Dissension in the Ranks

A commission was set up in 2009 to figure out who blew up the global economy. It ended up with three different conclusions -- and no real answers.

Mortgage Banking
March 2011

By Robert Stowe England

In a way, it has become one of the great, unsolved mysteries. What really caused the financial crisis and panics of 2007 and 2008? That was the assignment for the Financial Crisis Inquiry Commission, which Congress authorized with great fanfare in 2009.

The quest for the answer is not an idle pursuit. In fact, it is a vital, burning question that still commands wide public interest. The reason, of course, is because the aftermath of the financial crisis still is a considerable drag on the financial health and economic vitality of the nation.

After a huge bubble in credit and housing formed in the earlier part of the decade, the housing market crashed. Nearly half the mortgage funding system collapsed in 2007, wiping out billions of dollars in the value of existing private-label mortgage-backed securities (MBS) and collateralized debt obligations (CDOs) backed by the MBS. The key players in the government-affiliated mortgage sector--Fannie Mae and Freddie Mac--had to be rescued with billions in taxpayer funds in 2008. Then on Sept. 15, 2008, Lehman Brothers declared bankruptcy, unleashing global financial panic.

All six of Wall Street’s major investment banks failed, were acquired or had to convert to bank holding companies to survive. The world’s largest insurance company, American International Group Inc. (AIG), New York, had to be bailed out. The nation’s largest bank, Citigroup Inc., New York, had to be rescued with taxpayer money twice.

The nation’s largest mortgage company, Countrywide Financial Corporation, was acquired by Charlotte, North Carolina-based Bank of America in a distressed sale. And Bank of America also had to be rescued, thanks to hidden toxic assets in Merrill Lynch, which Bank of America had acquired with the government’s blessing to prevent the brokerage firm’s collapse.

Washington Mutual, the seventh-largest mortgage lender in early 2008, according to Inside Mortgage Finance, had to be rescued by JPMorgan Chase, New York. Wachovia Corporation knocked out by losses from its acquisition of Golden West Financial Corporation, had to be acquired by Wells Fargo & Co., San Francisco.

There were runs on banks, money market mutual funds, asset-backed commercial paper and interbank repurchase agreements or repos. The regulators had to take extraordinary and unprecedented measures to stem runs occurring throughout the system.

The economy was hard hit. Four million people lost their homes and millions more are still on a path to losing theirs. Eight millions jobs were lost. People lost a huge chunk of their savings and spent a big slice of what was left. The nation spent trillions on bailouts and stimulus. In short, havoc was unleashed. The nation is still tumbling down a massive debt hole.

So, why does the cause of the crisis remain such a mystery? Primarily, it’s because the list of potential causes is so long. But further complicating things is the fact that it’s difficult to sort out what factors are primary, secondary or merely coincidental. Beyond the obvious fact that the bankruptcy of Lehman triggered a horrendous financial panic in 2008, it was going to be a dogged task to sift through all the evidence and come to a compelling conclusion.

The Financial Crisis Inquiry Commission, which began its work in September 2009, interviewed more than 700 people--nearly all of them in private--and reviewed millions of pages of documents, including e-mails subpoenaed by the commission. The commission held 19 days of hearings where people ranging from former Federal Reserve Chairman Alan Greenspan to former Lehman Brothers Chairman and Chief Executive Officer Dick Fuld to Omaha, Nebraska-based Berkshire Hathaway Chairman and Chief Executive Officer Warren Buffett were questioned.

After all this activity, however, the crisis detectives disagreed and split into three camps—all offering different conclusions. A majority--all Democrats--published the official finding of the commission on Jan. 27. There were two separate dissents by the Republicans.

A Congress in which Democrats held supermajorities set up the commission with six Democrats and four Republicans. Former California State Treasurer Phil Angelides, a Democrat, was chairman, while former House Ways and Means Chairman Bill Thomas, a Republican and also of California, was vice chairman.

Lack of consensus

The commission’s failure to forge even a fig leaf of bipartisan agreement has been widely faulted. “In the end, there was no consensus--and I think that severely damages the long-term impact of the report,” says Arnold Kling, a former senior economist at Freddie Mac. “How can you have a long-term impact if you got absolutely no support from the Republican side?”

Kling does not attribute the failure to establish a consensus solely to the fact that the commission had six Democrats and four Republicans, making it vulnerable to potential partisan split. “That wasn’t the problem so much,” he says. “What I hear is that Angelides was not a consensus-builder. He did not conduct the inquiry from the standpoint of how to achieve the best result, but was more interested in short-term publicity.”

Angelides focused on “who could he bring to the hearings that the press would cover, as opposed to how best to analyze the problem, how can we best reach closure, come to consensus, do something for history,” Kling adds.

Other critics chime in. “I think it was doomed from the start, basically since the commission rushed ahead to solve the problem before getting an in-depth analysis,” says Robert Eisenbeis, managing director and chief monetary economist with Cumberland Advisors Inc., Vineland, New Jersey.

“There were too many politicians involved [as members of the commission],” Eisenbeis contends, naming Democrats Angelides and former Florida Senator Bob Graham as examples. Republican co-chair Thomas is also a politician. “Those are not the sort of people to do the forensic analysis that is needed,” he adds. “What you need is something like the forensic analysis that was done by [Anton] Valukas, the examiner in Lehman’s bankruptcy.”

“It was a nice litany of events. It didn’t come to any conclusion. It was a random, meandering report,” says Tom LaMalfa, a mortgage industry veteran who heads TSL Consulting, Shaker Heights, Ohio.

“I’m very disappointed--and I’m a liberal Democrat,” LaMalfa adds. “Sadly, they missed the ball.” Importantly, the commission completely glossed over the role of housing policy and Fannie Mae and Freddie Mac. “I don’t think the majority report came anywhere near addressing that central issue,” LaMalfa says.

The commission said that Fannie and Freddie played a role in the crisis, but their venture into subprime and risky lending and the purchase of subprime and alternative-A private-label mortgage-backed securities was not a “primary cause” of the crisis.

Perhaps no one is as disappointed in the failure to reach consensus as commission member Peter Wallison, co-director of financial policy studies at the American Enterprise Institute, Washington, D.C., former general counsel at Treasury and former White House counsel to President Reagan. “It was cooked,” he says of the inquiry process and outcome. “It was not a fact-finding effort. It was an effort to present the American people with one side of the issue.”

Wallison was so disenchanted with the commission’s findings, he filed his own dissent which contained his own findings

The final report is “all a series of statements and assertions backed up by interviews with people who made statements that backed up the statements in the report,” Wallison says.

While Angelides has boasted that commission staff interviewed 700 people, the commission members never knew where and when those interviews were to take place and were completely shut out of the process, according to Wallison.

“The trouble with all of that is that none of the commissioners ever had an opportunity to sit in on interviews or know the context in which [sources] were speaking, or ask questions [of the sources] about what they had done in the past or why they take the positions they were taking or look at documents that have some connection with determining the credibility of the statements being made,” Wallison points out.

More importantly, Wallison says, neither Angelides nor Executive Director Thomas Greene and his successor, Wendy Edelberg, asked the Republicans for their ideas about who should be brought before the commission as witnesses. “They did not solicit ideas for witnesses” and “never responded to any request of mine to have a particular witness,” he adds. “So we were just told who the witnesses would be,” and given virtually no time to prepare.

Missing witnesses

Some of the potential witnesses who might have shed light on the causes of the crisis chose not to participate, apparently due to missteps by the commission staff. For example, Christopher Whalen, co-founder and senior vice president and managing director of Institutional Risk Analytics, Torrance, California, says that when he got a call from the commission staff, he was put off by restrictions they wanted to place on him in order for him to be interviewed or testify before the commission.

“I didn’t expect anything from them and I wasn’t disappointed,” he says, in commenting on the conduct of the inquiry and the final report.

Whalen could have proven to be invaluable, given his experience working in bank supervision, in the fixed-income department at Bear Stearns & Co., and the pioneering work of his firm in analyzing risk in complex structured finance deals.

The commission wanted Whalen to sign a confidentiality agreement, which he found offensive. “I’ve testified on the Hill and I work with members of Congress all the time,” he says. “So, I didn’t see the need to cooperate with [the commission].”

Furthermore, Whalen adds, “I wasn’t impressed by the panel and I wasn’t impressed by the staff. I told them to go away.”

Whalen did not perceive the commission as being sincerely interested in getting at the truth. “All these Washington commissions are basically industry kabuki [theatre]. It’s like we all live in the Matrix,” he says, referring to the 1999 science fiction thriller The Matrix and its two sequels, which depict a future world where what is believed to be reality is, in fact, simulated by computers.

“Most of the news you see and most of the stuff like this, which is supposedly real, is just manufactured by various constituencies who want to achieve something,” Whalen says.

Janet Tavakoli, founder and president of Tavakoli Structured Finance Inc., Chicago, is another expert who could have enlightened the commission. She has deep knowledge and understanding of the complex world of collateralized debt obligations (CDOs) built from mortgage-backed securities, synthetic CDOs and credit default swaps. She could, as well, have pointed the commission toward activity that suggested the need for a fraud audit or where the Securities and Exchange Commission (SEC), the U.S. Attorney General or state attorneys general should be looking to investigate.

“The staff called me and they wanted me to consult with them and testify,” says Tavakoli. She found that request to be baffling. “You can’t have me consult and then say you also want me to testify. If you want me to testify, I want to make clear it would not be conditional.”

Tavakoli also found the ground rules for providing testimony suspicious. “But the problem with that is that they were saying the investment banks will not put forward their information until the day they are testifying,” she explains. “And they basically wanted me to give them questions in advance--but that just allows the other side to prepare,” she says. “Why would I do that? If they are inviting me to testify, I’m happy to do it. If they are shaking me down for information so they can feed it to the other side, I am not cooperating.”

Tavakoli was also disappointed to see that the staff and commission took no action on the information she provided them to help in their research and investigation. For example, she says, she informed the staff she had information about how the Bear Stearns hedge funds had connections with other banks, including Citigroup, that were worthy of investigation. “And yet, that didn’t come out in the hearings” when Bear Stearns executives and later Citigroup executives were called to testify, she says.

“So, I think it was rigged,” Tavakoli says, speaking of the way the commission did its work.

Tavakoli, too, was not impressed by Angelides. “He should have been grilling [former Citigroup Vice Chairman Robert] Rubin and [former Citigroup Chairman and Chief Executive Officer Chuck] Prince” when they testified at a hearing on April 8, 2010, she says.

The panel members should have asked the Citi executives “why the Bear Stearns [hedge fund] implosion didn’t give [Citigroup] cause for alarm” in the spring and early summer of 2007, Tavakoli says. “Instead, he gave them a free pass and let them get away with saying nobody could have known there were problems in 2007 until the fall,” she says.

Tavakoli points out that Bear Stearns was planning an initial public offering (IPO) for Everquest Financial Ltd., which was jointly managed and advised by Bear Stearns Asset Management Inc. and Stone Towers Debt Advisers LLC. The privately-held fund owned $743 million in CDO assets, including 90 percent of the equity interest in those CDOs, according to the S-1 filing of May 9, 2007. The equity tranche is generally the riskiest slice of the CDO. Everquest owned pieces of 19 CDOs, while its subsidiary, the Parapet CDO, which was a CDO of CDOs or CDO2, owned pieces of another 37 CDOs.

Hedge funds investing in CDOs had for several years engaged in profitable arbitrage between the high interest rate paid by the equity tranche and the lower coupon of the debt tranches of CDOs. The S-1 touted this “attractive arbitrage opportunity” employed by Everquest as an appealing feature that would reap rewards for investors in the IPO.

One of Everquest’s assets that caught Tavakoli’s eye was half the equity tranches of a “toxic CDO” named Octonian I that Bear Stearns bought from Citigroup in March 2007. Bear had sold $13.2 million of the $24 million in equity tranches of Octonian I to Everquest, according to the S-1.

Citigroup, stood to gain from the IPO because $150 million in cash from the proceeds of the IPO, would be used to pay down most of a $200 million credit line Citi had extended to Everquest. This would reduce Citi’s exposure to losses from the subprime CDOs assets in Everquest.

After reading the S-1, Tavakoli publicly told reporter Matt Goldstein of Business Week the Everquest IPO “should not come to market” because it was not appropriate for retail investors, and she claimed it had subprime assets in it. Business Week reported her comments. This prompted Ralph Cioffi, who headed two troubled hedge funds at Bear Stearns, to call Tavakoli, she says. Cioffi objected to Tavakoli’s comments on the assets that Everquest was going to acquire and said that the information was confidential. Tavakoli says she told Cioffi the information was public because of the S-1 filing, which stated, among other things, that “a substantial portion” of the assets backing the CDO were risky mortgages.

The Everquest S-1 offering was withdrawn June 25, 2007. By July 17, one of the two troubled Bear Stearns hedge funds that invested in subprime was worthless and shares in the other were worth 9 cents on the dollar.

Given all Citi’s close relationship with the hedge funds at Bear Stearns, inquiry commissioners should have had plenty of reason to raise doubts about claims from senior managers they were unaware of problems in subprime lending until the fall of 2007.

Deteriorating loan performance in the securities that were collateral for the Octonian I CDO triggered an event of default in February 2008, prompting Standard & Poor’s to downgrade even its AAA-tranches to junk, Tavakoli wrote in a blog April 8, 2010.

The work of the commission in conducting its investigation, in fact, has become the subject of a new congressional investigation by Rep. Darrell Issa (R-California), chairman of the House Committee on Oversight and Government Reform. Issa sent Angelides and Thomas a letter shortly after the final report was issued, requesting internal documents of the commission by Feb. 11. The commission closed shop Feb. 13 and transfers its materials to the National Archives.

The majority’s findings

The commission’s Democrats--Angelides, Brooksley Born, Byron Georgiou, Graham, Heather Murren, and John Thompson--presented the official findings at a press conference at George Washington University, Washington, D.C., on Jan. 27. Their descriptions of the majority’s findings were laced with rhetoric against the federal banking regulators, Wall Street and free markets.

Angelides led off the presentation. “We concluded first and foremost that this crisis was avoidable. Despite the expressed views of many in the circles of financial political power that the crisis could not have been foreseen, there were many, many warning signs that were ignored or discounted,” he said.

It was a point Angelides repeated, both at the conference and in the few interviews he granted. He declined to grant an interview to Mortgage Banking despite repeated requests.

“Let us be clear. This calamity was the result of human action, inaction and misjudgment--not of mother nature or computer models gone haywire,” he told a large retinue of reporters and the larger audience available through live network coverage.

“The captains of finance, the public stewards of our financial system, ignored warnings and importantly [failed] to question, to understand and to manage the emerging risks in a financial system that is so essential to the well-being of our country,” he said.

Angelides identified predatory lending and fraud as a major driver of “an explosion of risky subprime lending and securitization, unsustainable increases in housing prices and mortgage debt.” He also said risk was “seeded” into the financial system in the unregulated market for derivatives and the reliance by financial firms on short-term borrowing. This was compounded by a “pervasive permissiveness” on Wall Street, all of which he said is documented in The Financial Crisis Inquiry Report, which ran to 633 pages.

Next came a salvo against federal financial regulators and free markets by Thompson, chairman of the board and former chief executive officer of Symantec Corporation, Mountain View, California. “It is clear the sentries were not at their post,” he said, meaning the regulators failed to do their job.

“This was, in large part, because of the widely accepted belief in the self-correcting nature of the markets and [in] the ability of the financial firms to police themselves,” Thompson explained. “This misplaced confidence in deregulation of a highly competitive industry was championed by the former Federal Reserve Chairman Alan Greenspan and others and supported by successive administrations and Congresses.”

This  “laissez-faire approach opened wide gaps in the government’s oversight of the financial system in which trillions of dollars were at risk,” he said.

Thompson singled out for special blame the pernicious effect of the unregulated market for over-the-counter derivatives and a less-regulated parallel banking or shadow banking system, where loans where transformed into securities and financial institutions raised cash through short-term overnight contracts rather than more secure deposits.

“We do not accept the view that regulators lacked financial power to protect the financial system,” Thompson said.

“They had adequate power in many arenas and they chose not to use them,” he added. In a clear reference to Fed Chairman Ben Bernanke and Treasury Secretary Hank Paulson, Thompson said, “Where regulators thought they lacked authority, they could have sought new powers to fulfill their mission of protecting our country’s financial system.”

Thompson cited several missteps by federal regulators. First, the Federal Reserve failed to tighten mortgage lending standards when it had the power to do so, he said. Second, the SEC could have required more capital and halted risky practices at the big investment banks but did not.

Third, the Federal Reserve Bank of New York could have clamped down on banks, such as Citigroup, “when it dangerously increased its exposures to subprime securities” but failed to so, Thompson said. Fourth, policy makers and regulators could have stopped the “runaway subprime mortgage securitization train” but did not. Fifth, regulators continued to rate institutions as safe and sound when they were not.

Failure of risk management

Born, who was chairman of the Commodity Futures Trading Commission (CFTC) from 1996 to 1999, explained how weak risk management at financial firms contributed to the crisis.

“Some believe that firms will naturally shield themselves from fatal risk-taking as a form of self-preservation,” she said. “However, the commission concluded that dramatic failures of corporate governance and risk management at many systemically significant financial firms were critical causes of the crisis.” The report, she said, documents examples at AIG, Bear Stearns, Fannie Mae, Lehman Brothers and Merrill Lynch, among others.

“The government’s hands-off philosophy and financial firms’ increasingly perilous business decisions went hand-in-hand,” Born said.

“Too many of these firms acted recklessly, taking on too much risk and too little capital and too much dependence on short-term funding,” she said. Investment banks became too focused on “risky trading activities that produced empty profits.”

The Wall Street firms also acquired and supported subprime lenders in “creating, packaging and repackaging trillions in mortgage-related securities,” Born said.

Born faulted Wall Street’s reliance on mathematical models to measure and manage risk. “Too often, risk management became risk justification,” she said. She further charged that compensation schemes at Wall Street firms in an intensely competitive and lightly regulated environment “rewarded the big bet, where the payoff on the upside could be huge and the downside ignored.”

Born, who had sought to establish a regulatory regime for derivatives when she was chairman of the CFTC, now faulted the decision of Congress to enact the law that completely deregulated over-the-counter derivatives--the Commodity Futures Modernization Act of 2000.

“In the wake of that action, the market for these derivatives spiraled out of control and out of sight, growing to $673 trillion in notional amounts by 2008,” she said.

Born explained that the commission had concluded that over-the-counter derivatives--those not traded on exchanges--made a “significant” contribution to the crisis. The commission’s report, she said, “lays out how credit derivatives fueled mortgage securitization and amplified losses from the collapse of the housing bubble.”

The lack of transparency in the derivatives market made it impossible to know what risks had been lurking there, Born suggested.

“[M]illions of derivatives of all types between systemically important financial institutions were unseen and unknown when the financial system nearly collapsed,” she said. “The obligations hidden from view added to the market uncertainty and escalated the panic we saw in the fall of 2008.”

Commission member Georgiou addressed “critical vulnerabilities” of “inadequate capital, risky investments and lack of transparency” at financial institutions. The Nevada entrepreneur and plaintiff’s attorney, who litigated on behalf of investors in Enron, WorldCom, Dynergy and AOLTimeWarner, faulted the excessive borrowing by many financial institutions ahead of the crisis. “By operating [with] insufficient capital, they left themselves susceptible to financial distress or ruin if the value of their assets declined even modestly,” he said.

None of the key players in the “deeply flawed mortgage securitization game”--Bear Stearns, Goldman Sachs, Merrill Lynch, Morgan Stanley and Lehman Brothers--“had enough ‘skin in the game,’” according to Georgiou.

High leverage raised the overall risk at many financial institutions, he argued. “By one measure, as of 2007, their leverage ratios were as high as 40 to 1,” he said. With that level of leverage, he explained, a 3 percent negative move in the value of assets “could consume their entire capital reserve.” This vulnerability was aggravated by the fact the firms relied heavily on overnight borrowing from other banks.

“The kings of leverage were Fannie Mae and Freddie Mac,” Georgiou said, noting that their combined leverage ratio grew to 75 to 1.

The commissioner explained that high leverage was often concealed from the public and regulators in derivatives positions in off-balance-sheet entities and through an accounting practice known as window-dressing. Leverage risk was compounded “by the nature of the assets they were acquiring with that debt,” Georgiou said.

Households, too, loaded up with debt as national mortgage debt almost doubled from 2001 to 2007, according to Georgiou. Massive leverage, combined with unseen bad assets, “heightened the chances the system would rapidly unravel,” he said.

Georgiou’s comments echoed those in the majority report, which faulted the frailties of the shadow banking system or, as it as also known, the parallel banking system, which is made up of such activities as securitized loans and overnight funding between banks using sales and repurchase or repo agreements. These activities contrast with traditional banking, which is based on taking deposits and making loans to individuals and businesses.

“The shadow banking system that had evolved over the past few decades did not have the protections this country built in the early part of the 20th century to serve as bulwarks against runs on banks,” Georgiou said. “By 2008, the $13 trillion shadow banking network had become larger than our nation’s traditional banking system,” he added.

“As it turned out, we had a 21st-century financial system with 19th-century safeguards,” Georgiou said.

“When the housing and mortgage markets cratered, the lack of transparency, the extraordinary debt loads, the inadequate capital, the risky assets all came home to roost. What followed was the panic. In sum, we reaped what we had sown,” he concluded.

Commissioner Graham said the majority on the commission had concluded that the Federal Reserve Board and the New York Fed “were caught off-guard” by the events of 2007 and 2008.

They “did not have a clear grasp of the financial system that they were charged with overseeing, particularly as it had evolved in the years before the crisis,” he said.

A lack of transparency in the markets was one reason for that, plus a belief that innovations in the market had strengthened, not weakened it. “Policymakers believed risk had been diversified when, in fact, it had been concentrated,” Graham said.

Graham faulted the “ad hoc” and “inconsistent” approach to a series of crises that amounted to no more than putting “fingers in the dike.” The evidence is clear that officials did not recognize early on that “the bursting of the housing bubble could threaten the entire financial system.”

Graham said the Fed failed to appreciate the evidence of systemic vulnerability, such as the collapse of two hedge funds at Bear Stearns in June 2007. The vulnerabilities of those funds “were thought to be relatively unique, although many other funds were exposed to exactly the same risk,” he said.

The commission was dismayed that only a month from the collapse of Lehman Brothers, the New York Fed was still seeking information about the exposures for Lehman represented by 900,000 derivatives contracts, Graham said.

The commission found fault with the fact that federal officials rescued Bear Stearns and placed Fannie and Freddie into conservatorship but let Lehman fail and followed up with a rescue of AIG. “The inconsistent approach stoked uncertainty and panic in the markets,” he said.

Murren, a former equity analyst, speaking at the press conference unveiling the commission’s reportaddressed the majority’s finding that weakened accountability and ethics helped cause the crisis. The commission’s investigation found that “a systemic breakdown in accountability and ethics” was a major factor in causing the crisis, she said. These lapses led to a “loss of confidence on the part of investors, businesses and the public.”

Murren, who co-founded the Nevada Cancer Institute, where she served for many years as chairman and chief executive officer, gave examples of ethical breeches. Borrowers defaulted soon after getting a mortgage, she said, suggesting they never had the capacity or the intention to make the payments. Brokers put many qualified borrowers into higher-cost loans to earn higher commissions. Lenders “such as Countrywide” made loans with payments borrowers could not afford, she said.

“Mortgage fraud flourished in an environment of collapsing lending standards,” Murren said. From 2005 to 2007, one estimate placed the level of mortgage fraud at more than $100 billion, she noted.

“It would be simplistic to pin this on human failings, such as greed and hubris, but rather it was the failure to account for human weakness that proved relevant to this disaster,” Murren said. The final report, she said, chronicles the failures of a number of individuals and firms. She noted, however, this was not a blanket condemnation and that many other actors did not succumb to “the excesses” that occurred.

Even so, Murren then cast an even wider net of blame for the crisis. “We believe that we must also as a nation take responsibility for what we allowed to occur,” she said. “Collectively, although not unanimously, we acquiesced and embraced a system and a set of policies and actions that gave rise to a serious crisis.”

Fraud referrals

The commission’s report states somewhat mysteriously that the FCIC made referrals of potential fraud and wrongdoing to U.S. Attorney General Eric Holder, as well as to appropriate state attorneys general. These referrals are required under the statutory authority that set up the commission, which curiously did not suggest any referrals to the SEC. When queried at the press conference on the number of referrals, Angelides would only say cryptically that it was between one and 1,000.

One of the referrals that might have been made is one former SEC Chairman Christopher Cox commented on during his testimony before the FCIC. That related to unusual activity in the week leading up to Bear Stearns’ collapse that suggested an effort by naked short sellers to profit by bringing down Bear Stearns.

The FCIC was clearly patterned after the Pecora Commission that investigated the causes of the Great Depression in hearings held in 1932 and 1933. In that regard, it apparently falls short, according to historical accounts. Ferdinand Pecora, a Sicilian immigrant and former prosecutor who had investigated the notorious Wall Street “bucket shops” that sold fraudulent securities, led that celebrated commission.

The Pecora hearings were riveting, and the cigar-chomping flashy former prosecutor grilled bank executives mercilessly. He exposed National City Bank for selling what it knew were virtually worthless bonds of such nations as Peru, Brazil, Cuba and Chile. Charles “Sunshine Charley” Mitchell, chairman of National City (later to be called Citibank), admitted to a scheme to avoid paying income taxes on his $1 million annual salary under grilling by Pecora. Mitchell was indicted for tax evasion but later acquitted. He paid a fine of $1 million.

The Pecora hearings led to a public outcry against “banksters” and Wall Street that led to the creation of the Securities and Exchange Commission and the enactment of the Glass-Steagall Act that separates banking and investment banking. In the end, however, no one grilled by Pecora went to jail for selling worthless bonds.

Answering a question not asked

There were many who criticized The Financial Crisis Inquiry Report for failing to connect all the dots and relate the conclusions of the report to the underlying data.

“Other than as anecdote, as interesting little stories you’d find in a newspaper, I didn’t find much of interest,” says LaMalfa.

“It was like [one continuous] run-on sentence. It went from one thing to another--what Goldman was doing, what Morgan was doing. They tried to take on so much. They never applied Occam’s Razor to separate the wheat from the chaff,” LaMalfa adds. (Occam’s Razor is a principle that governs how to decide between competing theories. It recommends selecting the theory that makes the fewest new assumptions when all the hypotheses under consideration are equal in other respects.)

Curiously, the decision by Angelides to emphasize that the crisis was “preventable” and “avoidable” turned scrutiny away from its actual specific findings to the issue of whether it could have been avoided.

“They were absolutely answering a question that was not asked,” says LaMalfa. “It’s an interesting question, but it is not really germane,” he adds. “What Congress tasked the commission to do was to determine causation--what actually caused the financial crisis,” he says. “I don’t think the majority report came anywhere near addressing that issue.”

Kling said, “It’s almost a given that it could have been avoided.” But he added, “The more interesting question is (ital) how (end) it could have been avoided. That’s where the debate should be.”

Going about the investigative work

When the Financial Crisis Inquiry Commission began its work, LaMalfa was hopeful the commission’s work would lead to a consensus on the causes of the crisis, which would help prevent another one like it from occurring. “I attended the first six months of public hearings,” traveling from Cleveland to Washington to do so, says LaMalfa. “I wanted to listen to what they [were] saying,” he recalls.

LaMalfa says he had concerns about the role of Fannie Mae and Freddie Mac, and wanted to see how the commission would investigate their role. “I became somewhat disillusioned at what I observed first-hand” in the hearings, and disappointed at the lack of interest in Fannie and Freddie, he says.

“Many of the commissioners had pet theories that were preconceived, and they never left them,” he says. “Georgiou thought it was all about poor incentives. Born knew going into this [that] it was a derivatives calamity,” he explains.

“I could see they were meandering on these topics and not making much progress,” says LaMalfa, who was so concerned that he wrote Angelides and Thomas jointly. The letter had no effect, he said.

Finding other causes

Eisenbeis, who is a member of the Shadow Financial Regulatory Committee, which favors free markets, found that “a lot of the problems that were cited” by the majority in their report “were actually the result of government intervention of one sort or another in the markets.”

He cites government support of mortgages and homeownership, for example, as an interference that distorts the discipline of free markets. 
There were also incentives for borrowers to seek leverage because the mortgage interest is deductible, Eisenbeis adds.

Further, Fannie and Freddie “were using government backing to subsidize the mortgage market and rake off a portion of subsidy for themselves,” he adds. The Federal Home Loan Bank System, too, promoted homeownership.

Eisenbeis argues that the faulty business model of investment banks also played an important role. “What they used to do was help float and write securities issues” to power their earnings. However, that line of business “began to break down, so they sought other ways to obtain leverage” and “channeled funds into these instruments,” he says.

Also, the incentive to manage risk across the entire firm at investment banks broke down when Wall Street firms decided to go public, Eisenbeis adds. If they had remained partnerships, it would have maintained the incentive for everyone in the firm--including those at top--to be concerned about the risk in isolated areas, like trading desks.

“Once the incentive to monitor and control risk broke down, they got into trouble,” he says.

In the years running up to the crisis, Eisenbeis says, “I think a lot of times the people at the top didn’t understand what people below were doing. They didn’t understand the models and inherent risk in the models. They trusted them a bit too much. I think something like that has gotten overlooked” by the commission.

Eisenbeis does agree, however, with the view that policymakers were not prepared for the crisis, as the majority found. “You also have to fault the people making policy once the crisis broke, and how they managed it,” he says. “They were running around like chickens with their heads cut off.” Even though the events of 2007 should have been a wake-up call to regulators, they chose to minimize the impact of those events.

“They weren’t ready for Lehman and had no options,” Eisenbeis says.

One interesting document among the million that were gathered by the commission staff is a letter dated Dec. 21, 2010, from Fed Chairman Bernanke to the chairman and vice chairman of the commission. This letter confirms some of the claims about the Fed failing to realize the gravity of the situation early on.

The letter was a follow-up to a closed-door session between the commission and the Fed chairman in November to provide some of the answers that came up in that hearing. In the letter, Bernanke summarizes briefly some of the discussions of the Federal Open Market Committee (FOMC) at critical points leading up to and during the crisis.

In an August 2007 meeting--at the peak of the mortgage meltdown--Bernanke reported that “some staff and members believed that the data did not indicate that a collapse of the housing market was imminent.” One participant, however, was highly skeptical of this optimistic assessment. This unidentified participant “in a paraphrase of a quote he attributed to [Winston] Churchill, said that no amount of rewriting of history would exonerate us if we did not prepare for the more dire scenarios discussed in the staff presentation,” according to Bernanke’s letter to the commission.

In the summer of 2005, the FOMC discussed whether or not “the overvaluation in the housing market posed the major systemic risks that we now know it did,” Bernanke wrote. During the discussion, one participant was “worried that piggybacks and other nontraditional loans could be making the books at the GSEs [government-sponsored enterprises] look better than they really were,” the chairman recalled. A member of the staff, however, “replied that the GSEs were not large purchasers of private-label securities.”

This view of the unidentified FOMC staff member apparently ended the debate. The claim the staff member made, however, is at odds with the record. The fact is, Fannie and Freddie had already purchased substantial amounts of subprime and alt-A securities. The Fed apparently did not have access to the that kind of information, which was also not widely known because for many years Fannie and Freddie had not been required to file quarterly reports with the SEC.

Former Fannie Mae chief risk officer Edward Pinto has calculated from data made public by the GSEs in recent years that show Fannie and Freddie by 2005 had purchased $535 billion in private label subprime mortgage-backed securities (PMBS), plus another $284 billion in Alt-A PMBS. Wallison inserted these data in his dissent.

What if there had been a ban on certain products?

There has been widespread skepticism about the majority’s conclusion that banning certain mortgage products could have gone a long way toward preventing the crisis. This seems to be the primary corollary to the majority’s conclusion that the crisis was preventable and avoidable.

“That’s an interesting point of view,” offers Kling. “It’s not implausible, but it raises the question of what would have happened if they had done something like this.” Such a ban could have been broad or narrow--and each raises important questions, Kling says.

If the Fed had issued “a very broad-based ban on the types of loans that were going to minorities and low-income people, what kind of political firestorm would that have created?” Kling asks. “If they issued a narrow band on the absolute worst mortgages, would that have been enough to avert the crisis?”

He suggests, “So either the ban would be broad and cause political unrest or it would be really narrow and probably would not have averted the crisis.”

First dissenting report

The three dissenters on the commission, who together filed a separate report expressing their views, were not part of the official presentation at George Washington University. The commission media people, however, did arrange a phone conference with the three for interested reporters.

FCIC Vice Chairman Thomas, who participated in this event, was not available for interviews despite repeated requests. Douglas Holtz-Eakin, an economist and former head of the Congressional Budget Office (CBO), was part of this dissenting group. (See the separate interview with Holtz-Eakin also in this issue of Mortgage Banking.) The third member of this group of dissenters was Keith Hennessey, who served as assistant to the president for economic policy and director of the National Economic Council under George W. Bush.

In their dissent, the three panelists argued against the idea of “single-cause explanations” and found them “too simplistic because they are incomplete.” (Those arguments, the dissenters explained, include the argument that the crisis was caused by housing policy; another one that it was international capital flows or monetary policy and insufficient regulation of “an ambiguously defined” shadow banking sector.

“The majority’s approach to explaining the crisis suffers from the opposite problem--it is too broad,” the dissenters state in their report. “Not everything that went wrong during the financial crisis caused the crisis, and while some causes were essential, others had only a minor impact,” the three argue.

“The majority’s [lengthy] report is more an account of bad events than a focused explanation of what happened and why,” the dissenters maintain. “When everything is important, nothing is,” they write.

The existence of a credit bubble in other nations at the same time argues against the role of regulation, according to the dissenters. The bubble occurred in different regulatory and supervisory regimes from the one in the United States. “In many cases, these European systems have stricter regulation than the United States and still they faced financial firm failures similar to those in the United States,” the dissenters state.

“How can the ‘runaway mortgage securitization train’ detailed in the majority’s report explain housing bubbles in Spain, Australia and the United Kingdom, with mortgage finance systems vastly different from that in the United States?,” the trio ask.

“How did former Fed Chairman Alan Greenspan’s ‘deregulatory ideology’ also precipitate bank regulatory failures across Europe?,” the dissenters ask.

While the majority raised many issues that were relevant, they were not always essential, the dissenters say.

The dissenters looked for factors that were both decisive--not just relevant--and, to some extent, common to the United States and European nations that suffered housing bubbles. 
The dissenters identified 10 essential causes of the financial and economic crisis. These represent, in order, the chronology of how the crisis was created and played out, according to Holtz-Eakin, one of the dissenters.

• A credit bubble was caused by the flow of funds from nations with a savings glut into the United States and Europe, driving down the cost of borrowing. 
• The credit bubble led to a national housing bubble that began in the late 1990s and accelerated in the 2000s, with concentrated booms in California, Nevada, Arizona and Florida.
• Foreign credit fueled a surge of nontraditional mortgages. This trend was enhanced by overly optimistic assumptions about the course of housing prices and flaws in the mortgage markets. 
• Failures in credit rating and securitization turned bad mortgages into toxic financial assets.
• Financial institutions amassed a huge concentration of “highly correlated” risk that was tied to mortgage assets.
• Financial firms magnified the risk by increasing their leverage and exposing themselves to liquidity risk.
• The risk of contagion made the system vulnerable. 
• A lot of financial institutions made similar wrong bets on housing and endured a common shock, magnifying the scale of the crisis.
• The failure and near failure of 10 firms--Lehman Brothers, Fannie Mae, Freddie Mac, AIG, Merrill Lynch, Morgan Stanley, Goldman Sachs, Wachovia, Washington Mutual and Citigroup--triggered a global financial panic.
• The financial panic caused a severe contraction in the real economy.

However, not all students of the financial crisis agree with some of the conclusions reached by the dissenters either. For example, the decision to identify the flows of substantial funds into the United States from a savings glut overseas was misplaced, according to LaMalfa.

“It seems that emphasis was on something ordinary, not extraordinary,” he explains. “They never really addressed why so much of it went into mortgage-backed securities,” for example. “They never tied together why it was we ended with 27 million nonprime loans and why 14 million of the 27 million were sitting with Fannie and Freddie,” LaMalfa adds.

The dissenters “didn’t connect the dots” to identify “what was propelling this drastic increase in nontraditional, nonprime loans,” says LaMalfa. “That was something we didn’t have in the 1980s and the 1990s. Why was it that underwriting was loosened so dramatically and why weren’t the regulators honed in on that?,” he asks.

The elephant in the room

Some say there is one other significant contributing factor that was missed by the majority and the three dissenters. They missed the significance of the role of housing policy and the role of Fannie and Freddie in creating the crisis, according to LaMalfa. Indeed, he cites Wallison’s isolated dissent, as the best explanation of the crisis.

“I think Peter Wallison, even though we are on opposite ends of the political spectrum, hit the ball out of the park,” says LaMalfa. “It was the only one of the three that had a solid method and followed a line of inquiry from start to finish,” he maintains.

“It [Wallison’s dissent] explained all that happened,” claims LaMalfa, who prepared a paper for the commission and researched the factors that led to the dramatic rise of risky mortgage lending propelled by government housing policies.

LaMalfa said Wallison did a better job than he did himself in putting together an explanation of how Fannie and Freddie played such a key role in the financial crisis. “Like the Wizard of Oz, there was somebody behind the drapes--that was the puppeteer that prompted Fannie and Freddie to buy all these loans,” LaMalfa says. “It turned out it was the affordable-housing goals, and those goals kept going up and up until they reached 56 out of every 100 mortgages that had to meet one or more affordable-housing goals,” he says. “That drove the bus off the cliff.”

Wallison contends that the inquiry commission did not understand how the affordable-housing goals led to high levels of risky loans, because they did not want to hear or learn about the potential impact of housing policy on the crisis. So they were not aware that there were 27 million subprime and alt-A loans in the financial system by 2008, he contends. “It wasn’t a question of missing it. They didn’t even look for it,” he says.

Wallison sent a memo to Chairman Angelides informing him about in-depth forensic research by former Fannie chief risk officer Pinto, who had poured over publicly available information that began to come out of the GSEs after they were put into conservatorship. Pinto used this information to calculate the level of risky lending at the GSEs on the eve of the financial crisis, as well as volumes by year going back to the early 1990s.

While the commission majority “did admit” that housing policy played a role in its report, it was seen to be “marginal,” Wallison says. But Wallison adds, “It is a great leap of logic to say that [the influence the GSEs had on the market was] only marginal.”

Wallison faults the majority for not identifying in their report a specific number that clearly shows “the level of support [provided by Fannie and Freddie] for risky lending by [their] acquisition of mortgages and mortgage securities.”

Not a primary cause

The majority of the commission did provide an explanation of its views on potential risky lending at Fannie and Freddie in the final report.

“We examined the role of the GSEs,” the report states in the section on its conclusions (page xxvi). “These government-sponsored enterprises had a deeply flawed business model as publicly traded corporations with the implicit backing of and subsidies from the federal government and with a public mission,” the report states.

“Their $5 trillion mortgage exposure and market position was significant. In 2005 and 2006 they they decided to ramp up their purchase and guarantee of risky mortgages, just as the market was peaking,” the report continues.

“They suffered from many of the same failures of corporate governance and risk management as the commission discovered in other financial firms,” the report states, pointing out that $151 billion had been provided to the GSEs so far “to keep them afloat.”

“We conclude that these two entities contributed to the crisis, but were not a primary cause,” the majority states.

While the GSEs engaged in subprime and other risky lending, they concede, “they followed rather than led Wall Street and other lenders in the rush for fool’s gold.”

The majority report acknowledges that Fannie and Freddie purchased the AAA-rated tranches of private-label MBS and increased their share of that market over time, rising from 10.5 percent in 2001 to 40 percent in 2004, then falling back to 28 percent in 2008.

The report defends its conclusion that the GSEs’ impact was contributory but not preeminent by pointing out that GSE mortgages by the end of 2008 “were far less likely to be seriously delinquent that were non-GSE-securitized mortgages: 6.2 percent versus 28.3 percent.”

This comparison of delinquency rates between private-label and GSE mortgages misses a larger point, according to Wallison, and that is the relative size of total mortgages outstanding represented by that delinquency rate of the GSEs. With Fannie and Freddie sharing a far larger share of total outstanding mortgages than private-label, their total number of delinquencies, Wallison pointed out in his dissent.

Wall Street and the GSEs

In his dissent, Wallison attacks what he sees as the “myth” that “Wall Street banks led the way into subprime lending and the GSEs followed.” The majority report, he notes, uses this approach to explain why Fannie and Freddie acquired so many nontraditional mortgages. “This notion simply does not align with the facts,” Wallison claims.

“Not only were Wall Street institutions small fractions of the subprime [private-label mortgage-backed securities (PMBS)] market, but well before 2002 Fannie and Freddie were much bigger players [in subprime and other risky lending] than the entire PMBS market,” Wallison argues.

By 2001, Fannie and Freddie had already acquired $701 billion in nontraditional mortgages, Wallison writes. “Obviously the GSEs did not have to follow anyone into nontraditional mortgages or subprime lending; they were already the dominant players in that market well before 2002,” he states.

In 2002, the entire PMBS market was $134 billion. In contrast, Fannie and Freddie acquired $206 billion in whole subprime mortgages and $368 billion in other nontraditional mortgages, “demonstrating again that the GSEs were no strangers to risky lending well before the PMBS market began to develop,” Wallison writes.

In the years that the PMBS market issued $55 billion (2001) and $94 billion (2002), loans where borrowers had credit scores below 660 represented 16 percent (2001) and 17 percent (2002) of Fannie’s acquisition of whole loans, representing $159 billion (2001) and $206 billion (2002) in subprime loans.

“It would be more accurate to say Wall Street followed Fannie and Freddie into subprime lending rather than vice-versa,” Wallison concludes.

Because subprime and alt-A PMBS were “rich” in nontraditional mortgages eligible for credit under affordable-housing goals, Fannie and Freddie were also the largest purchasers of subprime PMBS from 2002 to 2006. They acquired 33 percent of total issuance or $579 billion, he notes.

The Department of Housing and Urban Development (HUD) also had in place a “best-practices initiative” for mortgage bankers that fostered higher levels of subprime and alt-A lending that went into the PMBS, according to Wallison. Countrywide, for example, entered into a $1 trillion commitment on nontraditional mortgage lending to conform to HUD’s best-practices initiative.

Banks, too, were subjected to government pressure to engage in riskier lending, Wallison argues. Higher and higher commitments made by banks to meet Community Reinvestment Act (CRA) requirements had reached $4.5 trillion by 2007, according to a report by the National Community Reinvestment Coalition, Wallison notes. “A substantial portion of these commitments appear to have been converted into mortgage loans, and thus would have contributed substantially to the number of subprime and other high risk loans outstanding in 2008,” he writes.

Wallison cites the work of Pinto to make his case. Pinto calculates the total subprime and alt-A loans purchased by the GSEs at $4.1 trillion as of June 30, 2008. High loan-to-value (LTV) mortgages to borrowers with credit scores higher than 660 are included in Pinto’s calculation for alt-A loans. Prior to the onset of the crisis, the GSEs had 12 million subprime and alt-A loans--37 percent of their total mortgage exposure of 32 million loans. The two GSEs, in turn, held or had guaranteed loans representing 58 percent of the 55 million mortgages outstanding by mid-2008.

Wallison takes exception to other findings by the majority--such as its belief that banning certain mortgage products could have prevented the crisis. “The idea here is that Ben Bernanke and Alan Greenspan would have stopped originators from making certain kinds of mortgages,” he says. “Meanwhile, the rest of the government, including Fannie Mae and FHA [the Federal Housing Administration] and laws applying to banks under the Community Reinvestment Act and others” were compelling lenders to make those kinds of mortgages, he explains.

“What they are saying is that even though the government was demanding [that these] loans be made, the Federal Reserve was supposed to enact regulations that would have essentially prevented them from being made,” he says.

In an environment where the government was setting higher homeownership goals, it is “exceedingly unlikely” the Fed would have banned the types of mortgage products that made it possible for the targeted population segments to increase their homeownership rates, Wallison says.

Sheer hindsight

He also faults the majority for its litany of institutions and people blamed for the crisis. “Much of the commission majority’s report, which criticizes firms, regulators, corporate executives, risk managers and rating agency analysts for failure to perceive the losses that lay ahead, is sheer hindsight,” Wallison states in his dissent.

“It appears that information about the composition of the mortgage market was simply not known when the bubble began to deflate,” so blaming all the parties for failing to know about the size of the risk is misplaced,” he argues.

More importantly, Wallison charged, the commission itself showed little interest in learning the full extent of risky lending and risky investing that was going on at Fannie and Freddie, as well as the level of risky lending being required by others in the mortgage industry from mortgage bankers to depository banks and thrifts from a variety of housing policies imposed on the financial industry.

“The commission never attempted a serious study of what was known about the composition of the mortgage market in 2007, apparently satisfied simply to blame market participants for failing to understand the risks that lay before them, without trying to understand what information was actually available,” Wallison states.

“The mortgage market is studied constantly by thousands of analysts, academics, regulators, traders and investors,” Wallison writes. “How could all these people have missed something as important as the actual number of nontraditional mortgages outstanding?” One reason it was missed, he explains, is that most assumed during the bubble years that all of the mortgages being acquired by Fannie and Freddie “continued to adhere to the same conservative underwriting policies they had previously pursued.”

In order to meet ever-rising affordable-housing goals, however, both GSEs began to steadily loosen their underwriting standards and acquire growing numbers of subprime and alt-A loans--loans that were not fully identified as such until after they were placed into conservatorship.

Fannie began in 2002 to identify the number of loans it acquired that had credit scores below 660--the industry demarcation line between prime and subprime--when it began to file reports with the SEC, after this was required by its regulator, the Office of Federal Housing Enterprise Oversight (OFHEO). In its first filing, Fannie revealed that 16 percent of its credit obligations were for mortgages with FICO® scores below 660.

Prior to this, Fannie reported only infinitesimal amounts of subprime, represented by mortgages identified as subprime by their originators.

Wallison also explained how the crash of mortgage values contributed to the panic that ensued. For starters, given that there were far more risky mortgages in the system, it aggravated the degree of the decline in housing prices.

Further, given that private mortgage-backed securities were integral to much of the overnight funding that was widespread on Wall Street, the decline in the value of those assets also fed the liquidity squeeze. “When AAA-rated PMBS became unmarketable, they lost their value for liquidity purposes, making it difficult or impossible for many financial institutions to fund themselves using these assets as collateral for repos,” Wallison writes.

“This was the liquidity challenge” that Federal Deposit Insurance Corporation (FDIC) Chairman Sheila Bair had identified in her testimony before the commission on Sept. 10, 2010, Wallison explains.

The crisis was further magnified as the value of mortgage assets on the balance sheets of banks and other institutions threatened to make them insolvent. This was “another major element of the loss-transmission mechanism,” Wallison states.

In the end, Wallison argues, government policy promoting homeownership drove a housing bubble from its normal term of three to four years to one that lasted 10 years, from 1997 to 2007.

“The bubble that ended in 2007 was unlike any bubble we ever had,” he says. “In this bubble, housing prices went up 90 percent in real terms, according to [Yale University professor of economics Robert] Shiller,” he adds.

All that enormous government focus was targeted to borrowers who were 80 percent or less of median income in a given market. “If you take that population and you focus all the attention on them . . . then you are going to get a lot of terrible mortgages,” Wallison says.

“None of this would have happened without so much government money pouring into the market to keep that market going,” he says.

The Financial Crisis Inquiry Report, in the end, “ignored all of this,” Wallison says. “They wanted to blame the private, and it was very inconvenient for them to have to deal with this problem of government having poured so much money in. It was a disruptive idea to what they had in mind,” he contends.

Congress thumbs its nose

There was yet one additional blow to the influence of the commission. Congress chose to ignore the commission’s ultimate conclusions and rushed ahead to enact sweeping financial market regulatory reform in the summer of 2010. That was well before the deadline for the final report on the commission’s findings.

LaMalfa faults the commission for remaining silent while Congress rushed to enact a new law. They should have been saying, “‘You tasked us to determine causation and now you’re pushing through with Dodd-Frank [the Dodd-Frank Wall Street Reform and Consumer Protection Act] without knowing where we end up in terms of our investigation,’” LaMalfa adds.

In that regard, Congress itself may have guaranteed that the work of the commission would be quickly relegated to the dustbin of history, despite the enormous effort that went into it. The fact that the commission split three ways, in the end, virtually ensured its findings would be largely ignored.

Thus, the Financial Crisis Inquiry Commission that began with such high hopes ended with a virtual bust. Sic transit gloria mundi. That is, the glory of this world is fleeting. For the commission, it vanished altogether. MB

Robert Stowe England is a freelance writer based in Arlington, Virginia. He can be reached at This email address is being protected from spambots. You need JavaScript enabled to view it..

Copyright March 2011 by Mortgage Banking Magazine. All Rights Reserved. Reprinted with Permission.



Robert Stowe England is an author and financial journalist who has specialized in writing about financial institutions, financial markets, retirement income issues, and the financial impact of population aging.

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