Street financial services firms had written off more than $100 billion in assets as a result of their subprime investments. Mortgage defaults worldwide totaled about $150 billion, but more write-offs were expected. The rating agencies had already downgraded more than 2,500 classes of collateralized debt obligations (CDOs), and the primary and secondary markets for such securities had collapsed. Standard & Poor’s prepared to downgrade another $10 billion of subprime CDOs. Ultimately, rating agency downgrades would affect $1.5 trillion in mortgage securitizations. The category of loans above subprime, called Alt-A, were also at risk because they, too, had been issued in large numbers at teaser rates that would reset over the next several months. Subprime and Alt-A mortgages constituted some 40 percent of all home mortgage loans, so the risk from defaults was not inconsiderable. Concerns also focused on mortgage defaults at all other levels of credit classification. Because about 55 million of the 80 million homes in the United States were mortgaged, a substantial increase in defaults could have devastating economic effects in the United States and abroad. President George W. Bush sought legislation to assist homeowners having trouble with mortgage payments. The administration initially proposed a voluntary program under which mortgage issuers would suspend resetting

473

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 474 The Subprime Crisis interest rates and increasing adjustable rate mortgages. One proposal would have allowed low-income homeowners to refinance their mortgage through government-sponsored enterprises (GSEs), such as Fannie Mae and Freddie Mac, which would also be allowed to purchase larger, “jumbo” mortgages. That program never really got off the ground. Economists predicted that the United States would fall into a recession that might be one of the most severe in its history. The chairman of the Federal Reserve (the Fed), Ben Bernanke, signaled on January 10, 2007, that the Fed recognized that the economy was declining and that another interest rate cut might be in order. He stated that he would, in the future, more clearly express to the market what the Fed’s views were on the economy. This approach reflected a departure from the calculated mumbling of his predecessor, Alan Greenspan, who turned out to be surprisingly articulate after he left office and wrote his memoirs. Those memoirs were remarkably free of the garbled and unintelligible “Fedspeak” used by Greenspan for years to deflect questions and obscure answers that might roil the markets. Although Bernanke promised to add more transparency to the Fed’s views as a result of criticism that he was not forthcoming and causing confusion and a loss of confidence in the market, that promise was never fulfilled. Losses on bank-issued credit cards mounted even for high-end consumers. American Express reported that the rate of spending by its more than 50 million cardholders was dropping. It had not experienced a decline in spending by its cardholders since 2001. This was not a signal that could be ignored. About 90 percent of Americans with incomes of more than $30,000 used credit cards in 2008, and about 40 percent of all transactions were paid by credit cards, up from 25 percent in 2000. The retail industry was experiencing its worst sales in seventeen years as 2008 began. At the same time, increased energy prices were a growing concern for consumers. Crude oil prices rose by 57 percent in 2007. A single floor trader on the New York Mercantile Exchange (NYMEX) bid the price of a barrel of crude oil above $100 for the first time ever in January 2008. This was a stunt, and the CFTC fined the trader’s firm, ConAgra Trade Group, $12 million for this conduct. That price did not last the day, but the market would soon overtake his stunt. Heating oil costs were expected to increase by 33 percent in 2008. The Dow Jones Industrial Average was off to a rocky start. The year began with a drop in the stock market after it was reported that the unemployment rate had risen to 5 percent, the highest rate in over two years. The Dow experienced a 3.5 percent fall in the first three days of trading, as well as more than five declines exceeding 200 points in the first ten trading days of the year. By January 15, the Dow was at 12051.11, down from the high of 14164.53 reached in October 2007. Other indexes were also down. The NASDAQ fell by 3.8 percent on its first day of trading in the new year. The Russell 2000 index of small cap stocks was down almost 20 percent over the previous six months.

The first thirteen trading days of 2008 were the worst ever for the Dow Jones Industrial Average for that period. It fell by 507 points during the week ending January 19, 2008. Things only got worse. Markets around the world plunged on January 21, 2008, a day on which the markets were closed in the United States because of the Martin Luther King holiday. Stock markets in Germany, India, and the UK were especially hard hit, falling from 5.5 percent to 7.4 percent. This sell-off was spurred by events at the French bank Société Générale.

Société Générale

Société Générale (SocGen), which had been selected as Risk Magazine’s “equity derivatives house of the year,” announced a write-off of nearly $3 billion in the fourth quarter of 2007. That write-off was needed to cover exposures from the U.S. housing market and from monoline bond insurers in the United States that were unable to fulfill their obligations to cover credit losses experienced by the bank. That problem was more than matched in January 2008, when Jérôme Kerviel, a midlevel employee at SocGen, set a new rogue trader record. Kerviel racked up $7.2 billion in trading losses on futures contracts that had a notional value of more than $75 billion. That loss far exceeded the $1.3 billion lost by the former king of rogue traders, Nick Leeson, who brought down the venerable Barings Bank in 1995. Kerviel had taken this huge position in the Dow Jones Euro Stoxx 50 Index and the German DAX Index. He had been bullish on the market. After the bank dumped his positions, a market panic broke out that only worsened the losses at SocGen and destabilized markets around the world. It was unclear what Kerviel’s motivations were because he was an employee, with a salary of about $150,000. He had been able to hack into the bank’s computers and cover up his trading losses for several months. Kerviel was given a rather mild sentence of three years in prison and a ridiculous fine of $6.7 billion. SocGen announced that Daniel Bouton was being replaced as CEO as a result of his failure to protect the firm from Kerviel. The plot thickened in August 2009, when French authorities charged Jean-Pierre Mustier, the head of the department at the bank where Kerviel worked, with insider trading. Re- markably, another French bank, Caisse d’Epargne, announced an unauthorized derivatives trading loss of over $800 million on October 17, 2008. Although U.S. markets were closed on January 19, the worldwide stock market sell-off resulting from Kerviel’s trading unsettled the Fed. In response, it announced a 75–basis-point reduction in interest rates on January 22, 2008, bringing short-term interest rates down to 3.5 percent. There seemed to be some disagreement as to the historical significance of this rate cut. The New York Times called it the largest rate cut ever by the Fed, while the Wall Street Journal claimed it was only the largest cut in the previous twenty years. In any event, the stock market initially plunged after it reopened on January 20,

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 476 The Subprime Crisis and the Dow fell 464 points after its opening. However, the announcement of the Fed’s interest-rate cut rallied the market two days later, and it closed to within 26 points of its prior-day close.

Countrywide Financial

Countrywide Financial Corporation, based in Calabasas, California, was a centerpiece of the subprime crisis. Founded in 1969 by Angelo Mozilo and David S. Loeb, it grew rapidly, becoming the nation’s largest mortgage lender in the early 1990s. Countrywide financed about 20 percent of all domestic mortgages in 2006, most of which were originated by mortgage brokers and sold to Countrywide. Between 1982 and 2003, Countrywide’s stock increased in value by 23,000 percent. The American Banker called Mozilo the “Banker of the Year” in 2004 as the result of his expansion of Countrywide’s lending. That expansion would come with a heavy price. Mozilo led Countrywide into the subprime market, and he became the sym- bol for all that was wrong with such lending. He sold $475 million of his own Countrywide stock between 2001 and 2006. After Countrywide collapsed in 2008, Mozilo’s compensation came under fire. Internal notes at Countrywide revealed that the company hired two compensation consultants to assess the appropriateness of Mozilo’s pay; the first had stated that Mozilo’s compensation was inflated. As the firm’s losses mounted Mozilo agreed to take a 79 percent cut in pay in 2007, decreasing his salary for the year to $10.8 million; however, his stock options netted him an additional $121.5 million. Before the subprime crisis, Mozilo was hailed as a hero for widening access to credit for low-income families. He also assisted the wealthy and well connected by arranging loans for them on favorable terms. These loans were carried out through a VIP program that was internally referred to at Countrywide as FOA (Friends of Angelo) loans. As described in Chapter 1, the VIP loan program had been used to make numerous loans to executives and employees at Fannie Mae. A congressional investigation during the subprime crisis also found that Mozillo had paved the way for loans on favorable terms to several high-profile individuals, including players with the National Football League and the purchaser of a home from Wayne Gretzky, the ice hockey star. Mozilo also helped the child of a casino manager buy a home in Nevada, even though the applicant did not qualify. Senator Christopher Dodd (D-CT) obtained loans from Countrywide, but he denied any special treatment. Dodd asserted that he obtained the loans through portfolio.com, but documents revealed that Countrywide had been involved in adjusting the loan terms. The senator saved about $75,000 in interest through these loans.1 Dodd, the chairman of the Senate Banking Committee, was leading the Democratic response to the subprime crisis. Another member of Congress, Representative Edolphus Towns (D-NY), had blocked Republican efforts to subpoena Countrywide records on the VIP loan program. However,

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. The Crisis Begins 477 it was revealed that Towns himself had received two loans from Countrywide, and they were apparently made through its VIP program. FOA loans also found their way into the 2008 presidential campaign. Senator Barack Obama’s choice of Washington insider James Johnson, the former head of Fannie Mae, as one of his vetters for vice-presidential candidates caused much criticism after it was discovered that he had obtained loans on favorable terms from Mozilo. Johnson was forced to resign from the Obama campaign. Johnson also referred Senator Kent Conrad (D-ND) to Mozilo. Conrad denied receiving any special treatment. However, an internal e-mail showed that Mozilo had asked for a discount on a loan for Conrad’s beach house. In addition, an exception was made for Conrad on a loan for a multiunit apartment building that had more units than Countrywide would normally finance. As penance, Conrad agreed to donate $10,500 to Habitat for Humanity. The Senate Ethics Committee later cleared both Dodd and Conrad of wrongdoing, but stated that they had used bad judgment. Actually, it was a common practice for mortgage lenders to grant favorable terms to individuals with personal or business ties to executives of the lender. The populist presidential campaign of Senator Barack Obama was hit by charges that he had received a healthy $1.32 million mortgage from Northern Trust in Chicago on his $1.65 million home at an interest rate that was below market. That miniscandal grew a bit after it was discovered that the wife of one of Obama’s principal supporters, Antoin Rezko, bought the lot next door and sold Obama a portion of that lot. Rezko was subsequently convicted on sixteen counts of corruption. Countrywide went on a lending spree between 2003 and 2006. Its loan portfolio grew from $62 billion to $463 billion. Much of that growth was in the form of subprime loans issued at initially low teaser rates. Trouble bubbled up at Countrywide in the fourth quarter of 2006, when its earnings began to decline as interest rates increased. Countrywide also experienced a sharp increase in delinquent mortgage payments. Overall, payments were late on 19 percent of subprime loans, up from 15.2 percent before the crisis. On July 24, 2007, Mozilo shocked financial analysts when he said: “We are experiencing a huge price depression, one we have not seen before—not since the Great Depression.”2 He also stated that he did not foresee a recovery until 2009, then two years away, a forecast that proved to be remarkably prescient. However, those remarks caused a precipitous drop in Countrywide’s stock, and the Dow Jones Industrial Average dropped by 226 points. As concerns over the subprime market grew, Countrywide became a leading target of critics of lending practices in that market. The company was accused of ignoring inflated income figures in loan applications and allowing no-doc loans through its “Fast and Easy” loan program for subprime borrowers. A federal judge authorized an inquiry into Countrywide’s loan-processing practices after a number of problems arose with its loan documentation for foreclosures. Among other things, Countrywide had credited payments made by a debtor to

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 478 The Subprime Crisis prebankruptcy debt, which was not permitted. Countrywide agreed to settle claims involving its documentation, a complaint that was made in a bankruptcy proceeding in Pittsburgh. The firm had been accused of misconduct by the bankruptcy trustee in that case for losing more than $5,000 in checks paid by homeowners while in foreclosure proceedings. Mozilo suffered another embarrassment when he inadvertently sent his criticism of a homeowner’s plea for readjustment of mortgage terms to that homeowner. Mozilo’s e-mail stated: “This is unbelievable. Most of these letters now have the same wording. Obviously they are being counseled by some other person or by the Internet. Disgusting.” In order to quell controversy, Countrywide announced the adjustment of the terms of more than 81,000 mortgages in order to keep them from defaulting. By this point Countrywide serviced $1.4 trillion in loans, had 900 offices nationwide, and was the largest servicer of mortgages in the United States. Countrywide announced in July 2007 that its earnings were down 33 percent and issued a profit warning for the rest of the year from expected losses from subprime mortgages. Bank of America sought to rescue Countrywide with a $2 billion investment on August 23, 2007. Later, Bank of America purchased $26 billion in Countrywide convertible preferred stock in order to provide it with capital needed for its survival. Countrywide announced that it was cutting its workforce by 20 percent, which meant a loss of 12,000 jobs. It also was able to obtain $12 billion in additional financing, but the meltdown at that company continued. In 2007 Countrywide had its first quarterly loss in twenty-five years, presaging the coming crisis. It took a $2.7 billion write-off on its mortgages at the end of the third quarter in 2007, resulting in a loss of $1.2 billion for the quarter. The situation only worsened. Countrywide Financial Group had been valued at $24 billion in mid-2007, but faced bankruptcy as 2008 began. In January 2008 Countrywide reported that its overdue payments from borrowers had risen to 7 percent, up from 5 percent the previous year. Bank of America then mounted another rescue effort, announcing on January 11, 2008, that it would purchase Countrywide in its entirety for $4 billion. However, when the Countrywide deal closed in July 2008 it was valued at only $2.5 billion, and the acquisition crippled Bank of America, at least for a time. The once widely admired Countrywide name was changed by Bank of America in February 2009. The Securities and Exchange Commission (SEC) later sued Mozilo, claiming that he had privately warned of the dangers of the subprime mortgages on Countrywide’s books while publicly stating that Countrywide was underwriting low-risk mortgages. This was a replay of the charges against Ken Lay and Jeffrey Skilling at Enron. In internal e-mails, Mozilo stated that subprime mortgages were “poison” and were “the most dangerous product in existence and there can be nothing more toxic.”3 Mozilo asserted that the sales were made pursuant to a prior written plan as

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. The Crisis Begins 479 permitted by SEC rules, but the SEC noted he had changed the plan on more than one occasion to vastly increase his sales. Charges were also brought against Countrywide’s chief operating officer (CEO), David Sambol, and its chief financial officer (CFO), Eric Sieracki. Sambol’s lawyer charged that the SEC was grandstanding. Mozilo settled the SEC’s claims for $67.5 million but Bank of America agreed to pay $45 million of that amount, as well as Mozilo’s legal expenses, leaving a mere wrist slap for Mozilo. Sambol settled for $5 million but Bank of America picked up that entire tab. Sieracki contended that he had did nothing wrong and paid only $130,000 to rid himself of the matter. The Countrywide acquisition made Bank of America the country’s largest mortgage lender, involving that bank in about 25 percent of all private sector mortgage loans. It also brought a host of problems. The bank later agreed to settle a class-action suit for $600 million, which charged that Countrywide had not disclosed the risks of its lending practices. Countrywide’s auditor agreed to pay an additional $24 million to settle claims over shortcomings in its audit work for Countrywide. In another case, Bank of America agreed to pay the Federal Trade Commission $108 million to settle charges that Countrywide inflated fees associated with mortgage defaults. Bank of America agreed to settle claims by several state attorneys general over lending practices at Coun- trywide. More problems followed from the attorneys general of California, Connecticut, and Florida, who demanded that Bank of America adjust the terms of mortgages issued by Countrywide for some 400,000 homeowners who were in danger of default. Bank of America agreed to that demand but then found itself in the middle of a conflict with investors in mortgages that had been securitized. Greenwich Financial Services Distressed Mortgage Fund 3 brought a class-action lawsuit, charging that this agreement with the states was unlawful and undercut the value of mortgages that were the subject of securitizations and that Countrywide was contractually required to purchase at par any mortgage loan that it modified. Mortgage modifications created another problem. Many of the securitized mortgages were registered with and recorded in the name of the Mortgage Electronic Registration Systems (MERS), so that when the mortgage was transferred in a securitization no local registration fees would need to be paid. MERS was created in 1993 at the recommendation of the Mortgage Bankers Association, Fannie Mae, and Freddie Mac as a means of saving on those transfer fees. Owned by a group of large banks, including JPMorgan Chase and Citigroup, MERS serviced some 3,000 firms that paid fees for that activity. However, MERS created some confusion for homeowners facing foreclosure during the subprime crisis because the registration of the mortgage in MERS’s name made it hard to tell who was the actual owner of the mortgage.4 On January 22, 2008, Bank of America reported a $5.4 billion writedown of its assets due to subprime mortgage losses. The bank still had $12 billion in exposure from subprime loans remaining on its books, including about $8 billion in CDOs. Bank of America’s loan portfolio was further weakened by

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 480 The Subprime Crisis its $21 billion purchase of LaSalle Bank in Chicago, which had a number of troubled loans on its books. In order to shore up its capital position, Bank of America announced on January 23, 2008, that it would make a preferred share offering totaling $6 billion. This soon became the public offering of choice for financial services firms to raise capital. In the case of trust preferred stock, banks could treat the proceeds from such offerings as Tier 1 capital required for regulatory capital requirements but also as debt for other purposes.

The Crisis Continues

JPMorgan Chase reported on January 16, 2008, that it would write down $2.3 billion in failed mortgage investments and credit card delinquencies, a relatively small amount, at least compared to the sum at Citigroup. Citigroup’s stock had reached $57 a share in December 2007, but fell below $29 as 2008 began. Citigroup’s stock lost another 14 percent in the week ending January 18, 2008. Citigroup reorganized its mortgage business at the beginning of the new year in an effort to better manage losses from the subprime lending that had caused the removal of Charles Prince as Citigroup’s CEO. The firm’s subprime problems appeared to be related to its ACC Capital Holdings unit, but its troubles were by no means over. The subprime losses at Citigroup caused pundits to question whether that conglomerate of financial services should be broken up because the management of such a diverse set of risks appeared to be a task beyond its management’s ability to handle. The Dow Jones Industrial Average fell by over 300 points on January 17, 2008, after Washington Mutual, another large mortgage lender, reported a loss of $1.87 billion in the fourth quarter of 2007. Merrill Lynch and Citigroup announced on January 15, 2008, that they would seek a total of $21.1 billion in new capital from foreign and domestic investors, which included sovereign wealth funds from South Korea, Singapore, Kuwait, and Saudi Arabia, a Japanese bank, and the state of New Jersey Division of Investment, which managed that state’s employee pension funds. Other investors solicited were the Olayan Group, a private equity group in Saudi Arabia, the T. Rowe Price Group, a mutual fund complex, and Capital Research & Management, a mutual fund manager. Sandy Weill, who had turned Citigroup into the world’s largest diversified financial services firm before his retirement, was also approached for an additional investment in Citigroup.

Policy Developments

President Bush sought a cooperative effort in Congress that would provide a stimulus to the declining economy as 2008 began. Fed chairman Bernanke advised Congress in January 2008 that he would support tax cuts or other

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. The Crisis Begins 481 stimulus to the economy. Some economists charged that Bernanke’s interest rate cuts were simply a replay of what caused the problems in the first place. Several mayors of large cities complained at the United States Conference of Mayors in January 2008 that the collapse of the subprime market was devastating their cities because of a sharp rise in vacant homes. Perhaps more important, their tax base was eroded by foreclosures and declining property values. Subprime borrowers were given some tax relief by being allowed to deduct the cost of mortgage insurance, provided that they earned less than $109,000 annually—which, of course, limited the value of the deduction to those with little or no tax exposure. The crisis caused even ardent capitalists to question the role of competitive markets. Bill Gates, of Microsoft, and once considered a ruthless capital- ist, called for a kinder, gentler “creative capitalism” that would help less- developed countries focus on building products and services. Gates’s remarks were made at a World Economic Forum conference in Davos, Switzerland, in January 2008. George Soros, the famous hedge fund manager, declared at that conference that the subprime crisis had ended U.S. economic supremacy and that the U.S. dollar would no longer be viewed as the reserve currency. Soros published a book in 2008 in which he asserted that a superbubble had developed over the past quarter century and was now bursting. He posited a theory that he called “reflexivity,” which asserted that markets do not reflect values but drive them. Soros later asserted that bank profits were “hidden gifts” from the government. Housing prices in the UK were falling. Like the United States, it faced a “reset” crisis from loans that had been issued at teaser rates and would reset at prohibitively higher rates. More than 4 million mortgages in England would reset, an increase of more than 50 percent over the previous year, causing the banks to worry about further losses. The Financial Services Authority in Lon- don tried to bolster its image by fining the Thinc Group, a financial adviser, $1.8 million in May 2008 for loose practices in its documentation of subprime loans. The firm had not properly vetted borrowers to determine whether they could repay the loans. Inflation in the eurozone was 3.2 percent in January 2008. This was a fourteen-year high, and the European Central Bank signaled that it would not lower interest rates. However, European economies were slowing as 2008 began. The Hypo Real Estate Group in Germany, a commercial bank, wrote down $580 million at the end of 2007 because of CDOs on its books. The German bank WestLB announced on January 21, 2008, that its owners contributed $3 billion to boost its capital as a result of losses in its mortgage portfolio. In January 2008 Warren Buffett’s Berkshire Hathaway purchased a 3 percent stake in Swiss Reinsurance, which had taken large losses from subprime exposures. Buffet contributed another $2.63 billion in January 2009. The Canadian Imperial Bank of Commerce announced on January 14, 2008, that it would

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 482 The Subprime Crisis issue $2.7 billion of its own stock at a discount in order to boost its capital. The bank was writing down a similar amount for its subprime exposure. The default rate on junk bonds was rising as 2008 began and was expected to reach 5.3 percent by year-end, up from 4.7 percent in the prior year. Com- mercial development also slowed in 2008, with construction in that sector falling by 1.7 percent in January, the largest decrease in fourteen years. Gold prices hit $901.60 per ounce on the Commodity Exchange (Comex) on January 14, 2008. The previous high for gold was $875 on January 1, 1980. Crude oil prices fell to $86.99 a barrel on January 23, 2008. Consumer spending rose only 0.1 percent in January 2008, while incomes rose 0.5 percent. Money market fund assets rose to $2.76 trillion, as consumers turned to cash-like investments for safety. Although the Dow Jones Industrial Average dipped by 250 points on January 23, 2008, it rallied after a surprise interest rate cut by the Fed rippled through the market. The Dow finished up for the first time in five days, closing at 12270. Still the market was down from its 2007 high. In prior stock market declines, many corporations rushed in and purchased their own shares, causing a rally in the stock. Few such purchases were made as the stock market fell at the end of 2007 and into 2008. Even some large law firms were hurt by the credit crunch as their structured finance groups were sidelined by the shutdown in the market for mortgage- backed special-purpose entities. Cadwalader, Wickersham & Taft, a large and old-line New York law firm, announced a layoff of thirty-five attorneys, a very rare step for a large law firm to take. Skadden Arps, Slate, Meagher & Flom put young attorneys on leave, at half pay, for a year.

Mortgages

Writedowns required by mark-to-market accounting resulted in $41.8 billion in losses at Merrill Lynch, $37 billion at Citigroup, $26 billion at American International Group (AIG), $13.5 billion at Lehman Brothers, and $12.3 billion at Wachovia. Those writedowns devastated the firms. Second mortgages were another growing problem. Citigroup had run a “live richly” campaign before the subprime crisis that was designed to encourage homeowners to seek second mortgages so that they could live it up. This was lucrative business for the banks because of higher returns on second mortgages. In 2008, however, delinquencies on second mortgages increased at a rate about 50 percent higher than those on first mortgages. Mortgage refinancings were up in January 2008 as lower interest rates attracted the attention of homeowners. Refinancing applications were at the highest level since March 2004. Between July 2007 and February 2008, mortgage companies restructured more than a million mortgages in order to ease their terms and allow the homeowners to avoid foreclosure. About 73 percent of these adjustments involved arrangements that allowed borrowers to catch up on missed payments or to apply missed payments to the principal of their mortgage. Only about 27

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. The Crisis Begins 483 percent of the adjustments involved reducing interest rates, forgiving some of the principal, or extending the maturity date. Nearly half the mortgages being adjusted in January 2008 were “prime” mortgages, issued to borrowers with good credit histories. The rate of foreclosures that involved prime mortgages increased by 41 percent in January 2008. Some states sought to impose moratoriums on foreclosures to give borrowers more time to refinance their delinquent mortgages. At the end of January 2008, interest rates on thirty-year fixed rate mortgages averaged around 5.48 percent. Fannie Mae, Freddie Mac, and the Federal Home Loan Banks (FHLBs) at the time provided 90 percent of financing for new mortgages. Fannie Mae and Freddie Mac planned to purchase or guarantee up to 80 percent of all new home loans made in 2008, up from 55 percent the previous year. This expansion of their role was a complete reversal from the government’s efforts to curb those agencies’ activities after they encountered accounting problems. The SEC opened some thirty-six investigations related to subprime lending losses as the crisis crested. The agency created a Subprime Working Group, and SEC chairman Christopher Cox advised Congress that the agency was working to create a multiprong response to the subprime crisis. Actually, the agency did very little that had a positive effect. An example of this more forceful approach involved Countrywide after it reported an $893 million loss for the first quarter of 2008. Countrywide became the subject of a number of investigations by the SEC and state attorneys general, as well as class-action lawsuits. The SEC examined whether Countrywide had maintained sufficient reserves in case of losses on its subprime loans. Criminalization of the subprime crisis began in earnest in March 2007 with an FBI investigation of Countrywide Financial for securities fraud. The FBI was investigating whether Countrywide had properly disclosed its financial condition to shareholders. The campaign against Countrywide Financial increased with leaks to the press in March that the company’s credit files often contained erroneous or questionable information about loan applicants. In response to those leaks, the states of Florida, Illinois, and California sued Countrywide in June 2008, charging that it had engaged in deceptive lending practices when making mortgages in those states. The federal government created a task force in January 2008 to investigate the mortgage industry. Participants included the FBI, the criminal division of the Internal Revenue Service (IRS), and U.S. attorneys in several cities, including New York, Los Angeles, Philadelphia, Dallas, and Atlanta. They investigated whether lenders had encouraged borrowers to submit inflated income figures in order to obtain loans for which they were not qualified. At- torney General Michael Mukasey was under fire in April 2008 for refusing to create a more aggressive task force, like the one created to investigate Enron, to attack subprime lenders. He calmly replied that he needed a task before creating a task force.

Nevertheless, as the Obama administration took office, the Justice Depart- ment announced that the president’s Corporate Fraud Task Force, which had been created to prosecute the Enron-era scandals, was being expanded to include six new agencies that would focus on mortgage and securitization fraud cases. In March 2009 Democratic senators also called for the creation of an interagency Economic Crisis Financial Crimes Task Force that would prosecute those contributing to the subprime crisis. The U.S. Attorney’s office in Brooklyn created a task force of its own that included New York State regulators. The number of mortgage fraud cases increased to 1,200 in 2007, compared with 436 cases in 2003. Prosecutors vied with one another to see who could conduct the most prosecutions for subprime problems. The U.S. Attorney’s office in Brooklyn appeared to exceed the Manhattan office in zeal. In the first months of 2008, some 400 people were charged with crimes in connection with loan schemes. “Operation Malicious Mortgage” resulted in 144 indictments. The FBI claimed that losses from those crimes totaled more than $1 billion. The FBI also announced in May 2008 that it had launched thirty-four task forces nationwide to investigate lending practices related to mortgages, particularly subprime mortgages. One fraud scheme investigated by the FBI involved loan brokers who required advance fees to obtain a loan but did not extend a loan after receiving the money. Two brokers working at Credit Suisse Securities were indicted for misleading customers as to the nature of their CDO investments. The defendants told investors that they were investing in safe student loans backed by the federal government. In fact, the investments involved risky mobile-home mortgages and other subprime mortgages. Federal prosecutors indicted nineteen people in California in March 2008 for mortgage fraud in a case in which investors purported to extend loans to homeowners having difficulty meeting their mortgage payments. The “investors” then refinanced the loan through a bank and stole the equity that had been accumulated in the home. New York attorney general Andrew Cuomo investigated Washington Mutual in order to determine whether it had pressured appraisal companies to use particular appraisers in order to assure that that the appraisal value of homes would be high enough to allow a larger mortgage than was justified by the real value of the property. Cuomo expanded his subprime investigation to include Fannie Mae and Freddie Mac. This raised a jurisdictional issue because both of those GSEs are federally chartered and regulated by federal agencies. Nevertheless, Fannie Mae and Freddie Mac entered into a settlement with Cuomo in which they agreed to adopt a code of good conduct and to buy mortgages only from lenders using independent appraisers. Critics charged that the code of conduct pushed by Cuomo would only increase settlement costs for borrowers. Because Fannie Mae and Freddie Mac controlled much of the mortgage market, this code of conduct would apply nationwide and to most mortgages.

The Crisis Continues

The Treasury Department reversed itself as the subprime crisis worsened and sought less regulation, rather than more, of Fannie Mae and Freddie Mac. The Fed was under attack in Congress for its failure to detect the large risk exposures by banks from subprime mortgages. Questions were also raised as to how the off-balance-sheet structured investment vehicles (SIVs) had been allowed to grow and present such dangers, particularly in light of the prior problems at Enron with off-balance-sheet structures. The Financial Accounting Standards Board (FASB) began to re-examine the treatment of off-balance-sheet vehicles once again in February 2008, but heavy industry lobbying sought to keep them off the balance sheet. The FASB issued guidance in April 2008 that allowed banks, starting in the second quarter of 2009, relief from fair-value accounting, which had forced banks to take massive writedowns because their mortgage holdings were priced at fire-sale prices unrelated to their actual value. Bernanke testified before Congress that he expected there would be some bank failures but did not expect a recession or a return of stagflation, the latter being a growing concern as commodity prices rose and the economy continued to slow. At the request of Treasury Secretary Henry Paulson, several large mortgage lenders agreed to create new programs that would allow troubled subprime borrowers to refinance their mortgages on more affordable terms or to freeze their floating interest rates for five years. Paulson also asked mortgage lenders to ease loan terms for borrowers above the subprime level. He noted that foreclosures were increasing even for prime mortgages. This was an expansion of an earlier program in which President Bush asked that mortgage lenders freeze rates on subprime mortgages that reset at higher levels as 2008 began. President Bush also cautioned in January 2008 that the economy appeared to be slowing. Congress and the White House were sharply divided, and any agreement on boosting the economy would be difficult to reach. Treasury Sec- retary Paulson announced the Bush administration’s opposition on February 28, 2008, to a plan circulating among Democrats in Congress that would bail out homeowners defaulting on their mortgages. Ironically in light of subsequent events, he asserted that there should be no bailouts for reckless lenders and speculators. Rather, he proposed a market-based disciplinary approach to meet the rising problems in the mortgage markets. Presidential candidate Senator John McCain also announced his opposition to any government bailout from the subprime crisis. He stated that it was not the responsibility of the government to bail out either the big banks or small borrowers who acted irresponsibly and blamed the crisis on “rampant speculation.” Representative Barney Frank, Democrat from Massachusetts and chairman of the House Financial Services Committee, embraced any and all new regulation, whatever its cost-effectiveness. He was wildly in favor of government bailouts and sought to have subprime mortgages refinanced with mortgages

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 486 The Subprime Crisis guaranteed by the Federal Housing Administration (FHA). Frank wanted Congress to appropriate $20 billion to allow the FHA to refinance mortgage- backed SIVs. At the same time, Senator Dodd sought the same amount to create a new “Home Ownership Preservation Corporation.” Paulson opposed those proposals. Under pressure to do something, the Bush administration proposed a $140 billion stimulus package. Bush and leaders in Congress agreed on a more inflated $168 billion stimulus package on February 8, 2008, largely a tax rebate package that would give tax credits ranging from $300 to $1,200 to approximately 120 million families. This seemed a strange solution because a similar rebate had been used in an effort to avoid a recession in 2001, but was found to have little effect on the economy. The Bush administration was criticized by conservatives for not insisting that tax cuts be made permanent as a part of the package in order to bolster business confidence. The stimulus package increased the limits on loans insured by the FHA to $700,000. However, the FHA faced a deficit in 2008 for the first time in its seventy-five-year history. The ceiling on mortgages that could be guaranteed by Fannie Mae and Freddie Mac was also raised by the stimulus package to $625,000, from $417,000. Fannie Mae declared that it was planning a new program to restructure loans for homeowners whose mortgages were “underwater,” that is, their homes were worth less than their mortgages. The President’s Working Group on Financial Markets (PWG) proposed broad changes in the regulation of securitized transactions and sought regulation of the mortgage origination process. The PWG wanted more disclosures about the risk characteristics of structured financial instruments and a distinctive system for rating such instruments. The PWG further sought enhancement of risk management controls and disclosure of off-balance-sheet transactions.

Auction Rate Security Market

An auction rate security (ARS) is a form of money market investment that is essentially a long-term bond using periodic auctions to reset the interest rate on the instrument at market rates.

In other words, ARS are long-term bonds whose interest rates are based on short- term market interest rates. The interest rates for ARS are typically set at a dutch auction, which are held at seven, twenty-eight, thirty-five, and forty-nine day intervals. . . . ARS are issued as either bonds or preferred stock and are designed to serve as money market-type instruments. Also, it is important to note that ARS have long-term maturity or no maturity at all. They have been marketed to rich individuals (for tax exemption purposes) and corporate treasuries (for liquid cash on corporate balance sheets, however taxable) as an alternative to money market funds.5

Municipalities and not-for-profit institutions issued many of these auction rate securities. There was also an active auction rate market for student loans that many individual investors used for their short-term investments.

Minimum investments were around $25,000. The principal underwriters for ARSs were Citigroup, UBS, Morgan Stanley, and Merrill Lynch, but other investment bankers also offered such programs. The brokerage firms were paid for the issuance of the securities when first underwritten. They also received an annual fee of 0.25 percent of the value of the securities being auctioned. Additional fees could be earned through interest rate swaps used in conjunc- tion with the notes. The auction rate market had about $330 billion in outstanding obligations in February 2008. More than 400 companies, including Google, Bed Bath and Beyond, and Starbucks, had large exposures from such investments in the first quarter of 2008. Auction rate securities typically paid one percentage point more than money market funds, which made them attractive to large investors seeking a place to invest funds for a short term with the assurance of liquidity. Liquidity, however, depended upon the success of the auctions, which allowed investors to sell out their positions and reset interest rates for new participants. Problems had previously arisen in the auction rate market. An auction involving MBank failed in 1989, resulting in a default. The SEC in 2006 charged several investment bankers, including Bear Stearns, JPMorgan Securities, Goldman Sachs, and Lehman Brothers, with manipulating auctions in order to assure their success and favoring some customers over others. However, those problems proved to be minor, at least in the context of the freezing of this market during the subprime crisis. Auctions for about $80 billion of these securities failed in the second week of February 2008 when buyers declined to participate in sufficient numbers to provide liquidity. In April, more than 500 auctions were scheduled during a single day for $27 billion in ARSs, but they, too, failed. Under the terms of many ARSs, if an auction failed, the holder would receive an interest rate below LIBOR until new buyers entered the market, allowing the auctions to be resumed. This meant that the holder would have to either sell at a large discount or accept a very low interest rate. As a result of the auction failures, ARSs posed an unexpected liquidity problem for the holder. However, it was a liquidity issue, not a default on payments, over how low the interest payments might be after an auction freeze. The liquidity problem could be solved in part by using the ARSs as collateral for a margin loan until they were refinanced. The auction rate market slowly thawed out in May 2008. By then, about 25 percent of the market had been refinanced. Much of the rest of the ARS market was expected to be refinanced by the end of 2008, allowing investors to reaccess their funds. The most problematic were the student loan auction rate notes, which reset at very low rates, even zero in some instances, when an auction failed. As a consequence, the issuer had no incentive to refinance those notes. Indeed, many of those issuers suffered losses in the student loan market, and this was a way for them to ease those problems. Citigroup, Bank

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 488 The Subprime Crisis of America, and UBS approached student loans authorities for a waiver of restrictions in order to prevent auction failures, but those lenders were more interested in a lower interest rate. After coming under pressure from regulators and threats of investor lawsuits, several investment banking firms agreed to buy back the ARSs that they had underwritten. Bank of America agreed to buy back $4.5 billion in ARSs from investors in September 2008; Morgan Stanley agreed to repurchase $4.5 billion. Nuveen Investments, a mutual fund manager, agreed to refinance $4.3 billion in ARSs issued by its mutual funds. However, that refinancing proceeded at a snail’s pace well into 2009. A company called SecondMarket bought those frozen ARSs at a discount of 13 percent. An already troubled Citigroup announced plans to buy back more than $7 billion in ARSs. Citigroup also agreed to pay a fine of $100 million to state regulators, which included New York attorney general Andrew Cuomo and regulators from forty-eight other states, who charged that misrepresentations had been made in connection with the ARS auctions. UBS, another troubled bank, initially lowered the value of ARSs, which meant a loss to the holders of that ARS debt who had invested in the belief that their funds were completely liquid and free of most risk. UBS clients wrote down an average 12 percent of the value of the securities. However, after pressure from attorneys general, led by Andrew Cuomo, and threats of class-action lawsuits, UBS announced a repurchase of ARSs totaling $19 billion. In August 2008, UBS agreed to buy back more than $41 billion in ARSs as a part of a settlement with various regulators and agreed to pay a $150 million fine. UBS further agreed to pay $35 million to municipalities in Massachusetts that had bought ARSs after they were told they were completely liquid, but those investments were frozen when the auctions broke down. The bank paid an additional $4.4 million to settle claims by the State of Massachusetts that it had misled investors into investing in ARSs. Somewhat bizarrely, $1 million of that amount was to be used to educate government officials about investing in government funds. UBS general counsel David Aufhauser, a former official in the Treasury Department, was charged with misconduct involving his personal sales of ARSs after he realized that the market was coming apart but before any disclosure to investors. He resigned from the bank, agreeing to forgo $6 million in compensation and to pay a $500,000 fine. In addition, he was barred from the securities business and from practicing law for two years. Another UBS executive, David Shulman, agreed to pay a fine of $2.75 million to New York attorney general Andrew Cuomo to settle charges that he sold his personal ARSs on inside information that the ARS market was becoming illiquid. UBS was also hit with an $81 million arbitration award in 2010 in favor of Kajeet Inc. as the result of the freezing of its ARS account. This was ten times the amount of Kajeet’s investment in the account. Wachovia Securities was the target of ten state securities regulators inves-

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. The Crisis Begins 489 tigating its role in the ARS market. It agreed to repay investors more than $8.5 billion in a settlement with state regulators concerning its ARS sales. A similar agreement was reached with the SEC in 2009, and Wachovia agreed to pay a fine of $50 million. In March 2009, Wachovia and Citigroup were forced to pay California investors $4.7 billion over auction rate claims, plus more than $12 million to regulators. Bank of America reached a settlement with the state of California to repurchase $3 billion of ARSs sold in that state. In another settlement, Wachovia and Citigroup agreed to pay $880 million to settle a case brought by the state of Michigan over auction rate securities. Morgan Stanley repaid its ARSs investors $4.5 billion plus penalties of $35 million. JPMorgan agreed to return $3 billion to ARS investors and pay penalties of $25 million. Merrill Lynch, already staggering from subprime losses, was also under attack for its ARS underwriting. Merrill Lynch was charged by the state of Massachusetts with engaging in fraud by co-opting firm’s independent financial analysts in their assessments of ARSs. The state charged that a Merrill Lynch executive, Francis Constable, had pressured the Merrill research department to retract a report by Martin Mauro that criticized the ARS market and thus could undermine it. The state further charged that, in other sales presentations, Merrill Lynch made positive statements about the ARS market even while Merrill executives knew it was having difficulties. Apparently, the massive financial analysts’ settlement by Spitzer and the SEC during the Enron-era scandals had little practical effect. In any event, in settlements with state officials and with the SEC, Merrill Lynch agreed to buy back $10 billion to $12 billion in ARSs. Cuomo and regulators from forty-eight states in addition to New York continued their broad-ranging investigation into the ARS market. Three investment banking firms reached global settlements with those regulators in August 2008. Goldman Sachs agreed to buy back $1.5 billion of ARSs from retail investors and pay a $22.5 million penalty. Deutsche Bank agreed to buy back $1 billion of those securities and pay a $15 million fine. In all, Cuomo and other regulators forced brokerage firms to repurchase $60 billion in ARSs. Still, some 400 businesses holding over $20 billion in ARSs remained locked into those investments because they were not protected by these settlements. The firm of Charles Schwab refused to settle and was sued by Cuomo in August 2009. Schwab blamed the problems on the underwriters of the ARSs. Charles R. Schwab, the founder of the company and a pioneer in discount brokerage, decided to fight back. He responded with an op-ed piece in theWall Street Journal that pointed out that his company did not recommend ARSs to clients because it is a discount broker that does not provide such services.6 Traditionally, discount brokers were not held accountable for assuring that their clients’ investments were suitable in light of their individual needs. This is because, unlike full-service brokers, which are subject to a “suitability” requirement, discount brokers do not make recommendations to their cus-

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 490 The Subprime Crisis tomers. Schwab stated that if discount brokers become liable for their clients’ purchases, they would have to become full-service brokers and charge much more for client transactions. In November 2008, Massachusetts regulators charged executives at Oppenheimer with liquidating $3 million of their personal holdings in ARS before advising their customers of problems. The Royal Bank of Canada agreed to buy back $850 million in ARSs. TD Ameritrade agreed in July 2009 to buy back $456 million in ARSs in a settlement with Cuomo, the SEC, and Pennsylvania authorities. Wells Fargo agreed to return as much as $1.4 billion in funds held by customers in ARSs. A federal criminal investigation into the auction rate market focused on two former Credit Suisse bankers. One of those bankers, Julian Tzolov, fled to his a native Bulgaria a few weeks before his trial and was declared a fugitive from justice. He was captured in Spain in July 2009 and pleaded guilty to criminal charges that, among other things, accused him of misleading investors on the risks of ARSs. The other Credit Suisse banker, Eric Butler, was convicted by a jury in August 2009 of charges that he misrepresented ARS risks. Butler was sentenced to five years in prison and fined $5 million. The Financial Industry Regulatory Authority (FINRA) pursued cases against City National Securities in California, BNY Mellon Capital Markets in New York, and Harris Investor Services in Chicago over their ARS programs. Those institutions agreed to repurchase some $60 million in ARSs and to pay a total of over $700,000 in fines. FINRA established a special arbitration procedure for ARS customers who claimed lost profits and lost opportunity costs due to the freezing of their funds in these securities. The agency also ordered Credit Suisse to pay $406 million to an institutional account because of unauthorized investments of that customer’s funds in ARSs. A federal district court dismissed a class-action suit under federal securities laws that had been brought against Northern Trust Securities, which had refunded the monies of its ARS investors. The court held that the plaintiffs could claim no damages beyond the amount of their investment.7 A class action against Raymond James Financial for its ARS sales was also dismissed.

More Citigroup Problems

As of November 2008, Citigroup had assets on its balance sheet valued at $2 trillion, including some $20 billion in mortgage-related securities marked down to between twenty-one and forty-one cents on the dollar. Citigroup also had another $1.23 trillion in assets in entities that were not on the balance sheet, some of which were tied to the mortgage market. It had previously moved $35 billion of those assets onto the balance sheet and planned to move an additional $122 billion back onto that statement. It announced on November 19, 2008, a buyout of the remaining $17.4 billion in assets held off its balance sheet in structured investment vehicles (SIVs), causing it to take a $1.1 billion writedown. Citigroup’s stock price fell by 23 percent on that day. In September 2008, Goldman Sachs had discussed a possible merger with Citigroup but that overture was rejected, presumably to the bank’s regret. Instead, Citigroup CEO Vikram Pandit reported on November 17, 2008, that Citigroup would cut 25,000 more jobs, pushing the total during the subprime crisis to 50,000. Many of those jobs were lost as a result of the sale of various Citigroup units to other companies. Citigroup teetered on the brink of collapse,

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 594 The Subprime Crisis and its share price was at a sixteen-year low that month. The bank’s market capitalization had fallen to $20.5 billion, down from $244 billion in 2006. Despite the announcement of a further capital injection from Prince Al- Waleed bin Talal of Saudi Arabia, Citigroup’s shares plunged by 26 percent on November 20, 2008. For its part, Citigroup blamed the decline of its stock price on short-sellers and urged the SEC to restore the uptick rule for short sales. Citigroup officials began to discuss with federal regulators what actions the bank could take to stop the precipitous decline in its stock price. By this point, Citigroup had posted losses and writedowns of over $65 billion. For the week ending November 21, 2008, Citigroup’s stock price fell by more than 60 percent. The Treasury Department stepped in over the weekend of November 22 and 23, 2008, to arrange a rescue of the bank. It initially considered guaranteeing Citigroup’s toxic assets by creating a “bad” bank to take those assets off the Citigroup balance sheet. The toxic assets would then receive some form of government backing. This arrangement worked successfully in the 1980s in connection with the failure of First City National Bank of Houston. The FDIC created a $1 billion “bad bank” for that bank’s distressed energy and commercial real estate assets, which were liquidated over several years. However, the “good bank,” which held First City’s good assets, subsequently failed again. The same approach was taken for Mellon Bank of Pittsburgh. Its distressed assets were sold to a “bad bank,” owned by private investors in a group called Grant Street National, and those assets were ultimately sold for a profit. Sweden implemented such a program in the 1990s during a financial crisis. The government nationalized the country’s ailing banks and placed their distressed assets into what was called a “bad bank,” and those assets were sold off in an orderly liquidation process. The remaining “good banks” were given capital to resume their operations, and the situation stabilized.12 However, that restructuring did not shield Sweden from the subprime crisis. In October 2008, Sweden announced the guaranteeing of $200 billion of its banks’ debt, equal to about 50 percent of the country’s GDP. In the end, the Treasury Department rejected such an approach for Citi- group. Rather, it injected the bank with $20 billion in capital on November 24, 2008, in addition to the prior $25 billion in an earlier injection. The Treasury Department also agreed to guarantee up to $306 billion of mortgage-backed investments and leveraged commercial loans owned by Citigroup. Under this arrangement, Citigroup was required to pay the first $29 billion in losses on that portfolio. Thereafter, the government would absorb 90 percent of any remaining losses up to $249 billion. In exchange for this further bailout, Citigroup was required to issue another $7 billion in preferred stock to the government, on which Citigroup would pay a dividend. The federal government was now Citigroup’s largest shareholder, owning 7.8 percent of the bank. Government officials began using their control over Citigroup to exercise veto power over new acquisitions, and the bank was under

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. The Crisis Continues 595 minute examination by bank examiners assigned to its offices. The Treasury Department also took over control of Citigroup’s compensation practices, limiting bonuses to senior executives for 2008 and 2009 to no more than 60 percent of the previous year’s bonuses. In addition, at least 50 percent of 2008 bonuses were to be paid in deferred stock or deferred cash payments. Citigroup’s problems were attributed to its failure to take over Wachovia and expand its retail business—a failure viewed, by the market, as evidence of structural weakness by Citigroup’s management. Management problems continued at the bank. As an interim measure, Robert Rubin became head of the Citigroup executive committee, and Sir Win Bischoff, head of Citigroup’s European operations, became chairman of the board. However, Rubin was later pushed aside after his role in steering Citigroup toward more risky investments was revealed. He was then demoted to “senior counselor” at Citigroup and relinquished his role as chairman of the bank’s executive committee. President-elect Obama made Rubin one of his host of economic counselors to deal with the ongoing subprime crisis in November 2008. However, a front-page article in the New York Times on November 23, 2008, revealed Rubin’s role in pressing Citigroup executives to take on greater risks in order to increase profits.13 Former CEO Charles Prince bought into that program fully, and that set the stage for the subprime debacle. Rubin defended himself in an interview for a front-page article in the Wall Street Journal,14 in which he denied having had operational responsibilities for risk management though admitting that he had encouraged increased risk taking by the bank in 2004 and 2005. That admission seemed to conflict with his public statements during the period that investors incurred too much risk. In the event, Rubin resigned from Citigroup on January 9, 2009. Citigroup was dismantling the financial supermarket that had been built by Sandy Weill. On January 13, 2009, Citigroup announced that it was selling several of its businesses including consumer finance units and its private label credit card, and it was cutting back on its trading activities. Later, in January 2009, Citigroup spun off its Smith Barney brokerage unit, one of its crown jewels, into a joint venture with Morgan Stanley. Morgan Stanley later took control of all of Smith Barney.

Government Action

Economic problems continued abroad, requiring further government intervention. The UK announced on November 24, 2008, the adoption of a $30 billion stimulus package involving expenditures for infrastructure and tax cuts. The following day, the government assumed majority control of the Royal Bank of Scotland. The European Union announced a $280 billion plan to increase spending in an effort to avoid a deep recession. Poland planned a $31.4 billion stimulus package for its economy at the end of November. Back in the United States, Fannie Mae and Freddie Mac announced on

November 20, 2008, that they would suspend mortgage foreclosure sales and evictions during the holiday season. Fannie Mae issued long-term debt in November 2008 but paid a high-risk premium for its issuance, raising $2 billion. The Fed lent further support on November 25, 2008, by agreeing to buy $600 billion of debt issued by Freddie Mac and Fannie Mae. After news spread of the government’s latest bailout of Citigroup, the Dow Jones Industrial Average jumped by 494 points on November 21, 2008, and rose another 396.97 points on November 24, 2008. President-elect Obama proposed a $500 billion stimulus package that he claimed would create 2.5 million jobs through increased spending on infrastructure and green projects. The commercial real estate securities market fell back in record amounts during the week of November 21, 2008. A $1.5 billion hedge fund that invested in such securities—whose investors included H. Ross Perot, the Texas billionaire and former presidential candidate—suffered enormous losses. Petra Capital Management, a $2 billion hedge fund that invested heavily in commercial real estate securities, faced huge margin calls. Another such fund, Guggenheim Partners, made a $300 million capital call on its investors. On November 25 and 27, 2008, the two days before the Thanksgiving holiday, Morgan Stanley and JPMorgan Chase sold $17.25 billion of the recently authorized FDIC guaranteed bonds. Bank of America made a $9 billion offering of such bonds on December 1, 2008. General Electric planned such an offering, as did Citigroup. These bonds were said to be synthetic Treasury bonds because they were fully guaranteed by the federal government, but which offered a higher rate than those issued by the Treasury directly. Finan- cial analysts predicted that such offerings would be used to raise over $250 billion that would mature in the first six months of 2009; in fact it reached $336 billion in March 2009. The program was extended in February 2009 to include mandatory convertible debt. The Federal Reserve Bank of New York announced the creation of a new facility that would purchase up to $200 billion in newly issued, triple-A-rated, securitized student and automobile loans, credit card receivables, and small- business loans guaranteed by the Small Business Administration. This was to be done through a new program called the Term Asset-Backed Securities Loan Facility (TALF), in which the New York Fed would make nonrecourse fully secured loans that would use a special-purpose vehicle (SPV) to purchase the loan collateral from the bank. TARP would initially fund the SPV by purchasing $20 billion in subordinated debt that it issued. That announcement caused a drop in interest rates even though the government cautioned that it would take some time to launch the TALF program. The rate on a thirty-year fixed mortgage fell to 5.5 percent, resulting in a surge in mortgage refinancing. It also rallied the stock market. By the end of November 2008, the federal government had lent $1.7 trillion to financial firms that were using mortgage-backed securities as collateral for those credit extensions. The government had also agreed to buy stock, corporate

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. The Crisis Continues 597 debt, and mortgages totaling $3 trillion. The government made another $3.1 trillion in guarantees for corporate bonds, money market funds, and increased FDIC deposit account insurance.

More Losses

In year ending December 2008, Swiss Reinsurance (Swiss Re) wrote off $2.47 billion on credit derivative investments; in the first eleven months of that year alone, its share price fell by 38 percent. Deutsche Bank spurned a bailout from the German government and showed a profit in the third quarter of 2008. Even so, its stock price declined by 50 percent between October and November. The Massachusetts Turnpike Authority faced a $467 million bill in No- vember 2008 from three interest rate swap contracts it had entered into with UBS, Lehman Brothers, and JPMorgan. The Pennsylvania State Employees Retirement System’s pension fund suffered from a similar problem, but the amount it had to pay under a “portable Alpha” trading program reached $2.5 billion. The portable Alpha trading program sought to obtain returns higher than the market could provide. This had been a successful strategy while the market was rising from 2003 to 2006, but was not successful when the market turned down. It was estimated that a total of $75 billion was invested in portable Alpha programs, including other state pension funds. The sums held in money market funds hit record levels in the last week of November, as investors fled to these now-government-guaranteed investments. The Dow and the S&P 500 rose again on November 26 and 28, 2008, extending the consecutive increases to five days in a row, during which Citi- group’s share price doubled. However, a report was published indicating an accelerated decline in consumer spending, as well as business investment. Retail sales fell in November by 5.5 percent over the previous year, the worst such decline in almost forty years. Online sales were at about the same level as the previous year, not a heartening statistic considering that it was still a developing market. Equities lost $10.4 trillion in market value between the high in October 2007 to the low in November 2008, comprising about 54 percent of total market value. The stock market dropped sharply on December 1, 2008, the first workday after Thanksgiving. The Dow fell by 679.95 points on that day, but recovered 270 points the next day, closing at 8419.09. Market uncertainty was amplified by predictions that Goldman Sachs would report a loss of $2 billion for its quarter ending November 28, 2008. The actual loss was $2.12 billion, the first loss for Goldman Sachs since it went public in 1999. However, its stock price rose 14 percent after that loss was announced. Then, several governors warned of large shortfalls in state budgets. Funding sources for municipalities were drying up. The Port Authority of New York and New Jersey did not receive a single bid in a $300 million note offering. Another blow came when

Pilgrim’s Pride, a large chicken producer, filed for bankruptcy protection on December 2, 2008. In November, sales of existing homes fell by 8.6 percent over the previous month. New home sales shrank by 2.9 percent. The median sales price of an existing home was $220,400, 11.5 percent lower than the previous year. The inventory of unsold homes dipped slightly in November, but there was still more than an eleven-month supply. It was estimated that 45 percent of existing home sales were the result of foreclosures. The number of delinquent mortgages was expected to double by the end of 2009. A survey found that 10 percent of U.S. households with mortgages were delinquent or in foreclosure. The yield on the ten-year Treasury note fell to 2.719 percent in the beginning of December 2008, the lowest yield on those securities in more than thirty years. The Federal Housing Administration (FHA) was reported to have experienced a 39 percent decline in its capital cushion for mortgages that it was insuring in December 2008. The FHA’s share of new insured mortgages increased to 26 percent in the third quarter of 2008, up from 3 percent in 2007. The FHA was practically the only insurer available for low-income individuals. Its up-front premiums charged to borrowers rose in October to 1.75 percent, up from 1.5 percent. Borrowers were also charged annual premiums that ranged from 0.5 percent to 0.55 percent of their loan balance. The Harvard endowment lost 22 percent of its value in the four-month period between July and November 2008. In all, the school’s endowment lost over $8 billion, which was more than the endowments of all but a few universities. Harvard warned that the loss could be even larger after some of its hard-to- value investments were priced. Nevertheless, the six top Harvard endowment fund managers were given bonuses of $26.8 million for their performance in the year ending June 30, 2008. Other schools faced losses. The Yale and Stanford endowments lost more than 25 percent of their value between July and December 2008. For Yale, this meant a loss of almost $6 billion, and it forecast a $100 million shortfall in revenues for 2009. The Massachusetts Institute of Technology reported that its endowment had contracted by more than 20 percent, and the Princeton endowment shrank by 23 percent. College endowments lost a total of $94.5 billion in 2008. The Nobel Prize endowment fell by 20 percent. By contrast, the Russian stock market had lost 70 percent during the year. Jobless claims were at a twenty-six-year high as December 2008 began. The unemployment rate rose to 6.7 percent at the end of November, the highest in fifteen years, after the economy lost 533,000 jobs. Some 1.3 million jobs had been lost since September 2008. The Fed’s Beige Book published on December 3, 2008, disclosed that economic activity was weakening in all Fed districts and across broad sectors of the economy. Concerns over the economy heightened after the National Bureau of Economic Research announced that the country had been in recession since December 2007. That prestigious group used a definition of recession that

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. The Crisis Continues 599 focused on whether there was a significant widespread decline in the economy lasting more than a few months. Generally, economists define a recession as two quarters in a row of reduced growth, which had not yet occurred. However, no matter how it was defined, the consensus was that the economy was in the midst of a very serious recession. The United States Department of Agriculture (USDA) became another lender of last resort. Consumers exiting the cities obtained loans through a program created in 1991 that was designed to encourage homeownership in rural areas. A 2 percent fee charged by the USDA for such loans could be included in the loan. Treasury Secretary Paulson considered, in the first week of December, whether to seek authorization from Congress to draw down the funds remaining in the $700 billion TARP bailout. However, he encountered resistance from members of Congress who questioned the efficacy of the program and entertained competing requests for funds from state governments and automakers. Paulson also considered the creation of a program to provide banks with incentives to offer new mortgages at rates as low as 4.5 percent. His announcement of that proposal caused a jump in the stock market. The Dow rose by 172.60 points, but dropped by 215.45 points on December 4, 2008. The market regained that loss and even picked up a little on the following day, and it rose again on December 8, 2008, with the Dow reaching 8934.18. Oil prices fell to $40.81 per barrel on December 5, 2008, and the thirty-year conventional mortgage rate fell to 5.53 percent. President-elect Obama warned that things were going to get worse before they got better. He was right. On December 8, 2008, federal regulators opened a $41.5 billion lending facility that Congress had authorized in September 2008 for “corporate credit unions,” wholesale credit unions that provided financing to retail credit unions. Still, five of these credit unions failed over the next two years and the government was forced to issue a $30 billion guarantee in September 2010 to protect the surviviors. Credit Suisse announced in December the elimination of 5,300 jobs, about 11 percent of its workforce. It had lost $2.48 billion over the previous two months. JPMorgan Chase laid off 4,000 employees at Washington Mutual that month. Together these cuts brought the number of jobs lost at financial services firms since October 2008 to more than 90,000, including 52,000 jobs at Citigroup. Merger volume on Wall Street was down 28 percent in December 2008. Much of the structured financing that had driven profits for investment banking firms for the previous few years had dried up. However, the corporate debt market showed improvement. Some $5 billion in investment-grade debt offerings were brought to market in the first week of December 2008. Bank of America received some negative publicity because of a sit-in protest by union employees of a door and window factory in Chicago that was closed because the bank had stopped its financing. Critics claimed that, because Bank of America had received large sums in the government bailout, it should

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 600 The Subprime Crisis make loans to companies like the one in Chicago, even if they were no longer creditworthy. The City of Chicago threatened to cut off its substantial business with the Bank of America as a result of that protest, which became national news after Illinois’s governor, Rod R. Blagojevich, asked state agencies to sever their business relationships with the bank as well. However, that story was superseded the next day when Blagojevich was arrested for trying to sell the Senate seat vacated by Obama after being elected president.

The Automakers Fail

Problems in Motor City

The automobile industry had long been at the center of America’s industrial might, but it had been losing market share to foreign manufacturers since the 1960s. Chrysler nearly failed in 1979, and it appealed to Congress for a bailout in the form of loan guarantees. Lee Iacocca, who had lost his job at Ford, agreed to lead a rescue effort, at a salary of $1. He sought $1.5 billion in guarantees from Congress and $2 billion in concessions from the Chrysler unions, dealers, and creditors. The bailout legislation set off a storm of controversy, but Congress eventually acceded to this request and created a Loan Guaranty Board authorized to guarantee up to $1.5 billion in loans with all of Chrysler’s assets used as collateral. The banks also helped by exchanging $1.3 billion in debt for Chrysler preferred stock. Chrysler recovered and became profitable in 1982 and subsequently was acquired by Daimler-Benz in 1998 for $36 billion. However, the merged entity, called DaimlerChrysler, was not successful. In 2007 an 80 percent stake in the old Chrysler was sold to a private equity group, Cerberus Capital Management, and renamed Chrysler. The deal with Cerberus was somewhat unusual in that it agreed to invest $7.4 billion in Chrysler but paid Daimler only $1.35 billion. Daimler also agreed to hold a large portion of Chrysler’s debt. Corporate raider Kirk Kerkorian had made an offer of $4.5 billion for Chrysler through his private equity firm, Tracinda, but was rebuffed in favor of the Cerberus bid. Cerberus raised $12 billion from several large investors, including Citigroup, to acquire its stake in Chrysler, as well as a 51 percent ownership interest in GMAC Financial Services, the financing arm of General Motors. Chrysler reported a loss of $2.9 billion in a two-month period in 2007, and its losses continued to mount as the subprime crisis deepened. On October 24, 2008, it announced the elimination of 5,000 jobs, bringing the total to 30,000. Warfare then broke out between Daimler and Cerberus Capital, with the latter claiming that Daimler had mismanaged the company while the closing was pending. Cerberus’s investment in GMAC also quickly soured as the financial services firm began to experience large subprime loan losses in March 2007. It reported a $2.52 billion loss for the third quarter of 2008. GMAC restructured $14

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. The Crisis Continues 601 billion in debt held by Residential Capital Corporation (ResCap), an affiliate that had lost $9.1 billion in the previous two years from subprime mortgages. Investors in the mortgage securities that ResCap issued were required to take reductions in their outstanding principal and to extend maturities. That effort bought some time, but ResCap securities soon had more troubles. GMAC refinanced its ResCap mortgage unit through a transaction valued at $60 billion and was able to arrange a debt-for-equity swap covering $21.2 billion of its debt. However, about 40 percent of GMAC bondholders refused to agree to the arrangement. An even larger percentage refused a debt–equity swap for ResCap notes. Standard & Poor’s then cut the GMAC credit rating to “selective default.” The Cerberus investments in GMAC and Chrysler were in even more serious difficulty in late 2008 as those two companies floundered in the face of sharply reduced demand for automobiles and the burgeoning credit problems associated with defaulting automobile loans. Chrysler then sought a government bailout of $7 billion in short-term funding but received only $4 billion in December 2008, despite being desperately needed, as Chrysler’s automobile sales dropped by 53 percent in December 2008. GMAC was trying to convert itself into a national bank in December in order to obtain a federal bailout, and that conversion was approved by the Fed in a 4-to-1 vote. Thereafter, on December 29, 2008, the Treasury Department purchased a $5 billion interest in GMAC and lent General Motors $1 billon to finance the reorganization of GMAC into a bank holding company. For its $5 billion the government was given 8 percent senior preferred equity. That bailout resulted in the reduction of Cerberus’s interest in GMAC from 51 percent to 14.9 percent in voting shares and one-third of total equity. This reduction was necessary in order for Cerberus to avoid being treated as a bank holding company, which would restrict its operations. Cerberus was also subordinated to the claims of the federal government for its bailout payments. On December 23, 2008, it suspended withdrawals by its investors.

General Motors and Ford

The government bailout allowed GMAC to assist General Motors (GM) by providing 0 percent financing on some models and reducing interest rates on other models as a part of a year-end sales program. GMAC was also able to begin a nationwide advertising program offering government-guaranteed certificates of deposits as a way of raising funds at a very favorable interest rate. It was not enough to save GM, which lost $10.46 billion in 2005; $2 billion in 2006; $38.7 billion in 2007; and $30.9 billion in 2008. Despite all the problems at GM, its CEO, Rick Wagoner, was given a 33 percent pay increase for the work he did in 2007. GM’s rival, the Ford Motor Company, lost $5 billion in 2002, returned to profitability in 2003, and posted a $2 billion profit in 2005. However, that

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 602 The Subprime Crisis profit was largely due to gains from financial services. The Ford automotive operations lost $3.9 billion in 2005, a loss that was mostly attributable to its North American operations. The faltering Ford was under fire in the press after disclosure that one of its executives, Mark Fields, was allowed to com- mute between his home in Florida and his job in Detroit on the company jet at a cost of more than $200,000 per quarter. He then gave up the jet. The operations that executive managed lost $3.3 billion in the first nine months of 2006. Ford tried to use a more balanced compensation arrangement for its new CEO, Alan Mulally, who was recruited from Boeing. However, it was not exactly a minimum wage. Mulally was given $2 million in salary, an $18.5 million signing bonus and, as compensation for loss of options at his old em- ployer, 600,000 shares of restricted stock and 4 million stock options. That hire came too late to prevent the record $12.7 billion loss by Ford in 2006, $5.8 billion of which came in the fourth quarter. Pundits computed that year’s loss as occurring at a rate of about $240,000 a minute. Ford’s annual loss declined to $2.7 billion in 2007, but then exploded to $14.7 billion in 2008. Kirk Kerkorian had accumulated Ford stock, but he reduced his $1 billion investment in the week of October 20, 2008, because of concerns about its viability. Those concerns were not without basis. Hav- ing lost its place as the number two automaker in the United States to Toyota, Ford fell to number three for the first time since the 1930s. Although much play was given in the press to executive compensation at GM and Ford, it was the labor unions that milked the U.S. automakers completely dry. Members of the United Auto Workers (UAW) union were paid $71 an hour, compared with $49 per hour paid to nonunion automobile employees at auto plants owned by foreign countries located in the United States. GM spent $4.8 billion on health care for employees in 2008, which added $1,500 to the cost of every car that it produced. The health-care liabilities of General Motors were twice its market capitalization. The UAW carried out a strike at GM in September 2007, but shortly afterward, the two sides reached a new labor agreement in which the UAW agreed to relieve GM of its long-term retiree health-care benefits in exchange for GM’s contribution of $30 billion to a new health-care trust to be managed by the union. Those obligations were thus moved off GM’s books. However, that $30 billion was some $20 billion less than the value of unfunded benefits due workers. The union intended to make up the shortfall from its investment of the trust funds. The stock market crash in 2008 forestalled that plan. Chrysler reached an agreement with the UAW in October 2007 that was similar to the one reached with GM. Motor vehicle sales were then at a twenty- five-year low, and many dealerships closed. Overall automobile sales fell by 32 percent in October 2008. GM sales fell by 45 percent compared with the previous year. Automobile sales in United States dropped further, by 36.7 percent in November and 35 percent in December.

The Motor City Bailout Begins

GM and Ford spent $14.6 billion of their available cash in the third quarter of 2008. By then, the automakers had exhausted their credit in the financial markets. They had raised some $56 billion in loans over the previous three years, and those loans were still outstanding. A further $50 billion or so of loans had been extended to their affiliates, backed by auto leases and car loans. Ford was in better shape than the other two big automakers because it had drawn down a $23.6 billion line of credit in November 2006, providing it with a large cash cushion. However, GM announced that it might run out of cash before year-end unless it was given a government rescue. It also launched talks with Chrysler about a possible merger. Both companies requested government assistance totaling $25 billion, but the Treasury Department turned them down. President-elect Obama then asked President Bush to help, and he considered providing the funds as loans under a program to develop fuel- efficient vehicles. GM became increasingly desperate in late November 2008 and increased its demands for assistance. Among other things, GM sought tax incentives to help spur car purchases. CEOs of the big three automakers testified before Congress in November 19, 2008, and received some sympathy until it became clear that they had no plans for restructuring or cutting labor and other costs, though they were much higher than their competitors. Two of the three made things worse by declining to agree to take a salary of $1, as Iacocca had done when Chrysler was bailed out in 1979. Their credibility was undermined further when it became clear that the auto executives had flown to Washington, DC, on their private corporate jets. Embarrassed, GM announced a few days later that it would give up two of its leased jets, leaving only three for the executives. The firm also closed its air transportation unit, which had forty-nine employees on the payroll. It then asked the Federal Aviation Administration (FAA) to block anyone from tracking its remaining jets in order to avoid further embarrassment. The Democratic leadership invited the CEOs to come back to Congress when they had a plan for reorganization and a return to profitability, which they did in December. Collectively they sought a $34 billion bailout. GM said it needed $4 billion immediately in order to survive until the end of the year. In total, GM requested $18 billion in loans, an increase of $6 billion over the amount sought two weeks earlier. Chrysler sought $7 billion immediately and requested an additional $6 billion from the Energy Department for the development of fuel-efficient vehicles. Ford asked for a $9 billion line of credit and an additional $5 billion from the Energy Department. As an alternative to an unsupervised bailout with taxpayer funds, Congress considered a “prearranged” bankruptcy for the automakers that would include a settlement with their creditors before filing so that the automakers could exit Chapter 11 quickly. The automakers warned, however, that consumers might

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 604 The Subprime Crisis not want to buy cars from a company in bankruptcy because of concerns over warranties. Consumers were, in any event, not buying cars. The debate continued over whether the automakers should reorganize under the bankruptcy laws, but the automakers continued to resist. One suggested model for their restructuring was based on the reorganization of the railroads in the Northeast in the 1970s, which led to the formation of Conrail. That effort was successful, resulting in the closure of nonprofitable lines and halving of the bloated workforce. The operation even turned a profit before being sold to private companies. The House approved a short-term cash infusion to save the automakers. However, Republicans in the Senate balked because the UAW refused to reduce wages of its members to the same level as those of workers at nonunion plants in the United States owned by foreign automobile manufacturers. The union stated that it would agree to some adjustments in 2011, when its contracts were up, but not before then. President Bush then intervened and on December 19, 2008, directed the Treasury Department to use TARP funds for a quick bailout of the automakers. The Bush administration agreed to lend $13.4 billion to GM and $4 billion to Chrysler. In the meantime, the controversy over the bailout caused Ford to reconsider its position, and it withdrew its bailout request. Al- though Ford posted a $5.9 billion loss in the fourth quarter of 2008, as of April 6, 2009, it paid off $9 billion in debt, cutting its debt load by 28 percent. The bailout loans to GM and Chrysler were conditioned upon obtaining concessions from employees, suppliers, dealers, and creditors. The UAW agreed to a 20 percent cut in hourly compensation and later agreed to bring its hourly wages in line with the non-union plants of foreign car manufacturers. Although the UAW membership shrank from 1.5 million in the 1970s to 431,000 in 2008, their political contributions assured that they would remain a powerful political force. The union had funding of $1.2 billion and collected annual dues totaling $161 million. The Bush administration wanted the automobile companies to replace two-thirds of their debt with stock and to use stock to fund retiree health-care programs. It reiterated the need for the UAW to make the wages of its members competitive with those at foreign companies. The union agreed to some other concessions, including allowing the automakers to delay payments to the health-care buyout arrangement and suspending a “Job Bank” program that paid workers even after they were laid off. On February 10, 2009, GM announced the elimination of 10,000 salaried jobs, in an apparent effort to set an example for reducing union wages. Chrysler bought out about 25 percent of its white-collar workers, a reduction of about 5,000 employees, and it shut a Delaware plant. One Chrysler executive felt the pain of reduced compensation. Jim Press, Chrysler’s deputy CEO, defaulted on a $600,00 credit union loan and owed back taxes of over $1 million. Chrysler tried to sell 30 percent of itself to Fiat in January 2009, with the option of increasing that stake to 55 percent. However, Fiat conditioned its

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. The Crisis Continues 605 investment on an additional $3 billion injection from the federal government. But that month Chrysler’s sales were down 55 percent and GM’s sales fell by 49 percent compared with the previous year. The two firms reported that they would need at least $21.6 billion to avoid bankruptcy. In exchange, GM offered to cut 47,000 jobs, to close five factories, and to end the production of some car lines, including Hummer and Saturn. GM’s downward spiral continued with the bankruptcy of Saab on February 20, 2009. The Obama administration initially took a tough stance on bailing out the automakers. It sent a team to the automakers to review their restructuring plans, which had to be completed by March 31, 2009 in order to obtain additional bailout funds. That team did not like what it saw and ordered GM CEO Rich Wagoner to resign, which he did on March 29, 2009. Wagoner had led GM since 2000. During his tenure, the automaker lost 10 percent of its market share, and the price of the company’s stock dropped from $80 per share to less than $4. Wagoner had won a rather dramatic battle with Kerkorian, who, in 2001, purchased about 10 percent of GM’s stock in order to force it to enter into merger negotiations with Nissan Motor Company and Renault. It was a Pyrrhic victory that prevented the restructuring desperately needed at GM. The Obama administration placed a great deal of pressure on GM and Chrysler’s creditors, demanding that they exchange much of their debt for equity positions. The administration wanted Chrysler’s creditors to give up 85 percent of their $7 billion in outstanding debt. The government also considered dividing the assets of GM and Chrysler into good and bad assets, after which the two companies would declare bankruptcy and rid themselves of the worst of their problems. “Good” assets for GM included Chevrolet, Buick, GMC, and Cadillac, while “bad” ones comprised Saturn, Pontiac, and Hummer. The former would go to a “new” GM to be owned by creditors and the UAW, and the latter would be left in an “old” GM for the benefit of its retirees. The government also pushed Chrysler to merge with Fiat. GM offered to make the federal government a majority stockholder in April 2009 in exchange for a loan of an additional $11.6 billion, which would bring the total bailout of the firm to more than $25 billion. Under this proposal, the UAW would be given a 39 percent ownership interest in lieu of cash payments to its retiree heath-care fund. GM debt holders resisted another proposal that would have them swap $27 billion in secured loans for a 10 percent ownership interest in GM. The company also sought an agreement by the unions to cut labor costs by $1 billion and to reduce its $20 billion obligation for UAW health-care costs. As 2009 began, GMAC had converted to bank status in order to be able to issue government guaranteed debt. However, GMAC failed to obtain approval for that funding and still sought it in April 2009. In May the Treasury Depart- ment announced approval of a bailout of as much as $14 billion for GMAC. In May 2009, GM closed 1,100 dealerships, about half the total number to be closed. The government pumped in another $4 billion to keep GM afloat on

May 22, 2009, but the company was forced to file for bankruptcy on June 1, 2009, as it continued to experience liquidity problems. This was the second- largest industrial bankruptcy on record, just behind WorldCom. After its bankruptcy filing, GM was dropped from the Dow Jones Industrial Average. GM reported that it had $82 billion in assets and $172 billion in debt. It had not been profitable since 2004. GM’s bankruptcy was expected to cost taxpayers $30 billion, in addition to the $20 billion already handed out to that company. In exchange, the government was given a 60 percent equity stake in the company. Bondholders were to be given a 10 percent stake, the UAW health-care fund 17.5 percent, and the Canadian government 12.5 percent. GM announced that, as a part of its reorganization, it would cut an additional 20,000 jobs and close seventeen factories and parts centers. This would shrink its workforce by 90 percent from the levels in the 1970s. Meanwhile, Fiat tried to bring in Opel to form a three-way alliance with Chrysler. That effort was interrupted by President Obama, who announced on April 30, 2009, that Chrysler was going into bankruptcy after creditors refused to settle their $6.9 billion in debt claims for $2 billion. The president attacked those creditors publicly, calling them “speculators” and stating: “I don’t stand with those who held out when everyone else was making sacrifices.”15 The creditors caved in the face of those remarks and agreed to accept the $2 billion in cash. It was also disclosed that the government had pushed Chrysler to make the deal, despite concerns by Chrysler executives over its viability. Chrysler announced on May 14, 2009, the closure of 789 dealerships in the United States, about 25 percent. On June 1, 2009, a bankruptcy judge approved the sale of Chrysler’s assets to Fiat. A federal appeals court then approved the transaction over the objection of a group of creditors, and the Supreme Court declined to review that decision. The petition for bankruptcy was followed by an announcement that Chrysler’s sales had fallen by 48 percent in April 2009. Industrywide, the decline was 34 percent. Chrysler Financial, the lending unit of Chrysler, was bailed out in January 2009 through an emergency $1.5 billion loan from the Treasury Department. Auto parts makers also suffered from the downturn in auto sales and sought access to TARP bailout funds. Some of those firms faced bankruptcy in 2009, including Visteon, a principal supplier to Ford, and Lear. The Obama administration announced in March 2009 that it would provide $5 billion to assist auto part suppliers through payments to the automakers. GM emerged from bankruptcy in July, only forty days after it filed. It had originally planned to sell its Opel and Vauxhall operations but backed off that plan before changing its mind again and announcing that it would sell 55 percent of Opel to Magna International, but GM later withdrew the proposal. A deal to sell Saturn to Penske Automotive Group fell through in September 2009 because of manufacturing concerns. Car sales were boosted by a provision in the stimulus package called the Car Allowance Rebate System (CARS) but

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. The Crisis Continues 607 more commonly called “cash for clunkers.” Under this program, consumers trading in a gas guzzler for a more fuel-efficient vehicle received a government voucher, valued at as much as $4,500, on their trade-in. The program proved so popular that the $1 billion allocated to it was exhausted in the first week. Congress quickly approved another $2 billion for the program. Toyota was the leading beneficiary of this giveaway, but the program helped auto sales overall. In August auto sales were the highest in more than a year. The Obama administration appointed Steven Rattner as its “car czar” to oversee the government’s investments in the automakers. However, he resigned on July 13, 2009, after only a few months on the job because of an investigation involving his activities while he was a partner in the Quadrangle Group, a private equity firm. The investigation, under New York attorney general Andrew Cuomo, concerned payments by private equity groups, such as Quadrangle and Carlyle, for the purpose of obtaining New York government pension fund monies for investment, a service for which they were paid large fees. Quadrangle later agreed to pay $7 million to the New York State pension fund and $5 million to settle SEC charges over those payments. In a statement accompanying the settlement Quadrangle disavowed the conduct engaged in by Rattner. The SEC subsequently adopted a rule prohibiting investment advisers managing funds of public pensions from contributing to politicians with oversight responsibility for the funds. The SEC had previously adopted such a rule for state and municipal bond underwritings. Foreign manufacturers also suffered during this global crisis. At Honda, sales were down 31.6 percent for the first nine months of 2008, and Nissan’s were down 42.2 percent. Toyota sales were down 33.9 percent, while its profits in its fiscal second quarter fell by 69 percent. The company issued a profit warning on December 22, 2008, advising that it expected to report an operating loss for the year of $1.7 billion—the first annual loss for the company since 1938. Although Toyota’s sales fell, it still surpassed GM in the number of cars produced in 2008, making Toyota the world’s largest car manufacturer. France provided $8.4 billion to Renault and PSA Peugeot Citroën in Febru- ary 2009 in order to prop up those companies. France’s $3.9 billion low-interest loans to Renault was conditioned on an agreement that the automaker would not close any factories in France or engage in mass layoffs there. Peugeot dismissed its CEO, Christian Streiff, at about the same time that Wagoner lost his post at GM. Peugeot lost $455 million in 2008, and the firm’s stock price fell by 70 percent over the previous year. Streiff had displeased the French government by announcing a large number of layoffs in France and by import- ing cars into France made in the Czech Republic. Porsche Automobile Holdings reported enormous profits, $10.9 billion. However, most of those earnings were from a transaction that allowed it to effectively corner the shares of Volkswagen, trapping short traders who had to buy Volkswagen shares at any cost. The result was a huge spike in the price of Volkswagen shares held by Porsche. Porsche had, at one point, acquired a

51 percent ownership stake in Volkswagen and options for 20 percent more. Much litigation followed that affair. It also turned sour for Porsche, which announced in July 2009 that it would take a $7 billion charge on its Volkswagen holdings and was in talks to be taken over by Volkswagen. The CEO and CFO of Porsche were under investigation for insider trading. The Porsche losses did not deter the hedge funds that were shorting Volkswagen.

The Madoff Fraud and Other Problems

Fraud Continues

The SEC brought a record number of insider-trading cases in 2008, while it appeared to ignore the subprime crisis destroying or maiming the nation’s largest broker-dealers. Matthew C. Devlin pleaded guilty to charges that he was running a $5 million insider-trading operation from information stolen from his wife, a partner at Brunswick Group, a communications firm. Devlin referred to his wife in e-mail messages as his “golden goose.” Four individuals pleaded guilty in that case, including a broker at Lehman Brothers. Charges were brought against six defendants in the “squawk box” case, in which traders at Merrill Lynch, Lehman Brothers Holdings, Citigroup’s Smith Barney unit, and Bank of America provided telephone access to their internal speaker systems to day traders at A.B. Watley, providing the Watley traders advance notice of large trades by customers of the brokers, which were announced on the squawk boxes. That advance knowledge allowed the A.B. Watley traders to trade in front of those orders and profit. After a first trial that resulted in a hung jury, the defendants were convicted after a retrial. Merrill Lynch settled squawk box charges brought against it by the SEC in this matter for $7 million in March 2009. Mark Cuban, the owner of the Dallas Mavericks professional basketball team, was charged with insider trading. Cuban had became a billionaire after he sold Broadcast.com to Yahoo! for $5.7 billion. Cuban ran into trouble with the SEC after he was told about a private investment in public equity (PIPE) transaction in the stock of another company, Mamma.com, that would be sold at a discount to the existing market price and would cause a loss in Cuban’s existing stock holdings in that company. After receiving that information, Cuban sold all of the stock in Mamma.com, avoiding losses of $750,000. A federal judge later dismissed the case, but that decision was reversed on appeal. However, Louis W. Zehil, a partner in the New York office of a large law firm, pleaded guilty to charges that he illegally sold PIPE securities he had bought for a profit of $17 million. The shares were restricted and were sold without SEC registration. JPMorgan Chase was under investigation by regulators in 2008 after an academic study found unusual trading activity by the bank in the stocks of companies involved in acquisitions for which JPMorgan investment bankers

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. The Crisis Continues 609 were acting as advisers. One such company was Rural Cellular Corporation, a small Minnesota company later acquired by Verizon Wireless for a substantial premium. JPMorgan asserted that it was only a coincidence and that the purchases were made on behalf of clients. The Wall Street Journal then conducted a study of transactions by other investment banking firms and found numerous instances of similar transactions in the stock of investment banking clients. Merrill Lynch was also under investigation for front-running trades (trading in advance of a customer order) placed by a mutual fund, Fidelity Investments. Jeffrey A. Royer, an FBI agent, was convicted of insider trading and sentenced to six years in prison. He had supplied negative information about companies that another defendant used to short sell stock. That information, disseminated on the Internet by the defendant on his blog, succeeded in de- pressing the price of the companies’ stock. Thomas Petters, the owner and founder of Petters Company, a private investment firm, was arrested in October 2008 for fraud, in which losses were estimated at as much as $2 billion. He was later convicted by a jury of running a Ponzi scheme. Norman Hsu, a fundraiser for Hillary Clinton’s presidential campaign, was indicted after it was discovered that he had been running a Ponzi scheme that raised $20 million from investors by promising extraordinary profits through short-term financing extended to other companies. Hsu pleaded guilty to fraud charges. He was also separately convicted by a jury on charges of campaign law violations and sentenced to twenty-four years in prison. Joseph Shereshevsky, the operator of WexTrust Capital, a hedge fund used to solicit investments from wealthy Orthodox Jews in the Norfolk, Virginia, area, was arrested in August 2008 and charged with running a Ponzi scheme, in which investors lost more than $100 million. His partner Steven Byers pleaded guilty to fraud charges, but Shereshevsky denied any wrongdoing. The KL Group, another hedge fund, defrauded wealthy Palm Beach investors of an estimated $200 million. Proving that there is no limit to the greed of fraudsters, Gordon Grigg and his firm, ProTrust Management, were charged by the SEC with defrauding investors by telling them that he was investing in TARP through government-guaranteed commercial paper and bank debt. TARP had no such investments available. Grigg pleaded guilty to criminal charges related to this fraud. Kenneth Starr, an investment adviser to entertainment stars, pleaded guilty to defrauding investors of $60 million in a Ponzi scheme. Among his clients were Al Pacino, Martin Scorsese, Sylvester Stallone, and Wesley Snipes.

The Madoff Fraud

These frauds turned out to be small potatoes. Bernard L. Madoff, a well-known figure in the securities business, was arrested on December 11, 2008, after he confessed that he had been running a giant Ponzi scheme involving some $50 billion that he was managing for wealthy investors. That figure grew after

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 610 The Subprime Crisis investigators determined that Madoff had been reporting to investors that he held $64.8 billion in their accounts. This turned out to be the largest investment fraud in history. Actual out-of-pocket losses (minus claimed false profits) were estimated in December 2009 at $19.4 billion, an increase over the $6 billion in original estimates. The Securities Investor Protection Corporation (SIPC), the government sponsored broker-dealer insurer, agreed to pay investors $534 million to cover their losses, with maximum coverage per account to be $500,000. The receiver appointed to liquidate the Madoff fund recovered about $1.5 billion, but the greatest relief of all was new IRS rules allowing the Madoff investors to deduct their losses, including fictitious gains reported to them by Madoff, on their tax returns by carrying them back for five years and forward for twenty years. Madoff had helped build, and was a former chairman of, NASDAQ and had served on the board of governors of the National Association of Securi- ties Dealers (NASD) (now FINRA), the self-regulatory body of the securities industry. He also served on an SEC advisory committee. Several of Madoff’s clients were recruited at the Palm Beach Country Club in Florida. Also among Madoff’s victims were a number of Jewish charities, including one sponsored by Elie Wiesel, a Nobel laureate. Tufts University lost $20 million; Yeshiva University lost more than $100 million, and Bard College lost $3 million. Mortimer Zuckerman lost millions of dollars. Jeffrey Katzenberg, the head of DreamWorks Animation, and Steven Spielberg’s Wunderkinder charity were hit as well. The actors Kevin Bacon and his wife, Kyra Sedgwick, were Madoff investors and lost money. The Madoff scandal exposed another questionable aspect of hedge fund investments, the money finders, or “placement agents,” that is, individuals with family, social, or other connections with wealthy investors. The money finders are paid a fee, usually a percentage of the money they refer to the hedge fund, for their referral service. They are supposed to use due diligence before making such recommendations, but their relationship with the hedge fund manager is often either social or fee-based, both of which discourage inquiry, which appeared to be the case for the Madoff scandal. Fund-of-funds, which invest in other hedge funds, were supposed to be receiving fees for finding and vetting the best hedge fund managers, but those managers had done little due diligence in Madoff’s case. Some money managers claiming expertise were simply placing money with Madoff and claiming success from his supposed returns. Bank regulatory authorities in Luxembourg accused UBS of a “serious failure” in due diligence while acting as custodian of a $1.4 billion hedge fund that sent money to Madoff. UBS was ordered to pay compensation to those investors.16 A number of other fund-of-funds had placed large amounts of their clients’ funds with Madoff, including Union Bancaire Privée, which raised some $1.25 billion for Madoff. Ascott Partners, a hedge fund headed by Ezra Merkin, the chairman of GMAC, lost $1.8 billion, including $3 million that it had invested for the

New York Law School. After his judgment was questioned with respect to his dealings with Madoff, Merkin resigned as chairman of GMAC, which was in the midst of a government rescue. Merkin was sued by New York attorney general Cuomo, who charged that Merkin had misled investors into thinking that he was actively managing their investments, when in fact he had simply given the funds to Madoff and collected more than $470 million in fees. The Fairfield Greenwich Group was the largest feeder fund for Madoff, raising over $7.5 billion. Massachusetts’s authorities charged that hedge fund with civil fraud because it failed to conduct the due diligence that it promised its investors. It was further charged that Fairfield ignored numerous red flags warning that Madoff was involved in improper activity. Some other sophisticated institutions also sustained losses. Kingate Manage- ment lost $3.5 billion; Tremont Group Holdings, a hedge fund owned by Mas- sachusetts Mutual Life Insurance Company, lost $3.3 billion; Banco Santander, $3.1 billion; HSBC Holdings, $1 billion; the Man Group, $360 million; the Royal Bank of Scotland, $360 million; and Nomura Holdings, $302 million. The government of Austria was forced to take over Bank Medici, which lost more than $2 billion in client funds through investments with Madoff. One unlucky investor, Martin Rosenman, gave Madoff $10 million only six days before the fraud was exposed. Worse yet, Madoff collected $250 million from his good friend Carl Shapiro just ten days before being arrested, in addition to $150 million that he had given Madoff earlier. Kenneth Langone, a former director of the New York Stock Exchange, declined a request from Madoff to make an investment. JPMorgan Chase withdrew $250 million of its funds from the Madoff program in the fall of 2008 because of its lack of transparency and concern over its exposure to hedge funds. However, some former senior Merrill Lynch executives, including Daniel Tully and David Komansky, suffered losses from their investments with Madoff. Madoff was released on bail after his arrest, but was confined to his New York residence after a shoving match and near-riot broke out among reporters when he decided to take a stroll. On January 5, 2009, the government petitioned a federal magistrate to revoke his bail after it was discovered that he had mailed some $1 million worth of jewelry to relatives and friends, which violated an SEC injunction freezing his assets. The government also reported that it found $173 million in signed checks made out to family and friends in Madoff’s offices. However, the magistrate refused to approve this petition. It was later discovered that Madoff’s wife, Ruth, had withdrawn $15.5 million from their bank accounts just before his arrest. Vanity Fair featured exposés on her and her family complete with a decades-old photograph of her sunbath- ing topless but otherwise a bit short of proof that she had participated in the fraud. She agreed to the U.S. attorney’s request that she relinquish any claims to assets of the Madoff family in excess of $2.5 million, which were assets unrelated to the fraud, forgoing claims against more than $80 million in other assets. She also had to disclose any purchases that she made in excess of $100.

The bankruptcy trustee then filed a $45 million lawsuit against her. The New York Times published a profile of Madoff on January 25, 2009, which quoted a criminal profiler who compared Madoff to serial killers like Ted Bundy.17 He was treated like one. Madoff pleaded guilty to eleven felony counts on March 12, 2009. Although he professed remorse for his crimes, Madoff refused to implicate others in his fraud. A federal judge immediately revoked Madoff’s bail and sent him to prison to await sentencing. He did not have to wait long. On June 29, 2009, Madoff was sentenced to 150 years in prison. Fortunately for Madoff, Americans never took to the guillotine. Otherwise, his investors, not without some cause, would have demanded its use. Shortly after his guilty plea, Madoff’s accountant, David G. Friehling, was arrested. He was the auditor for Madoff’s advisory service, but apparently he had certified the accuracy of the Madoff accounts without actually auditing them. Another Madoff associate, Frank DiPascali, pleaded guilty to criminal charges relating to his role in the fraud. The SEC admitted that it had ignored repeated signals that something was wrong at the Madoff firm. Some eighteen years before the discovery of the massive Madoff fraud, the agency had investigated Frank Avellino, who had been acting as a money finder for Madoff, and charged him with promising investors a guaranteed return of 20 percent per year. The SEC investigators thought that they had discovered a Ponzi scheme, but they were reassured after Avellino told them that the funds were invested with Madoff. The agency required Avellino to return $440 million in investor funds, but did not investigate to determine Madoff’s role in this apparent Ponzi scheme. The agency had received other credible allegations about Madoff’s Ponzi scheme at least nine years before his confession, and it was alerted in 2006 that Madoff had misled it on the nature of his investments, but did nothing. In addition, Harry Markopolos, a rival investor, had been telling the SEC for years that Madoff had to be running a Ponzi scheme because the returns reported by Madoff were not possible under the strategies that he claimed to be using. In fact, investigators determined, after discovery of the fraud, that Madoff had bought no securities for customer accounts for more than thirteen years. SEC chairman Christopher Cox issued a statement expressing his concern over the Madoff investigations and asked the SEC inspector general to review the handling of those complaints and inquiries. Cox said he found the SEC investigations to be “deeply troubling” because the agency had “credible and specific warnings” of Madoff’s Ponzi scheme. The SEC inspector general discovered that, in total, the SEC staff and the Financial Industry Regulatory Authority (FINRA) examined Madoff’s operations eight times in sixteen years but uncovered no evidence of his Ponzi scheme. They also let him off the hook on a number of technical violations that they did discover. Most embarrassing, the SEC inspector general stated that SEC staff members had acted incompetently in examining his operations, not even verifying the existence of the assets that he claimed to manage. Yet an SEC staff member received

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. The Crisis Continues 613 the agency’s highest performance rating because of the employee’s purported ability to understand and analyze Madoff’s operations. The SEC had failed to detect any of the massive accounting manipulations during the Enron-era scandals. It simply did not have the staff to review the accounting statements filed with it. The same problem was present in its investment adviser inspection program. The SEC’s Office of Compliance Inspections and Examinations, which was responsible for the oversight of investment advisers, was able to examine only 10 percent of the 11,000 SEC-registered investment advisers every three years. The SEC used a risk assessment program to prioritize its audits, but Madoff’s fraud, the biggest ever, did not show up on their radar. Those infrequent examinations were also limited in scope. Two Madoff victims sued the SEC, charging that it was guilty of “serial gross negligence” in carrying out its regulatory responsibilities. Even more embarrassing, after he registered as an investment adviser in 2006, in compliance with a new SEC rule requiring the registration of hedge funds, no examination was made of Madoff’s operations. Laughably, in light of Madoff’s fraud, the SEC had imposed that rule in order to stop hedge fund fraud. Even worse, an appeals court held that the SEC had not properly acted in imposing that requirement, but, unlike many other hedge funds, Madoff never bothered to deregister. JPMorgan Chase was sued for trading with Madoff’s brokerage firm and for maintaining his checking accounts. New York Attorney General Andrew Cuomo sued Ivy Asset Management, a unit of the Bank of New York, charging that Ivy had concluded in 1998 that Madoff had lied about his investments. Ivy then decided not to place additional investor funds with Madoff but did not inform existing investors of this concern. Ivy continued to earn millions in fees for maintaining those funds with Madoff over the next decade. AIG was involved in litigation over whether its homeowners’ policies covered losses from the fraud. It paid some claims for out-of-pocket losses but refused to cover the fictitious profits reported by Madoff. The bankruptcy trustee took the same approach and sought to claw back any profits received by the more fortunate Ponzi scheme investors. The SIPC provided $500,000 coverage on accounts, but only covering actual out-of-pocket losses.

Suicides and Scandals

Articles were published in both the New York Times and the Wall Street Jour- nal highlighting various suicides that appeared to be connected with financial distress, and some of them were spectacular. René-Thierry Magon de la Ville- huchet, cofounder of the investment advisory firm Access International Advi- sors (AIA Group), which suffered some $1.5 billion in losses from Madoff’s fraud, committed suicide on December 23, 2008. He lost $50 million of his own money in the Madoff fraud as well as other family money. Jeffrey L. Picower, who made some $7 billion in the Madoff Ponzi scheme, was found

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 614 The Subprime Crisis drowned in his pool in Palm Beach in October 2009, apparently stricken by a heart attack. He had been the target of numerous lawsuits and had a history of heart problems. The son of another Madoff investor who committed suicide was the subject of a BBC documentary on Madoff’s Ponzi scheme. The high- light of the broadcast was an interview with an investor who had retained the voluminous confirmation statements sent to her by Madoff for transactions in her account. This raised the troubling issue of how Madoff was able to carry out this fraud without a lot of clerical and computer support. In another case, Scott Coles, the operator of Arizona Commercial Lender Mortgages, donned a tuxedo and committed suicide after a large number of loans that he had made turned sour. Kirk Stephenson committed suicide after his investment firm lost a massive amount in the Lehman Brothers bankruptcy. Adolf Merckle, one of the richest men in Germany, committed suicide on January 6, 2008, by throwing himself under a train. His businesses were losing large sums of money. Patrick Rocca, described in the press as an “Irish property tycoon,” committed suicide in Dublin on January 20, 2009. One of the more shocking suicides occurred on April 22, 2009, after it was discovered that David Kellermann, Freddie Mac’s chief financial officer, had killed himself. He had been dealing with the SEC and Justice Department investigations of Freddie Mac’s accounting issues. That must have been stressful, but he had just obtained a favorable ruling from the SEC on the accounting treatment that allowed Freddie Mac to avoid a $30 billion charge against earnings. Ponzi schemes continued. The Madoff scandal was followed a few weeks later by the discovery of a Ponzi scheme being run by Joseph Forte in Broo- mall, Pennsylvania. He took in $50 million before confessing his scheme to a postal inspector. In one of the more dramatic escapes, Marc Schrenker, an investment adviser in Indiana accused of defrauding his customers, fled in his airplane. Schrenker, who had been living a lavish lifestyle in Indianapolis with his glamorous wife, Michel, jumped out of the airplane over Alabama. The crashed, but empty, plane was discovered in Florida, 200 miles away. No one was fooled, and Schrenker was found hiding in a campground near Quincy, Florida, where he slit his wrist just before being captured. Schrenker survived and was jailed. Idaho authorities charged Daren Palmer and his hedge fund, Trigon Group, with running yet a further Ponzi scheme in which investors lost over $100 million over seven years. In Sarasota, Florida, Arthur Nadel disappeared in January 2009. Nadel had been operating hedge funds that he claimed had assets worth $300 million, and he reported that they were earning on average 11 to 12 percent between 2000 and 2006. In fact, the hedge funds were worth less than $1 million and had negative returns. Nadel was arrested on January 27, 2009. On the day before the Nadel arrest, authorities took Nicholas Cosmo into custody and charged him with operating a $380 million Ponzi scheme in

Hauppauge, New York. Cosmo was selling investors private bridge loans for a minimum $20,000 investment and promised returns of 48 to 80 percent a year. After he admitted to running a $55 million Ponzi scheme in Southern California, Colin Nathanson was sentenced to twenty-seven years in prison. Al Parish received a sentence of twenty-four years after he was found guilty of running a $66 million Ponzi scheme in South Carolina. He was formerly an economist at Charleston Southern University. Scott Rothstein, a flamboyant lawyer in Florida who had operated a $1.2 billion Ponzi scheme, was given fifty years. Other frauds were uncovered. On the same day as the Madoff disclosures, Steven Gordon of Bayview Financial was arrested for falsifying mortgage applications by changing credit scores and identifying mobile homes as single-family residences in order to qualify the mortgages for securitization. He falsified information on more than 2,800 loans between 2001 and 2006 and earned more than $2.8 million in commissions on those loans. Bayview agreed to make good on the securitized mortgages. A new type of fraud appeared in the form of scams promising to help home owners facing foreclosure. Homeowners were asked for an upfront fee, but they received little or no services. The sharp increase in crude oil prices had given rise to still another class of swindlers, who pushed fraudulent investments in drilling operations. The SEC and state securities administrators investigated dozens of such cases across the country. The German engineering firm Siemens agreed to pay U.S. and European authorities a record $1.6 billion to settle claims that it had paid bribes of $1.4 billion to land government contracts around the world. In a separate case, Fiat agreed to pay $17 million to settle charges that it had paid kickbacks to Iraqi government officials. David Drumm, CEO, and Sean FitzPatrick, chairman, of the Anglo Irish Bank Corporation resigned in December 2008 after it was disclosed that FitzPatrick had concealed some $125 million in personal loans made to him by the bank. FitzPatrick was later arrested by the Irish Garda and was being sued by the bank to recover $100 million of the loans that he failed to repay.

A Bad Year Finally Ends

The Economy Continues to Struggle

The Fed surprised the market with a dramatic interest rate cut on December 16, 2008, pushing short-term Fed funds rates down to a target range of 0 to 0.25 percent. The average interest rate on thirty-year fixed-rate mortgages then dropped to 5.17 percent, the lowest level in over forty years. The Fed rate cut pushed the Dow up by 359.61 points, but it fell again on December 18 by 219.35 points. November retail sales were down by 5.5 percent, but here was some good news. The price of crude oil fell to $36.22 per barrel on December

18, 2008, despite an announcement by OPEC that it would reduce production by 2.5 million barrels a day. Credit rating agencies contributed to the gloom (which they had largely created through their rating downgrades). Moody’s announced that some $76 billion of commercial real estate CDOs were on credit watch, and it expected that those obligations would be sharply downgraded. On December 19, 2008, rating agencies also cut the ratings of eleven global banks—Bank of America, Citigroup, Goldman Sachs, Morgan Stanley, Wells Fargo, JPMorgan Chase, Barclays, UBS, Credit Suisse, the Royal Bank of Scotland, and Deutsche Bank—which comprised most of the major financial institutions in the United States and abroad. The government of Ireland announced over the weekend of December 20, 2008, that it would supply $7.66 billion to the three largest Irish banks, and it took control of the Anglo Irish Bank through a preferred stock arrangement that gave it 75 percent voting rights. A lengthy article was published on the front page of the New York Times on December 21, 2008, suggesting that President George W. Bush was responsible for the subprime crisis because he had sought to increase the number of minority homeowners by 5.5 million in 2002. The article noted that the neighborhood in Atlanta where Bush had announced that plan was struggling, with some 10 percent of the homes there in foreclosure. The American Dream Down Payment Assistance Act, which President Bush had championed, provided as much as $200 million annually to help first-time homeowners with their down payments and closing costs, but may have inadvertently added fuel to the fire. The New York Times article further reported that one of the Republican Party’s top ten donors in 2004 was Ronald Arnall, the founder of Ameriquest, one of the largest subprime lenders before the crisis. President Bush’s efforts to rein in Freddie Mac and Fannie Mae by tighter regulation were discounted as being more stringent than Congress could tolerate.18 Bush did not cover himself with glory in those events, but his contributions to the subprime lending crisis paled in comparison to the groundwork laid by the administration of Bill Clinton, which had imposed excessive quotas for subprime lending on banks and Fannie Mae and Freddie Mac. Another front-page article in the New York Times on December 25, 2008, reported that the number of federal criminal prosecutions for financial fraud in 2008 was the lowest since 1991. Criminal cases referred from the SEC to the Justice Department fell to just nine in 2007.19 Commercial real estate developers approached the government for a bailout, claiming that office buildings, shopping centers, hotels, and other commercial buildings were in danger of default and foreclosure. This was because $530 billion in commercial mortgages were coming due for refinancing in the next three years, of which $160 billion would have to be refinanced before year-end 2009. Little credit was available for those refinancings, and cash flows from commercial property were declining. Real estate investment trusts (REITs) experienced their worst year on record,

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. The Crisis Continues 617 in a decline of some 40 percent by year-end 2008. The CIT Group, a large commercial lender, faced bankruptcy in July 2009. It was a significant commercial lender to small and medium-size businesses and had been in business for over a hundred years. CIT carried $68 billion in liabilities and faced a liquidity crisis. It converted to bank holding company status in order to obtain funds from the TARP program. Although CIT had received $2.3 billion in TARP funds, it was unable to qualify for the government program that would guarantee its debt obligations, a facility that was made available to other financial institutions by the government. The government took a strong stance against further aid to CIT, which indicated its belief that the firm’s failure would not set off another panic. A group of creditors then agreed to provide $3 billion in order to keep CIT out of bankruptcy, but it went bankrupt on November 1, 2009, causing an expected loss of the government’s bailout funds. By December 2008, the FHA approved about 40,000 mortgages a month for insurance, compared with 12,250 the previous year. The FHA insured about 10 percent of California mortgages that month, an increase over 2 percent the year before. In all, the FHA was responsible for about a third of all mortgage loans originated in the fourth quarter of 2008. It approved loans with down payments as low as 3 percent, a minimum that was scheduled to increase to 3.5 percent in 2009. Even with that increase, a large number of defaults were assured by this lack of concern over credit quality. Private mortgage insurers required down payments of at least 10 percent for smaller mortgages and 15 percent for loans of more than $417,000. The FHA did not limit loans on the basis of credit scores, while private lenders placed increasing emphasis on such scores and required them to be higher than in the past. Concern was raised that this difference would cause the riskiest loans, the ones most likely to default, to be sent to the FHA, a form of adverse selection. The FHA did limit loans to the point where the total mortgage payments, excluding taxes and insurance, did not exceed 31 percent of the borrower’s gross income. By Christmas 2008, 25 banks had failed, and another 200 were on a regulatory watch list. Banks and savings and loan associations faced their first combined quarterly loss since 1990 in the fourth quarter of 2008. The banks cut their overseas lending by 5.4 percent in that quarter. There was, however, some good news. The thirty-year fixed-rate mortgage interest rate averaged only 5.14 percent at Christmas 2008, compared with 6.17 percent the previous year. Mortgage refinancing applications boomed. The ongoing mortgage loan modification programs continued to encounter difficulties in obtaining permission from the owners of the securitizations in which the loans had been packaged and sold. Investors in CDOs issued by Countrywide sued to stop CDO loan modifications, and a federal judge ruled in favor of those investors in August 2009. Another problem was that many of the service organizations for those securitizations were equipped to do little more than collect and pay out monthly mortgage payments. They did

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 618 The Subprime Crisis not have the personnel to handle loan modifications or even, in some cases, to supply loan histories and fees charged to individual loans. However, Bank of America reported the modification of 230,000 mortgages, covering debt of $44 billion. A giant chemical company, LyondellBasell Industries, announced on De- cember 30, 2008, that it faced bankruptcy. That company had been created by a merger in 2007, and the debt load resulting from that merger, combined with declining sales, caused deterioration in the company’s financial situation. An auction to settle the credit-default swaps for the U.S. unit of LyondellBasell valued its debt at just two cents on the dollar. Normally the recovery on defaulted junk bonds was around 40 percent.

Year-End Results

The Dow Jones Industrial Average closed up 108 points on December 31, 2008. However, for the year the Dow was down 33.8 percent, losing 4,488.43 points, the worst result since 1931. In that period, the S&P 500 fell 39.5 percent, falling by 22.5 percent in the fourth quarter alone. The decline in the S&P 500 Index in 2008 matched the decline in that index in 1937. In all, investors lost some $7 trillion in the stock market during 2008. The average loss of equity-based mutual funds was 36.7 percent for the year. A Wall Street Journal survey of 1,700 diversified U.S. mutual stock funds found that only one made money in 2008, and its return was only 0.4 percent. During 2008, household wealth in the United States shrank by $11.1 trillion, about 18 percent. More than $5 trillion of that amount, about 9 percent, was lost in the fourth quarter. The number of millionaires (those with investable assets of that amount, excluding primary residences) in the country fell to 6.7 million in 2008, compared with 9.2 million in 2007, a decline of 27 percent. Visa reported that in the fourth quarter of 2008 debit card volume had exceeded credit card volume for the first time. Christmas retail sales were disappointing, falling by some 8 percent over the previous year. Retailers had the worst holiday season since 1970. Consumer confidence dipped to a new low in December 2008. Housing prices had fallen every month since January 2007. The stock market continued to be highly volatile. The change in the S&P 500 exceeded 5 percent on eighteen separate trading days during the year, whereas only seventeen such volatile trading sessions had occurred over the previous fifty years. The Dow experienced two of the six largest one-day percentage gains in its history in October 2008. The Dow also had the worst one-week percentage decline in its history in October. Four of the twenty largest daily percentage declines in its history also occurred in the last four months of 2008. Stock and bond underwriting shrank by 38 percent during 2008. The number of IPOs plunged by 80 percent during 2008, and no new offerings were scheduled in early January 2009. Global merger activity contracted by 29 percent

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. The Crisis Continues 619 in 2008, but there were still $3.06 trillion in deals. Three giant bank mergers were completed in December 2008, including Wells Fargo’s acquisition of Wachovia, making it the nation’s fourth-largest bank. PNC completed its $3.91 billion acquisition of National City, making it the nation’s fifth-largest bank. In the meantime, twenty-eight banks and S&Ls failed between 2007 and 2008. That was bad, but a far cry from the number of failures experienced during the Great Depression or even during the S&L crisis in the 1980s. Wells Fargo reported a $2.55 billion loss in the fourth quarter of 2008, a loss attributed to its acquisition of Wachovia. However, the closing of the acquisition of Wachovia did not occur until after year-end, so Wachovia’s losses were not included in Wells Fargo’s results. This was fortunate, considering that Wachovia lost $11.2 billion in the fourth quarter of 2008, after taking a $37.2 billion writedown on its subprime mortgages. JPMorgan Chase reported a fourth-quarter profit, down 76 percent over the year before. Still, things could be a lot worse. Citigroup had an $8.3 billion loss for the fourth quarter, bringing its losses to $18.7 billion for 2008. It contemplated dividing itself into two businesses, in which a new Citicorp would take over the bank’s traditional banking operations, such as commercial banking, credit cards, and investment banking, while the bank’s noncore operations would be moved to a separate company, called Citi Holdings, but this plan stalled. Vikram S. Pandit, Citigroup’s CEO, announced that he and other executives at that bank would not receive bonuses for 2008, though his pay package still totaled $38.2 million. Bank of America and Citigroup’s stocks fell by more than 65 percent for the year. Bank of America’s CEO, Kenneth D. Lewis, initially refused to reject a bonus but finally gave in under pressure and agreed that he and other top executives at the bank would forgo bonuses for the year. UBS announced a reduction in its bonuses of more than 80 percent for 2008. AIG lost $37.6 billion during 2008. Lehman Brothers lost $2.3 billion before it failed. Morgan Stanley had a fourth-quarter loss of $2.37 billion, but it did have a profit for the year. Goldman Sachs reported a $2.1 billion loss for the fourth quarter, but that loss was smaller than expected, and the firm had an overall profit for its fiscal year. By year-end 2008, Washington Mutual had lost $8 billion over the previous sixteen months. Legg Mason announced a record $1.49 billion loss in the fourth quarter. Regions Financial Corporation in Alabama lost $6.22 billion in the fourth quarter and had to obtain $3.9 billion from the government as a bailout. Other banks accepting bailout money were Fifth Third Bank, which was given $3.4 billion; Great Southern Bancorp, $58 million; and UCBH Holdings, $299 million. Deutsche Bank reported a loss of $5 billion in 2008, its first loss in more than fifty years, and had $6.3 billion in trading losses in the fourth quarter. More than $1 billion of that amount was lost by a single trader, Boaz Wein- stein. UBS posted a $6.96 billion loss in the fourth quarter and a loss for the year of $17 billion. That figure had to be raised, embarrassingly, by $1 billion

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 620 The Subprime Crisis in March 2009. The bank announced the elimination of some 2,000 jobs in 2009. Credit Suisse suffered a fourth-quarter loss of $2.75 billion and a loss for the year of $6 billion. Lloyds Banking Group, which had acquired HBOS as a part of a government-assisted rescue in 2008, reported a loss for the year of $12 billion as a result of that acquisition. Hedge funds were down on average 19 percent in 2008. The Citadel Invest- ment Group saw its assets decline by 55 percent. At one point during 2008, the stock of Hartford Financial Services Group was down by 94 percent. Warren Buffett advised Berkshire Hathaway stockholders that the company had turned in the worst performance ever in 2008. The company’s stock declined by 30 percent for the year. His personal fortune shrank by some $25 billion during the subprime crisis, causing him to forfeit his position as the world’s richest man to Bill Gates, the founder of Microsoft. Prudential Financial lost $1.57 billion in the fourth quarter. Insurance companies offering guaranteed variable annuity contracts had also suffered large losses. These popular retirement contracts provided a rate of return based on market performance, but the insurance company protected the customer from any loss of principal. The SEC, thereafter, sought to extend its regulation over annuity contracts by adopting a rule in early 2009 that subjected fixed-index annuities to its regulation. These annuities credit the investor with a return based on a stock index. However, the District of Columbia Circuit Court held that the SEC had not acted properly in promulgating that rule. Outside the financial sector, Shell reported a loss of $2.81 billion in the fourth quarter of 2008, while ExxonMobil announced a $7.82 billion profit, and Chevron posted a $4.9 billion profit. BP reported a record profit, $25.6 billion, in 2008, but issued a profit warning for 2009 because of concerns over the decline in oil and gas prices. The year had certainly been a tumultuous one for crude oil. Oil prices rose to $145.29 per barrel on July 3, 2008, but closed at $44.60 on December 31, 2008. Dow Chemical reported an unexpected fourth-quarter loss of $1.55 billion. Time Warner announced a loss of $16 billion in the fourth quarter. Kodak suffered significant losses, putting its viability in question. Dell had a 48 percent drop in profit. Overall, corporate profits fell by $250 billion, a decline of 16.5 percent, the largest decline in fifty-five years. In total, profits at major companies in the United States fell by 32 percent in 2008. Despite widespread losses, CEOs at major companies around the world kept their jobs during the subprime crisis, with a turnover rate in 2008 of 14.4 percent, compared with 13.8 percent in 2007. Nevertheless, CEOs at Citigroup and Merrill Lynch were unceremoni- ously fired, albeit with generous compensation. In one eight-day period in January 2009, CEOs at Tyson Foods, Borders Group, Orbitz, Chico’s FAS, Seagate Technology, and Bebe Stores were all dismissed. U.S. government bond funds did well in 2008, rising by an average 20.4 percent, of which 17.5 percent was acquired in the fourth quarter. However, the yield on a three-month Treasury bill was only 0.016 percent. The Fed’s balance

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. The Crisis Continues 621 sheet grew at the end of 2008 from $900 billion to more than $2 trillion. It had purchased billions of dollars in mortgage-backed instruments of Freddie Mac, Fannie Mae, and Ginnie Mae, but it had a long way to go to reach its goal of $500 billion in such purchases by mid-2009. Fannie Mae had a $25.2 billion loss in the fourth quarter, pushing its total losses for the year to $30.9 billion. Freddie Mac reported a fourth-quarter loss of $30.8 billion, with a total for the year of $50.1 billion. In March 2009, after posting its fourth-quarter 2008 results, Freddie Mac announced that it would request another $30.8 billion in bailout funds from the federal government. Moody’s predicted that Federal Home Loan Banks (FHLBs) would fall below regulatory minimum capital requirements after they took expected write-offs on their $76 billion in mortgage-backed securities, in addition to $13.5 billion already written off. The FHLB in Seattle was the first bank in the system to announce a capital shortage. The FHLB of Pittsburgh reported a $187 million loss in the fourth quarter. The FHLB of Chicago lost nearly $120 million, and the FHLB of Boston lost $73.2 million. The FHLBs collectively had borrowed about $1.3 trillion; however, they had a credit facility at the Treasury Department that was untapped. A study conducted by the Treasury Department concluded that the larger banks receiving bailout money had not increased their lending in the fourth quarter of 2008. However, Bank of America claimed that it had increased lending by more than $115 billion in new credit in that quarter. Nevertheless, lending fell in the fourth quarter of 2008 by 1.4 percent, despite all the money infused into the banks by the federal government. There were reasons to hold back. Mortgage delinquencies on office buildings, hotels, and shopping malls rose sharply in the fourth quarter. During 2008, the rating agencies downgraded over 221,000 tranches of asset-backed securities, and banks experienced over $500 billion in losses on subprime mortgages. At the end of 2008, more than 10 percent of all mortgages in the United States were delinquent for more than sixty days. Prime loan delinquencies increased to 2.4 percent, up from 1.1 percent in the first quarter of 2008. Subprime delinquencies rose from 11 percent to 16 percent. That subprime rate was alarming, but it certainly did not justify the panic experienced in the credit markets. Sales of new homes declined by 15 percent in December. New home construction fell in December 2008 to the lowest amount since records began to be kept on that statistic in 1959. Migration to the Sunbelt slowed to a standstill. The overall slowdown in migration was the greatest since the Great Depression. However, pending home sales increased by 6.3 percent in December, and completed home sales rose by 6.5 percent in December 2008, the largest increase in seven years. That increase was attributed to declining housing prices. Median home prices fell to $180,800 as 2008 ended, compared with $230,900 in 2006. In Miami, housing prices were down by 23.5 percent from their peak. D.R. Horton, the largest home builder in United States, had better-than-

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 622 The Subprime Crisis expected quarterly results at year-end, but its orders fell by 35 percent in the fourth quarter. Still, that was better than the results reported by other builders, which had declines of as much as 80 percent. KB Homes lost $772 million in the fourth quarter of 2007, compared with $307 million in the fourth quarter of 2008. However, Beazer Homes USA, the Atlanta builder, reported a 53.2 percent decline in home closings over a year earlier and orders for new homes declined by 56 percent. Jumbo mortgages faced a rising delinquency rate, climbing to 6.9 percent, up from 2.6 percent a year earlier. Concern was also being raised that further massive losses in the so-called Alt-A mortgages would follow because of reset provisions that could double mortgage payments in 2009. The minutes of the Fed’s last meeting of the year in December 2008 evidenced a concern that the recession would be longer and deeper than had previously been predicted. The economy was, indeed, in a tailspin. The gross domestic product (GDP) contracted by 6.3 percent in the fourth quarter—the largest drop in GDP since the recession in 1982 and was well above the 3.8 percent decline initially predicted by the Commerce Department. Stock buybacks declined by 65 percent in the fourth quarter and by 28 percent for the year. Wholesale prices fell in December, removing any lingering concerns over inflation. Consumer confidence was at another new low. The number of people receiving unemployment benefits increased by 4.6 million in 2008, the most since 1982. The unemployment rate rose to 7.2 percent in December. Most of those job losses occurred in the fourth quarter of 2008. Consumer spending fell by 3.5 percent during the quarter, and spending on food was down 3.7 percent. Durable good orders shrank by 22.4 percent in the fourth quarter of 2008. Spending on business equipment and software decreased by 27.8 percent during that quarter, the largest decline in fifty years. However, productivity rose at an annual rate of 3.2 percent in the fourth quarter. Manufacturing activity around the world fell sharply in December. In the United States, that activity plunged to its lowest level since 1980. Ford forecast a 19 percent contraction in automobile sales, which turned out to be an understatement. World trade was also in decline. Imports and exports by the United States shrank by 18 percent between July and November 2008, mostly from imports. Japan experienced a 3.3 percent decline in GDP in the fourth quarter as its exports declined. State and municipal pension plans lost almost 30 percent of their value in 2008, a loss of some $900 billion.

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. The former chairman of the Federal Reserve, Alan Greenspan, once a hero, was being blamed for the housing bubble. (Mark Wilson, photographer, Getty Images ©)

U.S. Treasury Secretary Henry Paulson (L) and Federal Reserve Chairman Ben Bernanke testify before the House Financial Services Committee during the subprime crisis. (Chip Somodevilla, photographer, Getty Images ©)

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. Lloyd Blankfein, chairman and CEO of Goldman Sachs. He led the firm that every other investment bank tried to emulate, without success. (Jemal Countess, photographer, Getty Images © for Time Magazine)

President of the Federal Reserve Bank of New York and later Treasury Secretary Timothy Geithner was at the center of government efforts to bail out Wall Street during the subprime crisis. (Emmanuel Dunand/AFP, photographer, Getty Images ©)

Richard Fuld Jr. (L), CEO of Lehman Brothers when it failed. (Alex Wong, photographer, Getty Images ©)

Vikram Pandit, CEO of Citigroup, during the subprime crisis. (Bill Pugliano, photographer, Getty Images ©)

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. Maurice R. Greenberg, chairman of American International Group (AIG). His ouster by Eliot Spitzer left AIG adrift. (Choi Jae-Ku/AFP, photographer, Getty Images ©)

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. Stan O’Neal, chairman, chief executive, and president of Merrill Lynch. His appetite for risk brought down mighty Merrill. (Joe Raedle, photographer, Getty Images)

New York attorney general Andrew Cuomo continued Eliot Spitzer’s attacks on Wall Street. (Andrew H. Walker, photographer, Getty Images ©)

The New President

The New Year—2009

On the first day of trading in 2009, the Dow Jones Industrial Average jumped by 258.30 points, to close at 9034.69. However, the first full week of trading in the new year witnessed a disappointing decline of 4.8 percent in the S&P 500 Index, its worst performance since November. Crude oil prices remained volatile, jumping by 40 percent between Christmas and the first week of January 2009, before sharply declining once again, and they dipped to $35.40 a barrel on January 15, 2009. Layoffs were carried out at large companies across the country, including Hertz, ConocoPhilips, and AMD. Alcoa announced on Janu- ary 6, 2009, layoffs of 13,500 employees, about 13 percent of its workforce. The company had posted a loss of $1.19 billion in the fourth quarter of 2008, and its sales were down by 19 percent from the prior year. That news was followed by a report that Boeing was laying off 4,500 employees. Microsoft sustained an 11 percent decline in profits in 2008 and cut 5,000 jobs. A $100 million theme park, Hard Rock Park in Myrtle Beach, South Carolina, declared bankruptcy on January 6, 2009, after having been in operation for only nine months with few attendees. On January 12, 2009, the Dow Jones Industrial Average fell by 125.21 points. Among the shares hit hardest was Citigroup, which had reported that it would announce a loss of $10 billion for the fourth quarter of 2008. At this point, Citigroup had received $45 billion in government bailout funds. The market reacted badly to news of the most recent loss. Citigroup’s stock price fell below $5 on January 14, 2009, for the first time since November. The Dow dipped 248.42 points on that day, its sixth straight day of losses. On January 21, 2009, Citigroup appointed its new chairman: Richard Parsons, the head of Time Warner, which had been struggling for years. Those problems raised the question as to exactly what management abilities he would bring to the faltering Citigroup.

625

Responding to a request from President-elect Barack Obama, President Bush, on January 12, 2009, asked Congress to release the remaining $450 billion in the $700 billion Troubled Asset Relief Program (TARP). The president- elect stated that he would use $100 billion of those funds to stop foreclosures. On January 13, 2009, the chairman of the Federal Reserve, Ben Bernanke, announced that the government needed to provide more bailout funds to banks and financial institutions from TARP. However, one report claimed that the program was mishandled. Politics as usual guided the bailouts. Representative Barney Frank (D- MA), chairman of the House Financial Services Committee, used his political influence to require the Treasury Department to supply $12 million from TARP to rescue OneUnited Bank in Boston. He was undeterred by the fact that the bank did not qualify for the program and was under investigation by regulators. House Democrats revealed a proposed $825 billion stimulus plan on January 15, 2009, which sought $275 billion in tax cuts and $550 billion in new spending. However, Bernanke asserted that tax cuts and government spending on infrastructure were unlikely to lead to a recovery, unless the Wall Street financial institutions stabilized. The delinquency rate for both prime and subprime mortgages was a record 7.88 percent as 2009. Late payments on subprime mortgages were a staggering 21.88 percent. Homeowners owed $9.6 trillion on their mortgages, which meant that a total of $750 billion in residential mortgage debt was delinquent and that $196 billion in subprime debt was late by thirty days or more. Economists predicted that the housing slump would worsen during 2009 and would not recover until 2010. Treasury Secretary Henry Paulson considered selling off the portfolios of Freddie Mac and Fannie Mae, leaving them only the role of mortgage guarantors. However, it was unclear what effect such sales would have on the market. Moreover, without a government guarantee the mortgages would be unsalable at anything other than fire-sale prices, which meant that the government would retain its risk, regardless of its course of action. On January 16, 2009, JPMorgan Chase announced an expansion of its mortgage loan modification program to include not only mortgages in its own portfolio but also mortgages that it securitized. The value of those mortgages totaled more than $1 trillion. The modifications were intended to ease demands on borrowers and to avoid foreclosures. A drop in interest rates should have aided modifications and eased the pain of high-rate mortgage resets. Interest rates on thirty-year fixed-rate mortgages had fallen to 4.89 percent by mid-January 2009. However, many lenders still did not extend loans. It was estimated that only about half of refinancing applications were approved. Toll Brothers tried to kick-start its residential housing business by offering a 3.99 percent thirty-year, fixed-rate mortgage for homes it was building that cost under $417,000, with no points to be paid to the lender.

Trouble Abroad

Unemployment was rising in Germany, reaching 7.6 percent as 2009 began. The German government took a 25 percent ownership interest in Commerz- bank, after injecting it with an additional $13.63 billion. The Bank of England announced an interest rate cut of 0.50 percent on January 8, 2009, bringing its interest rate to 1.5 percent, and it cut rates further in February, to 1 percent, a record low. Canada cut its interest rates to their lowest level ever on January 20, reducing them to 1 percent. On January 19, 2009, the British government announced the creation of a $150 billion bailout program for its banks that limited their losses due to problem assets. Share prices in Great Britain then fell because the government’s rescue program was viewed as an admission of a worsening financial situation. The Royal Bank of Scotland (RBS) disclosed that it would report losses of as much as $41 billion for 2008, the largest loss ever for a British bank. RBS laid off 9,000 employees, and the UK government raised its ownership interest in the bank to 70.3 percent. The Global Investment House in Kuwait defaulted on $3 billion in debt on January 8, 2009. Banks were facing more than just financial problems. Lloyds TSB Group agreed to pay $350 million to New York State and U.S. federal authorities to settle claims that it had allowed Iran to illegally funnel billions of dollars through American banks. Nine other banks were under investigation for similar conduct. Some of the funds were used to buy materials that could assist in the development of Iran’s nuclear program. Barclays later agreed to pay $298 million to settle charges that it allowed accounts from Cuba, Iran, and other embargoed countries to transfer large amounts of funds in and out of the U.S. A federal judge reviewing the settlement called it a “sweetheart” deal but approved it anyway. Scandal broke out in India in January 2009 after Satyam Computer Services, a giant outsourcing firm, was discovered to have massively cooked its books. Its founder and chairman, Ramalinga Raju, confessed to the scheme after it became unmanageable. He stated that it was “like riding a tiger, not knowing how to get off without being eaten.”1

Inauguration Day

January 20, 2009, was the worst presidential inauguration day in the history of the Dow Jones Industrial Average, which declined by 332.13 points, to 7949.09. Bank stocks were hit the hardest, falling about 20 percent. The Citigroup stock price fell to $2.80 a share from a high in 2008 of $27.50. The plunge would continue, down to $.97 in March 2009. Bank of America’s stock price fell to $5.10, down from $40.65 in 2008. State Street, a traditionally staid bank located in Boston, saw its stock price fall by 59 percent on Inauguration Day, after reporting losses of almost $5 billion related to subprime securities. Moody’s downgraded State Street’s debt.

Financial service stocks were, on average, down by 70 percent on Inau- guration Day. Market volatility continued. The Dow rallied by 279.01 points on January 21, 2009, but the rain of bad news remained constant, and the Dow experienced its worst January ever. Capital One Financial Corporation announced on January 22, 2009, that it would write off an additional $1 billion to cover rising credit card defaults. General Electric Capital Corporation announced on January 23, 2009, that its net for the fourth quarter of 2008 had fallen by 44 percent. The company also warned that it expected an extremely difficult year ahead. General Electric had been able to sell $10 billion in bonds guaranteed by the Federal Deposit Insurance Corporation (FDIC) on January 5, 2009, in the largest such offering to date under that program, scheduled to end on June 30, 2009. Financial analysts projected that firms covered by the FDIC guaranteed loan program would raise more than $400 billion from such offerings before its termination date. The National Credit Union Administration (NCUA) stepped in on January 28, 2009, to rescue the Federal Credit Union wholesale network. The NCUA guaranteed the uninsured deposits at institutions that serviced smaller credit unions. The federal government pumped $1 billion into the largest wholesale credit union, U.S. Central Credit Federal Union, in Lenexa, Kansas. Pfizer acquired pharmaceutical rival Wyeth for $68 billion in late January. That brought some optimism to the market because of the size of the deal and the fact that Pfizer was able to obtain financing for the transaction. However, the economy took another blow with the announcement on the same day of layoffs at the firm totaling 65,000. Large-scale layoffs occurred at several large companies, including Home Depot, IBM, General Motors, and Texas Instru- ments. Macy’s announced 7,000 jobs cut. Total job losses in January 2009 reached almost 600,000, the highest in twenty-five years. The unemployment rate rose to 7.6 percent. Several states faced a crisis in their ability to pay unemployment benefits. The personal savings rate of Americans jumped by 5 percent in January 2009, the highest rate in fourteen years, signaling a sharp cutback in consumer spending. Manufacturing slowed further during January, but at a less rapid rate. Retail sales rose 1 percent in January as retailers slashed prices. Hous- ing starts fell during January 2009 to the lowest level in fifty years, and home resales dipped by 5.3 percent. The price of residences in the twenty largest metropolitan areas in the United States declined by 2.8 percent in January 2009, leaving prices in those areas down by about 30 percent from their peak before the crisis. The International Monetary Fund (IMF) raised its estimate for credit losses on U.S. assets from $1.43 trillion to $2.2 trillion. Britain had its widest trade deficit since 1697, when records were first kept. As noted, its central bank, the Bank of England, reduced interest rates in January 2009 to 1.5 percent, their lowest level since the bank was created in 1694. The economic summit at Davos, Switzerland, in January turned out to be a glum affair. However, Wen Jiabao, the Chinese prime minister, and

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. The Rise and Fall of the Subprime Crisis 629 his Russian counterpart, Vladimir Putin, used the occasion to lecture the West on its failings and to demand greater roles for themselves in world affairs. They were not the only ones worried about U.S. finances. Foreign investors withdrew $148.9 billion from their U.S. assets during January. The subprime crisis did not slow government investigations of business practices. Halliburton agreed to pay $559 million to settle Securities and Ex- change Commission (SEC) and Justice Department charges that a subsidiary paid bribes to foreign officials in order to obtain business.

Regulatory Proposals and Stimulus

In February 2009 the Obama administration announced that it would stress test the largest nineteen banks to determine their viability. Any problematic bank that failed the stress-test scenarios would have six months to raise capital privately. Failing that, the government would inject the bank with capital by buying convertible preferred shares from the undercapitalized bank, which would pay a 9 percent dividend and be convertible into common stock. At the same time that their lack of capital was questioned, banks were placed under enormous pressure to lend the funds that they received from the government. However, as a JPMorgan Chase executive warned, forced lending could distort the credit market and result in loans without proper credit support. One problem with restarting lending was that, as Vikram Pandit, the CEO of Citigroup, pointed out, loans could be obtained at a lower cost in the secondary market than through new originations. The new Treasury secretary, Timothy Geithner, held a press conference on February 10, 2009, to announce the Obama administration’s bailout plans. His performance was long on rhetoric and short on specifics, but he did mention the creation of a public/private fund that would provide up to $1 trillion in financing to private investors to allow them to buy distressed mortgage-related assets from banks. This plan met a rather cold reception because it contained no detailed pricing mechanism for the assets that would be purchased and sold. Geithner also announced an expanded program for supporting consumer- based securitized loans, including student loans, credit cards, and car loans. Geithner stated that the government planned to release the remaining $450 billion in TARP, but that large banks would have to pass their “stress test” before receiving more funding. At his press conference, Geithner promised to release another plan, at some time in the future, to provide assistance to homeowners facing foreclosure. In the meantime, mortgage-servicing firms were overwhelmed by foreclosures. They had some respite as foreclosures slowed, pending debate and passage of the Obama economic stimulus package. With the help of three Republicans, that $838 billion package passed the Senate on February 11, 2009. The Obama administration played up the disarray in the economy to help assure passage of the stimulus package. As soon as it passed, however,

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 630 The Crisis Abates the administration began to soft-pedal economic concerns with a speech by the president before a joint session of Congress on February 24, 2009. The stimulus package included an $8,000 tax credit for first-time homebuyers, payments of as much as $64,000 to doctors who digitized their medical records, health insurance for the unemployed, and $276.3 billion in tax cuts. The tax credit for first-time homebuyers proved especially popular, costing the government an estimated $1 billion in lost revenue, twice the amount projected, but helpful for the housing market while the credit was in place. The stimulus package also included something called Build America Bonds, which were non-tax exempt municipal and state government bonds that were supported with a government subsidy for one-third of their interest payments. The Obama administration later sought to make these bond subsidies permanent, albeit at a reduced subsidy of 28 percent. The New York Times later reported that the investment banks underwriting these offerings were charging higher than usual fees and that the offerings were sometimes underpriced, allowing quick profits by investors at the expense of the municipalities. The financial analysts at the investment banks were also questioning the viability of such offerings in view of the increasingly bad financial condition of state and municipal governments. The stimulus package prohibited financial institutions that received government bailout funds from hiring foreign employees. It also required steel and other products used in stimulus-related programs to be made in the United States. This “Buy American” approach appeared to be an effort to boost the labor unions and to repeat the mistakes made in the 1930s with the Smoot- Hawley tariffs, which were designed to force purchases only of goods made in the country. Retaliation followed enactment of Smoot-Hawley, nearly halting world trade in the 1930s. Canada, which purchased about 20 percent of U.S. exports, threatened reprisals, and Japan protested the provisions in the Obama stimulus package, as did the European Union. The Obama administration defended the legislation as permitted by the World Trade Organization’s pro- curement code, which allowed some buy-American provisions in government purchases. Other countries, including Russia, erected trade barriers to bolster their domestic industries against import competition.

The SEC

The SEC reeled from its failures during the subprime crisis. Mary Schapiro, the new SEC chair appointed by Obama, set about restoring the agency’s reputation through a number of aggressive enforcement actions and regulatory proposals that read like a wish list for corporate reformers. The proposed reforms included say-on-pay and director nominations by pension unions through proxy proposals that would be distributed at the company’s expense. Schapiro also sought legislation to make the agency self-funding through fees, so that it would have

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. The Rise and Fall of the Subprime Crisis 631 more independence from Congress. She also wanted federal securities laws to be revamped to more effectively regulate securitizations. Schapiro suggested that she might turn back the regulatory clock and re- instate the SEC’s traditional tick test for short sales, which prohibited short sales until there was an uptick in the price of the stock. The theory was that this would prevent short-sellers from unfairly driving down prices through a continuing stream of short sales at ever-falling prices. Fed chairman Bernanke supported her in that effort. The SEC short-sale proposals were published in April 2009. Another proposal would adopt circuit breakers to prohibit all short sales in the event of large market movement. The rules that were initially adopted only addressed naked short sales (short sales made without first borrowing the stock for delivery), which had been an issue at the height of the subprime crisis. This raised hopes that the SEC had realized that short selling is good for the market as a disciplinary tool. Those hopes were short-lived. The SEC proposed a modified form of its old uptick rule a few months later. The agency adopted that rule in February 2010. It imposed short-sale restrictions on stocks that dropped by 10 percent or more in a single trading day. Senator Carl Levin (D-MI) and Senator Charles Grassley (R-IA) introduced a bill called the Hedge Fund Transparency Act, which sought to require hedge funds to register with the SEC and to report their net asset value and identify their investors. Schapiro supported the regulation of hedge funds, as did Gary Gensler, the administration’s nominee to become chairman of the Commodity Futures Trading Commission (CFTC), who was under attack because of his prior support of deregulation. Not long after the Madoff fraud was uncovered, the Wall Street Journal reported on its front page that another giant Ponzi scheme was under way, this one managed by Danny Pang and involving hundreds of millions of dollars, including some $700 million from investors in Taiwan.2 Only after the Wall Street Journal article appeared did the SEC freeze his assets. The Justice Department also charged him with money laundering. Just a few months after his arrest, Pang was found dead in his home, his wife having been murdered earlier under mysterious circumstances. Another massive fraud was revealed on February 17, 2009, after the SEC charged Sir R. Allen Stanford with defrauding investors of some $8 billion. He had promised high returns from certificates of deposit, but he invested the customer funds in illiquid assets. Stanford was a high-profile financier who was an international cricket sponsor, operating from the Caribbean island of Antigua through his Stanford International Bank. That bank attracted a massive amount of funds from Latin American investors He made a number of loans to the Antiguan government, which awarded him with a knighthood because of his generosity. Stanford was particularly popular in Venezuela, despite its socialist government, and contributed heavily to political campaigns in the United States. The SEC had brought prior enforcement actions against the Stanford firm but let the firm off with only a slap to the wrist. The agency’s Fort

Worth office had investigated the firm for two years before a case was finally mounted. The SEC claimed that it stopped its investigation at the request of the Justice Department and that it had encountered jurisdictional problems in Antigua. However, an SEC inspector general report subsequently found that SEC examiners had concluded on four occasions that Stanford was commit- ting fraud, but no action was taken. Spencer Barasch, the head of the SEC’s Fort Worth office, was found to have repeatedly stopped investigations of the Stanford operations and then tried to represent Stanford after moving to private practice. The SEC inspector general sought to have Barasch disbarred from practicing law for this conduct. The SEC had other issues. On May 15, 2009, the SEC inspector general announced that two senior enforcement attorneys at the agency had apparently been trading on inside information about companies under investigation. The matter was referred to the Justice Department for further investigation. In June 2009, the Justice Department indicted Stanford, along with five of his cohorts. Among other things, the indictment charged that Stanford had paid a $100,000 bribe to Leroy King, the Antiguan financial services regulator, in order to deflect SEC inquiries made in 2005 and 2006 on the bona fides of the Stanford bank. Stanford surrendered to U.S. authorities and was denied bail. Though he had once been a billionaire, Stanford ran out of funds to pay his attorney before the trial even began. He was then supplied with a lawyer from the public defender’s office in Houston. Stanford was later able to claim coverage for his attorney fees under a company insurance policy. He then went through several sets of attorneys. Stanford remained in jail as a flight risk and was assaulted by a fellow inmate. Those problems were followed by the arrest of hedge fund managers Paul Greenwood and Stephen Walsh on charges of defrauding investors of $553 million, including the University of Pittsburgh, which lost $65 million, and Carnegie Mellon University, which lost nearly $50 million. At the time of his arrest, Greenwood was living on a 300-acre horse farm in North Salem, New York, where he was the town supervisor. Greenwood and Walsh had been two of the unsuccessful owners of the New York Islanders hockey team. That franchise seemed to be jinxed. It was sold to John Spano, who was arrested for fraud shortly afterward. The team was then acquired by Charles Wang, the former head of Computer Associates, which had been the center of a massive Enron-era accounting scandal.

Conditions Remain Uncertain

Credit markets thawed a little. Corporations sold $78.3 billion in investment- grade corporate bonds during the first six weeks of 2009. Cisco Systems sold $4 billion in bonds on February 9, 2009. Nevertheless, the market was not too happy with the Obama stimulus package. The Dow dropped to 7850.41 on February 13, 2009, and fell by 298 points, closing at 7552.60, on February

17, 2009, when the market was shaken by reports of the possible collapse of economies in Eastern Europe and projected defaults on loans made to those countries by Western banks. The market was also affected by announcements from General Motors and Chrysler that they would need at least $21.6 billion in government funding to avoid bankruptcy. Citigroup was in talks with the Treasury Department to obtain more financing. It was later agreed that the government would take a 34 percent ownership interest in Citigroup, which had reported losses of $28 billion in the previous five quarters. On February 18, 2009, President Obama announced a $200 billion plan to provide relief for mortgage loan modifications for homeowners who were underwater and had their mortgages via Fannie Mae and Freddie Mac. An additional $75 billion was to be used for modification of mortgages from private lenders. The initial plan sought to limit loan payments to 31 percent of the borrower’s income. They would be given a $1,000 per year “pay for success” fee for making the modified mortgage payments. This program, like its predecessors, was slow to get off the ground. Only 55,000 modification offers had been issued by mid-May 2009, by which time Bank of America had separately modified the terms of some 50,000 mortgages issued by Countrywide. BoA’s modifications were required by a settlement with various states. However, loan modifications were no panacea for subprime loan defaults. Some 65 percent or more of modified subprime loans fell into delinquency not long after being modified. On February 18, 2009, Freddie Mac completed a $10 billion loan offering, the largest in its history, and about two weeks later its CEO, David Moffett, who had been brought in by the government only six months earlier to reorganize the company, resigned. Fannie Mae disclosed on February 26, 2009, that it needed another $15 billion in funds from the federal government. In the meantime, Freddie Mac and Fannie Mae had been converted into government entities to manage mortgage loan modification programs, to refinance troubled loans, and to expand mortgage lending. Incredibly, the government also pushed them into further easing their lending guidelines so that they could continue to offer subprime loans.3 The price of gold passed $1,000 an ounce on February 20, 2009, and predictions of $2,000 per ounce were floated.4 The Dow was down 50 percent on February 23, 2009, from its high of 14087 on October 1, 2007. The market was hurt by predictions that American International Group’s (AIG’s) losses for 2008 would total $100 billion. The rating agencies also applied downward pressure on the market when they began downgrading life insurance companies as the portfolio values of their reserves declined. President Obama tried to sound upbeat in his State of the Union address delivered on February 24, 2009. On the same day, Fed chairman Bernanke testified before Congress and expressed confidence that the economy would recover by 2010. He denied any interest in nationalizing large banks like Citi-

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 634 The Crisis Abates group, stating, “nationalization, to my mind, is when the government seizes the bank, zeroes out the shareholders and begins to manage and run the bank. And we don’t plan anything like that.”5 This statement was made after bank stock prices in the United States tumbled upon reports that Chris Dodd, chairman of the Senate Banking Committee, had asserted that some large banks might have to be nationalized. With respect to the subprime crisis President Obama said, “This crisis is nei- ther the result of a normal turn of the business cycle nor an accident of history. We arrived at this point as a result of an era of profound irresponsibility that engulfed both private and public institutions from some of our largest companies’ executive suites to the seats of power in Washington, D.C.”6 He also stated, “For decades, too many on Wall Street threw caution to the wind, chased profits with blind optimism and little regard for serious risks—and with even less regard for the public good.”7 The president outlined seven principles for designing a new financial regulatory structure, to include “serious oversight” of large institutions that pose systemic risk; reform of the present regulatory structure; transparency; uniform regulation of financial products; accountability; comprehensiveness; and recognition of the global nature of financial services.8 In February 2009, the Dow Jones Industrial Average declined by 12 percent, closing at 7062.93 on the last trading day of the month. U.S. manufacturing fell by only 1.4 percent, the smallest decline in four months, but auto sales in the United States shrank by 41 percent that month. General Motors warned that its European operations would run out of money in the next few months. Consumer confidence fell to the lowest level in forty-one years. Many companies, including Microsoft, Office Depot, Target, and Macy’s, faced further declines in earnings. Wal-Mart reported strong sales, as consumers sought low prices. That little bit of good news was quickly offset by a report that the unemployment rate had risen to 8.1 percent in February 2009, the highest rate in twenty-five years. Job losses for the month totaled 697,000. The Fed’s Beige Book indicated that the recession had deepened in January and February 2009, as consumer and business spending fell. The Fed found sharp declines in manufacturing, weak conditions in the agriculture sector, and a slowing of mining and drilling. The Federal Housing Administration (FHA) reported that mortgage loans that were delinquent by ninety days or more had increased in February 2009 to 7.46 percent, up from 6.16 percent a year earlier. Judges in Lee County, Florida, one of the hardest-hit areas in the country in terms of real estate foreclosures, had another solution. They created a “rocket docket” for foreclosure proceedings that foreclosed 1,000 homes per day. As foreclosure sales increased, existing home sales jumped by 5.1 percent in February. Declines in housing prices and bank loan delinquencies still grew but at a slower rate, and home construction increased 22 percent in February 2009. Overall home sales in California rose by an astonishing 83 percent year on year. New home sales also rose in February, for the first time in seven months.

Lending by the large banks that had taken TARP funds declined by 23 percent in February 2009 compared with October 2008, when the program went into effect. General Electric (GE) suffered from concerns with its GECapital unit, which made loans to small-to-medium-size businesses and invested in commercial real estate. GE’s stock price plunged as concerns grew over the mounting losses in that unit. The firm wrote down $4 billion on its commercial real estate holdings and reserved about $10 billion for losses on $380 billion in receivables due GECapital. GE announced on February 27, 2009, that it would cut its quarterly dividend for the first time since 1938, by 68 percent, from $.31 a share to $.10. Those steps were not enough to protect GE’s coveted triple-A rating, which it lost on March 12, 2009, after having held it since 1956. Standard & Poor’s downgraded GE to AA, still investment grade and with a stable outlook. That downgrade removed uncertainty over GE’s condition, and the company’s stock price jumped 11 percent. The Obama administration considered the imposition of a requirement to mandate spinning off GECapital as a new structure to be regulated as a bank, but GE fought that effort and eventually prevailed. However, faced with charges that the firm had manipulated its accounts to increase earnings in 2002 and 2003 by $780 million, it accepted a settlement with the SEC in August 2009 and agreed to pay $50 million to settle those charges. GE had been famous for meeting and exceeding analysts’ expectations every quarter, and these manipulations were conducted in order to assure that result. Dividends were cut at numerous companies, including JPMorgan Chase, PNC Financial, CBS, the New York Times, Dow Chemical, and Pfizer. It appeared that 2009 would be the worst year for dividends since 1938. By the end of the first quarter alone, dividends had been reduced by more than $40 billion, and public companies that reduced dividends numbered 367. However, Oracle announced in March 2009 that it would pay a dividend for the first time. Kaspar Villiger, a former finance and defense minister of Switzerland, became the new chairman of UBS in March 2009. This was the second effort to deal with UBS’s burgeoning subprime and tax shelter problems by bringing in a new chairman. At the end of February 2009, HSBC announced that it was cutting back its U.S. consumer finance operations, the remains of its acquisition of Household Finance, and would raise $17 billion in new capital through a rights issue. HSBC had suffered $10 billion in losses from over the six years since acquiring Household Finance, and its acquisition of those operations was one of the factors that gave legitimacy to subprime lending by banks. Michael Geoghegan, HSBC’s CEO, said in 2009 that, “with the benefit of hindsight, this is an acquisition we wish we had not undertaken.”9 That was certainly an understatement. Bank of America’s CEO, Kenneth Lewis, asserted on March 2, 2009, that it had been a tactical mistake for the bank to have accepted TARP funds because it made the bank appear weak. The bank’s stock had lost 86 percent of

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 636 The Crisis Abates its value over the previous twelve months, but he said BoA would repay the TARP funds over the next two to three years. Lewis lost a shareholder vote on his continuation as both chairman and CEO. He was then stripped of his chairmanship by the board but continued as CEO. He remained a subject of controversy as Congress, the SEC, and New York attorney general Andrew Cuomo continued to probe his role in trying to walk away from the Merrill Lynch acquisition. Cuomo subsequently charged Lewis with fraud in not disclosing the unexpected losses at Merrill Lynch before the shareholder vote on the merger. Lewis hired Sallie Krawcheck, who had previously been CEO of Global Wealth Management at Citigroup, as a possible successor. Vikram Pandit, the Citigroup CEO, had previously forced her from her position at Citigroup. She was eventually beaten out of the Bank of America job by Brian Moynihan, a longtime Bank of America employee.

Executive Compensation

A Populist Issue Returns

The subprime crisis renewed populist and political focus on executive compensation. A study published in November 2008 found that top executives at 120 public companies involved directly in the subprime crisis and credit crunch received compensation that totaled more than $21 billion during the previous five years. Representative Henry Waxman (D-CA) held hearings in 2008 on the severance compensation paid to Charles Prince at Citigroup, F. Stanley O’Neal at Merrill Lynch, and Angelo Mozilo at Countrywide Finan- cial. All of those executives had led their firms into failure or near-failure, so members of Congress questioned them severely. Senator Carl Levin (D-MI) was a particularly aggressive corporate critic. The Democrats had plenty of ripe targets. Fifteen corporate executives at home building and financial services firms each received more than $100 million in compensation during the five-year period leading up to the subprime crisis. Mozilo alone took home over $470 million before Countrywide Financial had to be rescued by Bank of America. Robert Toll at Toll Brothers took home $427 million before that company’s housing sales dropped precipitously during the subprime crisis. Executives at large firms in the United States experienced an 8.5 percent drop in median salary and bonuses in 2008, down to a median of $2.24 million. However, when stock options were added in, median compensation fell by only 3.4 percent, to $7.56 million. Some of the winners were Sanjay Jha, who received over $100 million at Motorola; Lawrence Ellison at Oracle, who received $84.6 million; Robert Iger at Walt Disney, who received $51.1 million; and Vikram Pandit at Citigroup, who received $38.2 million. Aubrey McClendon, the CEO of the Chesapeake Energy Corporation, was paid $112 million in 2008, despite a steep decline in the price of the company’s stock.

Among other things, the company agreed to pay McClendon over $12 million for his art and map collection. Robert Rubin, treasury secretary in the Clinton administration and a Citibank senior executive, was paid $115 million by Citigroup between 1999 and the end of 2008, when he left because of the bank’s losses. Four CEOs serving at Citigroup between 1998 and 2008 were paid a total of $483.1 million, which did not include profits from their options. Prince, who was ousted from Citigroup in 2007 as its losses mounted during the subprime crisis, had been given a $23 million compensation package for 2005. Citigroup’s net profit for the fourth quarter of 2006 fell by 26 percent, but he received a princely $26 million for his work during the year. Ronald Logue, the CEO of State Street, was paid $28.7 million in 2008, an increase of $5 million over his pay in 2007. That remuneration was granted even though the price of the company’s stock fell from a high of $83 in 2008 to $22.63 on March 13, 2009, when his compensation package was announced. State Street also reported $3.6 billion in unrealized losses, resulting in a credit downgrade, and it was the recipient of $2 billion in government bailout funds in 2008. More fuel was added to the executive compensation fire after it was announced that executives at Fannie Mae and Freddie Mac would receive retention bonuses totaling $210 million. Both companies had failed in 2008 after massive losses and were placed in government-managed conservatorships. In remarks made on January 29, 2009, President Obama called bonuses of nearly $20 billion paid out to bank executives, while the government was bailing them out with taxpayer funds, “outrageous,” “shameful,” and the “height of irresponsibility.”10 Five days later, the president went further, announcing that, in the future, firms receiving bailout money would have to adopt a salary cap of $500,000 for executives, golden parachutes were prohibited, and spending on such things as corporate jets, office renovations, and holiday parties would have to be disclosed. On February 11, 2009, Congress called executives from eight of the major financial firms—including Pandit at Citigroup, Jamie Dimon at JPMorgan Chase, Lloyd Blankfein at Goldman Sachs, and Kenneth Lewis at Bank of America—for seven hours of testimony on their compensation arrangements. This experience persuaded Blankfein that the anger over bonuses at financial services firms was “understandable and appropriate,” as he put it in an address in Frankfurt, in September 2009.11 Nonetheless he did not offer to return to Goldman shareholders the record bonuses he received in 2006 and 2007, totaling $124 million, or the $1.1 million he received in 2008, at a time when Goldman posted its first-ever quarterly loss as a public company. Senator Claire McCaskill (D-MO) introduced a bill that would limit executive pay at companies receiving bailout funds to no more than $400,000—the same amount that the president of the United States is paid (in addition to $50,000 in travel expenses and $19,000 for entertainment, and perks like Air

Force One and a private residence at the White House) and what Blankfein was paid every two days in 2007.

Bonuses at AIG

Anger mounted after the announcement that AIG paid $165 million in bonuses for the 2008 work of the executives in AIG Financial Products (AIGFP), the unit that caused most of the losses at AIG and resulted in a $170-plus billion government bailout in 2008. Lawrence H. Summers, who succeeded Rubin as treasury secretary under the Clinton administration and was now a senior economic adviser to Obama, called those bonuses “outrageous.” However, he was not averse to excessive compensation for himself, having received $5.2 million in the previous year for his work at the hedge fund D.E. Shaw & Company, as well as $2.7 million in speaking fees, mostly from financial services firms. President Obama weighed in with a threat to employ every legal method to reclaim the AIG bonuses. His administration had some basis for taking that action, because the American taxpayer owned 80 percent of AIG after its bailout. Outrage grew after the president’s comments, and after it was revealed that more than $1 million was paid to each of seventy-three employees on an accelerated basis, including almost all the employees in AIGFP. AIG claimed that the bonuses were needed to retain key employees. How- ever, $33.6 million in bonuses was paid to employees who left the firm. More criticism was leveled at AIG after it was reported that the company had continued to retain the risk managers who were on duty when AIG took on the positions that caused it to fail. Another controversy arose over AIG’s bonus pool for 2010. Kenneth Feinberg, whom the Obama administration appointed special master for TARP executive compensation (called the “pay czar”), sought to require AIG to reduce $198 million in bonuses already promised for 2010 and to recover $45 million already paid out to employees. Some of those AIG employees resisted that effort. To add insult to injury, AIG was suing the government for a $306 million tax refund, claiming, among other things, that it had overpaid taxes as a result of its own accounting manipulations in 2004. However, the IRS responded at the end of March 2009 with the disclosure that it was investigating whether AIGFP had improperly structured tax shelters for some large financial institutions. New York attorney general Cuomo began an investigation of the AIGFP bonuses. He and Representative Frank called for disclosure of the names of executives receiving the AIG bonuses, even though they were targets of a number of death threats. Cuomo was given the names, but under a confidential- ity agreement. He then began harassing and threatening those executives and announced at the end of March 2009 that some of them had agreed to return about $50 million of the disputed bonuses, but others refused to do so. One of the AIG executives agreeing to repay his bonus was Douglas Pol-

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. The Rise and Fall of the Subprime Crisis 639 ing, who had received $6.4 million for his role as the lawyer for the financial products division. He had been accused of silencing an in-house auditor who had raised concerns about the accounting treatment for a joint venture led by Poling. The other result of this furor was that some twenty key employees left AIGFP, slowing the winding-down of that unit and damaging the taxpayers’ investment in AIG. The controversy over the AIG bonuses led to the resignation of two key AIG executives in France who managed Banque AIG, which had billions of dollars in exposures that could be endangered by mismanage- ment, and triggers on those exposures could be set off if French officials did not approve their replacements. The AIG bonuses resulted in some embarrassment for the Obama administration. The administration and the Treasury Department gave mixed signals on the bonuses. Geithner concluded that they were legally valid, while President Obama ordered their repayment. Geithner had been one of the architects of AIG’s rescue while head of the Federal Reserve Bank of New York, and he had been monitoring it as the bonuses were being paid. Senator Chris Dodd (D-CT) also admitted to adding language in a recently passed stimulus package that authorized the bonuses. However, Dodd claimed that he had done so at the request of Treasury officials. The outrage over the AIG bonuses continued to swell in the press and public. One poll found that 83 percent of Americans believed that the federal government should limit the amount of compensation paid to executives at firms receiving bailout funds. However, another poll found that only one-third of Americans thought that bonuses should otherwise be restricted. That con- trasted with the views of Europeans, where support for bonus curbs ranged from 65 to 79 percent. The House passed special legislation to impose a 90 percent surtax on the income of employees earning more than $250,000 at companies that had received $5 billion or more in government bailout funds. The law’s effect was not limited to AIG. If enacted, it would have affected thousands of employees at firms receiving bailouts, including Goldman Sachs, JPMorgan Chase, Morgan Stanley, Citigroup, and Wells Fargo, as well as Fannie Mae and Freddie Mac. Edward M. Liddy, a former Goldman Sachs board member brought back from retirement for $1 per year in order to save AIG, was pilloried in Congress and the press over AIG bonuses. Liddy said the once-sterling AIG brand had become so tarnished that it would have to change its name in order to stay in business. Robert Benmosche, who had previously conducted a successful turnaround at MetLife, replaced Liddy as AIG’s CEO in August 2009, the fifth CEO at AIG since 2005, when Hank Greenberg was ousted by New York attorney general Eliot Spitzer. That hire and his compensation package were valued at about $10 million. Interestingly, Feinberg approved that compensation package. Benmosche, who started his job by taking a two-week vacation in Croatia, consulted with Greenberg to tamp down the war waged by one of

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 640 The Crisis Abates his predecessors, Martin Sullivan, against Greenberg. That effort was almost immediately successful. AIG and Greenberg agreed on August 31, 2009, to settle their claims and to privately arbitrate any issues that could not be settled in an agreement formalized on November 25, 2009. The parties dropped all claims against each other, and AIG agreed to pay Greenberg an amount to be determined by an arbitrator, but not to exceed $150 million. The company also agreed to return personal items from Greenberg’s office that were seized when he was ousted. Greenberg later sold $278 million of his AIG shares to UBS AG through a variable prepaid forward sale. Under that arrangement, Greenberg was given an upfront payment for delivery of the shares at a future date and a promise of being allowed to share in increases in the share price in a specified amount.

The Controversy Continues

Waxman complained that the banks receiving TARP funds had expended $108 billion for employee compensation and bonuses for the first nine months of 2008. Cuomo took it a step further in July 2009, disclosing that nine financial services firms receiving government bailout funds during the subprime crisis in 2008 had paid out bonuses that year totaling $33 billion. Those firms paid more than $1 million in bonuses to each of almost 5,000 employees. Although that was an 11 percent decline from 2007, the amounts were still staggering. The TARP legislation limited tax deductions on executive pay at firms receiving bailout money to $500,000, prohibited golden parachutes in excess of three years’ pay, and allowed clawbacks of bonuses in cases in which an executive knowingly provided false financial information to the company that affected the bonus. Recipients of TARP funds also had to certify that their compensation schemes did not encourage excessive risk taking, left undefined. Previously the special master in charge of the compensation fund for victims of the 9/11 attacks, disbursing $7 billion in the process, Feinberg was now charged with monitoring compliance with executive compensation limits imposed on the top 100 executives at firms receiving TARP bailout funds. Feinberg reported directly to Treasury Secretary Geithner, but there was no appeal from his decisions. Feinberg oversaw pay practices at Bank of America, Citigroup, Wells Fargo, and AIG, as well as General Motors and Chrysler and their finance units. His attention focused on GM’s investment management unit, Promark Global Advisors, which managed $102 billion in pension funds and $18 billion for institutions and whose managers were paid $2 million or more. Restrictions on pay delayed GM’s efforts to obtain a new chief financial officer (CFO), a critical position that needed to be filled. Feinberg found that seventeen firms receiving TARP funds had paid out $1.58 billion in unwarranted bonuses after receiving those funds. Citigroup was the worst abuser, largely due to the $100 million it was contractually required

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. The Rise and Fall of the Subprime Crisis 641 to pay two traders at its commodity unit. Feinberg then caused Citigroup to sell that highly profitable Phibro energy trading unit because one of its traders, Andrew Hall, earned a $98 million bonus in 2008 and was looking at a $100 million bonus package in 2009, bonuses to which he was entitled under the terms of his employment contract. The unit was sold to Occidental Petroleum at what was then viewed to be a bargain basement price, but Phibro went on to sustain large trading losses in 2010. Feinberg trained his attention on guaranteed bonuses, which were becoming the newest focus for corporate reformers. His deepest stroke was made in October 2009, when he ordered cuts averaging 50 percent for salaries of 175 of the highest-paid executives at firms receiving TARP funds. He set off a controversy when the administration refused to allow FOXNews to be a part of a reporting pool interviewing Feinberg over the cuts, claiming that it was not a legitimate news organization. The Obama administration’s stimulus package added more restrictions on executive pay for companies receiving TARP funds and other government assistance, going beyond those in the original TARP legislation. Among other things, it extended the reach of its prohibitions to include additional executives; it required the firms to adopt policies prohibiting excessive entertainment or luxuries; it limited bonuses to no more than one-third of total annual compensation, except for allowing long-term restricted stock; and shareholders were required to be given a nonbinding say-on-pay vote. Dimon at JPMorgan stated that, when they criticize compensation of bankers, politicians should distinguish between well-run banks (like his own) and faltering financial institutions (like Citigroup). President Obama did so when he publicly chastised Citigroup in January 2009 for failing to cancel an order for a $50 million corporate jet, until it was put on the spot by the government. Citigroup then tried to back out of a $400 million marketing arrangement with the New York Mets baseball franchise in the hope of avoiding further criticism of its spending. Bank regulators investigated whether Fiderion Group, an executive search firm, had improperly entertained Regions Financial Corporation executives, after it was reported that Fiderion had spent more than $100,000 on golf outings for those officials over a six-year period. This disclosure was made after Regions received $3.5 billion in government bailout funds. Cuomo used his investigation of bonuses paid to Merrill Lynch executives to lever himself into a position to negotiate legislation with Congress that would tie the pay of Wall Street executives to long-term performance. He wanted to require public companies to defer bonus payments over several years, in order to assure that the bonuses were properly awarded. Ironically, Cuomo targeted Merrill Lynch’s bonuses even though that firm had implemented just such a bonus system in 2006, tying compensation to long-term performance. Repre- sentative Frank expressed support for that proposal and persuaded the House to approve a bill in July 2009 giving the SEC authority to ban compensation

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 642 The Crisis Abates arrangements that provide perverse incentives to take undue risk at companies with assets in excess of $1 billion. Corporate reformers proposed caps on the pay of CEOs that would limit their compensation to no more than twenty times the average worker’s salary. Cornell economist Herbert H. Frank, in an op-ed piece in the New York Times on January 4, 2009, argued that such a cap would discourage the most talented executives from accepting a position as CEO. He supported a cap on salaries for executives working at financial service firms receiving government bailout money but asserted that the “more prudent response” to excessive executive compensation at other firms was to raise marginal tax rates.12 However, that had been tried in the past; highly paid individuals simply turned to tax shelters or evaded high taxation in some other way. The subprime crisis did have some effect on wealth distribution. The number of individuals with $30 million or more fell by 25 percent in 2008. As outrage over AIG bonuses continued to mount, the Obama administration considered proposals that would regulate the income of executives at all financial services firms, not limited to those who received bailout money, tying their executive pay to long-term performance. This caused a strong reaction in the business community. Treasury Secretary Geithner clarified the administration’s approach on May 18, 2009, saying that it would not seek to set caps on pay but would, instead, seek to prevent executives from taking large amounts of short-term risk at the expense of their firm and the financial system. That seemed rather odd, however, since, by definition, the mortgages that had caused the subprime crisis were long-term instruments and were rated triple-A. Geithner further stated that the government would focus on golden parachutes and procedures to assure that compensation was aligned with risk management. He also wanted legislation for say-on-pay votes and requirements that members of compensation committees all be independent directors. This did not stop the backlash in the financial community. Business leaders began to express less enthusiasm for further participation in government bailout programs. Several large banks announced they would return bailout funds already received to avoid having their compensation dictated by Congress. President Obama then backed off his threats of retaliation against AIG executives who received bonuses and even questioned the propriety of the House legislation. The House then passed another bill that prohibited unreasonable or excessive bonuses, as defined by the Treasury Department, and mandated that bonuses be performance based. That legislation was not adopted, but other compensation restrictions were included in legislation that was enacted in 2010 (see Chapter 15). The SEC also weighed in on executive compensation. Mary Schapiro, the new SEC chair, announced in June 2009 that her agency would propose rules requiring additional disclosures on compensation calculations for lower- ranking employees who receive large payouts, such as traders at a financial services firm. The SEC also proposed requiring disclosures on how compensa-

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. The Rise and Fall of the Subprime Crisis 643 tion plans affected risk taking by employees and exploring how the company was managing those risks. This seemed to be another effort to discourage risk taking without any thought about the consequences. A group of business leaders from the Conference Board sought to head off further government intervention in September 2009 by proposing self-imposed curbs on executive pay, including banning golden parachutes, gross-ups to pay for additional taxes imposed on executive income, and personal use of corporate jets. Wells Fargo and Citigroup, which were subject to the bailout restrictions, sought to maintain the level of their top executives’ pay through salary increases, which were not risk based—bringing us full circle to the Omnibus Revenue Reconciliation Act of 1993, which demanded that firms do just the opposite. JPMorgan Chase, Morgan Stanley, and UBS announced similar plans. Merrill Lynch, however, which had received TARP funds and had to be rescued by Bank of America at the insistence of the government during the subprime crisis, awarded signing bonuses in the summer of 2009 that were larger than those at the height of the real estate bubble. A contrite Blankfein declared in April 2009 that the compensation system on Wall Street was flawed and that the large bonuses given to executives at firms that failed “look self-serving and greedy in hindsight.”13 However, after Goldman Sachs reported its second-quarter results on July 14, 2009 (the largest ever reported by that firm—$3.44 billion, more than the firm earned in all of 2008), Blankfein set aside $11.4 billion for year-end employee bonuses. Bonuses had shrunk by 70 percent at Goldman in 2008, displeasing its executives. Goldman Sachs extended loans to its employees in March 2009. Many of those employees had suffered losses on their Goldman Sachs investments and received margin calls from their own firm. Wall Street investment banks reserved $36 billion in the first quarter of 2009 for year-end bonuses, a pace, if kept up for the rest of the year, that would provide payouts near the record levels set in 2007. Bonuses were needed. Re- strictions on pay at Merrill Lynch, Citigroup, and UBS, which were imposed after they received bailout money, led some talented employees to be lured away to other firms that offered richer compensation packages. One executive headhunter estimated that those financial institutions had lost a quarter of their most productive employees. Bidding wars for talent broke out on Wall Street as the second quarter ended in 2009. Risk and innovation on Wall Street continued to be targets of hysteria. A front-page article in the New York Times on September 6, 2009, claimed that “new exotic investments” started to appear on Wall Street.14 The article focused on life insurance policies purchased from the ill and the elderly and then securitized. However, such viatical investments have been around for a long time and are frequently abused. This type of policy was the subject of somewhat sordid auctions at the Royal Exchange in London as early as 1844, in which the dying beneficiaries were trotted out for bidders to judge their life expectancy. Scam artists involved in viatical contracts also underpaid AIDS victims for their policies

150 years later and took advantage of the elderly and infirm. Securitization was one way to meet the needs of the dying by giving them access to the proceeds of their policies when they needed the funds while also assuring a fair price. In any event, these products were not attractive to investors and resulted in a lot of litigation over broker claims involved in originating such products.

Compensation Abroad

Compensation concerns spread abroad during the subprime crisis. In April 2009 the European Commission recommended caps on corporate pay such that severance pay would be limited to two years of fixed pay, a minimum of three years would be required for options to vest, and most bonuses would be paid on a deferred basis. The Group of Twenty also considered curbs on executive pay at its meeting in London that month. A report prepared by its Financial Stability Forum asserted that compensation paid to executives at financial services firms should be based not only on profitability but also on whether excessive risks had been taken in order to generate high returns. The president of Barclays bank, Robert Diamond Jr., was paid $30 million in 2007, despite some severe problems at that bank, which included a $3 billion writedown. The home and automobile of Sir Fred Goodwin, the former CEO of the Royal Bank of Scotland (RBS), were vandalized on March 24, 2009. Shareholders then added insult to injury by voting against his retirement package, which would have paid him $1 million per year. Goodwin eventually agreed to give up half of his $1 million pension. However, more controversy arose over the $16 million pay package of the bank’s new CEO, Stephen Hester, so he agreed to defer a portion of that compensation. At that point, the bank had received some $30 billion in government funds and had been nationalized. A parliamentary committee criticized bank executives at both RBS and HBOS, which had also been bailed out by the British government, for their compensation arrangements. Mervyn King, the governor of the Bank of England, refused a $500,000 increase in pay in 2008, attempting to set an example for bankers in the UK. Sir David Walker, a former Morgan Stanley executive, issued a report in July 2009 for the UK government recommending that corporate compensation committees be required to review executive pay at above-average levels and that such pay be publicly disclosed. Sir David further recommended the creation of board of director committees to assure that undue risks are not incurred. However, one executive was quoted as saying, “Risk should be managed by executives hour by hour, not by non-executives month to month.”15 Another called the proposal a Sarbanes-Oxley look-alike and noted the failure of that legislation in the United States. The Financial Services Authority (FSA), London’s financial services regulator, warned companies against the use of multiyear guaranteed bonuses during the subprime crisis. Instead, the FSA wanted bonuses to be aligned with risks

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. The Rise and Fall of the Subprime Crisis 645 incurred by executives and applied that requirement to twenty-six of the country’s largest banks. This was a new approach to the alignment of shareholder and executive interests. Previously, reformers had focused on share prices to align those interests, which gave rise to options as compensation and caused scandals as executives manipulated their accounts to increase share prices. The subprime crisis refocused reformers’ attention on risk, rather than share prices, which were the focus of earlier reforms. They sought to give incentives to executives to avoid undefined excessive risk. The FSA later dropped a proposal that would have required deferring two- thirds of bonuses and tying bonuses to group performance. It also announced in August 2009 that it might have to back off its requirement tying bonuses to risk because of concerns that it could hurt London’s standing as a financial center. The banks soon attempted to game the system to keep other firms from poaching their star traders. JPMorgan complained to the FSA in August 2009 that a compensation package offered by Barclays Capital (BarCap) in order to grab a high-powered team of JPMorgan traders was excessive. Five traders were offered a package valued at $50 million to join BarCap, which had also distributed two-year guaranteed bonuses. The risk-avoidance regulatory approach caught fire around the world. Ger- many’s financial regulator, Bundesanstalt für Finanzdienstleistungsaufsicht (German Federal Financial Supervisory Authority, or BaFin), announced in August 2009 that German banks would be required to avoid compensation plans that encouraged undue risk taking or that rewarded short-term profits. BaFin also required increased stress-testing of positions at all levels, tightened risk management controls, and directed that bank supervisory boards be given greater control over management. In October 2008, Germany and Sweden limited compensation for executives working at banks receiving government aid and guarantees. Germany limited compensation to about $670,000 for executives at its bailed-out banks. In Switzerland, restrictions on bank compensation took an interesting twist. The Credit Suisse Group dumped $5 billion of its toxic assets into a fund that was to be used as a bonus pool for 2,000 of its executives for their work in 2008. This was called an “eat your own cooking” bonus plan. The bank reported in August 2009 that this pool of assets had increased in value by 17 percent, and that number increased to 72 percent in February 2010. This indicated that those assets had been unnecessarily written down to fire-sale prices during the crisis. Credit Suisse did revise its compensation scheme to add more of a salary component, with bonuses split between cash and stock that would vest over four years and be subject to clawbacks. French prime minister François Fillon advised French banks not to hand out large bonuses to its employees in 2009. The banks had previously agreed to limit their bonuses as a condition of receiving $28 billion from the French government as a bailout, and stock option grants were prohibited. The banks agreed to tie their pay to profit, rather than revenue, in order to reduce incen-

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 646 The Crisis Abates tives for undue risk taking. Bonuses were to be paid over a three-year period, with forfeiture of the unpaid amounts if a trader lost money in the two-year period after the bonus year. However, BNP Paribas announced a $1.4 billion bonus pool for 2009. This made the prime minister angry because that bank had received a $7 billion bailout from the French government. France had other compensation problems. French workers held Luc Rous- selet, the manager of a 3M factory, captive in March 2009, demanding better severance benefits for planned layoffs. Similar action was taken at a Sony facility and at a Caterpillar plant in France. French president Nicolas Sarkozy then vowed that he would end “boss napping,” but workers responded to that challenge by taking managers of a British firm hostage. Other French workers facing layoffs threatened to blow up the plants where they worked, unless they were given increased severance pay. Workers at New Fabris, an auto supply company, wired gas canisters to an electrical cable and threatened to detonate them, unless they received $40,000 in severance payments from Renault and PSA Peugeot-Citroën, New Fabris’s principal clients. The workers were outraged because those auto companies had received $8 billion from the French government as a bailout in exchange for promises not to engage in mass layoffs of their autoworkers. However, that promise did not extend to auto suppliers like New Fabris. The Australian government announced in March 2009 that it planned to address executive compensation issues and limit excessive “golden handshake” termination payments by amending its Corporations Act to require shareholder approval for such payments that exceeded a specified level.

The Bottom Is Reached

The Market Decline

Stock markets around the world plunged on March 2, 2009. The Dow Jones Industrial Average fell by 299.64 points that day, down to 6763.29, a level last seen in 1997. The next day gold prices dropped to $912.90, while the price of crude oil rose to $41.65 per barrel. President Obama suggested that it would be a good time for investors to reenter the stock market “if you’ve got a long- term perspective on it.”16 That turned out to be excellent investment advice. The Federal Reserve (the Fed) and the Treasury Department announced an expansion of the previously announced $200 billion Term Asset-Backed Securities Loan Facility (TALF) to $1 trillion. This program made secured, nonrecourse loans available to banks and commercial firms, including hedge funds. The securities were permitted to be used for collateral for such loans including securitizations of credit card debt, consumer loans, and student loans with a triple-A rating. The use of the rating agencies as the arbiter of collateral quality for these loans seemed a bit strange in light of the ongoing criticism of the rating agencies’ failures in rating collateralized debt obligations (CDOs).

Moreover, because the loans were nonrecourse, the Fed would have to bear any losses (above a small haircut in the form of excess collateral in setting their loan value) in the event of a decline in the value of the collateral. This incongruity did not escape the notice of Neil Barofsky, a former prosecutor who was placed in charge of policing TARP bailouts. Referred to as the “TARP cop” in the press, he criticized the use of rating agencies in a report to Congress in April 2009, noting that their ratings had proved notoriously unreliable. Credit market participants did not initially give the TALF program an enthusiastic welcome. Not enough investors were interested in signing up for it, so the program was reworked but still failed to attract much interest. A principal concern was that, if investors made money from the program, they might be criticized in the press and before Congress as the executives at AIG had been. TALF was initiated on March 19, 2009, with three significant transactions. Nissan Motor Company and Ford Motor Credit Company sold more than $4 billion in bonds backed by auto loans, and Citigroup sold $3 billion in bonds backed by credit card payments. Still, by the end of July 2009, the Fed had made only about $35 billion in loans under this facility, a rather paltry drawdown on a $1 trillion facility. Nevertheless, the program picked up in August with borrowings reaching $77 billion and was being credited with having jump- started the securitization market for consumer receivables. The government extended the TALF program until March 31, 2010. Some former Countrywide executives were under fire for forming the Pri- vate National Mortgage Acceptance Company (PennyMac), which purchased distressed mortgages and foreclosed, or restructured, the loans in order to make them performing. In one transaction, PennyMac, which was funded by the money manager BlackRock and the hedge fund Highlands Capital, bought $560 million in distressed mortgages from the FDIC for $43.2 million. The FDIC acquired those loans when it took over the failed First National Bank of Nevada. PennyMac was allowed to keep from twenty to forty cents on every dollar that it collected on the mortgages. The Dow was down 25 percent for the year on March 5, 2009. Citigroup traded below $1 per share on that day, leading to the New York Stock Exchange (NYSE) temporarily suspending a rule requiring the delisting of securities that traded under a dollar. The day before, Moody’s announced that it was putting $100 billion in collateralized corporate loan obligations on a negative credit watch for a likely downgrade. That credit watch applied to 3,600 tranches of 760 issues. However, the highest rankings of those issues were excluded from the review. One survey reported that more than 10 percent of U.S. homeowners were delinquent on their mortgage or in foreclosure in March 2009. On March 4, 2009, President Obama announced a new plan to aid homeowners having trouble meeting their mortgage payments through a program that would modify the terms of loans issued or guaranteed by Fannie Mae or Freddie Mac. That modi-

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 648 The Crisis Abates fication would include reducing mortgage interest rates to as little as 2 percent. This program would not be available for mortgages in default or where the mortgages were more than 105 percent of the value of the home, an amount later increased to 125 percent. It was claimed that this program would be available to one in nine homeowners, and it was forecast to cost $75 billion in taxpayer funds. More assistance was planned for homeowners who had problems meeting payments on their home equity loans and for those who borrowed the cost of the down payment for their homes—“piggyback” loans. President Obama, surprisingly, stated that he would consider a cut in the corporate tax rate. However, that positive news was offset by a dispute over a proposal that would allow bankruptcy judges to reduce summarily, “cram down,” mortgage principal and interest payments in bankruptcy proceedings. Such a provision, supported by Democrats in Congress, was included in a congressional bill for the TARP bailout program in 2008, but was deleted in the interests of gaining Senate approval to pass the bill. Finance was stirring abroad. Bond issues by banks under government guarantee programs in Europe had raised $367 billion by March 2009, and an additional $630 billion was expected to be raised under such programs during the remainder of 2009. The United Arab Emirates announced the purchase of $10 billion in bonds from Dubai in order to assist that struggling government. China’s exports shrank by 25 percent in February 2009. Taiwan’s industrial production was down 43 percent, European production was down 12 percent, and production in Brazil was down 15 percent. Economists forecast a 9 percent decline in world trade in 2009. The European Central Bank cut its interest rates from 2.0 to 1.5 percent, and the Bank of England cut interest rates in March 2009 to a historic low of 0.5 percent. The UK government also announced a $105 billion plan to encourage bank lending.

Market Critics Emerge

Commercial credit markets froze up again in the second week of March 2009. Creditors were concerned that they would be the losers in the event of a default of a large company. Hysteria over economic conditions mounted in the press and in the Obama administration. Some pundits predicted a Dow “5000” in March 2009, the obverse of the prediction of a Dow 36000 during the stock market run-up in the 1990s. In a front-page article in the New York Times on March 12, 2009, the specter was raised of the Justice Department preparing broad-scale prosecutions against mortgage market participants, in an Enron redux.17 Lawrence Summers, senior economic adviser to the president, told the Fi- nancial Times that the view that capital markets were inherently self-stabilizing had been “dealt a fatal blow.” He denied that government intervention in the mortgage market had caused the crisis.18 The Financial Times also published a series of reports on the future of capitalism, the first of which was called “Seeds

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. The Rise and Fall of the Subprime Crisis 649 of Its Own Destruction.” That article mocked the Reagan era of deregulation, compared the subprime crisis to the fall of communism, and correctly predicted that the crisis would strengthen political control over the markets.19 Fed chairman Bernanke added to that debate on March 10, 2009, by asserting that regulators needed broader powers, including increased capital requirements for banks, restrictions on investments by money market funds, and powers to resolve failed financial institutions through a windup procedure. The SEC followed up on his desire for restrictions on money market fund investments by proposing to limit the investment risks that could be incurred by money market funds and requiring investments by those funds to be more liquid. However, the SEC already had a rule on its books, Rule 2a-7, that regulated the investments that money market funds could make. That rule did not prevent the Reserve Primary Fund (RPF) from breaking the buck and setting off a market panic in 2008. Under the new SEC proposal, money market funds would be limited to the highest quality investments, but this raised the question of how that status would be determined, considering that the SEC proposed ending the use of rating agencies as the basis for credit assessment. The ratings agencies had certainly established their fallibility with respect to credit assessment. It also appeared that the SEC was once again ineffective, since it had amended Rule 2a-7 in 1990 to address concerns over money market investments in commercial paper,20 but the Reseve Primary Fund, nevertheless, broke the buck as a result of investments in Lehman Brothers commercial paper. Obama clashed with European leaders over the action needed to deal with the ongoing global financial crisis at the Group of Twenty conference in London in March 2009. His administration wanted spending to be increased to restart economies, while European leaders wanted to concentrate on regulatory reform. Japan supported the U.S. position. The unemployment rate in the European Union at that point approached 10 percent. Nevertheless, Germany expressed concern over the possible rise of inflation in the United States because of the massive liquidity operations already under way and the spending programs proposed by the Obama administration. Mirek Topolanek, president of the European Union and prime minister of the Czech Republic, charged on March 26, 2009, that Obama’s plan to fight the subprime crisis was a “road to hell.” He contended that the United States was simply repeating mistakes of the 1930s through stimulus packages that did not work and through protectionist policies. Topolanek was himself in a bit of a spot. His government had just received a vote of no confidence at home, and he was forced to resign halfway through his six-month term as EU president, a post that rotates biannually among EU members.

Market Volatility

Crude oil closed at $47.07 per barrel on March 9, 2009. That day, the Japanese stock market fell to a twenty-six-year low. The Bank of Japan announced a

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 650 The Crisis Abates plan to issue $10 billion of subordinated debt from its large commercial banks on March 17, 2009. Some business was going forward. Merck announced its purchase of Schering-Plough for $41.1 billion in order to become less dependent on drug research and development, a risk-avoidance measure. That merger included $107.9 million in golden parachute payments to ten Schering-Plough executives. Dow Chemical announced the same day that it would purchase Rohm & Haas for $15.3 billion. Roche Holding, which already owned 66 percent of Genentech, bought the rest of the firm at a price that valued Genentech overall at $47 billion. The stock market rallied on March 10, 2009, after Citigroup announced that it had been profitable in January and February and looked forward to a profitable quarter. That would be a change from its five previous straight quarterly losses totaling $37 billion. The Dow rose 379.44 points after that report, closing at 6926.49. The Dow jumped 239.66 points on March 12, 2009, after news that retail sales had fallen less than forecast in February. Bank of America lent further support to the market by announcing that it did not expect to seek more bailout money. The week ending March 13, 2009, was the best week for the stock market since November 2008. It rallied from a twelve-year low on March 9 to rise 597 points during the remainder of the week. Thereafter, crude oil closed at just under $50 per barrel on March 17, 2009, and the Dow rose by 178.73 points, reaching 7395.70. The minutes of the Federal Reserve meeting on March 17 and 18, 2009, revealed deep concern over the possibility that the economy would continue to decline in 2009. The Fed announced on March 18, 2009, that it would buy up to $300 billion in long-term Treasury obligations, and some $750 billion in mortgage-backed securities and debt issued by Fannie Mae and Freddie Mac. That would bring the Fed’s total purchases of Fannie Mae and Freddie Mac securities to $1.25 trillion in the first three months of 2009. This announcement caused the largest one-day drop in yield on Treasury securities since the stock market crash of 1987. The ten-year Treasury note’s interest rate fell from 3 percent to 2.5 percent. The rate on thirty-year fixed mortgages declined to 4.75 percent. The Dow Jones Industrial Average rose by 90.88 points to 7486.58, an increase of 14 percent from its March 9, 2009, low. However, the dollar slid against the euro. The Wall Street Journal pointed out that the $300 billion purchase of Trea- sury securities by the Fed was undermining its independence from the Treasury Department. That independence had been achieved in 1951 through an accord negotiated by long-serving Fed chairman William McChesney Martin. Previ- ously, the Fed had acted with the Treasury to keep interest rates low, so that the financing of World War II could be achieved at a lower cost.21 The 1951 accord freed the Fed of that obligation and allowed it to focus on inflation and employment. The March 2009 action by the Fed appeared to be a return to the World War II practice in which it acted to keep government funding costs low. Some savings were needed. The Congressional Budget Office forecast

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. The Rise and Fall of the Subprime Crisis 651 in March 2009 that the budget deficit would be $2.3 trillion more than that claimed by the administration. A government debt auction in the UK on March 26, 2009, failed for the first time in seven years. An auction by the U.S. Treasury the same day was the subject of heavy bidding, suggesting continuing strong demand for U.S. Treasury securities. Gold prices were on the rise again as the size of the government bailouts continued to grow in the third week of March. Indeed, “gold parties” were being held in private residences to take advantage of high gold prices. A gold buyer would attend the party to appraise and purchase jewelry from the attendees. In the first quarter of 2009, state government revenues fell on average 11.7 percent, the sharpest decline ever, and continued to decline. The governor of Illinois, Patrick J. Quinn, who had replaced the disgraced Rod R. Blagojevich, sought a 50 percent increase in that state’s income tax in order to meet a budget shortfall. New York, New Jersey, and Maryland needed to increase taxes in order to close their growing budget deficits. After much struggle, the California legislature passed a budget with higher taxes, but voters in the state rejected the tax increases on May 20, 2009. The legislature tried again, finally passing a budget on July 21, 2009. But before doing so, the state ran out of money and issued IOUs to creditors, which it called “warrants,” in lieu of cash. The City of Philadelphia stopped paying its bills in July as a result of a budget crisis. New York City and State were caught cheating on their Medicaid claims and agreed to reimburse that system for $540 million in false claims. A growing problem was the underfunding of state employee pension plans. The SEC sued the State of New Jersey for misrepresenting the status of its funding of such plans. Unlike its cases against corporations and their officers, the SEC imposed no fine or other penalty in settling the case, and no public officials went to jail.

Government Interference

On March 23, 2009, Treasury Secretary Tim Geithner announced a trillion- dollar program to take toxic assets (renamed “legacy assets”) off the books of financial services firms. Under this program, called the Public-Private Investment Program (PPIP), private investor funds would be matched dollar- for-dollar by the Treasury to purchase CDOs, and the Treasury would provide additional funding in the form of loans on favorable terms. The government would then share in the returns on the CDOs with the investor. The government planned to initially fund this program with as much as $500 billion. The Dow jumped by almost 500 points after this announcement. The PPIP was met with enthusiastic approval on Wall Street after it was first announced, but enthusiasm died as the government tried to manage firms receiving bailout money. The FDIC dropped out of the program in May 2009. Some banks sought to use TARP funds to bid on their own legacy assets under

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 652 The Crisis Abates the program, but it stalled because, as Geithner stated, “investors are reluctant to participate.” On July 8, 2009, the Treasury Department announced that it would scale back the program to $30 billion and would work with a group of nine private investors to buy toxic assets. Only $3 billion was committed by private investors to the program by the end of September 2009, growing to $12.27 billion in the first week of October. Forty-seven banks and S&Ls failed in the United States between January 2008 and March 2009. Fed chairman Bernanke appeared before a congressional committee on March 24, 2009, to request legislation allowing the Fed to seize nonbank financial institutions and liquidate (“resolve”) them just as would be done for a failed bank. Bernanke asserted that the lack of such authority prevented the Fed from liquidating AIG and prevented it from stopping the controversial bonus payments to the AIG executives. That resolution authority was passed in 2010. President Obama met with the heads of fifteen of the largest banks at the White House on March 27, 2009. Some of the bankers informed him that they wanted to return the government funds that they had received in the bailout. The president rejected those requests, stating that repayment would be permitted only if the ongoing regulatory stress tests demonstrated that the banks were healthy. The Senate requested that the Fed reveal the names of firms receiving loans and what they were doing with the funds. Such disclosures had undermined the lending program of the Reconstruction Finance Corporation in the 1930s but, apparently, some lessons needed to be relearned. The Treasury Department reported at the end of March 2009 that it still had not disbursed $135 billion of the $700 billion available under TARP. That situation changed on April 8, 2009, with the announcement that the Treasury would supply insurance companies with funds under TARP, but details and amounts were not disclosed. The Treasury Department was later criticized by its inspector general for allowing insurance companies to qualify for TARP funds by buying small thrifts. Geithner stated in an interview on April 5, 2009, that as a condition of receiving TARP funds the federal government was prepared to force out senior executives and board members of firms, if the government concluded that they did not measure up to their jobs.

Economic News

The Dow closed at 7924.56 on March 26, 2009, an increase of more than 20 percent from its bottom earlier in the month. An increase of over 20 percent was generally defined as establishing a bull market. However, the Dow closed the first quarter of 2009 down 13 percent, the sixth straight quarterly decline. More bad news arrived in April, when it was reported that March retail sales had dropped by 1.7 percent and that auto sales continued their decline. Du- rable goods orders declined by 0.8 percent in March, but that was less than expected. The mobility of Americans continued to decrease in March 2009,

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. The Rise and Fall of the Subprime Crisis 653 reaching its lowest level since 1962, when the population was about one-third of the size it was in 2009. In March 2009 the unemployment rate was 8.5 percent nationwide but considerably higher in some states: in California, 11.2 percent; in Oregon, 12.1 percent; in North Carolina, 10.8 percent; and South Carolina, 11.4 percent. In order to boost the stock market, President Obama stated at a press conference on March 24, 2009, that he was “beginning to see signs of progress” in the economy. However, the economy had shrunk by 5.7 percent (later revised to 5.5 percent) in the first quarter of 2009, less than expected but still troublesome in light of the 6.3 percent contraction in the fourth quarter of 2008. Those were the two worst back-to-back declines in more than sixty years. Nevertheless, economists projected that the recession would be over by September 2009. Troubles continued abroad. In the eurozone the gross domestic product (GDP) declined by 2.5 percent over the previous quarter. Japan suffered a record drop in economic output in the first quarter. Merger and acquisition (M&A) activity fell globally in the first quarter, but underwriting increased. Canadian banks seemed to have recovered their strength and began to explore M&A opportunities in the United States. U.S. firms engaged in little M&A activity because of strains on their resources. However, Pulte acquired Centex for $41.3 billion, creating the largest U.S. home builder. That merger was considered good news because it helped reduce overcapacity and indicated that restructuring was under way in the housing market. KB Homes, which shifted the focus of its building to smaller, more affordable homes, had a first-quarter loss in 2009, but it was smaller than expected. The 800,000 homes put into foreclosure in the first quarter of 2009 set a new record. By then, 20 percent of all home mortgages were underwater. The delinquency rate on FHA mortgages increased. Approximately 10.2 percent of homeowners who received FHA loans in the first quarter of 2008 were delinquent in repayment by at least sixty days. The overall delinquency rate for FHA loans in February 2009 was 7.46 percent, up from 6.16 percent in February 2008. Existing home sales fell by 3 percent in March 2009. The median price of a home in the United States was $169,000 at the end of March, down 14 percent from a year earlier. Auto sales fell by 37 percent in March, but sales picked up in the last week of that month. Manufacturing continued to decline in March, but at a slower rate. American consumers increased their bank deposits by an additional $250 billion in the first quarter of 2009. That would normally be a favorable sign, but, under the circumstances, it was another signal that consumers had cut back on their spending, which in turn caused retail sales to decline in March 2009. Commercial real estate securitizations raised concerns in the first quarter of 2009. Between September 2008 and March 2009 their delinquency rate had doubled, to 1.8 percent. The share of corporate loans considered troubled increased to 7.75 percent at the end of March 2009, up from 4.1 percent in

March 2008. However, corporate profits rose in the first quarter of 2009, the first such increase after six quarterly declines. JPMorgan Chase reported a first-quarter profit of $2.14 billion in 2009 and announced that it would seek permission from the government to repay its $25 billion in TARP funds, which its CEO, Jamie Dimon, referred to as a “scarlet letter.” Goldman Sachs made a $1.81 billion profit in the first quarter of 2009 and planned a $5 billion stock offering. Bank of America reported profits of $4.2 billion for the first quarter of 2009, most of which came from its Merrill Lynch unit. However, Bank of America’s stock plunged after its announcement that it had reserved another $13.3 billion for credit- loss exposure. Nonperforming assets increased, and credit card losses rose to $1.7 billion. Citigroup reported a first-quarter profit in 2009 of $1.6 billion, its first quarterly profit in eighteen months. However, some of its more important units still experienced losses. General Electric also posted a profit in the first quarter, but it, too, still struggled. Morgan Stanley rocked the market with a larger-than-expected loss of $177 million, which followed a $2.3 billion loss in the previous quarter. The company cut its dividend by 81 percent. UBS experienced a first-quarter loss of $1.8 billion. The bank stated that it was cutting costs by 15 percent, which included the elimination of 7,500 jobs. Deutsche Bank had a profitable quarter, reporting a $1.55 billion profit, but its stock price fell due to concerns over its capital adequacy. Nomura Holdings, Japan’s largest brokerage firm, reported a first-quarter loss of $7.3 billion as a result of trading losses and costs associated with its acquisition of Lehman Brothers’ international operations. Nomura was also expanding its presence in New York. Credit Suisse had a surprising $1.7 billion profit for the quarter. AIG was stung, again, by a first-quarter loss, this time totaling $4.4 billion, its sixth quarterly loss in a row. General Motors reported a $6 billion loss for the quarter, while Ford lost $1.4 billion. Microsoft experienced a 32 percent decline in profits in the first quarter of 2009, the first such decline in its history as a public company. American Express reported a 56 percent decline in profits in the first quarter, but it was still able to post a $437 million profit. Berkshire Hathaway’s first-quarter profit declined by 10 percent, and the firm posted a loss of $1.5 billion. CIT Group had a $438 million loss for the quarter, the eighth loss in a row, and more losses were anticipated in the future. The net income of the Federal Home Loan Banks (FHLB) declined by 51 percent in the first quarter of 2009. Fannie Mae lost $23.17 billion during the quarter and sought an additional $19 billion from the federal government. Freddie Mac lost $9.85 billion in the first quarter and needed $6.1 billion in aid. On March 31, 2009, the Treasury Department extended its guarantee for money market funds from April 30, 2009, through September 18, 2009, its one-year anniversary, in the last extension of that program.

Sunrise in America

The Second Quarter Begins

The Group of Twenty meeting in London was held, appropriately, on April 1, 2009—April Fools’ Day. Anarchist demonstrators attacked the Bank of Eng- land and broke into the Royal Bank of Scotland, but were eventually repelled by riot police. President Obama admitted that the United States bore some responsibility for the worldwide financial crisis, but made little headway with European heads of state over his desire for larger stimulus programs. European leaders continued instead to advocate more regulation. The Group of Twenty agreed to work together to restructure national regulatory systems in such a way as to take account of systemic, prudential risk. They further agreed to implement new principles on corporate executive compensation, to promote corporate responsibility, to regulate the credit rating agencies and hedge funds, and to improve bank capital requirements. The representatives attending that event agreed on a set of principles for regulating financial markets. A new Financial Stability Board (FSB) including all Group of Twenty countries and the European Commission was created to replace the existing Financial Stabil- ity Forum that was composed of regulators from significant financial centers. The FSB would work with the International Monetary Fund (IMF) to provide early warnings of macroeconomic risk. The European Central Bank (ECB) cut its interest rate to 1.25 percent on April 2, 2009, and signaled that another cut could be expected. This was another case where the principal central banks were not coordinating their monetary policies. The Dow nearly reached 8000 that day, after the Financial Accounting Standards Board (FASB) announced relief for banks from fair-value accounting requirements, and some glimmers of good news in the economy emerged. However, jobless claims continued to increase, and the office vacancy rate reached 15.2 percent. A Chrysler stable value fund that was designed to profit even in adverse market conditions in 401(k) accounts, announced on April 2, 2009, that its value had declined by 11 percent. That announcement raised concerns over other stable value funds, which constituted a $520 billion market. However, those funds seemed to stabilize in August 2009. The Dow posted its fourth straight weekly gain in the week ending April 3, 2009, to close at 8017.59. That gain came despite an employment report of an additional 663,000 jobs lost in March; this brought the total number of jobs lost during the recession to 5.1 million and pushed the unemployment rate to 8.5 percent, the highest rate since 1983. Gold prices fell to $871.50 per ounce on April 6, 2009, after market optimism rose following the Group of Twenty meeting. As April 2009 began, HSBC raised $18.5 billion in a rights offering, which set a new record for such offerings. However, the same month Swiss Re announced the elimination of 1,000 jobs, or about 10 percent of its staff. Lending

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 656 The Crisis Abates by banks slowed in March and April 2009, even though cash on hand at banks had tripled from the levels of one year earlier. Berkshire Hathaway was the subject of a credit downgrade by Moody’s on April 8, 2009, losing its triple- A credit rating. Fitch ratings did the same a month earlier because of large unhedged market exposures. Some good news emerged in the second week of April, when a report on wholesale inventories indicated that they had been further reduced in March 2009, the sixth straight month of such reductions. Germany reported on April 9, 2009, that it would buying all outstanding shares of the Hypo Real Estate Holding group. The largest shareholder in that organization was J. Christopher Flowers, an American private equity investor, who owned 21.7 percent of Hypo. Unemployment in Spain rose to 17.4 percent in April 2009, raising concerns with its finances. The UK economy contracted in the first quarter to a degree not experienced in more than thirty years and did the same in the second quarter. The government of Hong Kong stated, in April 2009, that it expected the worst economic conditions that year since the conclusion of World War II. The Chinese economy as a whole, however, appeared to improve, assisted by a $585 billion stimulus package. In Russia the economy saw improvement as well. Japan announced a $154.6 billion stimulus package on April 9, 2009, in order to boost its long-lagging economy. The Dow Jones Industrial Average jumped by 246.27 points on April 9, 2009, closing at 8083.38. That rally was driven by better-than-expected results from Wells Fargo, which posted a record $3 billion gain in the first quarter of 2009, a 50 percent increase in net income, attributed to its Wachovia operations. Still, bad news flowed. The number of recipients of jobless benefits in the United States rose to over 6.1 million in the week of April 11, 2009. General Growth Properties, the second-largest U.S. mall owner, with 200 malls, declared bankruptcy in mid-April after it was unable to refinance $3.3 billion in maturing debt. A study by Standard & Poor’s in April 2009 estimated that 45 percent of outstanding privately issued subprime debt would become nonperforming. The rate for outstanding Alt-A debt, totaling $745 billion, was 31 percent, while that for the $406 billion in prime debt was 7 percent. Citigroup, JPMorgan Chase, and other mortgage servicers were given some $10 billion by the Treasury Department for mortgage loan modifications in April 2009. Applications for mortgage refinancing tripled in April 2009 over the level of a year before.

TARP Cops

On April 13, 2009, Herb Allison, the CEO of Fannie Mae, was selected by President Obama to head the Office of Financial Stability, the office with overall responsibility for TARP. Meanwhile, the head of Freddie Mac, David Moffett, had resigned in March and was not replaced until July 2009, when Charles Haldeman Jr., a former mutual fund executive, was appointed. This left Fannie Mae and Freddie Mac without CEOs. Because of the controversy

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. The Rise and Fall of the Subprime Crisis 657 over bonuses and government interference in firms receiving bailout money, the government was having trouble filling executive slots. Congressional witch hunts against executives also complicated the task. CFO jobs were particularly hard to fill because these individuals were the first to go to jail if the company ran into a problem. Financial institutions were also becoming wary of any further participation in government bailout programs for the same reasons. That situation was worsened by stories in the press about Neil Barofsky, a former prosecutor placed in charge of policing the TARP bailouts. Referred to as the “TARP cop” in the media, Barofsky in April 2009 investigated whether any banks had cooked their books in order to qualify for TARP funds. Goldman Sachs had not requested the funds in the first place and now sought permission from the government to repay its TARP funds. April 15, 2009, was a good day for the market. The Dow surpassed 8000, two initial public offerings (IPOs) came to market, and the junk bond market rallied. The cost of borrowing for junk bond–category borrowers fell in April, leading to a number of new junk bond issues. However, the stock market remained volatile. The Dow declined by 289 points on April 20, dipping under 8000 and ending a six-week market rally. Crude oil prices fell to $45.88 per barrel on that day. The IMF issued a less-than-optimistic statement on April 22, 2009, that the world was in the midst of the worst global recession since the Great Depres- sion. It forecast a 1.3 percent contraction of the global economy in 2009 and only slow growth in 2010. The Organization for Economic Cooperation and Development (OECD) predicted a decline in the world economy in 2009 of 2.75 percent. Europe expected a 4 percent contraction of its economies, while the United States anticipated shrinkage of 2.8 percent. The European Union approved a plan by the UK government to offer $72.5 billion in guarantees to banks underwriting mortgages and securitizing them through CDOs. The European Union also approved, on April 23, 2009, rules regulating credit rating agencies. Among other things, the rating agencies were required to disclose their rating methodologies, to differentiate ratings on complex products, and to hire at least two more independent directors. The Italian government seized assets totaling $300 million from UBS, JP- Morgan Chase, Deutsche Bank, and Defa at the end of April 2009, after a Milan prosecutor charged that they had refinanced a $2.2 billion municipal offering that was coupled with swaps. The prosecutor claimed that the refinancing did not effect a saving, a condition for refinancing municipal debt under Italian law, and that the banks had made $130 million in profits from the deal. Job claims in the United States fell in the last week of April 2009. The number of claims for the month was 491,000, down from 708,000 in March. The employment rate was at 8.9 percent in April, and Fed chairman Bernanke doubted that it would reach 10 percent. Manufacturing activity continued to slow in April 2009, but at a declining rate, and consumer confidence was up. Durable goods orders actually rose 1.9 percent in April. The Conference

Board’s index of leading indicators rose by 1 percent during the month. How- ever, retail sales were down 0.4 percent from the year before. Capital One Financial reported increased credit card losses in April. Housing starts, as a whole, fell by 12.8 percent in April 2009 over those in March. This was the lowest number of starts since 1959, but there was some good news—single-family construction rose by 2.8 percent in April. In addition, existing home sales rose by 2.9 percent during that month. Mortgage refinancing increased as interest rates declined, resulting in projected savings of $18 billion to homeowners. However, money market rates were also at a record low. The Dow jumped 168.78 points on April 30, 2009, closing at 8185.73. It was up more than 7 percent for the month. The stock market was up 34 percent from the low that it reached in March 2009. Hedge funds were up on average 4.2 percent in the first four months of the year. Business investment, however, was still anemic. Stockbrokers left the market in droves. Over 11,600 brokers gave up their registration in the first four months of 2009. The highest number of exits previously was in 2002, when the total for the year was 11,500. Congress passed a $3.5 trillion budget for the 2010 fiscal year, but the Senate balked at passing legislation that would allow judges to adjust (“cram down”) mortgages in foreclosure. The number of foreclosures increased in April to 342,000, up 32 percent from April 2008. Some 30 percent of residential mortgages were underwater. The pick-a-pay mortgage loans, which allowed borrowers to choose the amounts of their monthly payments, were suffering the highest delinquency rates. About 37 percent of such loans were delinquent, and about 20 percent were in foreclosure. That compared to a 34 percent delinquency rate and a 14.5 subprime foreclosure rate on subprime mortgages with more conventional terms. Wachovia, which had been rescued by Wells Fargo, put $115 billion of pick- a-pay mortgages onto its books. JPMorgan was holding $40 billion from such mortgages as a result of its rescue of Washington Mutual. The FHA supported the subprime market and guaranteed nearly 33 percent of all new mortgages, up from 2 percent in 2006. Almost 20 percent of its subprime mortgages were delinquent or in default in May 2009.

TARP Funds

A survey of banks receiving TARP funds found that more than 80 percent used some of those funds to make loans, over 40 percent also used them to bolster capital, and over 30 percent used them for investments and acquisitions. The government’s stress test results for U.S. banks were disclosed on May 7, 2007. Bank of America was found to need $33.9 billion in additional capital, Wells Fargo required $13.7 billion, GMAC $11.5 billion, Citigroup $5.5 billion, and Morgan Stanley $1.8 billion. Those not needing additional capital included JPMorgan Chase, Goldman Sachs, Bank of New York Mel- lon, and American Express.

Critics noted that the government had weakened its stress tests in response to demands from the banks that were tested. Among other things, the banks were allowed to value distressed CDOs by cash flow, rather than marking them to market. Nevertheless, the test results seemed to have restored the market’s confidence in financial institutions. After the results were announced, the Dow rose to 8512.28. Several investment banks—including Goldman Sachs, JPMorgan Chase, Morgan Stanley, Bank of New York Mellon, State Street, and U.S. Bancorp—then officially notified the Treasury of their desire to repay TARP funds. Morgan Stanley responded quickly to the government’s demand that it increase its capital, raising $9.2 billion by May 20, 2009. Wells Fargo also raised $7.5 billion in equity on June 1. Bank of America raised $7.3 billion on May 12 by selling a portion of its holdings in the China Construction Bank. Temasek Holdings, the Singapore sovereign wealth fund that had invested about $6 billion in Merrill Lynch before its rescue by Bank of America, was given a 3.8 percent stake in Bank of America in exchange for Temasek’s Merrill Lynch holdings. Temasek sold that stock in May 2009, taking a loss estimated at $2 billion. However, Bank of America was able to raise nearly $33 billion in capital during May and early June. In May 2009 Bank of America announced the hiring of some 6,000 new employees to handle a flood of mortgage refinancings that had been touched off by falling interest rates, which were below 5 percent for thirty-year fixed- rate mortgages in mid-month. The fact that no-doc and low-doc loans were abandoned, and credit standards tightened, meant that more manpower was needed to review applications. Government pressure led to the removal of Bank of America’s chief risk officer, Amy Woods Brinkley, and four directors resigned from the bank’s board and were replaced with directors experienced in banking. In a sign of the times, two of those new directors were former bank regulators. The government added another hurdle for repayment of TARP funds on June 1, 2009, requiring all banks seeking to repay the funds to raise more capital from private investors, even if the stress tests indicated that they had no need for additional capital. JPMorgan Chase and American Express objected to this requirement because they had both passed the government’s stress tests. Nevertheless, the bank regulators insisted that they prove their ability to raise additional capital, so both companies made equity offerings. JPMorgan Chase raised $5 billion and American Express raised $500 million. In all, the largest nineteen banks increased their capital by $85 billion in May and early June 2009. Citigroup raised $5.5 billion by May 20, allowing it to meet its stress test shortfall. In response to government pressure, Citigroup shook up its management team again on July 9, 2007. Chief financial officer Edward Kelly, who had been on the job for only four months and was Citigroup’s fifth CFO in as many years, was removed at government insistence because of dissatisfaction

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 660 The Crisis Abates over his work. Citigroup was still struggling, but bank officials worked on a strategy to avoid government pay caps by increasing base salaries by 50 percent and by issuing large amounts of stock options to employees, who had seen their Citigroup holdings plunge in value by 84 percent. They would have to share in the bank’s equity with the government, which took down its 34 percent stake in Citigroup in June 2009. JPMorgan and Bank of America also looked for ways to increase employee pay without setting off another political firestorm. The government continued to intrude on the management of financial services firms receiving TARP funds. The head of the FDIC, Sheila Bair, pressured Citigroup to reorganize its top management and sought to impose more regulation over the bank. She wanted to replace Citigroup’s CEO, Vikram Pandit, who had an investment banking background, with a commercial banking team. However, the Fed and the Treasury Department were not convinced that this was necessary. Bair also wanted to downgrade Citigroup’s regulatory rating, which caused it to delay converting preferred shares into common shares in a capital-raising effort. Bair lost on that issue as well, and the conversion proceeded in June 2009. The regulators did force Citigroup to hire outside consultants to determine whether its current management was capable of leading the bank. Ten banks—including JPMorgan Chase, Morgan Stanley, Bank of New York Mellon, Goldman Sachs, State Street, American Express, and BB&T— were allowed to repay their TARP funds to the federal government on June 9, 2009. All told, those ten banks repaid $68.3 billion of the $239.4 billion that had been injected into financial institutions by TARP. The government earned $1.8 billion in dividends from the ten banks. The government anticipated additional profit of around $4 billion from warrants received from these banks as a condition for receiving the funds. Banks repaying their bailout funds then tried to buy back the warrants, but the Treasury Department demanded an unrealistic price. This angered the banks, some of which had taken TARP funds only because the Treasury Department had asked them to do so in order to avoid stigmatizing banks, like Citigroup, that really did need the funds. As Jamie Dimon, CEO of JPMorgan Chase, stated, his bank “didn’t ask for it, didn’t want it, didn’t need it.”22 Indeed, JPMorgan had raised $11 billion in September from a stock offering in private markets. Morgan Stanley repurchased its warrants from the government for $950 million in August 2009, giving the government a total return of $1.27 billion for its $10 billion bailout of Morgan Stanley, an annualized return of some 20 percent. Goldman Sachs repurchased its warrants for $1.1 billion, and Bank of New York Mellon paid $136 million to repurchase its warrants.

Green Shoots

May Day celebrations in Europe turned into widespread protests over economic conditions, in which hundreds of thousands of demonstrators participated.

The demonstrations were mostly peaceful, and there was reason for protest. Eurozone industrial production had fallen by 20 percent in the previous twelve months. Standard & Poor’s placed the United Kingdom on a credit watch in May, signaling a credit downgrade in its triple-A rating because of its economic problems. This resulted in a sharp drop in the price of UK obligations and increases in its funding costs. Emerging markets bounced back, however, increasing in early May by 50 percent over their March 2009 lows. The banks tightened the terms of their lines of credit, which were often the last resource for firms experiencing liquidity problems. The United States issued some $10 billion in TALF bonds on May 4, 2009. The Federal Reserve created a loan program in May, to be launched in June 2009, which was intended to aid commercial real estate lending. The loans had terms of up to five years and were to be used to buy bonds backed by commercial real estate. Help was needed. The number of commercial mortgages at risk of default had quintupled in the first four months of 2009, at a value rising from $4.6 billion to $23.7 billion. Standard & Poor’s was causing confusion in the commercial mortgage-backed market in July 2009 by flip-flopping on the ratings it gave to certain issues. It first rated them triple-A, then downgraded them, and then restored the rating. The rating agency said the restoration was due to changes in its rating criteria. As May began, new job claims fell and productivity was up. Crude oil prices rose once again, reaching $58.63 per barrel on May 8, 2009. The government reported, in May 2009, that the budget deficit widened by another $90 billion, to total $1.8 trillion. A study determined that the Medicare fund would be exhausted by 2017, two years earlier than previously projected. Social Security was forecast to be bankrupt by 2037, four years earlier than had been projected just one year earlier. The federal government spent more than $1 trillion on Medicare and Social Security, which together comprised about a third of the budget in 2008. Jean-Claude Trichet, president of the European Central Bank, speaking on behalf of central bankers around the world, declared on May 11, 2009, that the global economic downturn had bottomed out around the world in March, except for the United States. However, Fed chairman Bernanke testified before Congress on May 5, 2009, expressing guarded optimism on the recovery of the economy. Bernanke stated that the Fed was seeing signs of “green shoots” in economic growth, and those words echoed around the world. The National Bureau of Economic Research concluded in 2010 that the Great Recession actually ended in June 2009. The economy did appear to be recovering, but it was not assisted by the stimulus package passed by Congress in February. About $45 billion had been given to the states from that package to cover Medicaid costs and jobless benefit claims. Only about $11 billion had been spent on “shovel-ready” highway projects, which were supposed to be the heart of the stimulus package economic recovery program and few jobs were created.

The Struggle Continues

New credit card legislation was passed in May 2009 that restricted the ability of credit card companies to increase interest rates on existing balances and required more disclosures on fees. It prohibited automatic fees on cardholders who exceeded their spending limits. Instead, cardholders would have to be given notice of the breach and fee, so that they could decide not to use the card in the future. This legislation was directed at the high charges placed on subprime credit card holders. President Obama signed that legislation even though it carried a provision allowing the right to carry firearms in national parks, a proposal demanded by Republicans for allowing the legislation to pass. Citigroup responded to that statute by sharply raising its fees in advance of the effective date of that legislation—2010. By November 2009, Citigroup charged 29.99 percent in interest for credit card balances. Bank of America also announced that it would be eliminating free checking services in order to make up for the revenue lost from this legislation. The legislation thus backfired, causing only more expense to cardholders. Concern over provisions in this legislation on customer remedies also caused two large arbitration bodies to withdraw from hearing further credit card claims that consumers were lodging against their credit card companies. This legislation came at an inopportune time for the credit card companies, which faced increasing credit card default as unemployment rose and the recession deepened. The Florida BankUnited failed on May 21, 2009, which was expected to cost the FDIC $4.9 billion. BankUnited was the thirty-fourth bank to fail in 2009, compared with twenty-five in all of 2008. The FDIC arranged to sell BankUnited to a group of private equity investors that included the Carlyle Group and the Blackstone Group, which contributed $900 million in equity to the bank in exchange for its assets. The FDIC agreed to assume 80 percent of the first $4 billion of losses at the bank and 95 percent of any additional losses. It raised its fees on larger banks on May 22, 2009, in order to increase its insurance fund by $5.6 billion. This met some objection considering that it was the failure of smaller banks that was draining the FDIC’s insurance fund. However, FDIC chair Sheila Bair scoffed at those objections, noting that the larger banks had been bailed out with a massive infusion of taxpayer funds through TARP. The Dow Jones Industrial Average rose to 8473.49 on May 26, 2009, after a report of the first increase in consumer confidence in eight months. The Dow was then some 30 percent higher than in March, but it was still down 3.5 percent for the year. Hedge funds gained 5 percent overall in May 2009. BMW sales were down 18 percent in May from the prior year, and Mercedes sales fell 12 percent. Crude oil sold at $62.45 per barrel. The spread on the yield curve for two- and ten-year Treasury notes widened to 2.75 percent on May 27, 2009, the highest ever. Nonfarm payrolls lost 345,000 jobs in May 2009, raising the unemployment

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. The Rise and Fall of the Subprime Crisis 663 rate to 9.4 percent. This was the highest unemployment rate in twenty-six years, but it was the smallest monthly job loss since September 2008. Employment actually increased in some states. Although the Fed’s Beige Book disclosed further weakening in the economy in April and May, the trend seemed to bottom out. New home prices also appeared to stabilize, and durable goods orders increased in May. A survey of 100 of the largest global financial institutions published in June by the accounting firm Deloitte found that many financial institutions still had not tightened their risk management controls. More than 40 percent of those institutions were not stress-testing their structured finance portfolios. German chancellor Angela Merkel launched an attack on central banks in the United States and Europe on June 2, 2009, claiming that they were laying the groundwork for another financial crisis. The following day, Fed chairman Bernanke warned that the economy was in danger from the large deficits that were accumulating. General Motors declared bankruptcy on June 1, 2009, and was dropped from the Dow Jones Industrial Average. The automaker was bailed out and reorganized by the government’s “car czar,” with the government and unions taking the lion’s share of what was left from that train wreck. At the same time Citigroup was ejected from the Dow, with both firms replaced by Travelers and Cisco Systems. Things looked slightly better for the automakers in June 2009, when sales declined by 28 percent. That was a lot, but it was the lowest decline in five months. On June 9, 2009, an auto parts trade group asked the federal government for $8 billion in loan guarantees for its members. Later, in July 2009, the Pension Benefit Guaranty Corporation took over $6.2 billion in liabilities of the pension fund of the bankrupt automotive parts firm Delphi. The Delphi pension plan had a total deficit of $33.5 billion. It sold its remaining assets to creditors and to GM. Adding uncertainty to car demand, the price of crude oil exceeded $70 per barrel on June 5, 2009. The interest on an average thirty-year fixed-rate mortgage rose to 5.79 percent on June 10, 2009. It was expected that recent increases from the less than 5 percent interest rate level for thirty-year mortgages, which had been available at the end of May, would cut refinancings in half. The government- sponsored enterprises (GSEs) took on most of the new mortgage risk. Govern- ment National Mortgage Association (Ginnie Mae) issued a record $43 billion in mortgage-backed securities in June 2009. The FHA’s overall default rate reached 7 percent of its insured mortgages, and the overall delinquency rate rose to 13 percent. It was insuring $560 billion in mortgages, four times the amount only three years earlier. The Dow rose to 8799.26 on June 12, 2009, putting it into positive territory for the year. However, the Dow suffered a setback on June 16, 2009, falling by 187.13 points, returning it to negative territory. The rise in the stock market was bringing back “reverse convertibles”—bonds that paid high rates but that

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 664 The Crisis Abates then converted into stocks after the share price dropped to a preset level. Such securities had suffered large losses in 2008, as the market plunged. Financial engineers tried to repair flaws in the auction rate securities market by creating an instrument that would require the borrower to repay the principal of the securities within a specified period after an auction failed. Goldman Sachs agreed to pay $60 million to Massachusetts in order to settle claims over its subprime securitizations. Of that amount, $50 million was to be used to reduce the principal due on subprime loans that were securitized. KB Homes reduced its losses and announced an improvement in house sales in June 2009. Its stock price had fallen by about 70 percent during the subprime crisis. However, the company was forced to enter into a deferred-prosecution agreement with the Justice Department on July 1, 2009. The company admitted that it had charged illegal fees in its home sales and made “gifts” to purchasers that were used for down payments on mortgages. Those gifts were recouped by increasing home prices. KB Homes agreed to pay $50 million in restitution to homeowners. The OECD concluded, on June 24, 2009, that the worldwide economic slump had reached bottom. This added to a growing number of such reports. Nevertheless, that day the ECB injected €622 billion into banking institutions in Europe as a stimulus measure. The Fed, at the same time, expressed the view that the U.S. economy was likely to remain weak for some time. It stated that it would maintain interest rates at zero for an extended period of time. It also announced that it would proceed with its plan to buy up to $300 billion in Treasury bonds in order to infuse the system with more liquidity and to drive down interest rates. The Fed continued with its plan to buy $1.25 trillion in mortgage-backed securities, but declined to expand that program further. In the second quarter, GDP contracted at an annual rate of 1 percent, much less than expected. Consumer saving was at its highest level since 1993, which meant that consumer demand was still dormant. However, consumer confidence increased for the fifth straight month. The unemployment rate stood at 9.5 percent on July 2, 2009. By then, some 6.5 million jobs had been lost as a result of the subprime crisis. The Dow fell by 223.32 points after this news was made public. Reports from the job market were, indeed, troubling. Jobless benefit claims had continued to exceed 600,000 for more than twenty straight weeks. The jobless situation was the worst in fifty years. Bank lending declined by 2.8 percent in the second quarter at the fifteen largest banks. A rogue trader hit the oil market on June 30, 2009, pushing crude oil prices up by more than $2 per barrel. The trader was identified as Steve Perkins, who worked at PVM Oil Associates, a large oil broker that lost some $10 million as a result of his trading. In another strange turn of events, Italian authorities arrested two Japanese citizens trying to smuggle $134 billion in U.S. government bearer bonds into Switzerland in a false-bottomed suitcase. The bonds turned out to be counterfeit.

Housing starts increased in June for the third month in a row. The gain in sales of new homes in June 2009 was the highest in eight years, but it was still 21 percent lower than in the previous June. Those sales were being driven by lower prices. The vacancy rate for apartments reached 22 percent at the end of the second quarter. Toll Brothers announced the reintroduction of adjustable rate mortgages that would begin with a low 3.75 percent interest rate and then reset after seven years at 275 basis points over LIBOR (the London Interbank Rate) with a cap of 8.75 percent. Numerous executives at major companies sold their stock in the summer of 2009, either a troubling sign of pessimism or an effort to cash in on a rising market. Investment banks were hard at work creating ways to avoid the expected increases in regulatory capital. One proposal was to take bank assets off the balance sheet by securitization (as if no one had tried that before), but the twist added was a pooling of those assets from several banks. Goldman Sachs created an asset insurance program similar to the UK government guarantee of bank assets but funded privately. British banks shunned the government program because of its high costs. Subprime securitization pools continued to dump foreclosed homes on the market at fire-sale prices in July 2009. The pools sold several times the number of homes foreclosed by banks, at prices lower than the banks were willing to accept. The securitized foreclosures were also less likely to allow loan modifications that would keep homes out of foreclosure. Loan modification programs were lagging. Only 200,000 mortgages had been modified in the government’s program by July. President Obama met with a group of mortgage servicers in July 2009 and urged them to speed up loan modifications. Treasury Secretary Geithner and the secretary of Housing and Urban Development (HUD), Shaun Donovan, called another meeting of the twenty-five largest mortgage servicers for July 28, 2009, in order to persuade them to accelerate the pace of mortgage modifications. Foreclosures then occurred at an annual rate of 3.5 million, up from 800,000 in 2005. A front-page article in the New York Times charged that mortgage modifications were slow because mortgage lenders received large late fees on delinquent payments.23 However, the Obama administration announced in November 2009 that one in five of the 650,000 homes eligible for its Making Home Affordable program benefited from mortgage modifications. Mortgage modifications did not come cheap. Fannie Mae suffered over $7.7 billion in losses from mortgage modifications in the third quarter of 2009. Yet as October began, only 116,000 mortgages had been modified under this program, now called the Home Af- fordable Refinance Program (HARP). Commercial loan defaults continued to increase and were expected to total $30 billion by year-end 2009. The federal government lost $2.3 billion in TARP funds as a result of the CIT bankruptcy, bringing total expected bailout losses to $117 billion. Surprisingly, this amount was roughly equal to the losses experienced during the savings and loan crisis in the 1980s, but the total

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 666 The Crisis Abates bailout cost for the subprime crisis was reduced even further in April 2010 to $89 billion. The bailout losses were concentrated mostly at Freddie Mac, Fannie Mae, AIG, the auto industry, and the mortgage modification program. Small community banks that accepted TARP funds were also having difficulty repaying those loans. Anton Antonucci Sr., the CEO of the failed Park Avenue Bank, was indicted for attempting to defraud TARP of $11 million. The banks had repaid $173 billion in TARP funds by February 2010, the federal government had made some $10 billion from those investments. The government made another $1.32 billion after it sold 20 percent of its holdings in Citigroup, reducing its ownership to 22 percent. Another sale in July 2010 reduced that interest to 18 percent and brought government profits to $2 billion. The Obama administration admitted on July 10, 2009, that it had been slow in implementing the giant stimulus plan approved by Congress months earlier, but Treasury Secretary Geithner told an audience in London three days later that the economy was showing positive signs and that additional stimulus was unnecessary. Notably, by then, the U.S. federal budget deficit topped $1 trillion for the first time and was expected to double by year’s end. Nevertheless, the worst of the subprime crisis appeared to be over. Minutes of the Fed’s meeting in July showed optimism for a recovery but expressed concern over high unemployment levels for an extended period. That concern was well founded, as unemployment exceeded 10 percent in fifteen states in mid-July 2009. Goldman Sachs reported its second-quarter results on July 14, 2009—$3.44 billion in profits, which was more than Goldman earned in all of 2008 and the highest ever reported by the firm. The attention getter was the $11.4 billion set aside for Goldman employee bonuses at year’s end. This announcement set off another populist furor in Congress. Several members of Congress asked the Fed to consider whether Goldman was too lightly regulated and whether it was taking on inordinate risk to realize those profits. JPMorgan had second-quarter earnings of $2.7 billion, an increase of 36 percent over the same quarter in 2008. Other financial institutions had large profits from refinancing and from a recovery of their mortgage portfolio values from the panic-driven writedowns of the previous year. BlackRock earned large sums from its management of the government portfolio of troubled assets from Bear Stearns and AIG. However, a scandal brewed over BlackRock’s wooing of business from Charles F. Millard, the head of the Pension Benefit Guaranty Corporation (PBGC). BlackRock and Goldman Sachs wanted to manage more than $1.5 billion in PBGC funds. They were given contracts, but those contracts were revoked after it was revealed that the firms had entertained Millard at expensive places, like the Ritz-Carlton, before the contracts were implemented. It was revealed in the press on July 16, 2009, that both Bank of America and Citigroup were operating under secret agreements with the FDIC to improve their corporate governance by revamping their boards and increasing risk

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. The Rise and Fall of the Subprime Crisis 667 controls. Citigroup had commissioned an independent review of the quality of its management to satisfy the regulators. That study, completed in October 2009, found with a few exceptions that Citigroup managers were well qualified. However, the FDIC was skeptical of the study’s methodology. In the meantime, the large banks paid millions of dollars to attract high-producing salespeople for bonds and other products. Both banks reported profits for the second quarter, but those profits were due to one-time gains. Bank of America warned of continuing difficulties as consumers struggled with the recession. The Dow fell to 8146.52 on July 10, 2009, but rallied to 8331.68 on July 13, 2009. The price of crude oil dipped to just under $60 per barrel. The Dow resumed its rise, closing at 8743.94 on July 17, 2009, after initial second- quarter earning reports showed profitable gains by several firms. However, General Electric’s earnings fell by 49 percent year on year, due to continuing problems in its financial services unit. Credit card delinquencies declined. Demand for loans from the Fed decreased in July, suggesting a recovery in the credit markets.

The Way to Recovery

The Rocky Road

In testimony before Congress on July 21, 2009, Fed chairman Bernanke stated that the economy continued to show signs of recovery. However, he cautioned that high unemployment was likely to persist and, therefore, the Fed would maintain interest rates at their current low levels. He also wrote in an op-ed piece in the Wall Street Journal that the Fed would be alert to signs of inflation that might be spurred by low interest rates and easy money at low rates. Bernanke simultaneously conducted a public relations campaign to justify the Fed’s bailout of the big banks. At a town hall meeting in Kansas City, Mis- souri, Bernanke said that he had to “hold my nose” in making the bailouts, especially with respect to financial institutions making “wild bets,” but did it out of concern that the entire financial system could collapse. Guaranty Financial Group, a large Texas bank, announced on July 24, 2009, that it would restate its accounts and take a large writedown. The bank stated that it expected to fail as a going concern. Microsoft announced its first-ever fiscal year loss in July. General Motors saw its sales continue to decline, for the sixth quarter in a row. Ford’s sales increased, and the firm even reported a profit. The Dow exceeded 9000 on July 23, 2009, as second-quarter earnings reports continued to be generally higher than expected at companies like Amazon.com and 3M. The housing market also showed further signs of strengthening. International financial institutions were showing mixed results. Nomura Holdings experienced a fiscal year-end loss of $7.45 billion. It continued to encounter difficulty integrating the Lehman operations that it had purchased.

Deutsche Bank reported an increase in earnings of 68 percent for the second quarter. HSBC Holdings beat analysts’ expectations with a profit of $3.35 billion in the second quarter. Barclays earned a similar amount. However, UBS reported a $1.3 billion loss for that quarter. Lloyds had a $6.8 billion loss in its first two quarters, but reported that its business was improving. In Germany, Commerzbank continued to experience losses, reporting a second-quarter loss of $1.8 billion. The Royal Bank of Scotland reported a loss of $1.7 billion for the first six months of 2009. Credit Suisse reported a 29 percent increase in earnings for the second quarter. Berkshire Hathaway made a $3.3 billion profit for the second quarter, compared with its first-quarter loss of $1.5 billion. AIG even reported a quarterly profit for the first time in two years, but that profit was due mainly to accounting changes and valuation adjustments. CentexCorp and Pulte Homes had mixed results. They planned a merger, which would create the largest home builder in the United States. Hedge funds had a good first half of 2009, with an average increase of 12.14 percent over the prior year. Morgan Stanley reported disappointing earnings on July 22, 2009, having lost $159 million in the second quarter. This was the third quarter in a row that Morgan Stanley reported a loss. Unlike Goldman Sachs, Morgan Stanley had taken a risk-adverse approach to recovery, which was the course dictated by the government and corporate reformers. Wells Fargo made $3.17 billion during the quarter, but its number of nonperforming mortgages increased by 45 percent over the prior year, totaling $18.3 billion. American Express experienced a 48 percent drop in earnings over the prior year. Bank of America announced on July 27, 2009, that it would close 10 percent of its 6,100 branches. Citigroup had a problem with two hedge funds in its Citigroup Alternative Investments division: One $3.4 billion fund was frozen by its investors after a number of deals fell through, and its co-head quit; another Citigroup fund, one for sustainable development programs, could not attract investors. The Fed and the Treasury Department entered into memorandums of understanding with hundreds of banks, that is, nonpublic agreements by the banks to take corrective measures, such as boosting capital or strengthening management. It was a further reflection that government regulators were taking over many management functions at the large banks. Citigroup reconstituted its board of directors as ordered by the government, adding three more new directors on July 24, 2009. In the last week of July the Treasury Department issued $200 billion in debt to fund federal government spending. It was estimated that the FDIC debt guarantee for debt issues of financial institutions would save those issuers some $24 billion in interest costs that they would have incurred absent such a guarantee. The banks also made large profits from their trading with the Fed and expected to realize fees of more than $38 billion in 2009 from customer overdraft charges. However, the Fed later curbed fees on overdraft

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. The Rise and Fall of the Subprime Crisis 669 charges, requiring the banks to obtain the permission of customers in advance of charging them. The Fed also proposed restrictions on fees and expiration dates for retail gift cards.

A Parting of the Clouds

A drumbeat of good news sounded as July ended. The Dow passed 9100 on July 27, 2009, driven by reports of a large increase in home sales. It was reported on July 28, 2009, that between April and May 2009 housing prices had risen for the first time in thirty-four months. The Fed disclosed on July 29, 2009, that its survey of regional economic conditions indicated that the economy was stabilizing. July was the Dow’s best monthly performance in almost seven years, and the number of job losses that month was the lowest in nine months. President Obama responded to that news by saying, “We’re pointed in the right direction.” Toll Brothers reported a declining number of house cancellations and an increasing number of orders for its lower-cost models. Its CEO made $50 million from stock sales during the year. Housing prices rose in July. The lower end of the housing market rebounded in July, but the higher end was still stalled. The delinquency rate on jumbo prime mortgages rose from less than 1 percent in 2007 to more than 7 percent in July 2009. The delinquency rate for ordinary prime loans was 6.4 percent in August 2009, while that for subprime delinquencies reached 25 percent. Delinquencies increased on prime mortgages. State tax revenues fell by 17 percent in the second quarter. Nevertheless, a feeling of elation was in the air as August began. The cash-for-clunkers tax credit in the stimulus package brought customers back to the automobile showrooms. The S&P 500 Index passed 1000 on August 3, 2009; the NASDAQ climbed above 2000; and the Dow closed at 9286.56. Those rises were aided by improved earnings reports from Tyson Foods and Pilgrim’s Pride. Leveraged loan prices increased, which suggested that market was thawing. The average bid on a leveraged-loan CDO increased to more than 90 percent in August, the first time that level had been reached in over a year. American Express experienced improved payments on its credit cards in August, but high-end cardholders still did not spend at their customary levels. The U.S. Postal Service lost $2.4 billion in the second quarter, but this attracted little notice. The jobless rate fell to 9.4 percent in the first week of August, defying expectations that it would increase, in the first drop in the unemployment rate in fifteen months. The Dow jumped to 9370.07 after that news was released, but the decline in unemployment was thought to be due to the fact that more people had stopped looking for a job. In any event, stocks were up almost 50 percent from their bottom in March 2009. The Fed announced on August 12, 2009, that it believed that the economy had leveled out and that it planned to start phasing out its emergency programs.

It also stated that it would not complete its $300 billion asset purchase program until October, a month later than originally planned. Economists asserted that as of August the Obama stimulus package had had only a small effect on the economy. It was also reported that the federal government sent 3,900 stimulus checks of $250 to jailed criminals. The administration forecast that the federal government would incur an additional $9 trillion in debt over the next decade, while others claimed that it could actually be much higher. KKR announced plans for six large IPOs of companies that it owned in August 2009. Sovereign wealth funds returned to Western investments in the third quarter, after withdrawing from the market as the subprime crisis peaked. The China Investment Corporation, a sovereign wealth fund, invested $1 billion with Oaktree Capital Management, a hedge fund that planned to use the money to invest in distressed debt. Distressed debt acquisitions increased. Buying the distressed debt of a company and then using it to take control from shareholders in a reorganization of the company was another popular program. Some 140 such transactions were carried out in the first seven months of 2009 and were valued at $85 billion. Productivity rose in the United States to its highest level in six years. A survey of economists by the Wall Street Journal in August 2009 found that a majority thought the recession had ended. Global conditions also seemed to be improving. Germany and France reported increases in growth for the second quarter, which took them officially out of recession, because they also had growth in the first quarter. Manufacturing increased in the UK and Italy. China, Indonesia, South Korea, and Singapore reported growth in the second quarter exceeding 10 percent. Japan’s economy also showed signs of recovery. The Swiss government sold its $6.5 billion stake in UBS on August 20, 2009. That bailout proved to be a good investment for the Swiss government—it made a profit of $1.13 billion from the sale, a 30 percent return on an investment that lasted ten months. However, UBS had trouble extricating itself from a Swiss government agreement guarantying some of its toxic assets. That arrangement turned out to be a very expensive one for the bank By August 16, 2009, the Dow had risen by 42 percent over its March 9 low, closing at 9321.40, but it was still 34 percent below its October 2007 high of 14164.53. Electricity prices dropped sharply in the summer of 2009, providing more relief for consumers. Still, problems persisted. Atticus Capital, a large hedge fund, closed its doors on August 11, 2009, and announced the return of $3 billion to investors. Colonial Bank, a large regional bank located in Mont- gomery, Alabama, failed on August 14, 2009, in the sixth-largest bank failure in U.S. history. Its assets were acquired by BB&T. As of August 16, 2009, seventy-seven banks had failed for the year, and 102 banks had failed in the past two years. The cost to the FDIC of those failures was about 10 percent more than that of the bank failures in the 1990s. Markets worldwide caught a case of the jitters on August 17, 2009. The Dow fell by 186.06 points. Japan’s markets were particularly hard-hit, and

European markets also plunged. Readers Digest, a conservative American icon, announced that it was declaring bankruptcy that day. Lowe’s also chose that day to report a profit decline of 19 percent in the second quarter. Home Depot later weighed in with an earnings decline of 7 percent for the quarter. Credit card delinquencies declined, but that business had another problem. Albert Gonzalez was charged with computer crimes associated with his hacking into various company computers in order to steal credit card information from 130 million consumer files for use in identify theft scams. He had previously been charged with stealing 40 million credit card numbers from TJ Maxx, costing it $200 million. Gonzalez was already in custody on another charge, which involved his hacking into the computers of Dave & Busters, a restaurant chain. Gonzalez had two Russian accomplices. A Fed survey in August of nineteen banks that had received bailout money found that they had reduced their loan balances by 1 percent in June 2009. They expressed a consensus view that lending would not pick up until the summer of 2010, attributing the lack of loan growth to tightened credit standards and low demand. Nevertheless, Citigroup investors had cause to smile, as the firm’s stock price had risen by 70 percent in one month. Freddie Mac faced more losses, this time from dodgy loans issued by Taylor, Bean & Whitaker Mortgage Corporporation, based in Ocala, Florida. That company, the twelfth-largest mortgage lender in the country, became insolvent in August 2009 due to the FHA’s revocation of its status as a mortgage originator that was qualified for FHA mortgage insurance coverage. The suspension was caused by state regulatory actions and misrepresentations made by Taylor Bean to the FHA concerning the decision of its auditor to discontinue its annual audit. Fannie Mae stopped dealing with Taylor Bean in 2002 because of concerns over its lending practices. However, Freddie Mac viewed this as an opportunity to expand its portfolio and began buying Taylor Bean loans in large amounts. The chairman of Taylor Bean was later indicted and charged with perpetrating a fraud involving billions of dollars. Ginnie Mae sold a massive amount of its securities to banks and thrifts, which used them to bolster their balance sheets. Some used TARP funds for such purchases. The amount of Ginnie Mae purchases by banks and thrifts increased from $41 billion in September 2008 to $113 billion one year later. These purchases supported the FHA mortgage insurance program that was backing much of the mortgage business in the wake of the subprime crisis. The FDIC prepared to seize the failing Guaranty Financial Group on August 20, 2009, and it did so a few days later, in the tenth-largest bank failure ever in the United States. The agency arranged its sale to a Spanish bank, Banco Bilbao Vizcaya Argentaria. The FDIC added 111 banks to its problem list, raising the number of troubled banks on that list to 416. The FDIC insurance fund was at its lowest level since 1993, falling to $10.3 billion in August 2009 from $45.2 billion a year earlier. The FDIC became a large landlord for assets from failed banks whose value totaled $1.8 billion but were difficult to sell

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 672 The Crisis Abates because of various flaws in the properties. The agency announced on August 27, 2009, that banks had an overall loss of $3.7 billion in the second quarter of 2007 over the prior year. Vulture investors thrived. SecondMarket bought frozen auction rate securities at discounts ranging from 10 to 13 percent and dealt in other illiquid securities. Cogent Partners brokered interests in private equity funds that were frozen, and Hedgebay Trading did the same for hedge funds that had suspended redemptions. In contrast, college endowment funds suffered. Harvard’s endowment had declined 30 percent in August 2009, despite the market rally, and Yale faced a 25 percent contraction. Collectively, the two endowment funds lost $17.8 billion in the fiscal year ending June 30, 2009. Columbia University’s endowment fared a bit better, but still fell in value by 21 percent. Natural gas prices plunged to a seven-year low. Retail chains reported that sales were still slow in August, while the housing market continued to improve. Housing sales were up 7.2 percent in July over those in June, but one in eight residential mortgages was in foreclosure or delinquent. Jobless claims also increased. Nevertheless, Fed chairman Bernanke stated on August 21, 2009, “Fears of a financial collapse have receded substantially.”24 That statement inspired a stock market rally, with the Dow closing at 9505.96. However, concerns were raised that the appearance of an economic recovery might be overly optimistic. To assure that was not the case, the Obama administration announced, on August 26, 2009, Bernanke’s reappointment as Fed chairman. That announcement was accompanied by a report that housing prices had increased in most major cities in June. Share prices for Fannie Mae, Freddie Mac, and AIG rose in late August, and short-sellers abandoned the stock market as it continued to climb. Some more good news emerged. World trade was reported to have increased in June by 2.5 percent. Orders for appliances were up, as were new home sales, and job losses were slowing, falling to 146,000 in August. The thrift industry was reported to have had an overall profit for the second quarter, the first in two years. The Commerce Department reported that consumer spending increased in July for the third straight month. However, as August ended the Fed warned that, while the economy was improving, it was still vulnerable to shocks. Several states closed their government operations for limited periods in order to save money. A judge prohibited the Rhode Island governor from shutting down the government there temporarily, so he began laying off employees. Unemployment hit 9.7 percent as September began, a twenty-six-year high, but the rate of job losses continued to decline. The Financial Times reported that, by the end of August 2009, the federal government had earned a $14 billion profit on its various subprime crisis loan programs.25 The New York Times reported on the same day that the government made another $4 billion on TARP loan payouts.26 Still another report indicated that the FDIC had received $9 billion in fees from its loan guarantee program. In the meantime, the Fed’s balance sheet grew from $800 billion in 2007 to $2

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. The Rise and Fall of the Subprime Crisis 673 trillion in 2009, as a result of assets acquired under its bailout programs. The government was involved in making 90 percent of residential mortgages. The FHA reported that its cash reserves were below 2 percent, and default rates rose, with delinquencies exceeding 14 percent, more than twice the rate for prime loans. The housing agency announced its intention to tighten its credit standards. The FDIC warned that it might have to borrow from the Treasury, as its insurance fund continued to be depleted. It then reached agreement with the large banks for a plan under which they would prepay $45 billion in FDIC safety fund fees, thereby shoring up the fund, which went into the red in October after nearly 100 banks had failed during the year at a cost of $26.6 billion. On September 10, 2009, Secretary Geithner announced that the government would allow its money market guarantee program to expire at the end of the month. The FDIC also planned to end its financial services firm debt guarantee program or to limit its access to troubled institutions. Later in the month, the Fed announced the extension but eventual phase-out of its program for purchasing billions of dollars of mortgages from Fannie Mae and Freddie Mac. It also considered the creation of a program to conduct repurchase agreements (repos) with money market funds. The Fed would collateralize its reverse repos with those funds, mortgage-backed securities, and Treasury obligations. This was intended to be an inflation-fighting tool, after the economy recovered. In the meanwhile, consumer confidence continued to grow, but the price of gold closed at $1,004.90 per ounce on September 11, 2009, setting a new record. The Dow closed at 9605.41 that day. Four days later, Fed chairman Bernanke declared that the recession in the United States was probably over, after a report of a sharp increase in retail sales. He cautioned, however, that growth in the economy was likely to be only moderate through 2010 and that job growth was also expected to be slow. Mervyn King, the governor of the Bank of England, made a similar statement about the British economy the same day but was more pessimistic on growth, expecting it to be even slower. Barclays announced on September 16, 2009, the sale of $12.3 billion in illiquid assets to a fund created by some of its former executives. The bank lent most of the purchase price to that fund. KKR provided $700 million in financing to the faltering Eastman Kodak. AMR obtained $2.9 billion in new financing in September. During the week of September 14, 2009, more than $40 billion in corporate bonds was sold. Housing prices were reported to have increased in July, and housing starts experienced an overall increase in August, but construction of single-family houses was down, as were sales of previously owned homes. Household wealth was reported to have increased by 3.9 percent in the second quarter of 2009. However, unemployment in California hit 12.2 percent, a seventy-year high. Bank of America paid $425 million to terminate a loss-sharing arrangement with the government over Merrill Lynch assets, which was a part of the Merrill Lynch rescue. The arrangement was never used, so it was a rather

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 674 The Crisis Abates steep price to pay to exit the program. The Government Accountability Of- fice (GAO) reported the recovery of AIG at the end of September 2009 but expressed doubt that the government would ever be repaid its bailout money. John Mack announced his departure as CEO of Morgan Stanley and declined any bonus for 2009 but planned to remain as chairman. He was succeeded as CEO by James Gorman. Jamie Dimon also shook up top management at JPMorgan Chase. The CDO market was liquidating and unwinding large amounts of transactions, as it became possible to sell the underlying collateral. An estimated $350 billion in notional amount of CDOs was in default. The IMF predicted that banks would face global write-offs of another $1.5 trillion by the end of 2010. The index of leading indicators increased in August 2009 for the fifth month in a row. The Dow was up 50 percent on September 22, 2009, over its low in March 2009. On September 23, 2009, the Fed announced that it would keep its interest rate target at 0.25 percent and expected the Fed funds rate to remain low for an extended period. Two days later, it reported that it would cut back its Term Auction Facility (TAF) by reducing funds available for eighty-four-day loans from $50 billion per month to $25 billion. It planned to maintain the resources for twenty-eight-day loans under this program at $75 billion through January 2010. In addition, it reduced its swap program for distressed debt from $75 billion monthly to $25 billion. Meeting in Pittsburgh on September 24 and 25, the Group of Twenty discussed how to coordinate their economies. Among other things, this would include increasing consumer demand in China, reducing worldwide reliance on consumer demand from the United States, and increasing investment in Europe. It was not clear how such coordination could be implemented, other than through peer review by the member nations and technical support from the IMF. The Group of Twenty also agreed to increase regulation of financial institutions, complex financial instruments, and executive pay. The UK government announced that its largest banks agreed to curb compensation by prohibiting multiyear guaranteed bonuses and a deferral of bonuses by prorating them over three years with clawback rights if the bonuses proved to be unjustified. The European Union announced the results of its bank stress tests on October 1, 2009, concluding that the twenty-two largest banks were in sound condition and could withstand losses of up to $585 billion if the economy faced difficulties again. The IPO market in the U.S. boomed as September ended. The IPO of A123 Systems was a hot issue, rising more than 50 percent on its first day of trading. Two large mergers were announced, one involving Xerox’s acquisition of Af- filiated Computer Services for $5.6 billion, and the other, Abbot Laboratories’ acquisition of the pharmaceutical business of Solvay for $6.6 billion. Toxic subprime securities had a rally in September and were expected to boost third-quarter results. Banks repackaged some of their securitizations by

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. The Rise and Fall of the Subprime Crisis 675 bundling bad mortgages in one offering and good mortgages in another. The good-mortgage pools were then given high credit ratings by the rating agencies, in a process called REMIC (real estate mortgage investment conduits) that reduced bank capital requirements. The Dow had its best third quarter in 2009 in seventy years. The job market was still suffering, and there were six people for every one job opening. Although the rate of job losses slowed in September, unemployment reached 9.8 percent for the month. Manufacturing activity increased, but car sales dropped sharply in September after the cash-for-clunkers program ended. The Fed also expressed concern over distressed commercial real estate loans, for which the banks were slow in recognizing losses and reserving against those losses. Corporate profits were up 10.8 percent for the third quarter.

Fourth Quarter

Australia raised its interest rates on October 6, 2009, providing another indication that recovery was under way around the globe. Norway raised its rates later in the month. Société Générale announced the same day that it would repay the bailout funds that it received from the French government, to be made from a $7 billion rights offering. Lloyds Banking Group encountered resistance from the UK government in trying to exit a government insurance plan on the value of its assets by raising private capital. European regulators forced large financial institutions bailed out during the subprime crisis to sell noncore operations. The European Union required such divestments as a condition of a state-sponsored bailout. For example, Royal Bank of Scotland was required to sell its profitable insurance operations, a commodity trading unit, and a payment services firm. The British government split Northern Rock, the bank that was nationalized during the subprime crisis, into a “good” bank and “bad” bank, so that assets could be sold. The Dutch government ordered ING to be broken up after a $14.9 billion bailout. The price of gold set a new record on October 7, 2009, reaching $1,050 per ounce. Traders predicted that it could go as high as $1,500 per ounce. The Dow Jones Industrial Average hit a yearly high on October 9, 2009, closing at 9864.94. Retail vacancies were up, and consumer credit was reported to have fallen by $12 billion in August, but retail sales rose in September for the first time in more than a year. Existing house sales were reported to have increased by 9.4 percent in September. The government’s $75 billion loan modification program was stalled. Some 500,000 mortgages had been modified as October began. However, the Congressional Oversight Panel reported that the program would delay only about half the predicted mortgage failures and that many of the mortgages being modified could be expected to default as well. These modifications were made as stated income loans that required no documentation of the borrower’s income for three months, during which the borrower was required to make

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 676 The Crisis Abates timely payments of the modified monthly mortgage payment, which in most cases did not occur. A front-page article in the New York Times claimed that this Making Home Affordable program was actually hurting many of the people it was seeking to help by encouraging them to continue to make mortgage payments on homes they could not afford and that they would eventually lose after their last savings were exhausted. The Obama administration announced in December that it would require lenders to submit plans to the Treasury Department showing how they would increase the number of mortgage modifications. The Treasury threatened to fine lenders who did not make sufficient numbers of modifications. That threat had little effect. In an article that appeared in the New York Times over the Thanksgiving weekend, Assistant Treasury Secretary Michael S. Barr criticized banks for continuing to drag their feet. Wells Fargo placed a giant bet in its mortgage modification program, allowing interest-only payments on subprime pick-a-pay mortgages for as much as ten years in the hope that the housing market would recover and bring the mortgages out from under water. Vulture investors bought subprime mortgages at a steep discount, modifying their terms to make them more affordable under a new FHA-guaranteed mortgage. This shifted the risk of default from the loan originators to the FHA. The FHA reported that more than 24 percent of the loans that it insured in 2006 and 2007 were delinquent or faced foreclosure. Lawrence Summers, Obama’s economic adviser and a former treasury secretary, stated on October 12, 2009, that the economy appeared to be returning to normal but that “major slack” remained in the system due to weak demand. Business was further heartened after the Obama administration reversed its plan to raise $200 billion from taxes on the foreign earnings of U.S. firms. The administration’s efforts to curb executive pay faltered. The larger financial firms planned to pay a record $140 billion in bonuses for 2009, a 20 percent increase over 2008. Goldman Sachs had another big profit of $3.19 billion in the third quarter, raising the potential for record bonuses. The firm made at least $100 million on more than half the trading days in the third quarter. Goldman tried to soft-pedal its bonus plans in order to dampen the public outcry. Goldman’s CEO, Lloyd Blankfein, publicly apologized for saying that Goldman was “doing God’s work” and admitted that it had made mistakes in the run-up to the subprime crisis. On November 17, 2009, he announced the creation of a $500 million fund to help small businesses hurt by the crisis. A front-page article in the New York Times derisively noted that this totaled only about 3 percent of the amount that Goldman had reserved for year-end employee bonuses. The Wall Street Journal pointed out that this was one way for Goldman to meet the Community Reinvestment Act requirements to which it was subject after converting to bank holding company status during the crisis. An inspector general’s report challenged Goldman’s claim that AIG’s failure would not have endangered the firm, noting that the government had

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. The Rise and Fall of the Subprime Crisis 677 fully covered Goldman’s $22.1 billion exposure to AIG. A New York Times article claimed that Goldman had put much of AIG’s exposure to subprime derivatives on AIG’s books. Another report criticized the Federal Reserve Bank of New York (New York Fed) for failing to negotiate a better deal with the investment banks holding positions with AIG. Neil Barofsky, the special inspector general in charge of overseeing TARP, issued a report in November 2009 that criticized the New York Fed for paying off Goldman and other investment banks in full when AIG was rescued. At the time of that bailout, the chairman of the New York Fed was Timothy Geithner, whose resignation from his current post as treasury secretary was now called for by a group of Republican senators. These criticisms were followed by a demand from some of Goldman’s largest shareholders that some of the money in the bonus pool be used for dividends. In December 2009, the firm announced that its thirty top executives would not receive bonuses, but, instead, would receive stock that could not be sold for five years. The market looked strong enough for the Blackstone Group to announce a plan to sell some of its portfolio companies through IPOs or private place- ments. Blackstone and Fortress Investment Group both had profitable quarters, positioning them to start earning performance fees once again. The private equity group Apollo Global Management announced renewed plans for a NYSE listing. JPMorgan weighed in on October 14, 2009, with a third-quarter profit of $3.59 billion. The Dow passed 10000 that day. IBM announced a 14 percent increase in profits for the third quarter. General Electric reported profits of $2.5 billion for the quarter. Citigroup had profits of $101 million for the quarter on revenues of $20.4 billion, its third straight quarterly profit. Bank of America had a larger than expected third-quarter loss of $1 billion. Charles Schwab experienced a 34 percent decline in profits in the third quarter. Morgan Stanley posted a $757 million profit, its first quarterly profit in a year. Deutsche Bank reported profits of $2.1 billion, but much of that was attributable to tax benefits. Credit Suisse reported a $2.33 billion profit for the quarter. However, UBS posted a loss for the quarter, after sizable assets were withdrawn from the bank as fears mounted over government prosecutions of tax evaders using that bank’s tax shelter programs. Lloyds Banking Group announced a further 1,000 job cuts, bringing its total cuts during the subprime crisis to 9,000. Barclays took write-offs totaling over $10 billion in the first three quarters of 2009 and expected at least another $5 billion in the fourth quarter. However, the bank did have a profitable third quarter. Freddie Mac lost $5 billion in the third quarter. Fannie Mae had a third- quarter loss of $19.8 billion and requested $15 billion more in government bailout funds. This brought the total bailout for Fannie Mae and Freddie Mac to $111 billion. Those two entities faced further large losses in commercial apartment buildings. AIG reported a reversal of collateral flows on its credit-default swaps,

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 678 The Crisis Abates bringing billions back into the firm. It posted its second quarterly profit in a row. Robert Benmosche, the firm’s new CEO, chafed under government pay restraints and threatened to resign, as did five other AIG executives. Ten executives who reported directly to Benmosche had lost a total of $168 million after AIG’s stock tumbled, and they were anxious to recover those losses. Barofsky relented and allowed one AIG executive to receive a $4.3 million bonus so that he would not resign. AIG general counsel Anastasia Kelly, who had led the executive pay revolt against Barofsky, resigned and demanded millions of dollars in compensation pay to which she was entitled under her employment contract if her pay was cut substantially. Kelly was subjected to an investigation by an outside law firm, but apparently they could find no wrongdoing. Kelly, who had formerly served as Fannie Mae’s general counsel during its subprime buildup, was paid $3.9 million in severance by AIG and was replaced by Thomas Russo, who had been the general counsel at Lehman Brothers at the time of its demise. The remaining executives receiving the controversial bonus payments agreed to return $40 million of the $168 million they had received. Barofsky was demanding a return of an additional $5 million, and AIG was trying to claw back that and more by withholding $21 million in bonuses due to workers who had left the firm. This continuing controversy led to another resignation by still another senior executive, John Plueger, the recently appointed head of AIG’s aircraft leasing unit. AIG settled class-action litigation brought by the public pension funds of Ohio, California, and other states for $725 million. Although this settlement was to be funded largely by a new capital raise, the effect was that the American taxpayers who bailed out AIG would bear this cost, directly or indirectly. The number of companies that exceeded earnings expectations set a new record in the third quarter of 2009, but a lot of those earnings were attributable to one-time cost-cutting measures, and revenues actually declined by 10 percent from the year before. Corporate bankruptcies slowed overall. However, Capmark, a major lender to commercial developers, declared bankruptcy as October ended. Housing prices had increased for three straight months, but concern rose that the market could weaken again as home price increases slowed in September. Housing sales were down by 10.6 percent in October from the prior year, and construction was flat, but pending sales were up as a result of the tax credit for new home purchases. Consumer confidence fell sharply in October 2009, but incomes and durable goods orders as well as business spending increased. Manufacturing worldwide increased in September but slowed in October. The stock market was in a slump at the end of October, as the Dow fell to 9762.69 on October 28, 2009. It rallied on October 29, after the release of a report that GDP grew in the third quarter, an increase driven largely by government spending, but the next day that average fell by almost 250 points. The price of gold reached $1,084.30 per ounce on November 4, 2009, and $1,138.60 on November 17. And in the beginning of November,

Warren Buffett announced the purchase of Burlington Northern Santa Fe for $26.3 billion. Issuers sold some $6 billion in corporate bonds in the first week of Novem- ber. Some $90 billion in bonds backed by consumer CDOs had been issued under the TALF program since its inauguration in March 2009, but by November of that year participants had lost interest. The Obama administration proposed that the remaining TARP funds be used to reduce the federal deficit. The Fed announced again that it intended to keep interest rates exceptionally low for an extended period, which meant at least six months. That statement was followed by a report that the unemployment rate had reached 10.2 percent in October, a twenty-six-year high. The stock market, nevertheless, rallied on November 9, 2009, with the Dow closing at 10226.94, its highest level in thirteen months. This did not satisfy some members of Congress, who, led by Representative Ron Paul (R-TX), inserted a provision in the regulatory reform legislation pending in the House Financial Services Committee that would require GAO audits of the Fed. A limited form of that provision and legislation broadly reforming financial services regulation passed the House on December 11, 2009, but passage was delayed in the Senate until July 2010. GDP had declined in the prior four quarters, but in the third quarter GDP growth was reported to be a low but positive 2.2 percent. The Obama administration claimed on October 30, 2009, that the stimulus package had created 640,000 jobs, but the economy lost 175,000 jobs in October alone. The Wall Street Journal claimed that the Obama administration had overstated by 20,000 the number of jobs created by the stimulus. President Obama asserted on November 18, 2009, that the U.S. economy could face a double-dip recession if government borrowing was not curbed. At the same time, however, he promoted health-care legislation under consideration in Congress that would cost nearly $1 trillion over the next decade. President Obama also signed an Executive Order on November 17, 2009, creating a new Financial Fraud En- forcement Task Force to replace the Corporate Fraud Task Force established by the Bush administration in 2002, which had a decided lack of success in its criminal trials and appeals. The creation of this new entity by President Obama followed the high-profile loss of a criminal case brought against two Bear Stearns hedge fund managers after the funds that they managed failed and touched off the subprime crisis. The Treasury was able to sell $44 billion in two-year notes on November 23, 2009, at a record low yield of 0.802 percent. Lloyds raised $14 billion on the same day through a rights offering, but sold the rights at a sharp discount. Loan balances fell by 3 percent in the third quarter. Mortgage delinquencies rose to one in seven residential mortgages that month, up from one in ten a year earlier. The number of homes underwater nationwide reached 23 percent in November. In Florida the proportion was 45 percent, while in Nevada it was 64 percent. The number of bank failures in 2009 reached 125 in November, at which

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 680 The Crisis Abates point the FDIC insurance fund had an $8.2 billion deficit. The number of problem banks rose from 416 to 552 in the third quarter. For the same period, state and city tax revenues declined by 7 percent, and further declines were predicted. California badly needed federal relief to cover a $21 billion shortfall in the state budget. Claims for unemployment benefits fell during Thanksgiving week. Financial markets were disrupted by the announcement on November 26, 2009, that Dubai World, the Dubai government’s investment arm, sought a moratorium on its $59 billion in debt. Japan startled the world on December 1, 2009, by announcing an injection of $115 billion into its economy, which was facing another round of deflation. In-store sales in the United States over Thanksgiving weekend were slightly higher than the year before, but online shopping increased 11 percent over the same period. The Fed’s Beige Book also showed modest improvements in the economy. The price of gold set still another record on December 2, 2009, closing a $1,212 an ounce. Two days later, it fell by $48.60, after a report was released showing that unemployment had fallen to 10 percent and that only 11,000 jobs were lost in November. It was also reported that consumer debt had fallen again in October. The news in the housing market for November, however, was not good. New home sales declined by 11.3 percent. Bernanke faced tough questioning at confirmation hearings for his second term as Fed chairman. He admitted that mistakes had been made all around, testifying that the Fed should have required banks to hold more capital and should have required better risk management controls. He also asserted that regulatory defects had allowed the banks to falter due to subprime lending, not a housing bubble touched off by low interest rates. President Obama announced a plan for $50 billion more in stimulus on December 9, 2009. At the same time, however, the government made it difficult for Citigroup to pay back the first $20 billion in TARP funds received by the bank. Citigroup’s stock had recovered to the point that Kuwait’s sovereign wealth fund was able to sell its $4.1 billion investment in Citigroup at a profit of $1.1 billion, a return on its investment of 36 percent. The Dow closed at 10471.50 on December 11, 2009. President Obama was displeased that bankers opposed his financial reform legislation. He called a group of them to the White House on December 15, 2009, to persuade them to increase lending. In December the government sold TARP warrants received from JPMorgan Chase for $936.1 million and those from Capital One Financial for $146.5 million, bringing the government’s total sales of those instruments to over $3 billion. However, it had to postpone a sale of its Citigroup equity after that financial group had difficulty selling $17 billion in stock on December 16, 2009. Citigroup claimed that the low price on that offering was due to a competing effort by Wells Fargo to raise capital. However, both Wells Fargo and Citigroup repaid a total of $45 billion in TARP funds, leaving $25 billion for Citigroup to repay. Citigroup also terminated the arrangement under which

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. The Rise and Fall of the Subprime Crisis 681 the federal government had agreed to share losses in a pool of what during the height of the subprime crisis had appeared to be $300 billion of potentially bad Citigroup assets. Those and other repayments returned $161 billion of the $245 billion used to rescue some 700 financial institutions under the TARP program. General Motors also announced its plan to repay its $6.7 billion in TARP loans in 2010, which it did, but the government still held a large equity stake from its capital injection under TARP. Fannie Mae and Freddie Mac had disbursed $112 billion of the $400 billion in government funds committed to their rescue. The government disclosed a suspension of purchases of Fannie Mae and Freddie Mac obligations and, instead, a raising of the $400 billion ceiling on its commitment to those GSEs. The government agreed to supply capital to them as needed, thereby creating an unlimited guarantee of their operations. Freddie Mac and Fannie Mae were also allowed to pay their CEOs $6 million each over the next two years. Pending home sales declined in November, but U.S. factory orders rose in that month. Christmas sales were up by 3.6 percent over the prior year, and automobile sales increased by 15 percent in December. Unemployment remained at 10 percent and 85,000 jobs were lost in December. Apartment vacancies were at a high of 30 percent in 2009 and rents were down by 3 percent. The Treasury Department raised a record $2.1 trillion through sales of debt instruments in 2009. The level of junk bond sales also set a record in 2009. David Tepper, a hedge fund manager, made $7 billion on bets in Citigroup and Bank of America shares in 2009, of which he retained $2.5 billion. The stock market as a whole experienced the worst decade ever between 1999 and 2009, worse than even the 1930s. NYSE-listed stocks lost, on average, 0.5 percent each year since 1999. That loss was even greater if inflation is factored in. Nevertheless, the stock market as a whole was up by almost 25 percent in 2009, after falling by 37 percent in 2008. The Dow rose 18.8 percent during 2009, an increase of 61 percent from its March 2009 low. The NASDAQ was up 43.9 percent in 2009 over the prior year, and the S&P 500 was up 23.5 percent. The price of gold at the end of the year was $1,095.20 an ounce, after reaching a record high of $1,217.40 on December 3. The price of crude oil closed for the year at $79.36 per barrel. Global manufacturing increased in December, and U.S. manufacturing grew in that month at the fastest rate in more than three years, but the number of bankruptcies in 2009 was almost one-third higher than in 2008. Venture capitalists began to make more investments in start-up enterprises. However, a survey of start-up companies indicated that less than 20 percent planned to make an initial public offering because of the regulatory hazards associated with that process. Further uncertainty was raised when the Bank for International Settlements invited central bank representatives from the major countries and leading fi- nanciers to a meeting in Basel to discuss concerns that there was a resurgence under way of excessive risk taking by large banks. Large brokerage firms still

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 682 The Crisis Abates handled almost half of the money under management for individual investors, but some brokers fled those firms as compensation limits continued to be an issue. However, adjustments in the delivery of financial services resulting from the subprime crisis had only just begun, with their ultimate course still anyone’s guess, especially with regulatory uncertainty hanging over the market. That uncertainty continued even after the enactment of regulatory reform legislation because of the complexities it involved. JPMorgan reported a profit of $3.28 billion in the fourth quarter of 2009, up from $702 million in fourth quarter of 2008. The bank tried to quell the furor over bonuses by restricting them to half the total amount paid in 2008. That effort failed. Critics pointed out that the bank was still paying out $9.3 billion in bonuses, an average of $378,000 per employee. The JPMorgan CEO Jamie Dimon was given a payout of $17.6 million, mostly in stock. JPMorgan was also requiring the bonus pool to share the cost of a 50 percent surcharge imposed by the English government on bankers posted in London. Most of JPMorgan’s profits were in trading and investment banking. Its retail banking operations posted a loss as a result of mortgage defaults and continuing expenses associated with the acquisition of Washington Mutual Inc. This last bit of news sent the stock market reeling. Citigroup posted a fourth-quarter loss of $7.6 billion, resulting in a loss of $1.6 billion for the year. The Citigroup CEO Vikram S. Pandit agreed to accept only $1 in salary until he returned Citigroup to profitability. Pandit later announced that he planned to sell about 40 percent of the bank’s operations and declared that no bank should be too big to fail. Bank of America lost $5.2 billion for the quarter and $2.2 billion for the year. It was reported in the press that the new Bank of America CEO, Brian Moynihan, was spending about half of his time in Washington, DC, meeting with regulators instead of focusing on bank business. The bank did announce that it was planning to add some 2,000 new brokers in its Merrill Lynch operations. Bank of America and its former CEO Kenneth Lewis were sued by New York Attorney General Andrew Cuomo for failing to disclose the large unexpected losses at Merrill Lynch just before the shareholder vote on their merger. The SEC brought similar charges against the bank but did not attack Lewis. Bank of America settled with the SEC by paying $150 million, money that would come out of shareholders’ pockets. Lewis took home an $83 million retirement package. His successor, Brian Moynihan, was paid $6.5 million in 2009. A Merrill Lynch executive, Thomas Montag, was paid $29.9 million in 2009. Morgan Stanley had a small profit in the fourth quarter but posted a loss for the year. Nevertheless, the company announced that its 2009 bonus pool would be increased over the 2008 amount. The new Morgan Stanley CEO, James Gorman, was paid $15 million for the year. Wells Fargo did better, reporting fourth-quarter profits of $2.82 billion. The Wells Fargo CEO, John G. Stumpf, was paid $18.4 million for his work in 2009.

Goldman Sachs had a staggering profit of $13.39 billion for the year and $4.79 billion for the fourth quarter. The firm had made trading profits of over $100 million on 131 separate trading days during 2009. Bowing to political pressure and public opinion, the firm announced that it was limiting its bonus pool to $16.19 billion, about $3 billion less than expected. Lloyd Blankfein, the Goldman CEO, was given a bonus of $9 million, down from $68 million in 2007. There is, however, more than one way to skin a cat. Blankfein received an additional $18.7 million in 2009 from his investments in Goldman Sachs private equity funds. Another $80 million was paid out to other senior Gold- man executives participating in those funds. American Express reported net income of $52 million in 2009, and its CEO, Kenneth Chenault, was paid $17.4 million for that work. UBS AG reported its first quarterly profit in more than a year but was being hurt by an exodus of wealthy clients concerned with disclosure of their accounts to tax authorities in the United States and Europe. Nevertheless, UBS paid out some $95 million in bonuses for 2009 to its most senior executives, which was ten times the amount paid in 2008. The Government of Singapore Investment Corp., a sovereign wealth fund, reported that the value of its UBS holdings had dropped from $11 billion to $6 billion, a paper loss of some $5 billion. Credit Suisse paid its CEO, Brady Dougan, $17.9 million for his work in 2009 after his bank made a profit of $6 billion. Barclays reported a $14.71 billion profit for 2009, driven largely by profits from its Lehman Brothers acquisition. Deutsche Bank AG posted a profit of $5.4 billion in 2009. Its CEO, Josef Ackermann, was paid $13 million for returning the bank to profitability. Foreign companies were continuing to delist from U.S. exchanges because of regulatory costs and liability exposures from shareholder lawsuits. Among those leaving were Daimler AG, Deutsche Telecom AG, and AXA SA. The federal government was experiencing large profits on the credit-default swaps it had taken over when it bailed out AIG. This was due to a recovering credit market and continued performance on the contracts it had insured with those instruments. In addition, AIG agreed to sell one of its insurance units to MetLife Inc. for $14 billion, of which amount, $9 billion would go to the government as a part of AIG’s bailout obligations. AIG later decided not to sell its derivatives portfolio because it was increasing in value. AIG, nevertheless, suffered an $8.9 billion loss in the fourth quarter. That news was offset somewhat by the announcement that AIG was planning to sell certain of its Asian life insurance operations to Prudential PLC for $35.5 billion, twice what it had been offered for that unit during the peak of the subprime crisis. How- ever, Prudential encountered difficulty in raising the money needed to close the transaction, and the deal fell through after AIG refused to reduce the price by $5 billion. Prudential was required to pay $500 million to avoid closing the sale. Another sale of other AIG operations was made to MetLife for $15 billion. AIG assured Congress in May 2010 that it would repay its obligations to the government from the bailout. The AIG CEO, Robert Benmosche, was

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 684 The Crisis Abates proving to be a prickly presence for government regulators. The AIG board chairman resigned in July 2010 after a dispute with Benmosche. Fannie Mae reported a $15.2 billion fourth-quarter loss and a $72 billion loss for the entire year. Ford Motor Co. posted a surprising profit of $2.7 billion for the year. Ford CEO Alan Mulally’s compensation for 2009 was set at $17.9 million, but increases in the value of his stock options added another $50 million to his compensation package. Ford sold its Volvo operations to Geely Holding Group, a Chinese company, for $1.4 billion, setting the stage for more competition in the auto market. The economy in the United States grew by 5.7 percent in the fourth quarter of 2009. This was the highest growth rate in six years. Inventories were dropping, which was a favorable sign that output would expand to refill inventories. Sales of existing homes were reported to have fallen by 16.7 percent in December, but the rate of mortgage delinquencies slowed in the fourth quarter. Bank lending declined at a rate last seen in 1942. U.S. household debt dropped by 1.7 percent in 2009, the first such decline since records began to be kept for that statistic in 1945. GDP increased by 5.6 percent in the fourth quarter and corporate profits rose by 8 percent during that period. However corporate profits for the full year were down 3.8 percent from those in 2008. Direct compensation for CEOs at public companies fell by 0.9 percent in 2009 to a still healthy $6.95 million. The highest paid executive was Lawrence J. Ellison. He received $85 million for his work in 2009. The real money was made at the hedge funds. The top twenty-five hedge fund managers averaged $1 billion each in compensation in 2009. The highest paid member of that group was David Tepper with $4 billion. New York Stock Exchange member firms reported record profits in 2009 of $61.4 billion.

A New Decade Begins

President Obama went on an attack against Wall Street in January 2010. He first flew to Boston in support of a Senate race for the seat left open by Ted Kennedy’s death, where he bashed the banks. That effort failed, giving the Republicans what they mistakenly thought were enough votes to block the administration’s health care bill. That angered the president and he announced two days later that the large banks would be limited in size and barred from trading for their own accounts. He had also previously announced plans for a tax on the large banks that would pay for TARP. This populist attack on the banks was, according to the New York Times, being fueled by unions that were being hurt by state government and industrial layoffs. The president’s attack on the banks followed a troubling report of job claims increasing to 482,000 in mid-January 2010. It also caused the Dow Jones Industrial Average to drop by 213.27 points. The Obama administration was by this time being criticized for not restoring jobs through its earlier massive stimulus package and for running up staggering deficits.

In another blow to the administration delivered on the same day as the announcement of the Obama bank proposal, the Supreme Court held that campaign spending limits on corporations and unions were unconstitutional, freeing the business community to unleash a counterattack. That did not deter the president. He left the next day for Ohio where he made a campaign-like speech that once again attacked the banks for their acceptance of bailout funds that he demanded be returned in full. That speech, and concerns that Ben Bernanke might not be approved in the Senate for a second term, sent the Dow plunging another 216.90 points. Bernanke was later approved, and he announced a plan to pay banks interest on their excess reserves held at the Fed. It was hoped that this would induce the banks not to reduce reserves as the economy improved. Unemployment dropped in January to 9.7 percent, down from 10 percent in December. However, 20,000 jobs were eliminated in January, and revised figures for 2009 showed that job losses had been much higher than predicted, 1.4 million greater. New single-family-home sales dropped by 11.2 percent in January, but prices were up. BlackRock Realty and Tishman Speyer Proper- ties put the giant Stuyvesant Town and Peter Cooper Village in bankruptcy on January 25, 2009. They had paid $5.2 billion for the property three years earlier. It was now worth less than $2 billion. CalPERS was also an investor in the projects, and it lost $500 million as a result. Despite that setback, BlackRock had a large increase in fourth-quarter income. Consumer borrowing increased in January 2010 for the first time in almost one year. The president released his budget request on February 1, 2010. He was seeking $3.8 trillion in funding, which would result in a record deficit of $1.6 trillion. The budget proposal would raise taxes on those families making over $250,000 by allowing the Bush tax cuts to expire. Continuing economic concerns spurred a market sell-off that occurred on February 4, 2009, pushing the Dow Jones Industrial Average under 10000 before it rose to 10058.64 on February 9, 2009. European markets also fell over concerns with Greek government debt. Speculators using credit-default swaps were blamed for worsening the situation. It was claimed that Goldman Sachs and others arranged swaps that concealed Greece’s true financial condition (and debt) when it was seeking approval from the European Union to use the euro as its currency. Greece was offered a $40 billion support package from the European Union, but it turned out that the Greek debt problem was even worse than expected. Greece then sought to increase the bailout to $60 billion, seeking funds from the European Union and the IMF. That amount proved to be inadequate and a $146.5 billion rescue package was agreed upon at the end of April. However, deadly violence broke out in Greece after the government acted to impose the harsh austerity measures demanded as a condition for the loan. The economic woes of Greece spread to Spain and Hungary. In Italy, a judge authorized criminal proceedings against eleven bankers working at JPMorgan, UBS, and

Deutsche Bank for their role in arranging credit-default swaps on a financing arrangement for the city of Milan that caused losses totaling $2.3 billion. It was also reported that economic growth in Europe had nearly stopped in the fourth quarter of 2009. Gold was dropping by some 14 percent in the first six weeks of 2010. The Dow Jones Industrial Average rallied and reached 10268.81 on February 16, 2010, but consumer confidence was declining. Millions of homeowners were unable or unwilling to refinance their homes to take advantage of lower interest rates. Some 4.3 million homes were subject to foreclosure in February 2010, up from 3.4 million in 2009. Many banks were choosing short sales over loan modifications because loan modifications were generally unwieldy and ineffective in preventing subsequent defaults. The number of modified mortgages that subsequently defaulted doubled in March 2010. The Obama administration was pushing banks to make short sales without recourse to the homeowners for any deficit in hopes this would spur a cleanup of delinquent mortgages. The administration later announced a new mortgage modification program that required mortgage lenders to allow three to six months of reduced mortgage payments for qualifying homeowners receiving unemployment benefits. In response to pressure from Massachusetts regulators, Bank of America announced that it would be reducing mortgage principal for some borrowers by as much as 30 percent. The Fed unsettled the market on February 19, 2010, after it raised its discount rate from 0.5 percent to 0.75 percent. The Treasury Department also announced that it was borrowing $200 billion that it would keep at the Fed for use in its credit operations. TALF ended its program in March 2010. Despite its shaky start, the program had financed some $100 billion in bonds that were backed by consumer debt, including credit cards, student, and auto loans. The program was credited with helping restore this credit market, and was expected to return a profit to the government. The FDIC reversed an earlier position and was challenging a $1.4 billion tax break claimed by JPMorgan Chase under the stimulus bill passed by the Obama administration in 2009 in connection with its acquisition of Washing- ton Mutual. The stimulus bill prohibited banks, like JPMorgan, that received TARP funds from claiming such tax breaks, but Washington Mutual had not taken such funds before its failure. The FDIC was also considering restricting so-called “Christmas capital” claimed by banks as revenue from assets bought at a discount when taking over a failed bank. Housing starts were down 5.9 percent in February due to a number of winter storms. New homes sales in February were the lowest on record and 13 percent lower than in February 2009. However, pending home sales rose by 8.2 percent in February, being spurred by foreclosures and the expiration of a new home tax credit of up to $8,000. The unemployment rate remained steady at 9.7 percent in February and job losses were lower than expected at

36,000. Retail sales also grew during the month. Credit markets were freeing up, allowing corporations to raise almost $200 billion in the first two months of 2010, up almost $40 billion for the same period in 2009. The picture continued to brighten with the Dow closing at 10907.42 on March 30, 2010. The Dow was then up over 67 percent over its March 2009 low and it was the highest close since May 2008. The dollar was strengthening against the euro, reaching $1.33 on March 24, 2010. Crude oil closed at $82.17 per barrel on March 29, 2010. The junk bond market was recovering with $31.5 billion in offerings in March 2010, the highest amount ever for a single month. The number of mortgage delinquencies fell in the first quarter of 2010, the first such decrease since 2006. The number of subprime delinquencies dropped slightly in March, the first monthly decline in four years. Such delinquencies fell from 46.9 percent of subprime mortgages to 46.3 percent. That was up from 6.2 percent in 2006. After much heated debate, the Obama administration’s universal healthcare legislation was passed. It was projected to cost $940 billion over the next ten years. The Congressional Budget Office announced a few days after the signing of that legislation that Social Security would be paying out more than it was taking in during 2010, six years ahead of previous predictions. Several companies announced massive loss charges to cover their expected increased health insurance costs under the Obamacare program. AT&T Inc. announced a $1 billion charge for those expenses; John Deere, $150 million; and Cater- pillar, $100 million. The Obama administration put an end to the private student loan market in 2010 with the passage of legislation that required students and parents to borrow directly from the federal government at a rate of 7.9 percent for parents, 4.5 percent for needy students and 6.8 percent for other students. Sallie Mae then laid off 2,500 employees and Citigroup took a $500 million loss on its student loan business. Jobless claims in the third week of March were the lowest since December 2008. Some 162,000 jobs were added in March, but about one-third of those were government hiring for the upcoming census. The unemployment rate was still high at 9.7 percent. Housing sales rose 27 percent in March, spurred by the $8,000 tax credit for first time homebuyers. Still, personal bankruptcies were up in March with filings at a rate of 6,900 per day. Auto sales were up during March and retail sales increased by 1.6 percent during the month. General Motors repaid $6.7 billion of its $50 billion TARP bailout loan. That payment was ahead of schedule, and the company had a first-quarter profit of $865 million, its first quarterly profit in three years. Chrysler also reported a profitable quarter. Ford posted a $2.1 billion profit for the quarter. The Dow went through 11000 on April 12, 2010, and then went to 11123.11 on April 14. The S&P 500 passed through 1200 on April 12 after JPMorgan Chase reported a 55 percent increase in profits for the first quarter of 2010.

Bank of America also had a good quarterly profit of $3.2 billion that was largely driven by profits at Merrill Lynch. Citigroup weighed in with a quarterly profit of $4.4 billion. The government then announced that it would begin selling its ownership interest in the bank that was taken as a part of the TARP bailout. The SEC agreed to an additional $75 million from Citigroup through the settlement of claims that Citigroup failed to disclose in a timely manner its $40 billion in subprime exposures during the crisis. However, a federal judge objected to the settlement. Goldman Sachs Group Inc. reported a $3.46 billion profit for the quarter, did not experience a single trading day with profits of less than $25 million, and made more than $100 million on thirty-five trading days. Nevertheless, the firm was staggering from a fraud action brought by the SEC concerning one of its subprime deals that is described in Chapter 7. A Senate investigation of the firm was also drawing headlines after a front-page article in theNew York Times reported that Goldman Sachs executives were bragging about making some serious money from shorting subprime mortgages during the crisis. This led to an announcement that the Justice Department would be conducting a criminal probe of Goldman. That report resulted in a $21 billion decline in Goldman’s stock price. Some shareholders sought to curb Goldman’s management through proxy resolutions. One proposal came from the Maryknoll Sisters of Ossining and sought to require greater disclosure on Goldman’s trading activities. It received only 33 percent of the vote. A proposal to split Blankfein’s roles as CEO and board chairman was also defeated but he remained under attack by populist critics. Freddie Mac reported a first-quarter loss of $6.7 billion and was requesting another $10.6 billion from the government. Fannie Mae weighed in with a quarterly loss of $11.5 billion and asked for $8.4 billion more in government funds. This would raise the total bailout to those two entities to $145 billion. Fannie Mae and Freddie Mac owned over 163,000 homes at the end of March that had been taken over in foreclosures. That was more homes than the number existing in some large cities. MBIA, the monoline CDO insurer, had tried to spin off its losses from those instruments but posted a first quarter loss of $1.48 billion. Another monoline insurer, Ambac, reached a deal that cancelled $16 billion in coverage for CDOs.

Recovery is Slow and Uncertain

President Obama traveled to Wall Street on April 22, 2010, to once again chide the bankers on their opposition to his financial reform legislation. He also used the SEC’s fraud case against Goldman Sachs (Chapter 7) as a means to demand more derivative regulation. Banker bashing became a popular pastime after the filing of the SEC’s action. Among other things, the SEC launched a broad-scale investigation of CDOs that was directed at several major financial

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. The Rise and Fall of the Subprime Crisis 689 institutions, including Morgan Stanley, JPMorgan, Citigroup, Deutsche Bank, and UBS, as well as Goldman Sachs. The Justice Department also began an investigation of CDO practices at Morgan Stanley, and Andrew Cuomo, the New York attorney general, began an investigation of eight major financial institutions concerning their role in rating CDOs. More corporate bashing broke out over the massive oil spill from an explosion that destroyed a BP drilling platform in the Gulf of Mexico. The Obama administration came under heavy criticism for responding inadequately to that disaster. The president then began publicly bashing the BP CEO Tony Hayward, stating that he would have fired Hayward if he worked in his administration. Hayward was then hauled before a congressional committee and given a pillorying that exceeded even the bombast in the Enron and subprime compensation hearings. The president also promised on national television that he was looking for some “ass to kick.” Hayward was removed from office by the BP board shortly afterwards. The president suspended all offshore drilling. After complaints were received that this would idle thousands of workers, the president demanded that BP pay their lost salaries, as well as the entire costs of the cleanup. Demands were being made that BP suspend its quarterly dividend, and the president ordered that BP create a multi-billion dollar fund to cover cleanup costs. BP thereafter agreed to those requisites, cutting its dividend and creating a $20 billion cleanup fund. The British government protested these attacks on one of its most important businesses. These attacks and the damage estimates from the oil spill caused BP’s stock price to be cut in half, shedding over $82 billion in value. Adding further to the company’s woes, a criminal investigation of the circumstances surrounding the explosion and spill was announced. President Obama also found himself in a slanging match with WellPoint Inc. CEO Angela Braly. Obama accused WellPoint of cutting off coverage of women with breast cancer during his weekly radio address on May 8, 2010. Braly then sent the president a letter in which she stated that he was spreading false information, and that her company had not singled out breast cancer pa- tients for rescission of coverage. However, WellPoint was forced to reduce its request for a 39 percent increase in premium costs in California to 14 percent, which the company predicted would cause it to lose $100 million. The unemployment rate rose to 9.9 percent in April even though the number of jobs increased by 290,000 during the month. The increase in the unemployment rate was attributed to a return of workers who had given up seeking employment until the economy strengthened. Inflation was at a forty-four year low as April ended, rising at a rate of less than 1 percent. Sales of new homes rose by 14.8 percent in April 2010, as the first-time home-buyer tax credit continued to attract buyers. The financial markets caused grave concern on May 6, 2010, when the Dow Jones Industrial Average dropped by almost 1,000 points in just a few minutes—the “flash crash.” The sell-off was variously attributed to trading

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 690 The Crisis Abates errors, uncertainty in Europe over economic conditions, a Procter & Gamble sell order, a large trade on the Chicago Mercantile Exchange by Waddell & Reed, a mutual fund, and a large options trade by a hedge fund advised by Nassim Taleb of “Black Swan” fame, which may have triggered high-frequency algorithmic sell orders. Even after several months of investigation, the SEC remained uncertain as to what was the actual cause of the crash. Mary Scha- piro, the SEC chair, summoned the leaders of the exchanges to Washington and they agreed to adopt circuit breakers to interrupt trading when such a sharp downturn begins. Schapiro blamed a lack of uniformity in exchange rules as furthering the problem. She also demanded that the exchanges build a multi-billion dollar repository for trading data so that future events could be more easily traced. The exchanges announced that trades executed at a price of more than 60 percent below the share prices at the time of the flash crash would be cancelled. This resulted in howls of outrage from traders who thought they had made the killing of a lifetime. Algorithmic traders were also under attack for using their computers to analyze price data faster than more conventional traders. The financial crisis that began in Greece continued to spread. The European Union announced a $1 trillion bailout for the affected countries on May 10, 2010. The IMF was to supply about one-half of that funding. The European Union had been prodded into action by the Obama administration, which reopened a swap facility with the European Union Central Bank that had been employed during the subprime crisis to assure liquidity in Europe. The crisis was driving down the euro and pushing gold to a new record of $1,219.90 per ounce. The euro hit a four-year low on May 19, 2010, falling to $1.21. Germany imposed restrictions on naked short sales on that day as a renewed credit crunch struck European borrowers. This unilateral and unexpected action by Germany sent stock markets reeling and irritated other European Union members. Germany also announced a $95 billion reduction in its government budget, as economic conditions in that country continued to falter. Great Britain announced that it too would be cutting public sector spending. France followed with a $54.8 billion cut in spending. The ECB predicted that Euro- pean Union banks would have to write off some $240 billion of their assets over the next two years. The Dow Jones Industrial dropped by 376 points on May 20, 2010, closing at 10068.01. However, there was some good news. Residential mortgage rates were at a near fifty-year low in the United States. The yield on two-year Treasury notes was the lowest in history on May 25, 2010. The Dow dropped below 10000 on May 26, 2010, and finished the month with the worst decline for the month of May since 1940. Home sales dropped in May after the expiration of the first-time homeowner tax credit. New homes sales dropped to the lowest level since record keeping for such statistics began in 1963. Auto sales and manufacturing were up for the month, but retail spending was lagging.

June began with a disappointing jobs report in the United States, causing a steep market sell-off. The Dow Jones Industrial Average dropped by over 12 percent between April 26, 2010, and June 11, 2010. It then rallied for a few days before faltering again. The Fed announced on June 23, 2010, that it expected the economic recovery in the United States to remain weak and that interest rates would remain unchanged at near zero for an extended period of time. Lincoln National, the insurance company, announced on June 14, 2010, that it would be raising over $1 billion to repay its TARP bailout. At the same time, state insurance regulators disclosed that they were backing down from a proposal that would have imposed steep capital charges for insurance companies investing in mortgage-backed securities. Marsh & McLennan agreed in June 2010 to pay $500 million to settle Enron-era charges that it mishandled pension funds of the State of Alaska between 1992 and 2004. The Group of Twenty meeting in Toronto on June 28, 2010, was marred by violent protests. The leaders attending the event rejected President Obama’s plea for them to continue stimulus spending. Instead, they agreed to cut their deficits in half over the next three years and to reduce stimulus spending. This reflected not only a concern over deficits but also a belief that economies outside the United States were recovering. The Bank for International Settle- ments also warned against the risks of growing deficits and of keeping interest rates too low for too long. The European Central Bank created some turmoil when it announced that it was not renewing a bank liquidity facility, thereby requiring banks to repay over $500 billion in one-year funds. The Dow Jones Industrial Average dropped by 268.22 points on June 29, 2010, over concerns with diminishing consumer confidence. The Dow dropped under 10000, settling at 9870.30. That average was down 12.8 percent from its high for the year at the end of June. It dropped again on July 2, 2010, after a discouraging jobs report was released. That report disclosed that, while the unemployment rate had fallen from 9.7 percent to a still unhealthy 9.5 percent, that drop was due to the fact that the labor force had decreased by 652,000. Only 83,000 new jobs were added in June and nonfarm payroll dropped by 125,000 after the temporary census workers were discharged. The market rallied on July 6, 2010, pushing back through 10000 and then the stock market had its best week in nearly a year. Wall Street was hiring again. JPMorgan reported a second-quarter 2010 profit of $4.8 billion, up 76 percent from a year earlier. However, the bank reported that losses from consumer loans remained at extremely high levels. Bank of America had a second-quarter profit of $3.1 billion, a drop of 3 percent from the year before. The bank also announced that it was projecting a loss of $4.3 billion in revenue as the result of the new financial services legislation and that it would take a $7 to $10 billion charge for costs associated with that legislation. AIG lost $2.7 billion in the second quarter, but the loss was lower than

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 692 The Crisis Abates expected. AIG announced that it was in talks with the government on repayment of its bailout funds, and its aircraft leasing unit repaid $3.9 billion to the government later in the year. AIG also disclosed plans to make a public bond offering. Citigroup had a second-quarter profit of $2.7 billion, which was 37 percent lower than the prior year. General Electric had a second-quarter profit of $3.1 billion, a 16 percent increase in profit over the year before. Goldman Sachs experienced an 82 percent decline in earnings in the second quarter due to a $550 million settlement with the SEC (described in the next chapter), increased taxes and losses in the equity market. UBS had second-quarter profits of $2 billion. It also announced that it was hiring executives from Goldman Sachs and Bank of America in order to beef up residential mortgage lending through its U.S. brokerage unit. Apparently UBS was prepared to once again face the risks of such lending. Morgan Stanley reported a profit of $1.96 billion, triple that of Goldman Sachs. Wells Fargo was down 3.5 percent for the quarter. MF Global Holdings posted a quarterly profit, after posting losses in the prior six quarters. That firm was headed by Jon Corzine, the former New Jersey governor and head of Goldman Sachs. He was brought in to turn MF Global around after he lost a Senate race. Apple, Microsoft, and Intel reported high earnings in the second quarter. Dell, the computer company, removed a cloud over its head with a $100 million settlement with the SEC, and Michael Dell, the company’s founder, paid $4 million to settle account manipulation charges for the period 2002 to 2006. Mark Hurd, the CEO at Hewlett-Packard Co. (H-P), was forced to resign after discovery that he had falsified expense reports for a contractor with whom he had a relationship. Hurd received a $35 million severance package and joined rival Oracle. H-P sued to stop that hire, but quickly settled. AT&T, Caterpillar, John Deere, and 3M had strong quarters. The airlines were also returning to profitability. Ford reported a profit of $2.6 billion in the second quarter, a 13 percent increase over that of the prior year. Bill Ford, the executive chairman at Ford, had forgone any compensation for the prior five years, but was given $15 million in compensation after the company announced its second-quarter results. He also cashed in $28 million in options stock after that announcement. Auto sales continued to increase in July, and General Motors reported a second-quarter profit of $1.3 billion. Its CEO, Edward Whiteacre Jr., stepped down and was replaced by Daniel Akerson. He was the fourth person to serve in that position over the last eighteen months. General Motors announced plans for an initial public offering in August 2010 that was expected to raise some $15 billion. Some lessons are never learned. General Motors also announced that it was paying $3.5 billion for AmeriCredit, a large subprime consumer lender. First-quarter growth in the U.S. was revised upward to 3.7 percent, but second-quarter growth was slower than expected, dropping to 2.4 percent, later revised downward to a troubling 1.6 percent. The Fed was predicting a moderate 3 percent growth rate in 2010 for the U.S. economy as the third

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. The Rise and Fall of the Subprime Crisis 693 quarter began. The consumer savings rate was up in May and June reaching 8 percent and 6.4 percent respectively, an increase from the pre-crisis rate of less than 2 percent, and an indication of continuing concerns by consumers with the economy. The trade deficit was increasing, as was the federal budget deficit. The eurozone economies were picking up after their stimulus package was rolled out in June. The results of European bank stress tests were announced on July 23, 2010. Only seven failed to pass, raising criticism that the tests were too lenient. The German economy was showing particularly strong signs of growth, but was facing a rising budget deficit. New single-family home sales in the United States jumped in June and housing prices rose in May. However, the housing market was still uncertain. Inventories were increasing and housing starts and sales were slowing as the loss of the $8,000 first-time home-buyer tax credit reduced interest in the market. Indeed, new homes sales dropped in July to a fifteen-year low, falling by 27 percent over the prior month. Nevertheless, the fixed rate for thirty-year mortgages fell to 4.49 percent in the first week of July, touching off a wave of refinancings. Fannie Mae posted a quarterly loss of $1.2 billion, after paying the government $1.9 billion in dividends for the use of its bailout funds. This was Fannie Mae’s lowest loss in three years, but it asked for $1.5 billion more in government bailout funds. Freddie Mac’s loss for the second quarter was $4.7 billion, and it sought an additional $1.8 billion in bailout money. The unemployment rate in the United States remained at 9.5 percent in July, with job losses of 131,000. At that time, over 11 percent of consumer debt, totaling $1.3 trillion, was delinquent. Some $30 billion in home equity and consumer lines of credit has been written off in the first seven months of 2010. Some one in seven mortgages in amounts of more than $1 million were also delinquent and one in twelve mortgages of less than $1 million in value were in the same condition. The Federal Reserve Board was funding most mortgages through its lending facilities, and had been doing so for over a year. The total for that funding exceeded $1 trillion. The government mortgage modification programs were still struggling in July. Over 600,000 trial modifications were cancelled after homeowners failed to meet their reduced obligations. This was about half of all the trial modifications made under the Home Affordable Modification Program (HAMP). Only 420,000 trial modifications had been made permanent at this point and the number of applications for modification under the program had slowed to a trickle. KKR withdrew plans for a $500 million stock offering on August 9, 2010, after it reported a 92 percent drop in earnings for the second quarter over the year prior. This was KKR’s first earnings report after its listing on the New York Stock Exchange. Quant hedge funds, those using quantitative analysis to guide their trading, had shrunk from about $1.2 trillion under management when the subprime crisis began in 2007 to less than $470 billion in August 2010 as investors lost faith in their profit-making abilities. On the other hand,

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 694 The Crisis Abates global merger activity was growing in August, including a $7.7 billion purchase of McAfee by Intel and a hostile takeover offer by BHP Billiton of $39 billion for the Potash Corp. in Canada. The Fed expressed concern on August 10, 2010, with the pace of the economy recovery and announced it would be buying Treasury bonds in order to boost liquidity. The Fed governors were split over whether to shrink its balance sheet by selling of assets. Bernanke persuaded a majority to maintain the assets, which if sold would reduce the money supply. This division was accompanied by renewed concerns with a possible “double-dip” recession, and the Dow dropped by 265.42 points on August 12, 2010, in response to those concerns. A technical indicator developed by James Miekka, called the “Hin- denburg Omen” (named after the famous dirigible explosion), was predicting a market crash in the next few months. This uncertainty was driving investors out of the stock market and into bonds, pushing yields down to very low levels. The thirty-year Treasury bond was yielding 3.67 percent on August 20, 2010 and the five-year Treasury only a meager 1.47 percent. Investors withdrew over $33 billion from equity-based mutual funds between January and July 2010. Foreign issuers were also making Yankee bond debt issues in the U.S. in record numbers. Even junk bond offerings were at a record rate for the total amount of issuance as investors retreated from equity. However, new layoffs were planned for Wall Street as the stock market faltered. At this point, the only thing clear was that the country had survived the subprime crisis, but it faced uncertainty over the recovery that seemed to be faltering in the third quarter of 2010. The upcoming mid-term elections were focusing on the economic problems that the Obama administration had, so far, been unable to fix. It appeared that the Obama stimulus package passed the year before was another costly failure. Politicians who voted for TARP were facing especially tough fights for reelection in November, a subject that was pushing health care aside as the hot button political issue. Another troubling financial indicator was emerging: the federal budget deficit for the fiscal year ending September 30, 2010, was a massive $1.65 trillion, an increase in excess of $1 trillion over the past two years. This was the largest deficit in percentage terms since World War II. The Republicans went on attack in the mid-term elections charging the Democrats with reckless spending as the cause of the deficit increase. A political fight was also brewing over whether the Bush tax cuts should be renewed before their expiration in 2011. The Obama administration was seeking renewal only for those taxpayers making under $250,000, while Republicans, and some Democrats, were seeking renewal of all the cuts. The Republicans claimed that it was the wealthy that created jobs and a tax increase would discourage those entrepreneurs from growing their businesses. The Democrats were continuing their populist campaign against the wealthy and were claiming that the tax increase would cut the deficit. They found an unexpected ally in Alan Greenspan, who was seeking to restore his tattered reputation by supporting more regulation and higher taxes, things that he had opposed while serving as chairman of the Fed. Meanwhile, it was reported in

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. The Rise and Fall of the Subprime Crisis 695 the press that the wealthy were engaging in a number of tax planning moves to cut their taxes in anticipation of the expected tax rise in 2011. President Obama’s “Recovery Summer” campaign failed to jump-start the stalled economy. Unemployment was at 9.6 percent as the third quarter ended. The president was under fire for his failed stimulus package, and it appeared that his party would lose control of the House and possibly the Senate. More criticism of the administration followed reports that stimulus checks in amounts of $250 were sent to 89,000 individuals who were either dead or in jail. It was also reported that Los Angeles spent $111 million in stimulus funds to save fifty-five jobs, at a cost of about $2 million per job. The Washington, D.C. area, where the funds were least needed, received nearly 300 percent more stimulus funds per capita than the rest of the country. The National Bureau of Economic Research (NBER) announced in Septem- ber 2010, rather belatedly, that the Great Recession had ended fifteen months earlier, in June 2009. There was little jubilation, since some 330,000 jobs had been lost after the recession ended. This was the longest economic downturn since the Great Depression and caused a loss of 7.3 million jobs, as well as an average decline of 21 percent in individual net worth. One in seven Americans were living in poverty in 2010, and almost half of all Americans were living in a home receiving government entitlements. Federal regulators seized three large “wholesale” credit unions in Septem- ber 2010. Those institutions provided financing and back-office services to retail credit unions. The government extended a $30 billion guarantee for the remaining wholesale credit unions and held credit union assets once valued at $50 billion for liquidation. Some 280 banks had failed between September 2008 and September 2010 and some 10 percent of all banks were on the FDIC watch list. However, many banks doubled their earnings in the third quarter by reducing loan loss reserves. The stock market faltered over the summer but gained during September and passed through 11000 on October 8, 2010. Foreign currency trading was at a record level, as the value of the dollar plunged to a record low. Gold rose to an incredible $1,370 an ounce in October. Other commodity prices were soaring, including cotton, which rose to a level that had not been seen since the civil war. Bank of America, JPMorgan Chase and GMAC Mortgage temporarily suspended further housing foreclosures in October because of documentation problems, apparently caused by the “robo-signing” of mortgage documents. Fannie Mae and Freddie Mac were holding nearly 200,000 foreclosed homes, double the amount of the prior year. The Fed was continuing its efforts to inflate the economy by low interest rates and quantitative easing through asset purchases. In the meantime, GDP grew by only a disappointing 2 percent annual rate in the third quarter.

What Caused the Subprime Crisis?

Little attention was being paid to the root causes of the subprime crisis in its aftermath. Congress had created a Financial Crisis Inquiry Commission (FCIC) when it enacted the Fraud Enforcement and Recovery Act in May 2009. That commission was tasked with determining the cause of the subprime crisis. Although FCIC was supposed to be bipartisan, its chairman was an extremist corporate governance activist, Phil Angelides, a former treasurer of California. Angelides was known for his support of the California Public Employees’ Retirement System (CalPERS) corporate governance campaigns. He was in all events unhurried and disorganized. FCIC did not begin its investigation until January 2010 and did not plan to file a report until the end of the year, and its hearings were desultory and few and far between. The FCIC made a few headlines by attacking Goldman Sachs’ lack of cooperation with its investigation. Those charges were made in the wake of a sensational lawsuit by the Securities and Exchange Commission (SEC) against Goldman Sachs (described below), and looked like just more piling on for publicity. The FCIC also issued a number of preliminary staff reports that variously stated that inflated ratings by the rating agencies “may have contributed” to the crisis; that “shadow” banking activities conducted by non-traditional financial institutions were vulnerable to financial stress because of high leverage, reliance on short-term credit and lack of a government guarantee for their debt; that there is an ongoing debate over whether securitization increased mortgage default rates and whether federal legislation led to increased subprime lending. Another staff report reviewed the growth of subprime lending at Fannie Mae and Freddie Mac. FCIC’s slow pace apparently led the president and Congress to write it off as a non-starter, and they pushed forward with regulatory reform legislation without stopping to determine what flaws in the present system had allowed the subprime crisis to arise unnoticed by regulators. The legislation that was passed in July 2010 was over 2,300 pages in length and intruded into every corner of finance, but offered no assurance that another financial crisis would

696

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. Regulation, Reform, and the Subprime Crisis 697 not occur in the future. Before describing that legislation, some consideration needs to be given to the root causes of the crisis.

Subprime Affirmative Action

Former treasury secretary Henry Paulson blamed the crisis on “bad lending practices.”1 Fed chairman Bernanke contended the cause was foreign investors with an overly large appetite for subprime securities, causing U.S. banks to lower their credit standards in order to meet that demand.2 Ber- nanke and President Obama blamed AIG’s failure on irresponsible bets on credit-default swaps. The new treasury secretary, Timothy Geithner, blamed compensation practices that inspired excessive risk taking at financial services firms. Actually, government housing policy can be more fairly blamed for laying the groundwork for the subprime crisis. That policy sought to aid the poor, especially racial minorities that historically have been the subject of discrimination, by providing financing that would allow them to live in their own homes. Although well intended, that policy was badly flawed in its implementation. The federal government forced the banks and the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac to make subprime loans in massive quantities. That effort began with the passage of the Home Mortgage Disclosure Act (HMDA) of 1975,3 which required banks to disclose the source of their mortgage loans. This was an attack on the practice called “redlining,” whereby banks refused to lend into areas with higher default rates. The “redlined” neighborhoods were often where minorities were concentrated. That legislation was followed by the Community Reinvestment Act (CRA) of 1977, which required banks to meet the credit needs of minorities. Under CRA, banking regulators scored banks on the amount of their loans to poorer neighborhoods. CRA scores were required to be considered by banking regulators before approving bank mergers. The CRA had little immediate effect until the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 removed restrictions on interstate mergers. The removal of those and other barriers to expansion set off a boom in bank mergers. The Clinton administration took advantage of the demand for bank mergers through its National Homeownership Strategy, which sought to increase lending to subprime borrowers through the pressure of the CRA. To demonstrate that the administration meant business, as one author asserts:

Banks were compelled to jump into line, and soon they were making thousands of loans without any cash-down deposits whatsoever, an unprecedented situation. Mortgage officers inside the banks were forced to bend or break their own rules in order to achieve a good Community Reinvestment Act rating, which would please the administration by demonstrating generosity to underprivileged borrowers even if they might default. Easy mortgages were the invention of Bill Clinton’s Democrats.4

The Federal Reserve (the Fed) also adopted new CRA requirements that, “in the words of the Federal Reserve Governor who wrote the regulations, set up soft quotas on lending in underserved areas.”5 In order to please regulators, banks made pledges of hundreds of billions of dollars in CRA loans. Bank of America announced a ten-year CRA subprime lending pledge of $750 billion in 2003. JPMorgan Chase made a larger $800 billion CRA pledge. Citibank made a ten-year $115 billion CRA pledge in 1999. Washington Mutual made a CRA pledge of $120 billion in 1998. Between 1992 and 2007, CRA pledges totaled over $4.5 trillion. The Clinton administration’s CRA efforts led to an 80 percent increase in the number of subprime mortgages. In 1995, banks were allowed to move their CRA loans off their balance sheets through securitizations. Bear Stearns made its first such offering in 1997, a $385 million offering. The firm underwrote an additional $1.9 billion in CRA securitizations over the next ten months. Ten years after that offering, such securitized loans would destroy that venerable firm and push Wall Street to the subprime abyss. The government also made it easy for the banks to obtain loans to meet these commitments by giving CRA credit for purchases of subprime mortgages originated by nonbank subprime lenders. This led to “warehouse” operations, in which mortgages were purchased from nonbank originators and then resold through securitizations.

CRA “Extortion”

Community activist groups used the CRA to demand funding for their organizations from banks as a condition of not protesting mergers on CRA grounds. The “CRA put a wad of power in the hands of community organizations to damage banks that they felt weren’t doing enough for poor people. These community organizations became the dispensers of money for zero-down mortgages for poor people, again a lovely thing, but it didn’t turn out so well.”6 Many large banks gave in to this CRA “extortion.” Senator Phil Gramm (R-TX) inserted a provision in the Gramm-Leach-Bliley Act in 1999 that required reports to be filed disclosing any CRA “extortion” payments, in order to discourage such activities. These community activist groups were another part of the federal housing policy that seeks to expand subprime lending regardless of the risks. This support is carried out through the Community Reinvestment Corporation, under the name NeighborWorks America. It is a congressionally chartered public nonprofit corporation, chaired by a Fed governor. It seeks to increase opportunities for families to live in affordable homes through networks of local partnerships, which grew to include some 236 organizations operating in more than 3,000 communities. Among other things, NeighborWorks administers a program that pays community organizations millions of dollars to provide counseling services for distressed subprime borrowers. One such recipient was the Association

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. Regulation, Reform, and the Subprime Crisis 699 of Community Organizations for Reform Now (ACORN), a community organization. ACORN’s Web site described itself as “the nation’s largest grassroots community organization of low- and moderate-income people with over 400,000 member families organized into more than 1,200 neighborhood chapters in about 75 cities across the country.”7 Congress gave ACORN $25 million in 2009 to counsel subprime lenders with problems repaying their mortgages, as part of a $333 million program for such counseling. About 2,700 such counselors were approved by HUD for this National Foreclosure Mitigation Counseling program, which, in addition to ACORN, included the Neighborhood Assistance Corporation, the Home Ownership Preservation Foundation, and the National Foundation for Credit Counseling. ACORN was at the center of the policies and programs that led to the massive increase in subprime lending but was accountable to no one. It was widely engaged in political activities in support of liberal candidates and was closely associated with the Obama presidential campaign. ACORN’s political activities led to scandals over what was claimed to be its fraudulent registration of voters, leading to numerous indictments in several cities across the country. Another scandal arose in September 2009, after FOXNews broadcast an undercover film in which two individuals pretended to seek counseling at ACORN offices in Washington, DC, Baltimore, Maryland, and Brooklyn, New York. They were seeking advice on how they could obtain a mortgage loan on a building so that they could start a brothel. One ACORN representative suggested that they use the term “performing arts” rather than the word “prostitute” on their loan application when describing the female applicant’s profession. They were advised on how to evade taxes and launder money. An ACORN representative further suggested that underage girls the filmmakers stated were being imported for prostitution should be referred to as “exchange students.” One ACORN representative even offered to help smuggle the girls into the United States. ACORN could not survive that publicity and was disbanded in March 2010 after its funding dried up. That still left open the question of how such an operation could be so deeply involved in national housing policy and be funded by taxpayers. Incredibly, the Democrats, led by Barney Frank (D-MA) were seeking to extend the CRA to nonbanks in September 2010. Lending to illegal aliens (“undocumented workers”) was another subprime favorite for activist groups. These loans were made to individuals without a Social Security number, but who did have an individual taxpayer identification number (ITIN). Several large banks, including JP Morgan Chase, were making these loans. Citigroup was making ITIN loans through a joint venture with ACORN. ITIN loans were first made in 2003, but they ran into much opposition from groups opposing illegal immigration. Efforts in Congress to pass immigration bills that would recognize undocumented workers failed, and many lenders pulled out of the program because of this controversy. The Mortgage Guarantee Insurance Corp. (MGIC) also stopped insuring ITIN loans in 2007.

Down Payment Policies

NeighborWorks America adopted a model affordable mortgage that required a down payment of only 5 percent. Significant down payments had long been considered an important tool for ensuring repayment of loans. However, as evidenced by the NeighborWorks proposal, that protection was being abandoned as a part of government and quasi-governmental policy:

In 1989 only 7 percent of home mortgages were made with less than 10 percent down payment. By August 1994, low down payment mortgage loans had increased to 29 percent. This trend continued unabated throughout the 1990’s so by 1999, over 50% of mortgages had down payments of less than 10%. In 1976 the average down payment by first time homebuyers was 18%, by 1999 that down payment had fallen to 12.6%. In 1999, more than 5% of all residential mortgages had no equity or had negative home-equity.8

The Federal Housing Administration (FHA) also lowered its standards and required only a 3 percent down payment. In 2004, President George W. Bush proposed a Zero-Down Payment Initiative that would have allowed FHA loans with no money down. Congress failed to act on that proposal, but a rising housing market obviated the need for such a program. “By 2005, a remarkable 43 percent of all first time homeowners put zero down or took out a mortgage in excess of the value of the home. If home prices were rising 10 percent a year, a zero down loan would gain a 10 percent equity stake in just 12 months. Or so the logic went.”9

Safety and Soundness Concerns

The Fed advised banks that CRA loans were to be made in a safe and sound manner, but subprime loans are by definition unsafe and unsound because the borrower has a poor credit history. The Fed has also argued that the CRA did not cause the subprime crisis because many subprime loans were issued by nonbanks and did not receive CRA credit.10 The staff of the FCIC also noted in a preliminary report that various studies questioned whether CRA loans were at the center of the defaults that occurred during the crisis and that subprime lending had soared outside the CRA-based lending. However, those claims ignore the fact that the CRA and government policy required and legitimatized this lending by large banks that had avoided such loans in the past. As former Fed chairman Alan Greenspan testified before Congress in October 2008: “Its instructive to go back to the early stages of the subprime market, which has essentially emerged out of the CRA.”11 Subprime lending increased by almost 40 percent between 1993 and 1998. The amount of securitized subprime mortgages grew from about $11 billion in 1994 to more than $140 billion in 2002.12 The share of subprime loans increased from less than 5 percent of home mortgages in 1994 to almost 20

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. Regulation, Reform, and the Subprime Crisis 701 percent in 2007. Subprime loan volume in the United States was estimated to be about $90 billion in 1995, and it expanded to $175 billion in 1998. That amount more than doubled by 2007. The government opened the door to the subprime market, pushed the banks through, and the banks then gorged themselves on what they believed to be a legitimate, socially responsible business for which they could model and hedge for its inherent risk. As former Senator Gramm opined: “It was not just that CRA and federal housing policy pressured lenders to make risky loans—but that they gave lenders the excuse and regulatory cover.”13 Historically, subprime and Alt-A loans were more costly to the lender to originate, to sell, and to service than conventional prime loans, and posed greater credit risk. Nevertheless, after being forced into the market by the government, investment banks soon found the business to their liking. Subprime lenders were initially non-banks until the CRA pushed the large banks into that market. There were only ten lenders in the subprime market in 1994, but that number increased to fifty by 1998. By 2001, ten of the twenty-five largest subprime lenders were banks or their affiliates. Investment banks like Merrill Lynch and Bear Stearns also became competitors in this market, spreading the cancer even further into the financial system. The banks found that subprime loans had their attractions. As with other mortgages, the lender made profits based on the spread between the funds it borrows and those it lends to the subprime borrower. Subprime interest rates had a spread of 300 or more basis points over conventional loans, and the high origination and other fees charged for subprime loans tempted lenders to originate large amounts of subprime loans. However, the default risk was traditionally considered too high for the conventional commercial and investment banks. They solved that problem through securitization, which made meeting CRA pledges easy and encouraged banks to plunge deeply into this market to meet their CRA quotas and carry out their merger programs.

Freddie Mac and Fannie Mae Quotas

Subprime lending was accelerated by the pressure placed on Freddie Mac and Fannie Mae by the Clinton administration to extend their operations into subprime mortgages. Fannie Mae and Freddie Mac were also pushed into the subprime business by Congress, which, in 1992, set specific volume goals for subprime lending by those GSEs for 1993 through 1995. Thirty percent of units financed were required to be for low- to moderate-income borrowers, and 30 percent had to be for properties located in large cities. In addition, these GSEs were required to make $3.5 billion in loans to subprime borrowers. These programs added new risks to the already complicated portfolios of these two GSEs. In 1996, HUD secretary Henry Cisneros mandated that Fannie Mae and Freddie Mac meet a quota in which 42 percent of their loan purchases and guarantees had to be for low- and middle-income families. In November

1999, Fannie Mae vice chair Jamie Gorelick announced, with much fanfare, that Fannie Mae would make $18 billion available in New Jersey alone for subprime loans, including those for no money down. The Clinton administration’s role in the subprime crisis did not pass entirely unnoticed. Cisneros was the subject of a front-page article in the New York Times on October 19, 2008, charging him with unleashing the subprime crisis by extending government loan programs to borrowers who could not afford a mortgage. After leaving the government, Cisneros was elected to the boards of KB Homes and Countrywide Financial Corporation, one of the nation’s largest home builders and one of the largest subprime mortgage lenders, respectively. Countrywide was a leading lender of subprime mortgages and had to be rescued during the subprime crisis by Bank of America, which in turn was bailed out by the taxpayers through TARP. KB Homes suffered massive losses during the subprime crisis and was accused by the Justice Department of misconduct in sales programs. At Fannie Mae, Franklin Raines expanded subprime exposure by loosening credit requirements. He had disparaged the risks of subprime lending by Fannie Mae, asserting in 2003 that its risk-based capital requirement would “protect us from failure under extreme interest rate changes, sustained, Depression-era credit conditions and catastrophic operations or management failure.”14 He noted that, even though it was a privately owned company, Fannie Mae was “an instrument of national housing policy.”15 He boasted that both Standard & Poor’s and the Corporate Library had given Fannie Mae high marks for its corporate governance structure. During his tenure at Fannie Mae, Raines expressed pride in the fact that Fannie had reduced the size of mortgage down payments from 10 to 20 percent of home value to $500. He was also pleased that many lenders were making loans with no down payment. He was equally proud of the fact that Fannie Mae had launched an American Dream Commitment to provide $2 trillion in subprime mortgages in the first ten years of the twenty-first century, which it soon increased by another $300 billion. Raines stated in 2003: “No single company in America provides more mortgage funds to underserved [subprime] families than we do. That, I believe, is the true test of whether we lead the market.”16 It was also the formula for the failure of Fannie Mae and Freddie Mac, as well as nearly destroying the nation’s economy. In September 1999, Fannie Mae announced an easing of lending requirements on subprime mortgage loan applications in order to increase homeownership rates for low-income borrowers. The program was intended to encourage banks to make loans to such borrowers, even though they were not able to meet the standards required for conventional loans. In another act of recklessness, Fannie Mae reduced down payment requirements.

Over the past decade Fannie Mae and Freddie Mac have reduced required down payments on loans that they purchase in the secondary market. Those requirements

have declined from 10% to 5% to 3% and . . . Fannie Mae announced that it would follow Freddie Mac’s recent move into the 0% down payment mortgage market. Although they are buying low down payment loans, those loans must be insured with “private mortgage insurance” (PMI). On homes with PMI, even the closing costs can now be borrowed through unsecured loans, gifts or subsidies. This means that not only can the buyer put zero dollars down to purchase a new house but also that the mortgage can finance the closing costs.17

Fannie Mae and Freddie Mac also ignored economics and sound business practices in order to further subprime growth. Fannie Mae subprime loans were issued at only one percentage point above that of a conventional thirty- year fixed mortgage, rather than the three- or four-point spread required for private market subprime loans. This meant that it was not being adequately compensated for this risk.

Andrew Cuomo

Andrew Cuomo succeeded Eliot Spitzer as a crusading New York attorney general. Cuomo had run unsuccessfully as a Democratic candidate for governor of New York in 2002. Cuomo was a lackluster campaigner who needed some pizzazz in order to resonate with voters. He decided not to seek the nomination for governor in 2006 because Eliot Spitzer had announced his candidacy and appeared unbeatable. Cuomo then ran for the post vacated by Spitzer as New York attorney general. Cuomo won that election, but it was the closest state- wide election in a year when Democrats swept the Republicans from office. Cuomo, nevertheless, was now positioned to follow Spitzer as governor in a future election, provided that he could garner sufficient publicity as a crusading attorney general, with Wall Street providing the perfect target and headline generator. Although Cuomo lacked much of Spitzer’s rancor, he was just as aggressive as Spitzer in seeking headlines from Wall Street prosecutions. Cuomo continued Spitzer’s expansive application of the Martin Act, which had been passed in the 1920s in New York to stop fraudulent securities operations but lay largely dormant until Spitzer arrived. In one remarkable instance, Dynegy was the target of Martin Act charges brought by Cuomo on grounds that it had not properly disclosed the carbon emissions from coal-fired power plants that Dynegy planned to build. Those plants were viewed by the green crowd of Democratic supporters as a leading contributor to global warming, hence the Cuomo campaign against Dynegy. Cuomo was joined by former vice president Al Gore, the leader of the climate change movement, in announcing that Dynegy agreed to a settlement in which it would disclose in its SEC filings risks relating to climate changes and its carbon emissions. Why Gore was present for the settlement of a state prosecution and why Cuomo dictated what should go into SEC financial reports were unasked and unanswered questions. Cuomo was front and center during the subprime crisis with high-profile (and well-publicized) investigations of auction rate securities, student loan

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 704 The Crisis Abates practices, and bonuses at Merrill Lynch and other firms receiving federal government bailout money, to name a few. Like Spitzer, Cuomo became a branch of government unto himself, often displacing the SEC as the regulator of Wall Street. But the consuming question is: What have these prosecutions accomplished beyond headlines for Cuomo? A case in point was the separate actions brought by the SEC, Cuomo and the North Carolina attorney general against Bank of America and its CEO Kenneth Lewis. Those actions charged fraud in failing to disclose some unexpected losses at Merrill Lynch before the shareholder vote to approve its merger with Bank of America. Govern- ment resources were being squandered to bring multiple actions for the same conduct, but no matter, Cuomo’s action brought him front-page headlines and raised his profile in the 2010 gubernatorial race. The auction rate security cases forced brokerage firms to cover the losses of investors, but served merely as a forced bailout of their frozen investments. This set the unfortunate precedent of making brokers guarantors of the securities that they sell. Most firms caved in to Cuomo’s intimidation and paid up without protest. However, Cuomo may have gone too far when he attacked discount brokers, like Charles Schwab, who sold auction rate paper. Those discount brokers do not make recommendations and do not underwrite auction rate securities. Schwab decided to challenge Cuomo’s overreaching by refusing to enter into the customary settlement. There is some irony present in Cuomo’s subprime crusades. The son of former governor of New York Mario Cuomo and the former husband of Kerry Kennedy (a daughter of Robert Kennedy), Cuomo served on his father’s staff in the governor’s office and founded a not-for-profit company called Hous- ing Enterprise for the Less Privileged (HELP). That role laid the groundwork for him to serve in the Department of Housing and Urban Development from 1993 until 2001, rising to become its head in 1997. As HUD secretary, Cuomo increased the subprime quota for Fannie Mae and Freddie Mac to 50 percent in 2000.18 This allowed Cuomo’s attorney general Web site to boast that “under his leadership, HUD was transformed from a bureaucratic backwater rife with waste to a revitalized engine for housing development.”19

Bush Administration

The policy of extending subprime lending was carried forward by the Bush administration, which added some fuel to the fire through the passage of the American Dream Down Payment Assistance Act, which was signed into law on December 16, 2003. This legislation authorized as much as $200 million annually to be given to low-income, first-time homebuyers, in order to allow them to make a down payment and to pay closing costs. The assistance provided could not exceed $10,000, or 6 percent of the purchase price of the home, whichever was greater. In 2002, President Bush announced that his administration intended to increase the number of minority homeowners by 5.5 million.

Freddie Mac and Fannie Mae increased their role in the subprime market in 2002, after being urged to do so by the Bush administration. They were pressured to make such loans in 2004 by HUD, which required Fannie Mae and Freddie Mac to make a higher percentage of their loans to low-income borrowers. Fannie Mae and Freddie Mac tried to meet those requirements by investing in privately created structured investment vehicles (SIVs) that were triple-A rated. Even though the default rate on subprime loans was six times higher than that of conventional loans:

By 2005, HUD required that 45 percent of all the loans bought by Fannie Mae and Freddie Mac be loans to borrowers with low and moderate incomes. HUD required further that Fannie and Freddie buy 32 percent of the loans in their portfolios from people in central cities and other underserved areas and that 22 percent of the loans they buy be to “very low income families or families living in low-income neighborhoods.”20

Between 2002 and 2007, $2.6 trillion in subprime mortgages was generated, representing about 20 percent of all mortgages. This growth was spurred by increases in acquisition and securitization by Fannie Mae and Freddie Mac. This figure did not provide the whole picture of the risks injected into the system. Loans rated just above subprime were classified as Alt-A loans. The borrower in an Alt-A had an above-subprime FICO score, but the loan had a defect such as little or no documentation (“no-doc” or “low-doc” loans) of the borrower’s creditworthiness. In “stated-income loans,” borrowers were allowed to state their income without documentation, earning them the sobriquet of “liar loans.” By 2006, 40 percent of new mortgage originations were either subprime or Alt-A. Clearly, government housing policy was the basis for the explosive growth in the subprime market. As one commentator noted:

It was government policy for these poor quality loans to be made. Since the early 1990s, the government has been attempting to expand home ownership in full disregard of the prudent lending principles that had previously governed the U.S. mortgage market. Now the motives of the GSEs fall into place. Fannie and Fred- die were subject to “affordable housing” regulations, issued by the Department of Housing and Urban Development (HUD), which required them to buy mortgages made to home buyers who were at or below the median income. This quota began at 30% of all purchases in the early 1990s, and was gradually ratcheted up until it called for 55% of all mortgage purchases to be “affordable” in 2007, including 25% that had to be made to low-income home buyers.21

Interest Rate Policies

Fed interest rate policies have proved a failure in the twenty-first century. This shortcoming actually stems from an earlier success. In 1982 the then-Fed

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 706 The Crisis Abates chairman, Paul Volcker, stepped in to apply some harsh medicine in the form of unprecedentedly high interest rate increases in order to curb rampant inflation. Volcker’s actions sent the country into a deep recession. Nevertheless, the economy recovered and entered a new era of prosperity. Volcker’s actions were seared into the minds of future Fed chairmen, influencing them to guard against inflation even at the risk of a serious recession. They also convinced the Fed that it could control the economy through interest rate hikes to stunt inflation or deflate bubbles and interest rate cuts to boost the economy when it appeared headed toward recession. Interest rate policy has proved a very blunt instrument that must be wielded with skill and finesse, two traits lacking in government. These rate policies have an identifiable effect on markets, to which the Fed has seemed oblivious. For example, the Fed increased short-term interest rates for the first time in five years in February 1994, causing turmoil in the bond market and resulting in massive losses totaling hundreds of billions of dollars. In particular, collateralized mortgage obligations (CMOs) were crushed by these increases because they slowed mortgage repayments, extending the average maturity of CMOs, and damaging their investors. As a result, the market in CMOs collapsed and sizeable losses were suffered by several large Wall Street financial firms. The Fed switched course in 1995 and dictated low interest rates to spur a lagging economy, setting off a bubble in the stock market. After that bubble was well under way, the then-chairman Alan Greenspan suggested that the market could be influenced by “irrational exuberance,” and later rapidly raised interest rates. This caused a precipitous disruption in the stock market in 2000 and crippled the economy in 2001. The Fed then dramatically slashed interest rates, pumped up liquidity, and set off another bubble in the residential housing market. The real estate bubble was then popped by the Fed through another dizzying series of rate increases that sent the economy into a near-fatal tailspin. Interest rates have been slashed once again, even more dramatically to near zero during the subprime crisis, and the process will undoubtedly start anew once the economy shows signs of recovery.

Targeted Interest Rates

In the off-season, that is, when it is not involved in an economic crisis, the Fed focuses on inflation and has grand debates over “targeted” inflation rates. The eruption of an economic crisis causes concerns over inflation to be abandoned, but not until much damage has been done to the economy. This approach is wrongheaded and must be corrected by adding more certainty to the process that would allow better business and economic planning. The Fed needs to identify the “normal” rate of interest, which it can lower or raise gradually, according to a prescribed formula, as inflation or other economic conditions dictate, but always with a view to returning to the equilibrium, “normal” inter-

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. Regulation, Reform, and the Subprime Crisis 707 est rate target. This will allow businesses to plan for increased, or decreased, interest rates without having to read the tea leaves to determine what the Fed will do in any given circumstance. The Fed certainly has a role to play in fighting inflation, as proved by Vol- cker in the 1980s, but more certainty could be added by indexing the interest rate to the rate of core inflation. This would, once again, allow more flexible financial planning when inflation is on the rise. This is not a new idea. John Taylor, a Stanford economics professor, posited the “Taylor Rule,” which created a formula for “setting interest rates that depended on where inflation was versus the Fed’s goal for it, how far from full employment the economy was and what the short term rate should be when the economy was perking along.”22 Economist Robert Barbera has also proposed a formula for interest rates that would account for changes in credit spreads as well as inflation. Something along these lines would be better than the present roller coaster approach. Although the effects of interest rate changes are not visible for some months, the Fed typically imposes a series of rapid interest rate changes in order to obtain a quick result, but inevitably, the Fed goes too far, stalling the economy or inflating a bubble. The Fed funds target rate was lowered to near zero in the subprime crisis. The only guidance on the Fed’s future course on rates was Fed chairman Bernanke’s statement that rates will stay low for an “extended period,” which is generally interpreted as meaning at least a period of several months, but nothing more. What is needed is firm guidance based on a recognized formula, so that financial markets can plan and adjust to changes in a rational fashion. For example, Bernanke could announce that the Fed and economists are forecasting a recovery in, say, mid-2011, and, therefore, the market should expect quarterly interest rate increases starting in, say, December 2011, at a rate of 0.25 percent, until the targeted “normal” rate (for example, 3 percent) is reached. He could further advise that the Fed will then pause and will not raise rates further, except in accordance with the prescribed inflation formula. This will remove the Fed from its role of managing the economy, a task that is beyond its abilities. It will allow for planning by investors and institutions exposed to interest rate risks.

Carry Trades

Subprime loans were often funded by the lender at short-term rates and then lent to the subprime borrower at higher long-term rates. This allowed a profit from the spread between the two because long-term interest rates are normally higher than short-term rates. As long as yield spreads were constant, that spread created a steady stream of profits from the collateralized debt obligations (CDOs) created to fund subprime mortgages. However, that advantage became a liability when short-term interest rates rose faster than long-term rates, cutting that profit margin. That is exactly what happened when the Fed

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 708 The Crisis Abates raised short-term interest rates, with seventeen straight increases between June 2004 and June 2006. CDOs funded with short-term commercial paper were no longer viable, and refunding became a problem with the arrival of the credit crunch in 2007. Had there been a stated policy on interest rate increases, the danger from this carry trade could have been more readily anticipated. Banks are also affected by mismatches between short- and long-term interest rates. As one writer noted:

The lesson drawn from the Panic of 1907 that led to the creation of the Fed was that banks play a unique and a vital role in the economy: they take deposits and borrowed short-term (the savings of a society), and they lend money for the long-term to finance the investments of the society. The mismatch between taking money that can be withdrawn at any time and lending it in ways that will be paid back only over time make them vulnerable. So they are required to set aside some money for emergencies, maintain substantial capital cushions to absorb losses, submit to government regulation to restrain from taking imprudent risks, and are offered the privilege of borrowing from the Fed in a crisis.23

This regulatory bargain is broken by the Fed when it squeezes the yield curve through inordinate short-term interest rate increases that the banks cannot plan for, or react to, in sufficient time to protect themselves. They are then helpless and dependent on the Fed for liquidity. Reducing interest rates in times of crisis also leads to other carry trade concerns. China, for example, criticized the Fed in November 2009 for allowing investors to borrow funds at extremely low rates in order to buy higher-yielding assets abroad. Germany had issued a similar warning earlier. The Fed concluded in November, however, that the risk that low interest rates would encourage excessive risk taking was relatively low.

The Fed’s Liquidity Role

A central bank’s crucial role in the economy is, as advocated by Walter Bagehot in the nineteenth century, that of providing liquidity in times of need. That role was fulfilled by the Fed and the Treasury Department, with some exceptions, heroically during the subprime crisis. Economist Anna Schwartz accused the Fed of failing to recognize and to deal with the fundamental breakdown in the economy during the Great Depression—the lack of liquidity in the financial system. Bernanke and Paulson were determined not to repeat that mistake during the subprime crisis. Although proving once again that you cannot please everyone, Schwartz accused Paulson and Bernanke of engaging in a rogue operation in making loans to save Bear Stearns. The government bailout and emergency loan facilities created by the bank regulators included the following. 1. increased use of the Fed discount window, increasing the amount of loans in that facility from $1.3 billion in September 2007 to $125 billion in June 2009;

2. the $700 billion Troubled Asset Relief Program (TARP) bailout package; 3. creation of the twenty-eight-day (and later eighty-four-day) Term Auction Facility (TAF), which increased from its initial $20 billion auction on December 17, 2007, to $421 billion in outstanding loans at the end of 2008; 4. Term Securities Lending Facility (TSLF), which extended the overnight borrowing facility available to primary dealers to loans with a tenure of twenty-eight days and allowed them to post illiquid collateral for that borrowing; that facility grew from $20 billion in borrowings in December 2007 to $150 billion in May 2008. It was closed on February 1, 2010; 5. the Asset-Backed Commercial Paper (ABCP) Money Market Mutual Fund Liquidity Facility (AMLF), which made nonrecourse loans on ABCP commercial paper in order to curb the panic in money market funds after the failure of the Reserve Primary Fund; this facility was closed on February 1, 2010; 6. the Commercial Paper Funding Facility (CPFF), created on October 7, 2008, to purchase unsecured ABCP from corporate issuers through a special purpose vehicle (SPV); by December 31, 2008, this program had purchased $334 billion in assets. It too was closed on February 1, 2010; 7. the Money Market Investor Funding Facility (MMIFF), established on October 21, 2008, to purchase up to $600 billion in assets from money market funds; this little-used facility was allowed to expire in June 2009; 8. the $600 billion Mortgage-Backed Purchase Program, created on November 25, 2008, to purchase $500 billion in direct obligations of Fannie Mae, Freddie Mac, and the Federal Home Loan Banks (FHLBs); that sum was increased to $1.25 trillion on March 18, 2009, and by June 2009, $427 billion of those purchases had been completed. The Fed completed its purchases under this program on March 31, 2010;24 9. expanded currency swap lines with foreign central banks, whose outstanding notional amount rose to $614 billion in December 2008 before declining to $176 billion in June 2009; 10. payment of interest on bank reserves held at the Fed; 11. the Federal Deposit Insurance Corporation (FDIC) Temporary Liquid- ity Guarantee Program (TLGP), which guaranteed debt issued by thrifts and banks with tenors ending by 2012; about $320 billion in debt was guaranteed under this program as of July 2009. This program is set to expire on December 31, 2010; 12. expansion of the FDIC account insurance maximum coverage amount from $100,000 to $250,000 in October 2008, which was made permanent in 2010; and

13. the $200 billion Term Asset-Backed Securities Loan Facility (TALF), expanded on March 3, 2009, to $1 trillion, which makes secured, nonrecourse loans available to banks and commercial firms, including hedge funds, using as collateral such things as credit card debt, consumer loans, and student loans.

In addition to these programs was the $168 billion stimulus package signed into law by President Bush on February 13, 2009, and the $787 billion stimulus package signed into law by President Obama almost one year later, on February 17, 2009.

“Helicopter Ben” and “Hank the Bazooka”

Fed chairman Bernanke had once praised the economist Milton Friedman for his statement that the government could stop deflation by dropping money from helicopters. That praise led Bernanke to be referred to as Helicopter Ben, a role he would fulfill grandly during the subprime crisis, along with Treasury Secretary Henry Paulson and Federal Reserve Bank of New York President Timothy Geithner. Paulson was a somewhat awkward statesman, but he was sincere in seeking funding from Congress that would convert his “squirt gun” ability to rescue financial institutions into a “bazooka” that would increase confidence in the market. This triumvirate appeared to have made one serious misstep in declining to rescue Lehman Brothers, a shortcoming that set off the Great Panic in the fall of 2008. However, they quickly reversed course and saved American In- ternational Group (AIG) and backed the money market funds in order to stop the panic. Another misstep occurred when Paulson and Bernanke decided to convert TARP from purchasing troubled financial assets from financial institutions to a capital injection program like the one used by the Reconstruction Finance Corporation in the 1930s, which failed so miserably. To be sure, TARP had a stabilizing effect, but it also touched off a populist crusade against large financial institutions that resulted in more costly regulations. Asset purchases under other Fed and Treasury programs did not receive similar opprobrium. Otherwise, Bernanke, Paulson, and Geithner’s efforts were a model of effective operation by a central bank and Treasury during a financial crisis. Nevertheless, the debate continues to rage over whether the federal government created a dangerous moral hazard in treating some financial institutions “as too big to fail.” Critics said that, instead of being the lender of last resort, the Fed had become the pawnbroker of last resort. An even more extreme view was expressed during the 1930s by Treasury Secretary Andrew Mellon, who, according to President Herbert Hoover, preached: “Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate.”25 What is clear from this and earlier financial crises is that the government behaves erratically and unpredictably. Sometimes, it steps in to save a particu-

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. Regulation, Reform, and the Subprime Crisis 711 lar firm, like Continental Illinois, but allows another one, like Penn Square or Drexel Burnham, to fail. In other instances, as when Enron was in extremis, the government turns its back on a faltering company because to save it would have been politically unpopular, even though its failure might have long-term economic consequences. Such uneven treatment was even more glaring during the subprime crisis. Bear Stearns, Merrill Lynch, Wachovia, and others were saved by shotgun marriages, while Citigroup, Bank of America, and AIG were simply bailed out with government cash. In contrast, Lehman Brothers was left to fail, touching off a worldwide panic. The policy debate on this issue has been unfocused. One group of critics contends that there should be no government bailouts. They would leave failure and success to the market. Many critics of bailouts view the cyclical turns in the market and economy as beneficial, a form of “creative destruction” necessary to advance society. Others want stability at all costs. They want an economy that they need not fear. Some critics would allow bailouts of financial services firms in order to avoid panics, while others would use bailouts only to rescue faltering industries, such as the automobile industry. Paulson and Bernanke tried to steer a middle course between those two extremes and, while their actions were uneven, they succeeded in preventing a complete collapse of the economy. Since at least 1790, the government has sought a formula or mechanism to prevent panics and economic downturns. Like the search for a cure for cancer, that effort has not been entirely successful. It is unlikely that a formula can be devised for scientifically choosing whether, or which, firms should be bailed out. The present ad hoc decision making seemed to work about as well as could be expected. Market participants were left with a lot of uncertainty over whether they will be bailed out if they overextend themselves. The government was left with the uncertainty of knowing that if it bails out too many firms, market discipline will falter. Conversely, if it does not bail out a firm that truly raises systemic concerns, like Lehman Brothers, a panic might develop. As will be seen, legislation that was passed in July 2010 sought to give some structure to this process, but it only served to make the decision-making process more unwieldy and bureaucratic. This is unfortunate because time and decisive decision making are crucial in a financial crisis.

Capital Requirements

Bank capital requirements became the focus of regulatory concern during the subprime crisis. Seeking to close the barn door while the horses were still bolting, the European Union was considering a revamping of its capital requirements in October 2008 at the height of the subprime crisis. The proposals included provisions to improve management of large exposures by banks from securitizations and purchases of collateralized debt, such as the subprime mortgages that had caused such massive losses to European

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 712 The Crisis Abates banks. The European Union also considered a proposal to create a “college of supervisors” to oversee cross-border banking groups, including those in the United States with subsidiaries in Europe. The EU further sought to improve the quality of bank capital. Jean-Paul Redouin, first deputy governor of the Banque de France, had a more astute interpretation of which reforms were needed. He charged in October 2007 that the subprime crisis had revealed a need to revise how risks are analyzed for new financial products. He also urged the development of a new and common framework for evaluating risks from complex structured products. The Basel Committee on Banking Supervision sought, in April 2008, to have banks increase their capital to support structured products and off-balance-sheet special-purpose entities, which at the time were causing much of the loss from subprime mortgages. The Basel Committee also announced on November 20, 2008, a revision of the Basel Accord (Basel III) in order to strengthen the capture of risk from trading assets and off-balance-sheet exposures. This would involve capital set-asides for collateralized debt obligations (CDOs). It sought to enhance the quality of Tier 1 capital by adding additional shock absorbers that could be drawn down during periods of stress and reduce pro-cyclical capital demands. The committee considered whether its risk-based measurement system should be supplemented by fixed gross measures of exposure in prudential and risk management systems in order to limit leverage. The Basel Committee agreed at the Group of Twenty meeting in September 2010 to require their banks to substantially raise their capital levels (from 2 percent to 7 percent of risk weighted assets) and quality. At least half of required equity would have to be from common stockholders and retained earnings. It was expected that this requirement would fall most heavily on European banks. Bank supervisors would also be allowed to curb dividends and stock buybacks that could deplete capital. However, bank regulators ultimately agreed to phase in those stricter standards starting in 2013. The Obama administration had proposed in June 2009 increasing capital requirements for large financial institutions and requiring banks to hold a portion of the loans that they originate on their own books. For reasons that were unclear, the new regulatory proposals also sought to require industrial loan companies to become bank holding companies subject to stringent federal regulation and capital requirements. These companies were often used by distributors, like Target, to provide financing for the sale of their goods to consumers. These industrial loan companies operated under state charters with only loose regulation. It was expected that many of these industrial loan companies would be shut down if they were to be regulated like banks because of the high cost of the new regulation. Those closures would make it harder for consumers to obtain credit and make it harder for these companies to sell their goods. Legislation passed in July 2010 imposed a moratorium on new FDIC insurance applications for industrial banks, credit card banks, and trust banks. Bernanke had added more fuel to the fire in October when he advised the

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. Regulation, Reform, and the Subprime Crisis 713 banking industry that the Fed would focus on capital requirements as a way of preventing future crises. He considered a capital surcharge for large banks, increases in Tier 1 capital, and “contingent” capital, debt that converted to common stock in times of stress. The International Monetary Fund joined the chorus in April 2010 by advocating customized higher capital requirements for banks posing systemic risk. However, the Group of Twenty nations had agreed at their conference in Toronto on June 27, 2010, to delay implementation of more strict capital charges for banks for several years, and regulators agreed to reduce those requirements because of concern over continuing economic weakness. Further talks in Basel in July 2010 resulted in a general agreement (Germany dissenting) that core capital should be redefined to limit non-traditional equity items to 15 percent of total capital. State insurance regulators in the United States also announced that they were backing down from a proposal that would have imposed steep capital charges for insurance companies investing in mortgage-backed securities. This focus on revising bank capital requirements underscores an unfortunate truth, which is that regulators are powerless to prevent financial crises. International bank regulators spent years developing the Basel I and Basel II capital requirements for banks, but those mandates failed to prevent many of the largest banks from leveraging themselves into a position that threatened their viability. Indeed, subprime lending by the regulated banks was actually encouraged by the Basel capital requirements, which were amended by regulators in the United States in 2001 to allow much reduced capital requirements for mortgage-backed instruments that were rated AA or triple-A. Those capital requirements were much lower than those for individual mortgages or for commercial loans. As one commentator noted, the banks reacted to that inducement by purchasing large amounts of securitized mortgages.26 Another problem with capital requirements was that regulators sent mixed messages to the banks as the subprime crisis peaked. Banks were urged to lend the funds supplied by the federal government under its bailout program. At the same time, bank regulators pressured the banks to increase their capital, requesting that Tier 1 capital be increased from 6 percent to 8 percent and that core capital be increased from 10 percent to 12 percent. However, those increased requirements removed funds needed for lending operations and thus added to the ongoing credit crunch. A similar thing happened in 1937 when the Fed doubled bank reserve requirements, helping to stop a nascent economic recovery. Capital-requirement increases should be countercyclical in order to avoid adding additional strains on the financial system in times of crisis. The Treasury Department recognized this point and issued a policy statement in September 2009 on increasing capital requirements. The statement declared that in the future new requirements would be countercyclical, requiring banks to increase capital in good times, so that it would be available in downturns. Financial reform legislation that was passed in 2010 now requires that capital requirements be countercyclical so that the amount of capital required increases

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 714 The Crisis Abates in times of economic expansion and decreases in times of economic contraction. During the subprime crisis and its aftermath, however, banks were required to raise capital in extreme market conditions, impeding their ability to do so and only at a high cost. The Treasury Department further suggested a simple leverage ratio for banks, which the FDIC had long advocated, and which would include off- balance-sheet items. Common equity would also be required to constitute a large majority of the banks Tier-1 capital. Those recommendations were included in the financial services legislation that was passed in July 2010. The Treasury Department did not envision applying any increased capital standards for some time because of the weakened condition of many banks. The FDIC announced in the wake of the subprime crisis that it would propose a cap on interest rates that undercapitalized banks could pay for deposits. This seemed to be a return to the days of interest rate caps that are unworkable in times of inflation. An internal report prepared by JPMorgan predicted that the profitability of large banks would be reduced by one-third if the capital and other regulations sought by the Obama administration were adopted. This is the crux of the problem. Financial institutions are, for the most part, highly leveraged, which means that they borrow money to finance their activities. Capital requirements do not deleverage banks; those requirements only restrain some leverage. In order to really deleverage the banks, capital requirements would have to be so high as to cause their exit from the business, or they would have to turn themselves into hedge funds where they could operate a leveraged business. Financial engineers may, however, have come up with a solution in the form of contingent convertible bonds (CoCos), which convert to equity when a bank becomes undercapitalized, thereby increasing the equity base and reducing creditor demands on assets.

SEC Capital Requirements

A problem began to develop with the new bank capital proposals as part of a long-running battle between the Securities and Exchange Commission (SEC) and bank regulators over bank loan loss reserves. The SEC was concerned that banks were creating excess reserves and using them as “cookie jars” to smooth earnings. Bank regulators, however, liked excess reserves; the more excess the better in their view, because those reserves can be used to offset losses in a downturn. The SEC had also stopped banks from creating secret reserves for use in market downturns, a common practice of foreign banks. That action was taken in the name of full disclosure, but it only weakened the banks. The SEC’s own minimum net capital program for broker-dealers was in tatters. After the failures of Merrill Lynch, Bear Stearns, and Lehman Brothers during the subprime crisis, the SEC came under severe criticism for failing to

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. Regulation, Reform, and the Subprime Crisis 715 recognize that the internal risk management systems of these broker-dealers failed to anticipate or model for dramatic market movements found in the “fat tails” in their bell curves. The SEC, pursuant to an EU directive, had allowed large broker-dealers to become “consolidated supervised entities” (CSEs) that did not have to comply with its net capital rule. Rather, such entities could use their own internal risk models for determining their capital needs. CSE status freed up capital for the large firms, but at the same time it reduced their cushion when losses were sustained. Of course, the CSE risk models were not the only ones with a flaw. Most risk models, including those in use by banks under Basel II, failed to identify the risk from fair-value accounting requirements that required CDOs to be marked down to fire-sale levels. Like the CSEs, large banks experienced massive losses from subprime exposures during the crisis. It is also notable that the squadrons of bank examiners employed by bank regulators failed to spot the dangers posed by the Super Senior subprime CDOs. The SEC admitted on September 26, 2008, that its CSE program was a failure and dropped it. By that point, no such entities were left to supervise. The only surviving CSEs, after the failures of Bear Stearns, Merrill, and Leh- man, were Goldman Sachs and Morgan Stanley. However, those two entities converted to bank holding company status during the subprime crisis so that they could access Fed lending facilities. Bank regulators then became the primary regulators for Morgan Stanley and Goldman Sachs, rather than the SEC. The SEC’s own inspector general found deficiencies in the way that the SEC monitored broker-dealers using the CSE risk-based capital system. The inspector general concluded that the SEC had failed to properly monitor large financial services firms as required by the Market Reform Act of 1990, which was passed after the holding company in the Drexel Burnham Lambert complex raided funds from its regulated broker-dealer in an unsuccessful effort to stave off bankruptcy. Some new securities market capital proposals seemed a bit extreme. In 2009, the industry’s self-regulatory body, the Financial Industry Regula- tory Authority (FINRA), proposed changes to its rules that would allow its executive vice president to unilaterally order large brokerage firms to increase their net capital when deemed necessary for investor protection. Critics charged that this was a very dangerous proposal because it would allow that individual to put larger brokerage firms out of business with a unilateral demand for increases in capital when the firm was stressed and its ability to raise capital limited.

Fair-Value Accounting

“The difficulty in putting a value on loans, securities, and exotic financial instruments banks were carrying on their books became one of the most debili- tating features of the Great Panic” in 2008.27 The adoption of a mark-to-market

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 716 The Crisis Abates accounting requirement for subprime securities, which wreaked havoc during the subprime crisis, seems strange. Mark-to-market, or “fair-value” accounting, was expanded by Enron, which used it to inflate its earnings in order to run up its stock price. Equally interesting is the fact that regulators resolutely resisted easing fair-value accounting requirements during the subprime crisis despite their crippling effect on major financial services firms. “What many people do not realize is that mark-to-market accounting existed in the Great Depression and, according to Milton Friedman, was an important reason behind many bank failures. In 1938, Franklin Delano Roosevelt called on a commission to study the problem and the rule was finally suspended.”28 Even earlier, the Reconstruction Finance Corporation (RFC) dropped fair-value accounting requirements in order to restart the banking system by allowing troubled banks to join the FDIC. Instead, the RFC “deemphasized the liquidity and marketability of bank assets, and evaluated high-grade securities at their potential, not market, value. The RFC gave book or cost value to the highest grade bonds, market value for bonds in default, face value for slow but sound assets, and a reasonable valuation for doubtful assets like real estate.”29 Historical-cost accounting was widely embraced during and after the Great Depression because of its perceived conservative approach to valuation. Robert E. Healy, one of the first of the SEC commissioners appointed by Franklin Roosevelt, conducted a lengthy investigation into questionable accounting practices, including improper asset write-ups. Healy became an advocate of historical-cost accounting for assets on the balance sheet, which was adopted into generally accepted accounting principles. However, mark-to-market accounting began to reappear during the 1970s. In December 1975, the Financial Accounting Standards Board (FASB) issued FAS 12, which required companies to record their marketable equity securities at the lower of their cost or their mark-to-market value. That directive was followed by others that expanded the use of fair-value accounting for tradeable instruments. For example, in 1998, the FASB issued FAS 133, which imposed fair-value reporting requirements on the valuation of derivative contracts. The FASB issued FAS 157 in 2006, which defined fair value as the price received in the sale of an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The problem during the subprime crisis was that the market was not orderly due to the panic among investors that allowed subprime instrument sales only at fire-sale prices.

The Fair-Value Fight

Fair-value pricing resulted in a pro-cyclical progression of writedowns that bore no relation to actual value during the subprime crisis. Those writedowns were at the center of the crisis. Critics of fair-value accounting charged that, because liquidity in subprime investments had dried up as the subprime crisis

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. Regulation, Reform, and the Subprime Crisis 717 grew, the only prices available for “fair-value” accounting were distress prices from desperate sellers. They asserted that those prices in no way reflected the actual value of the higher-rated subprime instruments as measured by their cash flows or defaults. They appear to have a point. As Fed chairman Bernanke testified before Congress on September 24, 2008, when he was seeking authority to purchase distressed bank assets, CDOs had two values: the price available in a quick sale in an illiquid market, and a much higher value if it is held to maturity. He noted that a vicious circle was being created by fair-value accounting, which required a markdown to the fire-sale price, which caused additional sales, which caused further markdowns and so on. Bernanke, nevertheless, rejected the suspension of fair-value accounting, on the grounds of shareholder protection and full disclosure even though their stock was being decimated by such accounting. At the same time, Bernanke wanted $700 billion from TARP to buy distressed securities at their hold-to- maturity (discounted cash flow) value. This raised a question in the press: If hold-to-maturity was good enough for taxpayers, why not for investors? In any event, that asset purchase plan was abandoned in favor of direct capital injections into financial institutions holding these securities. Simple math seems to suggest that many of the enormous writedowns on privately issued subprime mortgage-backed securities were unnecessary. Most of the massive writedowns on the Super Senior subprime securities had been taken by the end of 2008. At that time, some 16 percent of subprime loans were delinquent by more than sixty days. This meant that 84 percent of those mortgages were still performing. There is also the issue of credit protection. The Super Senior tranches of CDOs were protected from defaults by the lower tranches. But the Super Senior subprime securities were at the center of the crisis at most large banks and at AIG, which was weakened after it wrote off some $20 billion in Super Senior credit-default swaps (CDSs). AIG noted that these were marked-to-market unrealized losses due to fair-value accounting and that it did not expect to have an actual material loss from its Super Se- nior exposures. Fifty percent of UBS’s $18.7 billion in write-offs from U.S. mortgage exposure was due to Super Seniors. Merrill Lynch’s U.S. CDO subprime net exposure consisted primarily of its Super Senior CDO portfolio. On September 30, 2007, Citigroup had $55 billion in subprime exposure, $43 billion of which was due to exposures in Super Seniors. Of Citigroup’s $14.3 billion pretax loss (net of hedges) in 2008 from subprime-related direct exposure, $12 billion was attributable to net exposures to the Super Senior tranches of CDOs and derivatives on asset-backed securities, most of which related to Super Seniors. Subprime mortgages defaulted at a rate of about 4 to 5 percent in the years immediately preceding the subprime crisis, so the CDOs were modeled and overcollateralized to expect that loss amount. This would mean that the Super Seniors were exposed to only 12 percent of the 16 percent of delinquencies at the end of 2008. Moreover, the Super Seniors received default protection

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 718 The Crisis Abates from lower classes in the CDOs. The Super Senior tranches also generally had additional credit protection from CDS, or monoline insurance (which proved nearly nonexistent). That protection often totaled about 5 percent of the face value of the Super Senior. If available, such protection would offer further protection to the Super Seniors. Moreover, the 16 percent delinquency rate must be adjusted for the foreclosure value of the residences securing the subprime mortgage. The S&P Case-Shiller U.S. National Home Index indicated an 18.2 percent decline in housing prices in the United States in 2008. Assuming an even steeper decline in subprime-related homes, say 50 percent, the sale of the foreclosed houses would cut foreclosure losses in half. With credit protection, the Super Seniors faced an even smaller loss. In addition, at least some of the subprime loans would be refinanced, even if on modified terms, as interest rates dropped. These refinancings would further reduce exposure of the Super Seniors. So, even with a really sharp risk discount, it would be very hard to value these subprime mortgages based on their expected cash flows at values of only a small percentage of their face amount. Yet fair-value writedowns on subprime CDOs were often 50 percent or more. Indeed, Merrill Lynch sold some $30 billion of its subprime holdings for twenty-two cents on the dollar. Fair-value accounting thus appears to be anything but fair. One accountant complained to the FASB with respect to its fair-value accounting requirement: “May the souls of those who developed FASB 157 burn in the seventh circle of Dante’s Hell.”30 Warren Buffett likened mark-to-market requirements for measuring bank regulatory capital to throwing “gasoline on the fire in terms of financial institutions.”31 Former Fed chairman Paul Volcker was another opponent of fair-value accounting for banks. As one author noted:

The argument against fair value is a compelling one: volatile markets make securities valuation difficult and undermine investors’ confidence, forcing companies to mark down values, leading to greater illiquidity and further markdowns. The more the markdowns impair capital, the greater the loss of investor confidence, and the faster the churn of the self-reinforcing cycle.32

Other critics claimed that because the writedowns were excessive, they would give a boost to the company’s earnings in future periods when the markets resumed normal operation, at which time those instruments would be revalued upward to reflect their actual value. In other words, they would shed their panic discount. There seemed to be some indication that this was the case as the market recovered. A study published in August 2008 questioned the accuracy of the indexes used by many banks to value their subprime securities and, thereby, to assess their losses. The lack of a market for those securities made such indexes unreliable. Sixty-five members of Congress requested that the SEC suspend mark-

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. Regulation, Reform, and the Subprime Crisis 719 to-market accounting, asserting that it was exacerbating the subprime crisis and limiting banks’ ability to make loans. However, some activist shareholder rights groups opposed that request. The Consumer Federation of America and three other trade groups representing consumer interests petitioned the Trea- sury Department not to abandon fair-value accounting in its efforts to shore up faltering financial services firms. Lloyd Blankfein, the CEO of Goldman Sachs, was also a supporter of fair- value accounting. He believed, and publicly stated, that companies suffering from subprime writedowns had not accurately valued the instruments in their portfolios. Blankfein boasted that Goldman Sachs’ practice of daily marking of positions to market allowed it to avoid the worst of the subprime losses because that practice led the firm to recognize the risk in those instruments and caused it to sell off or hedge those positions before the crisis arose. He believed that if mark-to-market accounting had been more aggressive at other firms, there would have been an early warning of the subprime crisis. Blankfein and his predecessor as Goldman CEO, Treasury Secretary Paul- son, were in close contact throughout the subprime crisis. It is unclear how his views might have swayed Paulson, who was accused of acting inappropriately by staying too close to Blankfein during the crisis. For whatever reason, the Treasury Department refused to recognize the pernicious effects of fair-value accounting. It was not until the subprime crisis peaked in September 2008 that Paulson expressed the view that financial institutions should be allowed to treat their subprime assets as held-to-maturity, which would allow them to be valued at their amortized cost, rather than at distress prices. The American Bankers Association, the U.S. Chamber of Commerce, and Republicans in Congress called for legislation to suspend fair-value accounting during the subprime crisis, but Senator Chris Dodd (D-CT), chairman of the Senate Banking Committee, defended the requirement and blocked legislative relief. He had been one of the strongest advocates in Congress for expanding subprime lending and now exacerbated the crisis that lending caused. However, the FASB was pushed by other members of Congress to relieve the banks of this requirement. On September 30, 2008, the SEC proposed a temporary suspension of mark-to-market accounting. That suspension would have allowed financial institutions to value instruments based on their discounted cash flows, rather than by market valuations, which often were nonexistent in the panicked subprime mortgage markets. The European Union announced the adoption of the same approach. This effort was aided by Moody’s and Standard & Poor’s, which agreed to assess not only the probability of a loss but also the likely size of the loss. Unfortunately, that action came only after huge writedowns had been taken that were based only on rating downgrades (down to less than junk bond status)—themselves based solely on the likelihood of a loss, without regard to the size of the loss. Insurance companies treated their impaired mortgage-backed securities as only “temporarily impaired.” This meant that in measuring their regulatory

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 720 The Crisis Abates capital they did not have to include them as losses until it was determined that the losses were not temporary. However, such treatment raised alarms. MetLife had classified $27 billion in securities in that category, and concern arose that the company might face a huge loss in the future. Some large insurance companies, including MetLife, Prudential, and New York Life, were in talks with the government at the end of October 2008 over injecting funds into their operations through the sale of equity stakes.

The FASB Reacts

The Emergency Economic Stabilization Act passed on October 3, 2008, required the SEC to conduct a study of mark-to-market accounting. This caused the agency to change its position. On December 5, 2008, the SEC announced that it had decided not to suspend mark-to-market accounting. In the SEC report required by Congress, the agency asserted that mark-to-market accounting should not be eliminated or suspended, but it did suggest some improvements. The SEC report stated that it found no evidence that fair-value accounting had played any significant role in the collapse of financial institutions; rather, it blamed their liquidity problems on bank runs. That conclusion seemed at odds with the facts as massive writedowns were taken based on fire-sale prices, not the inherent value of actual cash flows and default rates. In the meantime, on October 10, 2008, the FASB issued fast-track guidance on how to fair-value assets that did not have an active market, such as subprime securities. That guidance was mostly gobbledygook. Under pressure from the European Union, the International Accounting Standards Board (IASB) agreed to allow European firms to change their accounting treatment of troubled assets. Relenting to pressure from the troubled financial services firms, the FASB announced on December 22, 2008, that it would make a change in its mark-to-market rules to provide some limited relief. The agency announced in January 2009 that it would allow firms to use methods other than “fair value” for certain subprime securitizations that were viewed as temporarily impaired in price. This, of course, raised the question of whether subprime instruments were impaired temporarily or permanently. The FASB issued a document providing guidance and relief to the banks on April 2, 2009. The text in it was carefully couched in ambiguity but was thought to provide financial institutions with more flexibility, allowing them to treat the subprime securities as held for investment. The guidance, which went into effect in the second quarter of 2009, was expected to boost the earnings of firms with subprime exposures when those financial institutions valued their assets at more realistic prices. The change certainly gave a boost to the stock market. The IASB agreed with the FASB, on March 24, 2009, that the two bodies should work together to achieve common standards. That agreement lasted less than two weeks. The IASB refused to follow the FASB’s interpretative guidance on fair-value accounting issued on April 2, 2009. Instead, the IASB

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. Regulation, Reform, and the Subprime Crisis 721 announced a six-month study of the issue. The Group of Twenty, at their meeting in London that same day, also called on the FASB and the IASB to further address fair-value accounting issues and provide more clarity and consistency. The result of all of this debate was confusion and uncertainty, the very thing accounting standards were supposed to prevent. The FASB’s actions also raised a storm of controversy. Critics claimed that it allowed institutions to cover up losses. A front-page Wall Street Journal article reported that financial services firms had spent $27.6 million lobbying Congress to pressure the FASB to grant that relief.33 A subsequent report by the Financial Crisis Advisory Group was critical of the pressure placed on the FASB by politicians with respect to their fair-value guidance. Nevertheless, that relief allowed banks to keep assets on their books at higher, more realistic values, and it did appear to ease the crisis. The Bank for International Settlements’ (BIS) Basel Committee on Bank- ing Supervision published proposed guidance for banks in November 2008 on how they should value financial instruments held in inventory. Its concern was that banks were using overly optimistic pricing models for instruments that did not have an ascertainable market price. The BIS also wanted independent verification of prices. Actually, it later appeared that the banks had become too pessimistic in their valuations during the subprime crisis, valuing their subprime investment at prices lower than would be justified by a discounted cash flow analysis. The Basel guidance was adopted as proposed on April 15, 2009. The FASB remained conflicted over fair-value requirements. It announced in August 2009 that it was considering expanding mark-to-market requirements to loans and all other financial instruments. It renewed that threat in May 2010 but met stiff resistance from the banks because of the serious effect such accounting could have on their balance sheets. This, of course, would only add further volatility to bank balance sheets and would surely lead to their complete destruction in the next financial crisis. The European Union was also inconsistent, announcing a delay in implementation of fair-value requirements that would have required large writedowns on assets of financial services firms in November 2009.

Real Estate Appraisals

The answer to the debate over how to value CDOs holding subprime mortgages appears to be a simple one. At the bottom, the CDO is simply the sum of the values of the residences underlying the mortgages in the securitized pool. A real estate appraiser seeks to determine the “market value” of the property, the same goal of fair-value accounting when it marks-to-market. Residential real estate appraisers define market value as: “The most probable price which a property should bring in a competitive and open market under all conditions requisite to a fair sale, buyer and seller each acting prudently, knowledge-

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 722 The Crisis Abates ably and, assuming the price is not affected by undue stimulus.”34 The 1936 Underwriting Manual prepared for the Federal Housing Administration by Frederick Babson sets forth the ground rules for determining the market value of residential property. They are:

1. Valuation presupposes the existence of a buyer. 2. Valuation presupposes the existence of a seller. 3. Valuation presupposes a sale in which the buyer is well-informed, and acts intelligently, voluntarily, and without necessity. 4. Valuation presupposes a sale in which the seller is well-informed, and acts intelligently, voluntarily, and without necessity. 5. Valuation endeavors to estimate prices which are fair and warranted, that is, prices which represent the worth at the time of appraisal of the future benefits which will arise from ownership, rather than prices which can be obtained in the market. 6. Valuation recognizes the importance and usefulness of sales prices, provided it is determined whether or not such sales prices were fair and warranted; and provided the motives, intelligence, and wisdom of the parties to the sales, as well as other conditions surrounding them and influencing the determination of the sales prices, are ascertained and weighed. 7. Valuation presupposes and recognizes that intelligent buyers and sellers consider the utility of real property. 8. Valuation recognizes that replacement cost at the time of appraisal sets one approximate upper limit of possible value. 9. Valuation recognizes that value may be less than replacement cost. 10. Valuation recognizes that the prices at which competing properties are available for purchase set or tend to set the approximate upper limit of possible value. 11. Valuation presupposes and recognizes that well-informed buyers and sellers are commonly aware of the existence of competing properties and compare their respective asking prices, desirability, advantages, and disadvantages, and future prospects. 12. Valuation presupposes and recognizes that well-informed buyers and sellers compare and contrast the advantages and disadvantages of renting with those involving ownership.35

Many of these elements were missing for subprime CDOs during the crisis. Comparable sales were scarce during the subprime crisis because most sales were made at distress prices under pressure and not “voluntarily and without necessity.” Typically, a residential real estate appraiser will compare the property being valued with properties recently sold in the same local area that have similar characteristics. Adjustments are then made to the value of the subject property to reflect differences between it and the one it is compared with, for

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. Regulation, Reform, and the Subprime Crisis 723 example, deducting an amount to reflect its having fewer bathrooms. That classic valuation method was not available during the subprime crisis. In the absence of the ability to compare like properties in the distressed subprime market, real estate appraisers use a reconstructed-value approach that seeks to establish value based on the cost of reconstructing the subject residence. The Marshall & Swift Residential Cost Handbook provides these costs and adjusts them by locale and quality of construction. However, the reconstructed-cost methodology is not favored because the market might not want to value the property at its reconstructed cost, particularly under distress conditions, such as those present during the subprime crisis. Reconstructed cost, therefore, is generally used only as a measure of the maximum value of the house.

Appraisal of Income-Producing Property

There is an alternative appraisal method available when the property generates income. Real estate appraisers value the property based on its expected income stream, as in the case of a rental property. Here, the property (the CDO) is income-producing because the underlying mortgages will produce an expected stream of income. The appraiser must make allowances for expected defaults, but then extrapolates the present value of the CDO based on its expected income stream. Supporting this methodology are the appraisal methods used to value the stock of corporations. Traditionally, corporate appraisal proceedings followed the “Delaware Block” approach, employed by the Delaware courts, where many important appraisal proceedings occur. Under the Delaware Block approach, appraisers determine the “fair value”36 of stock in the subject corporation by using three different methodologies: market value, net asset value, and earnings value.37 The Delaware court then assigns various weights to each methodology, depending on the nature of the property. The price at which the stock of the company being appraised is widely traded will be the price assigned to the appraisal, because that is the best determination of value. However, if the stock is illiquid, that methodology is given less weight, and the court might assign more weight to the net asset value or earnings value of the company. Net asset value is not completely useful because this is the liquidation value of the company, but the company is not being liquidated. Its value as an ongoing concern might better be measured by its income production. Delaware had, for years, used an earnings value appraisal method that relied on a capitalization chart prepared by Professor A.S. Dewing, but that chart became outdated, and more modern methods of determining earnings value were developed, including the discounted cash flow method. The Delaware Supreme Court abandoned its rigid block approach in 1983 and allowed the use of discounted cash flow and other recognized valuation methods.38 If balance sheet accounting based on the fair value of CDOs is thought to

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 724 The Crisis Abates be necessary, basic valuation principles would require that cash flow or other valuation methods be used to provide the best measure of the value of the instrument when the residential mortgage market is not functioning. When a market is disrupted or frozen, as in the case of subprime CDOs, alternative valuations should be used, or the fair-value requirement should simply be suspended until the market recovers.

Risk Models

Risk modeling took on new importance in financial markets with the creation of the Black-Scholes options pricing model in 1973. That pricing formula gave rise to a widespread belief that the risks from complex financial instruments could be scientifically predicted with a degree of certainty. Also in widespread use were “value at risk” (VaR) models, which financial institutions used to assess the risks presented by their portfolios and proprietary trading. Those models even became the basis for capital requirements in Basel II for banks worldwide. The VaR models looked to historical prices over a given period to determine the expected rate of price changes in the instrument. The results were back-tested to ensure that their predictive ability was accurate. Portfolios could also be stress-tested by using amounts larger than those predicted by the VaR model as a means of assessing risks from unexpected market movements. A risk model developed by David Li, the Gaussian Copula correlation model, did for CDOs what the Black-Scholes model did for options. It allowed what appeared to be a precise mathematical computation of the likely risks posed by these instruments. Subprime CDOs were often structured with tranches that had varying risk levels, which were designed to appeal to investors with different risk appetites. The top tranche—the “Super Senior”—was often given a triple-A or AA credit rating, even when backed by subprime debt. In order to assign a rating to the varying CDO tranches, the credit rating agencies employed statistical models that sought to determine the probability of defaults on the underlying mortgages. If a senior tranche was protected from that expected default rate by the lower tranches, or by other means, such as credit insurance, it would be given a high rating. The Gaussian Copula risk models failed to predict the massive losses sustained by commercial banks in the United States and Europe from their exposures to these subprime instruments. However, there was no cabal using a secret formula to deceive investors. Moody’s actually posted its model (CDOROM), which became the industry standard, on the Internet in 2004. The whole world was free to discover its flaws but, except for a few naysayers, the model went largely unchallenged. Interestingly, the New York Times accused the rating agencies of being too transparent because the issuers of CDOs were able to structure their offerings to accord with the model and obtain high credit ratings. These issuers were also accused elsewhere of gaming the ratings methodology by including loans with both high and low FICO credit scores

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. Regulation, Reform, and the Subprime Crisis 725 in order to meet the average score required by the rating agency for a highly rated offering. The inclusion of the lower scores, rather than those closer to the required average, assured a greater number of defaults. Another rating agency, Fitch, used a Monte Carlo multistep simulation default probability model to stress-test the CDOs that it was rating, a technique that seeks to look at a range of possible outcomes and their probability of occurrence. This too failed to reckon with declining credit standards and punitive interest rate increases. These risk models were created by the so-called “quants” who used quantitative analysis including complex mathematical formulas, which are little understood, except by the cognoscenti. They were treated as science since they were developed by the high-IQ quants, but as Warren Buffett warned, “beware of Geeks . . . bearing models.”39 The mathematical model used to rate CDOs proved badly flawed.40 Critics charged that these models were defective because they relied on historical prices generated by a rising market. That Pollyannist approach overlooked the possibility of a hundred-year “perfect” storm, which arrived in the form of the subprime crisis. These unusual events were given other names, such as “fat tails” and “outliers.” They were also called “black swans,” as a metaphor for the widely held belief that there was no such thing as a black swan, until explorers reached Australia and found just such a bird. The dangers posed by these outliers were well known and were even the subject of a book written by Nassim Nicholas Taleb, titled The Black Swan. He described the hazards of events that have a low probability and a large impact. He argued that risk managers were reckless in using risk assessment measures that exclude the possibility of such events. Some critics asserted that these risk models were like having safety airbags in an automobile that worked just fine until there was a wreck. As the world learned from the subprime crisis, a Hurricane Katrina does strike on occasion.41 However, the model builders had to contend with the fact that, although occasional and temporary regional downturns occurred, the housing market had not experienced a nationwide slump since the Great Depression.

Regulatory Reform

Financial Literacy of Regulators

A remarkable fact flowing from the subprime crisis was that financial regulators did not have a clue as to the dangers presented by subprime mortgages or the flaws in their modeling or the effects of mark-to-market accounting in a market panic. Bank regulators and the administrations of Bill Clinton and George W. Bush blindly forced massive subprime originations and investments, without any reflections on the dangers of such lending, and they were caught flat-footed when the subprime crisis arose. The SEC, in particular, seemed out of touch with the market that it regulated and the business activities of its registrants.

Despite the past claims of the superiority of SEC regulation, the largest investment banks under its supervision failed. The agency was helpless during the crisis. It could only lash out blindly by attacking naked short sales, which probably did not need attacking, and seeking more regulatory authority in areas that did not need regulating. Most embarrassing, Bernie Madoff carried out the world’s largest-ever fraud right under the SEC’s nose, and the agency, despite numerous clues, lent him legitimacy by having him register as an investment adviser and even had him serve on an agency advisory committee. In a prison interview, Madoff expressed disdain for the incompetency of the SEC examiners and was amazed that they had not caught him years earlier. SEC chairman Cox seemed to be missing in action as well as clueless as Bear Stearns, Merrill Lynch, and Lehman Brothers failed. He had publicly stated three days before Bear Stearns fell that the large investment banking firms regulated by the SEC, including Bear Stearns, had satisfactory financial cushions. Cox was also reported to be absent during critical phone calls, attended a birthday party as Bear Stearns’ rescue was being negotiated, and refused to interrupt a previously planned vacation in the Caribbean after Bear Stearns failed. The SEC was the assigned regulator of Bear Stearns, but it was only a bystander when Bear’s rescue was arranged by the Treasury Depart- ment and the Fed. These regulatory failures indicated that the SEC did not have the requisite expertise and financial sophistication to deal with complex financial markets. Such failings derive, in large measure, from the fact that the agency views itself primarily as a law enforcement agency and only secondarily as a financial regulator. As a law enforcement agency, it has proved a failure, as demonstrated by the Madoff case and the fact that it learned about the Enron-era accounting scandals from newspaper accounts. Spitzer may have been excessive in his attacks on financial services firms, but the SEC’s impotency opened the door for him. If financial service regulators are going to regulate, they should at least take time to learn the business and follow developments. Historically, most job training at the SEC is “on the job.” Such training, while valuable to the individual, results in a narrow set of skills. This “stovepipe” mentality develops expertise in only one narrow area for staff members and that is often parochial to not only the SEC but also a particular division in that agency. New employees at the SEC are typically very bright, newly minted lawyers, accountants, investigators, and auditors, or sometimes more seasoned individuals, but with very limited knowledge of the full spectrum of financial services and markets. The SEC is also marked by a revolving door for its employees who typically serve only a few years and then move to the private sector, which results in another serious drain in expertise. The performance of SEC entry-level employees and lateral hires is almost always excellent in the matters to which they are assigned. However, as a prac-

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. Regulation, Reform, and the Subprime Crisis 727 tical matter, they have no ability to do anything other than carry out particular tasks assigned to them. They do not have the wherewithal to uncover and pursue issues affecting financial services and markets overall. With notable exceptions, even the most experienced staff members lack broad-based knowledge. Today, financial services are completely intertwined. A banking regulator must know the securities and derivatives business, and how it is regulated, because the financial holding companies that they regulate have financial subsidiaries that are broker dealers, futures commission merchants, and OTC derivatives dealers. The SEC must know the banking business, and how it is regulated, because many of its large broker-dealers are part of a bank holding company structure. The SEC must know the derivatives business, particularly if it is to jointly regulate OTC derivatives with the CFTC. Federal financial service regulators must know the insurance business and its limitations, particularly credit insurance. In order to become more effective, the SEC must also become more of a financial services regulator and less of a law enforcement agency. The agency tries to cover its regulatory shortcomings with high-profile enforcement actions that are almost always settled by the respondent without admitting or denying any violations. This process has become the equivalent of a tax on public companies and registrants. The tax must be paid or the firm will lose its franchise. The SEC’s action against Goldman Sachs that is described below is a case in point. That case should never have been brought, but Goldman Sachs paid $550 million to settle it in order to protect its franchise from further adverse publicity and SEC attacks. In many instances, innocent shareholders end up paying the fines associated with such actions. The fine in the Goldman Sachs case, for example, came from the corporate treasury. The SEC enforcement actions accomplish little. The agency has been on an almost fifty-year crusade to stop insider trading, with a notable lack of success, but those cases generate a lot of publicity. Yet, SEC actions have proved no deterrent to insider trading. It is rare to see a merger that is not accompanied by insider trading, and reports surface almost daily in the press of further insider trading cases. One of the most spectacular reports was issued October 16, 2009, when six individuals were arrested and charged with participating in a giant inside-trading ring. The leader of the ring was a billionaire hedge fund manager for the Galleon Group named Raj Rajaratnam. Other members of his ring were executives at IBM, the consulting firm McKinsey, and Intel. It was reported in the press that the SEC and Justice Department had failed to pursue Galleon in a case brought in 2000 that involved inside information passed to the firm by Roomy Kahn, who had informed for the government regarding the charges brought against Galleon and Rajaratnam in 2009. A new approach is needed. An effective financial services regulator does not always act as an adversary to business. The idea of financial services regulation is to ensure its continued and effective development. Yale economist Robert Shiller has suggested that financial regulators “must hire enough

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 728 The Crisis Abates qualified staff to understand the complexity of the innovative process and talk to innovators with less of a disapprove-by-the-rules stance and more that of a contributor to a complex creative process.”42 That philosophy should be incorporated into the SEC.

Functional Regulation

The United Sates operates under a “functional” regulatory system in which different regulators regulate particular financial services. Since many large banks are engaged in multiple financial services activities, they have multiple regulators, none of whom coordinate with each other in any meaningful way. This has resulted in overlap and regulatory conflict and inefficiency. Under functional regulation, financial services firms are regulated at the state level by fifty state insurance commissioners, state securities commissioners in fifty states and the District of Columbia, fifty state bank regulators and fifty state attorneys general. Federal functional regulators include the Fed, the Office of the Comptroller of the Currency (OCC) in the Treasury Department, the Federal Deposit Insurance Corporation (FDIC), the SEC, the Commodity Futures Trading Commission (CFTC), the Federal Trade Commission (FTC) and self-regulatory bodies such as the Financial Industry Regulatory Authority (FINRA) and the National Fu- tures Association (NFA). The Justice Department has also become a financial services regulator and a new Consumer Financial Protection Bureau was created in 2010 with broad jurisdiction over many financial services.

Treasury Report

Treasury Secretary Henry Paulson warned in 2006 that the country was “creating a thicket of regulation that impedes competitiveness.”43 The Treasury Department thereafter conducted a study of the existing regulatory structure and it published its report in March 2008 (Treasury Blueprint).44 The Treasury Blueprint concluded that functional regulation was ineffective and was undermining America’s leading role in global financial services. The Blueprint also concluded that functional regulation “exhibit[ed] several inadequacies, the most significant being the fact that no single regulator possesses all of the information and authority necessary to monitor systemic risk, or the potential that events associated with financial institutions may trigger broad dislocation or a series of defaults that affect the financial system so significantly that the real economy is adversely affected.”45 The Treasury Blueprint recommended that the United States adopt a “Twin Peaks” approach to regulation, a system that is currently used in Australia and the Netherlands. The Treasury Blueprint actually took a “Three Peaks” approach that would have three separate bodies implementing three specific regulatory goals: (1) market stability regulation, (2) prudential financial regulation, and (3) business conduct regulation. This objectives-based approach would

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. Regulation, Reform, and the Subprime Crisis 729 require a consolidation and reshuffling of the existing functional regulators in the United States into essentially three principal regulators. The subprime crisis derailed that effort.

Subprime Crisis Regulation Proposals

Even while the Treasury study was proceeding to prepare the Blueprint in March 2008, a sea change was occurring as the subprime crisis flared and grew in intensity. Only a few days before publication of the Treasury Blueprint, the Wall Street Journal declared in a front-page article on March 24, 2008, that a new era of increased regulation could be expected due to problems in the subprime market.46 The subprime crisis did indeed touch off a wave of popu- lism that demanded more, not less, regulation. The presidential campaign of 2008 was fought and largely won over the concerns that regulation had been relaxed too much, and the functional regulators used that political concern as the argument for expanding their jurisdiction and for the most part avoided consolidation. Emerging from the disgrace of being forced to resign as governor of New York, Eliot Spitzer published an op-ed piece in the Washington Post on No- vember 16, 2008, in which he claimed that the subprime crisis had proved that he was right in his campaign against Wall Street as New York attorney general and in his efforts to stop the deregulation of financial markets. Spitzer argued that more regulation was needed because “unregulated competition drives corporate behavior and risk-taking to unacceptable levels.” He regret- ted the fact that “mistakes” in his “private life” prevented him from assisting the incoming Obama administration in ushering in a new era of Franklin Roosevelt–style regulations.47 Apparently President Obama did not need Spitzer’s aid in creating new regulations. The new treasury secretary, Tim Geithner, took an active approach when he announced the Obama administration’s new financial regulatory proposals in June 2009.48 Geithner asserted that the entire financial regulatory structure in the United States had to be revised because the existing system was a confused set of complex rules that created perverse incentives and regulatory competition, while leaving broad gaps in coverage. Geithner sought legislation to give the Fed oversight authority over all financial institutions that posed systemic risk if they failed. This would make the Fed the ultimate manager of those firms. As demonstrated by its strong-arm treatment of management at Bank of America and Citigroup, the Fed will not shy away from being an active manager, but in a time of crisis it is easy to forget that governments are institutionally incapable of running a business. The Treasury Department refined its proposals on July 23, 2009. It then sought the creation of a new national bank supervisor, and it wanted to establish a resolution program for failed financial institutions that would involve the participation of both the FDIC and the SEC. The federal government would be

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 730 The Crisis Abates given standby authority to bail out failing banks by providing loans, injecting capital, or assuming liabilities, plans that would have to be approved by the Fed and the Treasury Department (after consulting with the president), as well as the FDIC or the SEC, depending on the type of institution. The International Monetary Fund later proposed a similar program for European banks. The administration also asked for the elimination of the Office of Thrift Supervision, which would be folded into the OCC. The federal thrift and thrift holding company charters would be eliminated. That action was taken in response to the effort by AIG to avoid more stringent regulation by reor- ganizing into a thrift holding company. Bank examination fees would also be harmonized, with bank fees based on the bank’s size and financial condition. Smaller banks, those with less than $10 billion in assets, would not have to pay systemic based examination fees.

Turf Wars

The Fed was initially chosen by the Obama administration as the central systemic regulator, a role that would give it the power to designate financial institutions that were too big to fail. These institutions would be subjected to higher capital requirements. However, the recommendation to make the Fed the systemic regulator met resistance from some members of Congress and other regulators. FDIC chair Sheila Bair was seeking to create a financial stability oversight council that would be a superregulator with oversight of all financial regulators. However, the administration’s proposal for a regulatory council envisioned it only as a working group, and Bernanke urged Congress not to expand its powers beyond consultation. As will be seen, Congress followed the Bair approach to some degree. The Geithner proposal also created some regulatory conflicts over jurisdiction among the OCC, the SEC, and the FDIC. Those agencies found their power threatened, and they were critical of giving too much power to the Fed. Geithner became frustrated at a meeting with those regulators, including the heads of the SEC, the FDIC, the CFTC, and the Fed, and berated them for their intransigence on his proposal. That did not help matters, and the administration’s regulatory reform proposals started to bog down in Congress as lobbying intensified and the interested agencies continued to battle over turf. Robert Zoellick, president of the World Bank, also opposed the Geithner proposal, saying that authority over systemically important financial institutions should be given to the Treasury, instead, because it is more accountable to Congress. It was unclear why the president of the World Bank had any role to play in such a decision. President Obama tried to move his reforms forward with a speech on Wall Street on September 14, 2009, in which he criticized the banks receiving bailouts before an audience of financial leaders. He stated that “we will not go back to the days of reckless behavior and unchecked excess that was at the heart of

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. Regulation, Reform, and the Subprime Crisis 731 the crisis, where too many were motivated only by the appetite for quick kills and bloated bonuses.”49 That blast was followed by a Fed proposal that would allow it to block compensation schemes that it believed would encourage undue risk-taking. Senator Chris Dodd, chairman of the Senate Banking Committee, responded to this infighting in September 2009 with a legislative proposal to merge the four federal bank regulators (the Fed, the OCC, the FDIC, and the Office of Thrift Supervision [OTS]) into one banking superregulator. The Obama administration began shifting its position as opposition to its proposals mounted. Its reforms evolved into basically leaving the financial regulatory structure as is, with the exception of merging the OTS with the OCC. The OTS opposed that proposal, but was eventually eliminated. The Obama administration also wanted a systemic risk oversight group, a council of regulators that would be led by the Fed, but other regulators fought that proposal because they thought that it still gave the Fed too much power. Another fight broke out over the so-called “Volcker rule,” named after former Fed chairman Paul Volcker, who wanted a return to the days of the Glass-Steagall Act when commercial banking activities were separated from investment banks that conducted underwriting and other securities. That recommendation met opposition from Fed chairman Ben Bernanke and others. President Obama went on another populist attack against Wall Street in January 2010. He first announced plans for a tax on the large banks that would pay for TARP. He then flew to Boston in support of a Senate race for the seat left open by Ted Kennedy’s death, where he bashed the banks. A Republican won the seat. That loss enraged the president, and he announced his plan to support the Volcker rule two days later. A preliminary report by the European Union rejected the Volcker proposal as being inconsistent with its risk management principles.

The SEC and the Goldman Sachs Case

The SEC was the consolidated supervised entity (CSE) regulator for Lehman Brothers, but was caught flat-footed by the liquidity crisis at Lehman Broth- ers, even though SEC staff members had taken up residence at the firm to monitor its finances after Bear Stearns failed. More embarrassment over the Lehman failure followed when it was disclosed that Merrill Lynch executives had advised the SEC that Lehman was overstating its liquidity after the close of its first quarter in 2008. Merrill Lynch was concerned because its more conservative approach made it appear to be less liquid than Lehman, causing concerns among Merrill Lynch counterparties. The Fed also had staff on premises at Lehman during the crisis, and it too was warned by Merrill Lynch of the liquidity issue. Unlike the SEC, the Fed kept close watch, along with Treasury, on Lehman’s declining liquidity and sought to pressure that firm to raise more capital before it failed. The new SEC chair, Mary Schapiro, who was appointed by President

Obama, admitted in congressional testimony that the CSE program was inadequately staffed, stovepiped in sharing information, and insular. She further testified that CSE supervision required a bank regulator approach rather than the law enforcement, full disclosure approach of the SEC. Schapiro admitted that the SEC was ill-suited to act as a prudential regulator. She was also concerned that the agency’s many shortcomings might cause Congress to turn its lights off. To survive, the SEC went on a campaign against Wall Street, seeking other areas to regulate such as high frequency flash trading, corporate governance and executive pay. The agency set up a new division to control investment and business risk (something it had relied on the market to do in years past). It adopted political correctness as policy, requiring, among other things that public companies warn their investors of the risks that global warming might pose to their businesses, a matter that not even climatologists could agree upon. The agency also attempted to burnish its image and attract headlines by following Eliot Spitzer’s approach in bringing high-profile prosecutions against major industry players. Goldman Sachs became one such target. The sensational charges levied by the SEC against Goldman on April 16, 2010, for its sale of a synthetic collateralized debt obligation (CDO) involving some credit-default swaps (CDSs) to a German bank made headlines worldwide and caused a 125 point drop in the Dow Jones Industrial Average. The Justice Department then announced that it was conducting a criminal investigation of the SEC charges. The actions against Goldman cut the value of its stock by 20 percent. At the time this case was filed, the SEC and the Obama administration were seeking broader regulatory jurisdiction from Congress over credit-default swaps. Perhaps not coincidentally, the president announced on April 17, 2010, that he would veto financial services legislation if it did not regulate the over- the-counter derivatives business. This turned the case into a political football. Gordon Brown, the British prime minister, who was in a tight political race, charged that the case established the moral bankruptcy of Goldman Sachs, but he still lost the election. President Obama was, however, able to pass financial services reform legislation a few months later that contained provisions that extensively regulated derivatives. A provision was also added to that legislation to cover the SEC’s case against Goldman Sachs. SEC Chair Mary Schapiro was featured on the cover of Time magazine after the filing of the Goldman Sachs case. She, along with Sheila Bair, the FDIC head, and Elizabeth Warren, the advocate for the new financial services consumer protection agency, were dubbed the “New Sheriffs of Wall Street” by the magazine. That attention might beget bad fortune. That title had been bestowed by the television program 60 Minutes on the since disgraced Eliot Spitzer, also selected as “Crusader of the Year” by Time. This attention further harkened back to the famous Time cover of the “The Committee to Save the World” featuring Alan Greenspan, Robert Rubin, and Larry Summers for their

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. Regulation, Reform, and the Subprime Crisis 733 work during the Asian Flu financial crisis. Ironically, all three later suffered setbacks. Greenspan and Rubin were harshly attacked for their role in the subprime crisis, and Summers was forced out of his role as president of Harvard University for some politically incorrect remarks and was able to gain only a modest role in the Obama administration before resigning in 2010. The SEC continued its stepped-up enforcement activities by launching a broad-scale investigation of CDOs issued by Morgan Stanley, JPMor- gan, Citigroup, Deutsche Bank, and UBS, as well as Goldman Sachs. The Financial Crisis Inquiry Commission, appointed by Congress to determine the causes of the subprime crisis, also accused Goldman Sachs of dragging its feet in responding to document requests and claimed that when production was finally made it was so massive as to be useless. Goldman Sachs executives were pilloried before the Senate Finance Committee over the transaction at issue in the SEC’s case and over a CDO transaction called Timberwolf. An internal Goldman Sachs email was displayed at the hearing, which stated that one potential investor for Timberwolf was too smart to buy such “junk.” Following that hearing, the SEC commenced an investigation of that transaction. An investor in Timberwolf also brought a fraud action against Goldman Sachs, seeking $56 million in actual damages and punitive damages of $1 billion. The Justice Department then launched an investigation of CDO practices at Morgan Stanley, and New York attorney general Andrew Cuomo began an investigation of eight major financial institutions concerning their role in rating CDOs. The Justice Department did seem to have learned a lesson from its failure to convict two Bear Sterns hedge fund managers that had presided over the failed hedge funds—that was one of the early signals that a subprime meltdown was under way. The department announced in May 2010 that it would not be bringing criminal charges against the AIG executives who were responsible for the derivative product losses that caused AIG to fail. The SEC’s publicity efforts were given a setback when it was revealed that the commission had split on party lines in a 3-2 vote to approve the action against Goldman Sachs, which is unusual, suggesting that politics were at play. It was also reported that Robert Khuzami, the head of the SEC Division of Enforcement had supervised lawyers working on synthetic CDO deals while he was the general counsel of Deutsche Bank, a Goldman competitor and one of the leading issuers of these instruments. Criticism was also directed at the SEC because the agency filed the case during the trading day without advance notice to Goldman, resulting in a hammering of Goldman’s stock. Normally, defendants are given a courtesy call and an opportunity to settle the case before public announcement, unless there is some need for immediate action to protect investors. There appeared to be no need for haste in the Goldman case because the agency had been sitting on the case for months. Goldman lawyers had made an inquiry as to its status before the filing but received no response. Moreover, in cases where there is a need for urgency, the SEC will

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 734 The Crisis Abates seek temporary or preliminary injunctive relief from the court. No such relief was sought here. The timing of the filing of the Goldman case was also found to be “suspicious” by the SEC inspector general (IG) because it conveniently diverted attention from a recently published report by the IG on the agency’s failure to uncover the giant Stanford Ponzi scheme and misconduct by a senior staff member in connection with that case. In another report published a few days after the filing of the case against Goldman, the IG reported that high ranking SEC staff members spent considerable time watching pornography on their government computers during the subprime crisis. Thirty-three SEC staff members were involved in that activity, including seventeen employees making between $99,000 and $220,000 per year. One attorney spent up to eight hours a day watching porn, and an SEC accountant had tried to access porn sites 16,000 times. The SEC’s charges against Goldman Sachs seemed to be taken from a popular book called The Big Short written by Michael Lewis that was highly critical of Goldman’s role in underwriting CDOs. The SEC accused Goldman and one of its employees, Fabrice Tourre, of fraudulently arranging a synthetic CDO squared transaction called ABACUS 2007-AC1, a part of which was sold to IKB Deutsche Industriebank AG (IKB). A synthetic CDO squared is a CDO that uses other CDOs as a performance measure only; it does not include the actual CDOs or their underlying mortgages. The SEC alleged that Goldman did not tell IKB, or its Portfolio Selection Agent, ACA Management LLC (ACA), that the subprime CDOs used as a portfolio reference in the ABACUS transaction were subject to the approval of hedge fund manager John Paulson. He later became famous for having made $5.7 billion personally during 2007 and 2008 by betting against subprime mortgages. IKB had other problems. Its CEO, Stefan Ortselfen, was convicted of issuing a press release on July 20, 2007, that falsely assured its shareholders and investors that it had very little exposure to the U.S. subprime market. IKB nearly collapsed a week later and had to be bailed out with loans from the German government of over $13 billion. Ortselfen was given a ten-month suspended sentence by a German court and fined $127,000. The SEC claimed that the omission of Paulson’s role was important because he was taking a short position against those CDOs through CDSs written by Goldman Sachs. Although Paulson made nearly $1 billion from the transactions that were the subject of the SEC’s charges, the SEC did not sue him. Paulson was not charged because he had made no misrepresentations to the investors in the synthetic CDOs, a requirement imposed recently by the Supreme Court in some Enron-era litigation that rejected “scheme” liability for those participating in an accounting fraud but not making misrepresentations directly to investors. This gap allowed Paulson to keep his $1 billion in profits, which he subsequently used to make large gains through investments in gold before suffering losses by betting on the U.S. economic recovery.

A few internal Goldman emails were published that were embarrassing, including one by Tourre, in which he stated he had “managed to sell a few abacus bonds to widows and orphans that I ran into at the airport, apparently these Belgians adore synthetic abs cdo2.” However, Tourre and a senior representative for Paulson testified that they had not misled ACA about Paulson’s short position. There were other problems with the SEC’s case. ACA knew that Paulson was involved in the transaction and that there was no position in the ABACUS transaction in which Paulson could participate other than being short. ACA also dealt directly and independently with Paulson in negotiating the mortgages that would be included in the synthetic portfolio. ACA met separately with Paulson representatives and rejected many of Paulson’s proposed portfolio selections after rigidly testing them for performance. ACA also proffered CDOs of its own for inclusion in the reference portfolio. ACA, and not Goldman Sachs, was responsible for the disclosure of its role in the private placement memorandum given to IKB. ACA stated there that it had acted independently in selecting the CDOs for the referenced portfolio in the ABACUS transaction, and there was no reason to believe that was not the case, as seen from these negotiations. Still another flaw in the SEC’s case was that numerous courts had held that a party need not disclose information that is already publicly available. In this case, it was widely reported in the press, including the Wall Street Journal, the New York Times, the Financial Times, Euromoney magazine, and the Sunday Telegraph in London, that Paulson had been making a $1 billion bet against subprime mortgages for some time before the ABACUS transaction closed and that he was making incredible profits. A popular hedge fund newsletter, the Alternative Investment News that is published by Euromoney, also reported in the summer of 2006 that Paulson was forming a fund to short the subprime market. It followed up with a report in September 2006 that Paulson had in fact created such a fund. Paulson was even reported to have boasted that he doubled his money by shorting the subprime mortgage market some six weeks before the ABACUS 2007-AC1 deal closed. Several of these reports in the press were also made before the Goldman Sach’s management committee approved the ABACUS transaction. Goldman Sachs thus had no reason to believe that ACA was uninformed that Paulson was short. Goldman Sachs settled the SEC ABACUS case on July 15, 2010, agreeing to pay $550 million, most of which went to the alleged victims. The case was settled on the same day that the president’s massive financial reform legislation was passed. This was the largest fine ever imposed by the SEC on a Wall Street firm, but was generally viewed as a victory for Goldman because analysts had been predicting a fine of $1 billion or more for any settlement. The press also pointed out that the fine that was levied constituted only fourteen trading days of profit for Goldman. In addition, the SEC agreed as a part of the settlement to drop its intentional fraud charge, and Goldman admitted only that it made a “mistake” in not disclosing Paulson’s role to IKB. The

SEC approved the settlement in another 3-2 vote, because the Republican commissioners could not understand why such a large fine was merited for a simple mistake that was not fraudulent. The SEC also agreed not to bring other cases it had under review against Goldman, which was another considerable victory for the firm. Goldman had to warn its employees not to publically gloat over the terms of the settlement. The market agreed with this assessment and Goldman’s stock jumped sharply on the news of the settlement. No Goldman Sachs executives had to resign as a result of the settlement, and it appeared that Lloyd Blank- fein’s position as CEO had been strengthened. However, Fabrice Tourre was thrown under the bus by Goldman. He was not a part of the settlement, and he continued his vow to fight the charges. The SEC received another embarrassing setback shortly after settling the Goldman case when the Court of Appeals for the District of Columbia struck down SEC rules that required insurance annuities to register under the federal securities laws. The court held that the SEC had acted in an arbitrary and capri- cious manner in adopting those rules because the state insurance commissioners already regulated such products. Subsequent legislation also precluded the SEC from regulating those products. A few weeks later, the same court of appeals struck down an SEC approval of an NYSE Arca rule mandating charges for access to its proprietary data. The court held that the SEC did not adequately explain or support its action on the rule. The SEC then counterpunched with a high-profile case charging Sam and Charles Wyly with a $550 million fraud charge. The suit claimed that the brothers hid funds offshore in order to avoid paying taxes. The brothers responded that they were only deferring taxes and that the arrangement at issue had been cleared by their lawyers, one of whom was in prison on other charges. The Wylys also fired back with a front-page interview in theNew York Times in which they accused the SEC of playing politics by bringing the case. The SEC also began an aggressive program of rulemaking for all matter of things in order to boost its image as a regulator. One proposal would require the issuers of asset-backed securities to retain at least 5 percent of each offering on its books. However, it was the holding of such securities by the financial institutions issuing them that caused the subprime crisis.

Dodd-Frank Wall Street Reform and Consumer Protection Act

Congress passed its overhaul of financial regulation on July 15, 2010. That legislation had been stalled in Congress for many months, and a $19 billion surprise tax on banks was included in the proposed legislation at the last minute as a way of paying for the costs of the additional regulation it would impose. That unexpected tax bought some votes, but the death of Senator Robert Byrd on June 28, 2010, threatened the already razor-thin support needed to pass the bill over Republican objections. The Democrats then dropped the new tax and

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. Regulation, Reform, and the Subprime Crisis 737 substituted a provision for accelerating the end of the TARP program as a way of offsetting some of the costs of the new legislation, allowing them to draw a critical Republican vote. The House and Senate versions of the financial services reform legislation were then resolved among the Democrats after a marathon twenty-two hours of negotiations. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act) was massive in scope. Totaling over 2,300 pages, it touches on nearly every aspect of finance and constitutes a governmental intrusion into Wall Street unseen since the 1930s. President Obama pointedly signed the bill into law in the Ronald Reagan office building at the International Trade Center in Washington, DC, signaling that Reagan’s deregulation efforts were being reversed. Dodd-Frank was a grab bag of reforms that often had little or nothing to do with the subprime crisis. For example, each financial regulator is required by the legislation to create an Office of Minority and Women Inclusion that is to act as a sort of diversity cop over the hiring and employment practices of financial services firms. Despite its size, Dodd-Frank offered no assurance that another financial panic will not occur in the future. Indeed, that legislation ignored the most critical issues of subprime lending by Fannie Mae and Freddie Mac. Instead, Congress promised to review their status in the future. In that regard, Treasury Secretary Geithner in an address on August 17, 2010 indicated that Fannie Mae and Freddie Mac were responsible for much of the mortgage lending in America because private lenders had pretty much abandoned the field. This was a signal that the government intended to continue to subsidize mortgages by guarantying them and exposing itself to risks engendered by politically motivated lending policies. The Dodd-Frank Act sought to address the “too big to fail” problem by creating a Financial Stability Oversight Council (FSOC) chaired by the secretary of the treasury. The other voting members on the Oversight Council are the heads of the Fed, the OCC, the FDIC, the SEC, the CFTC, the Federal Housing Finance Agency, the National Credit Union Administration, a new Bureau of Consumer Financial Protection and an independent member appointed by the president and knowledgeable about insurance. The council also has a number of non-voting (advisory) members, including the heads of a new Federal In- surance Office and the Office of Financial Research, and delegates selected by state insurance, banking and securities commissions. The council is to act by majority vote, except for some actions a 2/3 vote is required including the vote of the chair. This structure guarantees that jurisdictional debates will be decided by politics, rather than economics or efficiency. The unwieldy nature of FSOC will also assure that there will be no fast action taken in future crises, which means that the economy may well collapse as these many regulators express their always conflicting opinions on what course to take. The purpose of the Council is to identify risks to the financial stability of the United States that could arise from the distress, failure, or ongoing activities, of

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 738 The Crisis Abates large, interconnected bank holding companies or nonbank financial companies, or that could arise outside the financial services marketplace. In response to the backlash from the TARP legislation, the council is also charged with eliminating any belief on the part of shareholders, creditors, and counterparties that the federal government will bail out a firm that is about to fail. The council is also tasked with a number of other duties, including information gathering and resolution of jurisdictional disputes among its members. The council is to be assisted by the newly created Office of Financial Research in the Department of Treasury that is to gather and analyze financial data. The Dodd-Frank legislation extends the power of the Fed over large nonbank financial companies, such as AIG, if they are determined to pose a systemic threat in the event of their failure. The council is authorized to require regulation by the Fed of nonbank financial companies by a 2/3 vote of the council, including the vote of the chair. That vote is to be based on a determination that there would be negative effects on the financial system if the company failed or its activities would pose a risk to the financial stability of the U.S. The Fed is authorized to require reports and conduct examinations of the activities of nonbank financial companies and recommend enforcement actions by their functional regulator or take its own action if the functional regulator fails to respond. The Fed is further authorized to establish prudential risk standards for these nonbank financial companies. The Fed may require nonbank financial companies to establish risk committees and to undergo financial stress tests to determine their vulnerability to adverse economic events. The Fed may also establish leverage ratios limiting debt to equity of no more than 15 to 1. The council may order the breakup of large complex companies or require divestment of some of a company’s holdings upon a 2/3 vote, including the chair, if the company poses a grave threat to the financial stability of the United States. This extraordinary power is to be used only as a last resort. The Dodd-Frank legislation sought to limit future bailouts of failing financial institutions, and the existing TARP program was reduced to $550 billion. The Fed, in consultation with the Treasury Department, is required to adopt regulations designed to assure that any emergency lending program or facility is for the purpose of providing liquidity to the financial system, and not to aid a failing financial company. The collateral given as security for emergency loans must be sufficient to protect taxpayers from losses, and any such program must be terminated in a timely and orderly fashion. Upon the written determination of the FDIC and the Fed, the FDIC is authorized to create a widely available program to guarantee obligations of solvent insured depository institutions or solvent depository institution holding companies (including any affiliates thereof). This authority may be exercised during times of severe economic distress (a “liquidity event”), except that a guarantee of obligations may not include the provision of equity in any form. The maximum amount of such a guarantee program is to be set by the

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. Regulation, Reform, and the Subprime Crisis 739 president and approved by Congress by joint resolution. A liquidity event is defined as an exceptional and broad reduction in the general ability of financial market participants to sell financial assets without an unusual and significant discount; or to borrow using financial assets as collateral without an unusual and significant increase in margin; or an unusual and significant reduction in the ability of financial market participants to obtain unsecured credit. These were all events that occurred during the subprime crisis. The council may order large financial holding companies to submit a resolution plan (a living will) on how the bank will be liquidated or otherwise resolved in the event of its failure. The legislation provides for the orderly liquidation of covered financial companies. The procedure involves the appointment of the FDIC as receiver of covered financial institutions. The FDIC must appoint SIPC to act as trustee for the liquidation of a broker-dealer. The Dodd-Frank Act authorized bank regulators to establish leverage requirements as well as risk-based capital requirements for banks. A study was ordered on what components may properly constitute Tier 1 capital. The use of trust preferred securities as Tier-1 capital is no longer permitted, and existing trust preferred securities (a popular hybrid debt/equity instrument) are to be phased out. Dodd-Frank requires the Fed to consider the risk to the economy of bank mergers. Concentration limits are imposed. Financial company mergers are thus prohibited if the consolidated liabilities of the merger would exceed 10 percent of the consolidated liabilities of all financial companies. A similar 10 percent test for deposits was adopted. The Fed was also given broader examination authority over bank and savings holding companies. Securities holding companies that are required by a foreign regulator to be subject to comprehensive consolidated supervision may register with the Fed. Dodd-Frank required exposures from derivatives to be included in lending limits. The new legislation also added further regulatory supervision over payment, clearing and settlement systems. The Fed was given an enhanced role in the supervision of risk management standards for systemically important payment, clearing, and settlement activities by financial institutions, which will be regulated as designated financial market utilities. A debate had broken out over the accountability of the Fed during the subprime crisis. Some critics and members of Congress wanted it to be audited, but supporters of the Fed thought this might impair its independence. Under Dodd-Frank, the Government Accountability Office (GAO) was directed to conduct a one-time audit of all Federal Reserve emergency lending that took place during the subprime crisis. The GAO was also given ongoing authority to audit emergency lending, discount window lending and open market transactions. The Dodd-Frank legislation additionally created a vice chairman for supervision, who will be a member of the Fed designated by the president to develop policy recommendations regarding supervision and regulation for the Fed. Directors elected by member banks to represent member banks will no longer be allowed to vote for presidents of the Federal Reserve Banks.

Dodd-Frank abolished the Office of Thrift Supervision (OTS). The OTS authority over savings and loan holding companies was transferred to the Fed, and the OCC received OTC’s powers over federal savings associations. The FDIC was authorized to make assessments to fund its insurance program based on asset size less tangible equity, and pro-cyclical assessments were prohibited. FDIC insurance was increased permanently to $250,000 except that there was no coverage limit on non-interest bearing accounts. Dodd-Frank adopted a modified version of the Volcker rule. Hedging activities using derivatives are permitted. Banks may also invest up to 3 percent of their Tier 1 capital in hedge funds and private equity funds, but such investments may not exceed 3 percent of the assets of the hedge fund or private equity group in which an investment is made. Nonbank financial firms are subject to additional capital requirements and quantitative limits with respect to their proprietary trading and hedge fund and private equity investments. Dodd-Frank prohibits proprietary trading by banks, but brokerage, market making, and hedging activities are still allowed. This meant that most banks would not be severely affected by the remnants of the Volcker proposal. Two exceptions were Goldman Sachs and Morgan Stanley, which converted to bank holding company status during the subprime crisis. They will be required to withdraw billions of dollars of firm funds invested in hedge funds and private equity, raising the issue of whether those two firms should reconvert from bank holding company to broker-dealer status. Dodd- Frank, however, added a “Hotel California” provision (after the Eagles song about the hotel “you can check out of but never leave”) that prohibits regulatory conversions by bank holding companies, such as Goldman and Morgan Stanley, that received TARP funds. JPMorgan also had to close its proprietary unit. Dodd-Frank further addressed asset-backed securities. Originators will be required to retain an interest in their securitizations, up to 5 percent. “Qualified residential mortgages” were exempt from this risk retention requirement. Such qualified mortgages would not allow balloon payments, negative amortization, prepayment penalties, interest-only payments, and other features that have been demonstrated to exhibit a higher risk of borrower defaults.

Elusive Systemic Risk

The effort in Dodd-Frank to isolate systemic risk is an elusive goal and misguided. As regulators force financial institutions to curb one product because bureaucrats conclude that they pose excessive risk, finance will be forced into other fields that create a new systemic risk, unknown to a clueless bureaucracy. Worse still, the government will try to manage the companies that pose systemic risk, to set their compensation policies, and to select their leaders, who will undoubtedly be friends of the regulator (that is, former regulators with little or no business experience). This is foolishness. It will not prevent or detect market panics. There will continue to be periodic downturns, panics, and business folly.

As Robert Rubin, the former secretary of the treasury, noted in his autobiography, there is a tendency in human nature to engage in “financial excess,” and humans have a “remarkable failure to draw lessons from past experience. . . . The proclivity to go to excess is a phenomenon of collective psychology that seems to repeat itself again and again.”50 Ironically, Rubin, who became a senior executive at Citigroup, was forced to resign because it was reported in the press that he had encouraged that bank to change its business model and take on more risk. Citigroup did so and nearly failed during the subprime crisis, surviving only on government bailouts. Two business models for financial services firms emerged as successful during the subprime crisis: Goldman Sachs, as an investment banker, and JPMorgan Chase, as a commercial bank, but they were opposites. Goldman Sachs became one of the most successful firms in Wall Street history by deliberately incurring large risks, but with careful management. In contrast, the JPMorgan Chase business model was to build a “fortress” balance sheet that would withstand the most severe economic downturn, which meant more limited risk taking. So which business model will the bureaucrats try to stamp out as posing excessive risk? The correct answer is “Goldman Sachs.” But Goldman Sachs has proved to be a successful business model that should have been allowed to continue. There is also irony here. Limited risk models are equally as likely to fail as those incurring more risk. Indeed, the business landscape is littered with the carcasses of businesses that matured and avoided risks, to their detriment. The automakers avoided innovation because it is risky; they merely offered slightly differing versions of the same models with only an occasional new product. That business model had been faltering for years and failed spectacularly during the subprime crisis. Staid Eastman Kodak, which also has a renowned politically correct corporate governance system, has avoided risk at all costs, and it is a poster child for the results of avoiding risks. Eastman Kodak is a failed enterprise that did much to undermine the economy of Rochester, New York by avoiding risks and ignoring competition.

The SEC, CFTC and Derivatives

Dodd-Frank reacted to the SEC’s case against Goldman Sachs by prohibiting conflicts of interest for a one-year period on the part of underwriters or placement agents after the issuance of asset-backed securities, including synthetic CDOs. However, underwriters may engage in hedging and market making activities. Dodd-Frank also requires the Government Accountability Office to prepare a report exploring whether the Supreme Court’s decision striking “scheme” liability, which allowed John Paulson to escape the SEC’s action against Goldman Sachs, should be overturned by Congress. Another report was required on whether private right of actions should be allowed against persons who aid or abet a violation of the federal securities laws, an action dis-

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 742 The Crisis Abates allowed by another Supreme court case and which stopped many class actions against accountants and lawyers, and also helped Paulson avoid charges in the SEC case. Dodd-Frank added aiding and abetting liability, which is already contained in the Securities Exchange Act of 1934, the Securities Act of 1933 and the Investment Advisers Act of 1940. The standard of proof for intent for aiding and abetting was lowered from “knowingly” to “recklessly.” The Treasury Blueprint for regulatory reform issued in March 2008 had recommended a merger of the SEC and the CFTC. It was reported in May 2009 that, while the Obama administration supported a merger of the two agencies, it was not prepared to take on a fight between the two congressional committees overseeing those agencies.51 Dodd-Frank, therefore, did not merge the two agencies, a merger that would have diluted the SEC’s authority. Another gift to the SEC was an increase in its budget to $1.3 billion in 2011 and to $2 billion in 2014. The SEC’s many blunders did not pass entirely unnoticed. Dodd-Frank subjected the agency to some limited oversight by the OCC, which must audit and report on the SEC’s effectiveness every three years. Other management problems at the SEC were addressed in the legislation, including the exceptionally high rate of employee turnover at the agency, which has had the effect of robbing it of needed expertise. An employee hotline was required so that misconduct could be discovered more quickly. Dodd-Frank also created a “Council of Inspectors General” composed of the inspectors general at the financial services regulators, including the Treasury, SEC, and the Fed. This was intended as another means to strengthen oversight of financial services regulators. In a response to the massive Madoff Ponzi scheme that was conducted for years despite the SEC’s supervision, the agency was directed to conduct a study of how it could enhance its examinations of investment advisers. A new Office of Investor Advocate was created at the SEC, and it was to be assisted by the appointment of an ombudsman to act as that advocate. This would undoubtedly lead to more corporate governance reforms. A study on the financial literacy of retail investors was ordered. The SEC was also authorized to restrict mandatory arbitration of retail customer claims. Most brokerage firms currently use such arbitration in order to avoid costly litigation of customer complaints in court. A study on the conflicts of interest among the departments of investment banking firms was also ordered, another throwback to Eliot Spitzer’s crusade against the financial analysts during the Enron-era scandals. The SEC was directed by Dodd-Frank to conduct a study of whether customers of broker-dealers should be given the same protections of fiduciary duties as those given to clients of investment advisers. The SEC was authorized to impose such a requirement after conducting that study, but there was to be no continuing fiduciary duty after personalized advice is given. As a practical matter, this would not change the existing duties of broker-dealers who may not recommend securities that are unsuitable for their customers. In any event, the lack of such fiduciary duties had nothing to do with the subprime crisis

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. Regulation, Reform, and the Subprime Crisis 743 and as limited by Dodd-Frank will have no substantive effect, except to set the stage for more abusive litigation and encourage disappointed investors to sue their brokers. A group of the largest Wall Street firms agreed to support this proposal. That support was probably due to the group’s desire to sell fee-based brokerage accounts, a product that a federal court ruled required fiduciary duties and could not be sold by broker-dealers unless they were registered as investment advisers under the Investment Advisers Act of 1940.52 The SEC was also given the authority it sought over securities based derivatives. Before passage of Dodd-Frank, the chairs of the SEC and the CFTC reached an agreement to divide their jurisdiction by giving the SEC control over derivatives related to publicly traded securities and credit-default swaps (CDSs), leaving the CFTC with jurisdiction over derivatives related to other commodity products.53 On August 11, 2009, the Obama administration submit- ted a 115-page legislative proposal to Congress on this division of jurisdiction. Dodd-Frank acted on that proposal by regulating the previously unregulated swaps market. The SEC was given jurisdiction over security-based swaps and the CFTC jurisdiction over other swaps, except that joint regulatory authority is given to both agencies for “mixed” swaps that have elements of both securities and commodities. Most swaps will now be exchange traded and cleared through a regulated central counterparty. Customer funds associated with exchange-traded swaps must be held in segregated accounts. Portfolio margining was encouraged, an arrangement by which margin may be reduced through offsetting commitments on another exchange. Federal assistance to any swap related transaction or entity is prohibited, an apparent effort to assure no more bailouts like AIG. However, insured depositories are allowed to engage in a number of swaps activities such as hedging and acting as a credit-default swaps dealer if the swaps are centrally cleared. The legislation allows regulators to impose capital and margin requirements on swap dealers and major swap participants, but not end-users. Dodd-Frank directs the CFTC to establish position limits on trading of swaps. It establishes a code of conduct for all registered swap dealers and major swap participants when advising a swap entity. When acting as counterparties to a pension fund, endowment fund, or state or local government, swap dealers are to have a reasonable basis to believe that the fund or governmental entity has an independent representative advising them. Futures commission merchants, who act as brokers for commodity traders, are required to appoint a chief compliance officer and assure that there are appropriate informational barriers (“Chinese Walls”) between analysts and others in order to prevent conflicts of interest. This was another leftover reform from the Enron-era scandals brought to the fore by New York attorney general Eliot Spitzer in the securities industry. Rewards for whistle-blowers are provided from successful recoveries. The CFTC’s antimanipulation authority for false reporting was expanded to swaps. The legislation also bars “disruptive” practices identified as conduct that demonstrates intentional or

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 744 The Crisis Abates reckless disregard for the orderly execution of transactions during the closing period on an exchange, or which constitutes “spoofing” (bidding or offering with the intent to cancel the bid or offer before execution). Once again, the need for this regulation is not evident. The CDS market operated efficiently throughout the subprime crisis. The Lehman CDSs were settled promptly and in full. The problems at AIG were not attributable to CDS. The event that triggered the credit downgrades at AIG, and caused what amounted to a bank run, was the fair-value accounting write-offs for AIG’s exposure to the Super Senior tranches of the subprime CDOs. As described above, that was a regulatory problem, for which regulators and the FASB must bear responsibility. Another regulatory target was to centralize the clearing and settlement of swaps, a process engaged in by clearinghouses on regulated exchanges and which provides transparency in the amount and nature of the trading on the exchange. SEC chairman Christopher Cox had sought authority from Con- gress to regulate the CDS market in September 2008, saying, “The regulatory black hole for credit-default swaps is one of the most significant issues we are confronting in the current credit crisis, and it requires immediate legislative action.”54 He argued that the market lacked transparency and was ripe for fraud and manipulation, of which very little could be found. The claim of lack of transparency became a new rationale for more regulation. Yet, no one could explain how transparency could have prevented the subprime crisis, or how it would add anything of value to the CDS market, and, worse still, nobody asked that question. Cox’s claims also showed just how out of touch his agency was with financial markets. Apparently without Cox’s knowledge, the Depository Trust and Clearing Corporation (DTCC), which the SEC regulates, established a Trade Information Warehouse (Warehouse) before the subprime crisis that was “the only global repository and centralized post- trade processing infrastructure for over-the-counter (OTC) credit derivatives. The Warehouse maintains the vast majority of CDS contracts in the market place.”55 Thus the information sought by Cox was there for the asking, if only he had known to ask. Indeed, the DTCC was able to assure the market that the CDS exposures from the Lehman Brothers bankruptcy were limited and manageable, which allayed concern among market participants. To be sure, concern was expressed even before the subprime crisis (in 2005) in a three-hundred-page report prepared by a former New York Fed president, Jerry Corrigan, over settlement procedures for credit derivatives. Many credit derivative dealers were behind in their trade confirmations, and some assigned their positions to other dealers without the permission of the counterparty. The industry addressed those problems after the Corrigan report was filed, and by most accounts the CDS market operated smoothly during the subprime crisis. The outstanding notional amount of CDSs, which totaled over $65 trillion in 2007, fell to an estimated $58 trillion in 2008 as the cost of these instruments increased during the crisis, but that was a normal market reaction. Treasury Secretary Geithner announced the administration’s plan to regulate

OTC credit-default swaps and other OTC derivatives by requiring them to be cleared through a central clearinghouse. This was not surprising. While president of the New York Fed, Geithner had been behind an industry-supported effort to create a central CDS clearing facility. A Wall Street Journal editorial expressed concern over this proposal because it would centralize and social- ize risk. The newspaper also objected to the proposed reliance by the New York Fed on credit ratings as a basis for access to the clearing facility. The Wall Street Journal was additionally critical of government efforts to create a regulated CDS market. The editorial noted that the market for CDSs operated well despite the failure of Lehman Brothers and AIG.56 Moreover, outstanding CDSs on bankrupt General Motors’ debt of $35 billion were only $2.2 billion in exposure and were easily settled. Although the Presidential Working Group supported Geithner’s concept for central clearing of CDSs, a jurisdictional fight broke out among the SEC, the CFTC, and the New York Fed over who would approve and regulate such clearinghouses. These regulators tried to resolve this dispute through a memorandum of understanding that promised enhanced cooperation and information sharing among the Fed, the SEC, and the CFTC, upon the development of such a facility. This truce did not last long, and the turf war continued. The SEC claimed that CDSs were securities subject to its jurisdiction. Using that regulatory role, the SEC proposed to exempt from most of its regulation CDS clearinghouses that complied with its standards, including the exclusion of non-eligible swap participants.57 The SEC made another effort to bring CDS under its wing by filing an inside-trading case in May 2005. The agency charged that Jon-Paul Rorech, a bond salesman at Deutsche Bank, had passed inside information to Renato Negrin, a hedge fund manager at Millennium Partners, who then used the information to make a quick profit of $1.2 million. In the scheme of things, this was hardly a massive fraud, but the SEC used it to justify the need for more regulation. The SEC was embarrassed once more, however, after a judge dismissed that case, finding that the SEC had no evidence to support its claims. The defendant, Jon-Paul Rorech, was soon thereafter hired by UBS AG. In the meantime, the industry continued working on the creation of a central clearinghouse. A problem that had to be surmounted in clearing OTC derivatives is that their terms are often non-uniform, unlike futures and options trading on exchanges. This makes it more difficult for the clearinghouse to assess its exposure when acting as a counterparty. Models have been developed that measure unique instruments, but difficulties remain. A model for OTC derivatives was developed by the IntercontinentalEx- change (ICE), which cleared what were effectively OTC derivatives, albeit with uniform terms. The legislation proposed by the Obama administration sought to require “standardized” OTC swaps to be registered with a regulated clearinghouse. A standardized swap would include any contract accepted by a clearinghouse and other contracts similar to those cleared by a clearing-

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 746 The Crisis Abates house, but many questions were left unanswered over how “standardized” CDS status would be attained. Adding to the regulatory expansion into this once-unregulated market was an announcement in July 2009 that the Antitrust Division in the Justice Department was focused on the CDS market. In particular, the division was investigating Markit Group Holdings, which was a company formed by a consortium of banks to collect pricing information, which was used to create the ABX index to track subprime mortgages, as well as the CDX index for CDSs. Banks participating in this enterprise included Goldman Sachs and JPMorgan Chase. New York attorney general Andrew Cuomo and U.S. attorney Michael Garcia in Manhattan reached an agreement in October 2008 to jointly investigate the CDS market, even though it showed few signs of illegal activities. Cuomo investigated whether swap dealers were manipulating the market for CDS. Eric Dinallo, the New York State superintendent of insurance (a protégé of Eliot Spitzer, who was planning to run for attorney general), jumped in and announced that a portion of the CDS market was subject to regulation as insurance. He was supported in that effort by Spitzer’s successor as governor of New York, David A. Paterson. However, Dodd-Frank excluded swaps from the definition of insurance. The Dodd-Frank Act almost completely reworked the landscape for swaps, subjecting them to intense regulation where there had been little or none before. The Commodity Futures Modernization Act of 2000 exempted most swaps from regulation, but that course was abandoned in Dodd-Frank. Dodd-Frank requires swap participants to be eligible contract entities (institutions or wealthy individuals) if the swap is not traded on a regulated contract market. Dodd- Frank also requires swaps to be cleared by a registered derivatives clearing organization (DCO) unless the CFTC rules otherwise. Swaps cleared by a DCO must be maintained at a registered futures commission merchant subject to CFTC segregation requirements for customer funds. Segregation may also be demanded for non-cleared swaps. The CFTC was allowed to regulate margin requirements when necessary to protect the integrity of derivative clearing organizations, a power previously withheld from that agency for futures. Dodd-Frank requires the CFTC to make public disclosures concerning the volume and nature of cleared swaps, but disclosure of trader identity is restricted. The act requires the reporting of non-cleared swaps to registered “swap data repositories” or (if the former doesn’t accept them) to the CFTC. Firms acting as swap dealers and major swap participants must register with the CFTC before they can engage in swap transactions. Firms engaged in securities-based swaps must register with the SEC. The CFTC and SEC are required to establish capital and margin requirements for the swap entities they regulate. Swap dealers and major swap participants are required to maintain trading records and disclose certain material risks to counterparties. The CFTC may also require the registration of foreign boards of trade that allow U.S. traders to access their electronic trading systems.

Hedge Funds

The subprime crisis refocused regulatory attention worldwide on hedge funds, even though they weathered the storm much better than the large highly regulated commercial and investment banks did. In testimony before Congress on March 26, 2009, Geithner indicated his support for requiring registration of hedge funds. Ironically, he cited the massive fraud by Bernard Madoff as evidence of the need for registration. However, Madoff had registered with the SEC as an investment adviser in 2006 as the result of an SEC rule requiring hedge funds to register as investment advisers. That rule was later stricken by a federal court but, unlike many hedge funds, Madoff did not deregister his firm and continued his fraud under the supervision of the SEC. In imposing that registration requirement, the SEC had claimed that registration of hedge funds would allow it to detect and prevent fraud at such operations. Yet the SEC was clueless about Madoff’s scheme, the largest financial fraud in world history. The SEC’s inspections of Madoff’s investment adviser operations failed to uncover any fraud, despite several warning signals. Ignoring that bit of history, Mary Schapiro, the head of the SEC appointed by the Obama administration, vowed at her confirmation hearings to seek greater regulation of hedge funds in order to make them more transparent and accountable. Schapiro sought regulation that went beyond the administration’s registration proposal. She wanted not only to renew the registration requirement but to also impose a new requirement that hedge funds be subject to books and records inspection by that agency, even though such measures had not uncovered the Madoff fraud. The Dodd-Frank Act responded to those requests by requiring hedge fund managers to register with the SEC as investment advisers if the assets they manage in the United States exceed $100 million. Venture capital advisers are exempted from registration with the SEC. Smaller hedge funds are subject to state regulation. Commodity trading advisors registered with the CFTC must also register with the SEC if their advice is primarily security related. Registered hedge fund managers must keep books and records that disclose the amount of assets under management, the degree of leverage in the funds they manage, any “side pocket” arrangements that give some investors greater rights than others and trading practices. The SEC is authorized to make periodic and surprise examinations of registered hedge funds. It was also ordered to study the effects of short sales, a favored trading technique of hedge funds, and to consider the feasibility of a program that would require orders to be marked as short or long. The European Union sought even tougher regulation of hedge funds and private equity, including capital requirements, risk management requirements, and a requirement to regularly report their investments, performance, and risk. That proposal was opposed by the United States and Great Britain. Especially controversial was a proposal that would have effectively excluded U.S. hedge

The Rating Agencies—Shoot the Messenger

Lloyd Blankfein, the CEO at Goldman Sachs, published an op-ed piece in the Financial Times in which he identified risk management flaws in the financial system that he believed had laid the groundwork for the subprime crisis. Blank- fein asserted that many financial institutions had erred in outsourcing their risk management to the rating agencies. He contended that the rating agencies had diluted their triple-A rating by giving that rating to more than 64,000 structured finance instruments, while only twelve operating companies in the world had such a rating. Where financial services firms did their own modeling, they failed to take into account multiple standard deviations, ignoring the possibility of a hundred-year storm. Blankfein pointed to flawed risk models that erroneously assumed positions could be fully hedged and that failed to capture off-balance-sheet risk. He also thought that the industry had not been able to keep up operationally with the complexity of the risks presented by new financial instruments.58 That was sound criticism, but what was the alternative? The rating agencies, including Moody’s, Standard & Poor’s, and Fitch, had become the arbiters of the interest rate paid by companies when borrowing money. A company’s credit status, as perceived by the ratings agencies, also measured its acceptance as a counterparty with other businesses. The higher the rating, the more exposure a counterparty would accept in trading or dealing with the rated company. A triple-A rating evidenced the rating agencies’ belief in a high likelihood that the debtor would not default. Lower ratings, those below “investment grade,” were considered high-risk “junk” bonds, which indicated a higher likelihood of default. A lower rating meant more risk to investors, and they therefore demanded higher interest payments to compensate for that risk, as well as reduced exposure. It was, consequently, important to the issuer to receive the highest possible rating for its issues. It was also important to maintain those ratings because a downgrade would result in a sharp fall in the value of the bond or other debt instrument being rated and would raise funding costs or even limit further access to the credit markets. Lower ratings could also impair the liquidity of instruments, as investors might be reluctant to buy them at anything other than distress prices because of the uncertainty of their performance. Downgrades can also set off “triggers” in lending arrangements or derivatives that will require more collateral or accelerated repayment or settlement, which is what happened at the Enron Corp. when it failed. The importance of the credit rating agencies grew when government regulators began using their ratings as regulatory tools. Such a role for the rating agencies dates back to the Great Depression when the Comptroller of the Cur- rency used their ratings to assess the quality of assets held by banks. The SEC recognized this role of the rating agencies by designating them as Nationally

Recognized Statistical Ratings Organizations (NRSROs). For example, the SEC’s net capital requirements used credit rating agency assessments as the basis for computing “haircuts” (reductions in the value of instruments to reflect their risk) on fixed income securities, and it limited money market investments to short-term debt instruments highly rated by the NRSROs. An internal SEC study found forty-four references to NRSROs in its rules and forms. Congress also adopted the NRSRO concept by defining an eligible “mortgage- related security,” in the Secondary Mortgage Market Enhancement Act of 1984, as being rated in one of the two highest rating categories by at least one NRSRO. In 1995, Fannie Mae allowed the use of a title insurer with a favorable credit rating from at least one independent credit rating agency. The Federal Deposit Insurance Act adopted the concept by defining “investment-grade” corporate obligations as being rated in one of the four highest categories by at least one NRSRO. The Education Department also uses NRSRO ratings to set eligibility standards for institutions seeking to participate in student financial aid programs. The rating agencies employed knowledgeable experts to assess credit quality, but they had a large field to cover. Moody’s, for example, employed some 1,200 analysts to rate the debt of 100 sovereign nations, 12,000 corporations, and nearly 30,000 state and municipal offerings, as well as 100,000 structured finance vehicles. That expertise was also compromised by the fact that the credit rating agencies had a conflict of interest because of the way in which they charged fees for their ratings. Starting in the 1970s, the rating agencies began charging a fee to the company they were rating, which was an inducement to the rating agencies to please the client. The credit rating agencies’ assessments of creditworthiness did not always prove reliable, a fact that was apparent long before the subprime crisis. An SEC investigation found that the sale of Penn Central commercial paper had been greatly aided by its “prime” rating from the National Credit Office, which was the highest rating grade issued by that rating agency. The high rating of the Penn Central commercial paper occurred just before its collapse in 1970. The SEC found that the rating had been given without adequate investigation.59 Moody’s and Standard & Poor’s had also given the highest rating to the municipal debt of Orange County, California, just before that county filed the largest municipal bankruptcy in history due to the speculative trading operations of the county treasurer, Robert Citron. The rating agencies also maintained their high rating for Enron until just before its collapse. After the Enron affair, Congress passed the Credit Rating Agency Reform Act of 2006,60 which required credit rating agencies to register with the SEC and to provide it with their performance measurement statistics, rating methodologies, a code of ethics, and financial statements.61 The credit rating agencies were also required to adopt procedures for the prevention of the misuse of inside information and to deal with conflicts of interest, such as their fee arrangements. The SEC was given rulemaking authority to deal with conflicts of interest. Tying practices, such as requiring payment for additional services in order to obtain or retain a

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 750 The Crisis Abates rating, were prohibited. That legislation did nothing to enhance credit ratings and did nothing to correct the shortcomings in the ratings methodology that were at the center of the subprime crisis. Congress became dissatisfied with the rating agencies once again after they began a massive downgrading of the subprime mortgages that they had once rated as triple-A or investment grade. Those downgrades affected thousands of mortgage securitizations totaling about $1.5 trillion in value. Those downgrades required the holders of those instruments to mark them down in price. That action, in turn, imposed losses on those investors. On July 10, 2007, Moody’s cut ratings on CDOs valued at $5 billion. Between July and August 2008 alone, Moody’s downgraded nearly 1,000 CDO issues valued at some $25 billion. By February 2009, the number of downgrades worldwide had reached over 16,000, more than 90 percent of which were CDOs.62 The effect on a securitized issue as a result of a credit downgrade can be seen from what happened to a Goldman Sachs mortgage-backed securities offering, made in 2006, which included subprime and second mortgages. It was a $338 million offering, of which $165 million was placed in a tranche that received a triple-A rating from both Moody’s and Standard & Poor’s. Eight months after its issuance, and in the midst of the subprime crisis, Moody’s announced that the offering was placed on credit watch. A few months later, it reduced the rating from triple-A to Baa, the lowest investment-grade level. Thereafter, it downgraded that rating to junk bond status and then lowered it further a few months later. After those downgrades, the value of those securities fell dramatically and trading in the issue stopped. The massive number of subprime downgrades suggested that something was wrong at the rating agencies, which gave the Super Seniors such high ratings and then switched and downgraded them to junk bond status. Members of Congress demanded that the SEC investigate Moody’s and Standard & Poor’s to determine whether they had properly maintained their independence. The press also criticized Moody’s for becoming too chummy with its structured investment vehicle (SIV) clients. The Wall Street Journal even faulted one Moody’s executive for going parachuting with a client. That charge was silly, but Moody’s had benefited from this lucrative market. Its profits rose by 375 percent over a six-year period, driven largely by structured finance ratings. Moody’s rated nine out of every ten dollars raised through structured instruments. In 2005, its structured finance ratings resulted in revenues of $715 million, which was more than 40 percent of Moody’s total revenues. Moody’s charged more than $200,000 to write a $350 million mortgage-backed offering, while a municipal bond offering in the same amount would generate fees of only $50,000. Standard & Poor’s and Moody’s revenues grew from $3 billion in 2002 to more than $6 billion in 2007 as a result of structured finance ratings. Moody’s had the highest profit margin of any company in the S&P 500 for five straight years. A study released by the SEC in July 2008 found that the rating agencies

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. Regulation, Reform, and the Subprime Crisis 751 had been careless in their approach to rating SIVs. The SEC found that the rating agencies were understaffed and overwhelmed by the large number of subprime securitized offerings. The analysts employed by the rating agencies were also found to have considered the risk of losing business if they did not give instruments the ratings sought by the issuer. The risks of the subprime securitizations were often not fully measured by the rating agencies. One analyst said that: “it could be structured by cows and we would rate it.” Moody’s discovered in February 2007 that it had committed a computer error in giving a triple-A rating to “constant proportion debt obligations” (CPDO), a form of synthetic debt security that was widely sold in Europe. Although it became aware of the error shortly after the securities were issued, Moody’s did not correct the rating for more than a year. The market value of those instruments at issuance was more than $1 billion, but their price plunged after the subprime crisis began. Moody’s was advised in May 2010 that the SEC staff was recommending an enforcement action for this failure. The charges were a bit convoluted. The SEC staff claimed that Moody’s filed a false NRSRO application because this activity did not comport with a code of ethics included in that application. This so-called “Wells notice” from the SEC caused a sharp sell-off in Moody’s stock. Standard & Poor’s also experienced a decline. Some $300 billion in CDOs was in default by February 2009.63 Banks in the European Union had been badly damaged by the triple-A rated “Super Senior” subprime CDOs. Their governments turned on the rating agencies, finding them a convenient scapegoat. The European Commission proposed legislation in November 2008 that would regulate credit rating agencies through its Commit- tee of European Securities Regulators. In the United States, Treasury Secretary Henry J. Paulson stated that he would seek additional regulation of the rating agencies, including requiring different ratings categories for mortgage-backed securities, the disclosure of conflicts of interest, and explanation of the basis for their reviews. He also wanted the rating agencies to assume a more aggressive regulatory role over loan originators. The President’s Working Group on Financial Markets endorsed this plan. Moody’s sounded a warning in 2008 that the United States was in danger of losing its triple-A credit rating in the future because of rising expenditures on Social Security and Medicare. Such a downgrade would be a disaster for federal financing because of the increased funding costs that would result. It was unclear whether Moody’s was serious or if this was simply a threat designed to have the federal government back off its criticism and attacks on the rating agencies. If it was the latter, it did not work. The House Financial Services Committee approved a bill to require credit rating agencies to use different rating measures for municipal securities and corporate bonds. That committee, as well as some states, believed that by using the same rating systems, municipal securities were receiving lower ratings than comparable corporate bonds. In response to that pressure, Moody’s announced in March 2010 that it was changing its ratings to use a single scale for municipal and corporate bonds.

Connecticut attorney general Richard Blumenthal, who was about to begin a campaign for a Senate seat, did not wait for legislation to be enacted. In July 2008 he filed suit against the rating agencies, claiming that they had systemati- cally and intentionally given lower ratings to states and municipalities than to corporations and other entities with higher default rates. The rating agencies entered into an agreement with New York attorney general Andrew Cuomo on June 5, 2008, pursuant to which they agreed to strengthen their independence and ensure that critical loan data were available before they rated loan pools. The rating agencies further agreed to increase their transparency in connection with their ratings for the residential mortgage-backed securities market. In order to restrict shopping for ratings, the settlement required the ratings firms to be paid for their reviews, even if they were not hired to rate the transaction. The theory was that the rating agencies would be less inclined to provide the desired rating merely in order to get paid. In addition, the rating agencies agreed to review due diligence reports on loans being securitized and to establish criteria for assessing the reliability of loan originators. The SEC also jumped on the rating agencies once again. An SEC staff study in July 2008 detailed what it called significant flaws in the rating processes at the larger credit rating agencies. The SEC proposed requiring credit rating firms to make more disclosures about how they rated securities and to provide special classifications for securitized instruments. The SEC also proposed prohibiting rating agencies from rating instruments that they designed, leaving them little incentive to develop new products, hardly a desirable economic goal. In addition, executives at rating agencies negotiating fees would be prohibited from involvement in the rating of the company’s securities. Under the SEC proposals, employees of rating agencies involved in advising on rating methodologies would be prohibited from receiving a gift of more than $25 per meeting on the issue. More significantly, the rating agencies would have to publish the performance of their ratings over one-, three-, and ten-year periods, including upgrades and downgrades. The SEC also proposed changing its rules to remove some references to NRSROs as value determiners, and it cautioned investors that a credit rating was only the first step in considering whether to make an investment. The SEC decided in December 2008 to defer action on the proposal to require the rating agencies to differentiate between bonds and structured investments in their rating methodologies. The agency also deferred action on its proposal requiring the rating firms to disclose all underlying information about debt offerings being rated. The SEC adopted some changes that required the rating agencies to take additional steps to mitigate conflicts of interest, to require more disclosures of their rating processes, and to disclose the performance of their ratings. This did not satisfy rating agency critics, and in July 2009 the Obama administration proposed the creation of a special office in the SEC to monitor rating agencies and the separation by rating agencies of ratings of structured finance from those of other debt offerings. Additional

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. Regulation, Reform, and the Subprime Crisis 753 disclosures would also be required. The SEC went a step further in April 2010, proposing a rule that would remove recognition of the rating agencies as an official evaluator of mortgage and other asset-backed securities. Instead, the return on the bonds would have to be vouchsafed by the CEO of the issuer and the issuer would have to invest its own funds in at least 5 percent of the issue. This was a radical departure from the view that investors accepted the risks of an investment and that issuers could not guarantee returns. The Dodd-Frank Act adopted many of these proposals. The legislation stated that regulation was justified because the ratings agencies are financial ‘‘gatekeepers’’ and should be subject to the same standards of liability and oversight as auditors, securities analysts, and investment bankers. The legislative justification statement also noted that the mis-rating of structured products had contributed substantially to the subprime crisis. Among other things, rating agencies were, in a Sarbanes-Oxley-like provision, required by Dodd-Frank to strengthen their internal controls and attest to their effectiveness. The SEC was directed to establish an Office of Credit Ratings, and the agency was required to conduct examinations of credit rating agencies at least once a year. The SEC was directed to adopt rules governing the procedures and methodologies for credit ratings, including qualitative and quantitative data and models, used by the rating agencies. Where the SEC was to obtain that expertise was left unsaid. Disclosure of rating methodologies was also required. At least 50 percent of the board of directors of the rating agencies were required to be independent directors. The rating agencies were required to become informers on their clients and to report any violations of the federal securities laws that they might observe in the course of gathering information for a rating. Ratings analysts will be required to pass qualifying exams and have continuing education. The SEC was directed by Dodd-Frank to study whether credit rating agencies should be assigned by an independent body to rate CDOs. The comptroller general was directed to report on alternatives to the credit rating agencies, including the creation of an independent professional analyst organization. Jules B. Kroll, the founder of the investigative firm Kroll Associates, which he had sold before it tanked to Marsh & McLennan in 2004, announced the formation of a new rating agency in August 2009. That business would charge subscription fees for information and services. Another commonsense approach might be to fix the risk models. Obviously, models cannot account for every unexpected risk, but stress-testing could be improved. Dodd-Frank also requires that all statutory or regulatory references to credit ratings by NRSROs be replaced by the term “meets the standards for creditworthiness as established by [the relevant federal regulator.]” A last-minute change in the Dodd-Frank legislation also made the ratings agencies liable for the quality of their ratings under the Securities Act of 1933. This caused all three of the rating agencies to suspend the use of their ratings for asset-backed bonds, which then had the effect of freezing that $1.2 trillion dollar market. Among those frozen out of the market was Ford Motor Company’s financing

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 754 The Crisis Abates arm. The SEC then acted to allow bond offerings to be made without credit ratings for a period of six months. More than thirty lawsuits were filed against the rating agencies claiming damage as the result of their faulty ratings. These cases were defended on that ground that the rating agencies were merely expressing an opinion on the creditworthiness of a company or instrument and that this was protected speech under the First Amendment to the Constitution. A federal judge ruled in one case that the rating agencies were not protected by the First Amendment where their ratings report went only to a select group of investors. In an earlier case, the Supreme Court held that a credit report issued by Dun & Bradstreet, which mistakenly reported that a private company was in bankruptcy, was not protected by the First Amendment privileges available to newspapers.64 One class-action lawsuit charged that Moody’s had falsely claimed that it was an independent body in issuing its ratings. A federal district court held that the complaint stated a cause of action because it charged that ratings were changed by Moody’s at the request of issuers and that Moody’s had falsely described its ratings methodologies. The California Public Employees Retire- ment System (CalPERS) sought to cut its $1 billion in losses from structured subprime products by suing the rating agencies. The lawsuit claimed that the rating agencies had made negligent misrepresentations to CalPERS by rating those instruments as triple-A. CalPERS claimed that the rating agencies had acted incompetently in issuing the ratings and in assessing the credit risks associated with those instruments. CalPERS was given more reason to be angry with the rating agencies after this lawsuit was filed. In December 2009, Moody’s downgraded its rating to Aa3. The National Association of Insurance Commissioners (NAIC), an organization of state insurance regulators, announced in October 2008 that it was considering entering the credit ratings business. NAIC already reviewed credit quality and rating securities owned by state-regulated insurance companies as reserve investments. That effort was given a boost in September 2009, when a whistle-blower, Eric Kolchinsky, a former analyst at Moody’s, charged that Moody’s continued to give inflated ratings to structured securities in 2009. Scott McCleskey, the former head of compliance at Moody’s, also claimed that it did not properly monitor the ratings that it gave municipal bonds, and he, and other compliance officers, had been replaced by structured finance analysts who rated the securities that had to be later downgraded. State insurance commissioners used that scandal to attack the rating agencies again and to try to remove rating agencies as the arbiters of investment risks embedded in insurance company portfolios. Replacing them with government ratings, however, is a prescription for disaster. Politics, not economics, will surely control such ratings. This also raises the question of how can a risk-modeling program be regulated without making the government itself a rating agency? The danger of having the government dictate risk management models is apparent. They can use that power to manage the form of business models.

When it came into office in 2009, the Obama administration stress-tested the largest nineteen banks to determine their viability. The stress tests sought to determine whether the banks could survive a 3.3 percent contraction in the economy in 2009 and flat growth in 2010. This stress-testing assumed an additional 22 percent decline in housing prices and an unemployment rate that would rise over the next two years to 10.3 percent. Banks that had problems surviving under these scenarios were given six months to raise capital privately. Failing that, the government would buy convertible preferred shares from the banks that would pay a 9 percent dividend and would convert to common stock. This effort was the first step in broadening risk models to test for the effects of catastrophic risks. That was commendable, but it became associated with nationalization of the financial services industry as well, because regulators were using its stress test as leverage to manage the banks’ balance sheets.

Consumer Protection

The Fed was directed by the Dodd-Frank Act to adopt regulations prohibiting lenders from making a residential mortgage loan unless the creditor makes a reasonable and good faith determination based on verified and documented information that, at the time the loan is consummated, the consumer has a reasonable ability to repay the loan, according to its terms, and all applicable taxes, insurance (including mortgage guarantee insurance), and assessments. That determination is to be based upon consideration of the consumer’s credit history, current income, expected income the consumer is reasonably assured of receiving, current obligations, debt-to-income ratio or the residual income the consumer will have after paying non-mortgage debt and mortgage-related obligations, employment status, and other financial resources other than the consumer’s equity in the dwelling or real property that secures repayment of the loan. A creditor shall determine the ability of the consumer to repay using a payment schedule that fully amortizes the loan over the term of the loan. Liar loans are prohibited—the lender must verify the borrower’s income. More consumer protection was added in the form of electric utility rate regulation. The Fed was directed to adopt rules regulating interchange fees for processing debit card transactions, which are required to be reasonable and proportional in relation to their expense to the issuer. The Fed was also authorized to regulate network fees charged for processing credit card transactions. Restrictions on access to networks by card companies were also attacked. In anticipation of these restrictions, many banks were raising other fees and planning to pass on to consumers other costs of the Dodd-Frank legislation and the Credit Card Accountability, Responsibility and Disclosure Act that was passed in 2009 (it restricted the ability of banks to increase rates). The average interest rate being charged on credit cards climbed to 14.7 percent. Other consumer protection in the Dodd-Frank legislation included disclosures on remittances, which are popular for recent immigrants sending money home to families.

Additional regulation was imposed on mortgage originators who were required to be registered or licensed, and a number of predatory practices were prohibited. Those practices include steering consumers to a residential mortgage for which they lack a reasonable basis to pay or which utilizes equity stripping (loans made to remove the equity built up in a home), imposes excess fees or has other abusive terms. If a mortgage originator is unable to provide a loan that a consumer qualifies for, the originator must discourage the consumer from seeking a mortgage from another mortgage originator. This adds a bit of paternalism to the application process. Falsi- fying borrowers’ credit history and property appraisals is prohibited, and origination fees and yield-spread premiums paid as origination fees to mortgage brokers are restricted. Prepayment penalties are limited when mortgages are paid off early and restrictions were placed on loans with negative amortization, and special disclosures are required for loans that reset interest rates after an introductory period. Property appraisers are required to be independent.

Consumer Financial Protection Bureau

The reforms sought by Treasury Secretary Geithner included a proposal for the creation of a Consumer Financial Protection Agency, an option that had been advocated by Harvard Law School professor Elizabeth Warren. As originally proposed, this agency would have vetted and overseen consumer credit items such as credit cards, mortgages, savings and banking accounts, and annuities. It would have required standardized financial products to be sold to retail investors, for which a safe harbor from litigation claims over their structure would be created. Non-standardized products would have been subject to litigation, which would mean that innovation in finance would be stifled. This proposal ran into opposition from Fed chairman Bernanke, the FDIC, and the SEC, as well as the business community.65 Representative Barney Frank watered down the administration’s proposed consumer financial protection agency’s powers in order to overcome industry resistance. Among other things, he removed the proposal to require financial services providers to offer certain plain-vanilla products, like fixed-rate mortgages. Moreover, financial services firms would not be required to determine whether consumers understood the products they are purchasing. The Dodd-Frank Act created the Consumer Financial Protection Bureau (CFPB) in the Fed headed by an independent director appointed by the president and confirmed by the Senate, touching off a fight over whether Professor Warren should head the new bureau. Since Senate confirmation was unlikely, she was appointed special advisor leading the creation of the bureau. The CFPB is tasked with implementing and enforcing federal consumer financial laws consistently for the purpose of ensuring that all consumers have access to markets for consumer financial products and services and that markets for

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. Regulation, Reform, and the Subprime Crisis 757 such products and services are fair, transparent, and competitive. The bureau was given a $500 million budget to carry out that task. The CFPB will regulate the offering and provision of consumer financial products or services under the existing federal consumer financial laws. It has independent authority to write rules governing consumer protection for customers of all financial institutions that offer consumer financial services or products. However, it must consult with other regulators before a proposal is issued, and regulators may appeal regulations they believe would put the safety and soundness of the banking system or the stability of the financial system at risk. The CFPB was given authority to examine and enforce regulations for banks and credit unions with assets of over $10 billion and all mortgage- related businesses (including lenders, servicers and mortgage brokers), payday lenders, student lenders (who will be overseen by a Private Education Loan Ombudsman), debt collectors, and consumer reporting agencies. The CFPB will also oversee enforcement of laws requiring nondiscriminatory access to credit for individuals and communities. Certain powers of the Federal Trade Commission were transferred to the CFPB but the two agencies were allowed to enforce each other’s rules. The CFPB was given the power to subpoena witnesses and to issue civil investigative demands for documents, and those demands are enforceable in court. The CFPB may issue a notice of charges upon the discovery of a violation and, after an opportunity for a hearing, issue a cease and desist or corrective action order and impose civil penalties or order equitable relief, all of which are subject to judicial review. The bureau may also make criminal referrals to the Justice Department. State laws inconsistent with CFPB rules are preempted, except that state laws offering greater protection than CFPB are deemed not inconsistent. CFPB will thus set the floor on consumer protection provisions at the state and federal level. There are a large number of exclusions from CFPB regulation, including auto dealers not providing non-assignable loans and other small businesses, persons, and entities regulated by the SEC and CFTC. The bureau is also prohibited from establishing usury limits on loans. However, “high cost” residential mortgages (generally those with interest rates over 6.5 points higher than the prime rate for a comparable transaction) are subject to regulation. The legislation created a new Office of Financial Education in the CFPB that is to develop and implement a strategy to improve the financial literacy of consumers in consultation with the Financial Literacy and Education Com- mission and consistent with the National Strategy for Financial Education. The bureau was directed to conduct a number of studies, including one on reverse mortgages in order to identify any improper activity and to prescribe disclosures, another on student loans, and still another on credit scores. A separate study was ordered to be prepared by the HUD secretary for shared appreciation mortgages in which the lender shares in equity appreciation of the home at the time of its sale in exchange for reduced or no interest payments.

Compensation Issues Again

The compensation of executives at Enron and other firms caught up in the scandals of that era caused much outrage. The subprime crisis had an even greater effect after it was revealed that executives at financial services firms that failed had collectively received tens of billions of dollars in compensation. Labor unions renewed their attacks on executive compensation during the subprime crisis, with proposals that would curb executive pay at large institutions that received bailout funds in the TARP.66 That concern was addressed in the stimulus package passed by Congress in February 2009, which contained some severe limitations on the pay of the top executives at firms receiving bailout funds. Reformers were not satisfied, and they sought legislation that would extend this requirement to all public companies. The result was predictable. Talented executives at large Wall Street financial services firms left their employment at firms receiving bailout money in droves for smaller private firms that were not subject to salary caps or government harassment.67 A study by Kenneth Feinberg, the Obama administration’s “special master for TARP executive compensation,” more commonly referred to as the “pay czar,” concluded that some 15 percent of senior executives had left firms that were subject to TARP pay restrictions. President Obama announced a proposal for a bonus tax in the United States that would be used to pay for TARP costs. The president, who reported an adjusted gross income of $5.5 million in 2009, continued his populist themes with a statement on January 14, 2010, that labeled forthcoming bonuses at financial services firms as obscene. The financial services firms were, indeed, preparing to pay out record bonuses for 2009, even exceeding 2007 levels, so they made good targets for these populist attacks. Bonuses on Wall Street increased by 17 percent in 2009 over the prior year. Overall compensation for Wall Street employees reached a record $140 billion that year. Only the most senior executives were taking pay cuts in order to avoid unfavorable publicity. Executives outside Wall Street were not so shy. The winner in excessive compensation for the decade was Larry Ellison at the Oracle Corp. He received $1.84 billion during that period. Barry Diller was the runner-up with $1.14 billion. No one objected after Forbes reported that Oprah Winfrey made $315 million in 2009, that movie director James Cameron made $210 million, that Beyonce made $87 million, and Lady Gaga scored $62 million. The New York Times did criticize Ellen V. Futter, the head of the American Museum of Natural History, for being paid $877,000 in 2010 while being housed in a $5 million apartment tax free. Glenn Lowry, director of the Museum of Modern Art was reported to have been paid $2 million and was living in the museum’s $6 million condominium. In the event, the Fed imposed permanent controls over bank employee compensation in June 2010 that were designed to assure that banks were not providing incentives for employees to incur undue risks. How the Fed could make such

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. Regulation, Reform, and the Subprime Crisis 759 determinations was unclear. The Dodd-Frank Act also gave corporate governance advocates a victory. Despite the need for risk taking in business, regulators were required to adopt rules prohibiting compensation practices in the form of excessive compensation that encourage excessive risk taking. Dodd-Frank contained a dream list of other reforms. Shareholders in public companies must now be given a say on executive pay in the form of the right to a nonbinding vote on executive pay and golden parachutes. The SEC, however, had already opened the door to such proposals, few of which succeeded. The SEC was given authority to allow shareholders proxy access to nomi- nate directors. This was a requirement that labor unions had long sought as a way of challenging management. Compensation committees were required to include only independent directors who would have authority to hire compensation consultants in order to strengthen their independence. However, those consultants have, in the past, been used only to find innovative ways to increase pay. Dodd-Frank requires that the ratio of the CEO’s pay to that of the average worker must be disclosed. Public companies will be required to disclose why they have or have not decided to split the role of chairman and CEO. This is another corporate reform that has not been shown to have had any efficacy. Broker voting restrictions on board votes were adopted by Dodd-Frank, a reform already embraced by the SEC. Public companies are now required to adopt claw back provisions for executive compensation that was paid on the basis of inaccurate financial information. The newest reform mantra is to prohibit compensation programs that provide incentives for executives to engage in undue or excessive risks. In October 2009, Kenneth Feinberg ordered the salaries of 175 of the highest-paid executives at firms receiving TARP funds to be cut an average of 50 percent. Fed chairman Bernanke at the same time announced that the Fed would adopt rules requiring the largest twenty-eight financial firms to justify their compensation programs and prove that they do not encourage excessive risk taking. However, in November 2009 Citigroup announced large option grants to its employees as bonuses. The following month, Feinberg announced rules limiting the salaries of the most highly compensated executives at firms receiving TARP funds to $500,000 and restricting cash bonuses to 45 percent of pay. This pushed the executives toward stock bonuses, which might signal a return to the Enron era of accounting manipulations in order to boost stock prices. The irony here is that it was the Super Senior tranches of the subprime CDOs that triggered and sustained the crisis. Those tranches were triple-A rated, the highest rating available for a debt instrument, which meant they should have had little risk exposure. The banks often eschewed investment in lower tranches even though they had an investment-grade AA rating and paid a much higher coupon. The banks did not want even a small increase in the risks that they were willing to assume. AIG also wrote its CDSs on the triple-A tranches of the CDOs, which it believed presented it with little or no risk. This was incorrect because the market collapsed, not because they wanted to take

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 760 The Crisis Abates on excessive risk. On the contrary, they thought of themselves as extremely conservative investors. The government had taken the same view when it gave the Super Seniors favorable capital treatment, thereby encouraging the banks to invest in those instruments. The incentive system is a critical factor in recruiting and retaining talented executives. It may also be of concern in managing risks associated with management decisions, the rogue trader being a prime example. If a trader’s compensation package is based purely on profits from trading, the trader is in an enviable position. He has the vast resources of his institution to use to incur risks that will maximize his bonus, if he is successful. If he is unsuccessful, his compensation is reduced, or he may lose his job. Those same adverse consequences would attach, however, if he were unsuccessful and did not incur great risk. For a risk-taker, this is a most desirable position, especially if he is playing with other people’s money. It is a “heads I win, tails you lose” proposition. Ideally, traders and executives should have an incentive arrangement that rewards those who are concerned with the long-term safety of the firm, as well as those who earn short-term trading profits. That is not an easy package to formulate. A possible alternative is to give the trader or executive a “capital” account at the firm, a proposal that reformers advocate. A significant portion of the executive’s bonus would be placed in the account each year. The account, which should pay above market return rates, could not be tapped until a few years after the trader left the firm or for some delayed period during which he remains with the firm. This would motivate traders and executives to take a longer-range profit-maximizing approach. They would be effectively building a retirement account, not a lifestyle that would require annual trading binges to finance. Such compensation schemes would be a sound way to manage risk-related compensation. Of course, the doctrine of unintended consequences must also be considered. Executives given options and stock in lieu of cash during the subprime crisis reaped a windfall after the stock market recovered in the fourth quarter of 2009. That did not mean that these executives will remain wealthy because markets go down as well as up as it did in 2010. In any event, despite all the efforts of the reformers, compensation at Wall Street firms rose by 17 percent in 2009. Escrowing bonuses also does not assure success. Lehman Brothers had a five-year vesting period for shares given as bonuses. Moreover, this is still a matter of business judgment, and it should not be mandated by the government or union pension funds, which will only try to curb risk. No business can suc- ceed without incurring risk. Nearly all successful businesses achieved success by incurring great risk. As the saying goes, no risk, no reward. Ironically, in the wake of the subprime crisis, some state pension funds, like Wisconsin, were taking on more risk by leveraging their portfolios in order to increase returns and make up for losses and shortfalls in funding. At the same time

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. Regulation, Reform, and the Subprime Crisis 761 reformers were seeking to reduce risk taking by the banks by deleveraging their balance sheets. Public companies that avoid risk will attract bureaucrats, not fearless leaders, as their executives. Failure in business because of excessive risk taking (among other reasons) is normal—indeed, desirable. Moreover, risk taking is necessary for the advancement of society. “No guts, no glory” is a principle well known to every businessperson. Now, however, government and corporate reformers are preaching risk avoidance, a way of thinking that is detrimental to society as a whole. For example, if risk is to be avoided, pharmaceutical companies must immediately give up their quest for a cure for cancer because it is not likely to be discovered. The quest for new inventions must also cease because most inventors fail. The same is true of most new businesses. A further concern with respect to executive compensation arose after the stock market declined in the third quarter of 2008. Many executives were forced to sell their company shares because of margin calls, which exposed an interesting phenomenon in public companies. Executives are expected to hold large amounts of the stock of the company that they manage—it’s a macho thing as well as a loyalty test. However, the executives want cash for spending and investment outside their company, so they borrow by margining their company stock, which exposes the executive to margin calls if the stock declines. The executive is under even more intense internal and external pressure not to sell company stock in a decline. Such sales must be reported to the SEC and made public, and the SEC and criminal prosecutors will wonder whether the sales were made on the basis of inside information. The alternatives for the executive are to accept a loss of his fortune by doing nothing or to try to stop the slide in the stock price by talking up the company and reassuring the public that all is well, even if it is not or to manipulate company accounts in order to bolster the stock. This concentration of stock in a single company violates a fundamental principle of modern portfolio theory: diversification of investments. The current macho stockholding view needs to be changed, perhaps by putting deferred bonuses into a more diversified investment or by encouraging executives to hedge a substantial portion of their company holdings. This might remove some of the pressure to take desperate measures in a market downturn that might mislead investors. Keeping a cool head for management in a crisis requires objectivity. An executive facing the loss of his fortune is not objective; instead, he is desperate.

Federal Insurance

The Treasury Blueprint that was published in March 2008 had sought to provide for a federal presence in insurance regulation, including the creation of an Office of National Insurance and optional federal charters that would allow

(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 762 The Crisis Abates insurance companies to be regulated at the federal level. Dodd-Frank did not provide for optional federal insurance charters, but it placed the federal government into the regulation of the insurance industry, which had previously been the sole domain of the states as a result of the passage of the McCarran- Ferguson Act of 1945. Dodd-Frank created a new Federal Insurance Office (FIO) in the Treasury Department. The FIO is directed to monitor all aspects of the insurance industry and to identify any issues that could pose a systemic risk to the industry or to the financial system as a whole. The FIO may recommend that the Financial Stability Oversight Council designate an insurance company for regulation as a non-bank financial company. Dodd-Frank also requires the FIO to monitor whether the poor have access to affordable insurance. Excluded from the jurisdiction of the FIO are health care insurance, certain long-term care insurance, and crop insurance. The FIO may preempt state laws that discriminate against foreign insurance companies, but substantive state insurance regulation is otherwise preserved. No state other than the home state of an insured may require any premium tax payment for commercial purchasers of non-admitted insurance, that is, insurance sold by an insurance company domiciled outside the state of sale. Such non-admitted insurers are subject to home state regulation only, and surplus lines brokers are subject to home state only regulation under certain circumstances. Limitations were also placed on the state’s ability to regulate reinsurance from other jurisdictions.

Regulation Abroad

The Financial Services Authority

Before the subprime crisis, the Financial Services Authority (FSA), Great Britain’s single regulator, was a model for regulation around the world. It lost that respect after the bank run on Northern Rock, the first run on a bank in England in more than a hundred years, which was blamed on lax regulation. The bailouts of the Royal Bank of Scotland and Lloyds were also viewed to be regulatory failures by the FSA. Nevertheless, the UK government began seeking to increase the FSA’s regulatory powers and costs. Lord Turner of Ecchinswell, chairman of the FSA, filed a lengthy report recommending that the agency abandon its “light-touch” approach to regulation, which it did. The FSA set out to prove its new toughness with the announcement that it was imposing a record $4.06 million fine on Barclays Bank PLC for its failure to provide accurate transaction reports on 57.5 million transactions. That situation sounded like it was most likely the result of a computer glitch, but that was immaterial to the FSA. In another action, the FSA fined an individual a record $1.5 million for insider trading. It also banned a Merrill Lynch trader from the securities business for mismarking his trading book by $100 million.

A larger fine of $40 million was levied against JPMorgan Chase for failing to properly segregate customer assets. The FSA fined Goldman Sachs $31 million for failing to advise the FSA that Fabrice Tourre was under investigation by the SEC when he moved to London. Tourre remains a defendant in the ABACUS 2007-ACI SEC case described above. Lord Turner wanted to increase capital and liquidity requirements for banks in order to restrict their ability to take excessive risks. Turner also supported calls for the creation of a pan-European regulatory body, a recommendation that the FSA had previously opposed. In addition, Turner approved of plans to curb excess executive compensation schemes at financial institutions regulated by the FSA. Those points were debatable, but in an interview Lord Turner strangely advocated that London give up its status as a world financial center because it was “bloated.” He contended that the financial services industry there was too big and should be curbed. Even odder was his suggestion that London adopt a form of “Tobin tax” (named after a plan by the Nobel Prize–winning economist James Tobin to tax financial services transactions). Such a tax would be used to support projects in less-developed countries. Prime Minister Brown advocated such a Tobin tax at the Group of Twenty meeting in Scotland in November 2009, but met stiff resistance from the United States. Brown retreated from the proposal for a time. He turned to advocating a universal bank tax after the Obama administration announced a plan to impose $90 billion in new taxes on banks to repay TARP losses. Brown claimed in February 2010 that there was worldwide support for such a tax. He was then under attack from his own finance minister, Alistair Darling, who claimed that Brown had directed the “forces of hell” against him for being too pessimistic on the economy. Mervyn King, the governor of the Bank of England, made a recommendation that large banks be required to split up into smaller units because large financial firms would surely find areas in which to encounter systemic risk. Brown rejected downgrading financial services in London but sought to limit bankers’ pay by tying it to long-term success and providing for clawbacks when losses later occurred. Brown also wanted higher capital requirements for banks. On December 9, 2009, the British government announced a 50 percent surcharge on banker bonuses of more than $40,700. This led to howls of outrage in the City of London. Even the New York Times thought this was a bad idea, but France announced the following day that it too would tax bankers’ bonuses on the same terms. Germany declined to follow suit, but Chancellor Angela Merkel thought that curbing bonuses was politically a good idea. Jean-Claude Trichet, the president of the European Central Bank, joined this chorus and criticized the bonus culture at financial services firms. In the event, the British banks simply grossed up the salaries of their executives to cover the tax, and bonuses were not reduced, so, as usual, shareholders bore the cost. The Conservative Party in the UK responded with a proposal to abolish the

FSA and to move its powers back to the Bank of England. The Conservatives also sought a new consumer protection agency, as well as a tax on banks to repay bailout expenses. The Conservatives were particularly critical of Bob Diamond, the head of Barclays Capital. He had safely steered Barclays through the subprime crisis but was criticized for the $100 million in compensation he had received. Undeterred, Barclays promoted Diamond to become CEO for the entire bank in September 2010. Hector Sants, the FSA CEO, was wielding a veto over the hiring of bank executives who did not have sufficiently strong ethical standards. The Conservative party was unable to obtain a majority in the May 2010 elections but was able to form a government coalition. They then announced plans to split the FSA into three new agencies and give the Bank of England overall leadership in dealing with systemic risk and in regulating large financial institutions. Professor Adam C. Pritchard at the University of Michigan Law School predicted that the regulatory uncertainty, which had pushed financial services to flee New York for London, was now present in London and would result in another migration to a more business-friendly venue.68 Friendlier business climates were becoming harder to find. In Germany, the finance minister proposed a global tax on financial transactions in order to end “binge drinking” in risky financial services.69 He was supported in that claim by a BIS study that concluded that because the big banks posed a systemic threat, they should pay higher taxes.

European Union

The European Union (EU) increasingly adopted a U.S.-style regulatory system that included antitrust prosecutions even more aggressive than those in the United States, a zeal that the Obama administration promised to match with the appointment of trust buster Christine Varney as head of the antitrust division in the Justice Department. The EU famously rejected a merger between General Electric and Honeywell in 2001 that had been approved by the U.S. Justice Department. The European Commission also imposed a record $1.3 billion fine against Microsoft in May 2008 because the company had failed to comply with earlier orders concerning its business practices that the EU found anticompetitive. The commission also opened additional investigations of Microsoft. The European Commission fined Intel $1.45 billion for antitrust violations. An EU ombudsman found that competition authorities had committed “mal- administration” in pursuing that case against Intel by withholding exculpatory information. That did not bother those authorities, who on the day following that report charged Standard & Poor’s with monopoly violations. The EU was fast becoming a world court for antitrust claims in the tech sector. EU competition authorities became increasingly aggressive, particularly against

American companies. Those officials staged dramatic Eliot Ness–style raids on the offices of pharmaceutical companies in 2008. GlaxoSmithKline was targeted for refusing to sell to Greek drug wholesalers. The refusal actually came from the Greek wholesalers, who did not want to pay prices as high as those paid by other Europeans. The EU also gradually expanded its regulation over financial services. Although the Sarbanes-Oxley legislation was a failure, the EU adopted a mini- version of it in May 2006. The EU version imposed responsibility on board members for financial statements and required them to adopt corporate governance codes. Auditors were also regulated, and independence requirements were imposed on board members. Interestingly, the Obama administration clashed with European leaders at Group of Twenty meetings over which actions were needed to deal with the ongoing global financial crisis. President Obama advocated increased spending as the means to restart economies, while some of his European counterparts wanted to concentrate on regulatory reform. In September 2009, the Group of Twenty also had difficulty agreeing on increased capital requirements for banks. France resisted a proposal by the United States and the UK to increase such requirements significantly, but those differences were later resolved. The Financial Stability Board, a group of regulators appointed by the Group of Twenty to design a more reliable financial system, recommended limits on bank employee bonuses until the banks increased their capital. The EU also proposed legislation that would require between 40 to 60 percent of bank bonuses to be deferred for three to five years and that 50 percent of the bonus paid out in the first year be in the form of company stock. This approach seemed short-sighted because it will encourage executives to inflate the bank’s share price through accounting manipulation, which was what occurred in America. Regulators around the world also pushed large banks to develop “living wills” that would set forth a plan for their liquidation in a crisis, which was not a bad idea, and was included in the Dodd-Frank Act. The European Shadow Financial Regulatory Committee, a group of academics and former regulators, urged the Group of Twenty to require banks to build up their reserves to levels high enough to withstand future financial crises, regardless of the amount. The EU announced a plan to create three pan-European regulatory bodies to enforce common rules for banking, securities, and insurance. They would strengthen existing EU coordinating bodies for financial services. However, concerns were raised over whether these regulators would interfere in the fiscal affairs of the individual member states. The proposed legislation would also create a European Systemic Risk Board, composed of central bank governors from the twenty-seven EU member states. A new European System of Financial Supervisors would be created to regulate particular banks. Those proposals were agreed to in September 2010.

The United States is at a turning point in its history. We looked into the abyss during the subprime crisis, and the view was frightening. Many of our leading financial institutions collapsed or had to be bailed out by the federal government. The Great Panic that followed the failure of Lehman Brothers pushed the world’s financial system perilously close to a breakdown and was saved only by desperate measures from the Federal Reserve and the Treasury De- partment. The administration of Barack Obama passed massive legislation as a corrective measure that intrudes into nearly every corner of finance. Sadly, it is unlikely that this legislation will do anything more than add unneeded costs to financial services. It certainly does nothing that will prevent future financial crises; it is more likely that these reforms, many of which have long been promoted by corporate activists, will only exacerbate future crises, but Congress seems heedless of such concerns. In the final analysis, it must be recognized that regulation cannot stop business cycles. The financial system will rebuild itself and begin another cycle of prosperity. That period of prosperity will inevitably lead to another downturn and to another crisis, as has occurred throughout history. The cyclical nature of finance is a lesson that history has taught time and time again. The succes- sion of bubbles, recessions, downturns, and depressions following periods of rapid economic growth has been a constant in finance. The government has long sought to mitigate or avoid these downturns, but those efforts have met with remarkably little success. In the present environment, attention will be diverted from the real causes of the subprime crisis—government policies that not only encouraged but required massive subprime lending. The banks were then left to twist in the wind by regulators when the market collapsed by refusing to suspend mark-to- market accounting. Instead of acknowledging those policy failures, Congress and regulators have tried to shift blame onto executive compensation schemes. This is not to suggest that business bears no responsibility for this debacle. The decline in lending standards must lie squarely on their doorstep. It is already clear that we have yet to learn that subprime loans are extremely risky. Despite the catastrophic failures associated with such lending, the Obama

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(c) 2011 M.E. Sharpe, Inc. All Rights Reserved. 768 conclusion administration proudly announced on September 28, 2009, that it planned to commit as much as $35 billion in order to finance continued subprime lending. The Federal Housing Administration (FHA) has continued its policy of low, but slightly increased, down payments that will allow subprime borrowers to obtain mortgages that they cannot afford. Fannie Mae and Freddie Mac continue to dominate the residential mortgage market and continue to pile up liabilities that the government must now fund. Although they are failed institutions, Fannie Mae and Freddie Mac provided approximately 77 percent of the liquidity in the mortgage market in the second quarter of 2009. Freddie Mac alone purchased or guaranteed $319 billion in mortgage loans and mortgage-related securities in the first half of 2009. Fannie Mae’s book of business reached $3.19 trillion on June 30, 2009, and it expanded its business despite a second-quarter 2009 loss of $14.8 billion. Finally, at long last, the new Fannie and Freddie regulator, the Federal Housing Finance Agency, announced on September 2, 2010, that those entities will no longer be allowed to buy risky mortgages in order to meet affordable housing goals. The Fed also remains rudderless in setting interest rate policy. It has pushed short-term rates down to nearly zero, setting the stage for the next bubble. The effects from those low rates are as yet unknown but are probably paving the way for the next crisis.

Chapter 9

1. Julian Patterson Forrester, “Fannie Mae/Freddie Mac Uniform Mortgage Instru- ments.” 2. Charles Morris, The Trillion Dollar Meltdown, p. 41. 3. Barry P. Bosworth et al., The Economics of Federal Credit Programs, p. 57. 4. FDIC, “Breaking New Ground in U.S. Mortgage Lending.” 5. Robert E. Rubin and Jacob Weisberg, In an Uncertain World, Tough Choices from Wall Street to Washington, p. 258. 6. For a description of an ABCP program, see NationsBank, N.A. v. Commercial Financial Services, 268 B.R. 579 (N.D. Okla. 2001). 7. In re First Alliance Mortgage Co., 471 F. 3d 977, 984 (9th Cir. 2006). 8. Evan M. Gilreath, “The Entrance of Banks into Subprime Lending.” 9. In re Countrywide Financial Corporation Securities Litigation, 2008 U.S. Dist. LEXIS 102000 (C.D. Cal. 2008). 10. Michael Moss and Geraldine Fabrikant, “Once Trusted Mortgage Pioneers, Now Pa- riahs,” p. A1. 11. Watters v. Wachovia, 550 U.S. 1 (2007). 12. Jo Becker, Sheryl Gay Stolberg, and Stephan Labaton, “White House Philosophy Stoked Mortgage Bonfire,” New York Times, December 21, 2008. 13. Gary Fields, “Vermont Mortgage Laws Shut the Door on Bust—and Boom,” Wall Street Journal, August 17, 2009. 14. Stephen A. Holmes, “Fannie Mae Eases Credit to Aid Mortgage Lending,” New York Times, September 30, 1999. 15. Gretchen Morgenson, “They Left Fannie Mae, But We Got the Legal Bills,” New York Times, September 6, 2009. 16. Office of Federal Housing Enterprise Oversight, “Report of Findings to Date from Special Examination of Fannie Mae.” 17. Paul Weiss Wharton, Rifkind and Garrison, “A Report to the Special Review Committee of the Board of Directors of Fannie Mae.” 18. Jason T. Strickland, “The Proposed Revelatory Changes to Fannie Mae and Freddie Mac,” pp. 274–275. 19. Michael Durrer, “Asset-Backed Commercial Paper Conduits.” 20. L. Gordon Crovitz, “When Even Good News Worsens a Panic,” Wall Street Journal, November 24, 2008. 21. Paul Muolo and Matthew Padilla, Chain of Blame, pp. 28–32. 22. Bosworth et al., The Economics of Federal Credit Programs, p. vii. 23. 12 U.S.C. §1841 (c) (2008). 24. 12 C.F.R. 225.2(a) (1984). 25. Board of Governors of the Federal Reserve System v. Dimension Financial Corp., 474 U.S. 361 (1986).

769

26. Greg Ip, “The Global Credit Crunch,” Wall Street Journal, October 7, 1998. 27. Gilreath, “The Entrance of Banks into Subprime Lending,” pp. 149, 153–154. Chapter 10

1. Morris, The Trillion Dollar Meltdown, pp. 133–134. 2. Robert F. Bruner, The Panic of 1907, p. 2. 3. 12 U.S.C. §3901. 4. Ethan S. Harris, Ben Bernanke’s Fed, p. 70. 5. Joshua Cooper Ramo, “The Three Marketeers,” Time, February 15, 1999. 6. Harris, Ben Bernanke’s Fed, p. 71. 7. James Grant, Mr. Market Miscalculates, pp. 129–130. 8. Ibid., p. 132. 9. Daniel McGinn, House Lust. 10. Gillian Tett, Fool’s Gold, p. 122. 11. Adam Michaelson, The Foreclosure of America, p. 213. 12. Roger T. Cole, director, Federal Reserve Division of Banking Supervision and Regula- tion, “Subprime Mortgage Market,” testimony before the U.S. Senate Committee on Banking, Housing, and Urban Affairs, March 22, 2007. 13. Harris, Ben Bernanke’s Fed, p. 71. 14. Charles D. Ellis, The Partnership. 15. Ibid., pp. 673–674. 16. De Kwiatkowski v. Bear Stearns & Co., 306 F.3d 1293 (2nd Cir. 2002). 17. Peter Wallison, Fair Value Accounting. 18. Ibid. 19. “Global Shares Hit by Bank Plan Doubt,” Financial Times (London), December 14, 2007. 20. Richard Fletcher, “Forking Out More to the Financial Regulator May Not Be Money Well Spent,” Daily Telegraph (London), October 18, 2008. 21. Peter Thal Larsen, “Gloves to Come Off as FSA Ends ‘Light Touch’ Era,” Financial Times (London), March 13, 2009. 22. UBS, Shareholder Report on UBS’s Write-Downs, April 2008, §4.2.2. 23. Tett, Fool’s Gold, pp. 63–64. 24. Freddie Mac, “Freddie Mac Releases Fourth Quarter Financial Results,” February 28, 2008. 25. Douglas McGray, “Checked Cashers Redeemed,” New York Times Magazine, November 9, 2008. Chapter 11

1. Lawrence G. McDonald and Patrick Robinson, A Colossal Failure of Common Sense, p. 243. 2. Muolo and Padilla, Chain of Blame, p. 9. 3. Kara Scannell and John R. Emshwiller, “Countrywide Chief Charged with Fraud,” Wall Street Journal, June 5, 2009. 4. Mike McIntire, “Murky Middleman,” New York Times, April 4, 2009. 5. Amod Choudhary, “Auction Rate Securities = Auction Risky Securities,” Duquesne Business Law Journal 11 (2008): 24–25. 6. Charles R. Schwab, “Brokers Aren’t Responsible for Bad Bets,” Wall Street Journal, August 19, 2009. 7. Aimis Art Corp. v. Northern Trust Securities, Inc., Civ. No. 08-8075 (SDNY August 6, 2009). 8. Blount v. Securities and Exchange Commission, 61 F.3d 938 (D.C. Cir. 1995). 9. Vikas Bajaj, “Downturn Tests the Fed’s Ability to Avert a Crisis,” New York Times, March 9, 2008. 10. William D. Cohan, House of Cards. 11. Kate Kelly, “Inside the Fall of Bear Stearns,” Wall Street Journal, May 9–10, 2009.

12. Eric Dash and Julie Creswell, “Pays for a Rush to Risk,” New York Times, November 23, 2008. 13. Jenny Anderson, “S.E.C. Unveils Measures to Limit Short Selling,” New York Times, July 16, 2008. 14. Kara Scannell, “Judge Rules for Pasternak in SEC’s Fraud Case,” Wall Street Journal, June 13, 2008. 15. Greg Hitt, “Economic Woes Get a Fix,” Wall Street Journal, July 19, 2003. 16. James Grant, “Why No Outrage?” Wall Street Journal, July 19–20, 2008. 17. Grant, Mr. Market Miscalculates, p. 32. 18. Charles Duhigg, “Doubts Raised on Big Backers of Mortgages,” New York Times, May 6, 2008. Chapter 12

1. Tim Carrington, The Year They Sold Wall Street, pp. 226–227. 2. “Lehman’s First,” Investment Dealers Digest, November 17, 2007. 3. Susanne Craig, Jeffrey McCracken, Aaron Lucchetti, and Kate Kelly, “The Weekend That Wall Street Died,” Wall Street Journal, December 29, 2008. 4. David Wessel, In Fed We Trust, p. 19. 5. McDonald and Robinson, A Colossal Failure of Common Sense, p. 307. 6. Ibid., p. 14. 7. Steve Stecklow and Diya Gullapalli, “A Money-Fund Manager’s Fateful Shift,” Wall Street Journal, December 8, 2008. 8. Matthew P. Fink, The Rise of Mutual Funds, p. 39. 9. Ibid., pp. 150–151. 10. John C. Whitehead, “Scary,” Wall Street Journal, December 22, 2005. 11. James Freeman, “Eliot Spitzer and the Decline of AIG,” Wall Street Journal, May 16, 2008. 12. Robert O’Harrow, Jr., and Brady Dennis, “Credit Rating Downgrade,” Los Angeles Times, January 2, 2009, http://articles.latimes.com/2009/jan/02/business/fi-aig2/. 13. Sudeep Reddy, “Bernanke Expresses Frustration Over AIG Rescue,” Wall Street Journal, March 4, 2009. 14. Noam Scheiber, “A New Theory of the AIG Catastrophe,” New Republic, April 15, 2009. 15. The author was counsel to Merrill Lynch in that affair and other matters. 16. Carrick Mollenkamp and Serena Ng, “Wall Street Wizardry Amplified Credit Crisis,” Wall Street Journal, December 27, 2007. 17. Gretchen Morgenson, “How the Thundering Herd Faltered and Failed,” New York Times, November 9, 2008. 18. Liz Rappaport, “Lewis Says U.S. Ordered Silence on Deal,” Wall Street Journal, April 23, 2009. 19. Susanne Craig, “Merrill’s $10 Million Men,” Wall Street Journal, March 4, 2009. 20. “Traders Group Faults SEC Over Decision on Short Selling Ban,” p. 85. 21. James S. Olson, Saving Capitalism, pp. 16–17. 22. “Give Bank Boards a Spine,” Wall Street Journal, May 27, 2008. Chapter 13

1. Peter Lattman and Jeffrey McCracken, “Buyout Shops Swoop in for a Feast on the Cheap,” Wall Street Journal, December 31, 2003. 2. Al Gore and David Blood, “We Need Sustainable Capitalism,” Wall Street Journal, November 5, 2008. 3. L. Gordon Crovitz, “No Such Thing as Riskless Venture Capital,” Wall Street Journal, August 10, 2009. 4. Peter S. Goodman, “Taking Hard New Look at a Greenspan Legacy,” New York Times, October 9, 2008. 5. Fannie Mae, Housing Matters, p. 208.

6. Jim Puzzanghera, “Former Fed Chief ‘Shocked’ by Crisis,” Los Angeles Times, October 24, 2008. 7. Alan Greenspan, “The Fed Didn’t Cause the Housing Bubble,” Wall Street Journal, March 11, 2009. 8. Eric Lipton and Stephen Labaton, “A Deregulator Looks Back, Unswayed,” New York Times, November 17, 2008. 9. Phil Gramm, “Deregulation and the Financial Panic,” Wall Street Journal, February 20, 2009. 10. Floyd Norris, “A Month-Long Walk on the Wild Side of the Stock Market,” New York Times, November 1, 2008. 11. Eric Lipton and Ron Dixon, “With Its Own Ills, Bank Lends Only a Trickle of Bailout Funds,” New York Times, January 14, 2009. 12. Carter Dougherty, “Sweden’s Fix for Banks,” New York Times, January 23, 2009. 13. Dash and Creswell, “Citigroup Pays for a Rush to Risk,” New York Times, November 23, 2008. 14. Ken Brown and David Enrich, “Rubin, Under Fire, Defends His Role at Citi,” Wall Street Journal, November 29–30, 2008. 15. Michael J. de la Merced, “Supreme Court Moves to Delay Chrysler’s Sale,” New York Times, June 9, 2009. 16. Stanley Pignal and Brooke Masters, “UBS Under Fire Over Madoff,” Financial Times (London), February 26, 2009. 17. Julie Cresswell and Landon Thomas, Jr., “The Talented Mr. Madoff,” New York Times, January 25, 2009. 18. Becker, Stolberg, and Labaton, “White House Philosophy Stoked Mortgage Bonfire.” 19. Eric Lichtblau, “Wall St. Fraud Prosecutions Fall Sharply,” New York Times, December 25, 2008. Chapter 14

1. Seth Niraj, Jackie Range, and Geeta Anand, “Corporate Scandal Shakes India,” Wall Street Journal, January 8, 2009. 2. Mark Maremount, “Highflying Financier Faces Questions Over Fund Empire,” Wall Street Journal, April 1, 2009. 3. Charles Duhigg, “Two Fallen Mortgage Giants Are Unlikely to Be Restored,” New York Times, March 3, 2009. 4. Allen Sykora, “Gold’s Perfect Storm,” Wall Street Journal, February 23, 2009. 5. “Bernanke Repeats Opposition to Outright Nationalization of Banks,” Securities Regula- tion and Law Report 41 (March 2, 2009). 6. Jonathan Weisman, “Obama Pushes Sweeping Change,” Wall Street Journal, February 27, 2009. 7. Ibid. 8. “Regulatory Reform,” Securities Regulation and Law Report 41 (March 2, 2009). 9. Floyd Norris, “The Deal That Fueled Subprime,” New York Times, March 6, 2009. 10. Maureen Dowd, “Disgorge, Wall Street Fat Cats,” New York Times, February 1, 2009. 11. Ulrike Dauer, “In Europe, Goldman’s Blankfein Assails Pay,” Wall Street Journal, September 10, 2009. 12. Robert H. Frank, “Should Congress Limit Executive Pay?” New York Times, January 4, 2009. 13. Aaron Lucchetti, “Goldman’s Blankfein Calls for Pay Change,” Wall Street Journal, April 8, 2008. 14. Jenny Anderson, “New Exotic Investments Emerging on Wall Street,” New York Times, September 6, 2009. 15. Patrick Jenkins and George Parker, “Bankers Rail Against Proposals in UK Government’s Walker Review,” Financial Times (London), July 17, 2009. 16. Edmund L. Andrews and Jackie Calmes, “Fed Chairman Tacitly Backs Calls for Spend- ing,” New York Times, March 4, 2009.

17. David Segal, “Financial Fraud Rises as Target for Prosecutors,” New York Times, March 12, 2009. 18. Edward Luce and Chrystia Freeland, “Summers Backs State Action,” Financial Times (London), March 9, 2009. 19. Martin Wolf, “Seeds of Its Own Destruction,” Financial Times (London), March 9, 2009. 20. SEC, Revisions to Rules Regulating Money Market Funds, 55 Fed. Reg. 30239 (July 25, 1990). 21. “Secretary of the Fed,” Wall Street Journal, March 20, 2009. 22. Patricia Crisafulli, The House of Dimon, p. 6. 23. Peter S. Goodman, “Late-Fee Profits May Trump Plan to Modify Loans,” New York Times, July 30, 2009. 24. “Experts on Bernanke Speech,” Business Week, August 21, 2009. 25. Francesco Guerrera and Krishna Guba, “Fed Turns a $14bn Profit on Crisis Loans,” Financial Times (London), August 31, 2009. 26. Zachery Kouwe, “As Banks Repay Bailout Money, U.S. Sees a Profit,”New York Times, August 31, 2009. Chapter 15

1. Kevin Phillips, Bad Money, p. 30. 2. Wessel, In Fed We Trust, p. 272. 3. 12 U.S.C. §§ 2801–2811. 4. McDonald and Robinson, A Colossal Failure of Common Sense, p. 4. 5. Congressional Senate Oversight Committee, Hearings on Regulation of the Financial Sector, January 14, 2009. 6. Cohan, House of Cards, p. 297. 7. ACORN, www.acorn.org/index.php?id=12342. 8. Congressional Senate Oversight Committee, Hearings on Regulation of the Financial Sector, January 14, 2009. 9. Ibid. 10. Randall S. Kroszner, “The Community Reinvestment Act and the Recent Mortgage Crisis,” address delivered before the Confronting Concentrated Poverty Policy Forum, Washing- ton, DC, December 3, 2008, www.federalreserve.gov/newsevents/speech/kroszner20081203a. htm. 11. Gramm, “Deregulation and the Financial Panic.” 12. Roberto Quercia, Michael Stegman, and Walt Davis, “Assessing the Impact of North Carolina’s Predatory Lending Law,” Housing Policy Debate 15 (2004). 13. Gramm, “Deregulation and the Financial Panic.” 14. Fannie Mae, Housing Matters, p. 6. 15. Ibid., p. 13. 16. Ibid., p. 17. 17. Congressional Senate Oversight Committee, Hearings on Regulation of the Financial Sector, January 14, 2009 18. Dick Morris and Eileen McGann, Catastrophe and How to Fight Back, p. 81. 19. Office of the Attorney General of the State of New York, www.oag.state.ny.us/about. html. 20. Howard Husock, “Housing Goals We Can’t Afford,” New York Times, December 11, 2008. 21. Peter J. Wallison, “Barney Frank, Predatory Lender,” Wall Street Journal, October 16, 2009. 22. Wessel, In Fed We Trust, p. 122. 23. Ibid., p. 149. 24. Hal S. Scott, The Global Financial Crisis. 25. Wessel, In Fed We Trust, p. 46. 26. Jeffrey Friedman, “Bank Pay and the Financial Crisis,” Wall Street Journal, September 24, 2009.

27. Wessel, In Fed We Trust, p. 128. 28. Brian S. Wesbury and Robert Stein, “Mr. President, Suspend Mark-to-Market,” Forbes. com, January 21, 2009, at http://www.forbes.com/2009/01/20/accounting-treasury-obama-oped- cx_bw_rs_0121wesburystein.html. 29. Olson, Saving Capitalism, pp. 79–80. 30. Accounting Principles, Securities Regulation & Law Report, Bureau of National Affairs, Washington, DC, October 27, 1980. 31. Holman W. Jenkins, Jr., “Buffett’s Unmentionable Bank Solution,” Wall Street Journal, March 11, 2009. 32. Todd Davenport, “Fair Value,” American Banker 173 (March 24, 2008). 33. Susan Pulliam and Tom McGinty, “Congress Helped Banks Defang Key Rule,” Wall Street Journal, June 3, 2009. 34. Appraisal Institute, The Appraisal of Real Estate, p. 23. 35. Guy Stewart, Discriminating Risk, pp. 47–48. 36. Delaware General Corp. Laws §262 (2008). 37. Bell v. Kirby Lumber Corp. 413 A.2d 137 (Del. 1980). 38. Weinberger v. UOP, Inc., 457 A.2d 701 (Del. 1983). 39. Vincent Ryan, “Shiller to CFOs: Quick Action Needed to Avert ‘D-Word,’” CFO, March 9, 2009, http://www.cfo.com/article.cfm/13257035/c_13254232?f=todayinfinance_next/. 40. Sam Jones, “Of Couples and Copulas,” Financial Times (London), April 25–26, §2, p. 2. 41. Nassim Nicholas Taleb, The Black Swan, p. xviii. 42. Robert Shiller, “In Defense of Financial Innovation,” Financial Times (London), Sep- tember 28, 2009. 43. Deborah Solomon, “Treasury’s Paulson Warns of the Costs of Rules Overlap,” Wall Street Journal, November 21, 2006. 44. Department of the Treasury, “Blueprint for a Modernized Financial Regulatory Struc- ture,” March 2008. 45. Ibid., p. 4. 46. Elizabeth Williamson, “Political Pendulum Swings Toward Stricter Regulation,” Wall Street Journal, March 24, 2008. 47. Eliot Spitzer, “How to Ground the Street,” Washington Post, November 16, 2008. 48. Department of the Treasury, “Financial Regulatory Reform,” June 17, 2009. 49. Andrew Ross Sorkin, “Bringing a Bitter Pill to Wall Street,” New York Times, September 15, 2009. 50. Rubin and Weisberg, In an Uncertain World, p. 294. 51. Damian Paletta, “Single Regulator Plan for Banks Now Close,” Wall Street Journal, May 28, 2009; Damian Paletta and Kara Scannell, “Financial Overhaul Raises Questions,” Wall Street Journal, May 29, 2009. 52. Financial Planning Ass’n, v. SEC, 482 F.3d 481 (D.C. Cir. 2007). 53. Stephen Labaton, “An Overhaul of Financial Rules Is Taking Shape,” New York Times, June 1, 2009, pp. B1, B5. 54. Robert O’Harrow, Jr., and Brady Dennis, “Downgrades and Downfall,” Washington Post, December 31, 2008, p. A01. 55. Depository Trust & Clearing Corporation (DTCC), DTCC Media Statement on General Motors Credit Default Swaps, June 4, 2009. 56. “The Meltdown That Wasn’t,” Wall Street Journal, November 15–16, 2008. 57. Securities and Exchange Commission, “Temporary Exemptions for Eligible Credit De- fault Swaps to Facilitate Operation of Central Counterparties to Clear and Settle Credit Default Swaps,” 2009 SEC LEXIS 71, January 14, 2009. 58. Lloyd Blankfein, “Do Not Destroy the Essential Catalyst of Risk,” Financial Times (London), February 9, 2009. 59. Ellis, The Partnership, pp. 98–105. 60. 109 Pub. L. No. 291, 120 Stat. 1327. 61. Ibid. 62. Paul J. Davies, “Half of All CDOs of ABS Failed,” Financial Times (London), Febru- ary 13, 2009.

63. Ibid. 64. Dun & Bradstreet v. Greenmoss Builders, Inc., 472 U.S. 749 (1985). 65. Stephen Labaton, “Regulators Spar for Turf in Financial Overhaul,” New York Times, July 25, 2009. 66. Craig Karmin, “Shareholders Renew Push to Regulate Executive Pay,” Wall Street Journal, February 13, 2009. 67. Graham Bowley and Louise Story, “Crisis Reshaping Wall St. as Stars Begin to Scatter,” New York Times, April 12, 2009. 68. Adam C. Pritchard, “London as Delaware,” University of Cincinnati Law Review. 69. Bertrand Benoit, “German Minister Calls for Global Tax,” Financial Times (London), September 12–13, 2009.

A Note on Sources

The Wall Street Journal, the New York Times, and the Financial Times (London) are the principal sources for market events, statistics, reports and other contemporaneous events described in text. Numerous government, corporate, and other Web sites also provided a treasure trove of information. Space prevents citation to the thousands of articles and Web sites used as sources, but they are readily accessible by searching on LEXIS-NEXIS or Google.com. The following selected bibliography contains some of the other sources consulted. I have also drawn on my previous law review articles in preparing this and the prior volume that are listed in the bibliography.

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Bowley, Graham, and Louise Story. “Crisis Reshaping Wall St. as Stars Begin to Scatter.” New York Times, April 12, 2009, p. A1. Brown, Ken, and David Enrich. “Rubin, Under Fire, Defends His Role at Citi.” Wall Street Journal, November 29–30, 2008, p. A1. Buckley, Robert M., John A. Tuccillo, and Kevin E. Villani, eds. Capital Markets and the Hous- ing Sector: Perspectives on Financial Reform. Cambridge, MA: Ballinger, 1977. Bruner, Robert F. The Panic of 1907, Lessons Learned from the Market’s Perfect Storm. Hobo- ken, NJ: John Wiley and Sons, 2007. Carrington, Tim. The Year They Sold Wall Street. Boston: Houghton Mifflin, 1985. Carroll, Paul B., and Chunka Mui. Billion Dollar Lessons. New York: Portfolio, 2008. Cendrowski, Harry, James P. Martin, Louis W. Petro, and Adam A. Wadecki. Private Equity: History, Governance, and Operations. Hoboken, NJ: John Wiley and Sons, 2008. Choudhary, Amod. “Auction Rate Securities = Auction Risky Securities.” Duquesne Business Law Journal 11 (2008): 24–25. Cohan, William D. House of Cards. New York: Doubleday, 2009. Cole, Roger T. “Subprime Mortgage Market.” Testimony before the U.S. Senate Committee on Banking, Housing, and Urban Affairs, March 22, 2007. Congressional Senate Oversight Committee, Hearings on Regulation of the Financial Sector, January 14, 2009. Countrywide Financial Corporation Securities Litigation, In re, 2008 U.S. Dist. LEXIS 102000 (C.D. Cal. 2008). Craig, Susanne. “Merrill’s $10 Million Men.” Wall Street Journal, March 4, 2009, p. A1. Craig, Susanne, Jeffrey McCracken, Aaron Lucchetti, and Kate Kelly. “The Weekend That Wall Street Died.” Wall Street Journal, December 29, 2008, p. A1. Cresswell, Julie, and Landon Thomas, Jr. “The Talented Mr. Madoff.” New York Times, January 25, 2009, p. BU1. Crisafulli, Patricia. The House of Dimon. Hoboken, NJ: John Wiley and Sons, 2009. Crovitz, L. Gordon. “No Such Thing as Riskless Venture Capital.” Wall Street Journal, August 10, 2009, p. A9. ———. “When Even Good News Worsens a Panic.” Wall Street Journal, November 24, 2008, p. A17. Dash, Eric, and Julie Creswell. “Citigroup Pays for a Rush to Risk.” New York Times, November 23, 2008, p. A1. Dauer, Ulrike. “In Europe, Goldman’s Blankfein Assails Pay.” Wall Street Journal, September 10, 2009, p. C1. Davenport, Todd. “Fair Value: Few Fans, But Fewer Alternatives; Despite Widespread Frustra- tion, Changes Don’t Seem Likely.” American Banker 173 (March 24, 2008): 1. Davies, Paul J. “Half of All CDOs of ABS Failed.” Financial Times (London), February 13, 2009, p. 25. Decovny, Sherree. Swaps. London: Prentice Hall Europe, 1998. De Kwiatkowski v. Bear Stearns & Co., 306 F.3d 1293 (2nd Cir. 2002). Department of the Treasury. “Blueprint for a Modernized Financial Regulatory Structure.” March 2008. ———. “Financial Regulatory Reform, A New Foundation: Rebuilding Financial Supervision and Regulation.” June 17, 2009. Depository Trust & Clearing Corporation (DTCC). DTCC Media Statement on General Motors Credit Default Swaps, June 4, 2009. Dougherty, Carter. “Sweden’s Fix for Banks: Nationalize.” New York Times, January 23, 2009, p. B1. Dowd, Maureen. “Disgorge, Wall Street Fat Cats.” New York Times, February 1, 2009, p. WK11. Duhigg, Charles. “Doubts Raised on Big Backers of Mortgages.” New York Times, May 6, 2008, p. A1. ———. “Two Fallen Mortgage Giants Are Unlikely to Be Restored.” New York Times, March 3, 2009, p A1. Dun & Bradstreet v. Greenmoss Builders, Inc., 472 U.S. 749 (1985). Durrer, Michael. “Asset-Backed Commercial Paper Conduits.” North Carolina Banking In- stitute 1 (1997): 119.

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Husock, Harold. “Housing Goals We Can’t Afford.” New York Times, December 11, 2008, p. A49. Ip, Greg. “The Global Credit Crunch: Credit Crunches Aren’t What They Used to Be—The Shift to Capital Markets from Banks Brings Tumult.” Wall Street Journal, October 7, 1998, p. A18. Jenkins, Holman W., Jr. “Buffett’s Unmentionable Bank Solution.” Wall Street Journal, March 11, 2009, p. A13. Jenkins, Patrick, and George Parker. “Bankers Rail Against Proposals in UK Government’s Walker Review.” Financial Times (London), July 17, 2009, p. 1. Jones, Sam. “Of Couples and Copulas.” Financial Times (London), April 25–26. Karmin, Craig. “Shareholders Renew Push to Regulate Executive Pay.” Wall Street Journal, February 13, 2009, p. C1. Kelly, Kate. “Inside the Fall of Bear Stearns.” Wall Street Journal, May 9–10, 2009, p. W3. Kouwe, Zachery. “As Banks Repay Bailout Money, U.S. Sees a Profit.”New York Times, August 31, 2009, p. A1. Kroszner, Randall S. “The Community Reinvestment Act and the Recent Mortgage Crisis.” Address delivered before the Confronting Concentrated Poverty Policy Forum, Washington, DC, December 3, 2008, www.federalreserve.gov/newsevents/speech/kroszner20081203a. htm. Labaton, Stephen. “An Overhaul of Financial Rules Is Taking Shape.” New York Times, June 1, 2009. ———. “Regulators Spar for Turf in Financial Overhaul.” New York Times, July 25, 2009, p. B1. Langley, Monica. Tearing Down the Walls. New York: Simon and Schuster, 2003. Lattman, Peter, and Jeffrey McCracken. “Buyout Shops Swoop In for a Feast on the Cheap.” Wall Street Journal, December 31, 2003, p. C1. Larsen, Peter Thal. “Gloves to Come Off as FSA Ends ‘Light Touch’ Era.” Financial Times (London), March 13, 2009, p. 17. “Lehman’s First.” Investment Dealers Digest, November 17, 2007. Lewis, Michael. The Big Short: Inside the Doomsday Machine. New York: W.W. Norton & Co., Inc. 2010. Lichtblau, Eric. “Wall St. Fraud Prosecutions Fall Sharply.” New York Times, December 25, 2008, p. A1. Lipton, Eric, and Ron Dixon. “With Its Own Ills, Bank Lends Only a Trickle of Bailout Funds.” New York Times, January 14, 2009, p. A1. Lipton, Eric, and Stephen Labaton. “A Deregulator Looks Back, Unswayed.” New York Times, November 17, 2008, p. A1. Lore, Kenneth G., and Cameron L. Cowan. Mortgage-Backed Securities. Danvers, MA: Thomson/West, 2007. Lowenstein, Roger. The End of Wall Street. New York: Penguin Press, 2010. Lucchetti, Aaron. “Goldman’s Blankfein Calls for Pay Change.” Wall Street Journal, April 8, 2008, p. C3. Luce, Edward, and Chrystia Freeland. “Summers Backs State Action.” Financial Times (Lon- don), March 9, 2009, p. 1. Mallaby, Sebastian. More Money than God. New York: Penguin Press, 2010. Maremount, Mark. “Highflying Financier Faces Questions Over Fund Empire.” Wall Street Journal, April 15, 2009, p. A1. Markham, Jerry W. “Banking Regulation: Its History and Future.” 4 North Carolina Banking Institute (2000): 221. ———. “Excessive Executive Compensation—Why Bother?” Maryland Journal of Business & Technology Law 2 (2008): 277. ———. “Federal Regulation of Margin in the Commodity Futures Industry—History and Theory.” Temple Law Review 64 (1991): 59. ———. “Glass Steagall vs. Gramm-Leach-Bliley—A Test Match for the Bankers.” University of Pennsylvania Law & Business Journal 4 (2010): 12. ———. “Guarding the Kraal—On the Trail of the Rogue Trader.” Iowa Journal of Corpora- tion Law 21 (1995): 131.

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A.B. Watley, 608 Alabama Lottery Foundation, 49 A.G. Edwards, 558 Alaska Permanent Fund, 277 A.P. Indy, 338 Albertsons, 267 A.R. Baron, 437–438 Alcatel, 39 A.W. Jones, 227 Alcoa, 625 A&P, 56 Aldus Equity, 73 A123 Systems, 674 Alexander Brown and Sons, 253 Aames Financial Corporation, 410 Alexander, Jacob “Kobi,” 111 ABACUS-2007 AC1, 734–735 Alliance Data Systems, 442, 511 Abbot Laboratories, 675 Allianz, 272, 520 ABN Amro, 397, 430 Allison, Herb, 656 Abu Dhabi fund, 267, 277–279 Allstate, 188 Abu Dhabi Investment Authority, 456 Alltel, 276 Abu Dhabi Securities Market, 152 Alpha, 597 ABX index, 407, 746 Alternative Investment Market, 80 ACA Capital Holdings, 405 Althing, 575 ACA Financial Guarantee Corporation, 405 Altman, Sidney, 338 ACA Management LLC (ACA), 734–735 Amalgamated Bank, 123 ACC Capital Holdings (ACCH), 435–436 Amaranth Advisors, 205–207, 209, 211, Accenture, 7 231 Access International Advisors (AIA Group), Amazon, 66, 70 443, 613 Amazon.com, 253, 667 Ace Cash Express, 468 Ambac Financial Corporation, 403–405, Ackerman, Don, 112 492, 570, 688 Ackermann, Josef, 683 AMD, 625 Ackman, William, 262 AmerCredit, 410 Adams, Samuel, 283 America Online (AOL), 54, 71 Adelphia Communications, 5–6, 42, 47, 78 American Bankers Association, 719 Advance America, 468 American Banking Association, 161 Affiliated Computer Services, 674 American Bond & Mortgage, 290 Aflac, 119 American Clearing Corporation, 160 Agassi, Andre, 337 American Diversified Savings Bank, 319 Agee, William, 93 American Dream Commitment, 702 Aguirre, Gary, 555 American Enterprise Institute, 239, 399, AIG Financial Products (AIGFP), 541, 544, 448, 520 638 American Express 129, 247, 474, 524, 585, Ainsley, P. Steven, 346 654, 658–660, 668–669, 683 Akerson, Daniel, 692 American Federation of Labor-Congress of Alabama Certificate of Need Board, 49 Industrial Organizations (AFL-CIO), Alabama Education Foundation, 49 264, 270, 344 785

American Federation of State, County and Arenas, Gilbert, 338 Municipal Employees (AFSCME), 95, Argent Mortgage, 435 120, 500 Argo, Carole, 111 American Home Mortgage Investment Arizona Commercial Lender Mortgages, 614 Corporation, 445 Armstrong, Lance, 337 American Homes Investment Mortgage Armstrong, William W., 185 Corporation, 467 Arnall, Roland, 435 American Institute of Real Estate Arnold, Jerry, 29 Appraisers, 300 Arnold, John, 582 American International Group (AIG), 41, Arthur Andersen, 6–10, 18, 19, 24, 25, 35, 62, 72, 170, 187, 273, 279, 328, 333, 36, 38, 39, 43, 44, 47, 60, 70, 322, 329, 430, 447, 469, 482, 526, 534–546, 433 560–562, 613, 633, 638–640, 642, 647, Ascott Partners, 610 652, 655, 666, 668, 672, 674, 676–678, Ashcroft, John, 201, 333 683–684, 691–692, 710–711, 717, 730, Aspen Institute, 81 733, 738, 743–745 Associates First Capital Corporation, 397 American Mortgage Insurance Company Association of Community Organizations (AMIC), 546 for Reform Now (ACORN), 699 American Museum of Natural History, 758 Assured Guaranty, 403, 405 American Research and Development ASTA/MAT, 505 (ARD), 251 Astor, John Jacob, 249, 453 American Savings & Loan Association, 318, AT&T Inc., 37, 38, 66, 687, 692 515 Attain System, 147 American Stock Exchange (AMEX), 80, Atticus Capital, 581, 670 144, 148, 149, 152, 153, 155, 158, 160, Aufhauser, David, 488 162, 167 Aurora Loan Services, 411 American Tobacco, 87 Aurora, 213, 214 American Tower, 511 Automatic Data Processing, 146 Americas Wealth Management (AWM), 272 Avago Technologies, 582 AmeriCredit, 692 Avellino, Frank, 612 Ameriquest Mortgage Company, 396, 435 Avery, Kenneth, 47 Amiel, Barbara, 58 Awesome Again, 338 Amos, Daniel P., 119 AXA Group, 272 AMR, 673 AXA SA, 683 Analog Devices, 108 Azerbaijan State Oil, 277 ANB Financial, 503 Azurix, 3, 24, 25 Andersen Worldwide, 35 Anderson, Fred, 109 Babson, Frederick, 722 Angelides, Phil, 696 Babson, Roger, 413 Anglo Irish Bank Corporation, 615–616 Baby Bells, 37–29 Annenberg, Moses, 96 Bache, 546 Annenberg, Walter, 96 Bachmann, John W., 163 Antioco, John F., 103 Bacon, Kevin, 610 Antonucci, Anton, Sr., 666 Bagehot, Walter, 708 AOL, 465 Baikal, 155 AOL Time Warner, 54, 55, 71 Bain Capital, 257, 441–442, 579, 581, 589 Apax Partners, 441 Bain Capital Partners, 530 Apollo Advisors, 258 Bair, Sheila, 265, 505, 587–588, 592, 660, Apollo Alternative Assets, 578 662, 730, 732 Apollo Global Management, 578, 677 Baker, James A., III, 30, 91 Apollo Management, 443, 578–579 Bally Total Fitness Holdings, 64 Apple Computer, 37, 103, 108, 109, Banc of America Securities, 232, 508 251–252, 692 Banco Bilbao Vizcaya Argentaria, 671 Applix, 34 Banco Santander, 574, 611 Arbor, Patrick, 216 Bancroft family, 347 Archipelago Holdings, 98, 147, 151 Bank de France, 712

Bank for International Settlements (BIS), Barr, Michael S., 676 166, 169, 173, 174, 177, 447, 681, 721, Barr, Wallace, 94 764 Barry, Christopher, 29 Bank Insurance Fund (BIF), 322 Bartiromo, Maria, 114 Bank Medici, 611 Baruch, Hurd, 168 Bank of America (BOA), 35, 56–57, 95, Basel Committee on Banking Supervision, 116, 124–125, 174, 272, 273, 291, 325, 171, 173, 184, 326, 506, 712, 721 389–390, 398–399, 416, 423, 434, 436, Bass brothers, 254 441, 450, 456, 459, 478–480, 489, 500, Bats Exchange Inc., 158 504, 508–509, 513, 528, 545, 548, Baukhage, H.R., 299 550–553, 567–568, 600, 608, 618–619, Bay Area Toll Authority, 492 621, 635, 637, 643, 654, 658–659, 668, Bayly, Daniel, 10–12 673, 682, 686, 688, 702, 704, 729 Bayou Securities, 246 Bank of America Securities, 253, 259 Bayview Financial, 615 Bank of Canada, 461 BB&T, 660, 670 Bank of Credit and Commerce (BCCI), 326 BBC, 614 Bank of East Asia, 575 BCE, 442–443 Bank of England, 429, 451–452, 461, 503, BCGi, 108 513, 566, 572, 628, 644, 648, 655, BDO Seidman, 62 763–764 Beal Bank, 396 Bank of Italy, 291 Bear Stearns, 170, 229, 236, 238, 247, 272, Bank of Japan, 461, 649 332, 682, 402, 417, 425, 437–440, 446, Bank of Korea, 575 459, 463, 487, 495–499, 524–526, 528, Bank of New England Corporation, 325 547, 591, 666, 708, 711, 714, 731 Bank of New York, 391, 412 Bear Stearns High-Grade Structured Credit Bank of New York Mellon, 172, 174, 464, Enhanced Leveraged Fund, 439 534, 553, 556, 568, 591, 658–660 Bear Stearns High-Grade Structured Credit Bank of New York Mellon Corp., 492 Fund, 439 Bank of North America, 294 Beattie, Richard, 541 Bank of the United States 95, 453 Beaumont, Ron, 45 Bank of Tokyo-Mitsubishi, 174 Beazer Homes USA, 78, 432, 449, 622 Bank One, 438, 498 Bebe Stores, 620 Bank One Corporation, 498 Beckham, David, 337, 496 Bank USA, 174 Bed Bath & Beyond, 109, 487 Bankers Mutual Fund, 314 Bell & Howell, 268 Bankers Trust, 253 Bell, Alexander Graham, 37, 251 Bankhaus Herstatt, 171 BellSouth, 37 Banking and Securities Industry Committee Bellway, 120 (BASIC), 161 Belnick, Mark, 52 BankUnited, 662 Bendix, 93 Banque AIG, 639 Beneficial Finance, 65, 408, 445 Banque Paribas, 573 Benmosche, Robert, 639, 678, 683–684 Baptist Foundation of Arizona, 7, 8, 329 Bennett, Philip R., 248 Barasch, Spencer, 632 Bent, Bruce R., 313, 531–532 Barbera, Robert, 707 Bent, Bruce, II, 532 Barclays, 34–36, 274, 423, 452, 508, Bentham, Jeremy, 283 528–530, 545, 572–573, 616, 627, 668, Benyo, Christopher, 55 673, 677, 683, 764 Benziger, Stephen J., 544 Barclays Bank, 501, 529, 573, 644 Berger, Michael, 247 Barclays Bank PLC, 762 Berkowitz, Sean, 28, 40 Barclays Capital (BarCap), 145, 645, 764 Berkshire Hathaway, 406, 465, 481, 490, Barclays Global investors (BGI), 274 502, 537–538, 620, 654, 656, 668 Barings, 475 Berkshire Hathaway Assurance Corporation, Barker, Randolph H., 500 570 Barofsky, Neil, 647, 657, 677–678 Berle, Adolf, 86, 250 Barone, Ronald, 24 Berliner, Paul S., 510–511

Berman, Ethan, 125 BNC Mortgage, 411, 445, 525 Berman, Gregg, 121 BNP Paribas, 445, 573, 646 Bermingham, David, 16 BNY Institutional Cash Reserves, 534 Bernanke, Ben S., 243, 279, 405, 422, BNY Mellon Capital Markets, 490 425–429, 434, 436, 444–445, 447, 451, Boeing, 66, 95 602, 625 474, 481, 485, 506, 519, 522, 527, 542, Boesky, Ivan, 256 545, 562, 566, 586, 592, 626, 631, 633, Bogle, John, 79 649, 652, 657, 661, 663, 667, 673, 680, Bohan Group, 408 685, 694, 697, 708, 710–711, 730–731, Boies, David, 541 759 Bolten, Joshua, 560 Bershad, David, 132 Bond & Mortgage Guarantee Company, Bessemer Trust, 251 289, 290 Beta Finance, 456 Bond Market Association, 175 Bethlehem Steel, 87 Bonderman, David, 442 Beverly Hills Savings & Loan, 317 Borders Group, 620 Bevill, Bresler, & Schulman, 319 Borse Dubai, 150 Bextra, 130–131 Boston Options Exchange (BOX), 158, 167 Beyonce, 758 Boston Red Sox, 346 Bhagat, Sanjai, 239 Boston Stock Exchange, 149 BHP Billiton, 694 Bouton, Daniel, 475 Bi-Lo, 56 Bowery Savings Bank, 284 Biggs, John, 79 Boyle, Dan, 10, 13 Bin-Abd-al-Aziz Al Saud, Abdullah, 457 BP, 516–517, 689 Bin-Talal, Al-Waleed, 454, 457, 594 BP America, 61 Birkenfeld, Bradley, 63 Brady Commission, 163, 194, 237, 415 Bischoff, Sir Win, 595 Brady, Nicholas, 194, 415–416 BISYS Group, 134 Braly, Angela, 689 Black, Bernard, 239 Brandeis, Louis D., 100, 184–185 Black, Conrad, 57–59 Brandon, Joseph P., 538 Black, Eli M., 443 Braniff Airlines, 324 Black, Leon, 443 Brant, Ryan, 111 Blackberry, 108 BRASS Utility System, 147 BlackRock, 272, 274, 278, 344, 381, 459, Brazos Higher Education Service 460, 497, 500, 504, 548, 647, 666, 685 Corporation, 389 BlackRock Realty, 685 Breeden, Richard, 44, 57, 333, 446 Blackstone Group, 257, 261, 267–269, 274, Brendsel, Leland, 399–400 278, 442–443, 465, 511, 524, 582, 662, Brennan, David, 216 677 Brent Oil Market, 196–197 Blagojevich, Rod R. 264–265, 348, 600, 651 Brewer, Lynn, 24 Blankfein, Lloyd, 427, 463, 468, 527–528, Bridge Trader, 147 543, 589, 637–638, 643, 676, 683, 688, Bridgepoint Capital, 578 719, 736, 748 Brightpoint, 536 Blitzer, David, 268 Brinkley, Amy Woods, 659 Blockbuster Video, 13, 103, 262 Bristol-Myers-Squibb, 57, 262, 333 Blodget, Henry, 66–67 Broad, Eli, 447 Blogen, 262 Broadband Services, 3, 13–15, 21, 27, 329 Bloomberg, 146, 550 Broadcast.com, 608 Bloomberg Tradebook, 147 Broadcom, 108, 110 Bloomberg, Michael, 82 Brobeck, Phleger & Harrison, 591 Blount Parrish, 491 Brocade Communications Systems, 108, Blount, William, 491 110–111 Blue Ribbon Commission of Money and Brodsky, David, 70–71 Credit, 310 Broidy, Elliott, 73 Blum, Michael, 548 BrokerTec Futures Exchange (BrokerTec), Blumenthal, Richard, 509, 752 216 BMW, 662 Brookings Institution, 239, 286

Brooklyn Building and Mutual Loan California Public Employees Retirement Association, 284 System (CalPERS) 95, 120–122, 124, Brooks Automation, 108 126, 127, 275, 278, 341–343, 344, 446, Brown, Gordon, 493, 752, 763 494, 554, 570, 579, 582, 589, 696, 754 Brown, Henry B.R., 313, 531 California State Teachers Retirement System Brown, James, 10–13 (CalSTRs), 120, 122, 342 Brown, Jerry, 515 Callan, Erin M., 526, 530 Brown, Kevin, 337 Camel, 74 Bruno, Joseph, 73–74 Cameron, James, 758 Brunswick Group, 608 Campbell, Bill, 71 BRUT System, 147 Campeau Corporation, 323 Bryan Cave, 536 Canadian Imperial Bank of Commerce Buffett, Warren, 34, 82, 115, 256, 348, 406, (CIBC), 34–35, 445, 481, 460 465, 481, 490, 537–538, 570–571, 586, Canary Capital Partners, 231–233, 235, 237 620, 679, 718, 725 Canary, Bill, 50 Buick, 605 Canary, Leura, 50, 51 Build America Bonds, 630 Cantor Financial Futures Exchange (CFFE), Bulldog Investors, 262 216 Bundesanstalt für Cantor Fitzgerald, 215 Finanzdienstleistungsaufsicht (BaFin), Cape Fear Company, 249 645 Capital One, 94, 106, 445 Bundy, Ted, 612 Capital One Financial Corporation, 463, Burlington Northern Santa Fe, 679 628, 658, 680 Burlington Northern, 285 Capital Research & Management, 480 Burnham, Daniel P., 65 Capmark, 678 Bush, Barbara, 30 Car Allowance Rebate System (CARS), 606 Bush, George H.W., 30, 91, 270, 320 Carlyle Group, 257, 265–266, 270–271, 275, Bush, George W., 4, 50, 51, 82, 92, 93, 103, 277, 278, 279, 494 579–580, 607, 662 122, 173, 210, 270, 279, 329, 330, 332, Carnegie Steel, 250, 251 397, 401, 419, 425–428, 435, 447, 451, Carnegie, Andrew, 85, 87 462, 466, 473, 480, 485–486, 492–493, Carney, Cormac J., 110 495, 499, 504, 513, 518, 522, 545, 560, Cash Management Account, 314 563–564, 567–569, 592–593, 603–604, Caspersen, Finn M.W., 65 616, 626, 679, 685, 694, 700, 704–705, Cassano, Joseph J., 541–542 710, 725 Caterpillar, 646, 687, 692 Bush, Neil, 320 Cauley, Gene, 134 Bushnell, David C., 500–501 Causey, Richard “Rick,” 20–21, 23, 25 Business Roundtable Institute for Corporate Cave, Bryan, 333 Ethics, 106 Cavuto, Neil, 52 Butler, Eric, 490 Cayne, James E., 437, 440, 469, 495–497 Butler, Louis, 128 CBS, 569, 635 Byers, Steven, 609 CDX index, 407, 746 Byrd, Robert, 736 CEC Entertainment, 108 Cedel International, 165 CA Technologies, 55 Celebrex, 130–131 CA, 55 Celeste, Richard F., 319 Cablevision, 108 Cendant, 53–55 Cabrini-Green, 305 Centauri, 456 Cacchione, Scott, 584 Centaurus Energy, 582 Cadillac, 605 Center for Public Integrity, 396 Cadwalader, Wickersham & Taft, 482 Centerbridge Partners, 442 Caesars Entertainment, 94 Centex, 431, 653 Caisse d’Epargne, 475, 573 CentexCorp, 668 Caldwell, Leslie, 19 Central Bank of Iceland, 574 California Department of Corporations, Central Bank of Kuwait, 576 243 Central Certificate Service (CCS), 161

Central Republic Bank and Trust, 568 Citibank, 454, 456, 637, 698 Central Statistical Board, 299 Citic Securities, 528 Central Trust, 290 Citicorp, 454, 619 Centro Properties, 453 CitiFinancial Credit Company, 397 Centrust Savings Bank, 320 Citigroup, 35, 56–57, 66, 68, 69, 106, 114, Cerberus Capital Management, 257, 267, 116, 134, 144, 184, 239, 259, 274, 441, 578, 600–601 277–278, 384–385, 390–391, 396–397, Chakrapani, Ramesh, 267 403–404, 407, 416, 423, 426, 428–430, Charles Schwab, 489, 677 433–434, 436, 441, 446, 453–457, 479, Charlow, David, 388–389 480, 482, 487–488, 492, 497–498, Charter Communications, 36, 128 500–501, 504, 509, 511, 513, 527–528, Chase Manhattan, 253 416 541, 543, 545, 548, 556, 560, 567–568, Chase National Bank, 227 571, 581, 584, 593–597, 599, 600, 608, Check ’n Go, 468 616, 619–620, 625, 627, 629, 633, Chenault, Kenneth 585, 683 636–637, 639, 640-643, 647, 650, 654, Cherkasky, Michael G. 535 656, 658-660, 662-663, 666-668, 671, Chertoff, Michael, 329 677, 680–682, 688–689, 692, 699, 711, Chesapeake Energy Corporation, 636 717, 729, 733, 741, 759 Chevrolet, 605 Citigroup Diners Club, 505 Chevron, 125, 620 Citizen Black, 58 Chicago Board of Trade (CBOT), 149, 154, Citron, Robert, 459, 547, 749 156–157, 189–190, 213–218, 407 City Bank, 453 Chicago Board Options Exchange (CBOE), City National Securities, 490 144, 156–159, 167, 190, 217, 223, 407 Cityscape Mortgage, 407 Chicago Butter and Egg Board, 190 Claiborne Farms, 338 Chicago Climate Exchange, 158 Claire’s, 443 Chicago Cubs, 348 Clarke, Charles, 16 Chicago Discount Commodity Brokers, 225 Clarke, Vaughn, 399 Chicago Housing Authority, 305 Clayton Holdings, 408 Chicago Mercantile Exchange (CME), 190, Clayton, Dubilier, & Rice, 275 212–215, 217–218, 220–222, 451, 690 Clear Channel Communications, 257, 441 Chicago Open Board of Trade, 189 Clear Lake National Bank, 396 Chicago Stock Exchange, 144, 148 Clearing House Association of the Banks of Chico’s, 620 Philadelphia, 170 Children’s Investment Fund Management, Clearing House Interbank Payments 263 Systems (CHIPS), 171 Chin, Denny, 6 Clearstream International, 165, 166 China Construction Bank, 659 Clifford Chance, 591 China Development Bank, 278 Clinton, Bill, 92, 122, 127, 273, 329, 339, China Investment Corporation, 277, 556, 670 384, 400–401, 563, 583, 590, 616, Christie, Chris, 333 637–638, 697–698, 701–702, 725 Christopher Flowers, 278 Clinton, Hillary, 273, 329, 339, 609 Chrysler, 261, 342, 418, 441, 600–606, 633, CMBX, 407 640, 655, 687 CNET, 108 Chrysler Financial 519, 606 Coehlo, Tony, 320 Chuck E. Cheese, 108 Coffee, Sugar and Cocoa Exchange, 206 Cincinnati Stock Exchange, 148 Cogent Partners, 672 Cioffi, Ralph, 439–440 Cohen, David, 345–346 Circuit City, 588 Cohn, Gary, 463 Cisco Systems, 70, 632, 663 Cole, James, 333, 536–537 Cisneros, Henry, 701–702 Coles, Scott, 614 CIT Group, 388–389, 467, 494, 617, 654, 665 Colgate-Palmolive, 103 Citadel Investment Group, 230, 496, 581, Collateral Management Service, 164 589, 620 Collins & Aikman, 77 Citi Holdings, 619 Collins, Joseph P., 248 Citi Residential Lending, 436 Colonial Bank, 670

Columbia Funds Distributors, 237 Corrigan, Jerry, 744 Columbia Savings & Loan, 318, 319 Corsair Capital, 588 Comcast, 94 Cortez, Joanne, 26 Commercial Capital, 426 Corzine, Jon, 560, 592 Commercial Paper Funding Facility (CPFF), Cosmo, Nicholas, 614–615 709 Coughlin Stoia Geller Rudman & Robbins, Commerzbank, 520, 668 36, 134 Committee for Economic Development, 310 Coughlin, Tom, 114 Committee for Uniform Security Procedures Coulbeck, Neil, 16 (CUSIP), 161 Coulson, Cromwell, 145 Committee on Capital Markets Regulation Council of Economic Advisors, 422, 425 (CCMR), 80–82 Country Music Awards, 14 Committee on Compensation Practices, 155 Countrywide Financial, 394, 396, 398, 401, Committee on Interbank Netting Schemes, 424, 433, 446, 476–479, 483, 508–509, 173 514, 521, 559, 617, 633, 636, 647, 702 Committee on Payment and Settlement Countrywide Mortgage Investment, 514 Systems, 166, 173 County of York Employees Retirement Plan, Committee to Save the World, 417, 732–733 550 Commodity Exchange (Comex), 190, 482 Couric, Katie, 103 Commodity Exchange Authority, 192 Coventree, 460 Commodity Exchange Commission, 192 Cowell, Simon, 337 Commodity Futures Trading Commission Cox, Christopher, 69, 121, 483, 498, 510, (CFTC), 174, 183, 192–193, 194–200, 566, 612, 726, 744 201, 205, 206–213, 217, 220, 224–225, Craigslist, 345 230, 246–247, 474, 502, 517, 560, 631, Cranston, Alan, 320 728, 730, 737, 741–747, 757 Crawford, Purdy, 460 Community Reinvestment Corporation, 698 Creative Artists Agency, 89 Compaq Computer, 94, 117 Credit Agricole, 501 Computer Associates, 55, 632 Credit Anstalt, 413 Comverse Technology, 111 Crédit Lyonnais, 443 ConAgra Foods, 56 Credit Suisse First Boston (CSFB), 16, 34, ConAgra Trade Group 474 35–36, 69–71 Conaway, Charles, 59 Credit Suisse, 63, 68, 155, 272, 443, 490, Conference Board, 465, 643 501, 520, 572, 578, 599, 616, 620, 645, Conference on Home Building and Home 654, 668, 677, 683 Ownership, 295 Credit Suisse Securities, 484 Conheeney, John, 213 Crest, 165 ConocoPhilips, 625 Criminal Division Public Integrity Section, Conrad, Kent, 477 333 Conrail, 604 Crittenton, Jarvis, 338 Consolidated Exchange, 140 Crocs, 217 Constable, Francis, 489 CrossFinder, 155 Consumer Federation of America, 719 Crovitz, L. Gordon, 347 Consumer Financial Protection Bureau Crow, Sheryl, 543 (CFPB), 756–757 Crumpler, Hannibal, 48 Continental Illinois National Bank and Cruz, Zoe, 555 Trust, 418, 515, 711 CSK Auto, 78 Continental Illinois National Bank, 324–325 CSX, 263 Cooper, Roy, 398 Cuban, Mark, 608 Copperfield, David, 337 Cunningham, Shirley, Jr., 135 Corcoran, Thomas S., 299 Cuomo, Andrew, 73, 100, 125, 266, 289, 327– Corinthian Colleges, 108 328, 343, 388–389, 484, 488–490, 508– Corporate Fraud Task Force 5, 33, 210, 332, 509, 511, 535, 539, 542, 544, 551, 553, 484, 679 563, 565, 607, 611, 613, 636, 638, 640– Corporate Library, 702 641, 682, 689, 703–704, 733, 746, 752 Corre’s Hotel, 139 Cuomo, Mario, 704

Custer, George Armstrong, 217 Deutsche Börse, 152, 165, 215 Customer Asset Protection Company (CAP), Deutsche Telecom AG, 683 531 Deutsche Terminbörse, 215 CVC Capital Partners, 258 Devaney, John, 580 CVS Caremark, 267 Devlin, Matthew C., 608 Cyberonics, 112 Dewey, Thomas E., 327 Dewing, A.S., 723 D.E. Shaw & Company, 638 Dexia, 573 D.R. Horton, 621 Dexia SA, 492 Daimler, 600 Diamond, Robert E., Jr. “Bob,” 274, 644, 764 Daimler-Benz, 600 Dick, Melvin, 47 DaimlerChrysler, 600 Digital Equipment Company, 251 Dallas Mavericks, 608 Diller, Barry, 758 Damiler AG, 683 Diller, Barry, 103 Darby, Giles, 16 Dillion, C. Douglas, 457 Darling, Alistair, 452, 513, 528, 763 Dillon Read Capital Management (Dillion Daschle, Tom, 592 Read), 457 Data Domain, 71 Dillon, Clarence, 457 Daugerdas, Paul M., 62 Dimon, James, “Jamie,” 82, 438, 455, 463, Dauman, Philippe, 337 497–498, 511, 637, 641, 654, 660, 674, 682 Dave & Buster’s, 671 Dinallo, Eric R., 406–407, 535, 538 David, George, 103, 113 DiNapoli, Thomas P., 343 Davies, George, 548 DiPascali, Frank, 612 Davis Selected Advisers, 550 Direct Edge, 154 Davis, Evelyn Y., 120, 347 Discover, 505, 555 Davis, Gray, 200 Discover Financial Services, 585 Dawes, Charles G., 568 Distorted Humor, 338 DAX Index, 475 Ditech, 502 De Kwiatkowski, Henryk, 438 DiTech Funding Corporation, 409 de la Villehuchet, René-Thierry, 443, 613 Dixon, Don, 317, 324 Dean Witter, 554 Dizona, Anthony, 202 DeConcini, Dennis, 320 Dodd, Christopher J., 401, 467, 476–477, Defa, 657 486, 564, 634, 639, 719, 731 Del Biaggio, William, 584 Doerr, John, 133 DeLaughter, Bobby, 134 Dole Food, 135 Dell Computers, 106, 516, 620, 692 Dollar General, 276, 578 Dell, Michael, 106, 516 Dolnick, Sam, 347 Deloitte & Touche, 42, 65, 663 Donaldson, William, 68 Delphi, 65, 663 Donohue, Tom, 535 Delta Air Lines, 465, 502 Donovan, Shaun, 665 Delta Clearing Corporation, 221 Donovan, Thomas, 216 DeMizio, Darin, 176 Dooley, Evan, 502 Department of Housing and Urban Dorada, 456 Development (HUD), 308–309 Dougan, Brady, 683 Depository Trust and Clearing Corporation Douglas Aircraft, 251 (DTCC), 744 Dow Chemical, 278, 620, 635, 650 Depository Trust Company, 162–164 Dow Jones CDX Indexes, 407 Derrick, James V., Jr., 27 Dow Jones Euro Stoxx 50, 475 Designated Market Makers, 145 Dow Jones Industrial Average, 68, 128, 148, Designed Order Turnaround (DOT), 144 158, 193, 208, 347, 413, 415, 417–419, Deutsche Bank, 34, 56, 62–63, 82, 174, 208, 421, 424, 426, 429, 432, 434, 450, 465, 217, 253, 441, 443, 489, 494, 501, 542, 474–475, 477, 480, 482, 490, 493, 497, 545, 556, 573, 578, 597, 616, 619, 654, 504, 506–507, 510, 563, 565–566, 584, 657, 668, 677, 686, 689, 733, 745 590, 596, 606, 618, 625, 627, 634, 636, Deutsche Bank AG, 683 650, 656, 662–663, 675, 684–686, 689, Deutsche Börse Clearing, 165 690–691, 732, 763

Dow Jones Wilshire Banks Index, 466 EMC Mortgage, 411, 438 Drake Capital, 580 Emergency Fleet Corporation, 286 DreamWorks Animation, 610 Emperor’s Club VIP, 74–75 Dreier, 244–245 Empire Savings and Loan, 318 Dreier, Marc, 244–245 Empire Savings Bank, 317 Drew, Daniel, 175 Encore Credit, 438 Drexel Burnham Lambert, 10, 96–97, Endeavor Capital, 580 182–183, 254, 256, 318, 320, 322–323, Energy Futures Holding, 276 443, 541, 711, 715 Energy Transfer Partners, 205 Drumm, David, 615 Engineered Support Systems, 109 Drysdale Securities, 169 Enron Broadband Services, 3, 13–14, 21, 329 Dubai Ports World, 279 Enron Corporation, 3–38, 44, 47–49, 51, 53, Dubai World, 680 59–60, 76, 78–79, 84, 97, 106–107, 114, Dubofsky, David, 232 115, 125, 129, 133, 139, 191, 199–211, Dudley, Robert, 516 225, 236, 239, 329–334, 341, 351–352, Duer, William, 412 384, 419, 426, 428, 433, 436, 445, 448– Dugan, John C. 500, 503 449, 452, 455, 459, 483–485, 489, 498, Duke Energy, 204 508–509, 526, 534–535, 542, 553–554, Dun & Bradstreet 754 582, 613, 632, 648, 689, 691, 711, 716, Duncan, Dan L., 92 726, 734, 742–743, 748–749, 758–759 Duncan, David, 8–9 Enron Creditors Recovery Corporation Duncan, Henry, 283 (ECRC), 34–35 Dune Capital Management, 516 Enron Task Force, 5, 7, 9–10, 12–14, 16–20, Dunn, Frank A., 41–42 24–25, 28, 31, 33, 40, 49, 96–97, Duperreault, Brain, 535 329–330, 332 Durbin, Richard, 211 EnronOnline 3, 199–200, 202, 206, 210 Dutch East India Company, 379 Enterasys Networks, 61 Dynegy, 4, 34, 36, 199, 204, 703 Enterprise Car Rental, 590 DynegyDirect, 199 ePlus, 109 Equal Employment Opportunity E*Trade Financial Corporation, 494 Commission, 344 Eagleton, Thomas, 214 Equitable Life Assurance Society, 185, 187, Easdaq, 147 285 Easterlin, Richard, 336 Equity Office Properties, 257 Eastern Air Lines, 251 Ernst & Young, 47, 54, 322, 530 Eastman Kodak, 423, 620, 673, 741 Ernst, Mark A., 72, 446 Ebarge, 10 Eurex Clearing, 158, 165, 215–218 Ebasco Services, 144 Euroclear Clearance System, 165 eBay, 112, 254 Euronext, 98, 150, 152, 154 Ebbers, Bernie, 6, 43–47, 54, 78, 133 Euronext Amsterdam, 269–270, 579 Economic Crisis Financial Crimes Task Euronext.liffe, 216 Force, 484 European Association of Central Economic Recovery Advisory Board, 590 Counterparty Clearing Houses (EACH), Education Finance, 389 166 Education Resources Institute, 390 European Central Bank (ECB), 445, 447, Edwards, John, 339 461, 566, 574, 655, 664, 690 Eichner, Bruce, 494 European Central Securities Depositories Eisenberg, Eugene M., 95 Association, 166 Eisenhower, Dwight D., 90, 306 European Commission, 167, 279, 644, 655, Eisner, Michael, 106, 122 751, 764 El Paso, 199, 203–204 European Energy Exchange, 165 Elgin Capital, 581 European Systemic Risk Board, 766 Eli Lilly, 262 European Union (EU), 43, 82, 166–167, Ellington, 432 226, 452, 461, 582, 595, 630, 649, Ellison, Lawrence J. “Larry,” 106 636, 684, 758 657, 674–675, 685, 690, 711–712, 719, Elson, Charles, 121 720–721, 731, 747–748, 751, 764–765

European Union Central Bank, 690 Federal Home Loan Mortgage Corporation Eustace, Paul, 247 (Freddie Mac), 273, 310, 377–378, 381, Evers, Medgar, 134 383–384, 387–388, 399–402, 420, 428, Exchange Stabilization Fund, 533 431–432, 436–437, 447, 450, 464, 474, ExxonMobil, 125, 423, 465, 502, 620 479, 483–486, 493, 506, 508, 511–512, 514–515, 520–523, 530, 563–564, 590, Factiva, 24 595–596, 614, 616, 621, 626, 633, 637, Fahey, John H., 298 639, 647, 650, 654, 656, 666, 671–673, Fair Isaac Credit Organization (FICO), 677, 681, 688, 693, 696–697, 701–705, 391–392, 705, 724 709, 737, 768 Fairbanks, Richard D., 106 Federal Housing Administration (FHA), Fairchild Engine and Airplane Corporation, 299–304, 306–308, 316 383–385, 117 394–395, 397, 446–447, 464, 486, 506, Fairchild Semiconductor, 253 512–513, 517–518, 562, 598, 617, 634, Fairfield Greenwich Group, 611 653, 658, 663, 671, 673, 676, 700, 768 Fakahany, Ahmass L., 549 Federal Housing Authority, 278, 309 Falciani, Herve, 64 Federal Housing Finance Agency, 522–523, Falcon Strategies, 505 737 Fallon Capital Management, 579 Federal Housing Finance Board, 521–522 Farm Credit System, 294, 377 Federal Insurance Office (FIO), 737, 762 Farmers Loan & Trust Company, Federal Insurance Solvency Commission 285 (FISC), 186 Fastow, Andrew, 3–5, 10–11, 16, 19–20, Federal National Mortgage Association 23, 25–27, 28–32, 48, 79, 133, 330 (Fannie Mae), 273, 302–304, 306, Fastow, Lea, 19–20 309–310, 377–379, 383–384, 387–388, Faulkner, Danny, 318 399–402, 420, 424, 428, 431, 436–437, Federal Accounting Standards Board 447–448, 450, 464, 474, 476–477, 479, (FASB), 410, 448–449, 485, 514, 655, 483–486, 493, 506, 508, 510–515, 716, 718–721, 744 520–523, 563–564, 590, 595–596, 616, Federal Agricultural Mortgage Corporation 621, 626, 633, 637, 639, 650, 654, 656, (Farmer Mac), 383, 523 665–666, 671–673, 677–678, 681, 684, Federal Aviation Administration (FAA), 688, 693, 696–697, 701–705, 709, 737, 603 768 Federal Deposit Insurance Corporation Federal Reserve Bank of Boston, 251, 492 (FDIC), 176, 181, 265, 291, 301, Federal Reserve Bank of New York (New 314, 316, 319, 322, 324–325, 384, York Fed), 63, 174, 183, 231, 268, 454, 396, 418, 505, 513, 515–516, 533, 522, 528, 533, 534, 543–544, 560, 569, 551, 563, 569, 587, 589, 592–594, 580, 592, 596, 639, 677, 710, 744–745 596–597, 628, 647, 651, 660, 662, Federal Reserve Bank of San Francisco, 666–668, 670-673, 680, 686, 709, 172, 427 712, 714, 716, 728–732, 737–740, Federal Reserve Board, 88 756 Federal Savings and Loan Advisory Council, Federal Energy Regulatory Commission 295 (FERC), 201, 203–207 Federal Savings and Loan Insurance Federal Express, 253 Corporation (FSLIC), 301, 307, 309, Federal Family Education Loan (FFEL), 314–316, 318–319, 322 389–390 Federal Trade Commission (FTC), 95, 186, Federal Family Education Loan Program, 191, 207–208, 396, 438, 479, 728, 757 388 Federal Work-Study, 387 Federal Financing Bank, 387 Feinberg, Kenneth, 553–554, 638–641, Federal Home Loan Bank Board (FHLBB), 758–759 295–298, 309, 316, 318, 321–322, 324, Fen-phen, 135 377 Ferguson, Ronald E., 537 Federal Home Loan Banks (FHLBs), 383, Ferrari, 468 420, 464, 483, 506, 515, 521-523, 621, FHASecure, 518 654, 709 Fiat, 604–606, 615

Fidelity Investments, 113, 240, 271–272, First National City Corporation, 454 588, 609 First Plus, 409–410 Fiderion Group, 641 First Priority Bank, 514 Field, Denis, 62 First Republic Bank, 272 Fields, Mark, 602 First Union, 411, 558 Fifth Third Bancorp, 423 Fischel, Daniel, 39–40 Fifth Third Bank, 500, 508, 619 Fish, Robert A., 65 Filene, Lincoln, 251 Fitch Ratings, 224, 404–405, 656, 725, 748 Fillon, François, 645 FitzPatrick, Sean, 615 Financial Accounting Standards Board Five Finance, 456 (FASB), 106, 107, 180, 410, 448–449, Fixed Income Clearing Corporation (FICC), 485, 513, 655, 716, 718–721, 744 172 Financial Corporation of America (FCA), Fleet Bank, 325 317–318 FleetBoston, 253 Financial Crisis Advisory Group, 721 FLIR Systems, 55 Financial Crisis Inquiry Commission Flores, James C., 95 (FCIC), 696, 733 Florida Local Government Investment Pool Financial Fraud Enforcement Task Force, (LGIP), 459 332, 679 Flowers, 573 Financial Guaranty Insurance Company, 502 Flowers, J. Christopher, 516, 656 Financial Industry Regulatory Authority Focus Capital, 580 (FINRA), 71, 152, 198, 223, 490, 510, Fond du Lac State Bank, 291 610, 612, 715, 728 Food Administration, 294 Financial Instruments Exchange (Finex), Forbes, Walter, 53–54 206 Ford Motor Company, 68, 112, 275, 423, Financial Literacy and Education 495, 502, 600–604, 606, 622, 654, 667, Commission, 757 684, 687, 692, 753 Financial Planning Association, 155–156 Ford Motor Credit Company, 647 Financial Security Assurance, 405 Ford, Bill, 692 Financial Services Authority (FSA), Ford, Gerald, 207 155–156, 206, 210, 452–453, 481, 510, Ford, Harrison, 341 513, 528, 644–645, 762–764 Ford, Henry, II, 112–113 Financial Services Roundtable, 81 Forney, John, 200 Financial Stability Board (FSB), 655, 765 Forte, Joseph, 614 Financial Stability Forum, 514, 644, 655 Fortis, 508, 573 Financial Stability Oversight Council Fortress Investment Group, 244–245, 339, (FSOC), 737, 762 442, 580, 582, 677 Financing Corporation (FICO), 322 Fortress Re, 65 Fink, Laurence D., “Larry,” 272–273, 381 Fortune 500, 52, 112, 178, 252 Fiorina, Carly, 94 FOXNews, 641, 699 Firebrand Partners, 345 Frank, Barney, 401, 467, 485–486, 626, 638, First Alliance Mortgage Corporation, 396, 641, 756 411 Frank, Herbert H., 642 First Beneficial Mortgage Corporation, 380 Frank, Thomas, 347 First Boston, 255, 272, 381 Frankfort Stock Exchange, 150, 165 First City National Bank, 594 Franklin Bank, 589 First Data Corp., 276, 444, 578 Franklin Savings Association, 319 First Federal Bank, 516 Franklin, Benjamin, 249, 283 First Franklin Financial Corporation, 548 Freidman, Fleischer, & Lowe, 390 First Heritage Bank, 514 Fremont General Corporation, 503 First Horizon National Bank, 398, 508 Friedman, Milton, 387, 710, 716 First National Bank, 514, 647 Friedman, Stephen, 560 First National Bank of New York, 454 Friehling, David G., 612 First National City Bank, 454 Friend, Irwin, 311 First National City Bank of New York, 454 Frist, Bill, 256 First National City Bank, 171 Fuhs, William, 10, 13

Fuld, Richard, 430, 468, 524–530 Giuliani Partners, 97 Futter, Ellen V., 758 Giuliani, Rudolph, 39, 96–97, 327, 329 FutureCom, 217 Gladstone, Larry, 494 Glanville, 281 Gableman, Michael, 128 GlaxoSmithKline, 57, 119, 131 Galleon Group, 727 Glendale Federal Bank, 323 Galloway, Scott, 345 Glenn, David, 399 Gann, Scott, 237–238 Glenn, John, 320 Gannett, 345 GLG Partners, 176 Garand, Christopher P., 537 Glisan, Ben F., Jr., 11, 25–26 Garcia, Michael, 746 Glitnir Bank, 574 Gates, Bill, 348, 481, 620 Global Crossing, 43 Gateway Capital, 247 Global Equity Opportunities (GEO), 447 GE Capital, 258, 463, 635 Global Exchange (Globex), 148, 213–214, Geely Holding Group 684 218 Geiger, Todd, 203 Global High Wealth Industry, 62 Geithner, Timothy F., 174, 528, 560, 576– Global Investment & Wealth Management 577, 592, 629, 639–640, 642, 651–652, (GIWN), 272 665–666, 673, 677, 710, 729–730, 737, Global Investment House, 627 744–745, 747, 756 Global Wealth Management, 272, 636 Gelb, Peter, 338 GMAC Financial Services, 441, 600–601, GEMCO, 146 610–611, 658 Gemstar-TV Guide, 78 Goal Financial, 389 Genader, Robert J., 403 Golden State Bancorp, 323 Genentech, 253, 650 Golden West Financial Corporation (Golden General Electric (GE), 450, 463, 570–571, West), 394, 558–559 596, 628, 635, 654, 667, 677, 692, 764 Golden, Michael, 346 General Electric Capital Corporation, 628 Goldman Sachs, 67, 69, 70, 82, 119, 141, General Electric, 14, 29, 62, 66, 99, 104, 144, 147, 151, 154–155, 183–184, 206, 107, 113, 258 208, 231, 236, 246, 276, 344, 382, 390, General Growth Properties, 656 402, 27–428, 430–432, 441, 446–447, General Motors (GM), 41, 68, 261, 342, 423, 456, 463, 465, 468, 487, 489, 496, 504, 426, 441, 449–450, 502, 504, 510, 547, 507, 511, 516, 524–525, 527–529, 536, 600–602, 604, 606–607, 628, 633–634, 541–545, 549, 552, 556, 559–560, 565, 640, 654, 663, 667, 681, 687, 692, 745 569–570, 581, 585, 589, 591, 593, 597, General Re (Gen Re), 537–538 616, 619, 637, 639, 643, 654, 657–660, Gensler, Gary, 560, 631 664–666, 668, 676, 683, 685, 688–689, Geoghegan, Michael, 635 692, 696, 715, 719, 727, 731–736, George M. Forman, 290 740–741, 746, 748, 750 Georgia Pacific, 259 Goldman Sachs Global Alpha Fund, 447 Getco, 145, 154 Goldsmith, Sir James, 254 GFINet System, 147 Gonzales, Alberto R., 50 Gibson Greetings, 254 Gonzalez, Albert, 671 Gibson, Mel, 337 Goodwin, Sir Fred, 644 Gifford, John, 109 Google, 71, 112, 253, 262, 487 Gilbert, Eddie, 111 Gordon, Daniel, 203 Gilbert, John, 118 Gordon, Steven, 615 Gilbert, Lewis, 118 Gore, Al, 253, 583, 703 Gillan, Kayla, 121, 344 Gorelick, Jamie, 401, 702 Gillette, 94 Gorman, James, 674, 682 Gilman, William 535 Gorton, Gary, 542 Gilmore, Vanessa, 14–15 Gottschalg, Oliver, 275 Gingrich, Newt, 127 Govan, Michael, 338 Giovannini Group, 167 Government Accountability Office (GAO), Giovannini, Alberto, 167 210, 228, 244, 342, 378, 674, 679, 739, Giuliani Capital Advisors, 97 741

Government National Mortgage Association Grubman, Jack, 66 (GNMA or Ginnie Mae), 164, 309, GSO Capital Partners, 261 377, 379–383, 387, 420, 493, 621, Guaranty Financial Group, 671 663, 671 Guaranty Trust Company of New York, 301 Government of Singapore Investment Guggenheim Partners, 582, 596 Corporation, 276–277, 683 Gulf Bank, 576 Government Securities Clearing Gunther IV, 338 Corporation, 163, 223 Guttenberg, Michael, 459 Gradient Analytics, 69 Graham family, 349 H.O. Stone, 290 Graham, Robert, 537 H&R Block, 72, 432, 446 Grain Corporation, 294 Haack, Robert, 181 Gramm, Phil, 587, 698, 701 Habitat for Humanity, 477 Grand Canyon Education, 593 Haldeman, Charles, Jr., 656 Grant & Ward, 413 Hale, Nathan, 96 Grant Street National, 594 Haligiannis, Angelo, 246 Grant Thornton, 57, 83 Hall, Andrew, 641 Grant, James, 518 Halliburton, 629 Grant, Tone, 248 Hambrecht & Quist, 253 Grant, Ulysses S., 413 Hamilton Bancorp, 231 Grassley, Charles, 544, 631 Hannon, Kevin, 215 Grasso, Richard, 70–72, 89, 94, 97–100, Harbinger Capital Partners, 345 102, 139, 150–151, 327–328, 427, 544, Hard Rock Park, 625 565 Harding, Raymond B., 73 Great South Bancorp, 619 Harman International, 441 Great Western Financial Corporation, 308 Harmon, Melinda, 9 Green Point, 445 Harrah’s Entertainment, 94, 443 Green, Jeff, 581 Harriman, Henry I., 299 Greenberg, Alan “Ace,” 437 Harriman, W. Averell, 298 Greenberg, Hank, 71, 328, 332 Harris, Charles L., 246 Greenberg, Jeffery W., 535 Hartford Financial Services Group, Greenberg, Maurice R. “Hank,” 447, 187–188, 238, 520, 620 526, 535–536, 538–541, 545–547, Havens, John, 456, 505 639–640 Hawaiian Telecom Communication, 271 Greenbrier Resort, 263 Hayden Stone, 252 Greenebaum Sons Investment, 290 Hayward, Tony, 689 Greenfield, Van D., 47 Hazan Capital Management, 176 Greenspan, Alan, 218, 397, 402, 417–422, HBOS, 573, 620, 644 424–425, 462, 474, 581, 586–587, 694, HCA, 256–257 700, 706, 733 HealthSouth, 47–48, 51, 121 Greenspon, Carolyn, 346 Healy, Robert E., 716 Greenstein, Jeffrey L., 273 Hearst, 345 Greenwich Financial Services Distressed Hearst, Robert, 449 Mortgage Fund, 479 Heath, Daniel, 331 Greenwood, Paul, 632 Hedgebay Trading, 672 Gregory, Joseph M., 526 HedgeStreet, 217 Gretzky, Wayne, 476 Heekin-Canedy, Scott, 346 Grigg, Gordon, 609 Hefner, Hugh, 113 Grimsson, Olafur, 575 Heilig-Meyers, 508 Grisham, John, 128 Heinen, Nancy R., 109 Group of Seven, 577 Hellman & Friedman, 530 Group of Ten, 166, 173–174 Helmsley, Leona, 338 Group of Thirty Financial Reform Working Hendrick, Max, II, 24 Group, 590 Henry Hub, 202 Group of Twenty, 180, 577, 582, 593, 644, Hensarling, Jeb, 131 655, 674, 691, 713, 765 Hertz, 275, 625

Hester, Stephen, 644 HSBC Holdings PLC, 64 Hevesi, Alan, 72–73, 265–266, 343 HSH Nordbank, 520 Hewlett-Packard Co.(HP), 94, 253, 692 Hsu, Norman, 609 Hewlett, Walter B., 117 Hu, Henry, 121 Hexion Specialty Chemicals, 578 Hubbard, Gardiner Greene, 251 High Voltage Engineering Company, 251 Hughes, Charles Evan, 185, 327 High Yield Debt Index, 407 Hughes, Harry, 319 Highbridge Capital Management, 582 Hummer, 605 Highlands Capital, 647 Hunt family, 546 Hiller, David, 348 Hunt, Jim, 311 Hilton Hotels, 257, 269 Hunter, Arthur, 186 Hirko, Joseph, 15 Hunter, Brian, 205 Hittner, David, 20 Huntington Bancshares, 508 Hohn, Christopher, 262 Huntsman Corporation, 443, 578 Holland Land Company, 249 Hurd, Mark, 692 Hollinger International, 57-58 Hurricane Katrina, 134, 205, 329, 422, 725 Hollyday, Guy T.O., 306 Hurricane Rita, 205 Home Affordable Modification Program, HVB Group, 62 693 Hyde, James, 185 Home Affordable Refinance Program Hypo Real Estate Holdings Group, 442, 481, (HARP), 665 573, 656 Home Depot, 70, 104, 433, 442, 520, 628, 671 IAC/Interactive, 103 Home Owner’s Loan Corporation (HOLC), Iacocca, Lee, 600, 603 297–298 IBM, 270, 628, 677, 727 Home Ownership Preservation Foundation, IBOXX, 407 699 Icahn, Carl, 254, 259, 261, 519 Home State Savings, 319 Ice Clear US, 223 Homestore, 54–55 ICE Futures Europe, 206, 208, 210 Honda, 607 ICE Futures U.S., 206 Honeywell, 764 iFund, 253 Hoover, Herbert, 89, 286–287, 294–296, Iger, Robert A., 122, 636 302, 568, 710 IKB Deutsche Industriebank AG (IKB), 445, Hope for Homeowners, 518 734, 736 Horwitz, Don L., 531 IMC Mortgage, 410 Houldsworth, John, 537 ImClone, 262 House Committee on Oversight and Immelt, Jeffrey, 571 Government Reform, 503, 564 Impac Companies, 445, 449 House of Commons Treasury Committee, Imperial Savings Association, 260 452 Incomco, 225 Household Finance, 397, 635 Independent Bank of Michigan, 591 Household International, 397, 408 Independent National Mortgage Corporation Housing and Home Finance Agency, 303 (IndyMac), 431, 433, 436, 514–516 Housing and Urban Development (HUD), Indiana Company, 249 378, 397, 451, 517–518, 665, 699, 701, IndyBank, 516 704–705, 757 ING Group, 520, 572 Housing Corporation, 286, 294 Inspector Javert, 6 Housing Enterprise for the Less Privileged Instinet Group, 146–149 (HELP), 704 Institutional Network Corporation, 146 Housing Finance Agency, 304 Institutional Shareholder Services (ISS), 179 Houston Astros, 34 Integrated Resources, 323 Houston Natural Gas, 18, 34 Intel, 68, 112, 251–252, 520, 692, 694, 727, Howard, Kevin A., 15 764 Howard, Timothy J., 401 Interactive Brokers, 465 HSBC, 408, 428, 432, 445, 453, 456, 508, IntercontinentalExchange (ICE), 205, 223, 520, 611, 635, 655, 668 745

Internal Revenue Service (IRS), 96, 100, Jha, Sanjay, 636 115, 265 Jiabao, Wen, 576, 628 International Accounting Standards Board Jianyin Investments, 278 (IASB), 720–721 Jim Walter Corporation, 323 International Brotherhood of Electrical Jobs, Steve, 109 Workers Pension Fund, 129 Jockey Club, 340 International Futures Exchange (Intex), 213 John Deere, 687, 692 International Harvester, 324 John F. Kennedy Center for the Performing International Management Associates, 246 Arts, 338 International Monetary Fund (IMF), 276, Johnson, Charles E., Jr., 54–55 279, 416–417, 499, 503, 574, 576–577, Johnson, Edward C., II, 271 592, 628, 655, 657, 674, 713, 730 Johnson, F. Ross, 255–256 International Organization of Securities Johnson, James, 401, 477 Commissions (IOSCO), 166–167, 174, Johnson, Lyndon B., 457 199 Johnson, Ned, 271 International Petroleum Exchange, 206 Jones, Alfred Winslow, 227–228 International Prisoner Transfer Program, 17 Jones, Barbara, 6, 46 International Stock Exchange (ISE), 158 Jones, Day, Reaves, & Pogue, 321 International Swap Dealers Association Jones, Edward D., 163 (ISDA), 196 Jones, Jesse, 568 International Swaps and Derivatives Jordan, Ruth, 52 Association (ISDA), 196, 458, 540 JPMorgan Chase, 34–35, 70, 82, 172, 174, InterNorth, 18, 34 178–179, 217, 259, 334, 390–391, Intuit, 71 407–408, 428, 442, 452, 456, 463, Invemed Associates, 70, 99 479, 480, 496–498, 504–507, 511, 513, Invesco, 534 527–528, 534, 558, 567, 581–582, 584, Investment Company Institute, 533 587, 596, 599, 608–609, 611, 613, 616, iPhone, 37, 253 619, 626, 629, 635, 637, 639, 643, 654, iPod, 253 656–660, 674, 680, 686–687, 698–699, Iranian Oil Stabilization Fund, 277 741, 746, 763 Irish Garda, 615 JWM Partners, 580 Irish Stock Exchange, 165 Island ECN, 147–148 Kahanek, Shelia, 10–11 Israel, Samuel, III, 246 Kahn, Roomy, 727 Ivy Asset Management, 613 Kaiser, Michael M., 338 Kajeet Inc., 488 J.B. Watkins Land Mortgage Company, 285 Kanas, John, 94 J.C. Flowers, 390, 442 Kaplan, 348 J.D. Reynolds, 234 Kaplan, Lewis, 61 Jackson, Andrew, 95, 294, 412 Karatz, Bruce, 110 Jackson, Frank G., 509 Karl, Max, 308 Jackson, Jesse, 8 Karvellas, Steven, 214 Jackson, Robert J., 96 Kashkari, Neel T., 565 Jacobs, Irwin, 254 Katten Muchin, 591 Jaguar, 495 Katzenberg, Jeffrey, 610 James River Company, 249 Kaufman, Henry, 532–533 James, LeBron, 337–338 Kaye, Scholer, Fireman, Hays, & Handler, Jana Partners, 262 321 Janus Capital Management, 238, 460 KB Homes, 110, 424, 430, 433, 435, 467, Jay Cooke & Company, 412 494, 622, 653, 664, 702 Jefferson, Thomas, 249 Keating, Charles H., Jr., 320 Jeffries Group, 464 Keker, John W., 133 Jenkins, Maynard, 78 Kellermann, David, 614 Jensen, Michael, 104 Kelly, Anastasia, 678 Jensen, Stephanie, 110 Kelly, Edward, 659 Jester, Dan, 560 Kelly, Robert, 553

Kennedy, John F., 90, 122, 311, 457, 592 Kroll, Jules B., 753 Kennedy, Joseph P., 49 Kuhn Loeb, 524 Kennedy, Kerry, 704 Kumar, Sanjay, 56 Kennedy, Robert, 328, 704 Kurer, Peter, 500 Kennedy, Ted, 339, 684, 731 Kuwait Investment Authority (KIA), 276, Kerkorian, Kirk, 261, 600,602, 605 278, 576 Kerry, John, 339 Kvalheim, Grant, 452 Kerry, Teresa Heinz, 339 Kerviel, Jérôme, 475 La Grenouille, 57 KeyCorp, 508 Lackner Butz, 290 Khuzami, Robert, 733 Lady Gaga, 758 Killefer, Nancy, 592 Laffer, Arthur, 91 Killinger, Kerry, 558 Lake, Simeon T., III, 20–21, 25, 29–32, 36 Kilts, James, 94 Lampert, Edward, 434 King Mambo, 338 Lancer Group, 248 King, Leroy, 632 Land Rover, 495 King, Mervyn, 644, 673, 763 Landis, James, 592 King, Stephen, 341 Landon, Alf, 114 Kingate Management, 611 Landsbanki, 575 Kipnis, Mark, 58 Langford, Larry, 491 Kirkland & Ellis, 35 Langone, Kenneth, 70, 99–100, 611 Kissinger, Henry, 57 LaPierre, Al, 491 Kitchen, Louise, 199 LaSalle Bank, 480 KKR Financial Holdings, 269 Lauer, Michael, 248 KKR Private Equity Investors (KPE), 253 Lavielle, Brian, 204 KL Group, 609 Lawson, Bill, 30 Kleiner, Eugene, 317–318 Lay, Kenneth, 3–6, 11, 14–15, 18–30, 34, Kleiner, Perkins, Caufield, & Byers, 253, 36, 40, 48, 78–79, 200, 330, 478 583 Lazar, Seymour M., 132 Kmart, 59 Lazard, 95 Knapp, Charles, 317–318 Lear Corporation, 262, 606 Knickerbocker Trust Company, 413 Lee Equity Partners, 442 Knight-Ridder, 146 Lee, Thomas H., 442 Koenig, Mark, 21 Leeson, Nick, 475 Kohlberg Kravis & Roberts (KKR), 254– Legg Mason, 274, 460, 501, 619 258, 265, 269–270, 276, 323, 440–441, Legg Mason Value Trust, 423, 501 443–444, 578–579, 582, 670, 673, 693 Lehman Brothers, 34–35, 43, 155, 170, Kohlberger, James, 345 183, 236, 268, 289, 325, 402, 425, 428, Kolchinsky, Eric, 754 430, 434, 445, 453, 463, 482, 487, 504, Komansky, David, 611 511–512, 516, 523–524, 540, 542, 550, Kopper, Michael, 16 556–558, 561, 570, 574–575, 585, 590, Korea Development Bank, 528 597, 608, 614, 619, 649, 654, 678, 683, Korean Investment Corporation, 276 710–711, 714, 726, 731, 744–745, 760, Kovacevich, Richard, 82 767 Kovachev, Kosta, 245 Lehman Brothers Holdings, 411, 442, Kozlowski, Dennis, 51–53, 113 468–469, 512, 533, 608 Kozlowski, Karen, 52 Lehman, Herbert H., 289 KPMG, 60–62, 65, 433 Lender Implode-o-Meter, 506 Kramer, Timothy, 204 Lennar, 494 Krause, Peter, 552 Leno, Jay, 337 Krautz, Michael W., 15 Lerach, William, 22, 36, 40, 132–134 Kravis, Henry, 269–270, 276, 578 Letterman, David, 337 Krawcheck, Sallie, 636 Levin, Carl, 208, 631, 636 Krens, Thomas, 338 Levin, Sander, 275 Kroger, 56 Levine, Dennis, 256 Kroll Associates, 53, 502, 753 Levinson, Adam, 244

Levitt & Sons, 305, 467 Long Term Capital Management (LTCM), Levitt, Abraham, 305 179, 230–231, 417, 525, 580 Levitt, Arthur, 79, 148, 538 Lord, Albert, L., 390 Levittown, 305–306 Los Angeles County Museum of Art, 338 Levy, Richard, 338 Lott, Trent, 134 Lewinsky, Monica, 54 Louisiana Sheriffs’ Pension and Relief Fund, Lewis, Joseph, 499 129 Lewis, Kenneth, 116, 124–125, 430, 441, Lowe’s, 104, 520, 671 528, 551–553, 619, 635–637, 682, 704 Lowitt, Ian T., 530 Lewis, Michaelm 734 Lowry, Glenn, 338, 758 Lewis, Salim “Cy,” 437 Loyal Company, 249 Lexecon, 40 Lubben, David, 108 Li, David, 260, 347, 724 Lucas, George, 337 Libyan Investment Authority, 277 Lucent Technologies, 38–39 Liddy, Edward M., 544, 560, 639 Lynch, Edmund, 546 Lieberman, Joseph, 211 Lynch, Peter, 113–114, 271 Liechti, Martin, 63 LyondellBasell Industries, 618 Lilien, R. Jarrett, 495 Limbaugh, Rush, 337 Mack, John, 116, 456, 469, 555–557, Lincoln Center for the Performing Arts, 338 674 Lincoln National, 187–188, 691 Macomb, Alexander, 412 Lincoln Savings & Loan Association, Macquarie Group, 570 320–321 Macy’s, 628, 634 Lincoln, Abraham, 122 Madison Dearborn Partners, 257, 443 Linens ’n Things, 443 Madoff, Bernard L., “Bernie,” 6, 133, 148, Litan, Bob, 239 236, 248, 331, 443, 533, 608–615, 631, Litowitz, Alec, 581 726, 742, 747 Little, Arthur D., 162 Madoff, Ruth, 611 LJM Swap Sub, 16 Madonna, 337 LJM1, 3, 23 Magellan Fund, 113, 271–272 LJM2, 3, 23 Maggio, Santo, 248 Lloyds, 572–573, 668, 679, 762 Magna International, 606 Lloyds Banking Group, 620, 677 Magnetar Capital, 581 Lloyds TSB Group, 627 Maheras, Thomas, 501 Loan Guaranty Board, 600 Maiden Lane III, 544 Lobsiger, Lydia, 291 Major League Baseball, 337 Lockhart, James B., III, 437, 523 Major, John, 270 Lockheed, 418 Making Home Affordable, 676 Loeb, David S., 476, 514 Malone, Wallace D., Jr., 103 Loehr, Christopher, 24 Mamma.com, 608 Loglisci, David, 73 Man Financial, 247 Logue, Ronald, 637 Man Group, 245, 247, 520, 611 London Interbank Offered Rate (LIBOR), Managed Funds Association, 242 420, 487, 505, 546, 561, 665 Manhattan Investment Fund, 247 London International Commodity Clearing ManorCare, 279 House, 213 Marin, Richard, 439 London International Financial Futures Marino, Daniel, 246 Exchange (LIFFE), 215–216 Mark, Reuben, 103 London Scottish Bank, 453 MarketXT, 147 London Stock Exchange, 80, 84, 98, Markit Group Holdings, 746 147–148, 150, 155, 165 Markit Partners, 407 Long Beach Financial, 557 Markopolos, Harry, 612 Long Beach Mortgage Company, 409, 435 Marmon Holdings, 465 Long Beach Savings & Loan, 435 Marquez, James G., 246 Long Distance Discount Services (LDDS), Marsh & McLennan, 271, 502, 534–535, 43 691, 753

Marsh, Inc., 535 Meriweather, John, 580 Marshall, John, 158 Merkel, Angela, 663, 763 Martin, Mike, 47 Merkin, Ezra, 610–611 Martin, William McChesney, Jr., 144, 650 Merrill Lynch, 6, 10–13, 35–36, 53, 66–69, Marx Brothers, 288 116, 124–125, 129, 147, 151, 168, 183, Maryknoll Sisters, 688 203, 213, 217, 236, 238, 272–274, 277, Masferrer, Eduardo, 231 314, 329, 382, 402, 405, 411, 420, 439, Massachusetts Land Bank, 283 446, 463, 469, 482, 487, 489, 504, 509, Massachusetts Mutual Life Insurance 512, 529, 543, 545–553, 555–556, 560, Company, 611 564, 608–609, 611, 620, 636, 641, 643, Massachusetts Turnpike Authority, 597 654, 659, 673, 682, 688, 701, 704, 711, Master Liquidity Enhancement Conduit 714–715, 717–718, 726, 731, 762 (MLEC), 456 Merrill Lynch Bank & Trust, 272 MATIF, 215 Merrill Lynch Global Private Equity, 275, Mauro, Martin, 489 443 Maxim Integrated Products, 109 Merrill Lynch Investment Management Mayer Brown, 248 Group, 273 Mayflower Hotel, 75 Merrill Lynch Ready Assets Trust, 314 MBank, 487 Merrill Scott & Associates, 61 MBIA, 403–406, 688 Merrill, Charles, 546 MCA Financial, 384 Merritt Commercial Savings and Loan McAfee, 33, 111, 694 Association, 319 McBirney, “Fast Eddie,” 324 Messier, Jean-Marie, 78, 126 McCain, John, 91–93, 320, 401, 485, 563 Metropolitan Life Insurance Company McCall, Carl, 99 (MetLife), 187–188, 443, 520, 639, 683, McCarthy, Ian J., 78 720 McCaskill, Claire, 637 Metropolitan Museum of Art, 85 McClendon, Aubrey, 636–637 Metropolitan Opera, 338 McCleskey, Scott, 754 Metts, J. Mark, 27 McCormick, Robert R., 348 Metzenbaum, Howard, 340 McDonald, John, 59 Meurs, Michael, 56 McGuire, William, 106, 108–109 Meyer, Saul, 73 MCI Communications, 43 MF Global Holdings, 245, 247, 465, 502, McKelvey, Andrew, 111 560, 692 McKinnell, Henry, 94 MGIC Investment Corp., 405 McKinsey & Company, 18, 727 Miami Heat, 338 McLeod-USA, 70 MIBA, 404–405, 570 McLeod, Clark E., 70 Michaels, 257 McMahon, Jeff, 10 Microsoft, 71, 262, 481, 620, 625, 634, 654, McNenney, Edward J., 535 667, 692, 764 McNerney, W. James, Jr., 95 Mid-American Energy Holdings, 34 McQuade, Eugene, 437 Midwest Stock Exchange, 148 McVay, Malcolm, 47 Miekka, James, 694 Means, Gardiner, 86 Miers, Harriet E., 51 Medicaid, 661, 651 Milberg Weiss & Bershad, 41, 53, 132–133 Medicare, 424, 495, 592, 661 Milken, Michael, 10, 39, 96–97, 182, 254, Medill, Joseph, 348 256, 318, 320, 322 Mehta, Zarin, 338 Millard, Charles E.F., 344, 666 Melamed, Leo, 212–213, 215 Millennium Partners, 745 Mellon Bank, 594 Miller, Bill, 423, 501 Mellon, Andrew, 85, 89, 91, 96, 710 Milton, Christian, 537 Mercantile Trust, 285 Minsky, Hyman, 412 Mercedes-Benz, 62, 89, 528, 662 Minute Maid, 251 Merck, 62, 130–131, 650 Mirant, 199 Merckle, Adolf, 614 Missal, Michael J., 433 Mercury Interactive, 108–109 Mitchell, Charles E., 87–88, 454

Mitsubishi UFG Financial Group (MUFG), Murphy, Kevin, 104 557 Murray, Bronson, 224 Mitsubishi UFJ, 575 Museum of Modern Art, 338, 758 Mizuho Financial Group, 501 Mustier, Jean-Pierre, 475 Moffett, David, 633, 656 Mutual Life Insurance Company of New Moffett, James, 299 York, 187 Money Market Investor Funding Facility Mutual Mortgage Insurance Fund, 305, 383 (MMIFF), 534, 709 Myers, David, 46 Money Market Mutual Fund Liquidity Facility (AMLF), 709 Nabors Industries, 95 Money Store, 409, 411 Nacchio, Joseph, 39–40 Monrad, Elizabeth, 537 Nadel, Arthur, 614 Monster Worldwide, 108, 111 Napier, Richard, 537 Montag, Thomas, 552, 682 Napoli, Paul J., 135 Montgomery Securities, 253 Nardelli, Robert, 104 Moody’s Investor Services, 178, 224, 275, NASDAQ, 80, 84, 98, 142–143, 145–155, 404–405, 435, 446–447, 459, 501, 616, 157, 158, 167, 193, 206, 239, 257–258, 627, 647, 656, 719, 724, 748–751, 754 277, 418–419, 424, 474, 538, 610, 681 Moonves, Leslie, 337 NASDAQ OMX Group, 158, 167 Moore, R.M., 48 Nathanson, Colin, 615 Morgan Crucible, 17 National Asset Management Agency Morgan Guaranty Trust Company, 165 (NAMA), 573 Morgan Library, 85 National Association of Criminal Defense Morgan Stanley, 57, 68, 70, 116, 122, 147, Lawyers, 71 176, 183–184, 236, 238, 261, 274, 277, National Association of Insurance 345, 426, 428, 433, 436, 456, 459, 469, Commissioners (NAIC), 186–187, 754 487–489, 504, 512, 529, 543, 554–557, National Association of Real Estate Boards, 568–569, 589–590, 595–596, 616, 619, 295 639, 643–644, 654, 658–660, 668, 674, National Association of Realtors, 467 677, 682, 689, 692, 715, 733, 740 National Association of Securities Dealers Morgan, Henry S., 554 (NASD), 53, 70–71, 152, 162, 198, 223, Morgan, J.P, 85, 86, 96, 250, 285, 413, 460, 232, 234, 610 497, 554 National Bank, 396 Morgenthau, Robert M., 214 National Bank of Hungry, 574 Morris, Henry, 73 National Basketball Association, 337 Morris, Robert, 249 National Bureau if Economic Research, 598 Mortgage Bankers Association, 396, 479 National City Bank, 87–88, 299, 453–454, Mortgage Electronic Registration System 508, 568 (MERS), 479 National City Company, 453–454 Mortgage Guaranty Insurance Corporation National City Corporation, 548, 588, 619 (MGIC), 308, 699 National Cordage Company, 413 Mortgage Origination Commission (MOC), National Credit Office, 749 408 National Credit Union Administration Motorola, 68, 119, 261, 636 (NCUA) 628,737 Moynihan, Brain T., 554, 636, 682 National Emergency Council, 297 Mozilo, Angelo, 401, 476–479, 514, 636 National Football League (NFL), 246, 337, Mudd, Daniel, 401 476 Mueller, Edward, 506–507 National Foreclosure Mitigation Counseling, Mukasey, Michael, 483 699 Mulally, Alan, 602, 684 National Foundation for Credit Counseling, Mulgrew, Gary, 16–17 699 Municipal and Infrastructure Assurance National Futures Association (NFA), 198, 728 Corporation (MIAC), 570 National Gallery of Art, 338 Municipal Securities Rulemaking Board National Institutional Delivery System, 162 (MSRB), 163, 570 National Market System (NMS), 142–143, Murdoch, Rupert, 114, 254, 347 146

National Mortgage Association, 302 New York Real Estate Securities Exchange, National Over-the-Counter Clearing 290 Corporation, 160–161 New York State Department of Insurance, 289 National Public Finance Guarantee Corp., New York State Ethics Commission, 74 405 New York State Public Employees National Quotations Bureau, 145 Federation (PEF), 343 National Recovery Administration, 299 New York Stock & Exchange Board, 139 National Securities Clearing Corporation New York Stock Exchange (NYSE), 27, (NSCC), 162–164 70–71, 80, 84, 89, 94, 97–100, 124, 139, National Stock Exchange, 148 140–162, 168, 181, 183, 189, 193–194, Nationally Recognized Statistical Ratings 198, 206, 227, 238–239, 249, 258, 270, Organizations (NRSROs), 749 309, 328, 377, 413–415, 418, 427, 443, NationsBank, 253 464, 525, 544, 549, 560, 565, 611, 647, Natixis, 573 677, 681, 684 NatWest Bank, 16 New York Times Company, 345–346, 635 Natwest Three, 15–17 New York Times News Service, 346 Negrin, Renato, 745 Newkirk, Warren H., 301 Neighborhood Assistance Corporation, 699 News Corporation, 114, 347–348 NeighborhoodWorks America, 700 Nicholas, Henry T., 110 NeighborWorks America, 698 Niederauer, Duncan, 560 Neiman Marcus, 588 Nifong, Michael, 328 Ness, Eliot, 765 Nigerian Barge Fiasco, 10–15, 17, 25, 329 Netscape, 253 Nightingale Finance, 540 Neubauer, Nikolas, 216 Nikkei Average, 567 Neuberger Investment Management 530 Nissan Motor Company, 605, 607, 647 New Century Financial Corporation Nix, 468 432–433 Nixon, Richard M., 58, 268, 311, 427, 524 New Court Securities, 253 Nomura Holdings, 501, 529, 611, 654, 667 New England Council (NEC), 251 Nordic Capital, 578 New England Industrial Development Norma CDO I, 548 Corporation (NEIDC), 251 Norman, Troy, 46 New Enterprises, 251 Norris, Ian, 17 New Fabris, 646 Nortel Network, 41–42 New Jersey Division of Investment, 480 North America Land Company, 249 New London Society United for Trade and North American Savings and Loan Commerce, 283 Association, 319 New Orleans Employees’ Retirement North Fork Bancorp, 94 System, 544 Northern Natural Gas (NNG), 34 New York Board of Trade (NYBOT), 206, Northern Rock, 451–452, 496, 675, 762 215 Northern Trust Securities, 490, 543 New York Civil Liberties Union, 42 NorthStar Education, 389 New York Clearing Corporation, 160–161 Northwest, 502 New York Clearing House, 170, 398 NovaStar Financial, 449 New York Common Retirement Fund, 265 NQLX, 217 New York Cotton Exchange, 206 Nuveen Investments, 488 New York Futures Exchange, 206 NYSE Arca, 151, 153, 157–158, 167m 736 New York Insurance Department, 535, 538 NYSE Arca Europe, 153 New York Islanders, 632 NYSE Euronext, 100, 152–154, 221, 502 New York Life, 720 NYSEG, 198 New York Life Insurance Company, 186 NYSELiffe, 153 New York Mercantile Exchange (NYMEX), 154, 190, 195, 205, 208, 214, 218, 221, O’Brien Conan, 337 474, 509, 517 O’Mahoney, Joseph, 186 New York Mets, 641 O’Meara, Christopher, 530 New York Philharmonic, 338 O’Neal, E. Stanley, 469, 547–550, 556, 564, New York Public Library, 85 636

Oaktree Capital Management, 670 Oracle Corp., 106, 635–636, 758 Obama, Barack, 37, 62, 64, 84, 92–93, Orbitz, 620 116–117, 119, 121, 124, 128, 156, 186, Organization for Economic Cooperation and 194, 208, 209, 265, 266, 332, 339, 344, Development (OECD), 657, 664 391, 401, 471, 477, 518, 545, 553, 560, Organization of Petroleum Exporting 563, 582–584, 586, 590, 592, 595–596, Countries (OPEC), 492, 588, 616 599–600, 603, 605–607, 626, 629–630, Ortselfen, Stefan, 734 632–635, 637–639, 641–642, 646–649, Osgood, Samuel, 453 652–653, 655–656, 662, 665–666, Ospel, Marcel, 458, 503 669–670, 672, 676, 679–680, 684–691, Osterberg, William P., 227 694, 697, 699, 710, 712, 714, 729–732, Overstock.com, 68 737, 742–743, 745, 747, 752, 755, 758, Ovitz, Michael, 88–89 763–765, 767 Owen, James, 516 Occidental Petroleum, 641 Owen, Richard, 71 Och-Ziff Capital Management, 245, 261, Oxford Provident, 284 465 Ochs-Sulzberger family, 345–346 Pacific Exchange, 147 Office Depot, 634 Pacific Life Insurance Company, 272 Office of Credit Ratings, 753 PacificAmerica Money Center, 410 Office of Federal Housing Enterprise and Pacino, Al, 609 Oversight (OFHEO), 378, 400, 402, Pahapill, Mary Anne, 41 437, 521–522 Pai, Lou, 32–33 Office of Financial Education, 757 Paine Webber, 457 Office of Financial Research, 737–738 Paine, Thomas, 249 Office of Financial Stability, 656 Palm Beach Country Club, 610 Office of Investor Advocate, 742 Palmer, Daren, 614 Office of National Insurance, 761 Pandit, Vikram S., 184, 456–457, 505, 593, Office of the Comptroller of the Currency 619, 629, 636–637, 660, 682 (OCC), 393, 395–396, 593, 728, Pang, Danny, 631 730–731, 737, 740, 742 Paris Bourse, 150, 215 Office of Thrift Supervision (OTS), 322, Parish, Al, 615 396, 437, 515, 730–731, 740 Park Avenue Bank, 666 Ohio Company, 249 Parmalat Finanziaria, 56–57 Ohio Life Insurance and Trust Company, Parsons, Richard, 625 412 Participants Trust Company, 163 Olayan Group, 480 Paterson, David A., 343, 746 Old Court Savings and Loan Association, Patman, Wright, 306 318 Patriarch Partners, 565 Old Lane Partners, 456, 505 Patterson, Mark, 560 Olenicoff, Igor, 63 Paul, David, 320 Olis, Jamie, 36 Paul, Ron, 679 OMX, 150, 158, 167, 277 Paul, Weiss, Rifkind, Wharton, & Garrison, OneChicago, 167, 217, 531 321 OneUnited Bank, 626 Pauley, William H., III, 69 OneWest Bank, 516 Paulson & Company, 231, 496, 582 Ontario Public Service Employees Union Paulson, Henry M., Jr., “Hank,” 76, 82, 151, Pension Fund, 41 279, 426–427, 431–432, 444, 447, 456, Ontario Teachers’ Pension Plan, 257, 443 485–486, 493, 496, 499, 507, 513, 522, Ontario Teachers’ Pension Plan Board, 41 527–528, 542–543, 545, 551, 560, 562, Opel, 606 566, 582, 591–592, 599, 626, 697, 708, Oppenheimer, 490 710–711, 719, 728, 751 OptiMark, 147 Paulson, John, 516, 581–582, 734–736, Options Clearing Corporation (OCC), 167, 741–742 220, 222–224 Pax World, 118 Options One, 446 Paxil, 131 Opus Capital Markets, 408 Payments Risk Committee, 174

Peacock Group, 261 Poling, Douglas, 638–639 Pell grants, 387 Pontiac, 605 Pellicano, Anthony, 89 Porsche Automobile Holdings, 607–608 Pelosi, Nancy, 117 Port Authority of New York and New Jersey, Peloton, 580 597 Pelton, Charles, 349 Portland General Electric, 14, 29 Penn Central, 566, 749 POSIT, 147 Penn National Gaming, 442 Posner, Gail, 338 Penn Square Bank, 324, 711 Posner, Victor, 338 Penn Traffic, 56 Potash Corp., 694 Pennsylvania Higher Education Assistance Potter, William, 282 Agency, 389 Powell, Colin, 253 Pennsylvania Land Company, 249 Powell, Earl A., III, 338 Pennsylvania State Employees Retirement Power Integrations, 108, 112 System, 597 Power, Richard, 53 Pension Benefit Guaranty Corporation Powernext, 154 (PBGC), 343–344, 663, 666 President’s Working Group on Financial Penske Automotive Group, 606 Markets (PWG), 194, 197, 243–244, Pequot Capital Management, 555 486, 745, 751 Perelman, Ronald, 254, 261, 323, 554 Presidential Task Force on Market Perkins loans, 387 Mechanisms, 163, 194, 220 Perkins, Steve, 664 Press, Jim, 604 Perkins, Tom, 253 Price, Joseph, 553 Perot, H. Ross, 596 Priceline.com, 253 Perpich, David, 347 PricewaterhouseCoopers, 38, 53, 65, 529, Perry Capital, 261 536, 540 Peter Cooper Village, 685 Primex Trading, 147 Peterson, Peter G., 268, 524 Prince, Charles O., III “Chuck,” 114, 423, Petra Capital Management, 596 428, 455–456, 480, 498, 595, 636–637 Petrocelli, Daniel, 21 Pritchard, Adam C., 764 Petters Company, 609 Pritzker family, 465 Petters, Thomas, 609 Private National Mortgage Acceptance Pfaff, Robert, 62 Company (PennyMac), 647 Pfizer, 68. 94, 130–131, 628, 635 Proctor & Gamble, 94, 690 Phallppou, Ludovic, 275 Project Hope Now, 451 PHH, 442 Promark Global Advisors, 640 Phibro, 641 Prosperity Bank, 589 Philadelphia Alternative Asset Management ProTrust Management, 609 Co. (PAAMCO), 247 Providence Equity Partners, 257 Philadelphia Board of Trade, 167 Provident Financial, 120 Philadelphia Stock Exchange (PHLX), 144, Provisional Federal Bank (PFB), 565 149, 157, 158, 167, 249 Prudential Financial (Prudential), 187, 520, Phipps, Henry, 251 558, 620, 683, 720 Pickens, T. Boone, Jr., 254 Prudential Securities, 409 Picower, Jeffrey L., 613 PSA Peugeot-Citroën, 607, 646 Pilgrim’s Pride, 598, 669 Public Company Accounting Oversight PIMCO, 272, 463, 585 Board (PCAOB), 77, 334 Pinnacle Foods, 257 Public Employees Retirement System of Pinto, Edward J., 590 Ohio, 43 Plains Exploration & Production, 95 Public Works Administration, 301 Playboy Enterprises, 113 Public-Private Investment Program (PPIP), Plueger, John, 678 651 PLUS loans, 387 Pulte Homes, 653, 668 PNC Bank, 273 Purcell, Philip, 68, 456, 554–555 PNC Financial Services Group, 273, 423, PurchasePro.Com, 54 536, 588, 619, 635 Purtich, Richard, 132

Putin, Vladimir, 629 Renaissance Technologies, 582 Putnam Investments, 271, 534 Renault, 605, 607, 646 Putnam Prime Money Market Fund, 271, Repo 105, 526, 530 534 Research in Motion, 108 Putnam, George, 271 Reserve Bank of Australia, 505 PVM Oil Associates, 664 Reserve Primary Fund (RPF), 531–534, 556, Pyxis, 463 649, 709 Residential Capital Corporation (ResCap), Qatalyst Group, 71 601 Qatar Investment Authority, 277 ResMAE Mortgage Corporation, 467 Quadrangle Group, 266, 607 Resolution Trust Corporation (RTC), Quaker Oats, 442 323–324, 438 Quantum Group, 179 Retail Energy Services, 33 Quattrone, Frank, 69–71, 133 Reuters, 146, 148, 213 Quellos Group, 273 Reyes, Gregory L., 110 Quest Software, 109 Rezko, Antoin, 477 Quinlan, Patrick D., Sr., 384–385 RFC Mortgage Company, 302 Quinn, Patrick J., 651 Rhode Island Share and Deposit Indemnity Quotron Systems, 146 Corporation, 323 Qwest Communications International, Rhythms NetConnections, 16 39–40, 506 Ricciardi, Christopher, 549 Rice, Kenneth, 13–15, 21 Radler, F. David, 58 Richmond Capital, 580 Raines, Franklin, 400–401, 521, 702 Richter, Jeff, 200 Rajaratnam, Raj, 727 Riefler, Winfield W., 299 Raju, Ramalinga, 627 Riegle, Don, 320 Rakoff, Jed S., 553 Rieker, Paula H., 21–22 Rambus, 108 Rigas, John, 5, 42, 78 Ramsey, Michael, 21, 23, 26, 28–29 Rigas, Michael, 42 RAND Corporation, 156 Rigas, Timothy, 42 Raptors, 3, 25, 579 Ripp, Joseph A., 55 Rattner, Steven, 266, 607 RiskMetrics, 95, 121, 124, 125, 179 Ray, Glenn, 26 Risoli, Paul, 459 Raymond Jones Financial, 490 Ritchie Capital Management, 248 Raytheon, 65 Ritz-Carlton, 666 RCA, 227, 299 Riverstone Holdings, 266 Read, William A., 457 RJR Nabisco, 255, 441 Readers Digest, 671 Roberts, Brian L., 95 Reagan, Ronald, 77, 91–92, 194, 220, 315, Roberts, George, 269–270 321, 546, 649, 737 Roberts, Kent, 111 Real Mex Restaurants, 579 Robertson Stephens, 253 Reconstruction Finance Corporation (RFC), Robinson, Janet L., 346 96, 296–297, 301–303, 325, 461, 568, Rocca, Patrick, 614 652, 710, 716 Roche Holding, 650 Red Hat, 253 Rock, Arthur, 252 Redouin, Jean-Paul, 712 Rockefeller family, 91, 125, 251 Redstone, Sumner, 569 Rockefeller, John D., 85–86 Reed, John, 66, 454–455 Roddenberry, Majel Barrett, 338 Refco, 225, 248, 442 Rogers, James B., 248 Regan, Donald, 546 Rogers, Rex, 79 Regions Financial Corporation. 508, 619, Rohatyn, Felix, 586 641 Rohm & Haas, 278, 650 Reich, John, 515 Rohner, Marcel, 457 Reich, Robert, 590 Roosevelt, Franklin Delano, 49, 89–91, Reid, Todd, 204 95–96, 185, 291, 295–299, 302–304, Reliant Energy, 199, 201 348, 414, 592, 716, 729

Rorech, Jon-Paul, 745 Savings Association Insurance Fund (SAIF), Rosenman, Martin, 611 322 Rosenwald, Julius, 287 Saxon Mortgage, 449 Ross, Steve, 94 SCA, 405 Ross, Wilbur L., 259, 405, 446 Scarface, 580 Rothstein, Scott, 135, 615 Schapiro, Mary, 84, 121, 149, 630–631, 642, Rousselet, Luc, 646 690, 731–732, 747 Rove, Karl, 50–51 Schering-Plough, 650 Rowling, J.K., 340 Schiff, Frederick S., 57 Royal Ahold, 56, 276 Schmidt, Eric, 71 Royal Bank of Canada, 490, 492 Schneider, Howard, 247 Royal Bank of Scotland (RBS), 16–17, Schrenker, Marc, 614 120, 452, 501, 572–573, 595, 611, Schrenker, Michel, 614 616, 627, 644, 655, 668, 675, Schulman, Steven, 132 762 Schumacher, Michael, 337 Royal Canadian Mounted Police, 41 Schumer, Charles “Chuck,” 82, 125, 154, Royal Dutch Shell, 120, 204, 206 325, 401, 407, 515 Royal Exchange, 643 Schwab, Charles R., 87, 468, 489–490, 501, Royer, Jeffrey A., 609 704 Rubenstein, David, 265, 270, 277 Schwartz, Alan, 495 Rubin, Howard A., 382, 547 Schwartz, Anna, 708 Rubin, Robert, 384, 417, 456, 560, 590, Schwarzenegger, Arnold, 200 637–638, 733, 741 Schwarzman, Stephen A., 268, 524 Rubinstein, Steven M., 63 Scient, 253 Ruble, R.J., 60 Scorsese, Martin, 609 Rudman, Warren, 401 Screen Actors Guild, 340 Rural Cellular Corporation, 609 Scruggs, David (Zack), 134 Rush, Walter, 29 Scruggs, Richard “Dickie,” 134 Russell 2000, 474 Scrushy, Richard, 47–49, 51 Russo, Thomas, 678 Seagate Technology, 620 Ryan, Debra, 246 Sears, Roebuck & Co., 287 Ryder Cup, 113 SecondMarket, 155, 488, 672 Secrest, George McCall, Jr., 28 S.W. Straus, 290 Secretariat, 338 S&P 500 Index, 94, 101, 125, 159, 276, 342, Securities Industry Automation Corporation 419, 423–424, 426, 465, 493, 501, 533, (SIAC), 162 561, 569, 584, 587–588, 592, 597, 618, Securities Information Center, 161 625, 669, 681, 687, 718, 750 Securities Investor Protection Corporation Saab, 605 (SIPC), 168, 181, 225, 314, 529, 531, Sabath, Adolf J., 290 610, 613, 739 SafeNet, 111 Security Capital Assurance, 405 Salomon Brothers, 114, 533 Security Pacific Bank, 589 Salomon Smith Barney, 66, 70 Sedgwick, Kyra, 610 Samantha, 338 Sedna Finance, 456 Samberg, Arthur, 555 Seidman, L. William, 323 Sambol, David, 479 SelectNet, 146 Samueli, Henry, 110 Semerci, Osman, 549 Sanders, Thomas, 251 SemGroup, 265 Sandler, Herbert, 394, 559 Sempra Energy, 199, 203 Sandler, Marion, 394, 559 Senate Banking Committee, 476, 634, 731 Sankaty Advisors, 589 Sentinel Advisors, 62 Sanmina-SCI, 108 Sentinel Management Group, 225 Sants, Hector, 452, 764 Sequoia Fund, 264 Sarkozy, Nicolas, 646 Service Employees International Union Saturn, 605–606 (SEIU), 264–265, 279, 516 Satyam Computer Services, 627 ServiceMaster, 276

Shafran, Steve, 560 Sonnenschein, 591 Shakespeare, William, 340 Sony, 646 Shapiro, Carl, 611 Soros Fund Management, 582 Shearson Hayden Stone, 524 Soros, George, 179, 230, 481, 516, 581–582, Shearson/American Express, 524 586 Sheen, Charlie, 337 Southern Pacific Funding Corporation, 410 Shelby, Rex, 15 SouthTrust Bank, 103 Shell Trading Gas and Power Company, SouthTrust Corporation, 558 202, 620 Southwest Airlines, 465 Shelton, E. Kirk, 54 Southwest Securities, 238 Shereshevsky, Joseph, 609 Sovereign Bancorp, 94, 464, 574 Shiller, Robert, 727 Spano, John, 632 Shin Corporation, 280 Spear, Leeds, & Kellogg, 151 Shinawatra, Taksin, 280 Spector, Warren, 440, 495 Shively, Hunter, 202 Spencer, Leanne, 401 Shulman, David, 488 Spielberg, Steven, 610 Sidhu, Jay, 94 Spitzer, Eliot, 66, 75, 81, 83, 89, 97–100, Sidley Austin Brown & Wood, 60 116, 139, 150, 231–238, 240, 327–329, Siegelman, Don, 48–51 332, 352, 389, 398, 404, 455, 489, 498, Siemens, 615 534–539, 541, 544, 565, 639, 703–704, Sieracki, Eric, 479 726, 729, 732, 742–743, 746 Sigma Finance Corporation, 574 Sprecher, Jeffrey, 206 Sigma X, 155 Sprint Nextel, 464–465 Sihpol, Theodore Charles, III, 232 Sprint, 43 Silverado Savings & Loan Association, 320 SS Central America, 412 Simmons Bedding Company, 275 St. Eve, Amy, 58 Simon, William, 254 St. Regis Monarch Beach, 543 Simons, James H., 581–582 Stafford loans, 387 Simpson, Jill, 50 Stalin, Joseph, 59, 122 Simpson, O.J., 21, 54, 255 Stallone, Sylvester, 609 Singapore International Monetary Exchange Standard & Poor’s, 24, 178, 224, 404, 473, (SIMEX), 213, 215 493, 521, 577, 585, 601, 635, 656, 661, Singapore Investment Corporation, 702, 719, 748–751, 764 457–458, 683 Standard Oil Company, 85, 125, 299 Singleton, Greg, 204 Stanford International Bank, 631–632 Skadden Arps, Slate, Meagher & Flom, 482 Stanford, Sir R. Allen, 248, 631–632, 734 Skilling, Jeffrey, 3–6, 11, 14–15, 18–32, 36, Starbucks, 487 40, 48, 59, 79, 115, 133, 199, 200, 330, Starr International, 538–539 351, 390, 478 Starr, Kenneth, 609 Slim, Carlos, 346 State Street Bank and Trust Company, 174 SLM Corporation, 388, 442 State Street Global Advisors, 272 Small Business Administration, 251, 596 State Street Securities, 450, 463, 627, 637, Smith Barney, 595, 608 659–660 Smith, Lanty L., 559 State Teachers Retirement System of Ohio, Smith, Weston, 48 43 Snapple, 442 Steele, Robert J., 559–561 Snipes, Wesley, 609 Steffan, Roger, 299 Snow, John, 401, 427 Steinberg, Saul, 254 Social Security Administration, 495, 592, Steinbrück, Peer, 574 661, 687, 699, 751 Stenfors, Alexis, 551 Société Générale (SocGen), 456, 475, 501, Stephenson, Kirk, 614 520, 542, 545, 675 Stern, Andy, 264–265, 278 Society for Worldwide Interbank Financial Stern, Edward J., 231 Telecommunications (SWIFT), 172–173 Stern, Howard, 336 Solomon R. Guggenheim Museum, 338 Stevens, Ted, 331–332 Solow Realty, 245 Stewart, Alexander, 85

Stewart, Martha, 5, 262 Task Force on Payment System Principles Stockman, David, 77 and Practices, 173 Stop & Shop, 56 Tavdy, David, 459 Storage Technology, 251 Taylor, Bean & Whitaker Mortgage Storch, Adam, 560 Corporation, 671 Storm Cat, 338 Taylor, John, 707 Stotler Funds, 225 TCI, 263 Streiff, Christian, 607 TD Ameritrade, 490 Strike System, 147 Technical Committee of the International Strong Mutual Fund, 231 Organization of Securities Commissions Strum, Donald, 66 (IOSCO), 166–167, 174, 199 Student Loan Insurance Fund (SLIF), 387 Teitelbaum, Herbert, 74 Student Loan Marketing Association Teixeira, Mark, 337 (Sallie Mae), 387–388, 390–391, Teledyne, 252 687 Telerate, 146 Student Loan Xpress, 388–389 Temasek Holdings, 278, 280, 453, 550, 659 Stumpf, John G., 682 Temple, Nancy, 8–9 Stuyvesant Town, 685 Temporary Liquidity Guarantee Program Subprime Working Group, 483 (TLGP), 709 Sullivan, Martin J., 469, 538–541, 543–544, Tepper, David, 681, 684 640 Term Asset Backed Securities Loan Facility Sullivan, Scott, 44-46 (TALF), 391, 596, 646–647, 661, 679, Sult, John R., 24 686, 710 Sulzberger, A.G., 347 Term Auction Facility (TAF), 674, 709 Sulzberger, Arthur, 346 Term Securities Lending Facility (TSLF), 709 Sulzberger, Arthur, Jr., 347 Terra Securities, 453 Summers, Lawrence H., “Larry,” 417, 590, Texas Instruments, 628 638, 648, 676, 733 Texas Pacific Group (TPG), 257–258, 278, Sun Capital Partners, 579 443 Sun-Times Media, 59 Texas Rangers, 436 Sunbeam, 7, 554 Thain, John 151–152, 549–552, 560 SunTrust Bank, 426, 460, 500 Thinc Group, 481 Super-DOT, 144 Third Avenue Management, 405 Superior Bank, 396 Third National Bank, 453 SuperMontage, 146, 149 Thomas H. Lee Partners, 275, 441–442 Supervalu, 267 Thomas Weisel Partners, 253 Susquehanna Company, 249 Thompson, G. Kennedy, 559 Sutherland, Kiefer, 337 Thompson, Larry D., 6–7, 61 Swartz, Mark, 52 Thomson Learning, 441 Swiss Bancorp, 457 Thomson, James B., 227 Swiss National Bank, 461, 574 Thomson, Todd, 114 Swiss Reinsurance (Swiss Re), 481, 520, Thornburg Mortgage, 494, 502 597, 655 Thornton, Grant, 57, 83 Swiss Stock Exchange, 215 3M, 667 Syncora, 405 3Par, 692 Syron, Richard F., 464 TIAA-CRE, 79, 531 Tiffany’s, 531 T. Rowe Price Group, 480 Tiger Management, 179, 231 Take-Two Interactive Software, 65, 111 Time Warner, 620–625 Taleb, Nassim Nicholas, 149, 180, 340, 690, Time, 94 725 Times Mirror, 348 Tandem Computers, 253 Timothy Plan, 118 Tannin, Matthew, 439–440 Tishman Speyer Properties, 685 Tarbell, Ida, 85 Title Guarantee & Trust Company, 289 Target, 520, 565, 634, 712 TJ Maxx, 671 Targus Group International, 65 TNK-BP, 516

Tobin, James, 763 U.S. Central Credit Federal Union, 628 Tokyo Stock Exchange, 152 U.S. Chamber of Commerce, 81, 123, 240, Toll Brothers, 424, 428–429, 431, 434, 445, 299, 535, 719 494, 587, 626, 636, 665, 669 U.S. Food Service, 276 Toll, Robert, 636 U.S. Mortgage Company, 285 TONTO System, 147 U.S. National Home Index, 718 Topolanek, Mirek, 649 U.S. Open, 543 Tops, 56 U.S. Postal Service, 669 Torkelsen, John, 133–134 U.S. Steel, 87 Toronto Stock Exchange, 148 UBS, 34, 56, 63–64, 154, 174, 229, 272, Toronto Teachers Pension Plan, 245 277, 278, 404, 423, 436, 457–459, Toronto-Dominion Bank, 34 487–488, 494–500, 503–508, 528, 545, Tottenham Benefit Bank, 283 548, 556, 574, 597, 610, 616, 619, 635, Tourre, Fabrice, 734–735 643, 654, 657, 668, 670, 677, 683, 685, Towns, Edolphus, 476–477, 553 689, 692, 717, 733 Toyota Motor Co., 129, 450, 495, 504, 602, UBS AG, 640, 683, 745 607 UBS Fund Service, 247 TPG Capital, 276, 442, 558, 579 UBS Warburg, 200 Trac-X, 407 UBSWenergy.com, 200 TRACE, 149 UCBH Holdings, 619 Tracinda, 600 Unicredit, 57 Trade Information Warehouse (Warehouse), Union Bancaire Privée, 610 744 Union for Textile and Hospitality Industry Tradewinds International II, 246 Workers, 123 Trading System, 147 Union Network International, 264 Transylvania Company, 249 Union Pacific, 285 Travelers Group, 454–455, 537, 663 United Airlines, 323, 518 Treacy, James J., 111 United Auto Workers (UAW), 602, 604–606 Tremont Group Holdings, 611 United Brands, 443 Tribune Company, 345, 348 United Brotherhood of Carpenters and Trichet, Jean-Claude, 661, 763 Joiners of America, 122 Trigon Group, 614 United Capital, 580 Trinkle, Tina, 11 United Copper Company, 413 Trotsen, Robert, 248 United Rentals, 441 Troubled Asset Relief Program (TARP), United State Department of Agriculture 565, 567–569, 578, 584–586, 591, 596, (USDA), 599 599, 604, 606, 609, 617, 626, 629, United States Futures Exchange (USFE), 635–636, 638, 640–641, 643, 647–648, 217 651–652, 654, 656–660, 665–656, 662, United States Housing Corporation, 294 671–672, 677, 679–681, 684, 709 United States League of Local Building and Trout Trading, 247 Loan Associations, 286, 300 Trubeck, William, 446 United Technologies, 103, 113 TRW, 442 UnitedHealth Group, 106, 108 Tucker, Paul, 452 Unites Cos Financial Corporation, 410 Tudor Investments, 579 University of Texas Investment Management Tullos, Nancy, 110 Company, 264 Tully, Daniel, 611 Turner, Lord, 762–763 VA Linux, 253 Turquoise, 147 Valdez, 128 TXU, 257, 276, 578 Valencia, Michelle, 204 Tyco International, 51–53, 113, 129, 133 Van der Hoeven, Cees, 56 Tyson Foods, 620, 669 Van Wagoner Emerging Growth Fund, 501 Tzolov, Julian, 490 Van Wagoner, Garrett, 235, 501 Vanguard, 79 U2, 114 Varney, Christine, 764 U.S. Bancorp, 423, 460, 659 Vauxhall, 606

Veco Corporation, 331 Washington Mutual (WaMu), 420, 426, 429, Venrock Associates, 252–253 433, 435, 442, 446, 450, 480, 484, 506, Verizon Wireless, 609 521, 557–560, 574, 583, 587, 599, 619, Vernon Savings Bank, 317 658, 682, 686, 698 Verrone, Robert, 559 Washington Post Company, 348–349 Vesco, Robert, 111 Washington Wizards, 338 Veterans Administration (VA), 302, 304, Washington, George T., 86, 88 309 383 Washington, George, 249 Vetra Finance, 456 Wasserstein, Bruce, 95 Viacom, 337, 569 Waste Management, 7 Villiger, Kaspar, 635 Watkins, Sherron, 4, 23–24, 27 Viniar, David, 431 Watson, Frank, 299 Vinson & Elkins, 24, 34, 79 Waxman, Henry A., 564, 636, 640 Vinson, Betty, 46 WCI Communities, 112, 519 Vioxx, 130 Weatherstone, Dennis, 179 Virginia House of Burgesses, 283 Weidner, Clinton Odell, II, 115 Virginia Yazoo Company, 249 Weil Gotshal, 529 Visa, 618 Weil, Raul, 63 Visteon, 606 Weill, Sanford “Sandy,” 66, 106, 116, 423, Vivendi Universal, S.A., 78, 126 454–455, 457, 480, 497–498, 524, 595 Volatility Index (VIX), 159, 566 Weinstein, Boaz, 619 Volcker, Paul, 79, 414, 546, 586, 590, Weiss, Melvyn, 133 706–707, 718, 731, 740 Welch, Jack, 99, 107, 113, 571 Volkswagen, 607–608 WellPoint Inc., 689 Volume Investors, 225 Wells Fargo, 82, 394, 398, 423, 426, 434, Volvo, 684 466, 490, 509, 512–513, 560–561, 567, 584, 616, 619, 639–640, 643, 656, Wachovia, 103, 174, 394, 398, 411, 423, 658–659, 668, 676, 680, 682, 692 426, 441, 482, 489, 506, 545, 549, 556, Werlein, Ewing, Jr., 12 558–561, 581, 595, 619, 656, 658, Wesray, 254 711 West, Stephen K., 239 Wachovia Bank and Trust, 558 Westar Energy, 114–115 Wachovia Corporation, 558 WestLB, 456, 481 Wachovia Loan and Trust, 558 WexTrust Capital, 609 Wachovia Mortgage Corporation, 398 Weymouth, Katherine, 349 Wachovia National Bank, 558 Wharton Private Equity Forum, 265 Wachovia Securities, 488, 558 White & Case, 590–591 Waddell & Reed, 149, 690 White House Domestic Council, 427 Wagoner, George Richard “Rick,” 601, 605 Whiteacre, Edward, Jr., 692 Wakefield, Priscilla, 283 Whitehead, John C., 536 Wal-Mart, 119, 334, 434, 634 Whitney family, 251 Walker, Frank C., 298 Whitney, J.H., 251 Walker, Sir David, 644 Whitney, Richard, 141 Wall, M. Danny, 321 Wie, Michelle, 337 Wallison, Peter, 239, 399, 448 Wiesel, Elie, 610 Walsh, Mark, 526 Wilde, Oscar, 19, 330, 333, 553 Walsh, Stephen, 632 Williams Companies, 199 Walt Disney Company, 88, 95, 106, 122, Williams, Julie L., 398 636 Williams, Serena, 337 Wang, Charles, 56, 632 Willumstad, Robert, 541, 543 War Finance Corporation, 294, 568 Wilshire Banks Index, 466 War Production Board, 304 Winfrey, Oprah, 115, 337, 758 Warburg Pincus, 404 Winkelreid, Jon, 463 Warburg, Paul, 413 Winnick, Gary, 43 Warner Brothers, 94 Winnipeg Commodity Exchange, 206 Warren, Elizabeth, 732, 756 Witness Systems, 109

Wittig, David, 114–115 Yahoo!, 71, 262, 608 Wolff, Stuart, 54 Yang, Jerry, 262 Wolfowitz, Paul, 560 Yates, Buford, 46 Woodin, William, 291 Yeager, F. Scott, 14–15 Woods, Tiger, 337 Young, Phua, 53 World Bank, 560, 577, 730 YouTube, 71 World Savings Bank, 394, 558 Yuen, Henry, 78 World Trade Organization, 630 WorldCom, 4, 6, 8, 35, 43–45, 78, 84, 129, Zales, 446 236, 606 Zarb, Frank, 538 Wright, Jim, 320 Zehil, Louis W., 608 Wright, Kirk, 246 Zela Finance, 456 Wrigley Field, 348 Zell, Sam, 348 Wuffli, Peter, 457 Zimmer Holdings, 333 Wunderkinder, 610 Zions Banccorporation, 432 Wyatt, Wilson, 304 Zito, Barry, 337 Wyeth, 628 Zoellick, Robert, 560, 730 Wyly, Charles, 736 Zuckerman, Mortimer, 610 Wyly, Sam, 736 Zurich American Insurance, 537 Wyoming Mineral Trust Fund, 277 Zurich Financial, 520, 574

Xerox, 65, 674

Absolute return strategies, 272 Bank capital requirements Algorithmic trading, 146, 193 Basel I, 177 Alternative Trading Systems, 147 Basel II, 178 Annuities Basel III fixed-index, 620 CDOs, 712 guaranteed variable counter-cyclical approach, 712, 713–74 Asian flu crisis, 417 leverage limits, 712, 714 Asset-backed commercial paper off balance sheet items, 712 background, 385 phase in, 712 Dodd-Frank, 740 response to subprime crisis, 712 subprime losses, 460 Tier 1 capital, 712 Asset management firms, 271 CAMELS, 177 Auction rate securities consolidated supervised entities, 184 auction failures, 487 cyclical concerns, 713 buybacks, 488 European Union, 711 description, 486 leverage ratio, 177 early problems, 487 mark-to-market, 177 reforms, 664 off balance sheet items, 180 Auto loan problems, 468 pro-cyclical concerns, 180 Automakers purpose, 176 bailouts, 600, 604 rating agencies role, 178 bankruptcy, 603, 606 role in subprime crisis, 711 car czar, 607, 663 TARP injections, 568–569 cash for clunkers, 607, 669 Tier 1 capital, 177 CEO changes, 692 trust preferred securities, dealership closings, 605 prohibited, 739 executive jets, 603 use of 178, 480 hearings, 603 well capitalized, 177 job banks, 604 Banker bashing, 684, 686, 689, 730, 731, 732 losses, 601–602 Bankers’ bonus concerns, 466, 468, 589 parts dealers, 606 Bank examination fees, 730 recovery, 687 Bank failures, 503, 617, 619, 652, 662, 670, sales, 653, 692 671, 679 unions, 604 Bank holiday, 297 Bank lending standards, 504 Bailouts Bank loan loss reserves list of programs, 708–709 conflict with SEC, 714 TARP implemented, 565, 591 during subprime crisis, 466, 467, 500, 502, Treasury proposal, 562 558

815

Bank losses, 503–504, 506, 619 Carry trades Bank nationalization, 325, 323–324 excessive risk taking, 708 Bank payment systems hedge funds, 230 check clearing, 170–171 in Japan, 575 CHIPS, 171 subprime crisis, 707–708 clearinghouses, 170 UBS losses, 458 concerns, 173 yield curve inversion, 427 core principles, 173 Certificated mortgages, 286 Dodd-Frank, 739 Class action lawsuits Fedwire, 172 abuses, 126 fixed-income, 172 coupon settlements, 127 generally, 170 Enron, 35 Herstatt crisis, 171 expert witnesses, 133 large value payments, 173 legislation, 127 minimum standards, 174 pension funds,126 payment-versus-payment, 172 professional plaintiffs, 232 SWIFT, 172 scandals, 131 Bank reserve requirements, 176 Class warfare, 95 Bank resolution authority, 652, 729 Clawback of compensation, 564 Bank runs, 451, 497 Clearing and settlement Bank supervision abroad, 712 book entry securities, 163 Bank stress tests centralized clearing and settlement, 162 abroad, 674, 693 competition, 221 bank taxes continuous net settlement system, 161 Tobin tax, 763 cross-border settlements, 166 U.S. proposal, 736 cross-margining, 222 in the U.S., 629, 652, 658 daily balance order system, 161 Beige book, 502, 598, 634, 663, 680 delivery-versus-payment, 166 Blank check offerings, 465 equity options, 167 Block trades, 141 European Union, 167 Blue ribbon studies, 310 international, 165 Brady Commission, 163, 194, 220 over-the counter, 221 Broadband Services case, 13 SEC action, 160 Broker-dealer capital requirements stock certificate issues, 161 background, 181 stock exchange problems, 159 consolidated supervised entities, 183, systemic risk, 162, 166 715 T+3, 163 description, 181–182 transfer agents, 164 failure during subprime crisis, 714 Treasury study, 164–165 haircuts, 180 Collateral arrangements, 169 holding company structures, 183 Collateralized debt obligations (CDOs) Market Reform Act of 1990, 183 cubed, 402 Brokered deposits, 515 description, 259, 402 Broker votes, 124 due diligence, 408, 509 Budget deficits fair value pricing, 717 abroad, 693 fire sales, 550 states, 406 Goldman Sachs case, 733 U.S., 425, 429, 512, 651, 661, 693, 694 losses, 674 Building and loan societies, 284 ratings downgrades, 435, 446, 447, 471, 473, 585, 621, 647 Capital requirements. See bank capital squared, 402 requirements, broker-dealer capital synthetic, 260, 402, 733 requirements, commodity market capital valuation flaws, 261 requirements, insurance industry capital Collateralized mortgage obligation, 260, 381 requirements Commercial bond market Carried interest, 274 liquidity concerns, 461

Commercial bond market (continued) Commodity markets (continued) mortgages, 661 portfolio insurance, 193 Committee on Compensation Practices, 155 portfolio margining, 223 Commodity market clearinghouses price explosions, 212 background, 218 price gouging, 207 clearing members, 219 price manipulation, 191 core principles, 219 principles based regulation, 197 cross-margining, 222 program trading, 193 good to the last drop, 219 Project A, 214 live another day, 219 regulation, 190–191 margin, 219 regulatory arbitrage, 205 registration, 219 round trip trades, 201 role, 219 runners, 214 Stock Market Crash of 1987, 220 segregation requirements, 224 Commodity markets self regulation, 198 attempted manipulation claims, 201 significant price discovery contract, 211 background, 189 SIMEX link, 213 black box trading, 213 Single stock futures, 225 boards of trade, 191 speculative limits, 210 bucket shops, 189 squeezes, 190 California electricity market, 200 stock exchange competition, 190 capital requirements, 196, 225, 521 Stock Market Crash of 1987, 193, 220 cascade theory, 193 Compensation circuit breakers, 194 abroad, 644 clearing. See commodity market AIG bonuses, 638 clearinghouses athletes, 337 commodity option problems, 195 bank restrictions, 758 contract markets, 191 caps, 637, 642 corners, 190 clawbacks, 120, 640 crude oil prices, 207, 424 consultants, 102 difference trades, 217 corporate jets, 115, 641 dual trading, 214 corporate perks, 112, 641 dynamic hedging, 193 Contract With America, 127 electronic trading, 199, 206, 212, 218 disclosures, 102–103, 642 Enron loophole, 210 Dodd-Frank, 759 ETFs, 209 eat your own cooking, 645 event contracts, 217 entertainers, 336, 758 exempt commercial markets, 198 excessive risk taking, 640, 642, 643 false reports cases, 202 golden parachutes, 642 Federal Trade Commission golf outings, 543, 641 manipulation authority, 208 gross-ups, 643 study, 191 horses, 338 FERC memorandum of understanding, 205 not-for-profits, 338 foreign futures, 198 options, 105 futures commission merchants, 192 pay czar, 638, 638 Globex, 213, 218 populist politicians, 339, 636, 638, 730–731 index traders, 208 risk taking, 731, 759 jurisdictional fights, 194, 206 say-on-pay, 630, 759 locals, 214 scalable pay, 340 manipulation standards, 202 subprime crisis, 636, 676 margin requirements, 193, 219–220 TARP effects, 758 mergers, 2218 Consolidated supervised entities monopoly, 191 background 183, 226 natural gas, 201 failures, 715 onion trading, 207 risk models, 715 open outcry trading, 212 SEC incompetency, 732

Constant proportion debt obligations, Fails to deliver, 159, 751 Fair value accounting Consumer confidence background, 448, 716 debt, 423 BIS, 721 delinquencies, 693 concerns over, 448 during the crisis, 426, 436, 468, 634 congressional action, 719, 720 post-crisis, 693 European Union, 719, 720 Convertible bond arbitrage, 175 FASB Corporate earnings, 464 adoption, 716 Corporate monitors, 333 criticism of, 721 Corporate reform failures, 351 relief, 720 Creative destruction, 711 Great depression, 716 Credit and debit cards GSEs, 447, 464 arbitration of disputes, 662 hedge funds, 229 banks, 712 held for investment, 720 delinquencies, 671 historical cost alternative, 716 interchange fees, 755 history of, 716 legislation, 662, 755 insurance industry, 719–720 losses, 474, 519 mutual funds, 235 network access, 755 pro-cyclical, 716–717 Credit crunch, 310, 441 rating agencies, 719 Credit default swaps relief from, 485, 655 AIG problems, 539 SEC antitrust concerns, 746 action, 719 definition, 406 study, 720 insurance, as, 407 super seniors, 717 Lehman settlements, 531 temporary impairment, 719–720 regulation, 744, 746 Warren Buffett, 718 Credit insurance, 285 write-downs, 448, 494, 519 Credit union bailouts, 599, 628 Fannie Mae and Freddie Mac Capital CUSIP, 161 requirements, 702 Custodial services, 168 Fat finger syndrome, 148 Fed interest rate increases, 421–422 Dark pools, 155 Fee based brokerage accounts, 155–156 Death spiral transactions, 176 Financial analysts scandals, 66, 68 Deferred prosecution agreements, 60, 201, Financial services legislation 333 bank tax, 736 Delaware block approach, 723 costs, 691 Deregulation debate, 728–729 Dodd-Frank DIP financing, 571 asset-backed securities, 740 Distressed debt purchases, 670 broker-dealers Dorian Gray theory, 18, 330 arbitrations, 742 Dot.com bubble, 418 fiduciary duties, 742 Double dip recession, 679, 694 financial analysts conflicts, 742 Bureau of Consumer Financial eCBOT, 149 Protection, 756 Electronic communication networks clearing and settlement, 739 description, 98, 146 derivatives jurisdiction, 743 regulation, 147 CFTC, 743 Energy prices, 516 Fannie Mae and Freddie Mac, 737 English rule for attorney fees, 127 FDIC insurance, 740 Enron bankruptcy, 34 Fed audits, 739 Enron Broadband case, 13, 329 Financial Stability Oversight Council, Enron Corporate Fraud Task Force, 5, 9 737 Exception loans, 509 hedge funds, 747 Extension risk, 381 leverage ratios, 738

Financial services legislation Hedge funds (continued) Dodd-Frank (continued) directional trading, 223 liquidity events, 738 Dodd-Frank, 747 living wills, 739 fair value issues, 229 non-bank financial companies, 738 fees, 228 passage, 736 fund-of-fund problems, 611 predatory lending practices, 756 give-ups, 229 rating agencies, 748 growth, 227 size of reform bill, 737 hedge fund hotels, 229 SEC reforms, 742 history, 227 short sales, 747 late trading, 231 swap regulation, 743 lockups, 228, 578 TARP, 738 losses, 231, 437, 445 too-big-to-fail, 737 management, 228 systemic risk, 740 market timing, 231 Volcker rule, 740 mutual fund scandals, 231 Flash crash, 148, 689 net asset value, 228, 229 Flash orders, 154 placement agents, 610 Flipping, 421, 435 prime brokers, 228 Floor traders, 141 private equity, 261 Foreign stock delistings, 83 private offering memorandum, 241 Forex fraud, 194 profitability, 228 Fourth market, 141 public offerings, 244, 693 Free credit balances, 167 quant funds, 693 Friendly societies, 282 quants, 229 Full disclosure, 100 redemptions, 228 Functional regulation regulation proposed reforms, 728 European Union, 747 regulators in, 728 U.S. 241, 631, 747 relative value trading, 230 Generally Accepted Accounting Principles secrecy, 230 (GAAP), 84 side pocket accounts, 229, 248 Global rescue efforts, 576 subprime crisis, 578, 620, 684 Good bank/bad bank proposals, 594 trading strategies, 229 Government Sponsored Enterprises volatility trading, 230 background, 294, 377 High frequency trading creation, 302 description, 153–154 implied guaranty, 310 hedge funds, 230 privatization, 306, 309 Home bias, 150, 166 savings & loan crisis, 378 Home improvement loans, 301 supervision, 378 Home ownership growth, 304, 308 Great Panic, 524 Honest services fraud, 6, 12, 17, 32, 49–51, Grocery store accounting, 56 59, 115 Hot boxed, 25 Hedge funds House lust, 42` abuses, 245 Household wealth, 423, 468 administrators, 229 Housing boom, 304, 421 alternative assets, 229 Housing market slowdown, 423, 424, 429, antifraud rule, 243 466, 504, 626 carried interest, 274 Housing projects, 305 carry trades, 230 clearing firms, 228, 247 Independent chairman, 124, 759 as corporate activists, 262–263 Industrial banks, 712 credit crunch, 442 Inflation defaults, 494 Bernanke’s view, 444, 445 definition, 227 interest rate concerns, 428, 429

Inflation (continued) Managed economy, 707 Volcker actions, 414 Market fragmentation, 142 Initial public offerings Merchant banking, 250 growth in 2007, 465 Merger activity resumption, 674 banks subprime crisis, 510, 519, 618 Community Reinvestment Act, 697 venture capital, 583 concentration limits, 739 Insider trading in general, 619 Cuban, Mark case, 608 removal of restrictions, 697 failure to stop, 727 general, 674 front-running, 609 global, 434, by SEC staff members, 632 U.S., 434, 694 Institutional traders, 14 Modern portfolio theory, 271 Insurance industry Money market funds antitrust exemption, 186 background, 313 bailout funds, 188 breaking-the-buck, 313, 460 capital requirements, 184, 187, 691, 713 capital injections, 460 demutalization, 187 college funds, 561 Dodd-Frank, 762 crisis, 532 disclosure of compensation, 185 government guarantee, 533, 654, 673 federal charter, 762 growth, 314 regulation, 185–187, 762 insurance concerns, 314 subprime crisis, 187–188, 586 loss record, 314 Interest only strips, 382 state and municipal funds, 459 Interest rates subprime crisis problems, 459 cuts, 449, 451, 493, 505, 566, 589, 615 Monoline insurance delayed effects, 707 credit ratings, 403 increases, 421, 425, 426 description, 403 policy failures, 706 losses, 403 regulatory bargain, 708 Mortgage brokers roller coaster changes, 707 abuses, 393 targeted, 706 fee restrictions, 462 Intermarket Trading System, 1421 regulation, 396, 408 International Financial Reporting Standards yield-spread-premium, 407 (IFRS), 84 Mortgage insurance, 403 International Prisoner Transfer Program, Mortgage modifications, 17 failure of modifications, 633, 675, 686, Interpositioning, 143 693 Inverse floaters, 381 initial efforts,446, 462, 482, 485, 518, 617, 626 Junk bonds Obama programs, 633, 647, 665 default rate, 482, 507 Mortgages recovery rate, 618 adjustable rate mortgages, 312, 393 Alt-A mortgages, 473, 494, 585, 705 Leveraged loans appraisals background, 258 abuses, 721 covenant lite, 260 background, 300, 484 credit crunch, 259, 443, 520 methodology, 721–722 growth, 259 consumer protection, 392 recovery, 669 conventional 304 subprime crisis, 577 covered mortgages, 513 vulture investors, 259 cram-downs, 648, 658 Liquidity crisis, 531 delinquencies, 427, 432, 466, 519, 626, Liquidity puts, 456 634, 658, 693 Loan offices, 282 farm foreclosures, 292 Low income housing, 303 Great Depression issues, 293

Mortgages (continued) Nigerian barge case, 10, 329 guarantees, 289 NINJA loans, 393 history, 281 No-doc loans, 393 home improvement loans, 301 NYSE insurance, 299, 303, 382 demutalization, 153 interest only, 420 Designated Order Turnaround system, 144 liar loans, 514, 705 electronic trading 152 national banks, 291 Euronext, 152 negative amortization, 420 high frequency trading, 153 payment shock, 393, 447 linkages, 150 Philadelphia plan, 287 mergers, 151–152 pick-a-pay, 394, 658 Rule 390, 142–143 piggy-back, 648 technology, 144 qualified residential mortgages, 740 refinancings, 617, 626, 656, 659 Options backdating, 107 residential foreclosures, 292, 297 spring-loaded options, 112 reverse mortgages, 313, 394, 466 Options exchanges rollover mortgages, 312 clearing, 167 secondary market, 382 competition, 157 securitization. See Securitization cross-margining, 223 stated income, 705 exotic trades, 159 step rate mortgages, 312 Justice Department action, 158 subsidies, 304 market shares, 158 suitability requirement, 755 subprime crisis, 159 tax benefits, 304 Order protection rule, 143 teaser rates, 393, 446 Ostrich jury instruction, 58 terms, 287 Over-the-counter derivatives underwater, 491, 492, 679 background 196 Municipal finance, 406, 570, 597 panics, 412 Mutual fund scandals regulation, 196 fair value pricing, 235 swaps. See swaps, forward pricing rule, 233, 234 hard close, 238 Paper work crisis, 159, 168 late trading, 232 Participation loans, 302 market timing, 232 Pass-through securities, 380 net asset value computations, 233, 240 Payday lending, 467 new rules, 238 Payment for order flow, 148 outside directors, 239 Permanent loan associations, 284 sticky assets, 236 Perp walks, 5, 330 Moral hazard, 291, 499, 710 Pharmaceutical accounting, 57 Mutual recognition, 155 Pink sheets, 145 PIPE transactions, 176, 257, 608 Naked access traders, 154 Placement agents, 266 NASDAQ Poison pill, 123 linkages, 150 Ponzi schemes SOES, 146 escapes by operators, 614 tiers, 146 homeowner insurance coverage, 613 TRACE, 149 losses, 609, 631 National Market System, 142 Madoff, Bernard, 609 National mortgage associations, 302 SIPC coverage, 610 National securities exchange, 141 Stanford, 631 NatWest Three, 15, 330 tax deductions, 610 Newspapers Portable alpha corporate governance, 345 background, 272, declining circulation, 346 losses, 597 influence peddling, 349 Poverty levels, 695

Predatory lending Rating agencies (continued) background, 393, 395 government use, 647, 748–749 cases, 397 lawsuits, 754 credit insurance, 395 Reform Act of 2006, 749 Dodd-Frank, 756 regulation abroad, 657, 751 flipping, 393 triggers, 748 negative amortization, 395 RAND study, 156 preemption, 398 Real estate bonds suitability requirement, 755 background, 288 Price quotations, 140 protective committees, 290 Private equity Real estate bubble, 421–422 annex funds, 578 Redlining, 697 background, 249 Regulatory turf wars, 730, 742 bank acquisitions, 265 Reinvestment risk, 380 carried interest, 274 Repos corporate governance roles, 262 background, 169, 174 credit crunch, 440 problems at Bear Stearns, 496 description, 254 subprime crisis, 589 dividend recaps, 274 Retail sales declines, 468 freedom of information acts, 264 Reverse conversions, 176 golden era, 276 Reverse convertibles, 495, 663 growth, 257 Risk modeling hedge fund ownership, 261 bank capital, 724 initial public offerings, 267, 269 Black-Scholes options model, 724 junk bond financing, 254 black swan flaw, 725 labor union attacks, 264 fat tails, 725 leveraged buyouts, 254 Gaussian Copula, 724 leveraged loans, 258 Monte Carlo simulations, 725 long term investors, 268 rating agencies, use of, 724 pension funds, 275 Value-at-risk (VaR) performance, 275 bank capital, 178 public listings, 266 commodity margin, 226 registration as investment companies, 270 flaws, 179–180, 715 subprime crisis, 577 Long Term Capital Management, 179 Prosecutorial abuses outliers, 725 coercive tactics, 330 quants, 725 Enron cases, 7–33 testing, 724 federal prosecutors, 328 Rogue traders, 475, 664 lack of success, 679 Rumor mongering, 510 New York attorney general Russian debt crisis, 231 Cuomo, 703 effectiveness of, 704 Savings and loan associations Spitzer, 327 demutalizations, 309, 323 other cases, 47–71 deposit growth, 308 Prudent man rule, 271 Great Depression problems, 296 Proxy votes, 117 holding companies, 308 Public Pension Fund Code of Conduct, 266 interest rate competition, 309 interest rate regulation, 307 Rating agencies mergers, 316 alternatives, 753 passbook savings, 315 bank capital role, 178 3–6–3 rule, 307 CDO downgrades, 750, Savings and Loan crisis conflict of interest, 749 background, 307 deficiencies, 178, 748 depositor runs, 319 Dodd-Frank, 748, 753 deregulation, 317, 321 gatekeepers, 753 flipping, 318

Savings and Loan crisis (continued) Special Study of the Securities Markets, 159 fraud, 317 Squawk box case, 608 insolvencies, 315, 318 Stable value funds, 655 interest rate increases, 312, 315 Staggered board terms, 125 junk bond investments, 316 State and municipal finance lawsuits, 321 Build America bonds, 630 liquidations, 321, 322 IOUs, 651 Keating five, 320 revenue declines, 680 net worth certificates, 316 subprime crisis, 630 Savings banks, 283 tax increases, 651 Savings rates, 422 underfunded pension plans, 651 Say-on-pay, 630 Stimulus programs Scheme liability, 734, 741 abroad, 656 Secular bear market, 567 Bush administration, 480, 486, 504, 710 Securities Information Center, 161 Obama administration Securitization additional requests, 680 fraud, 615 amount, 710 mortgages, 308 buy America, 630 private, 384 checks for crooks, 670 scoring, 385 contents, 630 Segregation of funds effects, 632, 670 box count, 168 European criticism, 649, 691 broker-dealers, 168 first-time homebuyer credits, 630 Customer Protection Rule, 168 passage, 629 good control location, 168 proposal, 626 Reserve Formula computation, 168 shortcomings, 679, 684 Sentencing abuses, 6 squandered funds, 695 Shareholder bill of rights, 125 shovel ready projects, 661 Short sales, mortgages, 435, 686 Stock buy-backs, 424, 426, 430, 482, 622 Short sales, stocks Stock lending, 175 abroad, 690 Stock Market Crash of 1987, 162, 193, 220, avoiding restrictions, 531 415 Dodd-Frank, 747 Stock market effectiveness of restrictions, 566 performance generally, 175 after subprime crisis, 690–691 naked, 175, 511 during subprime crisis, 618, 625, 627, PIPEs, 176 633, 652, 681 rumor mongering, 510 record in 2007, 450 temporary suspensions, 512, 531 volatility, 566, 567 tick test, 511, 594 Stock options, 104 tick test revival, 631 bullet dodging options, 112 Single family mortgage revenue bonds, 311 Stop construction order, 304 SOES bandits, 146 Street name, 162 Sovereign wealth funds Structured investment vehicles, 385, 456, description, 276 705 investments during subprime crisis, 453, Student loans 457–458 background, 386 locations, 277 nationalization, 687 losses, 278 scandals, 388 national security concerns, 278 Subprime crisis subprime crisis, 670 abroad, 572, 627, 648, 653, 657, 685, 690 transparency, 279 affirmative action loans Specialists Community Reinvestment Act, 697 description, 140–141 bailout programs, 708–710 scandals, 143 bailout costs, 666–667 trading ahead, 143 bottom reached, 646

Subprime crisis (continued) Subprime crisis causes (continued) carry trades, 707 Fannie Mae and Freddie Mac commercial credit markets, 648 down payments reduced, 702 consumer savings rates, 628, 653 down payments subsidized, 704 corporate profits, 620, 654, 684 failure of capital requirements, 702 counseling services, 698 increased subprime lending, 705 delinquency rates of mortgages, 626, loosened credit standards, 702 653 quotas, 701–702 dividend cuts, 635 financial regulator—SEC election issues conflicting roles, 727 during crisis, 563 financial illiteracy, 726 post-crisis, 694 Goldman Sachs case, 732 foreclosures, 653, 665 incompetency, 725, 731, 736, 745 GDP contraction, 622 revolving door, 726 government reaction staff misconduct, 734 government leadership, 710 undermining by New York attorney liquidity programs, 708–710 generals, 726 stimulus packages, 710 functional regulation, 728 green shoots, 660 inquiry into, 696 government behavior, 710 lending practices, 697 housing prices, 628, 653 loan quotas, 563, 616 investigations, 508 real estate appraisals, 721 jobless benefits, 656, 664 Subprime lending layoffs, 625, 628 bank lenders, 701 legacy assets, 651 Community Reinvestment Act liquidity measures, 708–710 ACORN, 699 manufacturing, 622 community groups use of, 698 mortgage delinquencies, 621, 647 costs, 701 mortgage modifications, 626 extortion, 698 mutual funds, effect on, 694 default rates, 705 pension fund losses, 622, 651 definition, 391 productivity, 622 first crisis, 410 prosecutions, 648, 679 growth during recovery Bush administration, 704 begins, 655, 691 Clinton administration, 699, 701 uncertainty over, 694, 695 illegal aliens, 699 regulatory reforms increases in, 705 debate over, 655, 696, 729 interest rates, 392 Dodd-Frank, 696 investigations, 483 European reforms, 655 non-bank lenders, 408 responsibility for, 616, 634, 655 percentages, 700 state and municipal finance, 630 pledges, 698 suicides, 613 quotas TARP Bush administration, 704 government profits, 660, 672 Cisneros, Henry, 701 repayment issues, 659 Cuomo, Andrew,704 use of funds, 658 soft, 698 too big to fail issues, 710–711 securitization, 701 world trade, 622, 648, 672 subprime crisis, 621 Subprime crisis causes warehouse operations, 409–411, 449, 458, capital requirements, 711, 713 548, 698 creative destruction, 711 Super seniors Community Reinvestment Act, 698, capital treatment, 458 700 description, 458 compensation practices, 697 fair value accounting, 717 down payment policies, 700–702 losses, 541, 549, 751

Super seniors (continued) Twin peak regulation, 728 valuations, 717 Tyco party, 52 Suspicious Activity Reports, 75 Swaps Unbanked consumers, 467 background, 196 Unemployment rates clearing, 744 after the crisis, 679, 689, 691 confirmations, 744 before the crisis, 434, 465 data repositories, 746 during the crisis, 474, 507, 588, dealers, 196 622, 634, 653, 655, 657, 663, exemption from regulation, 197 669, 675 independent research, 209 on Wall Street, 466 insider trading, 745 Union pension funds municipal losses, 491 abuses, 275, regulation, 743 board representation, 344 reports, 209 declining membership, 341 total return, 263 losses, 622 Systemic risk SEC assistance, 344 debate over, 655, 740 spiking, 343 Dodd-Frank, 740 subprime crisis, 588 payment systems, 173 underfunding, 342 securities settlements, 166 University endowment losses, 598, 672 Stock Market Crash of 1987, 162 Upstairs trading, 151

Target letters, 5, 9, 46 Variable forward contracts, 112, 640 TARP cop, 647, 657, 677 Venture capitalists Taxes after the crisis, 681 cuts, 694 angels, 250 increases on foreign earnings, 676 background, 250 planning, 695 blind pools, 252 refund anticipation loans, 446 hot issues, 253 shelters, 59–65 incubator loans, 250 Telecom scandals, 37 job creation, 252 Term auction facility, 461 regulation of, 584, 747 Third market, 141 subprime crisis, 583 Thompson memorandum, 6 Viatical insurance, 643 Tiered listings, 155 Volcker rule, 731, 740 Too big to fail, 324, 418 T+3, 163 Wall Street rule, 117, 123 Trade deficit Wealth disparity, 336, 422 U.K., 628 Wealth effect, 423 U.S., 23, 693 Warehouse lending, 410 Trade through rule, 143 Wild card certificates of deposit, 315 Transfer agents, 164 Wrap accounts, 241 Trust banks, 712 Trust preferred securities, 178, 739 Yield curve inversion, 427

Jerry W. Markham is a professor of law at Florida International University at Miami, where he teaches corporate and international business law. He was previously a partner in the international law firm of Rogers & Wells (now Clifford Chance), chief counsel for the Division of Enforcement of the U.S. Commodity Futures Trading Commission, secretary and counsel for the Chi- cago Board Options Exchange, and attorney in the Office of General Counsel at the U.S. Securities and Exchange Commission. Markham taught as an adjunct professor of law at the Georgetown Law School in Washington, DC, and was a professor of law at the University of North Carolina at Chapel Hill before moving to Florida. He holds law degrees from Georgetown and the University of Kentucky. Markham is the author of the three-volume series A Financial History of the United States, published by M.E. Sharpe and selected as a Choice Outstanding Academic Title for 2002. He also wrote a follow-on volume to that history covering the Enron-era scandals. Markham is the author and coauthor of several other books and articles on finance-related matters.

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