MARCH 2008: THE FALL OF BEAR STEARNS

That summer, the SEC felt Bear's liquidity was adequate for the immediate future, but supervisors "were suitably skeptical;' Eichner insisted. After the August 5 meet­ ing, the SEC required that Bear Stearns report daily on Bear's liquidity. However, Eichner admitted that he and his agency had grossly underestimated the possibility of a liquidity crisis down the road.20 Every weeknight Upton updated the SEC on Bear's $400 billion balance sheet, with specifics on repo and commercial paper. On September 27, Bear Stearns raised approximately $2.5 billion in unsecured lo-year bonds. The reports slowed to once a week. 21 The SEC's inspector general later criticized the regulators, writing that they did not push Bear to reduce leverage or "make any efforts to limit Bear Stearns' mort­ gage securities concentration;' despite "aware[ness] that risk management of mort­ gages at Bear Stearns had numerous shortcomings, including lack of expertise by risk managers in mortgage backed securities" and "persistent understaffing; a proximity of risk managers to traders suggesting a lack of independence; turnover of key per­ sonnel during times of crisis; and the inability or unwillingness to update models to reflect changing circumstances:'22 Michael Halloran, a senior adviser to SEC Chairman Christopher Cox, told the FCIC the SEC had ample information and authority to require Bear Stearns to de­ crease leverage and sell mortgage-backed securities, as other financial institutions were doing. Halloran said that as early as the first quarter of 2007, he had asked Erik Sirri, in charge of the SEC's Consolidated Supervised Entities program, about Bear Stearns (and Lehman Brothers), "Why can't we make them reduce risk?" According to Halloran, Sirri said the SEC's job was not to tell the banks how to run their compa­ nies but to protect their customers' assets. 23

"TURN INTO A DEATH SPIRAl:' In August, after the rating agencies revised their outlook on Bear, Cayne tried to ob­ tain lines of credit from Citigroup and JP Morgan. Both banks acknowledged Bear had always been a very good customer and maintained they were interested in help­ ing. 24 "We wanted to try to be belts-and-suspenders;' said CFO Samuel Molinaro, as Bear attempted both to obtain lines of credit with banks and to reinforce traditional sources of short-term liquidity such as money market funds. But, Cayne told the FCIC, nothing happened. "Why the [large] banks were not more willing to partici­ pate and provide lines during that period of time, I can't tell you;' Molinaro said. 25 A major money market fund manager, Federated Investors, had decided on Octo­ ber I to drop Bear Stearns from its list of approved counterparties for unsecured commercial paper,26 illustrating why unsecured commercial paper was traditionally seen as a riskier lifeline than repo. Throughout 2007, Bear Stearns reduced its unse­ cured commercial paper (from $20.7 billion at the end of 2006 to only $3.9 billion at the end of 2007) and replaced it with secured repo borrowing (which rose from $69 billion to $102 billion). But Bear Stearns's growing dependence on overnight repo would create a different set of problems. The tri-party repo market used two clearing banks, JP Morgan and BNY Mellon. FINANCIAL CRISIS INQUIRY COMMISSION REPORT

During every business day, these clearing banks return cash to lenders; take posses­ sion of borrowers' collateral, essentially keeping it in escrow; and then lend their own cash to borrowers during the day. This is referred to as "unwinding" the repo transac­ tion; it allows borrowers to change the assets posted as collateral every day. The transaction is then "rewound" at the end of the day, when the lenders post cash to the clearing banks in return for the new collateral. The little-regulated tri-party repo market had grown from $800 billion in average daily volume in 2002 to $1.7 trillion in 2005, $2.4 trillion in 2007, and $2.8 trillion by early 2008. 27 It had become a very deep and liquid market. Even though most bor­ rowers rolled repo overnight, it was also considered a very safe market, because transactions were overcollateralized (loans were made for less than the collateral was worth). That was the general view before the onset of the financial crisis. As Bear increased its tri-party repo borrowing, it became more dependent on JP Morgan, the clearing bank. A risk that was little appreciated before 2007 was that JP Morgan and BNY Mellon could face large losses if a counterparty such as Bear de­ faulted during the day. Essentially, JP Morgan served as Bear's daytime repo lender. Even long-term repo loans have to be unwound every day by the clearing bank, if not by the lender. Seth Carpenter, an officer at the Federal Reserve Board, compared it to a mortgage that has to be refinanced every week: "Imagine that your mortgage is only a week. Instead of a 30-year mortgage, you've got a one-week mortgage. If every­ thing's going fine, you get to the end of the week, you go out and you refinance that mortgage because you don't have enough cash on hand to payoff the whole mort­ gage. And then you get to the end of another week and you refinance that mortgage. And that's, for all intents and purposes, what repos are like for many institutions:'28 During the fall, Federated Investors, which had taken Bear Stearns off its list of approved commercial paper counterparties, continued to provide secured repo 10ans.29 Fidelity Investments, another major lender, limited its overall exposure to Bear, and shortened the maturities.30 In October, State Street Global Advisors refused any repo lending to Bear other than overnightY Often, backing Bear's borrowing were mortgage-related securities and of these, $17.2 billion-more than Bear's equity-were Level 3 assets. In the fourth quarter of 2007, Bear Stearns reported its first quarterly loss, $379 million. Still, the SEC saw "no evidence of any deterioration in the firm's liquidity po­ sition following the release and related negative press coverage:' The SEC concluded, "Bear Stearns' liquidity pool remains stable:'32 In the fall of 2007, Bear's board had commissioned the consultant Oliver Wyman to review the firm's risk management. The report, "Risk Governance Diagnostic: Rec­ ommendations and Case for Economic Capital Development;' was presented on Feb­ ruary 5, 2008, to the management committee. Among its conclusions: risk assessment was "infrequent and ad hoc" and "hampered by insufficient and poorly aligned resources;' "risk managers [were 1not effectively positioned to challenge front office decisions;' and risk management was "understaffed" and considered a "low pri­ ority:' Schwartz told the FCIC the findings did not indicate substantial deficiencies. He wasn't looking for positive feedback from the consultants, because the Wyman re- MARCH 2008: THE FALL OF BEAR STEARNS port was meant to provide a road map of what "the gold standard" in risk manage­ ment would be. 33 In January 2008, before the report was completed, Cayne resigned as CEO, after receiving $93.6 million in compensation from 2004 through 2007.34 He remained as non-executive chairman of the board. Some senior executives sharply criticized him and the board. Thomas Marano told the FCIC that Cayne played a lot of golf and bridge.35 Speaking of the board, Paul Friedman, a former senior managing director at Bear Stearns, said, "I guess because I'd never worked at a firm with a real board, it never dawned on me that at some point somebody would have or should have gotten the board involved in all of this;' although he told the FCIC that he made these com­ ments in anger and frustration in the wake of Bear's failure. 36 In its final report on Bear, the Corporate Library, which researches and rates firms for corporate gover­ nance, gave the company a "D;' reflecting "a high degree of governance risk" resulting from "high levels of concern related to the board and compensation:'37 When asked if he had made mistakes while at Bear Stearns, Cayne told the FCIC, "I take responsi­ bility for what happened. I'm not going to walk away from the responsibility:'38 At Bear, compensation was based largely on the return on equity in a given year. For senior executives, about half of each bonus was paid in cash, and about half in re­ stricted stock that vested over three years and had to be held for five. 39 The formula for the size of each year's compensation pool was determined by a subcommittee of the board. Stockholders approved the performance compensation plan and capital accu­ mulation plan for senior managing directors. Cayne told the FCIC he set his own compensation and the compensation for all five members of the Executive Commit­ tee. According to Cayne, no one, including the board, questioned his decisions.40 For 2007, even with its losses, Bear Stearns paid out 58% of revenues in compensa­ tion. Alix, who sat on the Compensation Committee, told FCIC staff the firm typically paid 50% but that the percentage increased in 2007 because revenues fell-if manage­ ment had lowered compensation proportionately, he said, many employees might have quit.4' Base salaries for senior managers were capped at $250,000, with the re­ mainder of compensation a discretionary mix of cash, restricted stock, and optionsY From 2000 through 2008, the top five executives at Bear Stearns took home over $326.5 million in cash and over $1.1 billion from stock sales, for more than a total of $1.4 billion. This exceeded the annual budget for the SEC. 43 Alan Schwartz, who took over as CEO after Cayne and had been a leading proponent of investing in the mort­ gage sector, earned more than $87 million from 2004 to 2007. Warren Spector, the co-president responsible for overseeing the two hedge funds that had failed, received more than $98 million during the same period. Although Spector was asked to re­ sign, Bear never asked him to return any money. In 2006, Cayne, Schwartz, and Spec­ tor each earned more than 10 times as much as Alix, the chief risk officer.44 Cayne was out, Schwartz was in, and Bear Stearns continued hanging on in early 2008. Bear was still able to fund its balance sheet through repo loans, though the interest rates the firm had to pay had increased.45 Marano said he worried this in­ creased cost would Signal to the market that Bear was distressed, which could "make our problems turn into a death spiral:46 286 FINANCIAL CRISIS INQUIRY COMMISSION REPORT

"DUTY TO PROTECT THEIR INVESTORS"

On Wednesday, January 30, 2008, Treasurer Upton reported an internal accounting error that showed Bear Stearns to have less than $5 billion in liquidity-triggering a report to the SEC. While the company identified the error, the SEC reinstituted daily reporting by the company of its liquidity.47 Lenders and customers were more and more reluctant to do business with the company. On February 15, Bear Stearns had $36.7 billion in mortgages, mortgage­ backed securities, and asset-backed securities on its balance sheet, down almost $10 billion from November. Nearly $26 billion were subprime or Alt-A mortgage-backed securities and CDOs. The hedge funds that were clients of Bear's prime brokerage services were particu­ larly concerned that Bear would be unable to return their cash and securities. Lou Lebedin, the head of Bear's prime brokerage, told the FCIC that hedge fund clients occasionally inquired about the bank's financial condition in the latter half of 2007, but that such inquiries picked up at the beginning of 2008, particularly as the cost in­ creased of purchasing credit default swap protection on Bear. The inquiries became withdrawals-hedge funds started taking their business elsewhere. "They felt there were too many concerns about us and felt that this was a short-term move:' Lebedin said. "Often they would tell us they'd be happy to bring the business back, but that they had the duty to protect their investors:' Renaissance Technologies, one of Bear's biggest prime brokerage clients, pulled out all of its business. By April, Lebedin's prime brokerage operation would be holding $90 billion in assets under manage­ ment, down more than 40% from $160 billion in January.48 Nonetheless, during the week of March 3, when SEC staff inspected Bear's liquid­ ity pool, they identified "no significant issues:' The SEC found Bear's liquidity pool ranged from $18 billion to $20 billion.49 Bear opened for business on Monday, March 10, with approximately $18 billion in cash reserves. The same day, Moody's downgraded 15 mortgage-backed securities issued by Bear Stearns Alt-A Trust, a special purpose entity. News reports on the downgrades carried abbreviated headlines stating, "Moody's Downgrades Bear Stearns;' Upton said. 50 Rumors flew and counterparties panicked.51 Bear's liquidity pool began to dry up, and the SEC was now concerned that Bear was being squeezed from all directions.52 While "everything rolled" during the day-that is, Bear's repo lenders renewed their commitments-SEC officials worried that this would "proba­ bly not continue:'53 On Tuesday, the Fed announced it would lend to investment banks and other "primary dealers:' The Term Securities Lending Facility (TSLF) would make avail­ able up to $200 billion in Treasury securities, accepting as collateral GSE mortgage­ backed securities and non-GSE mortgage-backed securities rated triple-A. The hope was that lenders would lend to investment banks if the collateral was Treasuries rather than other highly rated but now suspect assets such as mortgage-backed secu­ rities. The Fed also announced it would extend loans from overnight to 28 days, giv- MARCH 2008: THE FALL OF BEAR STEARNS ing investment banks an added breather from the relentless need to unwind repos every morning. With the TSLF, the Fed would be setting a new precedent by extending emergency credit to institutions other than commercial banks. To do so, the Federal Reserve Board was required under section 13 (3) of the Federal Reserve Act to determine that there were "unusual and exigent circumstances:' The Fed had not invoked its section 13(3) authority since the Great Depression; it was the Fed's first use of the authority since Congress had expanded the language of the act in 1991 to allow the Fed to lend to investment banks.54 The Fed was taking the unusual step of declaring its willing­ ness to soon open its checkbook to institutions it did not regulate and whose finan­ cial condition it had never examined. But the Fed would not launch the TSLF until March 27, more than two weeks later-and it was not clear that Bear could last that long. The following day, Jim Em­ bersit of the Federal Reserve Board checked on Bear's liquidity with the SEC. The SEC said Bear had $12.5 billion in cash-down from about $18 billion at the start of the week-and was able to finance all its bank loans and most of its equity securities through the repo market. He summarized, "The SEC indicates that no notable losses have been sustained and that the capital position of the firm is 'fine:"55 Derivatives counterparties were increasingly reluctant to be exposed to Bear. In some cases they unwound trades in which they faced Bear, and in others they made margin or collateral calls. 56 In Bear's last few years as an independent company, it had substantially increased its exposure to derivatives. At the end of fiscal year 2007, Bear had $13.4 trillion in notional exposure on derivatives contracts, compared with $8.7 trillion at 2006 fiscal year-end and $5.5 trillion at the end of 2005. Derivatives counterparties who worried about Bear's ability to make good on their payments could get out of their derivative positions with Bear through assign­ ments or novations. Assignments allow counterparties to assign their positions to someone else: if firm X has a derivatives contract with firm 1'; then firm X can assign its position to firm Z, so that Z now is the one that has a derivatives contract with Y. Novations also allow counterparties to get out of their exposure to each other, but by bringing in a third party: instead of X facing Y, X faces Z and Z faces Y. Both assign­ ments and novations are routine transactions on Wall Street. But on Tuesday, Brian Peters of the New York Fed advised Eichner at the SEC that the New York Fed was "seeing some HFs [hedge funds] wishing to assign 'trades the clients had done with Bear to other CPs [counterparties] so that Bear 'steps OUt:"57 Counterparties did not want to have Bear Stearns as a derivatives counterparty any more. Bear Stearns also encountered difficulties stepping into trades. Hayman Capital Partners, a hedge fund in Texas wanting to decrease its exposure to subprime mort­ gages, had decided to close out a relatively small $5 million subprime derivative posi­ tion with Goldman Sachs. Bear Stearns offered the best bid, so Hayman expected to assign its position to Bear, which would then become Goldman's counterparty in the derivative. Hayman notified Goldman by a routine email on Tuesday, March 11, at 4:06 RM. The reply 41 minutes later was unexpected: "GS does not consent to this trade:'s8 288 FINANCIAL CRISIS INQUIRY COMMISSION REPORT

That startled Kyle Bass, Hayman's managing partner. He told the FCIC he could not recall any counterparty rejecting a routine novation.59 Pressed for an explanation, Goldman the next morning offered no details: "Our trading desk would prefer to stay facing Hayman. We do not want to face Bear:'60 Adding to the mystery, 16 minutes later Goldman agreed to accept Bear Sterns as the counterparty after all. 61 But the damage was done. The news hit the street that Goldman had refused a routine transaction with one of the other big five investment banks. The message: don't rely on Bear Stearns. CEO Alan Schwartz hoped an appearance on CNBC would reassure markets. Questioned about this incident, Schwartz said he had no knowledge of such a refusal and rhetorically asked, "Why do rumors start?"62 SEC Chairman Cox told reporters his agency was monitoring capital levels at Bear Stearns and other securities firms "on a constant basis" and has "a good deal of comfort about the capital cushions at these firms at the momenf'63 Still, the run on Bear accelerated. Many investors believed the Fed's announce­ ment about its new loan program was directed at Bear Stearns, and they worried about the facility's not being available for several weeks. On Wednesday, March 12, the SEC noted that Bear paid another $1.1 billion for margin calls from 142 nervous derivatives counterparties.64 Repo lenders who had already tightened the terms for their contracts over the preceding four or five months shortened the leash again, demanding more collateral from Bear Stearns.65 Worries about a default quickly mounted.66 By that evening, Bear's ability to borrow in the repo market was drying up. The SEC noted that some large and important money funds, including Fidelity and Mel­ lon, had told Bear after the close of business Wednesday they "might be hesitant to roll some funding tomorrow:' The SEC said that though they believed the amounts were "very manageable (between $1 and $2 billion):' the withdrawals would not send a helpful Signal to the market.67 But the issue was almost moot. Schwartz called New York Fed President Timothy Geithner that night to discuss possible Fed flexibility in the event that some repo lenders did pull away.68 Upton, the treasurer, said that before that week, he had never worried about the disappearance of repo lending. By Thursday, he believed the end was near.69 Bear ex­ ecutives informed the board that the rumors were dissuading counterparties from doing business with Bear, that Bear was receiving and meeting significant margin calls, that $14 billion in repo was not going to roll over, and that "there was a reason­ able chance that there would not be enough cash to meet [Bear's 1needs:'7 0 Some repo lenders were already so averse to Bear that they stopped lending to the company at all, not even against Treasury collateral, Upton told the FCIC.?1 Derivatives counter­ parties continued to run from Bear. By that night, liquidity had dwindled to a mere $2 billion (see figure 15.1). Bear had run out of cash in one week. Executives and regulators continued to be­ lieve the firm was solvent, however. Former SEC Chairman Cox testified before the FCIC, '~t all times during the week of March 10 to 17, up to and including the time of its agreement to be acquired by JP Morgan, Bear Stearns had a capital cushion well above what is required:'72 MARCH 2008: THE FALL OF BEAR STEARNS

Bear Stearns Liquidity In the four days before Bear Stearns collapsed, the company's liquidity dropped by $16 billion. IN BILLIONS OF DOLLARS, DAILY

$25----~------

15 ----~-...... -----.-.. --

10

5

22 23 24 25 26 27 28 29 2 345 6 7 8910 12 13 FEBRUARY 2008 MARCH 2008 SOURCE: Securities and Exchange Commission

Figure 15.1

"THE GOVERNMENT WOULD NOT PERMIT A HIGHER NUMBER" On Thursday evening, March 13, Bear Stearns informed the SEC that it would be "unable to operate normally on FridaY:'73 CEO Alan Schwartz called JP Morgan CEO Jamie Dimon to request a $30 billion credit line. Dimon turned him down/4 citing, according to Schwartz, JP Morgan's own significant exposure to the mortgage mar­ ket. Because Bear also had a large, illiquid portfolio of mortgage assets, JP Morgan would not render assistance without government support. Schwartz spoke with Gei­ thner again. Schwartz insisted Bear's problem was liquidity, not insufficient capital. A series of calls between Schwartz, Dimon, Geithner, and Treasury Secretary Henry Paulson followed,75 To address Bear's liquidity needs, the New York Fed made a $12.9 billion loan to Bear Stearns through JP Morgan on the morning of Friday, March 14. Standard & Poor's lowered Bear's rating three levels to BBB. Moody's and Fitch also downgraded the company. By the end of the day, Bear was out of cash. Its stock plummeted 47%, closing below $30. The markets evidently viewed the loan as a sign of terminal weakness. After markets closed on Friday, Paulson and Geithner informed Bear CEO Schwartz that the Fed loan to JP Morgan would not be available after the weekend. Without that loan, Bear could not conduct business. In fact, Bear Stearns had to find a buyer be­ fore the Asian markets opened Sunday night or the game would be over,76 Schwartz, 290 FINANCIAL CRISIS INQUIRY COMMISSION REPORT

Molinaro, Alix, and others spent the weekend in due diligence meetings with JP Morgan and other potential buyers, including the private equity firm J.C. Flowers and Co. According to Schwartz, the participants determined JP Morgan was the only candidate with the size and stature to make a credible offer within 48 hours.n As Bear Stearns's clearing bank for repo trades, JP Morgan held much of Bear Stearns's assets as collateral and had been assessing their value daily,78 This knowl­ edge let JP Morgan move more quickly. On Sunday, March 16, JP Morgan informed the New York Fed and the Treasury that it was interested in a deal if it included financial support from the Fed,79 The Federal Reserve Board, again finding "unusual and exigent circumstances" as re­ quired under section 13(3) of the Federal Reserve Act, agreed to purchase $29.97 bil­ lion of Bear's assets to get them off the firm's books through a new entity called Maiden Lane LLC (named for a street alongside the New York Fed). Those assets­ mostly mortgage-related securities, other assets, and hedges from Bear's mortgage trading desk-would be under New York Fed management. To finance the purchases, JP Morgan made a $1.15 billion subordinated loan and the New York Fed lent $28.82 billion. Because of its loan, JP Morgan bore the risk of the first $1.15 billion of losses; the Fed would bear any further losses up to $28.82 billion.80 The Fed's loan would be repaid as Maiden Lane sold the collateral. On Sunday night, with Maiden Lane in place, JP Morgan publicly announced a deal to buy Bear Stearns for $2 a share. Minutes of Bear's board meeting indicate that JP Morgan had considered $4 but cut it to $2 "because the government would not permit a higher number.... The Fed and the Treasury Department would not sup­ port a transaction where [Bear Stearns] equity holders received any significant con­ sideration because of the 'moral hazard' of the federal government using taxpayer money to 'bail out' the investment bank's stockholders:'81 Eight days later, on March 24, Bear Stearns and JP Morgan agreed to increase the price to $10. John Chrin, co-head of the financial institutions mergers and acquisi­ tions group at JP Morgan, told the FCIC they increased the price to make Bear share­ holders' approval more likely.82 Bear CEO Schwartz told the FCIC the increase let Bear preserve the company's value "to the greatest extent possible under the circum­ stances for our shareholders, our 14,000 eII].ployees, and our creditors:'83

"IT WAS HEADING TO A BLACK HOLE" The SEC regulators Macchiaroli and Eichner were as stunned as everyone else by the speed of Bear's collapse. Macchiaroli had had doubts as far back as August, he told the FCIC, but he and his colleagues expected Bear would be able to fund itself through the repo market, albeit at higher margins.84 Fed Chairman Ben Bernanke later called the Bear Stearns decision the toughest of the financial crisis. The $2.8 trillion tri-party repo market had "really [begun] to break down;' Bernanke said. ''As the fear increased;' short-term lenders began de­ manding more collateral, "which was making it more and more difficult for the fi­ nancial firms to finance themselves and creating more and more liquidity pressure on MARCH 2008: THE FALL OF BEAR STEARNS 291 them. And, it was heading sort of to a black hole:' He saw the collapse of Bear Stearns as threatening to freeze the tri-party repo market, leaving the short-term lenders with collateral they would try to "dump on the market. You would have a big crunch in asset prices:'8 5 "Bear Stearns, which is not that big a firm, our view on why it was important to save it-you may disagree-but our view was that because it was so essentially in­ volved in this critical repo financing market, that its failure would have brought down that market, which would have had implications for other firms:' Bernanke told the FCIC.86 Geithner explained the need for government support for Bear's acquisition by JP Morgan as follows: "The sudden discovery by Bear's derivative counterparties that important financial positions they had put in place to protect themselves from finan­ cial risk were no longer operative would have triggered substantial further disloca­ tion in markets. This would have precipitated a rush by Bear's counterparties to liquidate the collateral they held against those positions and to attempt to replicate those positions in already very fragile markets:'87 Paulson told the FCIC that Bear had both a liquidity problem and a capital prob­ lem. "Could you just imagine the mess we would have had? If Bear had gone there were hundreds, maybe thousands of counterparties that all would have grabbed their collateral, would have started trying to sell their collateral, drove down prices, create even bigger losses. There was huge fear about the investment banking model at that time:' Paulson believed that if Bear had filed for bankruptcy, "you would have had Lehman going ... almost immediately if Bear had gone, and just the whole process would have just started earlier:'88

(;OMMISSI0N <;ONClvslONS ON eHAPTBR IS

The Commission c(;jncl.ud@th~ failure of B(lU Stearns aqd its multlttg~vern­ lr!.ent-as~isted resc;ue were ca.uslldbylts exposure fo risky mortgage assets, its re­ liance on $hort-term ftulding, and ftllhigh leverage. These were a result ofweak. corporate governanceaqd ri$kmanasement. Its execufive and employee comp.en­ ~ation system was based IllrgeIy on return on eqUity, creating fncentfYes to use ex­ cessi'Ve leverage and to focus on snort.-term gains such as annual growth goals. Bear experienced rllI1S by repo lenders, hedge fund customers, and derivatives c!Junterparties and was rescued bra gpvemment -assisted purchase. by JP Morgan because the government considered it too interconnected to fail. Bear's failure was in part a result of inadequate supervision by the Securities and Exchange Commission, which did not restrict its risky actMties and which allowed undue leverage and insufficient liquidity. 16 MARCH TO AUGUST 2008: SYSTEMIC RISK CONCERNS

CONTENTS

The Federal Reserve: "When people got scared"...... 293 JP Morgan: "Refusing to unwind ... would be unforgivable" ...... 295 The Fed and the SEC: "Weak liquidity position" ...... 296 Derivatives: "Early stages of assessing the potential systemic risk" ...... 298 Banks: "The markets were really, really dicey" ...... 301

JP Morgan's federally assisted acquisition of Bear Stearns averted catastrophe-for the time being. The Federal Reserve had found new ways to lend cash to the financial system, and some investors and lenders believed the Bear episode had set a precedent for extraordinary government intervention. Investors began to worry less about a re­ cession and more about inflation, as the price of oil continued to rise (hitting almost $144 per barrel in July). At the beginning of 2008, the stock market had fallen almost 15% from its peak in the fall of 2007. Then, in May 2008, the Dow Jones climbed to 13,058, within 8% of the record 14,164 set in October 2007. The cost of protecting against the risk of default by financial institutions-reflected in the prices of credit default swaps-declined from the highs of March and April. "In hindsight, the mar­ kets were surprisingly stable and almost seemed to be neutral a month after Bear Stearns, leading all the way up to September;' said David Wong, Morgan Stanley's treasurer.' Taking advantage of the brief respite in investor concern, the top ten American banks and the four remaining big investment banks, anticipating losses, raised just under $100 billion and $40 billion, respectively, in new equity by the end ofJune. Despite this good news, bankers and their regulators were haunted by the speed of Bear Stearns's demise. And they knew that the other investment banks shared Bear's weaknesses: leverage, reliance on overnight funding, dependence on securitization markets, and concentrations in illiquid mortgage securities and other troubled assets. In particular, the run on Bear had exposed the dangers of tri-party repo agreements and the counterparty risk caused by derivatives contracts. And the word on the street-despite the assurances of Lehman CEO Dick Fuld at

292 MARCH TO AUGUST 2008: SYSTEMIC RISK CONCERNS 293 an April shareholder meeting that "the worst is behind us"2-was that Bear would not be the only failure.

THE FEDERAL RESERVE: "WHEN PEOPLE GOT SCARED"

The most pressing danger was the potential failure of the repo market-a market that "grew very, very quickly with no single regulator having a purview of it;' former Treasury Secretary Henry Paulson would tell the FCIC,3 Market participants believed that the tri-party repo market was a relatively safe and durable source of collateral­ ized short-term financing. It was on precisely this understanding that Bear had shifted approximately $30 billion of its unsecured funding into repos in 2007. But now it was clear that repo funding could be just as vulnerable to runs as were other forms of short-term financing. The repo runs of 2007, which had devastated hedge funds such as the two Bear Stearns Asset Management funds and mortgage originators such as Countrywide, had seized the attention of the financial community, and the run on Bear Stearns was similarly eye-opening. Market participants and regulators now better appreciated how the quality of repo collateral had shifted over time from Treasury notes and se­ curities issued by Fannie Mae and Freddie Mac to highly rated non-GSE mortgage­ backed securities and collateralized debt obligations (CDOs).4 At its peak before the crisis, this riskier collateral accounted for as much as 30% of the total posted.5 In April 2005, the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 had dramatically expanded protections for repo lenders holding collateral, such as mortgage-related securities, that was riskier than government or highly rated corpo­ rate debt. These protections gave lenders confidence that they had clear, immediate rights to collateral if a borrower should declare bankruptcy. Nonetheless, Jamie Di­ mon, the CEO of JP Morgan, told the FCIC, "When people got scared, they wouldn't finance the nonstandard stuff at all:'6 To the surprise of both borrowers and regulators, high -quality collateral was not enough to ensure access to the repo market. Repo lenders cared just as much about the financial health of the borrower as about the quality of the collateral. In fact, even for the same collateral, repo lenders demanded different haircuts from different bor­ rowers/ Despite the bankruptcy provisions in the 2005 act, lenders were reluctant to risk the hassle of seizing collateral, even good collateral, from a bankrupt borrower. Steven Meier of State Street testified to the FCIC: "I would say the counterparties are a first line of defense, and we don't want to go through that uncomfortable process of having to liquidate collateraI:'8 William Dudley of the New York Fed told the FCIC, '~t the first sign of trouble, these investors in tri-party repo tend to run rather than take the collateral that they've lent against. ... So high -quality collateral itself is not sufficient when and if an institution gets in trouble:'9 Moreover, if a borrower in the repo market defaults, money market funds-fre­ quent lenders in this market-may have to seize collateral that they cannot legally own. For example, a money market fund cannot hold long-term securities, such as 294 FINANCIAL CRISIS INQUIRY COMMISSION REPORT agency mortgage-backed securities. Typically, if a fund takes possession of such col­ lateral, it liquidates the securities immediately, even-as was the case during the cri­ sis-into a declining market. As a result, funds simply avoided lending against mortgage-related securities. In the crisis, investors didn't consider secured funding to be much better than unsecured, according to Darryll Hendricks, a managing director and global head of risk methodology at UBS, as well as the head of a private-sector task force on the repo market organized by the New York Fed. 'o As noted, the Fed had announced a new program, the Term Securities Lending Facility (TSLF), on the Tuesday before Bear's collapse, but it would not be available until March 27. The TSLF would lend a total of up to $200 billion of Treasury securi­ ties at anyone time to the investment banks and other primary dealers-the securi­ ties affiliates of the large commercial banks and investment banks that trade with the New York Fed, such as Citigroup, Morgan Stanley, or Merrill Lynch-for up to 28 days. The borrowers would trade highly rated securities, including debt in govern­ ment-sponsored enterprises, in return for Treasuries. The primary dealers could then use those Treasuries as collateral to borrow cash in the repo market. Like the Term Auction Facility for commercial banks, described earlier, the TSLF would run as a regular auction to reduce the stigma of borrowing from the Fed. However, after Bear's collapse, Fed officials recognized that the situation called for a program that could be up and running right away. And they concluded that the TSLF alone would not be enough. So, the Fed would create another program first. On the Sunday of Bear's collapse, the Fed announced the new Primary Dealer Credit Facility-again invoking its au­ thority under 13(3) of the Federal Reserve Act-to provide cash, not Treasuries, to investment banks and other primary dealers on terms close to those that depository institutions-banks and thrifts-received through the Fed's discount window. The move came "just about 45 minutes" too late for Bear, Jimmy Cayne, its former CEO, told the FCIC." Unlike the TSLF, which would offer Treasuries for 28 days, the PDCF offered overnight cash loans in exchange for collateral. In effect, this program could serve as an alternative to the overnight tri-party repo lenders, potentially providing hundreds of billions of dollars of credit. "So the idea of the PDCF then was ... anything that the dealer couldn't finance-the securities that were acceptable under the discount win­ dow-if they couldn't get financing in the market, they could get financing from the Federal Reserve;' said Seth Carpenter, deputy associate director in the Division of Monetary Affairs at the Federal Reserve Board. ''And that way, you don't have to worry. And by providing that support, other lenders know that they're going to be able to get their money back the next day:'" By charging the Federal Reserve's discount rate and adding additional fees for reg­ ular use, the Federal Reserve encouraged dealers to use the PDCF only as a last re­ sort. In its first week of operation, this program immediately provided over $340 billion in cash to Bear Stearns (as bridge financing until the JP Morgan deal officially closed), Lehman Brothers, and the securities affiliate of Citigroup, among others. However, as the immediate post-Bear concerns subsided, use of the facility declined MARCH TO AUGUST 2008: SYSTEMIC RISK CO~CER~S 295 after April and ceased completely by late July.' 3 Because the dealers feared that mar­ kets would see reliance on the PDCF as an indication of severe distress, the facility carried a stigma similar to the Fed's discount window. "Paradoxically, while the PDCF was created to mitigate the liquidity flight caused by the loss of confidence in an investment bank, use of the PDCF was seen both within Lehman, and possibly by the broader market, as an event that could trigger a loss of confidence;' noted the Lehman bankruptcy examiner.'4 On May 2, the Fed broadened the kinds of collateral allowed in the TSLF to in­ clude other triple-A-rated asset-backed securities, such as auto and credit card loans. In June, the Fed's Dudley urged in an internal email that both programs be extended at least through the end of the year. "PDCF remains critical to the stability of some of the [investment banks];' he wrote. ''Amounts don't matter here, it is the fact that the PDCF underpins the tri-party repo system:" 5 On July 30, the Fed extended both pro­ grams through January 30, 2009.

IP MORGAN: "REFUSING TO UNWIND ... WOULD BE UNFORGIVABLE" The repo run on Bear also alerted the two repo clearing banks-JP Morgan, the main clearing bank for Lehman and Merrill Lynch, as it had been for Bear Stearns, and BNY Mellon, the main clearing bank for Goldman Sachs and Morgan Stanley-to the risks they were taking. Before Bear's collapse, the market had not really understood the colossal expo­ sures that the tri-party repo market created for these clearing banks. As explained earlier, the "unwind/rewind" mechanism could leave JP Morgan and BNY Mellon with an enormous "intraday" exposure-an interim exposure, but no less real for its brevity. In an interview with the FCIC, Dimon said that he had not become fully aware of the risks stemming from his bank's tri -party repo clearing business until the Bear crisis in 2008.'6 A clearing bank had two concerns: First, if repo lenders aban­ doned an investment bank, it could be pressured into taking over the role of the lenders. Second, and worse-if the investment bank defaulted, it could be stuck with unwanted securities. "If they defaulted intraday, we own the securities and we have to liquidate them. That's a huge risk to us;' Dimon explained.'7 To address those risks in 2008, for the first time both JP Morgan and BNY Mellon started to demand that intraday loans to tri-party repo borrowers-mostly the large investment banks-be overcollateralized. The Fed increasingly focused on the systemic risk posed by the two repo clearing banks. In the chain-reaction scenario that it envisioned, if either JP Morgan or BNY Mellon chose not to unwind its trades one morning, the money funds and other repo lenders could be stuck with billions of dollars in repo collateral. Those lenders would then be in the difficult position of having to sell offlarge amounts of collateral in or­ der to meet their own cash needs, an action that in turn might lead to widespread fire sales of repo collateral and runs by lenders.'8 The PDCF provided overnight funding, in case money market funds and other FINANCIAL CRISIS INQUIRY COMMISSION REPORT repo lenders refused to lend as they had in the case of Bear Stearns, but it did not pro­ tect against clearing banks' refusing exposure to an investment bank during the day. On July 11, Fed officials circulated a plan, ultimately never implemented, that ad­ dressed the possibility that one of the two clearing banks would become unwilling or unable to unwind its trades. 19 The plan would allow the Fed to provide troubled in­ vestment banks, such as Lehman Brothers, with $200 billion in tri-party repo financ­ ing during the day-essentially covering for JP Morgan or BNY Mellon if the two clearing banks would not or could not provide that level of financing. 20 Fed officials made a case for the proposal in an internal memo: "Should a dealer lose the confi­ dence of its investors or clearing bank, their efforts to pull away from providing credit could be disastrous for the firm and also cast widespread doubt about the in­ strument as a nearly risk free, liquid overnight investmenf'21 But the New York Fed's new plan shouldn't be necessary as long as the PDCF was there to back up the overnight lenders, argued Patrick Parkinson, then deputy direc­ tor of the Federal Reserve Board's Division of Research and Statistics. "We should tell [JP Morgan] that with the PDCF in place refusing to unwind is unnecessary and would be unforgiveable:' he emailed Dudley and others.22 A week later, on July 20, Parkinson wrote to Fed Governor Kevin Warsh and Fed General Counsel Scott Alvarez that JP Morgan, because of its clearing role, was "likely to be the first to realize that the money funds and other investors that provide tri-party financing to [Lehman Brothers] are pulling back significantly." Parkinson described the chain-reaction scenario, in which a clearing bank's refusal to unwind would lead to a widespread fire sale and market panic. "Fear of these consequences is, of course, why we facilitated Bear's acquisition by JPMC:' he said. 23 Still, it was possible that the PDCF could prove insufficient to dissuade JP Morgan from refusing to unwind Lehman's repos, Parkinson said. Because a large portion of Lehman's collateral was ineligible to be funded by the PDCF, and because Lehman could fail during the day (before the repos were settled), JP Morgan still faced signifi­ cant risks. Parkinson noted that even if the Fed lent as much as $200 billion to Lehman, the sum might not be enough to ensure the firrn's survival in the absence of an acquirer: if the stigma associated with PDCF borrowing caused other funding counterparties to stop providing funding to Lehman, the company would fai1.24

THE FED AND THE SEC: "WEAK LIQUIDITY POSITION" Among the four remaining investment banks, one key measure of liquidity risk was the portion of total liabilities that the firms funded through the repo market: 15% to 20% for Lehman and Merrill Lynch, 10% to 15% for Morgan Stanley, and about 10% for Goldman Sachs!S Another metric was the reliance on overnight repo (which ma­ ture in one day) or open repo (which can be terminated at any time). Despite efforts among the investment banks to reduce the portion of their repo financing that was overnight or open, the ratio of overnight and open repo funding to total repo fund­ ing still exceeded 40% for all but Goldman Sachs. Comparing the period between March and May to the period between July and August, Lehman's percentage fell MARCH TO AUGUST 2008: SYSTEMIC RISK CONCERNS 297 from 45% to 40%, Merrill Lynch's fell from 46% to 43%, Morgan Stanley's fell from 70% to 55%, and Goldman's fell from 18% to 10%.'6 Another measure of risk was the haircuts on repo loans-that is, the amount of excess collateral that lenders de­ manded for a given loan. Fed officials kept tabs on the haircuts demanded of invest­ ment banks, hedge funds, and other repo borrowers. As Fed analysts later noted, "With lenders worrying that they could lose money on the securities they held as col­ lateral, haircuts increased-doubling for some agency mortgage securities and in­ creasing significantly even for borrowers with high credit ratings and on relatively safe collateral such as Treasury securities:"7 On the day of Bear's demise, in an effort to get a better understanding of the in­ vestment banks, the New York Fed and the SEC sent teams to work on-site at Lehman Brothers, Merrill Lynch, Goldman Sachs, and Morgan Stanley. According to Erik Sirri, director of the SEC's Division of Trading and Markets, the initial rounds of meetings covered the quality of assets, funding, and capital.'8 Fed Chairman Ben Bernanke would testify before a House committee that the Fed's primary role at the investment banks in 2008 was not as a regulator but as a lender through the new emergency lending facilities.'9 Two questions guided the Fed's analyses: First, was each investment bank liquid-did it have access to the cash needed to meet its commitments? Second, was it solvent-was its net equity (the value of assets minus the value ofliabilities) sufficient to cover probable losses?3 0 The U.S. Treasury also dispatched so-called SWAT teams to the investment banks in the spring of 2008. The arrival of officials from the Treasury and the Fed created a full-time on-site presence-something the SEC had never had. Historically, the SEC's primary concern with the investment banks had been liquidity risk, because these firms were entirely dependent on the credit markets for funding. 31 The SEC already required these firms to implement so-called liquidity models, designed to ensure that they had sufficient cash available to sustain themselves on a stand-alone basis for a minimum of one year without access to unsecured funding and without having to sell a substantial amount of assets. Before the run on Bear in the repo market, the SEC's liquidity stress scenarios-also known as stress tests-had not taken account of the possibility that a firm would lose access to secured funding. According to the SEC's Sirri, the SEC never thought that a situation would arise where an investment bank couldn't enter into a repo transaction backed by high-quality collateral includ­ ing Treasuries. He told the FCIC that as the financial crisis worsened, the SEC began to see liquidity and funding risks as the most critical for the investment banks, and the SEC encouraged a reduction in reliance on unsecured commercial paper and an extension of the maturities of repo loans.3' The Fed and the SEC collaborated in developing two new stress tests to determine the investment banks' ability to withstand a potential run or a systemwide disruption in the repo market. The stress scenarios, called "Bear Stearns" and "Bear Stearns Light;' were developed jointly with the remaining investment banks. In May, Lehman, for example, would be $84 billion short of cash in the more stringent Bear Stearns scenario and $15 billion short under Bear Stearns Light.33 The Fed conducted another liquidity stress analysis in June. While each firm ran FINANCIAL CRISIS INQCIRY COMMISSION REPORT different scenarios that matched its risk profile, the supervisors tried to maintain comparability between the tests. The tests assumed that each firm would lose 100% of unsecured funding and a fraction of repo funding that would vary with the quality of its collateral. The stress tests, under just one estimated scenario, concluded that Goldman Sachs and Morgan Stanley were relatively sound. Merrill Lynch and Lehman Brothers failed: the two banks came out $22 billion and $15 billion short of cash, respectively; each had only 78% of the liquidity it would need under the stress scenario.34 The Fed's internal report on the stress tests criticized Merrill's "significant amount of illiquid fixed income assets" and noted that "Merrill's liquidity pool is low, a fact [the company] does not acknowledge:' As for Lehman Brothers, the Fed concluded that "Lehman's weak liquidity position is driven by its relatively large exposure to overnight [commercial paper], combined with significant overnight secured [repo] funding of less liquid assets:'35 These "less liquid assets" included mortgage-related securities-now devalued. Meanwhile, Lehman ran stress tests of its own and passed with billions in "excess cash:'3 6 Although the SEC and the Fed worked together on the liquidity stress tests, with equal access to the data, each agency has said that for months during the crisis, the other did not share its analyses and conclusions. For example, following Lehman's failure in September, the Fed told the bankruptcy examiner that the SEC had de­ clined to share two horizontal (cross-firm) reviews of the banks' liquidity positions and exposures to commercial real estate. The SEC's response was that the documents were in "draft" form and had not been reviewed or finalized. Adding to the tension, the Fed's on-site personnel believed that the SEC on-site personnel did not have the background or expertise to adequately evaluate the data.37 This lack of communica­ tion was remedied only by a formal memorandum of understanding (MOU) to gov­ ern information sharing. According to former SEC Chairman Christopher Cox, "One reason the MOU was needed was that the Fed was reluctant to share supervi­ sory information with the SEC, out of concern that the investment banks would not be forthcoming with information if they thought they would be referred to the SEC for enforcemenf'38 The MOU was not executed until July 2008, more than three months after the collapse of Bear Stearns.

DERIVATIVES: "EARLY STAGES OF ASSESSING THE POTENTIAL SYSTEMIC RISK" The Fed's Parkinson advised colleagues in an internal August 8 email that the sys­ temic risks of the repo and derivatives markets demanded attention: "We have given considerable thought to what might be done to avoid a fire sale oftri-party repo col­ lateral. (That said, the options under existing authority are not very attractive-lots of risk to Fed/taxpayer, lots of moral hazard.) We still are at the early stages of assess­ ing the potential systemic risk from close-out of OTC derivatives transactions by an investment bank's counterparties and identifying potential mitigants:'39 The repo market was huge, but as discussed in earlier chapters, it was dwarfed by MARCH TO AUGUST 2008: SYSTEMIC RISK CONCERNS 299

Notional Amount and Gross Market Value of OTe Derivatives Outstanding IN TRILLIONS OF DOLLARS, SEMIANNUAL

Notional Amount _ • Gross Market Value $800------$40

~ ~ 600 30

500------~~---- 25

400------~~----__~ 20

300------~~~------15

200------~~~~ 10

100 _____ ----~~;:._ 5 0--"'1"'"-""1'.... 1"'-'''1'''"-..,.... o 1999 2001 2003 2005 2007 2009 June 2010 SOURCE: Bank for International Settlements

Figure 16.1

the global derivatives market. At the end of June 2008, the notional amount of the over-the-counter derivatives market was $673 trillion and the gross market value was $20 trillion (see figure 16.1). Adequate information about the risks in this market was not available to market participants or government regulators like the Federal Re­ serve. Because the market had been deregulated by statute in 2000, market partici­ pants were not subject to reporting or disclosure requirements and no government agency had oversight responsibility. While the Office of the Comptroller of the Cur­ rency did report information on derivatives positions from commercial banks and bank holding companies, it did not collect such information from the large invest­ ment banks and insurance companies like AIG, which were also major OTC deriva­ tives dealers. During the crisis the lack of such basic information created heightened uncertainty. At this point in the crisis, regulators also worried about the interlocking relation­ ships that derivatives created among the small number of large financial firms that act as dealers in the OTC derivatives business. A derivatives contract creates a credit relationship between parties, such that one party may have to make large and unex­ pected payments to the other based on sudden price or rate changes or loan defaults. If a party is unable to make those payments when they become due, that failure may 300 FINANCIAL CRISIS INQUIRY COMMISSION REPORT cause significant financial harm to its counterparty, which may have offsetting obli­ gations to third parties and depend on prompt payment. Indeed, most OTC deriva­ tives dealers hedge their contracts with offsetting contracts; thus, if they are owed payments on one contract, they most likely owe similar amounts on an offsetting contract, creating the potential for a series oflosses or defaults. Since these contracts numbered in the millions and allowed a party to have virtually unlimited leverage, the possibility of sudden large and devastating losses in this market could pose a sig­ nificant danger to market participants and the financial system as a whole. The Counterparty Risk Management Policy Group, led by former New York Fed President E. Gerald Corrigan and consisting of the major securities firms, had warned that a backlog in paperwork confirming derivatives trades and master agree­ ments exposed firms to risk should corporate defaults occur.40 With urging from New York Fed President Timothy Geithner, by September 2006, 14 major market participants had significantly reduced the backlog and had ended the practice of as­ signing trades to third parties without the prior consent of their counterpartiesY Large derivatives positions, and the resulting counterparty credit and operational risks, were concentrated in a very few firms. Among U.S. bank holding companies, the following institutions held enormous OTC derivatives positions as of June 30, 2008: $94.5 trillion in notional amount for JP Morgan, $37.7 trillion for Bank of America, $35.8 trillion for Citigroup, $4.1 trillion for Wachovia, and $3.9 trillion for HSBC. Goldman Sachs and Morgan Stanley, which began to report their holdings only after they became bank holding companies in 2008, held $45.9 and $37.0 tril­ lion, respectively, in notional amount of OTC derivatives in the first quarter of 2009.4' In 2008, the current and potential exposure to derivatives at the top five U.S. bank holding companies was on average three times greater than the capital they had on hand to meet regulatory requirements. The risk was even higher at the investment banks. Goldman Sachs, just after it changed its charter, had derivatives exposure more than 10 times capital. These concentrations of positions in the hands of the largest bank holding companies and investment banks posed risks for ilie financial system because of their interconnections with other financial institutions. Broad classes of OTC derivatives markets showed stress in 2008. By the summer of 2008, outstanding amounts of some types of derivatives had begun to decline sharply. As we will see, over the course of the second half of 2008, the OTC deriva­ tives market would undergo an unprecedented contraction, creating serious prob­ lems for hedging and price discovery. The Fed was uneasy in part because derivatives counterparties had played an im­ portant role in the run on Bear Stearns. The novations by derivatives counterparties to assign their positions away from Bear-and the rumored refusal by Goldman to accept Bear as a derivatives counterparty-were still a fresh memory across Wall Street. Chris Mewbourne, a portfolio manager at PIMCO, told the FCIC that the ability to novate ceased to exist and this was a key event in the demise of Bear Stearns.43 Credit derivatives in particular were a serious source of worry. Of greatest interest were the sellers of credit default swaps: the monoline insurers and AIG, which back- MARCH TO AUGUST 2008: SYSTEMIC RISK CONCERNS 301 stopped the market in CDOs. In addition, the credit rating agencies' decision to issue a negative outlook on the monoline insurers had jolted everyone, because they guar­ anteed hundreds of billions of dollars in structured products. As we have seen, when their credit ratings were downgraded, the value of all the assets they guaranteed, in­ cluding municipal bonds and other securities, necessarily lost some value in the mar­ ket, a drop that affected the conservative institutional investors in those markets. In the vernacular of Wall Street, this outcome is the knock-on effect; in the vernacular of Main Street, the domino effect; in the vernacular of the Fed, systemic risk.

BANKS: "THE MARKETS WERE REALLY, REALLY DICEY" By the fall of 2007, signs of strain were beginning to emerge among the commercial banks. In the fourth quarter of 2007, commercial banks' earnings declined to a 16- year low, driven by write-downs on mortgage-backed securities and CDOs and by record provisions for future loan losses, as borrowers had increasing difficulty meet­ ing their mortgage payments-and eyen greater difficulty was anticipated. The net charge-off rate-the ratio of failed loans to total loans-rose to its highest level since 2002, when the economy was coming out of the POSt-9tll recession. Earnings con­ tinued to decline in 2008-at first, more for big banks than small banks, in part be­ cause of write-downs related to their investment banking-type activities, including the packaging of mortgage-backed securities, CDOs, and collateralized loan obliga­ tions. Declines in market values required banks to write down the value of their holdings of these securities. As previously noted, several of the largest banks had also provided support to off-balance-sheet activities, such as money market funds and commercial paper programs, bringing additional assets onto their balance sheets­ assets that were losing value fast. Supervisors had begun to downgrade the ratings of many smaller banks in response to their high exposures in residential real estate con­ struction, an industry that virtually went out of business as financing dried up in mid-2007. By the end of 2007, the FDIC had 76 banks, mainly smaller ones, on its "problem list"; their combined assets totaled $22.2 billion.44 (When large banks started to be downgraded, in early 2008, they stayed off the FDIC's problem list, as supervisors rarely give the largest institutions the lowest ratings.)45 The market for nonconforming mortgage securitizations (those backed by mort­ gages that did not meet Fannie Mae's or Freddie Mac's underwriting or mortgage size guidelines) had also vanished in the fourth quarter of 2007. Not only did these non­ conforming loans prove harder to sell, but they also proved less attractive to keep on balance sheet, as house price forecasts looked increasingly grim. Already, house prices had fallen about 7% for the year, depending on the measure. In the first quarter of 2008, real estate loans in the banking sector showed the smallest quarterly increase since 2003. 46 IndyMac reported a 21% decline in loan production for that quarter from a year earlier, because it had stopped making nonconforming loans. Washing­ ton Mutual, the largest thrift, discontinued all remaining lending through its sub­ prime mortgage channel in April 2008. But those actions could not reduce the subprime and Alt-A exposure that these 302 FINANCIAL CRISIS INQUIRY COMMISSION REPORT large banks and thrifts already had. And on these assets, the markdowns continued in 2008. Regulators began to focus on solvency, urging the banks to raise new capitaL In January 2008, Citigroup secured a total of $14 billion in capital from Kuwait, Sin­ gapore, Saudi Prince Alwaleed bin Talal, and others. In April, Washington Mutual raised $7 billion from an investor group led by the buyout firm TPG CapitaL Wa­ chovia raised $6 billion in capital at the turn of the year and then an additional $8 bil­ lion in April 2008. Despite the capital raises, though, the downgrades by banking regulators continued. "The markets were really, really dicey during a significant part of this period, starting with August 2007;' Roger Cole, then -director of the Division of Banking Su­ pervision and Regulation at the Federal Reserve Board, told the FCICY The same was true for the thrifts. Michael Solomon, a managing director in risk management manager in the Office of Thrift Supervision (OTS), told the FCIC, "It was hard for businesses, particularly small, midsized thrifts-to keep up with [how quickly the ratings downgrades occurred during the crisis1 and change their business models and not get stuck without the chair when the music stopped ... They got caught. The rating downgrades started and by the time the thrift was able to do something about it, it was too late ... Business models ... can't keep up with what we saw in 2008:'48 As the commercial banks' health worsened in 2008, examiners downgraded even large institutions that had maintained favorable ratings and required several to fix their risk management processes. These ratings downgrades and enforcement ac­ tions came late in the day-often just as firms were on the verge of failure. In cases that the FCIC investigated, regulators either did not identify the problems early enough or did not act forcefully enough to compel the necessary changes.

Citigroup: "Time to come up with a new playbook" For Citigroup, supervisors at the New York Fed, who examined the bank holding company, and at the Office of the Comptroller of the Currency, who oversaw the na­ tional bank subSidiary, finally downgraded the company and its main bank to "less than satisfactory" in April 2008-five months after the finn's announcement in No­ vember 2007 of billions of dollars in write-downs related to its mortgage-related holdings. The supervisors put the company under new enforcement actions in May and June. Only a year earlier, both the Fed and the OCC had upgraded the company, after lifting all remaining restrictions and enforcement actions related to complex transactions that it had structured for Enron and to the actions of its subprime sub­ sidiary CitiFinancial, discussed in an earlier chapter. "The risk management assess­ ment for 2006 is reflective of a control environment where the risks facing Citigroup continue to be managed in a satisfactory manner;' the New York Fed's rating upgrade, delivered in its annual inspection report on April 9, 2007, had noted. "During 2006, all formal restrictions and enforcement actions between the Federal Reserve and Citigroup were lifted. Board and senior management remain actively engaged in im­ proving relevant processes:'49 But the market disruption had jolted Citigroup's supervisors. In November 2007, MARCH TO AUGUST 2008: SYSTEMIC RISK CONCERNS the New York Fed led a team of international supervisors, the Senior Supervisors Group, in evaluating 11 of the largest firms to assess lessons learned from the finan­ cial crisis up to that point. Much of the toughest language was reserved for Citigroup. "The firm did not have an adequate, firm-wide consolidated understanding of its risk factor sensitivities;' the supervisors wrote in an internal November 19 memo describ­ ing meetings with Citigroup management. "Stress tests were not designed for this type of extreme market event. ... Management had believed that CD Os and lever­ aged loans would be syndicated, and that the credit risk in super senior AAA CDOs was negligible:'5 0 In retrospect, Citigroup had two key problems: a lack of effective enterprise-wide management to monitor and control risks and a lack of proper infrastructure and in­ ternal controls with respect to the creation of CDOs. The OCC appears to have iden­ tified some of these issues as early as 2005 but did not effectively act to rectify them. In particular, the OCC assessed both the liquidity puts and the super-senior tranches as part ofits reviews of the bank's compliance with the post-Enron enforcement ac­ tion, but it did not examine the risks of these exposures. As for the issues it did spot, the OCC failed to take forceful steps to require mandatory corrective action, and it relied on management's assurances in 2006 that the executives would strive to meet the OCC's goals for improving risk management. In contrast, documents obtained by the FCIC from the New York Fed give no in­ dication that its examination staff had any independent knowledge of those two core problems. An evaluation of the New York Fed's supervision of Citigroup, conducted by examiners from other Reserve Banks (the December 2009 Operations Review of the New York Fed, which covered the previous four years), concluded:

The supervision program for Citigroup has been less than effective. Al­ though the dedicated supervisory team is well qualified and generally has sound knowledge of the organization, there have been significant weaknesses in the execution of the supervisory program. The team has not been proactive in making changes to the regulatory ratings of the firm, as evidenced by the double downgrades in the firm's financial component and related subcomponents at year-end 2007. Additionally, the supervisory program has lacked the appropriate level of focus on the firm's risk oversight and internal audit functions. As a result, there is currently significant work to be done in both of these areas. Moreover, the team has lacked a disciplined and proactive approach in assessing and validating actions taken by the firm to address supervisory issuesY

Timothy Geithner, secretary of the Treasury and former president of the Federal Reserve Bank of New York, reflected on the Fed's oversight of Citigroup, telling the Commission, "I do not think we did enough as an institution with the authority we had to help contain the risks that ultimately emerged in that institution:'5 2 In January 2008, an OCC review of the breakdown in the CDO business noted that the risk in the unit had grown rapidly since 2006, after the OCe's and Fed's 304 FINANCIAL CRISIS INQUIRY COMMISSION REPORT lifting of supervisory agreements associated with various control problems at Citi­ group. In April 2008, the Fed and OCC downgraded their overall ratings of the com­ pany and its largest bank subsidiary from 2 (satisfactory) to 3 (less than satisfactory), reflecting weaknesses in risk management that were now apparent to the supervisors. Both Fed and OCC officials cited the Gramm-Leach-Bliley Act of 1999 as an ob­ stacle that prevented each from obtaining a complete understanding of the risks assumed by large financial firms such as Citigroup. The act made it more difficult­ though not impossible-for regulators to look beyond the legal entities under their direct purview into other areas of a large firm. Citigroup, for example, had many reg­ ulators across the world; even the securitization businesses were dispersed across sub­ sidiaries with different supervisors-including those from the Fed, OCC, SEC, OTS, and state agencies. In May and June 2008, Citigroup entered into memoranda of understanding with both the New York Fed and OCC to resolve the risk management weaknesses that the events of 2007 had laid bare. In the ensuing months, Fed and OCC officials said, they were satisfied with Citigroup's compliance with their recommendations. Indeed, in speaking to the FCIC, Steve Manzari, the senior relationship manager for Citigroup at the New York Fed from April to September 2008, complimented Citigroup on its assertiveness in executing its regulators' requests: aggressively replacing manage­ ment, raising capital from investors in late 2007, and putting in place a number of much needed "internal fixes:' However, Manzari went on, "Citi was trapped in what was a pretty vicious ... systemic event;' and for regulators "it was time to come up with a new playbook:'53

Wachovia: "The Golden West acquisition was a mistake" At Wachovia, which was supervised by the OCC as well as the OTS and the Federal Reserve, a 2007 end-of-year report showed that credit losses in its subsidiary Golden West's portfolio of "Pick-a-Pay" adjustable-rate mortgages, or option ARMs, were ex­ pected to rise to about 1 % of the portfolio for 2008; in 2006, losses in this portfolio had been less than 0.1 %. It would soon become clear that the higher estimate for 2008 was not high enough. The company would hike its estimate of the eventual losses on the portfolio to 9% by June and to 22% by September. Facing these and other growing concerns, Wachovia raised additional capital. Then, in April, Wachovia announced a loss of $350 million for the first three months of the year. Depositors withdrew about $15 billion in the following weeks, and lenders reduced their exposure to the bank, shortening terms, increasing rates, and reducing loan amounts. 54 By June, according to Angus McBryde, then Wachovias senior vice president for Treasury and Balance Sheet Management, management had launched a liqUidity crisis management plan in anticipation of an even more adverse market reaction to second-quarter losses that would be announced in July.55 On June 2, Wachovias board ousted CEO Ken Thompson after he had spent 32 years at the bank, 8 of them at its helm. 56 At the end of the month, the bank an­ nounced that it would stop originating Golden West's Pick-a-Pay products and would MARCH TO AUGUST 2008: SYSTEMIC RISK CONCERNS 305 waive all fees and prepayment penalties associated with them. On July 22, Wachovia reported an $8.9 billion second-quarter loss. The new CEO, Robert Steel, most re­ centlyan undersecretary of the treasury, announced a plan to improve the bank's fi­ nancial condition: raise capital, cut the stock dividend, and layoff 10% to 12 % of the staff. The rating agencies and supervisors ignored those reassurances. On the same day as the announcement, S&P downgraded the bank, and the Fed, after years of "satis­ factory" ratings, downgraded Wachovia to 3, or "less than satisfactorY:' The Fed noted that 2008 projections showed losses that could wipe out the recently raised capital: 2008 losses alone could exceed $3 billion, an amount that could cause a fur­ ther ratings downgrade. 57 The Fed directed Wachovia to reevaluate and update its capital plans and its liquidity management. Despite having consistently rated Wa­ chovia as "satisfactory" right up to the summer meltdown, the Fed now declared that many ofWachovia's problems were "long-term in nature and result[edl from delayed investment decisions and a desire to have business lines operate autonomouslY:'58 The Fed bluntly criticized the board and senior management for "an environment with inconsistent and inadequate identification, escalation and coverage of all risk­ taking activities, including deficiencies in stress testing" and "little accountability for errors:' Wachovia management had not completely understood the level of risk across the company, particularly in certain nonbank investments, and management had delayed fixing these known deficiencies. In addition, the company's board had not sufficiently questioned investment decisions. 59 Nonetheless, the Fed concluded that Wachovia's liquidity was currently adequate and that throughout the market dis­ ruption, management had minimized exposure to overnight funding markets. On August 4, the oee downgraded Wachovia Bank and assessed its overall risk profile as "high:' The oee noted many of the same issues as the Fed, and added par­ ticularly strong remarks about the acquisition of Golden West, identifying that mort­ gage portfolio and associated real estate foreclosures as the heart of Wachovia's problem. The oee noted that the board had "acknowledged that the Golden West acquisition was a mistake:'6o The oee wrote that the market was focused on the company's weakened condi­ tion and that some large fund providers had already limited their exposure to Wa­ chovia. Like the Fed, however, the oee concluded that the bank's liquidity was adequate, unless events undermined market confidence.61 And, like the Fed, the oee approved of the new management and a new, more hands-on oversight role for the board of directors. Yet Wachovia's problems would continue, and in the fall regulators would scram­ ble to find a buyer for the troubled bank.

Washington Mutual: "Management's persistent lack ofprogress" Washington Mutual, often called WaMu, was the largest thrift in the country, with over $300 billion in assets at the end of 2007. At the time, $59 billion of the home loans on its balance sheet were option ARMs, two times its capital and reserves, with 306 FINANCIAL CRISIS INQUIRY COMMISSION REPORT concentrated exposure in California. The reason WaMu liked option ARMs was sim­ ple: in 2005, in combination with other nontraditional mortgages such as subprime loans, they had generated returns up to 8 times those on GSE mortgage-backed secu­ rities.62 But that was then. WaMu was forced to write off $1.9 billion for the fourth quarter of 2007 and another $1.1 billion in the first quarter of 2008, mostly related to its portfolio of option ARMs. In response to these losses, the Office of Thrift Supervision, WaMu's regulator, re­ quested that the thrift address concerns about asset quality, earnings, and liquidity­ issues that the OTS had raised in the past but that had not been reflected in supervisory ratings. "It has been hard for us to justify doing much more than con­ stantly nagging (okay, 'chastising) through ROE [Reports ofExaminationj and meet­ ings, since they have not really been adversely impacted in terms oflosses:'63 the OTS's lead examiner at the company had commented in a 2005 email. Indeed, the nontradi­ tional mortgage portfolio had been performing very well through 2005 and 2006. But with WaMu now taking losses, the OTS determined on February 27, 2008, that its condition required a downgrade in its rating from a 2 to a 3, or "less than sat­ isfactorY:'64 In March, the OTS advised that WaMu undertake "strategic initiatives"­ that is, either find a buyer or raise new capital. In April, WaMu secured a $7 billion investment from a consortium led by the Texas Pacific Group, a private equity firm.65 But bad news continued for thrifts. On July 14, the OTS closed IndyMac Bank in Pasadena, California, making that company the largest-ever thrift to fail. On July 22, 2008, WaMu reported a $3.3 billion loss in the second quarter. WaMu's depositors withdrew $10 billion over the next two weeks. 66 And the Federal Home Loan Bank of San Francisco-which, as noted, had historically served with the other 11 Federal Home Loan Banks as an important source of funds for WaMu and others-began to limit WaMu's borrowing capacity. The OTS issued more downgrades in various as­ sessment categories, while maintaining the overall rating at 3. As the insurer of many of WaMu's deposits, the FDIC had a stake in WaMu's condition, and it was not as generous as the OTS in its assessment. It had already dropped WaMu's rating significantly in March 2008, indicating a "high level of concern:'67 The FDIC expressly disagreed with the OTS's decision to maintain the 3 overall rating, recommending a 4 instead.68 Ordinarily, 4 would have triggered a formal en­ forcement action, but none was forthcoming. In an August 2008 interview, William Isaac, who was chairman of the FDIC from 1981 until 1985, noted that the OTS and FDIC had competing interests. OTS, as primary regulator, "tends to want to see if they can rehabilitate the bank and doesn't want to act precipitously as a rule:' On the other hand, "The FDIC's job is to handle the failures, and it-generally speaking­ would rather be tougher ... on the theory that the sooner the problems are resolved, the less expensive the cleanup will be:'69 FDIC Chairman Sheila Bair underscored this tension, telling the FCIC that "our examiners, much earlier, were very concerned about the underwriting quality of WaMu's mortgage portfolio, and we were actively opposed by the OTS in terms of go­ ing in and letting our [FDIC] examiners do loan-level analysis:'70 MARCH TO AUGUST 2008: SYSTEMIC RISK CONCERNS 307

The Treasury's inspector general would later criticize OTS's supervision of Wash­ ington Mutual: "We concluded that OTS should have lowered WaMu's composite rat­ ing sooner and taken stronger enforcement action sooner to force WaMu's management to correct the problems identified by OTS. Specifically, given WaMu management's persistent lack of progress in correcting OTS-identified weaknesses, we believe OTS should have followed its own policies and taken formal enforcement action rather than informal enforcement action:'71

Regulators: 'j1 lot of that pushback" In these examples and others that the Commission studied, regulators either failed or were late to identify the mistakes and problems of commercial banks and thrifts or did not react strongly enough when they were identified. In part, this failure reflects the nature of bank examinations conducted during periods of apparent financial calm when institutions were reporting profits. In addition to their role as enforcers of regu­ lation, regulators acted something like consultants, working with banks to assess the adequacy of their systems. This function was, to a degree, a reflection of the supervi­ sors' "risk-focused" approach. The OCC Large Bank Supervision Handbook published in January 2010 explains, "Under this approach, examiners do not attempt to restrict risk-taking but rather determine whether banks identify, understand, and control the risks they assume:'7 2 As the crisis developed, bank regulators were slow to shift gears. Senior supervisors told the FCrC it was difficult to express their concerns force­ fully when financial institutions were generating record-level profits. The Fed's Roger Cole told the FCIC that supervisors did discuss issues such as whether banks were growing too fast and taking too much risk, but ran into pushback. "Frankly a lot of that pushback was given credence on the part of the firms by the fact that-like a Citigroup was earning $4 to $5 billion a quarter. And that is really hard for a supervi­ sor to successfully challenge. When that kind of money is flowing out quarter after quarter after quarter, and their capital ratios are way above the minimums, it's very hard to challenge:'73 Supervisors also told the Fcrc that they feared aggravating a bank's already-exist­ ing problems. For the large banks, the issuance of a formal, public supervisory action taken under the federal banking statutes marked a severe regulatory assessment of the bank's risk practices, and it was rarely employed for banks that were determined to be going concerns. Richard Spillenkothen, the Fed's head of supervision until early 2006, attributed supervisory reluctance to "a belief that the traditional, nonpublic (behind-the-scenes) approach to supervision was less confrontational and more likely to induce bank management to cooperate; a desire not to inject an element of contentiousness into what was felt to be a constructive or equable relationship with management; and a fear that financial markets would overreact to public actions, possibly causing a run:' Spillenkothen argued that these concerns were relevant but that "at times they can impede effective supervision and delay the implementation of needed corrective action. One of the lessons of this crisis ... is that the working pre­ sumption should be earlier and stronger supervisory follow Up:'74 308 FINANCIAL CRISIS INQUIRY COMMISSION REPORT

Douglas Roeder, the OCC's senior deputy comptroller for Large Bank Supervision from 2001 to 2010, said that the regulators were hampered by inadequate informa­ tion from the banks but acknowledged that regulators did not do a good job of inter­ vening at key points in the run-up to the crisis. He said that regulators, market participants, and others should have balanced their concerns about safety and sound­ ness with the need to let markets work, noting, "We underestimated what systemic risk would be in the marketplace:'75 Regulators also blame the complexity of the supervisory system in the United States. The patchwork quilt of regulators created opportunities for banks to shop for the most lenient regulator, and the presence of more than one supervisor at an organ­ ization. For example, a large firm like Citigroup could have the Fed supervising the bank holding company, the OCC supervising the national bank subsidiary, the SEC supervising the securities firm, and the OTS supervising the thrift subsidiary-creat­ ing the potential for both gaps in coverage and problematic overlap. Successive Treas­ ury secretaries and Congressional leaders have proposed consolidation of the supervisors to simplify this system over the years. Notably, Secretary Henry Paulson released the "Blueprint for a Modernized Financial Regulatory Structure" on March 31, 2008, two weeks after the Bear rescue, in which he proposed getting rid of the thrift charter, creating a federal charter for insurance companies (now regulated only by the states), and merging the SEC and CFTC. The proposals did not move forward in 2008,76

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CONTENTS

'fI.good time to buy" ...... 310 "The only game in town" ...... 311 '1t5 a time game ... be cool" ...... 312 "The idea strikes me as perverse" ...... 314 '1t will increase conjidence" ...... 315 "Critical unsafe and unsound practices" ...... 318 "They wentfrom zero to three with no warning in between" ...... 319 "The worst-run jinancial institution" ...... 321 "Wasn't done at my pay grade" ...... 322

From the fall of 2007 until Fannie Mae and Freddie Mac were placed into conserva­ torship on September 7, 2008, government officials struggled to strike the right bal­ ance between the safety and soundness of the two government -sponsored enterprises and their mission to support the mortgage market. The task was critical because the mortgage market was quickly weakening-home prices were declining, loan delin­ quencies were rising, and, as a result, the values of mortgage securities were plum­ meting. Lenders were more willing to refinance borrowers into affordable mortgages if these government-sponsored enterprises (GSEs) would purchase the new loans. If the GSEs bought more loans, that would stabilize the market, but it would also leave the GSEs with more risk on their already-strained balance sheets. The GSEs were highly leveraged-owning and guaranteeing $5.3 trillion of mort­ gages with capital ofless than 2%. When interviewed by the FCrC, former Treasury Secretary Henry Paulson acknowledged that after he was briefed on the GSEs upon taking office in June 2006, he believed that they were "a disaster waiting to happen" and that one key problem was the legal definition of capital, which their regulator lacked discretion to adjust; indeed, he said that some people referred to it as "bullsh*t capital:" Still, the GSEs kept buying more of the riskier mortgage loans and securi­ ties, which by fall 2007 constituted multiples of their reported capital. The GSEs

309 310 FINANCIAL CRISIS INQUIRY COMMISSION REPORT reported billions of dollars of net losses on these loans and securities, beginning in the third quarter of 2007. But many in Treasury believed the country needed the GSEs to provide liquidity to the mortgage market by purchasing and guaranteeing loans and securities at a time when no one else would. Paulson told the FCIC that after the housing market dried up in the summer of 2007, the key to getting through the crisis was to limit the decline in housing, prevent foreclosures, and ensure continued mortgage funding, all of which required that the GSEs remain viable. 2 However, there were constraints on how many loans the GSEs could fund; they and their regulators had agreed to portfo­ lio caps-limits on the loans and securities they could hold on their books-and a 30% capital surplus requirement. So, even as each company reported billions of dollars in losses in 2007 and 2008, their regulator, the Office of Federal Housing Enterprise OverSight (OFHEO), loos­ ened those constraints. "From the fall of 2007, to the conservatorships, it was a tightrope with no safety net;' former OFHEO Director James Lockhart testified to the FCIC.3 Unfortunately, the balancing act ultimately failed and both companies were placed into conservatorship, costing the U.S. taxpayers $151 billion-so far.

'~ GOOD TIME TO BUY"

In an August 1, 2007, letter to Lockhart, Fannie Mae CEO Daniel Mudd sought im­ mediate relief from the portfolio caps required by the consent agreement executed in May 2006 following Fannie's accounting scandal. "We have witnessed growing evi­ dence of turmoil in virtually all sectors of the housing finance market;' Mudd wrote, and "the immediate crisis in subprime is indicative of a serious liquidity event im­ pacting the entire credit market, not just subprime."4 As demand for purchasing loans dried up, large lenders like Countrywide kept loans that they normally securitized, and smaller lenders went under. A number of firms told Fannie that they would stop making loans if Fannie would not buy them. Mudd argued that a relaxed cap would let his company provide that liquidity. "A moderate, 10 percent increase in the Fannie Mae portfolio cap would provide us with flexibility ... and send a strong signal to the market that the GSEs are able to address liquidity events before they become crises:' He maintained that the consent agree­ ment allowed OFHEO to lift the cap to address "market liquidity issues:' Moreover, the company had largely corrected its accounting and internal control deficiencies­ the primary condition for removing the cap. Finally, he stressed that the GSEs' char­ ter required Fannie to provide liquidity and stability to the market. "Ultimately:' Mudd concluded, "this request is about restoring market confidence that the GSEs can fulfill their stabilizing role in housing:'5 Fannie Mae executives also saw an opportunity to make money. Because there was less competition, the GSEs could charge higher fees for guaranteeing securities and pay less for loans and securities they wanted to own, enabling them (in theory) to increase returns.6 Tom Lund, a longtime Fannie Mae executive who led the firm's single-family business, told the FCIC that the market moved in Fannie Mae's favor af- SEPTEMBER 2008: THE TAKEOVER OF FANNIE MAE AND FREDDIE MAC 311 ter August 2007 as competitors dropped out and prices of loans and securities fell. Lund told FCIC staff that after the 2007 liquidity shock, Fannie had "more comfort that the relationship between risk and price was correcf'7 Robert Levin, the com­ pany's chief business officer, recalled, "It was a good time to buY:'8 On August 10, OFHEO's Lockhart notified Fannie that increasing the portfolio cap would be "premature" but the regulator would keep the request under "active consideration:' Lockhart wrote that he would not authorize changes, because Fannie could still guarantee mortgages even if it couldn't buy them and because Fannie re­ mained a "Significant supervisory concern:' In addition, Lockhart noted that Fannie could not prudently address the problems in the subprime and Alt-A mortgage mar­ ket, and the company's charter did not permit it to address problems in the market for jumbo loans (mortgages larger than the GSEs' loan limit).9 Although there had been progress in dealing with the accounting and internal control deficiencies, he ob­ served, much work remained. Fannie still had not filed financial statements for 2006 or 2007, "a particularly troubling issue in unsettled markets:'lo As Lockhart testified to the FCIC, "It became clear by August 2007 that the tur­ moil was too big for the Enterprises [the GSEs] to solve in a safe and sound manner:' He was worried that fewer controls would mean more losses. "They were fulfilling their mission:' Lockhart told the FCrC, "but they had no power to do more in a safe and sound manner. If their mission is to provide stability and lessen market turmoil, there was nothing in their capital structure" that would allow them to do SO.l1 Lockhart had worried about the financial stability of the two GSEs and about OFHEO's ability to regulate the behemoths from the day he became director in May 2006, and he advocated for more regulatory powers for his largely toothless agency. Lockhart pushed for the power to increase capital requirements and to limit growth, and he sought authority over mission goals set by the Department of Housing and Urban Development, as well as litigation authority independent of the Department of

Justice. His shopping list also included the authority to put Fannie and Freddie into I receivership, a power held by bank regulators over banks, and to liquidate the GSEs if necessary. As it stood, OFHEO had the authority to place the GSEs in conservator­ ship-in effect, to force a government takeover-but because it lacked funding to op­ erate the GSEs ,as conservator, that authority was impracticable. The GSEs would

deteriorate even further before Lockhart secured the powers he sought. 12

"THE ONLY GAME IN TOWN" But Fannie and Freddie were "the only game in town" once the housing market dried up in the summer of 2007, Paulson told the FCIC. And by the spring of 2008, "[the GSEs,] more than anyone, were the engine we needed to get through the problem:" 3 Few doubted Fannie and Freddie were needed to support the struggling housing market. The question was how to do so safely. '4 Purchasing and' guaranteeing risky mortgage-backed securities helped make money available for borrowers, but it could also result in further losses for the two huge companies later on. "There's a real trade­ off:' Lockhart said in late 2007-a trade-off made all the more difficult by the state of 312 FINANCIAL CRISIS INQUIRY COMMISSION REPORT the GSEs' balance sheets. '5 The value of risky loans and securities was swamping their reported capital. By the end of 2007, guaranteed and portfolio mortgages with FICO scores less than 660 exceeded reported capital at Fannie Mae by more than seven to one; Alt-A loans and securities, by more than six to one. Loans for which borrowers did not provide full documentation amounted to more than ten times re­ ported capital.'6 In mid-September, OFHEO relented and marginally loosened the GSEs' portfolio cap, from about $728 billion to $735 billion. It allowed Fannie to increase the amount of mortgage loans and securities it owned by 2% per year-a power that Freddie al­ ready had under its agreement with OFHEO. OFHEO ruled out more dramatic in­ creases "because the remediation process is not yet finished, many safety and soundness issues are not yet resolved, and the criteria in the Fannie Mae consent agreement and Freddie Mac's voluntary agreement have not been mef" 7 As the year progressed, Fannie and Freddie became increasingly important to the mortgage market. By the fourth quarter of 2007, they were purchasing 75% of new mortgages, nearly twice the 2006 level. With $5 trillion in mortgages resting on ra­ zor-thin capital, the GSEs were doomed if the market did not stabilize. According to Lockhart, "a withdrawal by Freddie Mac and Fannie Mae or even a drop in confi­ dence in the Enterprises would have created a self-fulfilling credit crisiS:'18 In early October, Senator Charles Schumer and Representative Barney Frank in­ troduced similar bills to temporarily lift portfolio limits on the GSEs by 10 percent, or approximately $150 billion, most of which would be designated for refinancing subprime loans. The measures, which Federal Reserve Chairman Ben Bernanke called "ill advised:' were not enacted. 19 In November, Fannie and Freddie reported third-quarter losses of $1.5 billion and $2 billion, respectively. At the end of December 2007, Fannie reported that it had $44 billion of capital to absorb potential losses on $879 billion of assets and $2.2 trillion of guarantees on mortgage-backed securities; if losses exceeded 1-45%, it would be insolvent. Freddie would be insolvent iflosses exceeded 1.7%. Moreover, there were serious questions about the validity of their "reported" capital.

"IT'S A TIME GAME ... BE COOL' In the first quarter, real gross domestic product fell 0.7% at an annual rate, reflecting in part the first decline in consumer spending since the early 1990S. The unemploy­ ment rate averaged 5% in the first three months of 2008, up from a low of 4-4% in spring of 2007. As the Fed continued to cut interest rates, the economy was sinking further into recession. In February, Congress passed the Economic Stimulus Act, which raised the limits on the size of mortgages that Fannie and Freddie could pur­ chase, among other measures. The push to get OFHEO to loosen requirements on the GSEs also continued. Schumer pressed OFHEO to justify or lower the 30% capital surcharge; such a strin­ gent requirement, he wrote Lockhart on February 25, hampered Fannie's ability to provide financing to homeowners.2o SEPTEMBER 2008: THE TAKEOVER OF FANNIE MAE AND FREDDIE MAC 313

Two days later, Fannie CEO Mudd reported losses in the fourth quarter of 2007, acknowledging that Fannie was "working through the toughest housing and mort­ gage markets in a generation:'21 The company had issued $7.8 billion of preferred stock, had completed all 81 requirements of the consent agreement with OFHEO, and was discussing with OFHEO the possibility of reducing the 30% capital surplus requirement. The next day, Freddie also reported losses and said the company had raised $6 billion of preferred stock. As both companies had filed current financial statements by this time, fulfilling a condition of lifting the restrictions imposed by the consent agreements, Lockhart an­ nounced that OFHEO would remove the portfolio caps on March 1, 2008. He also said OFHEO would consider gradually lowering the 30% capital surplus require­ ment, because both companies had made progress in satisfying their consent agree­ ments and had recently raised capital through preferred stock offerings. Mudd told the FCIC that he sought relief from the capital surplus requirement because he did not want to face further regulatory discipline if Fannie fell short of required capital levels. 22 On February 28, 2008, the day after OFHEO lifted the growth limits, a New York Fed analyst noted to Treasury that the 30% capital surcharge was a constraint that prevented the GSEs from providing additional liquidity to the secondary mortgage market.>3 Calls to ease the surcharge also came from the marketplace. Mike Farrell, the CEO of Annaly Capital Management, warned Treasury Undersecretary Robert Steel that a crisis loomed in the credit markets that only the GSEs could solve. "We be­ lieve that we are nearing a tipping point; ... lack of transparency on pricing for vir­ tually every asset class" and "a dearth of buyers" foreshadowed worse news, Farrell wrote. Removing the capital surcharge and passing legislation to overhaul the GSEs would make it possible for them to provide more stability, he said. Farrell recog­ nized that the GSEs might believe their return on capital would be insufficient, but contended that "they will have to get past that and focus on fulfilling their charters;' because "the big picture is that right now whatever is best for the economy and the financial security of America trumps the ROI [return on investment] for Fannie and Freddie shareholders:'14 Days before Bear Stearns collapsed, Steel reported to Mudd that he had "encour­ aging" conversations with Senator Richard Shelby, the ranking member of the Senate Committee on Banking, Housing, and Urban Affairs, and Representative Frank, chairman of the House Financial Services Committee, about the possibility of GSE reform legislation and capital relief for the GSEs. He intended to speak with Senate Banking Committee Chairman Christopher Dodd. Confident that the government desperately needed the GSEs to back up the mortgage market, Mudd proposed an "easier trade:' If regulators would eliminate the surcharge, Fannie Mae would agree to raise new capital.15 In a March 7 email to Fannie chief business officer Levin, Mudd suggested that the 30% capital surplus requirement might be reduced without any trade: "It's a time game ... whether they need us more ... or if we hit the capital wall first. Be coo1:'16 314 FINANCIAL CRISIS INQUIRY COMMISSION REPORT

On the next day, March 8, Treasury and White House officials received additional information about Fannie's condition. The White House economist Jason Thomas sent Steel an email enclosing an alarming analysis: it claimed that in reporting its 2007 financial results, Fannie was masking its insolvency through fraudulent ac­ counting practices. The analysis, which resembled one offered in a March 10 Barron's article, stated:

Any realistic assessment of Fannie Mae's capital position would show the company is currently insolvent. Accounting fraud has resulted in several asset categories (non-agency securities, deferred tax assets, low­ income partnership investment) being overstated, while the guarantee obligation liability is understated. These accounting shenanigans add up to tens of billions of exaggerated net worth. Yet, the impact of a tsunami of mortgage defaults has yet to run through Fannie's income statement and further annihilate its capital. Such grim results are a logical consequence of Fannie's dual mandate to serve the housing market while maximizing shareholder returns. In try­ ing to do both, Fannie has done neither well. With shareholder capital depleted, a government seizure of the company is inevitable.27

Given ilie turmoil of the Bear Stearns crisis, Paulson said he wanted to increase confidence in the mortgage market by having Fannie and Freddie raise capital. Steel told him that Treasury, OFHEO, and the Fed were preparing plans to relax the GSEs' capital surcharges in exchange for assurances that the companies would raise capital. On March 16, 2008, Steel also reported to his Treasury colleagues that William Dudley, then executive vice president of the New York Fed, wanted to "harden" the implicit government guarantee of Freddie and Fannie. Steel wrote that Dudley "leaned on me hard" to make the guarantee explicit in conjunction wiili dialing back the surcharge and attempting to raise new capital, and Steel worried about how this might affect the federal government's balance sheet: "I do not like that and it has not been part of my conversation with anyone else. I view that as a very significant move, way above my pay grade to double the size of the U.S. debt in one fell swOOp:'28

"THE IDEA STRIKES ME AS PERVERSE" Regulators at OFHEO and the Treasury huddled wiili GSE executives to discuss low­ ering capital requirements if ilie GSEs would raise more capital. "The entire mort­ gage market was at risk:' Lockhart told the FCIC.2 9 The pushing and tugging continued. Paulson told ilie FCIC that personal commitments from Mudd and Fred­ die Mac CEO Richard Syron to raise capital cinched the deal. 30 Just days earlier, on March 13, Syron had announced in a quarterly call to investors that his company would not raise new capital. Fannie and Freddie executives prepared a draft press re­ lease before a discussion with Lockhart and Steel. It announced a reduction in the capital surcharge from 30% to 20%. Lockhart was not pleased; the draft lacked a com- SEPTEMBER 2008: THE TAKEOVER OF FANNIE MAE AND FREDDIE MAC 315 mitment to raise additional capital, stating instead that the GSEs planned to raise it "over time as needed:'3 1 It looked as if the GSEs were making the deal with their fin­ gers crossed. In an email to Steel and the CEOs of both entities, Lockhart wrote: "The idea strikes me as perverse, and I assume it would seem perverse to the markets that a regulator would agree to allow a regulatee to increase its very high mortgage credit risk leverage (not to mention increasing interest rate risk) without any new capital:' The initial negotiations had the GSEs raising $2 of capital for each $1 of reduction in the surplus. Lockhart wrote in frustration, "We seem to have gone from 2 to 1 right through 1 to 1 to now 0 to 1:'3 2 Despite Lockhart's reservations, OFHEO announced the deal, unaltered in any material way, on March 19. OFHEO agreed to ease the capital restraint from 30% to 20%; Fannie and Freddie pledged to "begin the process to raise significant capital;' giving no concrete commitmentY Paulson told the FCIC that the agreement, which included a promise to raise capital, was "a no-brainer;' and that he had no memory of Lockhart ever having called it "perverse:'34 The market analyst Joshua Rosner panned the deal. "We view any reduction [in capital] as a comment not only on the GSEs but on the burgeoning panic in Wash­ ington;' he wrote. "If this action results in the destabilizing of the GSEs, OFHEO will go from being the only regulator that prevented its charges from getting into trouble, to a textbook example of why regulators should be shielded from outside political pressure:'35 Fannie would keep its promise by raising $7.4 billion in preferred stock. Freddie reneged. Executive Vice President Donald Bisenius offered two reasons why, in hind­ sight, Fannie Mae did not raise additional capital. First was protecting the assets of existing shareholders. ''I'm sure [Fannie's] investors are not very happy;' Bisenius told the FCIC. "Part two is ... if you actually fundamentally believe you have enough cap­ ital to withstand even a fairly significant downturn in house prices, you wouldn't raise capital:'36 Similarly, CEO Syron spoke of the downside of raising capital on August 6, 2008: "Raising a lot more capital at these kinds of prices could be quite dilutive to our shareholders, so we have to balance the interest of our shareholders:'37 But Lockhart saw it differently; in his view, Syron's public comments put "a good face on Freddie's inability to raise capital:' He speculated that Syron was masking a different concern: lawsuits. "[ Syron 1was getting advice from his attorneys about the high risk of raising capital before releasing [quarterly earnings] ... and our lawyers could not disagree because we know about their accounting issues;' Lockhart told the FCIC.38

"IT WILL INCREASE CONFIDENCE" In May, the two companies announced further losses in the first quarter. Even as the situation deteriorated, on June 9 OFHEO rewarded Fannie Mae for raising $7.4 bil­ lion in new capital by further lowering the capital surcharge, from 20% to 15%. In June, Fannie's stock fell 28%; Freddie's, 34%. The price of protection on $10 million in Fannie's debt through credit default swaps jumped to $66,000 in June, up from 316 FINANCIAL CRISIS INQUIRY COMMISSION REPORT

$47,700 in May; between 2004 and 2006, it had typically been about $13,000. In Au­ gust, they both reported more losses for the second quarter. Even after both Fannie and Freddie became public companies owned by share­ holders, they had continued to possess an asset that is hard to quantify: the implicit full faith and credit of the U.S. government. The government worried that it could not let the $ 5.3 trillion GSEs fail, because they were the only source ofliquidity in the mortgage market and because their failure would cause losses to owners of their debt and their guaranteed mortgage securities. Uncle Sam had rescued GSEs before. It bailed out Fannie when double-digit inflation wrecked its balance sheet in the early 1980s, and it came through in the mid-1980s for another GSE in duress, the Farm Credit System. In the mid-1990S, even a GSE-type organization, the Financing Cor­ poration, was given a helping hand. As the market grappled with the fundamental question of whether Fannie and Freddie would be backed by the government, the yield on the GSEs' long-term bonds rose. The difference between the rate that the GSEs paid on their debt and rates on Treasuries-a premium that reflects investors' assessment of risk-widened in 2007 to one-half a percentage point. That was low compared with the same figure for other publicly traded companies, but high for the ultra-safe GSEs. By June 2008, the spread had risen 65% over the 2007 level; by September 5, just before regulators parachuted in, the spread had nearly doubled from its 2007 level to just under 1%, making it more difficult and costly for the GSEs to fund their operations. On the other hand, the prices of Fannie Mae mortgage-backed securities actually increased slightly over this time period, while the prices of private-label mortgage-backed securities dra­ matically declined. For example, the price of the FNCI7 index-an index of Fannie mortgage-backed securities with an average coupon of 7%-increased from 102 in January 2007 to 103 on September 5, 2008, two days prior to the conservatorship. As another example, the price of the FNCI5 index-Fannie securities with an average coupon of 5%-increased from 95 to 96 during the same time period. In July and August 2008, Fannie suffered a liquidity squeeze, because it was un­ able to borrow against its own securities to raise sufficient cash in the repo market. Its stock price dove to less than $7 a share. Fannie asked the Fed for help.39 A senior adviser in the Federal Reserve Board's Division of Banking Supervision and Regula­ tion gave the FCIC a bleak account of the situation at the two GSEs and noted that "liquidity was just becoming so essential, so the Federal Reserve agreed to help pro­ vide it:'40 On July 13, the Federal Reserve Board in Washington authorized the New York Fed to extend emergency loans to the GSEs "should such lending prove necessary ... to promote the availability of home mortgage credit during a period of stress in fi­ nancial markets:'4 1 Fannie and Freddie would never tap the Fed for that fundingY Also on July 13, Treasury laid out a three-part legislative plan to strengthen the GSEs by temporarily increasing their lines of credit with the Treasury, authorizing Treasury to inject capital into the GSEs, and replacing OFHEO with the new Federal Housing Finance Agency (FHFA), with the power to place the GSEs into receiver­ ship. Paulson told the Senate that regulators needed "a bazooka" at their disposal. SEPTEMBER 2008: THE TAKEOVER OF FANNIE MAE AND FREDDIE MAC 317

"You are not likely to take it out;' Paulson told legislators. "I just say that by having something that is unspecified, it will increase confidence. And by increasing confi­ dence it will greatly reduce the likelihood it will ever be used:'43 Fannie's Mudd and Freddie's Syron praised the plan.44 At the end of July, Congress passed the Housing and Economic Recovery Act (HERA) of 2008, giving Paulson his bazooka-the ability to extend secured lines of credit to the GSEs, to purchase their mortgage, securities, and to inject capital. The 261-page bill also strengthened regulation of the GSEs by creating FHFA, an inde­ pendent federal agency, as their primary regulator, with expanded authority over Fannie's and Freddie's portfolios, capital levels, and compensation. In addition, the bill raised the federal debt ceiling by $800 billion to $10.6 trillion, providing funds to operate the GSEs if they were placed into conservatorship. After the Federal Reserve Board consented in mid-July to furnish emergency loans, Fed staff and representatives of the Office of the Comptroller of the Currency (OCC), along with Morgan Stanley, which acted as an adviser to Treasury, initiated a review of the GSEs. Timothy Clark, who oversaw the weeklong review for the Fed, told the FCIC that it was the first time they ever had access to information from the GSEs. He said that previously, "The GSEs [saw] the Fed as public enemy number one.... There was a battle between us and them:' Clark added, "We would deal with OFHEO, which was also very guarded. So we did not have access to info until they wanted funding from US:'45 Although Fed and OCC personnel were at the GSEs and conferring with executives, Mudd told the FCIC that he did not know of the agencies' involvement until their enterprises were both in conservatorship.46 The Fed and the OCC discovered that the problems were worse than their suspi­ cions and reports from FHFA had led them to believe. According to Clark, the Fed found that the GSEs were significantly "underreserved;' with huge potential losses, and their operations were "unsafe and unsound:'47 The OCC rejected the forecasting methodologies on which Fannie and Freddie relied. Using its own metrics, it found insufficient reserves for future losses and identified significant problems in credit and risk management. Kevin Bailey, the OCC deputy comptroller for regulatory policy, told the FCIC that Fannie's loan loss forecasting was problematic, and that its loan losses therefore were understated. He added that Fannie had overvalued its deferred tax assets-because without future profits, deferred tax assets had no value.48 Loss projections calculated by Morgan Stanley substantiated the Fed's and OCC's findings. Morgan Stanley concluded that Fannie's loss projection methodology was flawed, and resulted in the company substantially understating losses. Nearly all of the loss projections calculated by Morgan Stanley showed that Fannie would fall be­ low its regulatory capital requirement. Fannie's projections did not. All told, the litany of understatements and shortfalls led the OCC's Bailey to a firm conclusion. If the GSEs were not insolvent at the time, they were "almost there;' he told the FCIC.49 Regulators also learned that Fannie was not charging offloans un­ til they were delinquent for two years, a head-in-the-sand approach. Banks are re­ quired to charge off loans once they are 180 days delinquent. For these and numerous other errors and flawed methodologies, Fannie and Freddie earned rebukes. "Given 318 FINANCIAL CRISIS INQUIRY COMMISSION REPORT the role of the GSEs and their market dominance;' the OCC report said, "they should be industry leaders with respect to effective and proactive risk management, produc­ tive analysis, and comprehensive reporting. Instead they appear to significantly lag the industry in all respects:'5 0

"CRITICAL UNSAFE AND UNSOUND PRACTICES" Paulson told the FCIC that although he learned of the Fed and OCC findings by Au­ gust 15, it took him three weeks to convince Lockhart and FHFA that there was a cap­ ital shortfall, that the GSEs were not viable, and that they should be placed under government controlY On August 22, FHFA informed both Mudd and Syron that their firms were "adequately capitalized" under the regulations, a judgment based on finan­ cial information that was "certified and represented as true and correct by [GSE] man­ agement:' But FHFA also emphasized that it was "seriously concerned about the current level of Fannie Mae's capital" if the housing market decline continued.52 Fannie's prospects for increasing capital grew gloomier. Fannie informed Treasury on August 25-and repeatedly told FHFA-that raising capital was infeasible and that the company was expecting additional losses. Even Fannie's "base-case earnings forecast" pointed to substantial pressure on solvency, and a "stressed" forecast indi­ cated that "capital resources will continue to decline:'53 By September 4, Lockhart and FHFA agreed with Treasury that ilie GSEs needed to be placed into conservatorship. That day, Syron and Mudd received blistering midyear reviews from FHFA. The opening paragraph of each letter informed the CEOs that their companies had been downgraded to "critical concerns;' and that "the critical unsafe and unsound practices and conditions that gave rise to the Enterprise's existing condition, the deterioration in overall asset quality and significant earnings losses experienced ilirough June 2008, as well as forecasted future losses, likely re­ quire recapitalization of the Enterprise:'54 A bad situation was expected to worsen. The 21-page report sent to Fannie identified sweeping concerns, including fail­ ures by the board and senior management, a Significant drop in ilie quality of mort­ gages and securities owned or guaranteed by the GSE, insufficient reserves, the almost exclusive reliance on short-term funding, and the inability to raise additional capital. FHFA admonished management and the board for their "imprudent deci­ sions" to "purchase or guarantee higher risk mortgage products:' The letter faulted Fannie for purchasing high-risk loans to "increase market share, raise revenue and meet housing goals;' and for attempting to increase market share by competing with Wall Street firms that purchased lower-quality securities. FHFA, noting "a conflict between prudent credit risk management and corporate business objectives;' found that these purchases of higher-risk loans were predicated on the relaxing of under­ writing and eligibility standards. Using models that underestimated this risk, the GSE then charged fees even lower than what its own deficient models suggested were appropriate. FHFA determined that iliese lower fees were charged because "fo­ cus was improperly placed on market share and competing with Wall Street and [Freddie Mac]:'55 SEPTEMBER 2008: THE TAKEOVER OF FANNIE MAE AND FREDDIE MAC 319

Even after internal reports pointed to market problems, Fannie kept buying and guaranteeing riskier loan products, FHFA said. "Despite signs in the latter half of 2006 and 2007 of emerging problems, management continued activity in risky pro­ grams, and maintained its higher eligibility program for Alt-A loans without estab­ lishing limits:'56 The company also bought private-label securities backed by Alt-A and subprime 10ansY Losses were likely to be higher than the GSEs had estimated, FHFAfound. FHFA also noted "increasing questions and concerns" regarding Fannie's account­ ing. The models it used to forecast losses had not been independently validated or updated for several years. FHFA judged that in an up-to-date model, estimated losses would likely show a "material increase:' In addition, Fannie had overvalued its de­ ferred tax assets. Applying more reasonable projections of future performance, FHFA found this benefit to be significantly overstated. 58 The 22-page report delivered to Freddie included similarly harsh assessments of that GSE's safety and soundness, but more severe criticisms of its management and board. In particular, the report noted a significant lack of market confidence, which had "eliminated the ability to raise capital:' FHFA, for its part, "lost confidence in the Board of Directors and the executive management team;' holding them accountable for losses stemming from "a series of ill-advised and poorly executed decisions and other serious misjudgments:' According to the regulator, they therefore could not be relied on, particularly in light of their widespread failures to resolve regulatory issues and address criticisms. In addition, FHFA said that Freddie's failure to raise capital despite its assurances "invite[d]" the conclusion that the board and CEO had not ne­ gotiated "in good faith" about the capital surcharge reduction.59 As in its assessment of Fannie, FHFA found that Freddie's unsafe and unsound practices included the purchase and guarantee of higher-risk loan products in 2006 and 2007 in a declining market. Even after being told by the regulator in 2006 that its purchases of subprime private-label securities had outpaced its risk management abil­ ities, Freddie bought $22 billion of subprime securities in each subsequent quarter. FHFA also found that "aggressive" accounting cast doubt on Freddie's reported earnings and capital. Despite "clear signals" that losses on mortgage assets were likely, Freddie waited to record write-downs until the regulator threatened to issue a cease and desist order. Even then, one write-down was reversed "just prior to the issuance of the second quarter financial statements:' The regulator concluded that rising delinquencies and credit losses would "result in a substantial dissipation of earnings and capital:'60

"THEY WENT FROM ZERO TO THREE WITH NO WARNING IN BETWEEN" Mudd told the FCIC that its regulator had never before communicated the kind of criticisms leveled in the September 4 letter. He said the regulator's "chronicling of the situation" then was "inconsistent with what you would consider better regulatory practice to be-like, first warning: fix it; second warning: fix it; third warning: you're 320 FINANCIAL CRISIS INQUIRY COMMISSION REPORT out of here. Instead, they went from zero to three with no warning in between:'61 A review of the examination reports and other documents provided by FHFA to the FCIC largely supports Mudd's view on this specific point. While OFHEO's examina­ tion reports noted concerns about increasing credit risk and slow remediation of de­ ficiencies required by the May 2006 consent agreement, they do not include the sweeping criticisms contained in the September 4 letter. Two days after their two companies were designated "critical concerns;' Mudd at Fannie and Syron at Freddie faced a government takeover. On September 6, FHFA Acting Deputy Director Chris Dickerson sent separate memos to Lockhart recom­ mending that FHFA be appointed conservator for each GSE.62 Still, conservatorship was not a foregone conclusion. Paulson, Lockhart, and Bernanke met with Mudd, Syron, and their boards to persuade them to cede con­ trol,63 Essentially the GSEs faced a Hobson's choice: take the horse offered or none at all. "They had to voluntarily agree to a consent agreement;' Lockhart told the FCIC. The alternative, a hostile action, invited trouble and "nasty lawsuits;' he noted. "So we made a ... very strong case so the board of directors did not have a choice:'64 Paulson reminded the GSEs that he had authority to inject capital, but he would not do so un­ less they were in conservatorship.65 Mudd was "stunned and angry;' according to Paulson.66 Tom Lund, who ran Fan­ nie Mae's single-family business, told the FCIC that conservatorship came as a sur­ prise to everyone. 67 Levin told the FCIC that he never saw a government seizure coming. He never imagined, he said, that Fannie Mae was or might become insol­ vent.68 Interviewed in 2010, Mudd told the FCIC: "I did not think in any way it was fair for the government to have been in a position of being in the chorus for the com­ pany to add capital, and then to inject itself in the capital structure:'69 The conserva­ torship memoranda reiterated all the damning evidence presented in the letters two days earlier. Losses at Fannie Mae for the year were estimated to be between $18 bil­ lion and $50 billion,7° Freddie Mac's memorandum differed only in the details. Its losses, recorded at $1 billion in the first six months of 2008, were projected to end up between $11 and $32 billion by the end ofthe year,71 Although the boards had a choice, the only realistic option was assent. "We were go­ ing to agree to go in a conservatorship anyway,' Syron told the FCIC. "There was a very clear message that the [September 41 letter was there as a mechanism to bring about a resulf'72 Mudd agreed, observing that "the purpose of the letter was really to force con­ servatorship:'73 The boards of both companies voted to accept conservatorship. Both CEOs were ousted, but the fundamental problems persisted. As promised, the Treasury was prepared to take two direct steps to support solvency. First, it would buy up to $200 billion of senior preferred stock from the GSEs and extend them short-term secured loans. In addition, it pledged to buy GSE mortgage-backed secu­ rities from Wall Street firms and others until the end of 2009. Up front, Treasury bought from each GSE $1 billion in preferred stock with a 10% dividend. Each GSE also gave Treasury warrants to purchase common stock representing 79.9% of shares outstanding. Existing common and preferred shareholders were effectively wiped out. The decline in value of the preferred stock caused losses at many banks that held SEPTEMBER 2008: THE TAKEOVER OF FANNIE MAE AND FREDDIE MAC 321 these securities, contributing to the failure of 10 institutions and to the downgrading of 3 5 to less than "well capitalized" by their regulators/4 Paulson told the Fcrc that he was "naive" enough to believe that the action would halt the crisis because it "would put a floor under the housing market decline, and provide confidence to the market:' He realized he was wrong on the next day, when, as he told the FCrC, "Lehman started to gO:'75 Former Treasury Assistant Secretary Neel Kashkari agreed. "We thought that after we stabilized Fannie and Freddie that we bought ourselves some time. Maybe a month, maybe three months. But they were such profound interventions, stabilizing such a huge part of the financial markets, that would buy us some time. We were surprised that Lehman then happened a week later, that Lehman had to be taken over or it would go into bankruptci'76 The firms' failure was a huge event and increased the magnitude of the crisis, ac­ cording to Fed Governor Kevin Warsh and New York Fed General Counsel Tom Bax­ terP Warsh also told the Fcrc that the events surrounding the GSE takeover led to "a massive, underreported, underappreciated jolt to the system:' Then, according to Warsh, when the market grasped that it had misunderstood the risks associated with the GSEs, and that the government could have conceivably let them fail, it "caused in­ vestors to panic about the value of every asset, to reassess every portfolio:'78 FHFA Director Lockhart described the decision to put the GSEs into conservator­ ship in the context of Lehman's failure. Given that the investment bank's balance sheet was about one-fifth the size of Fannie Mae's, he felt that the fallout from Lehman's bankruptcy would have paled in comparison to a GSE failure. He said, "What happened after Lehman would have been very small compared to these $5.5 trillion institutions failing:'79 Major holders of GSE securities included the Chinese and Russian central banks, which, between them, owned more than half a trillion dollars of these securities, and U.S. financial firms and investment funds had even more extensive holdings. A 2005 Fed study concluded that U.S. banks owned more than $1 trillion in GSE debt and securities-more than 150% of the banks' Tier 1 cap­ ital and 11 % of their total assets at the time.8o Testifying before the FCrC, Mudd claimed that failure was all but inevitable. "rn 2008, the companies had no refuge from the twin shocks of a housing crisis followed by a financial crisis;' he said. "A monoline GSE structure asked to perform multiple tasks cannot withstand a multiyear 30% home price decline on a national scale, even without the accompanying global financial turmoil. The model allowed a balance of business and mission when home prices were rising. When prices crashed far beyond the realm of historical experience, it became 'The Pit and the Pendulum; a choice be­ tween horrible alternatives:'81

"THE WORST- RUN FINANCIAL INSTITUTION" When interviewed by the FCrC, FHFA officials were very critical of Fannie's manage­ ment. John Kerr, the FHFA examiner (and an acc veteran) in charge of Fannie ex­ aminations, minced no words. He labeled Fannie "the worst-run financial institution" he had seen in his 30 years as a bank regulator. Scott Smith, who became 322 FINANCIAL CRISIS INQUIRY COMMISSION REPORT associate director at FHFA after that agency replaced OFHEO, concurred; in his view, Fannie's forecasting capabilities were not particularly well thought out, and lacked a variety of stress scenarios. Both officials noted Fannie's weak forecasting models, which included hundreds of market simulations but scarcely any that contemplated declines in house prices. To Austin Kelly, an OFHEO examination specialist, there was no relying on Fannie's numbers, because their "processes were a bowl of spaghetti:' Kerr and a colleague said that that they were struck that Fannie Mae, a multitrillion-dollar company, employed unsophisticated technology: it was less tech­ savvy than the average community bank.8> Nonetheless, OFHEO's communications with Fannie prior to September 4 did not fully reflect these criticisms. FHFA officials conceded that they had made mis­ takes in their oversight of Fannie and Freddie. They paid too much attention to fix­ ing operational problems and did not react to Fannie's increasing credit risk. Lockhart told the FCIC that more resources should have been dedicated to assessing credit risk of their mortgage assets and guarantees.83 Current FHFA Acting Director Edward DeMarco told the FCIC that it would not pass the "reasonable person test" to deny that OFHEO took its eye off the ball by not paying sufficient attention to credit risk and instead focused on operational risk, accounting and lack of audited results.84 To Mudd and others, OFHEO's mistakes were not surprising. Mudd told the FCIC that the regulators' skill levels were "developing but below average:'8 5 Henry Cisneros, a former housing and urban development secretary, expressed a similar view. "OFHEO;' Cisneros told the FCIC, "was puny compared to what Fannie Mae and Freddie Mac could muster in their intelligence, their Ivy League educations, their rocket scientists in their place, their lobbyists, their ability to work the Hill:'86 The costs of the bailouts have been enormous and are expected to increase. From January 1, 2008, through the third quarter of 2010, the two companies lost $229 bil­ lion, wiping out $71 billion of combined capital that they had reported at the end of 2007 and the $7 billion of capital raised by Fannie in 2008. Treasury narrowed the gap with $151 billion in support. FHFA has estimated that costs through 2013 will range from $221 billion to $363 billion. The Congressional Budget Office has pro­ jected that the economic cost of the GSEs' downfall, including the total financial cost of government support as well as actual dollar outlays, could reach $389 billion by 2019.

"WASN'T DONE AT MY PAY GRADE" Fannie's two most senior executives were asked at an FCIC hearing how their charter could have been changed to make the company more sound, and to avoid the multi­ billion-dollar bailout. Mudd, who made approximately $65 million from 2000 to 2008, testified that "the thing that would have made the institution more sound or have produced a different outcome would have been for it to have become over time a more normal financial institution able to diversify, able to allocate capital, able to be SEPTEMBER 2008: THE TAKEOVER OF FANSIE MAE AND FREDDIE MAC 323 long or short in the market, able to operate internationally. And if the trade for that would have been, you know, a cut in the so-called implicit ties with the government, I think that would have-that would have been a better solution:'87 Chief Business Of­ ficer Levin, who received approximately $45 million from 2000 to 2008, answered only that making such decisions "wasn't done at my pay grade:'88

COMMISSION CONCLUSIONS ONCHAPTE! 11

The COn;l1llis~ion .C(1ncIndes that th~ 1:>1.l~i~ model of Fannie Mae and Freddie Mac ~tbe GSBs); as. private-secto.r, publicly traded, pro.!it-makil'lg c()mpa~ with implicit'~9veri:tmel'lt bacltin$ and it Jiub1icmillsi~. Wts1Uni.'!am:el'ltallyflawed. We fin

CONTENTS "Get more conservatively funded" ...... 325 "This is not sounding good at all" ...... 327 "Spook the market" ...... 328 '1magination hat" ...... 331 "Heads offamily" ...... ·333 "Tell those sons of bitches to unwind" ...... 334 "This doesn't seem like it is going to end pretty" ...... 335 "The only alternative was that Lehman had to fail" ...... 338 I\. calamity" ...... 339

Solvency should be a simple financial concept: if your assets are worth more than your liabilities, you are solvent; if not, you are in danger of bankruptcy. But on the af­ ternoon of Friday, September 12, 2008, experts from the country's biggest commer­ cial and investment banks'met at the Wall Street offices of the Federal Reserve to ponder the fate of Lehman Brothers, and could not agree whether or not the 157- year-old firm was solvent. Only two days earlier, Lehman had reported shareholder equity-the measure of solvency-of $28 billion at the end of August. Over the previous nine months, the bank had lost $6 billion but raised more than $10 billion in new capital, leaving it with more reported equity than it had a year earlier. But this arithmetic reassured hardly anyone outside the investment bank. Fed offi­ cials had been discussing Lehman's solvency for months, and the stakes were very high. To resolve the question, the Fed would not rely on Lehman's $28 billion figure, given questions about whether Lehman was reporting assets at market value. As one New York Fed official wrote to colleagues in July, "Balance-sheet capital isn't too rele­ vant if you're suffering a massive run:" If there is a run, and a firm can only get fire­ sale prices for assets, even large amounts of capital can disappear almost overnight. The bankers thought Lehman's real estate assets were overvalued. In light of

324 SEPTEMBER 2008: THE BANKRUPTCY OF LEHMAN 325

Lehman's unreliable valuation methods, the bankers had good reason for their doubts. None of the bankers at the New York Fed that weekend believed the $54 bil­ lion in real estate assets (excluding real estate held for sale) on Lehman's books was an accurate figure. If the assets were worth only half that amount (a likely scenario, given market conditions), then Lehman's $28 billion in equity would be gone. In a fire sale, some might sell for even less than half their stated value. "What does solvent mean?" JP Morgan CEO Jamie Dimon responded when the FCIC asked if Lehman had been solvent. "The answer is, I don't know. I still could not answer that question:" JP Morgan's Chief Risk Officer Barry Zubrow testified be­ fore the FCIC that "from a pure accounting standpoint, it was solvent;' although "it obviously was financing its assets on a very leveraged basis with a lot of short-term fi­ nancing:'3 Testifying before the FCIC, former Lehman Brothers CEO Richard Fuld insisted his firm had been solvent: "There was no capital hole at Lehman Brothers. At the end of Lehman's third quarter, we had $28.4 billion of equity capital:'4 Fed Chairman Ben Bernanke disagreed: "I believe it had a capital hole:' He emphasized that New York Federal Reserve Bank President Timothy Geithner, Treasury Secretary Henry Paul­ son, and SEC Chairman Christopher Cox agreed it was "just way too big a hole. And my own view is it's very likely that the company was insolvent, even, not just illiq­ uid:'5 Others, such as Bank of America CEO Ken Lewis, who that week considered acquiring Lehman with government support, had no doubts either. He told the FCIC that Lehman's real estate and other assets had been overvalued by $60 to $70 bil­ lion-a message he had delivered to Paulson a few days before Lehman declared bankruptcy.6 It had been quite a week; it would be quite a weekend. The debate will continue over the largest bankruptcy in American history, but nothing will change the basic facts: a consortium of banks would fail to agree on a rescue, two last-minute deals would fall through, and the government would decide not to rescue this investment bank-for financial reasons, for political reasons, for practical reasons, for philo­ sophical reasons, and because, as Bernanke told the FCIC, if the government had lent money, "the firm would fail, and not only would we be unsuccessful but we would have saddled the taxpayer with tens of billions of dollars of losses:'7

"GET MORE CONSERVATIVELY FUNDED"

After the demise of Bear Stearns in March 2008, most observers-including Bernanke, Paulson, Geithner, and Cor-viewed Lehman Brothers as the next big worry among the four remaining large investment banks. Geithner said he was "con­ sumed" with finding a way that Lehman might "get more conservatively funded:'9 Fed Vice Chairman Donald Kohn told Bernanke that in the wake of Bear's collapse, some institutional investors believed it was a matter not of whether Lehman would fail, but when. 10 One set of numbers in particular reinforced their doubts: on March 18, the day after JP Morgan announced its acquisition of Bear Stearns, the market FINANCIAL CRISIS INQUIRY COMMISSION REPORT

(through credit default swaps on Lehman's debt) put the cost of insuring $10 million of Lehman's five-year senior debt at $310,000 annually; for Merrill Lynch, the cost was $241,000; and for Goldman Sachs, $165,000. The chief concerns were Lehman's real estate-related investments and its reliance on short-term funding sources, including $7.8 billion of commercial paper and $197 billion of repos at the end of the first quarter of 2008. There were also concerns about the finn's more than 900,000 derivative contracts with a myriad of counterparties. 11 As they did for all investments banks, the Fed and SEC asked: Did Lehman have enough capital-real capital, after possible asset write-downs? And did it have suffi­ cient liquidity-cash-to withstand the kind of run that had taken down Bear Stearns? Solvency and liquidity were essential and related. If money market funds, hedge funds, and investment banks believed Lehman's assets were worth less than Lehman's valuations, they would withdraw funds, demand more collateral, and cur­ tail lending. That could force Lehman to sell its assets at fire-sale prices, wiping out capital and liquidity virtually overnight. Bear proved it could happen. "The SEC traditionally took the view that liquidity was paramount in large securi­ ties firms, but the Fed, as a consequence of its banking mandate, had more of an em­ phasis on capital raising:' Erik Sirri, head of the SEC's Division of Trading and Markets, told the FCIC. "Because the Fed had become the de facto primary regulator because of its balance sheet, its view prevailed. The SEC wanted to be collaborative, and so came to accept the Fed's focus on capital. However, as time progressed, both saw the importance of liquidity with respect to the problems at the large investment banks:'" In fact, both problems had to be resolved. Bear's demise had precipitated Lehman's "first real financing difficulties" since the liquidity crisis began in 2007, Lehman Treasurer Paolo Tonucci told the FCIC.'3 Over the two weeks following Bear's collapse, Lehman borrowed from the Fed's new lending facility, the Primary Dealer Credit Facility (PDCF),'4 but had to be careful to avoid seeming overreliant on the PDCF for cash, which would signal funding problems. Lehman built up its liquidity to $45 billion at the end of May, but it and Merrill performed the worst among the four investment banks in the regulators' liquidity stress tests in the spring and summer of 2008. Meanwhile, the company was also working to improve its capital position. First, it reduced real estate exposures (again, excluding real estate held for sale) from $90 bil­ lion to $71 billion at the end of May and to $54 billion at the end ofthe summer. Sec­ ond, it raised new capital and longer-term debt-a total of $15.5 billion of preferred stock and senior and subordinated debt from April through June 2008. Treasury Undersecretary Robert Steel praised Lehman's efforts, publicly stating that it was "addressing the issues:'" But other difficulties loomed. Fuld would later describe Lehman's main problem as one of market confidence, and he suggested that the company's image was damaged by investors taking "naked short" positions (short selling Lehman's securities without first borrowing them), hoping Lehman would fail, and potentially even helping it fail by eroding confidence. "Bear went down on ru­ mors and a liquidity crisis of confidence:' Fuld told the FCIC. "Immediately there- SEPTEMBER 2008: THE BANKRUPTCY OF LEHMAN 327 after, the rumors and the naked short sellers came after US:'16 The company pressed the SEC to clamp down on the naked short selling. 17 The SEC's Division of Risk, Strategy and Financial Innovation shared with the FCIC a study it did concerning short selling. As Chairman Mary Schapiro explained to the Commission, "We do not have information at this time that manipulative short selling was the cause of the col­ lapse of Bear and Lehman or of the difficulties faced by other investment banks dur­ ing the fall of 2008:' The SEC to date has not brought short selling charges related to the failure of these investment banks. IS On March 18, Lehman reported better-than-expected earnings of $489 million for the first quarter of 2008. Its stock jumped nearly 50%, to $46.49. But investors and analysts quickly raised questions, especially concerning the reported value of Lehman's real estate assets. Portfolio. com called Lehman's write-downs "suspiciously minuscule:'19 In a speech in May, David Einhorn of Greenlight Capital, which was then shorting Lehman's stock, noted the bank's large portfolio of commercial real es­ tate loans and said, "There is good reason to question Lehman's fair value calcula­ tions .... I suspect that greater transparency on these valuations would not inspire market confidence:'>o Nell Minow, editor and co-founder of the Corporate Library, which researches and rates firms on corporate governance, raised other reasons that observers might have been skeptical of management at Lehman. "On Lehman Brothers' [board], ... they had an actress, a theatrical producer, and an admiral, and not one person who understood financial derivatives:'" The Corporate Library gave Lehman a D rating in June 2004, a grade it downgraded to F in September 2008.22 On June 9, Lehman announced a preliminary $2.8 billion loss for its second quarter-the first loss since it became a public company in 1994. The share price fell to $30. Three days later Lehman announced it was replacing Chief Operating Officer Joseph Gregory and Chief Financial Officer Erin Callan. The stock slumped again, to $22.70.

"THIS IS NOT SOUNDING GOOD AT ALr'

After Lehman reported its final second-quarter results on June 12, the New York Fed's on-site monitor at Lehman, Kirsten Harlow, reported that there had been "no adverse information on liquidity, novations, terminations or ability to fund either se­ cured or unsecured [funds]:'>3 The announced liquidity numbers were better that quarter, as were the capital numbers. Nevertheless, Lehman's lenders and supervisors were worried. The next morning, William Dudley, then head of the New York Fed's Markets Group (and its current president), emailedBernanke.Geithner. Kohn, and others that the PDCF should be extended because it "remains critical to the stability" of some of the investment banks-particularly Lehman. "I think without the PDCF, Lehman might have experi­ enced a full blown liquidity crisis;' he wrote.>4 Just one week after the earnings release, Harlow reported that Lehman was in­ cleed having funding difficulties. Four financial institutions had "trading issues" ~ith Lehman and had reduced their exposure to the firm, including Natixis, a FINANCIAL CRISIS INQUIRY COMMISSION REPORT

French investment bank that had already eliminated all activity with Lehman. JP Morgan reported that large pension funds and some smaller Asian central banks were reducing their exposures to Lehman, as well as to Merrill Lynch. And Citi­ group requested a $3 to $5 billion "comfort deposit" to cover its exposure to Lehman, settling later for $2 billion. 2s In an internal memo, Thomas Fontana, the head of risk management in Citigroup's global financial institutions group, wrote that "loss of confidence [in Lehman] is huge at the momenf'26 Timothy Clark, sen­ ior adviser in the Federal Reserve's banking supervision and regulation division, was short and direct: "This is not sounding good at all:'2 7 On June 25, results from the regulators' most recent stress test showed that Lehman would need $15 billion more than the $54 billion in its liquidity pool to sur­ vive a loss of all unsecured borrowings and varying amounts of secured borrowings!8 Lehman's borrowings in the overnight commercial paper market were increasing, however, from $3 billion at the end of November 2007 to $8 billion at ilie end of May 2008. And it was reliant on repo funding, particularly the portions that matured overnight and were collateralized by illiquid assets. 29 As of mid-June, 62% of Lehman's liquidity was dependent on borrowing against nontraditional securities, such as illiquid mortgage-related securities-which could not be financed with the PDCF and of which investors were becoming increasingly wary. 30 On July 10, Federated Investors-a large money market fund and one of Lehman's largest tri-party repo lenders-notified JP Morgan, Lehman's clearing bank, that Fed­ erated would "no longer pursue additional business with Lehman;' because JP Mor­ gan was "unwilling to negotiate in good faith" and had "become increasingly uncooperative" on repo termsY Dreyfus, another large money market fund and a Lehman tri-party repo lender, also pulled its tepo line from the firmY

"SPOOK THE MARKET" As the Fed considered ilie risks of the tri -party repo market, it also mulled over more specific measures to help Lehman. The New York Fed and FDIC both rejected the company's proposal to convert to a bank holding company, a proposal which Geith­ ner told Fuld was "gimmicky" and "[could not] solve a liquidity/capital problem:'H A proposal by the Fed's Dudley followed the Bear Stearns model: $60 billion of Lehman's assets would be held by a new special-purpose vehicle, financed by $5 bil­ lion of Lehman's equity and a $55 billion loan from ilie Fed. This proposal would re­ move the illiquid assets from the market and potentially avert a fire sale that could render Lehman insolvent.34 It didn't go anywhere. But when that idea was floated in July, the need for such action was still somewhat speculative. Not so by August. In an August 8 email to colleagues at the Federal Re­ serve and Treasury, Patrick Parkinson, then the deputy director of ilie Federal Re­ serve Board's Division of Research and Statistics, described a "game plan" that would (1) identify activities of Lehman that could significantly harm financial markets and the economy if it filed for chapter 11 bankruptcy protection, (2) gather information SEPTEMBER 2008: THE BANKRUPTCY OF LEHMAN 329 to more accurately assess the potential effects of its failure, and (3) identify risk miti­ gation actions for areas of serious potential harm.35 As they now realized, regulators did not know nearly enough about over-the­ counter derivatives activities at Lehman and other investment banks, which were ma­ jor OTC derivatives dealers. Investment banks disclosed the total number of OTC derivative contracts they had, the total exposures of the contracts, and their esti­ mated market value, but they did not publicly report the terms of the contracts or the counterparties. Thus, there was no way to know who would be owed how much and when payments would have to be made-information that would be critically impor­ tant to analyze the possible impact of a Lehman bankruptcy on derivatives counter­ parties and the financial markets. Parkinson reviewed a standing recommendation to form a "default management group" of senior executives of major market participants to work with regulators to anticipate issues if a major counterparty should default. The recommendation was from the private-sector Counterparty Risk Management Policy Group, the same group that had alerted the Fed to the backlog problem in the OTC derivatives market earlier in the decade. Parkinson suggested accelerating the formation of this group while being careful not to signal concerns about anyone market participant. 36 On August 15, Parkinson emailed New York Fed officials that he was worried that no sensible game plan could be formulated without more information.37 He was in­ formed that New York Fed officials had just met with Lehman two days earlier to ob­ tain derivative-related information, that they still needed more information, and that the meeting had "caused a stir:' which in turn required assurances that requests for information would not be limited to Lehman.38 New York Fed officials were also "very reluctant" to request copies of the master agreements that would shed light on the Lehman's derivatives counterparties, be­ cause such a request would send a "huge negative signal:'39 The formation of the in­ dustry group seemed "less provocative:' wrote a New York Fed official, but could still "spook the markef'40 Parkinson believed that the information was important, but at­ tempting to collect it was "not without risks:'4 1 He also recognized the difficulties in unraveling the complex dependencies among the many Lehman subsidiaries and their counterparties, which would keep lawyers and accountants busy for a long timeY On August 28, Treasury's Steve Shafran informed Parkinson that Secretary Paul­ son agreed on the need to collect information on OTC derivatives. 43 It just had to be done in a way that minimized disruptions. On September 5, Parkinson circulated a draft letter requesting the information from Lehman CEO Fuld.44 Geithner would ask E. Gerald Corrigan, the Goldman Sachs executive and former New York Fed president who had co-chaired the Counterparty Risk Management Policy Group re­ port, to form an industry group to advise on information needed from a troubled in­ vestment bank. Parkinson, Shafran, and others would also create a "playbook" for an investment bank failure at Secretary Paulson's request. Events over the following week would render these efforts moot. 330 FINANCIAL CRISIS INQUIRY COMMISSION REPORT

On September 4, executives from Lehman Brothers apprised executives at JP Morgan, Lehman's tri-party repo clearing bank, of the third-quarter results that it would announce two weeks later. A $3.9 billion loss would reflect "significant asset write-downs:' The firm was also considering several steps to bolster capital, includ­ ing an investment by Korea Development Bank or others, the sale of Lehman's invest­ ment management division (Neuberger Berman), the sale of real estate assets, and the division of the company into a "good bank" and "bad bank" with private equity sponsors.45 The executives also discussed JP Morgan's concerns about Lehman's repo collateral. On Monday, September 8, more than 20 New York Fed officials were notified of a meeting the next morning "to continue the discussion of near-term options for deal­ ing with a failing nonbank:' They received a list documenting Lehman's tri-party repo exposure at roughly $200 billion. Before its collapse, Bear Stearns's exposure had been only $50 to $80 billion. The documentation further noted that 10 counterpar­ ties provided 80% ofLehman's repo financing, and that intraday liquidity provided by Lehman's clearing banks could become a problem. Indeed, JP Morgan, Citigroup, and Bank of America had all demanded more collateral from Lehman, with the threat they might "cut off Lehman if they don't receive it:'46 On Tuesday morning, September 9, news there would be no investment from Ko­ rea Development Bank shook the market. Lehman's stock plunged 55% from the day before, closing at $7.79. To prepare for an afternoon call with Bernanke, Geithner di~ rected his staff to "put together a quick 'what's different? what's the same?' list about [Lehman] vs [Bear Stearns], as well as about mid-March (then) vs. early Sept (now):'47 The Fed's Parkinson em ailed Treasury's Shafran about his concerns that Lehman would announce further losses the next week, that it might not be able to raise equity, and that even though its liquidity position was better than Bear Stearns's had been, Lehman remained vulnerable to a loss of confidence.48 At 5:00 P.M., Paulson convened a call with Cox, Geithner, Bernanke, and Treasury staff "to deal with a possible Lehman bankruptcY:'49 At 5:20 P.M., Treasury Chief of Staff Jim Wilkinson emailed Michelle Davis, the assistant secretary for public affairs at Treasury, to express his distaste for government assistance: "We need to talk.... I just can't stomach us bailing out lehman.... Will be horrible in the press don't u think:'5 0 That same day, Fuld agreed to post an additional $3.6 billion of collateral to JP Morgan. Lehman's bankruptcy estate would later claim that Lehman did so because of JP Morgan's improper threat to withhold repo funding. Zubrow said JP Morgan re­ quested the collateral because of its growing exposure as a derivatives trading coun­ terparty to LehmanY Steven Black, JP Morgan's president, said he requested $5 billion from Lehman, which agreed to post $3.6 billionY He did not believe the re­ quest put undue pressure on Lehman. On Tuesday night, executives of Lehman and JP Morgan met again at Lehman's request to discuss options for raising capital. The JP Morgan group was not impressed. "[Lehman] sent the Junior Varsity:' JP Morgan executives reported to Black. "They have no proposal and are looking to us for ideas/credit line to bridge them to the first quarter when they intend to split into good bank/bad bank:' Black responded, "Let's give them an order for the same drugs SEPTEMBER 2008: THE BANKRUPTCY OF LEHMAN 331 they have apparently been taking to think we would do something like thaf'53 The Lehman bankruptcy estate has a different view. It alleges Black agreed to send a due diligence team, following Dimon's suggestion that his firm might be willing to pur­ chase Lehman preferred stock, but instead sent over senior risk managers to probe Lehman's confidential records and plans.54 The bankruptcy estate alleges that later that night, JP Morgan demanded that Lehman execute amended agreements to its tri-party repo services before prean­ nouncing its third-quarter earnings at 7:30 the next morning. The amendments re­ quired Lehman to provide additional guarantees, increased Lehman's potential liability, and gave JP Morgan additional control over Lehman bank accounts." Again, the Lehman bankruptcy estate argues that Lehman executed the agreements because JP Morgan executives led Lehman to believe its bank would refuse to extend intraday credit if Lehman did not do so. JP Morgan denies this. Black told the FCIC, "JPMC never told Lehman that it would stop extending credit and clearing if the September Agreements were not executed before the markets opened on [Wednesday,] Septem­ ber 10, 2008:'56 Before the market opened on Wednesday, Lehman announced its $3.9 billion third-quarter loss, including a $5.6 billion write-down. Four hours later, Matthew Rutherford, an adviser to Treasury, emailed colleagues that several large money funds had reduced their exposure to Lehman, although there was not yet "a wholesale pull back of [repo ]lines:'57 "Importantly, Fidelity, the largest fund complex, stressed that while they hadn't made any significant shifts yet today, they were still in the process of making deci­ sions and wanted to update me later in the day:' Rutherford wrote. By Friday, Fidelity would have reduced its tri-party repo lending to Lehman to less than $2 billion from over $12 billion the previous Friday; according to fidelity's response to an FCIC sur­ vey of market participants, in the week prior to Bear's demise in March, Fidelity had pulled its entire $9.6 billion repo line to that company.

"IMAGINATION HAT" At the Federal Reserve, working groups were directed to "spend the next few hours fleshing out how a Fed-assisted BofA acquisition transaction might look, how a pri­ vate consortium of preferred equity investors transaction might look, and how a Fed takeout of tri-party repo lenders would 100k:'58 That day, New York Fed Senior Vice President Patricia Mosser circulated her opinion on Dudley's request for "thoughts on how to resolve Lehman:' She laid out three options: (1) find a buyer at any price, (2) wind down Lehman's affairs, or (3) force it into bankruptcy. Regarding option 1, Mosser said it "should be done in a way that requires minimal temporary support. ... No more Maiden Lane LLCs and no equity position by [the] Fed. Moral hazard and reputation cost is too high. If the Fed agrees to another equity investment, it signals that everything [the Fed] did in March in terms of temporary liquidity backstops is useless. Horrible precedent; in the long run MUCH worse than option 3:' Option 3, bankruptcy, would be "[a] mess on every level, but fixes the moral hazard problem:'59 332 FINANCIAL CRISIS INQUIRY COMMISSION REPORT

On Wednesday night, a New York Fed official circulated a "Liquidation Consor­ tium" game plan to colleagues.6o The plan was to convene in one room senior-level representatives of Lehman's counterparties in the tri-party repo, credit default swap, and over-the-counter derivatives markets-everyone who would suffer most if Lehman failed-and have them explore joint funding mechanisms to avert a failure. According to the proposed game plan, Secretary Paulson would tell the participants they had until the opening of business in Asia the following Monday morning (Sun­ day night, New York time) to devise a credible plan. The game plan stated that "we should have in mind a maximum number of how much we are willing to finance be­ fore the meeting starts, but not divulge our willingness to do so to the consortium:'61 Indeed, Paulson would tell the consortium when it met two days later that the gov­ ernment was willing to let Lehman fail. 62 Former Bank of America CEO Ken Lewis told the FCIC that Treasury Secretary Paulson had called him on Wednesday, September 10, and asked him to take another look at acquiring Lehman, assuring him that Fuld was ready to deal. Paulson and Geithner had arranged for Fuld and Lewis to discuss an acquisition in July, but Fuld had not been interested in selling the entire firm at that time. Because of this history, Lewis expressed his concerns to Paulson that Fuld would not want to sell the entire company or would not be willing to sell at a realistic price. Still, a team of Bank of America executives began reviewing Lehman's books, and on the next day, Fuld sounded optimistic about a deal. But Bank of America determined that Lehman's as­ sets were overvalued, and Lewis told Paulson there would be no deal without govern­ ment assistance. Undeterred, Paulson told Lewis-as Lewis informed the FCIC-to put on his "imagination hat" and figure out a deal. His insistence kept the Bank of America executives working, but on Friday, September 12, Lewis called Paulson to repeat his assessment-no government support, no deal. Apparently Fuld had been kept out of the loop, and began to call Lewis at home. Lewis's wife told Fuld that Lewis would not come to the phone and to stop calling.63 On Thursday September 11, an email time-stamped 8:26 A.M. from Susan Mc­ Cabe, a Goldman Sachs executive, to Dudley and others set the tone for the day: "It is not pretty, This is getting pretty scary and ugly again .... They [Lehman] have much bigger counter-party risk than Bear did, especially in Derivatives market, so [t]he market is getting very spooked, nervous. Also have Aig, Wamu concerns. This is just spinning out of control again. Just fyi, this is shaping up as going to be a rough dai'64 Bernanke was informed that if Lehman failed, "it would be a much more complex proposition to unwind their positions than it would have been to unwind the posi­ tions held by Bear Stearns;' because Lehman was "nearly twice the size of Bear Stearns:'65 Some believed government action was required. At 10:46 A.M., Hayley Boesky, a senior New York Fed official, forwarded to her colleagues an email from the hedge fund manager Louis Bacon suggesting the New York Fed could "attempt to stabilize or support the LEH situation" but noting that "none of the above will fix the funda­ mental problem, which is too many bad assets that need to get off too many balance sheets:'66 SEPTEMBER 2008: THE BANKRUPTCY OF LEHMAN 333

At 1:40 P.M., Fed officials circulated the outline of a plan to create a "Lehman De­ fault Management Group;' a group of Lehman counterparties and creditors who would make plans to cope with a Lehman bankruptcy. They would agree to hold off on fully exercising their rights to close out their trades with Lehman; instead, they would establish a process to "net down" -that is, reduce-all exposures using a com­ mon valuation method.67 A little before midnight on Thursday, Boesky notified col­ leagues that panicked hedge funds had called to say they were "expecting [a) full blown recession" and that there was a "full expectation that Leh goes, wamu and then ML [Merrill Lynch):' They were ''ALL begging, pleading for a large scale solution which spans beyond just LEH:' Boesky compared the level of panic to the failure of Bear Stearns-"On a scale of 1 to 10, where 10 is Bear-Stearns-week-panic, r would put sentiment today at a 12:'68 At almost the same time, JP Morgan demanded that Lehman post another $5 bil­ lion in cash "by the opening of business tomorrow in New York"; if it didn't, JP Mor­ gan would "exercise our right to decline to extend credit to yoU:'6 9 JP Morgan CEO Dimon, President Black, and CRO Zubrow had first made the demand in a phone call earlier that evening to Lehman CEO Fuld, CFO Ian Lowitt, and Treasurer Paolo TonuccVo Tonucci told the JP Morgan executives on the call that Lehman could not meet the demand. Dimon said Lehman's difficulties in coming up with the money were not JP Morgan's problem, Tonucci told the FCrc. "They just wanted the cash. We made the point that it's too much cash to mobilize. There was no give on that. Again, they said 'that's not our problem, we just want the cash:"7 1 When Tonucci asked what would keep JP Morgan from asking for $10 billion tomorrow, Dimon replied, "Nothing, maybe we will:'7 2 Under normal circumstances, Tonucci would not have tolerated this treatment, but circumstances were far from normal. "JPM as 'clearing bank' continues to ask for more cash collateral. If we don't provide the cash, they refuse to clear, we fail;' was the message circulated in an email to Lehman executives on Friday, September 12. So Lehman "delivered the $5 billion in cash only by pulling virtually every unencum­ bered asset it could deliver:'73 JP Morgan's Zubrow saw it differently. He told the FCIC that the previously posted $3.6 billion of collateral by Lehman was "inappropriate" because it was "illiq­ uid" and "could not be reasonably valued:' Moreover, Zubrow said the potential col­ lateral shortfall was greater than $ 5 billion.74 Lehman's former CEO, Fuld, told the Fcrc that he agreed to post the $5 billion because JP Morgan said it would be re­ turned to Lehman at the close of business the following day.7 5 The Lehman bank­ ruptcy estate made the same allegation. This dispute is now the subject of litigation; the Lehman bankruptcy estate is suing JP Morgan to retrieve the $5 billion-and the original $3.6 billion.76

"HEADS OF FAMILY" Should Lehman be allowed to go bankrupt? Within the government, sentiments var­ ied. On Friday morning, as Secretary Paulson headed to New York to "sort through 334 FINANCIAL CRISIS INQUIRY COMMISSION REPORT

this Lehman mess;' Wilkinson wrote that he still "[couldn't] imagine a scenario where we put in [government] money ... we shall see:'77 That afternoon, Fed Gover­ nor Warsh wrote, in response to a colleague's hope the Fed would not have to protect some of Lehman's debt holders, "I hope we don[']t protect anything!"78 But on Friday, Fed Chairman Bernanke was taking no chances. He stayed behind in Washington, in case he had to convene the Fed's board to exercise its emergency lending powers.79 Early Friday evening, Treasury Secretary Paulson summoned the "heads of fam­ ily" -the phrase used by Harvey Miller, Lehman's bankruptcy counsel, to describe the CEOs of the big Wall Street firms8°-to the New York Fed's headquarters. Paulson told them that a private-sector solution was the only option to prevent a Lehman bank­ ruptcy. The people in the room needed to come up with a realistic set of options to help limit damage to the system. A sudden and disorderly wind -down could harm the capital markets and pose the significant risk of a precipitous drop in asset prices, re­ sulting in collateral calls and reduced liquidity: that is, systemic risk. He could not of­ fer the prospect of containing the damage if the executives were unable to fashion an orderly resolution of the situation, as had been done in 1998 for Long-Term Capital Management. Paulson did offer the Fed's help through regulatory approvals and access to lending facilities, but emphasized that the Fed would not provide "any form of ex­ traordinary credit support:'81 As New York Fed General Counsel Tom Baxter told the FCIC, Paulson made it clear there would be no government assistance, "not a penni'82 H. Rodgin Cohen, a veteran Wall Street lawyer who has represented most of the major banks, including Lehman, told the FCIC that the government's "not a penny" posture was a calculated strategy: "I don't know exactly what the government was thinking, but my impression was they were playing a game of chicken or poker or whatever. It was said on more than one occasion that it would be very politically diffi­ cult to rescue Lehman. There had been a lot of blowback after Bear Stearns. 1 believe the government thought that it could, with respect to a game of chicken, persuade the private sector to take a big chunk" ofLehman's liabilities.83 The Fed's internal liquidation consortium game plan would seem to confirm Co­ hen's view, given that it contemplated a financial commitment, even though that was not to be divulged.84 Moreover, notwithstanding Paulson's "not a penny" statement, the United Kingdom's chancellor of the exchequer, Alistair Darling, said that Paulson told him that "the FRBNY might be prepared to provide Barclays with regulatory as­ sistance to support a transaction if it was required:'85 At that consortium meeting on Friday night, Citigroup CEO Vikram Pandit asked if the group was also going to talk about AIG. Timothy Geithner said simply: "Let's focus on Lehman:'86

"TELL THOSE SONS OF BITCHES TO UNWIND" What would happen if JP Morgan refused to provide intraday credit for Lehman in the tri-party repo market on Monday, September is? The Fed had been considering this possibility since the summer. As Parkinson noted, the fundamental problem was that even if Lehman filed for bankruptcy, the SEC would want Lehman's broker-