United States Senate PERMANENT SUBCOMMITTEE ON INVESTIGATIONS Committee on Homeland Security and Governmental Affairs

Carl Levin, Chairman Tom Coburn, Ranking Minority Member

WALL STREET AND

THE FINANCIAL CRISIS:

Anatomy of a Financial Collapse

MAJORITY AND MINORITY

STAFF REPORT

PERMANENT SUBCOMMITTEE

ON INVESTIGATIONS

UNITED STATES SENATE

April 13, 2011

SENATOR CARL LEVIN

Chairman

SENATOR TOM COBURN, M.D.

Ranking Minority Member

PERMANENT SUBCOMMITTEE ON INVESTIGATIONS

ELISE J. BEAN

Staff Director and Chief Counsel

ROBERT L. ROACH

Counsel and Chief Investigator

LAURA E. STUBER

ZACHARY I. SCHRAM

DANIEL J. GOSHORN

DAVID H. KATZ

Counsel

ALLISON F. MURPHY

ADAM C. HENDERSON Professional Staff Member

PAULINE E. CALANDE

Detailee

MICHAEL J. MARTINEAU

Detailee

CHRISTOPHER J. BARKLEY

Staff Director to the Minority

ANTHONY G. COTTO Counsel to the Minority KEITH B. ASHDOWN

Chief Investigator to the Minority

JUSTIN J. ROOD

Senior Investigator to the Minority

VANESSA CAREIRO

BRITTANY CLEMENT

Law Clerk

DAVID DeBARROS

Law Clerk

ERIN HELLING

Law Clerk

HELENA MAN

Law Clerk

JOSHUA NIMMO

ROBERT PECKERMAN

Intern

TANVI ZAVERI

Law Clerk

MARY D. ROBERTSON

Chief Clerk

5/10/11

Permanent Subcommittee on Investigations

199 Russell Senate Office Building – Washington, D.C. 20510

Main Number: 202/224-9505

Web Address: www.hsgac.senate.gov [Follow Link to “Subcommittees,” to “Investigations”]

WALL STREET AND THE FINANCIAL CRISIS:

Anatomy of a Financial Collapse

TABLE OF CONTENTS

EXECUTIVE SUMMARY. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 A. Subcommittee Investigation . . . … . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 B. Overview . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 (1) High Risk Lending: Case Study of Washington Mutual Bank. . . . . . . . . . . . . . . . . . 2 (2) Regulatory Failure: Case Study of the Office of Thrift Supervision.. . . . . . . . . . . . . 4 Inflated Credit Ratings: Case Study of Moody’s and Standard & Poor’s. . . . . . . . . . 5 (3) (4) Investment Bank Abuses: Case Study of Goldman Sachs and Deutsche Bank.. . . . . 7 C. Recommendations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12

II. BACKGROUND. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15 A. Rise of Too-Big-To-Fail U.S. Financial Institutions. . . . . . . . . . . . . . . . . . . . . . . . . . . 15 B. High Risk Mortgage Lending. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17 C. Credit Ratings and Structured Finance. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26 D. Investment Banks. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32 E. Market Oversight. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36 F. Government Sponsored Enterprises. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41 G. Administrative and Legislative Actions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43 H. Financial Crisis Timeline. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45

III. HIGH RISK LENDING:

CASE STUDY OF WASHINGTON MUTUAL BANK. . . . . . . . . . . . . . . . . . . . . . . . . . . 48 A. Subcommittee Investigation and Findings of Fact.. . . . . . . . . . . . . . . . . . . . . . . . . . . . 50 B. Background. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51 (1) Major Business Lines and Key Personnel. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51 (2) Loan Origination Channels. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52 (3) Long Beach. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54 (4) Securitization.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55 (5) Overview of WaMu’s Rise and Fall. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56 C. High Risk Lending Strategy.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58 (1) Strategic Direction.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60 (2) Approval of Strategy. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60 (3) Definition of High Risk Lending.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62 (4) Gain on Sale. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64 (5) Acknowledging Unsustainable Housing Price Increases.. . . . . . . . . . . . . . . . . . . . . . 65 (6) Execution of the High Risk Lending Strategy.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 68 D. Shoddy Lending Practices. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75 (1) Long Beach. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75

(2) WaMu Retail Lending. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 86 (a) Inadequate Systems and Weak Oversight. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 86 (b) Risk Layering.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90 (c) Loan Fraud. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95 (d) Steering Borrowers to High Risk Option ARMs. . . . . . . . . . . . . . . . . . . . . . . . . 104 (e) Marginalization of WaMu Risk Managers.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 109 E. Polluting the Financial System. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 116 (1) WaMu and Long Beach Securitizations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 116 (2) Deficient Securitization Practices. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 122 (3) Securitizing Delinquency-Prone Loans. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125 (4) WaMu Loan Sales to Fannie Mae and Freddie Mac. . . . . . . . . . . . . . . . . . . . . . . . . . 136 F. Destructive Compensation Practices.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 143 (1) Sales Culture. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 143 (2) Paying for Speed and Volume.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 147 (a) Long Beach Account Executives. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 148 (b) WaMu Loan Consultants. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 149 (c) Loan Processors and Quality Assurance Controllers. . . . . . . . . . . . . . . . . . . . . . 151 (3) WaMu Executive Compensation.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 153 G. Preventing High Risk Lending. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 155 (1) New Developments. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 155 (2) Recommendations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160

Ensure “Qualified Mortgages” Are Low Risk. . . . . . . . . . . . . . . . . . . . . . . . . . . 160
Require Meaningful Risk Retention. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160 3. Safeguard Against High Risk Products. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160
Require Greater Reserves for Negative Amortization Loans.. . . . . . . . . . . . . . . 160 5. Safeguard Bank Investment Portfolios.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160

IV. REGULATORY FAILURE:

CASE STUDY OF THE OFFICE OF THRIFT SUPERVISION. . . . . . . . . . . . . . . . . . . 161 A. Subcommittee Investigation and Findings of Fact.. . . . . . . . . . . . . . . . . . . . . . . . . . . . 162 B. Background . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 165 (1) Office of Thrift Supervision. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 165 (2) Federal Deposit Insurance Corporation.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 166 (3) Examination Process. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 167 C. Washington Mutual Examination History. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 169 (1) Regulatory Challenges Related to Washington Mutual.. . . . . . . . . . . . . . . . . . . . . . . 169 (2) Overview of Washington Mutual’s Ratings History and Closure.. . . . . . . . . . . . . . . 173 (3) OTS Identification of WaMu Deficiencies. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 177 (a) Deficiencies in Lending Standards.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 177 (b) Deficiencies in Risk Management. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 182 (c) Deficiencies in Home Appraisals.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 187 (d) Deficiencies Related to Long Beach. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 191 (e) Over 500 Deficiencies in 5 Years. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 195 (4) OTS Turf War Against the FDIC. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 196

D. Regulatory Failures. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 208 (1) OTS’ Failed Oversight of WaMu. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 209 (a) Deference to Management. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 209 (b) Demoralized Examiners.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 215 (c) Narrow Regulatory Focus . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 224 (d) Inflated CAMELS Ratings.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 228 (e) Fee Issues. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 230 (2) Other Regulatory Failures. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 231 (a) Countrywide.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 231 (b) IndyMac. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 233 (c) New Century . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 235 (d) Fremont. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 237 E. Preventing Regulatory Failures.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 239 (1) New Developments. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 239 (2) Recommendations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 241

Complete OTS Dismantling.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 241 Strengthen Enforcement.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 241 2. 3. Strengthen CAMELS Ratings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 242
Evaluate Impacts of High Risk Lending. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 242

INFLATED CREDIT RATINGS: CASE STUDY OF MOODY’S AND STANDARD & POOR’S. . . . . . . . . . . . . . . . . . . . . 243 A. Subcommittee Investigation and Findings of Fact.. . . . . . . . . . . . . . . . . . . . . . . . . . . . 245 B. Background . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 247 (1) Credit Ratings Generally. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 247 (2) The Rating Process. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250 (3) Record Revenues.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 256 C. Mass Credit Rating Downgrades.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 259 Increasing High Risk Loans and Unaffordable Housing.. . . . . . . . . . . . . . . . . . . . . . 259 (1) (2) Mass Downgrades. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 263 D. Ratings Deficiencies. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 267 (1) Awareness of Increasing Credit Risks.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 268 (2) CRA Conflicts of Interest. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 272 (a) Drive for Market Share. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 273 (b) Investment Bank Pressure. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 278 Inaccurate Models. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 288 (a) Inadequate Data. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 288 (b) Unclear and Subjective Ratings Process. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 294 (4) Failure to Retest After Model Changes. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 297 (5) Inadequate Resources. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 304 (6) Mortgage Fraud. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 310 E. Preventing Inflated Credit Ratings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 313 (1) Past Credit Rating Agency Oversight. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 313

(3)

iii

(2) New Developments. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 315 (3) Recommendations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 316

Rank Credit Rating Agencies by Accuracy. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 316
Help Investors Hold CRAs Accountable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 316 3. Strengthen CRA Operations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 316
Ensure CRAs Recognize Risk. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 316 5. Strengthen Disclosure. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 317
Reduce Ratings Reliance. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 317

VI.

INVESTMENT BANK ABUSES:
CASE STUDY OF GOLDMAN SACHS AND DEUTSCHE BANK.. . . . . . . . . . . . . . . . 318 A. Background. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 321 Investment Banks In General.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 321

(1) (2) Roles and Duties of an Investment Bank: Market Maker, Underwriter,

Placement Agent, Broker-Dealer.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 322 (3) Structured Finance Products. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 325 B. Running the CDO Machine: Case Study of Deutsche Bank. . . . . . . . . . . . . . . . . . . . 330 (1) Subcommittee Investigation and Findings of Fact. . . . . . . . . . . . . . . . . . . . . . . . . . . 333 (2) Deutsche Bank Background. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 334 (3) Deutsche Bank’s $5 Billion Short . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 337 (a) Lippmann’s Negative Views of Mortgage Related Assets. . . . . . . . . . . . . . . . . 337 (b) Building and Cashing in the $5 Billion Short. . . . . . . . . . . . . . . . . . . . . . . . . . . 341 (4) The “CDO Machine” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 346 (5) Gemstone.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 350 (a) Background on Gemstone. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 350 (b) Gemstone Asset Selection. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 353 (c) Gemstone Risks and Poor Quality Assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 357 (d) Gemstone Sales Effort. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 363 (e) Gemstone Losses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 371 (6) Other Deutsche Bank CDOs. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 372 (7) Analysis. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 374 C. Failing to Manage Conflicts of Interest: Case Study of Goldman Sachs. . . . . . . . . . 376 (1) Subcommittee Investigation and Findings of Fact. . . . . . . . . . . . . . . . . . . . . . . . . . . 376 (2) Goldman Sachs Background. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 378 (3) Overview of Goldman Sachs Case Study. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 382 (a) Overview of How Goldman Shorted the Subprime Mortgage Market. . . . . . . . 382 (b) Overview of Goldman’s CDO Activities.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 388 (4) How Goldman Shorted the Subprime Mortgage Market.. . . . . . . . . . . . . . . . . . . . . . 398 (a) Starting $6 Billion Net Long. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 398 (b) Going Past Home: Goldman’s First Net Short. . . . . . . . . . . . . . . . . . . . . . . . . . 404 (c) Attempted Short Squeeze.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 425 (d) Building the Big Short. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 430 (e) “Get Down Now”.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 440

(f) Profiting from the Big Short: Making “Serious Money”.. . . . . . . . . . . . . . . . . . 444 (g) Goldman’s Records Confirm Large Short Position. . . . . . . . . . . . . . . . . . . . . . . 445 (i) Top Sheets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 446 (ii) Risk Reports.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 455 (h) Profiting From the Big Short. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 466

(5) How Goldman Created and Failed to Manage Conflicts of Interest in its

Securitization Activities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 474 (a) Background. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 477 (i) Goldman’s Securitization Business. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 477 (ii) Goldman’s Negative Market View. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 478 (iii) Goldman’s Securitization Sell Off. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 481 AA. RMBS Sell Off.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 481 BB. CDO Sell Off. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 492 CC. CDO Marks. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 503 DD. Customer Losses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 507 (b) Goldman’s Conflicts of Interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 513 (i) Conflicts of Interest Involving RMBS Securities. . . . . . . . . . . . . . . . . . . . 513 (ii) Conflicts of Interest Involving Sales of CDO Securities. . . . . . . . . . . . . . 516 AA. Hudson Mezzanine Funding 2006-1. . . . . . . . . . . . . . . . . . . . . . . . . 517 BB. Anderson Mezzanine Funding 2007-1.. . . . . . . . . . . . . . . . . . . . . . . 532 CC. Timberwolf I. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 541 DD. Abacus 2007-AC1. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 560 (iii) Additional CDO Conflicts of Interest. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 574 AA. Liquidation Agent in Hudson 1. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 574 BB. Collateral Put Provider in Timberwolf. . . . . . . . . . . . . . . . . . . . . . . 588 (6) Analysis of Goldman’s Conflicts of Interest. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 602 (a) Securities Laws. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 603 (b) Analysis .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 609 (i) Claiming Market Maker Status.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 609 (ii) Soliciting Clients and Recommending Investments. . . . . . . . . . . . . . . . . . 613 (iii) Failing to Disclose Material Adverse Information. . . . . . . . . . . . . . . . . . . 615 (iv) Making Unsuitable Investment Recommendations. . . . . . . . . . . . . . . . . . 619 (7) Goldman’s Proprietary Investments. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 624 D. Preventing Investment Bank Abuses.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 636 (1) New Developments. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 636 (2) Recommendations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 638

Review Structured Finance Transactions.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 639
Narrow Proprietary Trading Exceptions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 639
Design Strong Conflict of Interest Prohibitions.. . . . . . . . . . . . . . . . . . . . . . . . . 639 4. Study Bank Use of Structured Finance. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 639

#

Wall Street and The Financial Crisis:

Anatomy of a Financial Collapse

April 13, 2011

In the fall of 2008, America suffered a devastating economic collapse. Once valuable

securities lost most or all of their value, debt markets froze, stock markets plunged, and storied financial firms went under. Millions of Americans lost their jobs; millions of families lost their homes; and good businesses shut down. These events cast the United States into an economic recession so deep that the country has yet to fully recover.

This Report is the product of a two-year bipartisan investigation by the U.S. Senate Permanent Subcommittee on Investigations into the origins of the 2008 financial crisis. The goals of this investigation were to construct a public record of the facts in order to deepen the understanding of what happened; identify some of the root causes of the crisis; and provide a factual foundation for the ongoing effort to fortify the country against the recurrence of a similar crisis in the future.

Using internal documents, communications, and interviews, the Report attempts to provide the clearest picture yet of what took place inside the walls of some of the financial institutions and regulatory agencies that contributed to the crisis. The investigation found that the crisis was not a natural disaster, but the result of high risk, complex financial products; undisclosed conflicts of interest; and the failure of regulators, the credit rating agencies, and the market itself to rein in the excesses of Wall Street.

While this Report does not attempt to examine every key moment, or analyze every

A. Subcommittee Investigation

important cause of the crisis, it provides new, detailed, and compelling evidence of what happened. In so doing, we hope the Report leads to solutions that prevent it from happening again.

I. EXECUTIVE SUMMARY

investigation into some of the key causes of the financial crisis. Since then, the Subcommittee has engaged in a wide-ranging inquiry, issuing subpoenas, conducting over 150 interviews and depositions, and consulting with dozens of government, academic, and private sector experts.
The Subcommittee has accumulated and reviewed tens of millions of pages of documents, including court pleadings, filings with the Securities and Exchange Commission, trustee reports, prospectuses for public and private offerings, corporate board and committee minutes, mortgage transactions and analyses, memoranda, marketing materials, correspondence, and emails. The Subcommittee has also reviewed documents prepared by or sent to or from banking and

In November 2008, the Permanent Subcommittee on Investigations initiated its

B. Overview

(1) High Risk Lending:

Case Study of Washington Mutual Bank

securities regulators, including bank examination reports, reviews of securities firms, enforcement actions, analyses, memoranda, correspondence, and emails.

In April 2010, the Subcommittee held four hearings examining four root causes of the financial crisis. Using case studies detailed in thousands of pages of documents released at the hearings, the Subcommittee presented and examined evidence showing how high risk lending by U.S. financial institutions; regulatory failures; inflated credit ratings; and high risk, poor quality financial products designed and sold by some investment banks, contributed to the financial crisis. This Report expands on those hearings and the case studies they featured. The case studies are Washington Mutual Bank, the largest bank failure in U.S. history; the federal Office of Thrift Supervision which oversaw Washington Mutual’s demise; Moody’s and Standard & Poor’s, the country’s two largest credit rating agencies; and Goldman Sachs and Deutsche Bank, two leaders in the design, marketing, and sale of mortgage related securities. This Report devotes a chapter to how each of the four causative factors, as illustrated by the case studies, fueled the 2008 financial crisis, providing findings of fact, analysis of the issues, and recommendations for next steps.

The first chapter focuses on how high risk mortgage lending contributed to the financial

crisis, using as a case study Washington Mutual Bank (WaMu). At the time of its failure, WaMu was the nation’s largest thrift and sixth largest bank, with $300 billion in assets, $188 billion in deposits, 2,300 branches in 15 states, and over 43,000 employees. Beginning in 2004, it embarked upon a lending strategy to pursue higher profits by emphasizing high risk loans. By 2006, WaMu’s high risk loans began incurring high rates of delinquency and default, and in 2007, its mortgage backed securities began incurring ratings downgrades and losses. Also in 2007, the bank itself began incurring losses due to a portfolio that contained poor quality and fraudulent loans and securities. Its stock price dropped as shareholders lost confidence, and depositors began withdrawing funds, eventually causing a liquidity crisis at the bank. On September 25, 2008, WaMu was seized by its regulator, the Office of Thrift Supervision, placed in receivership with the Federal Deposit Insurance Corporation (FDIC), and sold to JPMorgan Chase for $1.9 billion. Had the sale not gone through, WaMu’s failure might have exhausted the entire $45 billion Deposit Insurance Fund.

This case study focuses on how one bank’s search for increased growth and profit led to

the origination and securitization of hundreds of billions of dollars in high risk, poor quality mortgages that ultimately plummeted in value, hurting investors, the bank, and the U.S. financial system. WaMu had held itself out as a prudent lender, but in reality, the bank turned increasingly to higher risk loans. Over a four-year period, those higher risk loans grew from 19% of WaMu’s loan originations in 2003, to 55% in 2006, while its lower risk, fixed rate loans fell from 64% to 25% of its originations. At the same time, WaMu increased its securitization of

subprime loans sixfold, primarily through its subprime lender, Long Beach Mortgage Corporation, increasing such loans from nearly $4.5 billion in 2003, to $29 billion in 2006.
From 2000 to 2007, WaMu and Long Beach together securitized at least $77 billion in subprime loans.

WaMu also originated an increasing number of its flagship product, Option Adjustable

Rate Mortgages (Option ARMs), which created high risk, negatively amortizing mortgages and, from 2003 to 2007, represented as much as half of all of WaMu’s loan originations. In 2006 alone, Washington Mutual originated more than $42.6 billion in Option ARM loans and sold or securitized at least $115 billion to investors, including sales to the Federal National Mortgage Association (Fannie Mae) and Federal Home Loan Mortgage Corporation (Freddie Mac). In addition, WaMu greatly increased its origination and securitization of high risk home equity loan products. By 2007, home equity loans made up $63.5 billion or 27% of its home loan portfolio, a 130% increase from 2003.

At the same time that WaMu was implementing its high risk lending strategy, WaMu and

Long Beach engaged in a host of shoddy lending practices that produced billions of dollars in high risk, poor quality mortgages and mortgage backed securities. Those practices included qualifying high risk borrowers for larger loans than they could afford; steering borrowers from conventional mortgages to higher risk loan products; accepting loan applications without verifying the borrower’s income; using loans with low, short term “teaser” rates that could lead to payment shock when higher interest rates took effect later on; promoting negatively amortizing loans in which many borrowers increased rather than paid down their debt; and authorizing loans with multiple layers of risk. In addition, WaMu and Long Beach failed to enforce compliance with their own lending standards; allowed excessive loan error and exception rates; exercised weak oversight over the third party mortgage brokers who supplied half or more of their loans; and tolerated the issuance of loans with fraudulent or erroneous borrower information. They also designed compensation incentives that rewarded loan personnel for issuing a large volume of higher risk loans, valuing speed and volume over loan quality.

As a result, WaMu, and particularly its Long Beach subsidiary, became known by

industry insiders for its failed mortgages and poorly performing residential mortgage backed securities (RMBS). Among sophisticated investors, its securitizations were understood to be some of the worst performing in the marketplace. Inside the bank, WaMu’s President Steve Rotella described Long Beach as “terrible” and “a mess,” with default rates that were “ugly.”
WaMu’s high risk lending operation was also problem-plagued. WaMu management was provided with compelling evidence of deficient lending practices in internal emails, audit reports, and reviews. Internal reviews of two high volume WaMu loan centers, for example, described “extensive fraud” by employees who “willfully” circumvented bank policies. A WaMu review of internal controls to stop fraudulent loans from being sold to investors described them as “ineffective.” On at least one occasion, senior managers knowingly sold delinquency-prone loans to investors. Aside from Long Beach, WaMu’s President described WaMu’s prime home loan business as the “worst managed business” he had seen in his career.

Documents obtained by the Subcommittee reveal that WaMu launched its high risk

lending strategy primarily because higher risk loans and mortgage backed securities could be sold for higher prices on Wall Street. They garnered higher prices because higher risk meant the securities paid a higher coupon rate than other comparably rated securities, and investors paid a higher price to buy them. Selling or securitizing the loans also removed them from WaMu’s books and appeared to insulate the bank from risk.

The Subcommittee investigation indicates that unacceptable lending and securitization

practices were not restricted to Washington Mutual, but were present at a host of financial institutions that originated, sold, and securitized billions of dollars in high risk, poor quality home loans that inundated U.S. financial markets. Many of the resulting securities ultimately plummeted in value, leaving banks and investors with huge losses that helped send the economy into a downward spiral. These lenders were not the victims of the financial crisis; the high risk loans they issued were the fuel that ignited the financial crisis.

(2) Regulatory Failure:

Case Study of the Office of Thrift Supervision

The next chapter focuses on the failure of the Office of Thrift Supervision (OTS) to stop

the unsafe and unsound practices that led to the demise of Washington Mutual, one of the nation’s largest banks. Over a five year period from 2004 to 2008, OTS identified over 500 serious deficiencies at WaMu, yet failed to take action to force the bank to improve its lending operations and even impeded oversight by the bank’s backup regulator, the FDIC.

Washington Mutual Bank was the largest thrift under the supervision of OTS and was among the eight largest financial institutions insured by the FDIC. Until 2006, WaMu was a profitable bank, but in 2007, many of its high risk home loans began experiencing increased rates of delinquency, default, and loss. After the market for subprime mortgage backed securities collapsed in July 2007, Washington Mutual was unable to sell or securitize its subprime loans and its loan portfolio fell in value. In September 2007, WaMu’s stock price plummeted against the backdrop of its losses and a worsening financial crisis. From 2007 to 2008, WaMu’s depositors withdrew a total of over $26 billion in deposits from the bank, triggering a liquidity crisis, followed by the bank’s closure.

OTS records show that, during the five years prior to WaMu’s collapse, OTS examiners

repeatedly identified significant problems with Washington Mutual’s lending practices, risk management, asset quality, and appraisal practices, and requested corrective action. Year after year, WaMu promised to correct the identified problems, but never did. OTS failed to respond with meaningful enforcement action, such as by downgrading WaMu’s rating for safety and soundness, requiring a public plan with deadlines for corrective actions, or imposing civil fines for inaction. To the contrary, until shortly before the thrift’s failure in 2008, OTS continually rated WaMu as financially sound.

The agency’s failure to restrain WaMu’s unsafe lending practices stemmed in part from

an OTS regulatory culture that viewed its thrifts as “constituents,” relied on bank management to

correct identified problems with minimal regulatory intervention, and expressed reluctance to interfere with even unsound lending and securitization practices. OTS displayed an unusual amount of deference to WaMu’s management, choosing to rely on the bank to police itself in its use of safe and sound practices. The reasoning appeared to be that if OTS examiners simply identified the problems at the bank, OTS could then rely on WaMu’s assurances that problems would be corrected, with little need for tough enforcement actions. It was a regulatory approach with disastrous results.

Despite identifying over 500 serious deficiencies in five years, OTS did not once, from

2004 to 2008, take a public enforcement action against Washington Mutual to correct its lending practices, nor did it lower the bank’s rating for safety and soundness. Only in 2008, as the bank incurred mounting losses, did OTS finally take two informal, nonpublic enforcement actions, requiring WaMu to agree to a “Board Resolution” in March and a “Memorandum of Understanding” in September, neither of which imposed sufficient changes to prevent the bank’s failure. OTS officials resisted calls by the FDIC, the bank’s backup regulator, for stronger measures and even impeded FDIC oversight efforts by at times denying FDIC examiners office space and access to bank records. Tensions between the two agencies remained high until the end. Two weeks before the bank was seized, the FDIC Chairman contacted WaMu directly to inform it that the FDIC was likely to have a ratings disagreement with OTS and downgrade the bank’s safety and soundness rating, and informed the OTS Director about that communication, prompting him to complain about the FDIC Chairman’s “audacity.”

Hindered by a culture of deference to management, demoralized examiners, and agency infighting, OTS officials allowed the bank’s short term profits to excuse its risky practices and failed to evaluate the bank’s actions in the context of the U.S. financial system as a whole. Its narrow regulatory focus prevented OTS from analyzing or acknowledging until it was too late that WaMu’s practices could harm the broader economy.

OTS’ failure to restrain Washington Mutual’s unsafe lending practices allowed high risk

loans at the bank to proliferate, negatively impacting investors across the United States and around the world. Similar regulatory failings by other agencies involving other lenders repeated the problem on a broad scale. The result was a mortgage market saturated with risky loans, and financial institutions that were supposed to hold predominantly safe investments but instead held portfolios rife with high risk, poor quality mortgages. When those loans began defaulting in record numbers and mortgage related securities plummeted in value, financial institutions around the globe suffered hundreds of billions of dollars in losses, triggering an economic disaster. The regulatory failures that set the stage for those losses were a proximate cause of the financial crisis.

Case Study of Moody’s and Standard & Poor’s

(3) Inflated Credit Ratings:

The next chapter examines how inflated credit ratings contributed to the financial crisis

by masking the true risk of many mortgage related securities. Using case studies involving Moody’s Investors Service, Inc. (Moody’s) and Standard & Poor’s Financial Services LLC

(S&P), the nation’s two largest credit rating agencies, the Subcommittee identified multiple problems responsible for the inaccurate ratings, including conflicts of interest that placed achieving market share and increased revenues ahead of ensuring accurate ratings.

Between 2004 and 2007, Moody’s and S&P issued credit ratings for tens of thousands of U.S. residential mortgage backed securities (RMBS) and collateralized debt obligations (CDO).
Taking in increasing revenue from Wall Street firms, Moody’s and S&P issued AAA and other investment grade credit ratings for the vast majority of those RMBS and CDO securities, deeming them safe investments even though many relied on high risk home loans.1 In late 2006, high risk mortgages began incurring delinquencies and defaults at an alarming rate.
Despite signs of a deteriorating mortgage market, Moody’s and S&P continued for six months to issue investment grade ratings for numerous RMBS and CDO securities.

Then, in July 2007, as mortgage delinquencies intensified and RMBS and CDO securities

began incurring losses, both companies abruptly reversed course and began downgrading at record numbers hundreds and then thousands of their RMBS and CDO ratings, some less than a year old. Investors like banks, pension funds, and insurance companies, who are by rule barred from owning low rated securities, were forced to sell off their downgraded RMBS and CDO holdings, because they had lost their investment grade status. RMBS and CDO securities held by financial firms lost much of their value, and new securitizations were unable to find investors.
The subprime RMBS market initially froze and then collapsed, leaving investors and financial firms around the world holding unmarketable subprime RMBS securities that were plummeting in value. A few months later, the CDO market collapsed as well.

Traditionally, investments holding AAA ratings have had a less than 1% probability of

incurring defaults. But in 2007, the vast majority of RMBS and CDO securities with AAA ratings incurred substantial losses; some failed outright. Analysts have determined that over 90% of the AAA ratings given to subprime RMBS securities originated in 2006 and 2007 were later downgraded by the credit rating agencies to junk status. In the case of Long Beach, 75 out of 75 AAA rated Long Beach securities issued in 2006, were later downgraded to junk status, defaulted, or withdrawn. Investors and financial institutions holding the AAA rated securities lost significant value. Those widespread losses led, in turn, to a loss of investor confidence in the value of the AAA rating, in the holdings of major U.S. financial institutions, and even in the viability of U.S. financial markets.

Inaccurate AAA credit ratings introduced risk into the U.S. financial system and

constituted a key cause of the financial crisis. In addition, the July mass downgrades, which were unprecedented in number and scope, precipitated the collapse of the RMBS and CDO secondary markets, and perhaps more than any other single event triggered the beginning of the financial crisis.

1 S&P issues ratings using the “AAA” designation; Moody’s equivalent rating is “Aaa.” For ease of reference, this Report will refer to both ratings as “AAA.”

The Subcommittee’s investigation uncovered a host of factors responsible for the

inaccurate credit ratings issued by Moody’s and S&P. One significant cause was the inherent conflict of interest arising from the system used to pay for credit ratings. Credit rating agencies were paid by the Wall Street firms that sought their ratings and profited from the financial products being rated. Under this “issuer pays” model, the rating agencies were dependent upon those Wall Street firms to bring them business, and were vulnerable to threats that the firms would take their business elsewhere if they did not get the ratings they wanted. The rating agencies weakened their standards as each competed to provide the most favorable rating to win business and greater market share. The result was a race to the bottom.

Additional factors responsible for the inaccurate ratings include rating models that failed to include relevant mortgage performance data; unclear and subjective criteria used to produce ratings; a failure to apply updated rating models to existing rated transactions; and a failure to provide adequate staffing to perform rating and surveillance services, despite record revenues.
Compounding these problems were federal regulations that required the purchase of investment grade securities by banks and others, which created pressure on the credit rating agencies to issue investment grade ratings. While these federal regulations were intended to help investors stay away from unsafe securities, they had the opposite effect when the AAA ratings proved inaccurate.

Evidence gathered by the Subcommittee shows that the credit rating agencies were aware

of problems in the mortgage market, including an unsustainable rise in housing prices, the high risk nature of the loans being issued, lax lending standards, and rampant mortgage fraud. Instead of using this information to temper their ratings, the firms continued to issue a high volume of investment grade ratings for mortgage backed securities. If the credit rating agencies had issued ratings that accurately reflected the increasing risk in the RMBS and CDO markets and appropriately adjusted existing ratings in those markets, they might have discouraged investors from purchasing high risk RMBS and CDO securities, and slowed the pace of securitizations.

It was not in the short term economic interest of either Moody’s or S&P, however, to

provide accurate credit ratings for high risk RMBS and CDO securities, because doing so would have hurt their own revenues. Instead, the credit rating agencies’ profits became increasingly reliant on the fees generated by issuing a large volume of structured finance ratings. In the end, Moody’s and S&P provided AAA ratings to tens of thousands of high risk RMBS and CDO securities and then, when those products began to incur losses, issued mass downgrades that shocked the financial markets, hammered the value of the mortgage related securities, and helped trigger the financial crisis.

Case Study of Goldman Sachs and Deutsche Bank

(4) Investment Bank Abuses:

The final chapter examines how investment banks contributed to the financial crisis,

using as case studies Goldman Sachs and Deutsche Bank, two leading participants in the U.S. mortgage market.

Investment banks can play an important role in the U.S. economy, helping to channel the nation’s wealth into productive activities that create jobs and increase economic growth. But in the years leading up to the financial crisis, large investment banks designed and promoted complex financial instruments, often referred to as structured finance products, that were at the heart of the crisis. They included RMBS and CDO securities, credit default swaps (CDS), and CDS contracts linked to the ABX Index. These complex, high risk financial products were engineered, sold, and traded by the major U.S. investment banks.

From 2004 to 2008, U.S. financial institutions issued nearly $2.5 trillion in RMBS and

over $1.4 trillion in CDO securities, backed primarily by mortgage related products. Investment banks typically charged fees of $1 to $8 million to act as the underwriter of an RMBS securitization, and $5 to $10 million to act as the placement agent for a CDO securitization.
Those fees contributed substantial revenues to the investment banks, which established internal structured finance groups, as well as a variety of RMBS and CDO origination and trading desks within those groups, to handle mortgage related securitizations. Investment banks sold RMBS and CDO securities to investors around the world, and helped develop a secondary market where RMBS and CDO securities could be traded. The investment banks’ trading desks participated in those secondary markets, buying and selling RMBS and CDO securities either on behalf of their clients or in connection with their own proprietary transactions.

The financial products developed by investment banks allowed investors to profit, not

only from the success of an RMBS or CDO securitization, but also from its failure. CDS contracts, for example, allowed counterparties to wager on the rise or fall in the value of a specific RMBS security or on a collection of RMBS and other assets contained or referenced in a CDO. Major investment banks developed standardized CDS contracts that could also be traded on a secondary market. In addition, they established the ABX Index which allowed counterparties to wager on the rise or fall in the value of a basket of subprime RMBS securities, which could be used to reflect the status of the subprime mortgage market as a whole. The investment banks sometimes matched up parties who wanted to take opposite sides in a transaction and other times took one or the other side of the transaction to accommodate a client.
At still other times, investment banks used these financial instruments to make their own proprietary wagers. In extreme cases, some investment banks set up structured finance transactions which enabled them to profit at the expense of their clients.

Two case studies, involving Goldman Sachs and Deutsche Bank, illustrate a variety of troubling practices that raise conflicts of interest and other concerns involving RMBS, CDO, CDS, and ABX related financial instruments that contributed to the financial crisis.

The Goldman Sachs case study focuses on how it used net short positions to benefit from

the downturn in the mortgage market, and designed, marketed, and sold CDOs in ways that created conflicts of interest with the firm’s clients and at times led to the bank=s profiting from the same products that caused substantial losses for its clients.

From 2004 to 2008, Goldman was a major player in the U.S. mortgage market. In 2006

and 2007 alone, it designed and underwrote 93 RMBS and 27 mortgage related CDO

securitizations totaling about $100 billion, bought and sold RMBS and CDO securities on behalf of its clients, and amassed its own multi-billion-dollar proprietary mortgage related holdings. In December 2006, however, when it saw evidence that the high risk mortgages underlying many RMBS and CDO securities were incurring accelerated rates of delinquency and default, Goldman quietly and abruptly reversed course.

Over the next two months, it rapidly sold off or wrote down the bulk of its existing

subprime RMBS and CDO inventory, and began building a short position that would allow it to profit from the decline of the mortgage market. Throughout 2007, Goldman twice built up and cashed in sizeable mortgage related short positions. At its peak, Goldman’s net short position totaled $13.9 billion. Overall in 2007, its net short position produced record profits totaling $3.7 billion for Goldman’s Structured Products Group, which when combined with other mortgage losses, produced record net revenues of $1.1 billion for the Mortgage Department as a whole.

Throughout 2007, Goldman sold RMBS and CDO securities to its clients without disclosing its own net short position against the subprime market or its purchase of CDS contracts to gain from the loss in value of some of the very securities it was selling to its clients.

The case study examines in detail four CDOs that Goldman constructed and sold called Hudson 1, Anderson, Timberwolf, and Abacus 2007-AC1. In some cases, Goldman transferred risky assets from its own inventory into these CDOs; in others, it included poor quality assets that were likely to lose value or not perform. In three of the CDOs, Hudson, Anderson and Timberwolf, Goldman took a substantial portion of the short side of the CDO, essentially betting that the assets within the CDO would fall in value or not perform. Goldman’s short position was in direct opposition to the clients to whom it was selling the CDO securities, yet it failed to disclose the size and nature of its short position while marketing the securities. While Goldman sometimes included obscure language in its marketing materials about the possibility of its taking a short position on the CDO securities it was selling, Goldman did not disclose to potential investors when it had already determined to take or had already taken short investments that would pay off if the particular security it was selling, or RMBS and CDO securities in general, performed poorly. In the case of Hudson 1, for example, Goldman took 100% of the short side of the $2 billion CDO, betting against the assets referenced in the CDO, and sold the Hudson securities to investors without disclosing its short position. When the securities lost value, Goldman made a $1.7 billion gain at the direct expense of the clients to whom it had sold the securities.

In the case of Anderson, Goldman selected a large number of poorly performing assets

for the CDO, took 40% of the short position, and then marketed Anderson securities to its clients. When a client asked how Goldman “got comfortable” with the New Century loans in the CDO, Goldman personnel tried to dispel concerns about the loans, and did not disclose the firm’s own negative view of them or its short position in the CDO.

In the case of Timberwolf, Goldman sold the securities to its clients even as it knew the securities were falling in value. In some cases, Goldman knowingly sold Timberwolf securities to clients at prices above its own book values and, within days or weeks of the sale, marked

down the value of the sold securities, causing its clients to incur quick losses and requiring some to post higher margin or cash collateral. Timberwolf securities lost 80% of their value within five months of being issued and today are worthless. Goldman took 36% of the short position in the CDO and made money from that investment, but ultimately lost money when it could not sell all of the Timberwolf securities.

In the case of Abacus, Goldman did not take the short position, but allowed a hedge fund,

Paulson & Co. Inc., that planned on shorting the CDO to play a major but hidden role in selecting its assets. Goldman marketed Abacus securities to its clients, knowing the CDO was designed to lose value and without disclosing the hedge fund’s asset selection role or investment objective to potential investors. Three long investors together lost about $1 billion from their Abacus investments, while the Paulson hedge fund profited by about the same amount. Today, the Abacus securities are worthless.

In the Hudson and Timberwolf CDOs, Goldman also used its role as the collateral put provider or liquidation agent to advance its financial interest to the detriment of the clients to whom it sold the CDO securities.

The Deutsche Bank case study describes how the bank’s top global CDO trader, Greg

Lippmann, repeatedly warned and advised his Deutsche Bank colleagues and some of his clients seeking to buy short positions about the poor quality of the RMBS securities underlying many CDOs. He described some of those securities as “crap” and “pigs,” and predicted the assets and the CDO securities would lose value. At one point, Mr. Lippmann was asked to buy a specific CDO security and responded that it “rarely trades,” but he “would take it and try to dupe someone” into buying it. He also at times referred to the industry’s ongoing CDO marketing efforts as a “CDO machine” or “ponzi scheme.” Deutsche Bank’s senior management disagreed with his negative views, and used the bank’s own funds to make large proprietary investments in mortgage related securities that, in 2007, had a notional or face value of $128 billion and a market value of more than $25 billion. Despite its positive view of the housing market, the bank allowed Mr. Lippmann to develop a large proprietary short position for the bank in the RMBS market, which from 2005 to 2007, totaled $5 billion. The bank cashed in the short position from 2007 to 2008, generating a profit of $1.5 billion, which Mr. Lippmann claims is more money on a single position than any other trade had ever made for Deutsche Bank in its history. Despite that gain, due to its large long holdings, Deutsche Bank lost nearly $4.5 billion from its mortgage related proprietary investments.

known as Gemstone CDO VII Ltd. (Gemstone 7), which issued securities in March 2007. It was one of 47 CDOs totaling $32 billion that Deutsche Bank underwrote from 2004 to 2008.
Deutsche Bank made $4.7 million in fees from Gemstone 7, while the collateral manager, a hedge fund called HBK Capital Management, was slated to receive $3.3 million. Gemstone 7 concentrated risk by including within a single financial instrument 115 RMBS securities whose financial success depended upon thousands of high risk, poor quality subprime loans. Many of those RMBS securities carried BBB, BBB-, or even BB credit ratings, making them among the highest risk RMBS securities sold to the public. Nearly a third of the RMBS securities contained

The Subcommittee also examined a $1.1 billion CDO underwritten by Deutsche Bank

subprime loans originated by Fremont, Long Beach, and New Century, lenders well known within the industry for issuing poor quality loans. Deutsche Bank also sold securities directly from its own inventory to the CDO. Deutsche Bank’s CDO trading desk knew that many of these RMBS securities were likely to lose value, but did not object to their inclusion in Gemstone 7, even securities which Mr. Lippmann was calling “crap” or “pigs.” Despite the poor quality of the underlying assets, Gemstone’s top three tranches received AAA ratings. Deutsche Bank ultimately sold about $700 million in Gemstone securities, without disclosing to potential investors that its global head trader of CDOs had extremely negative views of a third of the assets in the CDO or that the bank’s internal valuations showed that the assets had lost over $19 million in value since their purchase. Within months of being issued, the Gemstone 7 securities lost value; by November 2007, they began undergoing credit rating downgrades; and by July 2008, they became nearly worthless.

Both Goldman Sachs and Deutsche Bank underwrote securities using loans from

subprime lenders known for issuing high risk, poor quality mortgages, and sold risky securities to investors across the United States and around the world. They also enabled the lenders to acquire new funds to originate still more high risk, poor quality loans. Both sold CDO securities without full disclosure of the negative views of some of their employees regarding the underlying assets and, in the case of Goldman, without full disclosure that it was shorting the very CDO securities it was marketing, raising questions about whether Goldman complied with its obligations to issue suitable investment recommendations and disclose material adverse interests.

The case studies also illustrate how these two investment banks continued to market new CDOs in 2007, even as U.S. mortgage delinquencies intensified, RMBS securities lost value, the U.S. mortgage market as a whole deteriorated, and investors lost confidence. Both kept producing and selling high risk, poor quality structured finance products in a negative market, in part because stopping the “CDO machine” would have meant less income for structured finance units, smaller executive bonuses, and even the disappearance of CDO desks and personnel, which is what finally happened. The two case studies also illustrate how certain complex structured finance products, such as synthetic CDOs and naked credit default swaps, amplified market risk by allowing investors with no ownership interest in the reference obligations to place unlimited side bets on their performance. Finally, the two case studies demonstrate how proprietary trading led to dramatic losses in the case of Deutsche Bank and undisclosed conflicts of interest in the case of Goldman Sachs.

Investment banks were the driving force behind the structured finance products that

provided a steady stream of funding for lenders originating high risk, poor quality loans and that magnified risk throughout the U.S. financial system. The investment banks that engineered, sold, traded, and profited from mortgage related structured finance products were a major cause of the financial crisis.

C. Recommendations

The four causative factors examined in this Report are interconnected. Lenders

introduced new levels of risk into the U.S. financial system by selling and securitizing complex home loans with high risk features and poor underwriting. The credit rating agencies labeled the resulting securities as safe investments, facilitating their purchase by institutional investors around the world. Federal banking regulators failed to ensure safe and sound lending practices and risk management, and stood on the sidelines as large financial institutions active in U.S. financial markets purchased billions of dollars in mortgage related securities containing high risk, poor quality mortgages. Investment banks magnified the risk to the system by engineering and promoting risky mortgage related structured finance products, and enabling investors to use naked credit default swaps and synthetic instruments to bet on the failure rather than the success of U.S. financial instruments. Some investment banks also ignored the conflicts of interest created by their products, placed their financial interests before those of their clients, and even bet against the very securities they were recommending and marketing to their clients. Together these factors produced a mortgage market saturated with high risk, poor quality mortgages and securities that, when they began incurring losses, caused financial institutions around the world to lose billions of dollars, produced rampant unemployment and foreclosures, and ruptured faith in U.S. capital markets.

Nearly three years later, the U.S. economy has yet to recover from the damage caused by

the 2008 financial crisis. This Report is intended to help analysts, market participants, policymakers, and the public gain a deeper understanding of the origins of the crisis and take the steps needed to prevent excessive risk taking and conflicts of interest from causing similar damage in the future. Each of the four chapters in this Report examining a key aspect of the financial crisis begins with specific findings of fact, details the evidence gathered by the Subcommittee, and ends with recommendations. For ease of reference, all of the recommendations are reprinted here. For more information about each recommendation, please see the relevant chapter.

Recommendations on High Risk Lending

Ensure “Qualified Mortgages” Are Low Risk. Federal regulators should use their regulatory authority to ensure that all mortgages deemed to be “qualified residential mortgages” have a low risk of delinquency or default.
Require Meaningful Risk Retention. Federal regulators should issue a strong risk retention requirement under Section 941 by requiring the retention of not less than a 5% credit risk in each, or a representative sample of, an asset backed securitization’s tranches, and by barring a hedging offset for a reasonable but limited period of time.
Safeguard Against High Risk Products. Federal banking regulators should safeguard taxpayer dollars by requiring banks with high risk structured finance products, including complex products with little or no reliable performance data, to meet conservative loss reserve, liquidity, and capital requirements.

Require Greater Reserves for Negative Amortization Loans. Federal banking regulators should use their regulatory authority to require banks issuing negatively amortizing loans that allow borrowers to defer payments of interest and principal, to maintain more conservative loss, liquidity, and capital reserves.
Safeguard Bank Investment Portfolios. Federal banking regulators should use the Section 620 banking activities study to identify high risk structured finance products and impose a reasonable limit on the amount of such high risk products that can be included in a bank’s investment portfolio.

Recommendations on Regulatory Failures

Complete OTS Dismantling. The Office of the Comptroller of the Currency (OCC)

should complete the dismantling of the Office of Thrift Supervision (OTS), despite attempts by some OTS officials to preserve the agency’s identity and influence within the OCC.

Strengthen Enforcement. Federal banking regulators should conduct a review of

their major financial institutions to identify those with ongoing, serious deficiencies, and review their enforcement approach to those institutions to eliminate any policy of deference to bank management, inflated CAMELS ratings, or use of short term profits to excuse high risk activities.

Strengthen CAMELS Ratings. Federal banking regulators should undertake a

comprehensive review of the CAMELS ratings system to produce ratings that signal whether an institution is expected to operate in a safe and sound manner over a specified period of time, asset quality ratings that reflect embedded risks rather than short term profits, management ratings that reflect any ongoing failure to correct identified deficiencies, and composite ratings that discourage systemic risks.

Evaluate Impacts of High Risk Lending. The Financial Stability Oversight Council

should undertake a study to identify high risk lending practices at financial institutions, and evaluate the nature and significance of the impacts that these practices may have on U.S. financial systems as a whole.

Recommendations on Inflated Credit Ratings

Rank Credit Rating Agencies by Accuracy. The SEC should use its regulatory

authority to rank the Nationally Recognized Statistical Rating Organizations in terms of performance, in particular the accuracy of their ratings.

Help Investors Hold CRAs Accountable. The SEC should use its regulatory

authority to facilitate the ability of investors to hold credit rating agencies accountable in civil lawsuits for inflated credit ratings, when a credit rating agency knowingly or recklessly fails to conduct a reasonable investigation of the rated security.

Strengthen CRA Operations. The SEC should use its inspection, examination, and regulatory authority to ensure credit rating agencies institute internal controls, credit rating methodologies, and employee conflict of interest safeguards that advance rating accuracy.
Ensure CRAs Recognize Risk. The SEC should use its inspection, examination, and

regulatory authority to ensure credit rating agencies assign higher risk to financial instruments whose performance cannot be reliably predicted due to their novelty or complexity, or that rely on assets from parties with a record for issuing poor quality assets.

Strengthen Disclosure. The SEC should exercise its authority under the new Section

78o-7(s) of Title 15 to ensure that the credit rating agencies complete the required new ratings forms by the end of the year and that the new forms provide comprehensible, consistent, and useful ratings information to investors, including by testing the proposed forms with actual investors.

Reduce Ratings Reliance. Federal regulators should reduce the federal government’s

reliance on privately issued credit ratings.

Recommendations on Investment Bank Abuses

Review Structured Finance Transactions. Federal regulators should review the

RMBS, CDO, CDS, and ABX activities described in this Report to identify any violations of law and to examine ways to strengthen existing regulatory prohibitions against abusive practices involving structured finance products.

Narrow Proprietary Trading Exceptions. To ensure a meaningful ban on

proprietary trading under Section 619, any exceptions to that ban, such as for market- making or risk-mitigating hedging activities, should be strictly limited in the implementing regulations to activities that serve clients or reduce risk.

Design Strong Conflict of Interest Prohibitions. Regulators implementing the

conflict of interest prohibitions in Sections 619 and 621 should consider the types of conflicts of interest in the Goldman Sachs case study, as identified in Chapter VI(C)(6) of this Report.

Study Bank Use of Structured Finance. Regulators conducting the banking

activities study under Section 620 should consider the role of federally insured banks in designing, marketing, and investing in structured finance products with risks that cannot be reliably measured and naked credit default swaps or synthetic financial instruments.

Understanding the recent financial crisis requires examining how U.S. financial markets

II. BACKGROUND

have changed in fundamental ways over the past 15 years. The following provides a brief historical overview of some of those changes; explains some of the new financial products and trading strategies in the mortgage area; and provides background on credit ratings, investment banks, government sponsored enterprises, and financial regulators. It also provides a brief timeline of key events in the financial crisis. Two recurrent themes are the increasing amount of risk and conflicts of interest in U.S. financial markets.

A. Rise of Too-Big-To-Fail U.S. Financial Institutions Until relatively recently, federal and state laws limited federally-chartered banks from branching across state lines.2 Instead, as late as the 1990s, U.S. banking consisted primarily of thousands of modest-sized banks tied to local communities. Since 1990, the United States has witnessed the number of regional and local banks and thrifts shrink from just over 15,000 to approximately 8,000 by 2009,3 while at the same time nearly 13,000 regional and local credit unions have been reduced to 7,500.4 suffered losses, the United States could quickly close its doors, protect its depositors, and avoid significant damage to the U.S. banking system or economy. Decentralized banking also promoted competition, diffused credit in the marketplace, and prevented undue concentrations of financial power.

This broad-based approach meant that when a bank

In the mid 1990s, the United States initiated substantial changes to the banking industry,

and exempted investment bank holding companies from direct federal

some of which relaxed the rules under which banks operated, while others imposed new regulations, and still others encouraged increased risk-taking. In 1994, for the first time, Congress explicitly authorized interstate banking, which allowed federally-chartered banks to open branches nationwide more easily than before.5 In 1999, Congress repealed the Glass- Steagall Act of 1933, which had generally required banks, investment banks, securities firms, and insurance companies to operate separately,6 and instead allowed them to openly merge operations.7 The same law also eliminated the Glass-Steagall prohibition on banks engaging in proprietary trading8

2 See McFadden Act of 1927, P.L. 69-639 (prohibiting national banks from owning branches in multiple states); Bank Holding Company Act of 1956, P.L. 84-511 (prohibiting banking company companies from owning branches in multiple states). See also “Going Interstate: A New Dawn for U.S. Banking,” The Regional Economist, a publication of the Federal Reserve Bank of St. Louis (7/1994).
3 See U.S. Census Bureau, “Statistical Abstract of the United States 2011,” at 735, http://www.census.gov/compendia/statab/2011/tables/11s1175.pdf.
4 1/3/2011 chart, “Insurance Fund Ten-Year Trends,” supplied by the National Credit Union Administration (showing that, as of 12/31/1993, the United States had 12,317 federal and state credit unions). 5 Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994, P.L. 103-328 (repealing statutory prohibitions on interstate banking).
6 Glass-Steagall Act of 1933, also known as the Banking Act, P.L. 73-66. 7 Gramm-Leach-Bliley Act of 1999, also known as the Financial Services Modernization Act, P.L. 106-102. Some banks had already begun to engage in securities and insurance activities, with the most prominent example at the time being Citicorp’s 1998 merger with the Travelers insurance group. 8 Glass-Steagall Act, Section 16.

regulation.9 In 2000, Congress enacted the Commodity Futures Modernization Act which barred federal regulation of swaps and the trillion-dollar swap markets, and which allowed U.S. banks, broker-dealers, and other financial institutions to develop, market, and trade these unregulated financial products, including credit default swaps, foreign currency swaps, interest rate swaps, energy swaps, total return swaps, and more.10

In 2002, the Treasury Department, along with other federal bank regulatory agencies,

altered the way capital reserves were calculated for banks, and encouraged the retention of securitized mortgages with investment grade credit ratings by allowing banks to hold less capital in reserve for them than if the individual mortgages were held directly on the banks’ books.11 In 2004, the SEC relaxed the capital requirements for large broker-dealers, allowing them to grow even larger, often with borrowed funds.12 In 2005, when the SEC attempted to assert more control over the growing hedge fund industry, by requiring certain hedge funds to register with the agency, a federal Court of Appeals issued a 2006 opinion that invalidated the SEC regulation.13

These and other steps paved the way, over the course of little more than the last decade,

for a relatively small number of U.S. banks and broker-dealers to become giant financial conglomerates involved in collecting deposits; financing loans; trading equities, swaps and commodities; and issuing, underwriting, and marketing billions of dollars in stock, debt instruments, insurance policies, and derivatives. As these financial institutions grew in size and complexity, and began playing an increasingly important role in the U.S. economy, policymakers began to ask whether the failure of one of these financial institutions could damage not only the U.S. financial system, but the U.S. economy as a whole. In a little over ten years, the creation of too-big-to-fail financial institutions had become a reality in the United States.14

9 Gramm-Leach-Bliley Act of 1999, also known as the Financial Services Modernization Act, P.L. 106-102. See also prepared statement of SEC Chairman Christopher Cox, “Role of Federal Regulators: Lessons from the Credit Crisis for the Future of Regulation,” October 23, 2008 House Committee on Oversight and Government Reform Hearing, (“It was a fateful mistake in the Gramm-Leach-Bliley Act that neither the SEC nor any regulator was given the statutory authority to regulate investment bank holding companies other than on a voluntary basis.”). 10 The 2000 Commodity Futures Modernization Act (CFMA) was enacted as a title of the Consolidated Appropriations Act of 2001, P.L. 106-554. 11 See 66 Fed. Reg. 59614 (Nov. 29, 2011), http://www.federalregister.gov/articles/2001/11/29/01-29179/risk-based- capital-guidelines-capital-adequacy-guidelines-capital-maintenance-capital-treatment-of. 12 See “Alternative Net Capital Requirements for Broker-Dealers That Are Part of Consolidated Supervised Entities,” RIN 3235-AI96, 17 CFR Parts 200 and 240 (8/20/2004) (“amended the net capital rule under the Securities Exchange Act of 1934 to establish a voluntary alternative method of computing net capital for certain broker-dealers”). The Consolidated Supervised Entities (CSE) program, which provided SEC oversight of investment bank holding companies that joined the CSE program on a voluntarily basis, was established by the SEC
in 2004, and terminated by the SEC in 2008, after the financial crisis. The alternative net capital rules for broker- dealers were terminated at the same time. 13 Goldstein v. SEC, 451 F.3d 873 (D.C. Cir. 2006). 14 The financial crisis has not reversed this trend; it has accelerated it. By the end of 2008, Bank of America had purchased Countrywide and Merrill Lynch; Wells Fargo had acquired Wachovia Bank; and JPMorgan Chase had purchased Washington Mutual and Bear Stearns, creating the largest banks in U.S. history. By early 2009, each controlled more than 10% of all U.S. deposits. See, e.g., “Banks ‘Too Big To Fail’ Have Grown Even Bigger:
Behemoths Born of the Bailout Reduce Consumer Choice, Tempt Corporate Moral Hazard,” Washington Post

Over the last ten years, some U.S. financial institutions have not only grown larger and

more complex, but have also engaged in higher risk activities. The last decade has witnessed an explosion of so-called “innovative” financial products with embedded risks that are difficult to analyze and predict, including collateralized debt obligations, credit default swaps, exchange traded funds, commodity and swap indices, and more. Financial engineering produced these financial instruments which typically had little or no performance record to use for risk management purposes. Some U.S. financial institutions became major participants in the development of these financial products, designing, selling, and trading them in U.S. and global markets.

In addition, most major U.S. financial institutions began devoting increasing resources to

so-called “proprietary trading,” in which the firm’s personnel used the firm’s capital to gain investment returns for the firm itself rather than for its clients. Traditionally, U.S. banks, broker- dealers, and investment banks had offered investment advice and services to their clients, and did well when their clients did well. Over the last ten years, however, some firms began referring to their clients, not as customers, but as counterparties. In addition, some firms at times developed and used financial products in transactions in which the firm did well only when its clients, or counterparties, lost money. Some U.S. banks also sponsored affiliated hedge funds, provided them with billions of dollars in client and bank funds, and allowed the hedge funds to make high risk investments on the bank’s behalf, seeking greater returns.

By 2005, as U.S. financial institutions reached unprecedented size and made increasing

use of complex, high risk financial products, government oversight and regulation was increasingly incoherent and misguided.

B. High Risk Mortgage Lending The U.S. mortgage market reflected many of the trends affecting the U.S. financial

system as a whole. Prior to the early 1970s, families wishing to buy a home typically went to a local bank or mortgage company, applied for a loan and, after providing detailed financial information and a down payment, qualified for a 30-year fixed rate mortgage. The local bank or mortgage company then typically kept that mortgage until the homeowner paid it off, earning its profit from the interest rates and fees paid by the borrower.

which effectively limited the number of loans one bank could have on its books. To increase their capital, some lenders began selling the loans on their books to other financial institutions that wanted to service the loans over time, and then used the profits to make new loans to prospective borrowers. Lenders began to make money, not from holding onto the loans they originated and collecting mortgage payments over the years, but from the relatively short term fees associated with originating and selling the loans.

Lenders were required to keep a certain amount of capital for each loan they issued,

(8/28/2009). Those banks plus Citigroup also issued one out of every two mortgages and two out of every three credit cards. Id.

By 2003, many lenders began using higher risk lending strategies involving the

origination and sale of complex mortgages that differed substantially from the traditional 30-year fixed rate home loan. The following describes some of the securitization practices and higher risk mortgage products that came to dominate the mortgage market in the years leading up to the financial crisis.

Securitization. To make home loans sales more efficient and profitable, banks began

making increasing use of a mechanism now called “securitization.” In a securitization, a financial institution bundles a large number of home loans into a loan pool, and calculates the amount of mortgage payments that will be paid into that pool by the borrowers. The securitizer then forms a shell corporation or trust, often offshore, to hold the loan pool and use the mortgage revenue stream to support the creation of bonds that make payments to investors over time.
Those bonds, which are registered with the SEC, are called residential mortgage backed securities (RMBS) and are typically sold in a public offering to investors. Investors typically make a payment up front, and then hold onto the RMBS securities which repay the principal plus interest over time. The amount of money paid periodically to the RMBS holders is often referred to as the RMBS “coupon rate.”

For years, securitization worked well. Borrowers paid their 30-year, fixed rate mortgages

with few defaults, and mortgage backed securities built up a reputation as a safe investment.
Lenders earned fees for bundling the home loans into pools and either selling the pools or securitizing them into mortgage backed securities. Investment banks also earned fees from working with the lenders to assemble the pools, design the mortgage backed securities, obtain credit ratings for them, and sell the resulting securities to investors. Investors like pension funds, insurance companies, municipalities, university endowments, and hedge funds earned a reasonable rate of return on the RMBS securities they purchased.

Due to the 2002 Treasury rule that reduced capital reserves for securitized mortgages,

RMBS holdings also became increasingly attractive to banks, which could determine how much capital they needed to hold based on the credit ratings their RMBS securities received from the credit ratings agencies. According to economist Arnold Kling, among other problems, the 2002 rule “created opportunities for banks to lower their ratio of capital to assets through structured financing” and “created the incentive for rating agencies to provide overly optimistic assessment of the risk in mortgage pools.”15

joined with Wall Street’s growing appetite for securitization fees, prompted lenders to issue mortgages not only to well qualified borrowers, but also higher risk borrowers. Higher risk borrowers were often referred to as “subprime” borrowers to distinguish them from the more creditworthy “prime” borrowers who traditionally qualified for home loans. Some lenders began

High Risk Mortgages. The resulting increased demand for mortgage backed securities,

15 “Not What They Had In Mind: A History of Policies that Produced the Financial Crisis of 2008,” September 2009, Mercatus Center, http://mercatus.org/sites/default/files/publication/NotWhatTheyHadInMind(1).pdf.

to specialize in issuing loans to subprime borrowers and became known as subprime lenders.16 Subprime loans provided new fuel for the securitization engines on Wall Street.

Federal law does not define subprime loans or subprime borrowers, but in 2001, guidance issued by federal banking regulators defined subprime borrowers as those with certain credit risk characteristics, including one or more of the following: (1) two or more 30-day delinquencies in the last 12 months, or one or more 60-day delinquencies in the last 24 months; (2) a judgment or foreclosure in the prior 24 months; (3) a bankruptcy in the last five years; (4) a relatively high default probability as evidenced by, for example, a credit score below 660 on the FICO scale; or (5) a debt service-to-income ratio of 50% or more. definition to any borrower with a credit score below 660 or even 620 on the FICO scale;18 while still others failed to institute any explicit definition of a subprime borrower or loan.19 Credit scores are an underwriting tool used by lenders to evaluate the likelihood that a particular individual will repay his or her debts. FICO credit scores, developed by the Fair Issacs Corporation, are the most widely used credit scores in U.S. financial markets and provide scores ranging from 300 to 850, with the higher scores indicating greater creditworthiness.20

17 Some financial institutions reduced that

High risk loans were not confined, however, to those issued to subprime borrowers.

Some lenders engaged in a host of risky lending practices that allowed them to quickly generate a large volume of high risk loans to both subprime and prime borrowers. Those practices, for example, required little or no verification of borrower income, required borrowers to provide little or no down payments, and used loans in which the borrower was not required to pay down the loan amount, and instead incurred added debt over time, known as “negative amortization” loans. Some lenders offered a low initial “teaser rate,” followed by a higher interest rate that

16 A Federal Reserve Bank of New York research paper identifies the top ten subprime loan originators in 2006 as HSBC, New Century, Countrywide, Citigroup, WMC Mortgage, Fremont, Ameriquest Mortgage, Option One, Wells Fargo, and First Franklin. It identifies the top ten originators of subprime mortgage backed securities as Countrywide, New Century, Option One, Fremont, Washington Mutual, First Franklin, Residential Funding Corp., Lehman Brothers, WMC Mortgage, and Ameriquest. “Understanding the Securitization of Subprime Mortgage Credit,” by Adam Ashcraft and Til Schuermann, Federal Reserve Bank of New York Staff Report No. 318, (3/2008) at 4. 17 Interagency “Expanded Guidance for Subprime Lending Programs, (1/31/2001) at 3. See also “Understanding the Securitization of Subprime Mortgage Credit,” by Adam Ashcraft and Til Schuermann, Federal Reserve Bank of New York Staff Report No. 318, (3/2008) at 14. 18 See, e.g., 1/2005 “Definition of Higher Risk Lending,” chart from Washington Mutual Board of Directors Finance Committee Discussion, JPM_WM00302979, Hearing Exhibit 4/13-2a; 4/2010 “Evaluation of Federal Regulatory Oversight of Washington Mutual Bank,” report prepared by the Offices of Inspector General at the Department of the Treasury and Federal Deposit Insurance Corporation, at 8, Hearing Exhibit 4/16-82. 19 See, e.g., Countrywide Financial Corporation, as described in SEC v. Mozilo, Case No. CV09-03994 (USDC CD Calif.), Complaint (June 4, 2009), at ¶¶ 20-21. 20 To develop FICO scores, Fair Isaac uses proprietary mathematical models that draw upon databases of actual credit information to identify factors that can reliably be used to predict whether an individual will repay outstanding debt. Key factors in the FICO score include an individual’s overall level of debt, payment history, types of credit extensions, and use of available credit lines. See “What’s in Your FICO Score,” Fair Isaac Corporation, http://www.myfico.com/CreditEducation/WhatsInYourScore.aspx. Other types of credit scores have also been developed, including the VantageScore developed jointly by the three major credit bureaus, Equifax Inc., Experian Group Ltd., and TransUnion LLC, but the FICO score remains the most widely used credit score in U.S. financial markets.

took effect after a specified event or period of time, to enable borrowers with less income to make the initial, smaller loan payments. Some qualified borrowers according to whether they could afford to pay the lower initial rate, rather than the higher rate that took effect later, expanding the number of borrowers who could qualify for the loans. Some lenders deliberately issued loans that made economic sense for borrowers only if the borrowers could refinance the loan within a few years to retain the teaser rate, or sell the home to cover the loan costs. Some lenders also issued loans that depended upon the mortgaged home to increase in value over time, and cover the loan costs if the borrower defaulted. Still another risky practice engaged in by some lenders was to ignore signs of loan fraud and to issue and securitize loans suspected of containing fraudulent borrower information.

These practices were used to qualify borrowers for larger loans than they could have

otherwise obtained. When borrowers took out larger loans, the mortgage broker typically profited from higher fees and commissions; the lender profited from higher fees and a better price for the loan on the secondary market; and Wall Street firms profited from a larger revenue stream to support bigger pools of mortgage backed securities.

The securitization of higher risk loans led to increased profits, but also injected greater

Because higher risk loans required

risks into U.S. mortgage markets. Some U.S. lenders, like Washington Mutual and Countrywide, made wholesale shifts in their loan programs, reducing their sale of low risk, 30-year, fixed rate mortgages and increasing their sale of higher risk loans.21 borrowers to pay higher fees and a higher rate of interest, they produced greater initial profits for lenders than lower risk loans. In addition, Wall Street firms were willing to pay more for the higher risk loans, because once securitized, the AAA securities relying on those loans typically paid investors a higher rate of return than other AAA investments, due to the higher risk involved. As a result, investors were willing to pay more, and mortgaged backed securities relying on higher risk loans typically fetched a better price than those relying on lower risk loans.
Lenders also incurred little risk from issuing the higher risk loans, since they quickly sold the loans and kept the risk off their books.

After 2000, the number of high risk loans increased rapidly, from about $125 billion in dollar value or 12% of all U.S. loan originations in 2000, to about $1 trillion in dollar value or 22 Altogether from 2000 to 2007, U.S. lenders originated 34% of all loan originations in 2006. about 14.5 million high risk loans.23 The majority of those loans, 59%, were used to refinance

21 See, e.g., “Shift to Higher Margin Products,” chart from Washington Mutual Board of Directors meeting, at JPM_WM00690894, Hearing Exhibit 4/13-3 (featuring discussion of the larger “gain on sale” produced by higher risk home loans); “WaMu Product Originations and Purchases By Percentage - 2003-2007,” chart prepared by the Subcommittee, Hearing Exhibit 4/13-1i (showing how higher risk loans grew from about 19% to about 55% of WaMu’s loan originations); SEC v. Mozilo, Case No. CV09-03994 (USDC CD Calif.), Complaint (June 4, 2009), at ¶¶ 17-19 (alleging that higher risk loans doubled at Countrywide, increasing from about 31% to about 64% of its loan originations). 22 8/2010 “Nonprime Mortgages: Analysis of Loan Performance, Factors Associated with Defaults, and Data Sources,” Government Accountability Office (GAO), Report No. GAO-10-805 at 1. These figures include subprime loans, Alt A, and option payment loans, but not home equity loans, which means the totals for high risk loans are understated. 23 Id. at 5.

an existing loan, rather than buy a new home.24 GAO, many of these borrowers:

In addition, according to research performed by

“refinanced their mortgages at a higher amount than the loan balance to convert their home equity into money for personal use (known as ‘cash-out refinancing’). Of the subprime mortgages originated from 2000 through 2007, 55 percent were for cash-out refinancing, 9 percent were for no-cash-out refinancing, and 36 percent were for a home purchase.” Some lenders became known inside the industry for issuing high risk, poor quality loans, yet during the years leading up to the financial crisis were able to securitize and sell their home loans with few problems. Subprime lenders like Long Beach Mortgage Corporation, New Century Financial Corporation, and Fremont Loan & Investment, for example, were known for issuing poor quality subprime loans. Despite their reputations for poor quality loans, leading investment banks continued to do business with them and helped them sell or securitize hundreds of billions of dollars in home mortgages.

These three lenders and others issued a variety of nontraditional, high risk loans whose subsequent delinquencies and defaults later contributed to the financial crisis. They included hybrid adjustable rate mortgages, pick-a-payment or option ARM loans, interest-only loans, home equity loans, and Alt A and stated income loans. Although some of these loans had been in existence for years, they had previously been restricted to a relatively small group of borrowers who were generally able to repay their debts. In the years leading up to the financial crisis, however, lenders issued these higher risk loans to a wide variety of borrowers, including subprime borrowers, who often used them to purchase more expensive homes than they would have been able to buy using traditional fixed rate, 30-year loans.

Hybrid ARMs. One common high risk loan used by lenders in the years leading up to

the financial crisis was the short term hybrid adjustable rate mortgage (Hybrid ARM), which was offered primarily to subprime borrowers. From 2000 to 2007, about 70% of subprime loans were Hybrid ARMs.27 Hybrid ARMs were often referred to “2/28,” “3/27,” or “5/25” loans.
These 30-year mortgages typically had a low fixed teaser rate, which then reset to a higher floating interest rate, after two years for the 2/28, three years for the 3/27, or five years for the 5/25. The initial loan payment was typically calculated by assuming the initial low, fixed interest rate would be used to pay down the loan. In some cases, the loan used payments that initially covered only the interest due on the loan and not any principal; these loans were called “interest only” loans. After the fixed period for the teaser rate expired, the monthly payment was typically recalculated using the higher floating rate to pay off the remaining principal and interest owing over the course of the remaining loan period. The resulting monthly payment was much

24 7/28/2009 “Characteristics and Performance of Nonprime Mortgages,” GAO, Report No. GAO-09-848R at 24, Table 3. 25 Id. at 7. 26 For more information about Long Beach, see Chapter III of this Report. For more information about New Century and Fremont, see section (D)(2)(c)-(d) of Chapter IV. 27 8/2010 “Nonprime Mortgages: Analysis of Loan Performance, Factors Associated with Defaults, and Data Sources,” GAO, Report No. GAO-10-805 at 5, 11.

larger and sometimes caused borrowers to experience “payment shock” and default on their loans. To avoid the higher interest rate and the larger loan payment, many of the borrowers routinely refinanced their loans; when those borrowers were unable to refinance, many were unable to afford the higher mortgage payment and defaulted.

Pick-A-Payment or Option ARMs. Another common high risk loan, offered to both prime and subprime borrowers during the years leading up to the financial crisis, was known as the “pick-a-payment” or “option adjustable rate mortgage” (Option ARM). According to a 2009 GAO report:

“[P]ayment-option ARMs were once specialized products for financially sophisticated borrowers but ultimately became more widespread. According to federal banking regulators and a range of industry participants, as home prices increased rapidly in some areas of the country, lenders began marketing payment-option ARMs as affordability products and made them available to less-creditworthy and lower-income borrowers.”28

Option ARMs typically allowed the borrower to pay an initial low teaser rate, sometimes

as low as a 1% annual rate for the first month, and then imposed a much higher interest rate linked to an index, while also giving the borrower a choice each month of how much to pay down the outstanding loan balance. These loans were called “pick-a-payment” or “option” ARMs, because borrowers were typically allowed to choose among four alternatives: (1) paying the fully amortizing amount needed to pay off the loan in 30 years; (2) paying an even higher amount to pay off the loan in 15 years; (3) paying only the interest owed that month and no principal; or (4) making a “minimum” payment that covered only a portion of the interest owed and none of the principal. If the minimum payment option were selected, the unpaid interest would be added to the loan principal. If, each month, the borrower made only the minimum payment, the loan principal would increase rather than decrease over time, creating a negatively amortizing loan.

Typically, after five years or when the loan principal reached a designated threshold, such

as 110%, 115%, or 125% of the original loan amount, the loan would “recast.” The borrower would then be required to make the fully amortizing payment needed to pay off the remaining loan amount within the remaining loan period. The new monthly payment amount was typically much greater, causing payment shock and increasing loan defaults. For example, a borrower taking out a $400,000 loan, with a teaser rate of 1.5% and subsequent interest rate of 6%, might have a minimum payment of $1,333. If the borrower then made only the minimum payments until the loan recast, the new payment using the 6% rate would be $2,786, an increase of more than 100%. What began as a 30-year loan for $400,000 became a 25-year loan for $432,000. To avoid having the loan recast, option ARM borrowers typically sought to refinance their loans. At some lenders, a significant portion of their option ARM business consisted of refinancing existing loans.

Home Equity Loans. A third type of high risk loan that became popular during the

years leading up to the financial crisis was the home equity loan (HEL). HELs provided loans

287/28/2009 “Characteristics and Performance of Nonprime Mortgages,” GAO, Report No. GAO-09-848R at 12-13.

secured by the borrower’s equity in his or her home, which served as the loan collateral. HELs typically provided a lump sum loan amount that had to be repaid over a fixed period of time, such as 5, 10, or 30 years, using a fixed interest rate, although adjustable rates could also be used. A related loan, the Home Equity Line of Credit (HELOC), created a revolving line of credit, secured by the borrower’s home, that the borrower could use at will, to take out and repay various levels of debt over time, typically using an adjustable rate of interest. Both HELs and HELOCs created liens against the borrower’s house which, in the event of a default, could be sold to repay any outstanding loan amounts.

During the years leading up to the financial crisis, lenders provided HELs and HELOCs to both prime and subprime borrowers. They were typically high risk loans, because most were issued to borrowers who already had a mortgage on their homes and held only a limited amount of equity. The HEL or HELOC was typically able to establish only a “second lien” or “second mortgage” on the property. If the borrower later defaulted and the home sold, the sale proceeds would be used to pay off the primary mortgage first, and only then the HEL or HELOC. Often, the sale proceeds were insufficient to repay the HEL or HELOC loan. In addition, some lenders created home loan programs in which a HEL was issued as a “piggyback loan” to the primary home mortgage to finance all or part of the borrower’s down payment.29 Taken together, the HEL and the mortgage often provided the borrower with financing equal to 85%, 90%, or even 100% of the property’s value.30 The resulting high loan-to-value ratio, and the lack of borrower equity in the home, meant that, if the borrower defaulted and the home had to be sold, the sale proceeds were unlikely to be sufficient to repay both loans.

Alt A Loans. Another type of common loan during the years leading up to the financial

crisis was the “Alt A” loan. Alt A loans were issued to borrowers with relatively good credit 31 For example, Alt histories, but with aggressive underwriting that increased the risk of the loan. A loans often allowed borrowers to obtain 100% financing of their homes, to have an unusually high debt-to-income ratio, or submit limited or even no documentation to establish their income levels. Alt A loans were sometimes referred to as “low doc” or “no doc” loans. They were originally developed for self employed individuals who could not easily establish their income by producing traditional W-2 tax return forms or pay stubs, and so were allowed to submit “alternative” documentation to establish their income or assets, such as bank statements.32 The reasoning was that other underwriting criteria could be used to ensure that Alt A loans would be repaid, such as selecting only borrowers with a high credit score or with a property appraisal showing the home had substantial value in excess of the loan amount. According to GAO, from 2000 to 2006, the percentage of Alt A loans with less than full documentation of the borrower’s income or assets rose from about 60% to 80%.33

29 7/28/2009 “Characteristics and Performance of Nonprime Mortgages,” GAO, Report No. GAO-09-848R at 9. 30 Id. GAO determined that, in 2000, only about 2.4% of subprime loans had a combined loan-to-value ratio, including both first and second home liens, of 100%, but by 2006, the percentage had climbed tenfold to 29.3%. 31 Id. at 1. GAO treated both low documentation loans and Option ARMs as Alt A loans. This Report considers Option ARMs as a separate loan category.
32 See id. at 14. 33 Id.

Stated Income Loans. Stated income loans were a more extreme form of low doc Alt A loans, in that they imposed no documentation requirements and required little effort by the lender to verify the borrower’s income. These loans allowed borrowers simply to “state” their income, with no verification by the lender of the borrower’s income or assets other than to consider the income’s “reasonableness.” They were sometimes called “NINA” loans, because “No Income” and “No Assets” of the borrower were verified by the lender. They were also referred to as “liar loans,” since borrowers could lie about their incomes, and the lender would make little effort to substantiate the claimed income. Many lenders believed they could simply rely on the other underwriting tools, such as the borrower’s credit score and the property appraisal, to ensure the loans would be repaid. Once rare and reserved only for wealthier borrowers, stated income loans became commonplace in the years leading up to the financial crisis. For example, at Washington Mutual Bank, one of the case studies in this Report, by the end of 2007, stated income loans made up 50% of its subprime loans, 73% of its Option ARMs, and 90% of its home equity loans.34

Nationwide, the percentage of high risk loans issued with low or no documentation of borrower income or assets was less dramatic. According to GAO, for example, from 2000 to 2006, the nationwide percentage of subprime loans with low or no documentation of borrower income or assets grew from about 20% to 38%.

Volume and Speed. When lenders kept on their books the loans they issued, the

creditworthiness of those loans determined whether the lender would turn a profit. Once lenders began to sell or securitize most of their loans, volume and speed, as opposed to creditworthiness, became the keys to a profitable securitization business.

In addition, in the years leading up to the financial crisis, investors that might normally

insist on purchasing only high quality securities, purchased billions of dollars in RMBS securities containing poor quality, high risk loans, in part because those securities bore AAA ratings from the credit rating agencies, and in part because the securities offered higher returns compared to other AAA rated investments. Banks also bought investment grade RMBS securities to take advantage of their lower capital requirements. Increasingly, the buyers of RMBS securities began to forego detailed due diligence of the RMBS securities they purchased.
Instead, they, like the lenders issuing the mortgages, operated in a mortgage market that came to be dominated by volume and speed, as opposed to credit risk.

Lenders that produced a high volume of loans could sell pools of the loans to Wall Street

or to government sponsored entities like Fannie Mae and Freddie Mac. Likewise, they could securitize the loans and work with Wall Street investment banks to sell the securities to investors.
These lenders passed on the risk of nonpayment to third parties, and so lost interest in whether the sold loans would, in fact, be repaid. Investment banks that securitized the loans garnered fees for their services and also typically passed on the risk of nonpayment to the investors who

34 4/2010 “Evaluation of Federal Regulatory Oversight of Washington Mutual Bank,” prepared by the Offices of Inspector General at the Department of the Treasury and Federal Deposit Insurance Corporation, at 10, Hearing Exhibit 4/16-82. 35 7/28/2009 “Characteristics and Performance of Nonprime Mortgages,” GAO, Report No. GAO-09-848R at 14.

bought the mortgage backed securities. The investment banks were typically interested in loan repayment rates only to the extent needed to ensure defaulting loans did not cause losses to the mortgage backed securities they sold. Even some of the investors who purchased the mortgage backed securities lost interest in their creditworthiness, so long as they could buy “insurance” in the form of credit default swaps that paid off if a mortgage backed security defaulted.

To ensure an ongoing supply of loans for sale, lenders created compensation incentives

that encouraged their personnel to quickly produce a high volume of loans. They also encouraged their staffs to issue or purchase higher risk loans, because those loans produced higher sale prices on Wall Street. Loan officers, for example, received more money per loan for originating higher risk loans and for exceeding established loan targets. Loan processing personnel were compensated according to the speed and number of the loans they processed.
Loan officers and their sales associates received still more compensation, often called yield spread premiums, if they charged borrowers higher interest rates or points than required in the lender’s rate sheets specifying loan prices, or included prepayment penalties in the loan agreements. The Subcommittee’s investigation found that lenders employed few compensation incentives to encourage loan officers or loan processors to produce high quality, creditworthy loans in line with the lender’s credit requirements.

As long as home prices kept rising, the high risk loans fueling the securitization markets

produced few problems. Borrowers who could not make their loan payments could refinance their loans or sell their homes and use the sale proceeds to pay off their mortgages. As this chart shows, over the ten years before the crisis hit, housing prices shot up faster than they had in decades, allowing price increases to mask problems with the high risk loans being issued.36

36 See “Estimation of Housing Bubble: Comparison of Recent Appreciation vs. Historical Trends,” chart prepared by Paulson & Co. Inc., Hearing Exhibit 4/13-1j.

Borrowers were able to pay for the increasingly expensive homes, in part, because of the exotic, high risk loans and lax loan underwriting practices that allowed them to buy more house than they could really afford.

C. Credit Ratings and Structured Finance
Despite the increasing use of high risk loans to support mortgage related securities,

mortgage related securities continued to receive AAA and other investment grade ratings from the credit rating agencies, indicating they were judged to be safe investments. Those credit ratings gave a sense of security to investors and enabled investors like pension funds, insurance companies, university endowments, and municipalities, which were often required to hold safe investments, to continue to purchase mortgage related securities.

Credit Ratings Generally. A credit rating is an assessment of the likelihood that a particular financial instrument, such as a corporate bond or mortgage backed security, may

default or incur losses.37 repaid and so qualifies as a safe investment.

A high credit rating indicates that a debt instrument is expected to be

Credit ratings are issued by private firms that have been officially designated by the SEC

Financial instruments bearing AAA through BBB- ratings are generally

Credit ratings use a scale of letter grades to indicate credit risk, ranging from AAA to D,

as Nationally Recognized Statistical Rating Organizations (NRSROs). NRSROs are usually referred to as “credit rating agencies.” While there are ten registered credit rating agencies in the United States, the market is dominated by just three: Moody’s Investors Service, Inc. 38
(Moody’s); Standard & Poor’s Financial Services LLC (S&P); and Fitch Ratings Ltd. (Fitch). By some accounts, these firms issue about 98% of the total credit ratings and collect 90% of total credit rating revenue in the United States.39

with AAA ratings designating the safest investments. Investments with AAA ratings have historically had low default rates. For example, S&P reported that its cumulative RMBS default rate by original rating class (through September 15, 2007) was 0.04% for AAA initial ratings and 1.09% for BBB. referred to as “investment grade,” while those with ratings below BBB- (or Baa3) are referred to as “below investment grade” or sometimes as having “junk” status. Financial instruments that default receive a D rating from Standard & Poor’s, but no rating at all from Moody’s.

Investors often rely on credit ratings to gauge the safety of a particular investment. Some institutional investors design an investment strategy that calls for acquiring assets with specified credit ratings. State and federal law also restricts the amount of below investment grade bonds that certain investors can hold, such as pension funds and insurance companies. limited by law in the amount of noninvestment grade bonds they can hold, and are typically required to post additional capital for investments carrying riskier ratings. Because so many federal and state statutes and regulations required financial institutions to hold securities with investment grade ratings, the credit rating agencies were not only guaranteed a steady business, but were encouraged to issue AAA and other investment grade ratings. Issuers of securities and other financial instruments also worked hard to obtain favorable credit ratings to ensure more investors could buy their products.

Banks are also

Although the SEC has generally overseen the credit rating industry for many years, it had

no statutory basis to exercise regulatory authority until enactment of the Credit Rating Agency Reform Act in September 2006. Concerned by the inflated credit ratings that had been issued for

37 See 9/3/2009 “Credit Rating Agencies and Their Regulation,” prepared by the Congressional Research Service Report No. R40613 (revised report issued 4/9/2010). For more information about the credit rating process and the credit rating agencies, see Chapter V, below. 38 See 9/25/2008 “Credit Rating Agencies—NRSROs,” SEC, http://www.sec.gov/answers/nrsro.htm. 39 See 9/3/2009 “Credit Rating Agencies and Their Regulation,” prepared by the Congressional Research Service Report No. R40613 (revised report issued 4/9/2010). 40 Prepared Statement of Vickie A. Tillman, Executive Vice President, Standard & Poor’s Credit Market Services, “The Role of Credit Rating Agencies in the Structured Finance Market,” before the U.S. House of Representatives Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises of the Committee on Financial Services, Serial No. 110-62 (9/27/2007), S&P SEC-PSI 0001945-71, at 51. (See Chapter V below.) See also 1/2007 “Annual 2006 Global Corporate Default Study and Ratings Transitions,” S&P.
41 For more detail on these matters, see Chapter V, below.

bonds from Enron Corporation and other troubled corporations, Congress strengthened the SEC’s authority over the credit rating industry. Among other provisions, the law established criteria for the NRSRO designation and authorized the SEC to conduct examinations of credit rating agencies. The law also, however, prohibited the SEC from regulating credit rating criteria or methodologies used in credit rating models. In June 2007, the SEC issued implementing regulations, which were essentially too late to affect the ratings already provided for mortgage related securities. One month later, in July 2007, the credit rating agencies issued the first of several mass downgrades of the ratings earlier issued for mortgage related securities.

Structured Finance. In recent years, Wall Street firms have devised increasingly

complex financial instruments for sale to investors. These instruments are often referred to as structured finance. Because structured finance products are so complicated and opaque, investors often place particular reliance on credit ratings to determine whether they should buy them.

Among the oldest types of structured finance products are RMBS securities. To create

these securities, issuers – often working with investment banks – bundle large numbers of home loans into a loan pool, and calculate the revenue stream coming into the loan pool from the individual mortgages. They then design a “waterfall” that delivers a stream of revenues in sequential order to specified “tranches.” The first tranche is at the top of the waterfall and is typically the first to receive revenues from the mortgage pool. Since that tranche is guaranteed to be paid first, it is the safest investment in the pool. The issuer creates a security, often called a bond, linked to that first tranche. That security typically receives a AAA credit rating since its revenue stream is the most secure.

The security created from the next tranche receives the same or a lower credit rating and so on until the waterfall reaches the “equity” tranche at the bottom. The equity tranche typically receives no rating since it is the last to be paid, and therefore the first to incur losses if mortgages in the loan pool default. Since virtually every mortgage pool has at least some mortgages that default, equity tranches are intended to provide loss protection for the tranches above it. Because equity tranches are riskier, however, they are often assigned and receive a higher rate of interest and can be profitable if losses are minimal. One mortgage pool might produce five to a dozen or more tranches, each of which is used to create a residential mortgage backed security that is rated and then sold to investors.

Cash CDOs. Collateralized debt obligations (CDOs) are another type of structured finance product whose securities receive credit ratings and are sold to investors. CDOs are a more complex financial product that involves the re-securitization of existing income-producing assets. From 2004 through 2007, many CDOs included RMBS securities from multiple mortgage pools. For example, a CDO might contain BBB rated securities from 100 different RMBS securitizations. CDOs can also contain other types of assets, such as commercial mortgage backed securities, corporate bonds, or other CDO securities. These CDOs are often called “cash CDOs,” because they receive cash revenues from the underlying RMBS bonds and other assets. If a CDO is designed so that it contains a specific list of assets that do not change, it is often called a “static” CDO; if the CDO’s assets are allowed to change over time, it is often

referred to as a “managed” CDO. Like an RMBS securitization, the CDO arranger calculates the revenue stream coming into the pool of assets, designs a waterfall to divide those incoming revenues among a hierarchy of tranches, and uses each tranche to issue securities that can then be marketed to investors. The most senior tranches of a CDO may receive AAA ratings, even if all of its underlying assets have BBB ratings.

Synthetic CDOs. Some investment banks also created “synthetic CDOs” which

mimicked cash CDOs, but did not contain actual mortgages or other assets that produced income.
Instead, they simply “referenced” existing assets and then allowed investors to use credit default swaps to place bets on the performance of those referenced assets. Investors who bet that the referenced assets would maintain or increase in value bought the CDO’s securities and, in exchange, received periodic coupon payments to recoup their principal investment plus interest.
Investors who bet that the referenced assets would lose value or incur a specified negative credit event purchased one or more credit default swap contracts referencing the CDO’s assets, and paid monthly premiums to the CDO in exchange for obtaining a large lump sum payment if the loss or other negative credit event actually occurred. Investors in synthetic CDOs who bet the referenced assets would maintain or increase in value were said to be on the “long” side, while investors who bet the assets would lose value or fail were said to be on the “short” side. Some investment banks also created “hybrid CDOs” which contained some cash assets as well as credit default swaps referencing other assets. Others created financial instruments called CDO squared or cubed, which contained or referenced tranches from other CDOs.

Like RMBS mortgage pools and cash CDOs, synthetic and hybrid CDOs pooled the

payments they received, designed a waterfall assigning portions of the revenues to tranches set up in a certain order, created securities linked to the various tranches, and then sold the CDO securities to investors. Some CDOs employed a “portfolio selection agent” to select the initial assets for the CDO. In addition, some CDOs employed a “collateral manager” to select both the initial and subsequent assets that went into the CDO.

Ratings Used to Market RMBS and CDOs. Wall Street firms helped design RMBS and CDO securities, worked with the credit rating agencies to obtain ratings for the securities, and sold the securities to investors like pension funds, insurance companies, university endowments, municipalities, and hedge funds. Without investment grade ratings, Wall Street firms would have had a more difficult time selling structured finance products to investors, because each investor would have had to perform its own due diligence review of the product. In addition, their sales would have been restricted by federal and state regulations limiting certain institutional investors to the purchase of instruments carrying investment grade credit ratings.
Still other regulations conditioned capital reserve requirements on the credit ratings assigned to a bank’s investments. Investment grade credit ratings, thus, purported to simplify the investors’ due diligence review, ensured some investors could make a purchase, reduced banks’ capital calls, and otherwise enhanced the sales of the structured finance products. Here’s how one federal bank regulator’s handbook put it:

“The rating agencies perform a critical role in structured finance – evaluating the credit quality of the transactions. Such agencies are considered credible because they possess

the expertise to evaluate various underlying asset types, and because they do not have a financial interest in a security’s cost or yield. Ratings are important because investors generally accept ratings by the major public rating agencies in lieu of conducting a due diligence investigation of the underlying assets and the servicer.”42

The more complex and opaque the structured finance instruments became, the more reliant investors were on high credit ratings for the instruments to be marketable.

In addition to making structured finance products easier to sell to investors, Wall Street firms used financial engineering to combine AAA ratings – normally reserved for ultra-safe investments with low rates of return – with high risk assets, such as the AAA tranche from a subprime RMBS paying a relatively high rate of return. Higher rates of return, combined with AAA ratings, made subprime RMBS and related CDOs especially attractive investments.

Record Ratings and Revenues. From 2004 to 2007, Moody’s and S&P produced a record

number of ratings and a record amount of revenues for rating structured finance products. A 2008 S&P submission to the SEC indicates, for example, that from 2004 to 2007, S&P issued more than 5,500 RMBS ratings and more than 835 mortgage related CDO ratings.43 According to a 2008 Moody’s submission to the SEC, from 2004 to 2007, Moody’s issued over 4,000 RMBS ratings and over 870 CDO ratings.44

Revenues increased dramatically over the same time period. The credit rating agencies charged substantial fees to rate a product. To obtain a rating during the height of the market, for example, S&P generally charged from $40,000 to $135,000 to rate tranches of an RMBS and 45 Surveillance fees generally ranged from $30,000 to $750,000 to rate the tranches of a CDO. from $5,000 to $50,000 per year for mortgage backed securities.46 Over a five-year period, Moody’s gross revenues from RMBS and CDO ratings more than tripled, going from over $61 million in 2002, to over $260 million in 2006.47 S&P’s revenue also increased. S&P’s gross revenues for RMBS and mortgage related CDO ratings quadrupled, from over $64 million in

42 11/1997 Comptroller of the Currency Administrator of National Banks Comptroller’s Handbook, “Asset Securitization,” at 11. 43 3/14/2008 compliance letter from S&P to SEC, SEC_OCIE_CRA_011218-59, at 20. These numbers represent the RMBS or CDO pools that were presented to S&P which then issued ratings for multiple tranches per RMBS or CDO pool. (See Chapter V below.) 44 3/11/2008 compliance letter from Moody’s to SEC, SEC_OCIE_CRA_011212 and SEC_OCIE_CRA_011214. These numbers represent the RMBS or CDO pools that were presented to Moody’s which then issued ratings for multiple tranches per RMBS or CDO pool. The data Moody’s provided to the SEC on CDOs represented ABS CDOs, some of which may not be mortgage related. However, by 2004, most, but not all, CDOs relied primarily on mortgage related assets such as RMBS securities. Subcommittee interview of Gary Witt, former Managing Director of Moody’s RMBS Group (10/29/2009). (See Chapter V below.) 45 “U.S. Structured Ratings Fee Schedule Residential Mortgage-backed Financings and Residential Servicer Evaluations,” prepared by S&P, S&P-PSI 0000028-35; and “U.S. Structured Ratings Fee Schedule Collateralized Debt Obligations Amended 3/7/2007,” prepared by S&P, S&P-PSI 0000036-50. (See Chapter V below.) 46 Id.
47 3/11/2008 compliance letter from Moody’s to SEC, SEC_OCIE_CRA_011212 and SEC_OCIE_CRA_011214. The 2002 figure does not include gross revenue from CDO ratings as this figure was not readily available due to the transition of Moody’s accounting systems. (See Chapter V below.)

2002, to over $265 million in 2006.48 Altogether, revenues from the three leading credit rating agencies more than doubled from nearly $3 billion in 2002 to over $6 billion in 2007.49

Conflicts of Interest. Credit rating agencies are paid by the issuers seeking ratings for

the products they sell. Issuers and the investment banks want high ratings, whether to help market their products or ensure they comply with federal regulations. Because credit rating agencies issue ratings to issuers and investment banks who bring them business, they are subject to an inherent conflict of interest that can create pressure on the credit rating agencies to issue favorable ratings to attract business. The issuers and investment banks engage in “ratings shopping,” choosing the credit rating agency that offers the highest ratings. Ratings shopping weakens rating standards as the rating agencies who provide the most favorable ratings win more business. In September 2007, Moody’s CEO described the problem this way: “What happened in ’04 and ’05 with respect to subordinated tranches is that our competition, Fitch and S&P, went nuts. Everything was investment grade.” conflicts of interest faced by credit rating agencies have increased in recent years, particularly given the expansion of large credit rating agencies into ancillary advisory and other businesses, and the continued rise in importance of rating agencies in the U.S. securities markets.”51

Mass Downgrades. The credit ratings assigned to RMBS and CDO securities are designed to last the lifetime of the securities. Because circumstances can change, however, credit rating agencies conduct ongoing surveillance of each rated financial product to evaluate the rating and determine whether it should be upgraded or downgraded. Prior to the financial crisis, the numbers of downgrades and upgrades for structured finance ratings were substantially lower. thousands of downgrades of RMBS and CDO ratings, the first mass downgrades in U.S. history. From 2004 through the first half of 2007, Moody’s and S&P provided AAA ratings to a

Beginning in July 2007, however, Moody’s and S&P issued hundreds and then

50 In 2003, the SEC reported that “the potential

majority of the RMBS and CDO securities issued in the United States, sometimes providing 53 By 2010, analysts had determined that AAA ratings to as much as 95% of a securitization. over 90% of the AAA ratings issued to RMBS securities originated in 2006 and 2007 had been downgraded to junk status.54

48 3/14/2008 compliance letter from S&P to SEC, SEC_OCIE_CRA_011218-59, at 18-19. (See Chapter V below.) 49 “Revenue of the Three Credit Rating Agencies: 2002-2007,” chart prepared by the Subcommittee using data from http://thismatter.com/money, Hearing Exhibit 4/23-1g. 50 9/10/2007 Transcript of Raymond McDaniel at Moody’s MD Town Hall Meeting, Hearing Exhibit 4/23-98.
51 1/2003 “Report on the Role and Function of Credit Rating Agencies in the Operation of the Securities Markets,” prepared by the SEC, at 40. The report continued: “[C]oncerns had been expressed that a rating agency might be tempted to give a more favorable rating to a large issue because of the large fee, and to encourage the issuer to submit future large issues to the rating agency.” Id. at 40 n.109. 52 See, e.g., 3/26/2010 “Fitch Ratings Global Structured Finance 2009 Transition and Default Study,” prepared by Fitch.
53 See “MBS Ratings and the Mortgage Credit Boom,” Federal Reserve Bank of New York Staff Report no. 449, May 2010, at 1.
54 See, e.g., “Percent of the Original AAA Universe Currently Rated Below Investment Grade,” chart prepared by BlackRock Solutions, Hearing Exhibit 4/23-1i. See also 3/2008 “Understanding the Securitization of Subprime Mortgage Credit,” Federal Reserve Bank of New York Staff Report no. 318, at 58 and chart 31 (“92 percent of 1st-

Moody’s and S&P began downgrading RMBS and CDO products in late 2006, when residential mortgage delinquency rates and losses began increasing. Then, in July 2007, both S&P and Moody’s initiated the first of several mass downgrades that shocked the financial markets. On July 10, S&P placed on credit watch the ratings of 612 subprime RMBS with an original value of $7.35 billion. Later that day, Moody’s downgraded 399 subprime RMBS with an original value of $5.2 billion. Two days later, S&P downgraded 498 of the ratings it had placed on credit watch.

In October 2007, Moody’s began downgrading CDOs on a daily basis, downgrading

more than 270 CDO securities with an original value of $10 billion. In December 2007, Moody’s downgraded another $14 billion in CDOs, and placed another $105 billion on credit watch. Moody’s calculated that, overall in 2007, “8725 ratings from 2116 deals were downgraded and 1954 ratings from 732 deals were upgraded,”55 which means that it downgraded over four times more ratings than it upgraded. On January 30, 2008, S&P either downgraded or placed on credit watch over 8,200 ratings of subprime RMBS and CDO securities, representing issuance amounts of approximately $270.1 billion and $263.9 billion, respectively.56

These downgrades created significant turmoil in the securitization markets, as investors

were required by regulations to sell off assets that had lost their investment grade status, holdings at financial firms plummeted in value, and new securitizations were unable to find investors. As a result, the subprime RMBS and CDO secondary markets slowed and then collapsed, and financial firms around the world were left holding billions of dollars in suddenly unmarketable RMBS and CDO securities.

D. Investment Banks Historically, investment banks helped raise capital for business and other endeavors by helping to design, finance, and sell financial products like stocks or bonds. When a corporation needed capital to fund a large construction project, for example, it often hired an investment bank either to help it arrange a bank loan or raise capital by helping to market a new issue of shares or corporate bonds to investors. Investment banks also helped with corporate mergers and acquisitions. Today, investment banks also participate in a wide range of other financial activities, including offering broker-dealer and investment advisory services, and trading derivatives and commodities. Many have also been active in the mortgage market and have worked with lenders or mortgage brokers to package and sell mortgage loans and mortgage backed securities. Investment banks have traditionally performed these services in exchange for fees.

lien subprime deals originated in 2006 as well as … 91.8 percent of 2nd-lien deals originated in 2006 have been downgraded.”). 55 2/2008 “Structured Finance Ratings Transitions, 1983-2007,” Credit Policy Special Comment prepared by Moody’s, at 4.
56 6/24/2010 supplemental response from S&P to the Subcommittee, Exhibit N, Hearing Exhibit 4/23-108 (1/30/2008 “S&P Takes Action on 6,389 U.S. Subprime RMBS Ratings and 1,953 CDO Ratings,” S&P’s RatingsDirect). Ratings may appear on CreditWatch when events or deviations from an expected trend occur and additional information is needed to evaluate the rating.

If an investment bank agreed to act as an “underwriter” for the issuance of a new security

to the public, it typically bore the risk of those securities on its books until the securities were sold. By law, securities sold to the public generally must be registered with the SEC.57
Registration statements explain the purpose of a proposed public offering, an issuer’s operations and management, key financial data, and other important facts to potential investors. Any offering document or prospectus provided to the investing public must also be filed with the SEC. If an issuer decides not to offer a new security to the general public, it can still offer it to investors through a “private placement.”58 Investment banks often act as the “placement agent” in these private offerings, helping to design, market, and sell the security to selected investors.
Solicitation documents in connection with private placements are not required to be filed with the SEC. Under the federal securities laws, however, investment banks that act as an underwriter or placement agent may be liable for any material misrepresentations or omissions of material facts made in connection with a solicitation or sale of a security to an investor.59

In the years leading up to the financial crisis, RMBS securities were generally registered with the SEC and sold in public offerings, while CDO securities were generally sold to investors through private placements. Investment banks frequently served as the underwriter or placement agent in those transactions, and typically sold both types of securities to large institutional investors.

In addition to arranging for a public or private offering, some investment banks take on the role of a “market maker,” standing willing and able to buy or sell financial products to their clients or other market participants. To facilitate client orders to buy or sell those products, the investment bank may acquire an inventory of them and make them available for client transactions.60 the financial products and make it easier and more attractive for clients to buy and sell them.
Market makers typically rely on fees in the form of markups in the price of the financial products for their profits.

By filling both buy and sell orders, market makers help create a liquid market for

At the same time, investment banks may decide to buy and sell the financial products for

their own account, which is called “proprietary trading.” Investment banks often use the same inventory of financial products to carry out both their market making and proprietary trading activities. Investment banks that trade for their own account typically rely on changes in the values of the financial products to turn a profit.

Inventories that are used for market making and short term proprietary trading purposes are typically designated as a portfolio of assets “held for sale.” Investment banks also typically maintain an inventory or portfolio of assets that they intend to keep as long term investments.

57 Securities Act of 1933, 15 U.S.C. § 77a (1933). 58 See, e.g., Securities Act of 1933 §§ 3(b) and 4(2); 17 CFR § 230.501 et seq. (Regulation D). 59 Securities Act of 1933, § 11, 15 U.S.C. § 77k; and Securities Exchange Act of 1934, § 10(b), 15 U.S.C. § 78j(b), and Rule 10b-5 thereunder. 60 For a detailed discussion of market making, see “Study & Recommendations on Prohibitions on Proprietary Trading & Certain Relationships with Hedge Funds & Private Equity Funds,” prepared by the Financial Stability Oversight Council, at 28-29 (Jan. 18, 2011) (citing SEC Exchange Act Rel. No. 34-58775 (Oct. 14, 2008)).

This inventory or portfolio of long-term assets is typically designated as “held for investment,” and is not used in day-to-day transactions.

Investment banks that carry out market-making and proprietary trading activities are

required – by their banking regulator in the case of banks and bank holding companies61 and by the SEC in the case of broker-dealers62 capital to meet their regulatory requirements and financial obligations. These capital requirements typically vary based on how the positions are held and how they are classified. For example, assets that are “held for sale” or are in the “trading account” typically have lower capital requirements than those that are “held for investment,” because of the expected lower risks associated with what are expected to be shorter term holdings.

– to track their investments and maintain sufficient

Many investment banks use complex automated systems to analyze the “Value at Risk” (VaR) associated with their holdings. To reduce the VaR attached to their holdings, investment banks employ a variety of methods to offset or “hedge” their risk. These methods can include diversifying their assets, taking a short position on related financial products, purchasing loss protection through insurance or credit default swaps, or taking positions in derivatives whose values move inversely to the value of the assets being hedged.

Shorting the Mortgage Market. Prior to the financial crisis, investors commonly

purchased RMBS or CDO securities as long-term investments that produced a steady income. In 2006, however, the high risk mortgages underlying these securities began to incur record levels of delinquencies. Some investors, worried about the value of their holdings, sought to sell their RMBS or CDO securities, but had a difficult time doing so due to the lack of an active market.
Some managed to sell their high risk RMBS securities to investment banks assembling cash CDOs.

Some investors, instead of selling their RMBS or CDO securities, purchased “insurance” against a loss by buying a credit default swap (CDS) that would pay off if the specified securities incurred losses or other negative credit events. By 2005, investment banks had standardized CDS contracts for RMBS and CDO securities, making this a practical alternative.

Much like insurance, the buyer of a CDS contract paid a periodic premium to the CDS seller, who guaranteed the referenced security against loss. CDS contracts referencing a single security or corporate bond became known as “single name” CDS contracts. If the referenced security later incurred a loss, the CDS seller had to pay an agreed-upon amount to the CDS buyer to cover the loss. Some investors began to purchase single name CDS contracts, not as a hedge to offset losses from RMBS or CDO securities they owned, but as a way to profit from particular RMBS or CDO securities they predicted would lose money. CDS contracts that paid off on securities that were not owned by the CDS buyer were known as “naked credit default swaps.”

61 See, e.g., 12 CFR part 3, Appendix A (for the Office of the Comptroller of the Currency), 12 CFR part 208, Appendix A and 12 CFR part 225, Appendix A (for the Federal Reserve Board of Governors) and 12 CFR part 325, Appendix A (for the Federal Deposit Insurance Corporation). 62 Securities Exchange Act of 1934, Rule 15c3-1.

Some investors purchased large numbers of these CDS contracts in a concerted strategy to profit from mortgage backed securities they believed would fail.

Some investment banks took the CDS approach a step further. In 2006, a consortium of

Borrowing from longstanding practice in commodities

investment banks led by Goldman Sachs and Deutsche Bank launched the ABX Index, which created five indices that tracked the aggregate performance of a basket of 20 designated subprime RMBS securitizations.63 markets, investors could buy and sell contracts linked to the value of one of the ABX indices.
Each contract consisted of a credit default swap agreement in which the parties could essentially wager on the rise or fall of the index value. According to a Goldman Sachs employee, the ABX Index “introduced a standardized tool that allow[ed] clients to quickly gain exposure to the asset class,” in this case subprime RMBS securities. An investor – or investment bank – taking a short position in an ABX contract was, in effect, placing a bet that the basket of subprime RMBS securities would lose value.

Synthetic CDOs provided still another vehicle for shorting the mortgage market. In this

approach, an investment bank created a synthetic CDO that referenced a variety of RMBS securities. One or more investors could take the “short” position by paying premiums to the CDO in exchange for a promise that the CDO would pay a specified amount if the referenced assets incurred a negative credit event, such as a default or credit rating downgrade. If that event took place, the CDO would have to pay an agreed-upon amount to the short investors to cover the loss, removing income from the CDO and causing losses for the long investors. Synthetic CDOs became a way for investors to short multiple specific RMBS securities that they expected would incur losses.

Proprietary Trading. Financial institutions also built increasingly large proprietary

holdings of mortgage related assets. Numerous financial firms, including investment banks, bought RMBS and CDO securities, and retained these securities in their investment portfolios.
Others retained these securities in their trading accounts to be used as inventory for short term trading activity, market making on behalf of clients, hedging, providing collateral for short term loans, or maintaining lower capital requirements. Deutsche Bank’s RMBS Group in New York, for example, built up a $102 billion portfolio of RMBS and CDO securities, while the portfolio at an affiliated hedge fund, Winchester Capital, exceeded $8 billion.64 Other financial firms, including Bear Stearns, Citibank, JPMorgan Chase, Lehman Brothers, Merrill Lynch, Morgan Stanley, and UBS also accumulated enormous propriety holdings in mortgage related products.
When the value of these holdings dropped, some of these financial institutions lost tens of

63 Each of the five indices tracked a different tranche of securities from the designated 20 subprime RMBS securitizations. One index tracked AAA rated securities from the 20 subprime RMBS securities; the second tracked AA rated securities from the 20 RMBS securitizations; and the remaining indices tracked baskets of A, BBB, and BBB rated RMBS securities. Every six months, a new set of RMBS securitizations was selected for a new ABX index. See 3/2008 “Understanding the Securitization of Subprime Mortgage Credit,” prepared by Federal Reserve Bank of New York, Report No. 318, at 26. Markit Group Ltd. administered the ABX Index which issued indices in 2006 and 2007, but has not issued any new indices since then. 64 For more information, see Chapter VI, section discussing Deutsche Bank.

billions of dollars,65 and either declared bankruptcy, were sold off,66 or were bailed out by U.S. taxpayers seeking to avoid damage to the U.S. economy as a whole.67

One investment bank, Goldman Sachs, built a large number of proprietary positions to 68 Goldman Sachs had helped to build an active mortgage market in

short the mortgage market. the United States and had accumulated a huge portfolio of mortgage related products. In late 2006, Goldman Sachs decided to reverse course, using a variety of means to bet against the mortgage market. In some cases, Goldman Sachs took proprietary positions that paid off only when some of its clients lost money on the very securities that Goldman Sachs had sold to them and then shorted. Altogether in 2007, Goldman’s mortgage department made $1.1 billion in net revenues from shorting the mortgage market.69 Despite those gains, Goldman Sachs was given a $10 billion taxpayer bailout under the Troubled Asset Relief Program,70 tens of billions of dollars in support through accessing the Federal Reserve’s Primary Dealer Credit Facility,71 and billions more in indirect government support72

to ensure its continued existence.

E. Market Oversight U.S. financial regulators failed to stop financial firms from engaging in high risk,

conflict-ridden activities. Those regulatory failures arose, in part, from the fragmented nature of U.S. financial oversight as well as statutory barriers to regulating high risk financial products.

65 See, e.g., Goldman Sachs Group, Inc., 2008 Annual Report 27 (2009) (stating that the firm had “long proprietary positions in a number of [its] businesses. These positions are accounted for at fair value, and the declines in the values of assets have had a direct and large negative impact on [its] earnings in fiscal 2008.”); see also, Viral V. Acharya and Matthew Richardson, “Causes of the Financial Crisis,” 21 Critical Review 195, 199-204 (2009) (citing proprietary holdings of asset backed securities as one of the primary drivers of accumulated risks causing the financial crisis); “Prop Trading Losses Ain’t Peanuts,” The Street (1/27/2010),
http://www.thestreet.com/story/10668047/prop-trading-losses-aint-peanuts.html. 66 See, e.g., “Lehman Files for Bankruptcy; Merrill is Sold,” New York Times (9/14/2008); and discussion in Chapter III of Washington Mutual Bank which was sold to JPMorgan Chase. 67 See, e.g., Capital Purchase Program Transactions, under the Troubled Asset Relief Program, U.S. Department of the Treasury, at http://www.treasury.gov/initiatives/financial-stability/investment- programs/cpp/Pages/capitalpurchaseprogram.aspx.
68 For more information, see Chapter VI, section describing Goldman Sachs. 69 Id. Goldman’s Structured Product Group Trading Desk earned $3.7 billion in net revenues, which was offset by losses on other desks within the mortgage department, resulting in the $1.1 billion in total net revenues. 70 See, e.g., Capital Purchase Program Transactions, under the Troubled Asset Relief Program, U.S. Department of the Treasury, available at http://www.treasury.gov/initiatives/financial-stability/investment- programs/cpp/Pages/capitalpurchaseprogram.aspx and an example of a transactions report at http://www.treasury.gov/initiatives/financial-stability/briefing-room/reports/tarp- transactions/DocumentsTARPTransactions/transactions-report-062309.pdf. 71 See data available at http://www.federalreserve.gov/newsevents/reform_pdcf.htm showing Goldman Sachs’ use of the Primary Dealer Credit Facility 85 times in 2008. 72 See, e.g., prepared statement of Neil Barofsky, Special Inspector General of the Troubled Asset Relief Program, “The Federal Bailout of AIG,” before the House Committee on Oversight and Government Reform (1/27/2010), http://oversight.house.gov/images/stories/Hearings/pdfs/20100127barofsky.pdf (noting that some firms, including Goldman Sachs, disproportionately benefited from the federal government’s bailout of AIG).

Oversight of Lenders. At the end of 2005, the United States had about 8,800 federally

insured banks and thrifts,73 plus about 8,700 federally insured credit unions, many of which were in the business of issuing home loans.74 On the federal level, these financial institutions were overseen by five agencies: the Federal Reserve which oversaw state-chartered banks that were part of the Federal Reserve System as well as foreign banks and others; the Office of the Comptroller of the Currency (OCC) which oversaw banks with national charters; the Office of Thrift Supervision (OTS) which oversaw federally-chartered thrifts; the National Credit Union Administration which oversaw federal credit unions; and the Federal Deposit Insurance Corporation (FDIC) which oversaw financial institutions that have federal deposit insurance (hereinafter referred to as “federal bank regulators”).75 In addition, state banking regulators oversaw the state-chartered institutions and at times took action to require federally-chartered financial institutions to comply with certain state laws.

The primary responsibility of the federal bank regulators was to ensure the safety and

soundness of the financial institutions they oversaw. One key mechanism they used to carry out that responsibility was to conduct examinations on a periodic basis of the financial institutions within their jurisdiction and provide the results in an annual Report of Examination (ROE) given to the Board of Directors at each entity. The largest U.S. financial institutions typically operated under a “continuous exam” program, which required federal bank examiners to conduct a series of specialized examinations during the year with the results from all of those examinations included in the annual ROE.

Federal examination activities were typically led by an Examiner in Charge and were

organized around a rating system called CAMELS that was used by all federal bank regulators.
The CAMELS rating system evaluated a financial institution’s: (C) capital adequacy, (A) asset quality, (M) management, (E) earnings, (L) liquidity, and (S) sensitivity to market risk.
CAMELS ratings are on a scale of 1 to 5, in which 1 signifies a safe and secure bank with no cause for supervisory concern, 3 signifies an institution with supervisory concerns in one or more areas, and 5 signifies an unsafe and unsound bank with severe supervisory concerns. In the annual ROE, regulators typically provided a financial institution with a rating for each CAMELS component, as well as an overall composite rating on its safety and soundness.

In addition, the FDIC conducted its own examinations of financial institutions with

federal deposit insurance. The FDIC reviews relied heavily on the examination findings and ROEs developed by the primary regulator of the financial institution, but the FDIC assigned its own CAMELS ratings to each institution. In addition, for institutions with assets of $10 billion or more, the FDIC established a Large Insured Depository Institutions (LIDI) Program to assess and report on emerging risks that may pose a threat to the federal Deposit Insurance Fund.
Under this program, the FDIC performed an ongoing analysis of emerging risks within each

73 See FDIC Quarterly Banking Profile, 1 (Fourth Quarter 2005) (showing that, as of 12/31/2005, the United States had 8,832 federal and state chartered insured banks and thrifts). 74 See 1/3/2011 chart, “Insurance Fund Ten-Year Trends,” supplied by the National Credit Union Administration (showing that, as of 12/31/2005, the United States had 8,695 federal and state credit unions). 75 The Dodd-Frank Act has since abolished one of these agencies, the Office of Thrift Supervision, and assigned its duties to the OCC. See Chapter IV.

insured institution and assigned a quarterly risk rating, using a scale of A to E, with A being the best rating and E the worst.

If a regulator became concerned about the safety or soundness of a financial institution, it

had a wide range of informal and formal enforcement actions that could be used to require operational changes. Informal actions included requiring the financial institution to issue a safety and soundness plan, memorandum of understanding, Board resolution, or commitment letter pledging to take specific corrective actions by a certain date, or issuing a supervisory letter to the financial institution listing specific “matters requiring attention.” These informal enforcement actions are generally not made public and are not enforceable in court. Formal enforcement actions included a regulator issuing a public memorandum of understanding, consent order, or cease and desist order requiring the financial institution to stop an unsafe practice or take an affirmative action to correct identified problems; imposing a civil monetary penalty; suspending or removing personnel from the financial institution; or referring misconduct for criminal prosecution.

A wide range of large and small banks and thrifts were active in the mortgage market.

Banks like Bank of America, Citigroup, JPMorgan Chase, and Wells Fargo originated, purchased, and securitized billions of dollars in home loans each year. Thrifts, whose charters typically required them to hold 65% of their assets in mortgage related assets, also originated, purchased, sold, and securitized billions of dollars in home loans, including such major lenders as Countrywide Financial Corporation, IndyMac Bank, and Washington Mutual Bank. Some of these banks and thrifts also had affiliates, such as Long Beach Mortgage Corporation, which specialized in issuing subprime mortgages. Still more lenders operated outside of the regulated banking system, including New Century Financial Corporation and Fremont Loan & Investment, which used such corporate vehicles as industrial loan companies, real estate investment trusts, or publicly traded corporations to carry out their businesses. In addition, the mortgage market was populated with tens of thousands of mortgage brokers that were paid fees for their loans or for bringing qualified borrowers to a lender to execute a home loan.76

Oversight of Securities Firms. Another group of financial institutions active in the

mortgage market were securities firms, including investment banks, broker-dealers, and investment advisors. These security firms did not originate home loans, but typically helped design, underwrite, market, or trade securities linked to residential mortgages, including the RMBS and CDO securities that were at the heart of the financial crisis. Key firms included Bear Stearns, Goldman Sachs, Lehman Brothers, Merrill Lynch, Morgan Stanley, and the asset management arms of large banks, including Citigroup, Deutsche Bank, and JPMorgan Chase.
Some of these firms also had affiliates which specialized in securitizing subprime mortgages.

Securities firms were overseen on the federal level by the Securities and Exchange

Commission (SEC) whose mission is to “protect investors, maintain fair, orderly, and efficient

76 1/2009 “Financial Regulation: A Framework for Crafting and Assessing Proposals to Modernize the Outdated U.S. Financial Regulatory System,” prepared by the Government Accountability Office, Report No. GAO-09-216, at 26-27.

markets, and facilitate capital formation.”77 The SEC oversees the “key participants in the securities world, including securities exchanges, securities brokers and dealers, investment advisors, and mutual funds,” primarily for the purpose of “promoting the disclosure of important market related information, maintaining fair dealing, and protecting against fraud.”78

The securities firms central to the financial crisis were subject to a variety of SEC

regulations in their roles as broker-dealers, investment advisors, market makers, underwriters, 79 The and placement agents. Most were also subject to oversight by state securities regulators. securities firms were required to submit a variety of public filings with the SEC about their operations and in connection with the issuance of new securities. The SEC’s Office of Compliance Inspections and Examinations (OCIE) conducted inspections of broker-dealers, among others, to understand industry practices, encourage compliance, evaluate risk management, and detect violations of the securities laws. In addition, under the voluntary Consolidated Supervised Entities program, the SEC’s Division of Trading and Markets monitored the investment activities of the largest broker-dealers, including Bear Stearns, Goldman Sachs, Lehman Brothers, Merrill Lynch, Morgan Stanley, Citigroup, and JPMorgan Chase, evaluating their capital levels, use of leverage, and risk management.80

Like bank regulators, if the SEC became concerned about a particular securities firm, it could choose from a range of informal and formal enforcement actions. Informal actions could include issuing a “deficiency letter” identifying problems and requiring the securities firm to take corrective action by a certain date. Formal enforcement actions, undertaken by the SEC’s Division of Enforcement, could include civil proceedings before an administrative law judge; a civil complaint filed in federal district court; civil fines; an order to suspend or remove personnel from a firm or bar them from the brokerage industry; or a referral for criminal prosecution.
Common securities violations included selling unregistered securities, misrepresenting information about a security, unfair dealing, price manipulation, and insider trading.81

Statutory and Regulatory Barriers. Federal and state financial regulators responsible for oversight of banks, securities firms, and other financial institutions in the years leading to the financial crisis operated under a number of statutory and regulatory constraints.

One key constraint was the sweeping statutory prohibition on the federal regulation of

The key statutory section

any type of swap, including credit default swaps. This prohibition took effect in 2000, with enactment of the Commodity Futures Modernization Act (CFMA).82 explicitly prohibited federal regulators from requiring the registration of swaps as securities; issuing or enforcing any regulations or orders related to swaps; or imposing any recordkeeping

77 See SEC website, “About the SEC: What We Do,” 78 Id. 79 Some firms active in the U.S. securities and mortgage markets, such as hedge funds, operated without meaningful federal oversight by taking advantage of exemptions in the Investment Company Act of 1940. 80 See 9/2008 “SEC’s Oversight of Bear Stearns and Related Entities: The Consolidated Entity Program,” report prepared by Office of the SEC Inspector General, Report No. 446-A.Report No. 446-A, (9/2008). 81 See SEC website, “About the SEC: What We Do,” www.sec.gov. 82 CFMA was included as a title of H.R. 4577, the Consolidated Appropriations Act of 2001, P.L.106-554.

www.sec.gov.

requirements for swaps.83 In addition, the law explicitly prohibited regulation of any “‘interest rate swap,’ including a rate floor, rate cap, rate collar, cross-currency rate swap, basis swap, currency swap, equity index swap, equity swap, debt index swap, debt swap, credit spread, credit default swap, credit swap, weather swap, or commodity swap.”84 These prohibitions meant that federal regulators could not even ask U.S. financial institutions to report on their swaps trades or holdings, much less regulate swap dealers or examine how swaps were affecting the mortgage market or other U.S. financial markets.

As a result, the multi-trillion-dollar U.S. swaps markets operated with virtually no

disclosure requirements, no restrictions, and no oversight by any federal agency, including the market for credit default swaps which played a prominent role in the financial crisis. On September 23, 2008, in a hearing before the Senate Committee on Banking, Housing, and Urban Affairs, then SEC Chairman Christopher Cox testified that, as a result of the statutory prohibition, the credit default swap market “is completely lacking in transparency,” “is regulated by no one,” and “is ripe for fraud and manipulation.”85 In a September 26, 2008 press release, he discussed regulatory gaps impeding his agency and again raised the issue of swaps:
“Unfortunately, as I reported to Congress this week, a massive hole remains: the approximately $60 trillion credit default swap market, which is regulated by no agency of government. Neither the SEC nor any regulator has authority even to require minimum disclosure.”86 In 2010, the Dodd-Frank Act removed the CFMA prohibition on regulating swaps.87

A second significant obstacle for financial regulators was the patchwork of federal and

state laws and regulations applicable to high risk mortgages and mortgage brokers. Federal bank regulators took until October 2006, to provide guidance to federal banks on acceptable lending 88 Even then, the regulators issued voluntary guidance practices related to high risk home loans. whose standards were not enforceable in court and failed to address such key issues as the acceptability of stated income loans.89 In addition, while Congress had authorized the Federal Reserve, in 1994, to issue regulations to prohibit deceptive or abusive mortgage practices – regulations that could have applied across the board to all types of lenders and mortgage brokers – the Federal Reserve failed to issue any until July 2008, after the financial crisis had already hit.90

83 CFMA, § 302, creating a new section 2A of the Securities Act of 1933. 84 CFMA, § 301, creating a new section 206A of the Gramm-Leach-Bliley Act. 85 Statement of SEC Chairman Christopher Cox, “Turmoil in U.S. Credit Markets: Recent Actions Regarding Government Sponsored Entities, Investment Banks and Other Financial Institutions,” before the U.S. Senate Committee on Banking, Housing and Urban Affairs, S.Hrg. 110-1012 (9/23/2008). 86 9/26/2008 SEC press release, “Chairman Cox Announces End of Consolidated Supervised Entities Program,” http://www.sec.gov/news/press/2008/2008-230.htm. 87 Title VII of the Dodd-Frank Act. 88 10/4/2006 “Interagency Guidance on Nontraditional Mortgage Product Risks,” (NTM Guidance), 71 Fed. Reg. 192 at 58609. 89 For more information, see Chapter IV. 90 Congress authorized the Federal Reserve to issue the regulations in Section 151 of the Home Ownership and Equity Protection Act of 1994 (HOEPA), P.L. 103-325. The Federal Reserve did not issue any regulations under HOEPA, however, until July 2008, when it amended Regulation Z. The new rules primarily strengthened consumer protections for “higher priced loans,” which included many types of subprime loans. See “New Regulation Z Rules Enhance Protections for Mortgage Borrowers,” Consumer Compliance Outlook (Fourth Quarter 2008) (Among

A third problem, exclusive to state regulators, was a 2005 regulation issued by the OCC to prohibit states from enforcing state consumer protection laws against national banks.91 After the New York State Attorney General issued subpoenas to several national banks to enforce New York’s fair lending laws, a legal battle ensued. In 2009, the Supreme Court invalidated the OCC regulation, and held that states were allowed to enforce state consumer protection laws against national banks.92 effectively unable to enforce state laws prohibiting abusive mortgage practices against federally- chartered banks and thrifts.

During the intervening four years, however, state regulators had been

Systemic Risk. While bank and securities regulators focused on the safety and

soundness of individual financial institutions, no regulator was charged with identifying, preventing, or managing risks that threatened the safety and soundness of the overall U.S. financial system. In the area of high risk mortgage lending, for example, bank regulators allowed banks to issue high risk mortgages as long as it was profitable and the banks quickly sold the high risk loans to get them off their books. Securities regulators allowed investment banks to underwrite, buy, and sell mortgage backed securities relying on high risk mortgages, as long as the securities received high ratings from the credit rating agencies and so were deemed “safe” investments. No regulatory agency focused on what would happen when poor quality mortgages were allowed to saturate U.S. financial markets and contaminate RMBS and CDO securities with high risk loans. In addition, none of the regulators focused on the impact derivatives like credit default swaps might have in exacerbating risk exposures, since they were barred by federal law from regulating or even gathering data about these financial instruments.

F. Government Sponsored Enterprises

Between 1990 and 2004, homeownership rates in the United States increased rapidly

from 64% to 69%, the highest level in 50 years.93 While many highly regarded economists and officials argued at the time that this housing boom was the result of healthy economic activity, in retrospect, some federal housing policies encouraged people to purchase homes they were ultimately unable to afford, which helped to inflate the housing bubble.

Fannie Mae and Freddie Mac. Two government sponsored entities (GSE), the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac), were chartered by Congress to encourage homeownership primarily by providing a secondary market for home mortgages. They created that secondary market by purchasing loans from lenders, securitizing them, providing a guarantee that they would make up the cost of

other requirements, the rules prohibited lenders “from making loans based on collateral without regard to [the borrower’s] repayment ability,” required lenders to “verify income and obligations,” and imposed “more stringent restrictions on prepayment penalties.” The rules also required lenders to “establish escrow accounts for taxes and mortgage related insurance for first-lien loans.” In addition, the rules “prohibit[ed] coercion of appraisers, define[d] inappropriate practices for loan servicers, and require[d] early truth in lending disclosures for most mortgages.”). 91 12 CFR § 7.4000. 92 Cuomo v. Clearing House Association, Case No. 08-453, 129 S.Ct. 2710 (2009). 93 U.S. Census Bureau, “Table 14. Homeownership Rates by Area: 1960 to 2009,” http://www.census.gov/hhes/www/housing/hvs/annual09/ann09t14.xls.

any securitized mortgage that defaulted, and selling the resulting mortgage backed securities to investors. Many believed that the securities had the implicit backing of the federal government and viewed them as very safe investments, leading investors around the world to purchase them.
The existence of this secondary market encouraged lenders to originate more loans, since they could easily sell them to the GSEs and use the profits to increase their lending.

Over time, however, Fannie Mae and Freddie Mac began to purchase larger quantities of

higher risk loans, providing a secondary market for those loans and encouraging their proliferation. Between 2005 and 2007, Fannie Mae alone purchased billions of dollars in high risk home loans, including Option ARM, Alt A, and loans with subprime characteristics. For example, data from Fannie Mae shows that, in mid 2008, 62% of the Option ARM loans on its books had been purchased between 2005 and 2007.94 Likewise, 84% of its interest-only loans were purchased in that time frame, as were 57% of those with FICO scores less than 620; 62% of its loans with loan-to-value ratios greater than 90; and 73% of its Alt A loans.95 While these loans constituted only a small percentage of Fannie Mae’s purchases at the time, they came to account for some its most significant losses. By the middle of 2009, Fannie Mae reported an unpaid principal balance of $878 billion for its loans with subprime characteristics, nearly a third of its total portfolio of $2.7 trillion.96

According to economist Arnold Kling, Fannie Mae and Freddie Mac purchased these

loans after “lowering their own credit standards in order to maintain a presence in the market and to meet their affordable housing goals.”97

Throughout their history, Fannie Mae and Freddie Mac were able to bundle the

mortgages they purchased into securities that were popular with investors, because many believed the securities carried the implicit support of the federal government. The Congressional Budget Office found the following:

“Because of their [Fannie Mae and Freddie Mac] size and interconnectedness with other financial institutions, they posed substantial systemic risk—the risk that their failure could impose very high costs on the financial system and the economy. The GSEs’ market power also allowed them to use their profits partly to benefit their other stake- holders rather than exclusively to benefit mortgage borrowers. The implicit guarantee created an incentive for the GSEs to take excessive risks: Stakeholders would benefit when gambles paid off, but taxpayers would absorb the losses when they did not. …

One way that Fannie Mae and Freddie Mac increased risk was by expanding the volume of mortgages and MBSs held in their portfolios, which exposed them to the risk of losses

94 Fannie Mae, 2008 Q2 10-Q Investor Summary, August 8, 2008, http://www.fanniemae.com/media/pdf/newsreleases/2008_Q2_10Q_Investor_Summary.pdf. 95 Id. 96 Fannie Mae, 2009 Second Quarter Credit Supplement, August 6, 2009, http://www.fanniemae.com/ir/pdf/sec/2009/q2credit_summary.pdf. 97 “Not What They Had In Mind: A History of Policies that Produced the Financial Crisis of 2008,” September 2009, Mercatus Center, http://mercatus.org/sites/default/files/publication/NotWhatTheyHadInMind(1).pdf.

from changes in interest or prepayment rates. Over the past decade, the two GSEs also increased their exposure to default losses by investing in lower-quality mortgages, such as subprime and Alt-A loans.”98

The risks embedded in their mortgage portfolios finally overwhelmed the GSEs in

September 2008, and both Fannie Mae and Freddie Mac were taken into conservatorship by the federal government. Since that time, the Treasury Department has spent nearly $150 billion to support the two GSEs, a total which projections show could rise to as high as $363 billion.99

Ginnie Mae. Additional housing policies that allowed borrowers with less than adequate credit to obtain traditional mortgages included programs at the Federal Housing Administration (FHA) and the Department of Veterans Affairs (VA). Both agencies provided loan guarantees to lenders that originated loans for borrowers that qualified under the agencies’ rules. Many of the loans guaranteed by the FHA and VA, some of which required down payments as low as 3%, were bundled and sold as mortgage backed securities guaranteed by the Government National Mortgage Association (Ginnie Mae), a government corporation. Ginnie Mae guaranteed investors the timely payment of principal and interest on mortgage backed securities backed by federally insured or guaranteed loans.

In the years leading up to the financial crisis, FHA guaranteed millions of home loans According to FHA data, as of 2011, nearly 20% of all

worth hundreds of billions of dollars.100 FHA loans originated in 2008 were seriously delinquent, meaning borrowers had missed three or more payments, while loans originated in 2007 had a serious delinquency rate of over 22%. The 2007 and 2008 loans, which currently make up about 15% of FHA’s active loan portfolio, remain the worst performing in that portfolio. In 2009 and 2010, FHA tightened its underwriting guidelines, and the loans it guaranteed performed substantially better. By early 2011, the serious delinquency rate for all FHA borrowers was about 8.8%, down from over 9.4% the prior year.

G. Administrative and Legislative Actions In response to the financial crisis, Congress and the Executive Branch have taken a

number of actions. Three that have brought significant changes are the Troubled Asset Relief Program, Federal Reserve assistance programs, and the Dodd-Frank Wall Street and Consumer Protection Act.

Troubled Asset Relief Program (TARP). On October 3, 2008, Congress passed and President Bush signed into law the Emergency Economic Stabilization Act of 2008, P.L. 110-

This law, which passed both Houses with bipartisan majorities, established the Troubled

98 Congressional Budget Office, “Fannie Mae, Freddie Mac, and the Federal Role in the Secondary Mortgage Market,” December 2010, at x, http://www.cbo.gov/ftpdocs/120xx/doc12032/12-23-FannieFreddie.pdf. 99 Federal Housing Finance Agency, News Release, “FHFA Releases Projections Showing Range of Potential Draws for Fannie Mae and Freddie Mac,” October 21, 2010, http://fhfa.gov/webfiles/19409/Projections_102110.pdf. 100 The statistics cited in this paragraph are taken from the U.S. Department of Housing and Urban Development, “FHA Single-Family Mutual Mortgage Insurance Fund Programs, Quarterly Report to Congress, FY 2011 Q1,” March 17, 2011, at 4 and 19, http://www.hud.gov/offices/hsg/rmra/oe/rpts/rtc/fhartc_q1_2011.pdf.

Asset Relief Program (TARP) and authorized the expenditure of up to $700 billion to stop financial institutions from collapsing and further damaging the U.S. economy. Administered by the Department of the Treasury, with support from the Federal Reserve, TARP funds have been used to inject capital into or purchase or insure assets at hundreds of large and small banks.

The largest recipients of TARP funds were AIG, Ally Financial (formerly GMAC

Financial Services), Bank of America, Citigroup, Goldman Sachs, JPMorgan Chase, Morgan Stanley, PNC Financial Services, U.S. Bancorp, and Wells Fargo, as well as Chrysler, and General Motors. Most have repaid all or a substantial portion of the TARP funds they received.

Although initially expected to cost U.S. taxpayers more than $350 billion, the

Congressional Budget Office estimated in November 2010, that the final cost of the TARP program will be approximately $25 billion.101

Federal Reserve Emergency Support Programs. In addition, as the financial crisis began to unfold, the Federal Reserve aggressively expanded its balance sheet from about $900 billion at the beginning of 2008, to more than $2.4 trillion in December 2010, to provide support to the U.S. financial system and economy. Using more than a dozen programs, through more than 21,000 individual transactions, the Federal Reserve provided trillions of dollars in assistance to U.S. and foreign financial institutions in an effort to promote liquidity and prevent a financial 102 In some instances, the Federal Reserve created new programs, such as its Agency collapse. Mortgage Backed Securities Purchase Program which purchased more than $1.25 trillion in mortgage backed securities backed by Fannie Mae, Freddie Mac, and Ginnie Mae.103 instances, it modified and significantly expanded existing programs, such as by lowering the quality of collateral it accepted and increasing lending by the discount window.

In other

Dodd-Frank Act. On July 21, 2010, Congress passed and President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act, P.L. 111-203. This law, which passed both Houses with bipartisan majorities, expanded the authority of regulatory agencies to try to prevent future financial crises. Among other provisions, the law:

– established a Financial Stability Oversight Council, made up of federal financial

regulators and others, to identify and respond to emerging financial risks;

– established a Consumer Financial Protection Bureau to strengthen protection of

American consumers from abusive financial products and practices;

– restricted proprietary trading and investments in hedge funds by banks and other large

financial institutions;

101 11/2010 “Report on the Troubled Asset Relief Program,” prepared by the Congressional Budget Office, http://www.cbo.gov/ftpdocs/119xx/doc11980/11-29-TARP.pdf.
102 “Usage of Federal Reserve Credit and Liquidity Facilities,” Federal Reserve Board, available at http://www.federalreserve.gov/newsevents/reform_transaction.htm. 103 “Agency Mortgage-Backed Securities Purchase Program,” Federal Reserve Board, available at http://www.federalreserve.gov/newsevents/reform_mbs.htm.

– prohibited sponsors of asset backed securities from engaging in transactions that would

involve or result in a material conflict of interest with investors in those securities;

– established procedures to require nonbank firms whose failure would threaten U.S.

financial stability to divest some holdings or undergo an orderly liquidation;

– strengthened regulation of credit rating agencies;

– strengthened mortgage regulation, including by clamping down on high cost mortgages,

requiring securitizers to retain limited liability for securities reliant on high risk mortgages, banning stated income loans, and restricting negative amortization loans;

– required better federal regulation of mortgage brokers;

– directed regulators to require greater capital and liquidity reserves;

– required regulation of derivatives and derivative dealers;

– required registration of certain hedge funds and private equity funds;

– authorized regulators to impose standards of conduct that are the same as those applicable to investment advisers on broker-dealers who provide personalized investment advice to retail customers; and

– abolished the Office of Thrift Supervision.

H. Financial Crisis Timeline

This Report reviews events from the period 2004 to 2008, in an effort to identify and

explain four significant causes of the financial crisis. A variety of events could be identified as the start of the crisis. Candidates include the record number of home loan defaults that began in December 2006; the FDIC’s March 2007 cease and desist order against Fremont Investment & Loan which exposed the existence of unsafe and unsound subprime lending practices; or the collapse of the Bear Stearns hedge funds in June 2007. Still another candidate is the two-week period in September 2008, when half a dozen major U.S. financial institutions failed, were forcibly sold, or were bailed out by U.S. taxpayers seeking to prevent a collapse of the U.S. economy.

This Report concludes, however, that the most immediate trigger to the financial crisis was the July 2007 decision by Moody’s and S&P to downgrade hundreds of RMBS and CDO securities. The firms took this action because, in the words of one S&P senior analyst, the investment grade ratings could not “hold.” By acknowledging that RMBS and CDO securities containing high risk, poor quality mortgages were not safe investments and were going to incur losses, the credit rating agencies admitted the emperor had no clothes. Investors stopped buying, the value of the RMBS and CDO securities fell, and financial institutions around the world were

suddenly left with unmarketable securities whose value was plummeting. The financial crisis was on.

timeline of some key events from 2006 through 2008. The succeeding chapters provide more detailed examinations of the roles of high risk lending, federal regulators, credit ratings agencies, and investment banks in causing the financial crisis.

Because of the complex nature of the financial crisis, this chapter concludes with a brief

Financial Crisis Timeline104

December 2006: Ownit Mortgage Solutions bankruptcy

February 27, 2007: Freddie Mac announces it will no longer buy the most risky subprime mortgages

March 7, 2007: FDIC issues cease and desist order against Fremont for unsafe and unsound banking

April 2, 2007: New Century bankruptcy

June 17, 2007: Two Bear Stearns subprime hedge funds collapse

July 10 and 12, 2007: Credit rating agencies issue first mass ratings downgrades of hundreds of RMBS and CDO securities

August 6, 2007: American Home Mortgage bankruptcy

August 17, 2007: Federal Reserve: “[M]arket conditions have deteriorated … downside risks to growth have increased appreciably.”

August 31, 2007: Ameriquest Mortgage ceases operations

December 12, 2007: Federal Reserve establishes Term Auction Facility to provide bank funding

January 2008: ABX Index stops issuing new subprime indices

January 11, 2008: Countrywide announces sale to Bank of America

January 30, 2008: S&P downgrades or places on credit watch over 8,000 RMBS and CDO securities

March 24, 2008: Federal Reserve Bank of New York forms Maiden Lane I to help JPMorgan Chase acquire Bear Stearns

May 29, 2008: Bear Stearns shareholders approve sale

July 11, 2008: IndyMac Bank fails and is seized by FDIC

July 15, 2008: SEC restricts naked short selling of some financial stocks

September 7, 2008: U.S. takes control of Fannie Mae and Freddie Mac

September 15, 2008: Lehman Brothers bankruptcy

September 15, 2008 Merrill Lynch announces its sale to Bank of America

September 16, 2008: Federal Reserve offers $85 billion credit line to AIG; Reserve Primary Money Fund NAV falls below $1

September 21, 2008: Goldman Sachs and Morgan Stanley convert to bank holding companies

September 25, 2008: WaMu fails, is seized by FDIC, and is sold to JPMorgan Chase

October 3, 2008: Congress and President Bush establish TARP

October 12, 2008: Wachovia is sold to Wells Fargo

October 28, 2008: U.S. uses TARP to buy $125 billion in preferred
stock at nine banks

November 25, 2008: Federal Reserve buys Fannie and Freddie assets

104 Many of these events are based upon a timeline prepared by the Federal Reserve Bank of St. Louis, “The Financial Crisis: A Timeline of Events and Policy Actions,” http://timeline.stlouisfed.org/index.cfm?p=timeline.

III. HIGH RISK LENDING:

CASE STUDY OF WASHINGTON MUTUAL BANK

Washington Mutual Bank, known also as WaMu, rose out the ashes of the great Seattle

fire to make its first home loan in 1890. By 2004, WaMu had become one of the nation’s largest financial institutions and a leading mortgage lender. Its demise just four years later provides a case history that traces not only the rise of high risk lending in the mortgage field, but also how those high risk mortgages led to the failure of a leading bank and contributed to the financial crisis of 2008.

For many years, WaMu was a mid-sized thrift, specializing in home mortgages. In the

1990s, WaMu initiated a period of growth and acquisition, expanding until it became the nation’s largest thrift and sixth largest bank, with $300 billion in assets, $188 billion in deposits, 2,300 branches in 15 states, and over 43,000 employees. In 2003, its longtime CEO, Kerry Killinger, said he wanted to do for the lending industry what Wal-Mart and others did for their industries, by catering to middle and lower income Americans and helping the less well off buy homes.105

Soon after, WaMu embarked on a strategy of high risk lending. By 2006, its high risk loans began incurring record rates of delinquency and default, and its securitizations saw ratings downgrades and losses. In 2007, the bank itself began incurring losses. Its shareholders lost confidence, and depositors began withdrawing funds, eventually causing a liquidity crisis. On September 25, 2008, 119 years to the day of its founding, WaMu was seized by its regulator, the Office of Thrift Supervision (OTS), and sold to JPMorgan Chase for $1.9 billion. Had the sale not gone through, WaMu’s failure might have exhausted the $45 billion Deposit Insurance Fund.
Washington Mutual is the largest bank failure in U.S. history.

This case study examines how one bank’s strategy for growth and profit led to the

origination and securitization of hundreds of billions of dollars in poor quality mortgages that undermined the U.S. financial system. WaMu had held itself out as a prudent lender, but in reality, the bank turned increasingly to higher risk loans. Its fixed rate mortgage originations fell from 64% of its loan originations in 2003, to 25% in 2006, while subprime, Option ARM, and home equity originations jumped from 19% of the originations to 55%. Using primarily loans from its subprime lender, Long Beach Mortgage Corporation, WaMu’s subprime securitizations grew sixfold, increasing from about $4.5 billion in 2003, to $29 billion in securitizations in 2006.
From 2000 to 2007, WaMu and Long Beach together securitized at least $77 billion in subprime loans. WaMu also increased its origination of Option ARMs, its flagship product, which from 2003 to 2007, represented as much as half of all of WaMu’s loan originations. In 2006 alone, Washington Mutual originated more than $42.6 billion in Option ARM loans and sold or securitized at least $115 billion, including sales to the Federal National Mortgage Association (Fannie Mae) and Federal Home Loan Mortgage Corporation (Freddie Mac). In addition, WaMu dramatically increased its origination and securitization of home equity loan products. By 2007,

105 “Saying Yes, WaMu Built Empire on Shaky Loans,” New York Times (12/27/2008) http://www.nytimes.com/2008/12/28/business/28wamu.html?_r=1 (quoting Mr. Killinger: “We hope to do to this industry what Wal-Mart did to theirs, Starbucks did to theirs, Costco did to theirs and Lowe’s-Home Depot did to their industry. And I think if we’ve done our job, five years from now you’re not going to call us a bank.”).

home equity loans made up $63.5 billion or 27% of its home loan portfolio, a 130% increase from 2003.

At the same time that WaMu was implementing its High Risk Lending Strategy, WaMu

and Long Beach engaged in a host of shoddy lending practices that contributed to a mortgage time bomb. Those practices included qualifying high risk borrowers for larger loans than they could afford; steering borrowers to higher risk loans; accepting loan applications without verifying the borrower’s income; using loans with teaser rates that could lead to payment shock when higher interest rates took effect later on; promoting negatively amortizing loans in which many borrowers increased rather than paid down their debt; and authorizing loans with multiple layers of risk. In addition, WaMu and Long Beach failed to enforce compliance with their lending standards; allowed excessive loan error and exception rates; exercised weak oversight over the third party mortgage brokers who supplied half or more of their loans; and tolerated the issuance of loans with fraudulent or erroneous borrower information. They also designed compensation incentives that rewarded loan personnel for issuing a large volume of higher risk loans, valuing speed and volume over loan quality.

WaMu’s combination of high risk loans, shoddy lending practices, and weak oversight

produced hundreds of billions of dollars of poor quality loans that incurred early payment defaults, high rates of delinquency, and fraud. Long Beach mortgages experienced some of the highest rates of foreclosure in the industry and their securitizations were among the worst performing. Senior WaMu executives described Long Beach as “terrible” and “a mess,” with default rates that were “ugly.” WaMu’s high risk lending operation was also problem-plagued.
WaMu management knew of evidence of deficient lending practices, as seen in internal emails, audit reports, and reviews. Internal reviews of WaMu’s loan centers, for example, described “extensive fraud” from employees “willfully” circumventing bank policy. An internal review found controls to stop fraudulent loans from being sold to investors were “ineffective.” On at least one occasion, senior managers knowingly sold delinquency-prone loans to investors. Aside from Long Beach, WaMu’s President Steve Rotella described WaMu’s prime home loan business as the “worst managed business” he had seen in his career.

Documents obtained by the Subcommittee reveal that WaMu launched its High Risk

Lending Strategy primarily because higher risk loans and mortgage backed securities could be sold for higher prices on Wall Street. They garnered higher prices, because higher risk meant they paid a higher coupon rate than other comparably rated securities, and investors paid a higher price to buy them. Selling or securitizing the loans also removed them from WaMu’s books and appeared to insulate the bank from risk.

From 2004 to 2008, WaMu originated a huge number of poor quality mortgages, most of

which were then resold to investment banks and other investors hungry for mortgage backed securities. For a period of time, demand for these securities was so great that WaMu formed its own securitization arm on Wall Street. Over a period of five years, WaMu and Long Beach churned out a steady stream of high risk, poor quality loans and mortgage backed securities that later defaulted at record rates. Once a prudent regional mortgage lender, Washington Mutual

tried – and ultimately failed – to use the profits from poor quality loans as a stepping stone to becoming a major Wall Street player.

Washington Mutual was far from the only lender that sold poor quality mortgages and

mortgage backed securities that undermined U.S. financial markets. The Subcommittee investigation indicates that Washington Mutual was emblematic of a host of financial institutions that knowingly originated, sold, and securitized billions of dollars in high risk, poor quality home loans. These lenders were not the victims of the financial crisis; the high risk loans they issued became the fuel that ignited the financial crisis.

A. Subcommittee Investigation and Findings of Fact

As part of its investigation into high risk lending and the Washington Mutual case study, the Subcommittee collected millions of pages of documents from Washington Mutual, JPMorgan Chase, OTS, the FDIC, eAppraiseIT, Lenders Service Inc., Moody’s, Standard & Poor’s, various investment banks, Fannie Mae, Freddie Mac, and others. The documents included email, correspondence, internal memoranda, reports, legal pleadings, financial analysis, prospectuses, and more. The Subcommittee also conducted more than 30 interviews with former WaMu employees and regulatory officials. The Subcommittee also spoke with personnel from the Offices of the Inspector General at the Department of Treasury and the FDIC, who were engaged in a joint review of WaMu’s regulatory oversight and the events leading to its demise. In addition, the Subcommittee spoke with nearly a dozen experts on a variety of banking, accounting, regulatory, and legal issues. On April 13, 2010, the Subcommittee held a hearing which took testimony from former WaMu officials and released 86 exhibits.106

In connection with the hearing, the Subcommittee released a joint memorandum from

Chairman Carl Levin and Ranking Member Tom Coburn summarizing the investigation to date into Washington Mutual and the role of high risk home loans in the financial crisis. The memorandum contained the following findings of fact, which this Report reaffirms.

High Risk Lending Strategy. Washington Mutual (WaMu) executives embarked upon a High Risk Lending Strategy and increased sales of high risk home loans to Wall Street, because they projected that high risk home loans, which generally charged higher rates of interest, would be more profitable for the bank than low risk home loans.
Shoddy Lending Practices. WaMu and its affiliate, Long Beach Mortgage Company (Long Beach), used shoddy lending practices riddled with credit, compliance, and operational deficiencies to make tens of thousands of high risk home loans that too often contained excessive risk, fraudulent information, or errors.

106 “Wall Street and the Financial Crisis: The Role of High Risk Loans,” before the U.S. Senate Permanent Subcommittee on Investigations, S.Hrg. 111-67 (April 13, 2010) (hereinafter “April 13, 2010 Subcommittee Hearing”).

Steering Borrowers to High Risk Loans. WaMu and Long Beach too often steered borrowers into home loans they could not afford, allowing and encouraging them to make low initial payments that would be followed by much higher payments, and presumed that rising home prices would enable those borrowers to refinance their loans or sell their homes before the payments shot up.
Polluting the Financial System. WaMu and Long Beach securitized over $77

billion in subprime home loans and billions more in other high risk home loans, used Wall Street firms to sell the securities to investors worldwide, and polluted the financial system with mortgage backed securities which later incurred high rates of delinquency and loss.

Securitizing Delinquency-Prone and Fraudulent Loans. At times, WaMu selected

and securitized loans that it had identified as likely to go delinquent, without disclosing its analysis to investors who bought the securities, and also securitized loans tainted by fraudulent information, without notifying purchasers of the fraud that was discovered.

Destructive Compensation. WaMu’s compensation system rewarded loan officers

and loan processors for originating large volumes of high risk loans, paid extra to loan officers who overcharged borrowers or added stiff prepayment penalties, and gave executives millions of dollars even when their High Risk Lending Strategy placed the bank in financial jeopardy.

B. Background

Washington Mutual Bank was a federally chartered thrift whose primary federal regulator

was the Office of Thrift Supervision (OTS). As an insured depository institution, it was also overseen by the Federal Deposit Insurance Corporation (FDIC). Washington Mutual was a full service consumer and business bank. This Report focuses only on WaMu’s home lending and securitization business. As part of that business, WaMu originated home loans, acquired home loans for investment and securitization, sold pools of loans, and also securitized pools of home loans that it had originated or acquired. It was also a leading servicer of residential mortgages.

(1) Major Business Lines and Key Personnel

From 2004 to 2008, WaMu had four major business lines.107

The Home Loans Group handled WaMu’s home mortgage originations, securitizations, and servicing operations. The Commercial Group handled apartment buildings and other commercial properties. The Retail Banking Group provided retail banking services to consumers and businesses across the country.
The Card Services Group handled a credit card business purchased from Providian Financial Corporation.

107 9/25/2008 “OTS Fact Sheet on Washington Mutual Bank,” Dochow_Darrel-00076154_001.

For most of the five-year period reviewed by the Subcommittee, WaMu was led by its

longtime Chairman of the Board and Chief Executive Officer (CEO) Kerry Killinger who joined the bank in 1982, became bank president in 1988, and was appointed CEO in 1990. Mr. Killinger was the moving force behind WaMu’s acquisitions and growth strategy during the 1990s, and made the fateful decision to embark upon its High Risk Lending Strategy in 2005.
Mr. Killinger stepped down as Chairman of the Board in June 2008, after shareholders opposed having the same person occupy the bank’s two top positions. He was dismissed from the bank on September 8, 2008, the same day WaMu was required by its regulator, OTS, to sign a public Memorandum of Understanding to address its lending and securitization deficiencies. Two weeks later the bank failed.

Other key members of the bank’s senior management included President Steve Rotella

who joined the bank in January 2005; Chief Financial Officer Tom Casey; President of the Home Loans Division David Schneider who joined the bank in July 2005; and General Counsel Faye Chapman. David Beck served as Executive Vice President in charge of the bank’s Capital Markets Division, oversaw its securitization efforts, and reported to the head of Home Loans.
Anthony Meola headed up the Home Loans Sales effort. Jim Vanasek was WaMu’s Chief Credit Officer from 1999 until 2004, and was then appointed its Chief Risk Officer, a new position, from 2004-2005. After Mr. Vanasek’s retirement, Ronald Cathcart took his place as Chief Risk Officer, and headed the bank’s newly organized Enterprise Risk Management Division, serving in that post from 2005 to 2007.

(2) Loan Origination Channels WaMu was one of the largest mortgage originators in the United States.108

It originated

and acquired residential mortgages through several methods, which it referred to as loan origination channels. WaMu referred to them as its retail, wholesale, subprime, correspondent, and conduit channels.

Retail Channel. In WaMu’s parlance, “retail channel” loans were loans originated by WaMu employees, typically loan officers or sales associates operating out of WaMu branded loan centers. The prospective borrower typically communicated directly with the WaMu loan officer, who was often called a “loan consultant.” WaMu considered all retail channel loans to be “prime” loans, regardless of the characteristics of the loan or the creditworthiness of the borrower, and sometimes referred to the retail channel as the “prime” channel. The retail channel originated significant numbers of Option ARM loans, which WaMu treated as prime loans, despite their inherent risks. According to the Inspectors General of the U.S. Treasury Department and the FDIC, who prepared a report on WaMu’s failure (hereinafter “IG Report”), “Option ARMs represented as much as half of all loan originations from 2003 to 2007 and approximately $59 billion, or 47 percent, of the home loans on WaMu’s balance sheet at the end

108 See, e.g., “Mortgage Lender Rankings by Residential Originations,” charts prepared by MortgageDaily.com (indicating WaMu was one of the top three issuers of U.S. residential mortgages from 2003 to 2005); “Washington Mutual to Acquire PNC’s Residential Mortgage Business,” Business Wire (10/2/2000), http://findarticles.com/p/articles/mi_m0EIN/is_2000_Oct_2/ai_65635032.

of 2007.”109 loans and home equity lines of credit.

The retail channel was also used to originate substantial numbers of home equity

Wholesale Channel. According to WaMu, its “wholesale channel” loans were loans that

the bank acquired from third party mortgage brokers. These brokers, who were not WaMu employees, located borrowers interested in purchasing a home or refinancing an existing mortgage, and explained available loans that could be underwritten by WaMu. The borrower’s primary, and sometimes sole, contact was with the mortgage broker. The mortgage broker would then provide the borrower’s information to a WaMu loan officer who would determine whether the bank would finance the loan. If the bank decided to finance the loan, the broker would receive a commission for its efforts. Third party mortgage brokers typically received little guidance or training from WaMu, aside from receiving daily “rate sheets” explaining the terms of the loans that WaMu was willing to accept and the available commissions. WaMu treated wholesale loans issued under the WaMu brand as prime loans.

Subprime Channel. WaMu also originated wholesale loans through its subprime

affiliate and later subsidiary, Long Beach Mortgage Company (Long Beach). Long Beach was a purely wholesale lender, and employed no loan officers that worked directly with borrowers.
Instead, its account executives developed relationships with third party mortgage brokers who brought prospective loans to the company, and if Long Beach accepted those loans, received a commission for their efforts. WaMu typically referred to Long Beach as its “subprime channel.”
Later, in 2007, when the bank decided to eliminate Long Beach as a separate entity, it rebranded Long Beach as its “Wholesale Specialty Lending” channel.

At times, WaMu also acquired subprime loans through “correspondent” or “conduit”

channels, which it used to purchase closed loans – loans that had already been financed – from other lenders for investment or securitization. For example, WaMu at times operated a correspondent channel that it referred to as “Specialty Mortgage Finance” and used to purchase subprime loans from other lenders, especially Ameriquest, for inclusion in its investment portfolio. In addition, in 2005, its New York securitization arm, Washington Mutual Capital Corporation, established a “subprime conduit” to purchase closed subprime loans in bulk from other lenders for use in securitizations. At the end of 2006, WaMu reported that its investment portfolio included $4 billion in subprime loans from Long Beach and about $16 billion in subprime loans from other parties.110

Other Channels. At times, WaMu also originated or acquired loans in other ways. Its “Consumer Direct” channel, for example, originated loans over the phone or internet; borrowers did not need to meet in person with a WaMu loan officer. In addition, in 2004, Washington Mutual Capital Corporation (WCC) set up a conduit to purchase closed Alt A loans in bulk from

109 4/2010 “Evaluation of Federal Regulatory Oversight of Washington Mutual Bank,” report prepared by the Offices of Inspector General at the Department of the Treasury and Federal Deposit Insurance Corporation, Hearing Exhibit 4/16-82 (hereinafter “IG Report”). 110 See 3/1/2007 Washington Mutual Inc. 10-K filing with the SEC, at 56.

other lenders and use them in securitizations. WCC shut down both the Alt A and subprime conduits in April 2008, after it became too difficult to find buyers for new securitizations.111

The Treasury and the FDIC IG report examining the failure of WaMu found that, from

2003 to 2007, the bulk of its residential loans – from 48% to 70% – came from third party lenders and brokers.112 That report also determined that, in 2007, WaMu had 14 full-time employees overseeing 34,000 third party brokers doing business with the bank nationwide, and criticized the Bank’s oversight and staffing effort.113

(3) Long Beach

WaMu had traditionally originated mortgages to well qualified prime borrowers. But in

1999, WaMu bought Long Beach Mortgage Company,114 which was exclusively a subprime lender to borrowers whose credit histories did not support their getting a traditional mortgage.115 Long Beach was located in Anaheim, California, had a network of loan centers across the country, and at its height had as many as 1,000 employees.

Long Beach made loans for the express purpose of securitizing them and profiting from the gain on sale; it did not hold loans for its own investment. It had no loan officers of its own, but relied entirely on third party mortgage brokers bringing proposed subprime loans to its doors. In 2000, the year after it was purchased by WaMu, Long Beach made and securitized approximately $2.5 billion in home loans. By 2006, its loan operations had increased more than tenfold, and Long Beach securitized nearly $30 billion in subprime home loans and sold the securities to investors.116

Long Beach’s most common subprime loans were short term, hybrid adjustable rate

mortgages, known as “2/28,” “3/27,” or “5/25” loans. These 30-year mortgages typically had a low fixed “teaser” rate, which then reset to a higher floating rate after two years for the 2/28, three years for the 3/27, or five years for the 5/25.117 Long Beach typically qualified borrowers according to whether they could afford to pay the initial, low interest rate rather than the later,

111 See 6/11/2007 chart entitled, “Capital Markets Division Growth,” JPM_WM03409858, Hearing Exhibit 4/13- 47c. 112 See prepared statement of Treasury IG Eric Thorson, “Wall Street and the Financial Crisis: Role of the Regulators,” before the U.S. Senate Permanent Subcommittee on Investigations, S.Hrg. 111-672 (April 16, 2010) (hereinafter “April 16, 2010 Subcommittee Hearing”), at 5. 113 See 4/2010 IG Report, at 11, Hearing Exhibit 4/16-82. 114 Washington Mutual Inc. actually purchased Long Beach Financial Corporation, the parent of Long Beach Mortgage Corporation, for about $350 million. 115 12/21/2005 OTS internal memorandum from OTS examiners to Darrel Dochow, OTSWMS06-007 0001009, Hearing Exhibit 4/16-31 (“LBMC was acquired … as a vehicle for WMI to access the subprime loan market. LBMC’s core business is the origination of subprime mortgage loans through a nationwide network of mortgage brokers.”). 116 “Securitizations of Washington Mutual Subprime Home Loans,” chart prepared by the Subcommittee, Hearing Exhibit 4/13-1c. 117 For more information about these types of loans, see Chapter II.

For “interest-only” loans, monthly loan payments were calculated to

higher interest rate.118 cover only the interest due on the loan and not any principal. After the fixed interest rate period expired, the monthly payment was typically recalculated to pay off the entire remaining loan within the remaining loan period at the higher floating rate. Unless borrowers could refinance, the suddenly increased monthly payments caused some borrowers to experience “payment shock” and default on their loans.

From 1999 to 2006, Long Beach operated as a subsidiary of Washington Mutual Inc., the parent of Washington Mutual Bank. Long Beach’s loans repeatedly experienced early payment defaults, high delinquency rates, and losses, and its securitizations were among the worst performing in the market.119 In 2006, in a bid to strengthen Long Beach’s performance, WaMu received permission from its regulator, OTS, to purchase the company from its parent and make it a wholly owned subsidiary of the bank. WaMu installed new management, required the head of Long Beach to report to its Home Loans Division President, and promised OTS that it would improve Long Beach. When Long Beach’s loans continued to perform poorly, in June 2007, WaMu shut down Long Beach as a separate entity, and took over its subprime lending operations, rebranding Long Beach as its “Wholesale Specialty Lending” channel. WaMu continued to issue and securitize subprime loans. After the subprime market essentially shut down a few months later in September 2007, WaMu ended all of its subprime lending.

From 2000 to 2007, Long Beach and WaMu together securitized tens of billions of

dollars in subprime loans, creating mortgage backed securities that frequently received AAA or other investment grade credit ratings.120 Although AAA securities are supposed to be very safe investments with low default rates of one to two percent, of the 75 Long Beach mortgage backed security tranches rated AAA by Standard and Poor’s in 2006, all 75 have been downgraded to junk status, defaulted, or been withdrawn.121 In most of the 2006 Long Beach securitizations, the underlying loans have delinquency rates of 50% or more.122

(4) Securitization

Washington Mutual depended on the securitization process to generate profit, manage

risk, and obtain capital to originate new loans. Washington Mutual and Long Beach sold or securitized most of the subprime home loans they acquired. Initially, Washington Mutual kept most of its Option ARMs in its proprietary investment portfolio, but eventually began selling or securitizing those loans as well. From 2000 to 2007, Washington Mutual and Long Beach

118 See April 13, 2010 Subcommittee Hearing at 50. 119 See 4/14/2005 email exchange between OTS examiners, “Fitch – LBMC Review,” Hearing Exhibit 4/13-8a (discussing findings by Fitch, a credit rating agency, highlighting poor performance of Long Beach securities). 120 “Securitizations of Washington Mutual Subprime Home Loans,” chart prepared by the Subcommittee, Hearing Exhibit 4/13-1c. 121 See Standard and Poor’s data at www.globalcreditportal.com. 122 See, e.g., wamusecurities.com (subscription website maintained by JPMorgan Chase with data on Long Beach and WaMu mortgage backed securities showing, as of March 2011, delinquency rates for particular mortgage backed securities, including LBMLT 2006-1 – 58.44%; LBMLT 2006-6 – 60.06%; and LBMLT 2005-11 – 54.32%).

securitized at least $77 billion in subprime home loans. Washington Mutual sold or securitized at least $115 billion of Option ARM loans, as well as billions more of other types of high risk loans, including hybrid adjustable rate mortgages, Alt A, and home equity loans.

When Washington Mutual began securitizing its loans, it was dependent upon investment

banks to help underwrite and sell its securitizations. In order to have greater control of the securitization process and to keep securitization underwriting fees in house, rather than paying them to investment banks, WaMu acquired a company able to handle securitizations and renamed it Washington Mutual Capital Corporation (WCC), which became a wholly owned subsidiary of the bank.123 WCC was a registered broker-dealer and began to act as an underwriter of WaMu and Long Beach securitizations.124 subsidiaries, Washington Mutual Mortgage Securities Corp. and Washington Mutual Asset Acceptance Corp., that provided warehousing for WaMu loans before they were securitized.
WCC helped to assemble RMBS pools and sell the resulting RMBS securities to investors. At first it worked with other investment banks; later it became the sole underwriter of some WaMu securitizations.

WCC worked with two other bank

WCC was initially based in Seattle with 30 to 40 employees.125 In 2004, it moved its

headquarters to Manhattan.126 At the height of WCC operations, right before the collapse of the securitization market, WCC had over 200 employees and offices in Seattle, New York, Los Angeles, and Chicago, with the majority of its personnel in New York.127 in December 2007, after the securitization markets collapsed.

WCC closed its doors

(5) Overview of WaMu’s Rise and Fall

Washington Mutual Bank (WaMu) was a wholly owned subsidiary of its parent holding company, Washington Mutual Inc.128 From 1996 to 2002, WaMu acquired over a dozen other financial institutions, including American Savings Bank, Great Western Bank, Fleet Mortgage Corporation, Dime Bancorp, PNC Mortgage, and Long Beach, expanding to become the nation’s largest thrift and sixth largest bank. WaMu also became one of the largest issuers of home loans in the country. Washington Mutual kept a portion of those loans for its own investment portfolio, and sold the rest either to Wall Street investors, usually after securitizing them, or to Fannie Mae or Freddie Mac. From 2000 to 2008, Washington Mutual sold over $500 billion in loans to Fannie Mae and Freddie Mac, representing more than a quarter of its loan production during those years.

123See 6/11/2007 chart entitled, “Capital Markets Division Growth,” JPM_WM03409858, Hearing Exhibit 4/13-47c.
124 Prepared statement of David Beck, April 13, 2010 Subcommittee Hearing at 2. 125 Subcommittee interview of David Beck (3/2/2010). 126 Id. 127 Id.
128 9/25/2008 “OTS Fact Sheet on Washington Mutual Bank,” Dochow_Darrel-00076154_001, at 002. Washington Mutual Inc. also owned a second, much smaller thrift, Washington Mutual Bank, FSB. Id.

In 2006, WaMu took several major actions that reduced the size of its Home Loans Group. It sold $140 billion in mortgage servicing rights to Wells Fargo; sold a $22 billion portfolio of home loans and other securities; and reduced its workforce significantly.129

In July 2007, after the Bear Stearns hedge funds collapsed and the credit rating agencies

downgraded the ratings of hundreds of mortgaged backed securities, including over 40 Long Beach securities, the secondary market for subprime loans dried up. In September 2007, due to the difficulty of finding investors willing to purchase subprime loans or mortgage backed securities, Washington Mutual discontinued its subprime lending. It also became increasingly difficult for Washington Mutual to sell other types of high risk loans and related mortgage backed securities, including its Option ARMs and home equity products. Instead, WaMu retained these loans in its portfolios. By the end of the year, as the value of its loans and mortgage backed securities continued to drop, Washington Mutual began to incur significant losses, reporting a $1 billion loss in the fourth quarter of 2007, and another $1 billion loss in the first quarter of 2008.

earnings, and liquidity, OTS and the FDIC lowered the bank’s safety and soundness rating to a 3 on a scale of 1 to 5, signaling it was a troubled institution.130 In March 2008, at the request of OTS and the FDIC, Washington Mutual allowed several potential buyers of the bank to review its financial information.131 JPMorgan Chase followed with a purchase offer that WaMu declined.132 Instead, in April 2008, Washington Mutual’s parent holding company raised $7 billion in new capital and provided $3 billion of those funds to the bank.133 By June, the bank had shut down its wholesale lending channel.134 It also closed over 180 loan centers and terminated 3,000 employees.135 In addition, WaMu reduced its dividend to shareholders.136

In February 2008, based upon increasing deterioration in the bank’s asset quality,

In July 2008, a $30 billion subprime mortgage lender, IndyMac, failed and was placed

into receivership by the government. In response, depositors became concerned about Washington Mutual and withdrew over $10 billion in deposits, putting pressure on the bank’s liquidity. After the bank disclosed a $3.2 billion loss for the second quarter, its stock price continued to drop, and more deposits left.

129 Subcommittee interview of Steve Rotella (2/24/2010). See also 3/1/2007 Washington Mutual Inc. 10-K filing with the SEC, at 1 (Washington Mutual reduced its workforce from 60,789 to 49,824 from December 31, 2005 to December 31, 2006.); “Washington Mutual to cut 2,500 jobs,” MarketWatch (2/15/2006), available at http://www.marketwatch.com/story/washington-mutual-cutting-2500-mortgage-jobs. 130 See 2/27/2008 letter from Kerry Killinger to Washington Mutual Board of Directors, Hearing Exhibit 4/16-41. 131 Subcommittee interviews of WaMu Chief Financial Officer Tom Casey (2/20/2010); and OTS West Region Office Director Darrel Dochow (3/3/2010); 4/2010 “Washington Mutual Regulators Timeline,” prepared by the Subcommittee, Hearing Exhibit 4/16-1j.
132 Subcommittee interview of Tom Casey (2/20/2010). 133 4/2010 “Washington Mutual Regulators Timeline,” prepared by the Subcommittee, Hearing Exhibit 4/16-1j. 134 See 2/27/2008 letter from Kerry Killinger to Washington Mutual Board of Directors, Hearing Exhibit 4/16-41. 135 “Washington Mutual to Take Writedown, Slash Dividend,” Bloomberg (12/10/2007), available at http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aNUz6NmbYZCQ. 136 Id.

On September 8, 2008, Washington Mutual signed a public Memorandum of

Understanding that it had negotiated with OTS and the FDIC to address the problems affecting the bank. Longtime CEO Kerry Killinger was forced to leave the bank, accepting a $15 million severance payment.137

Allen Fishman was appointed his replacement.

On September 15, 2008, Lehman Brothers declared bankruptcy. Three days later, on

September 18, OTS and the FDIC lowered Washington Mutual’s rating to a “4,” indicating that a bank failure was a possibility. The credit rating agencies also downgraded the credit ratings of the bank and its parent holding company. Over the span of eight days starting on September 15, nearly $17 billion in deposits left the bank. At that time, the Deposit Insurance Fund contained about $45 billion, an amount which could have been exhausted by the failure of a $300 billion institution like Washington Mutual. As the financial crisis worsened each day, regulatory concerns about the bank’s liquidity and viability intensified.

close the bank. Unable to wait for a Friday, the day on which most banks are closed, the agencies acted on a Thursday, September 25, 2008, which was also the 119th anniversary of WaMu’s founding. That day, OTS seized Washington Mutual Bank, placed it into receivership, and appointed the FDIC as the receiver. The FDIC facilitated its immediate sale to JPMorgan Chase for $1.9 billion. The sale eliminated the need to draw upon the Deposit Insurance Fund.
WaMu’s parent, Washington Mutual, Inc., declared bankruptcy soon after.

Because of its liquidity problems and poor quality assets, OTS and the FDIC decided to

C. High Risk Lending Strategy

In 2004, Washington Mutual ramped up high risk home loan originations to borrowers

that had not traditionally qualified for them. The following year, Washington Mutual adopted a high risk strategy to issue high risk mortgages, and then mitigate some of that risk by selling or securitizing many of the loans. When housing prices stopped climbing in late 2006, a large number of those risky loans began incurring extraordinary rates of delinquency as did the securities that relied on those loans for cash flow. In 2007, the problems with WaMu’s High Risk Lending Strategy worsened, as delinquencies increased, the securitization market dried up, and the bank was unable to find buyers for its high risk loans or related securities.

The formal initiation of WaMu’s High Risk Lending Strategy can be dated to January 2005, when a specific proposal was presented to the WaMu Board of Directors for approval.138 WaMu adopted this strategy because its executives calculated that high risk home loans were more profitable than low risk loans, not only because the bank could charge borrowers higher interest rates and fees, but also because higher risk loans received higher prices when securitized and sold to investors. They garnered higher prices because, due to their higher risk, the securities paid a higher coupon rate than other comparably rated securities.

137 “Washington Mutual CEO Kerry Killinger: $100 Million in Compensation, 2003-2008,” chart prepared by the Subcommittee, Hearing Exhibit 4/13-1h. 138 See 1/2005 “Higher Risk Lending Strategy ‘Asset Allocation Initiative,’” submitted to Washington Mutual Board of Directors Finance Committee Discussion, JPM_WM00302975-93, Hearing Exhibit 4/13-2a.

Over a five-year period from 2003 to 2008, Washington Mutual Bank shifted its loan

originations from primarily traditional 30-year fixed and government backed loans to primarily higher risk home loans. This shift included increased subprime loan activity at Long Beach, more subprime loans purchased through its Specialty Mortgage Finance correspondent channel, and more bulk purchases of subprime loans through its conduit channel for use in securitizations.
WaMu also increased its originations and acquisitions of Option ARM, Alt A, and home equity loans. While the shift began earlier, the strategic decision to move toward higher risk loans was not fully articulated to regulators or the Board of Directors until the end of 2004 and the beginning of 2005.139

In about three years, from 2005 to 2007, WaMu issued hundreds of billions of higher risk

loans, including $49 billion in subprime loans140 and $59 billion in Option ARMs.141 Data compiled by the Treasury and the FDIC Inspectors General showed that, by the end of 2007, Option ARMs constituted about 47% of all home loans on WaMu’s balance sheet and home equity loans made up $63.5 billion or 27% of its home loan portfolio, a 130% increase from 2003.142 According to an August 2006 internal WaMu presentation on Option ARM credit risk, from 1999 until 2006, Option ARM borrowers selected the minimum monthly payment more than 95% of the time.143 The data also showed that at the end of 2007, 84% of the total value of the Option ARMs was negatively amortizing, meaning that the borrowers were going into deeper debt rather than paying off their loan balances.144 In addition, by the end of 2007, stated income loans – loans in which the bank had not verified the borrower’s income – represented 73% of WaMu’s Option ARMs, 50% of its subprime loans, and 90% of its home equity loans.145 WaMu also originated numerous loans with high loan-to-value (LTV) ratios, in which the loan amount exceeded 80% of the value of the underlying property. The Treasury and the FDIC Inspectors General determined, for example, that 44% of WaMu’s subprime loans and 35% of its home equity loans had LTV ratios in excess of 80%.146 Still another problem was that WaMu had high geographic concentrations of its home loans in California and Florida, states that ended up suffering above-average home value depreciation.147

139 See, e.g., 12/21/2004 “Asset Allocation Initiative: Higher Risk Lending Strategy and Increased Credit Risk Management,” Washington Mutual Board of Directors Discussion, JPM_WM04107995-8008, Hearing Exhibit 4/13- 2b; 1/2005 “Higher Risk Lending Strategy ‘Asset Allocation Initiative,’” submitted to Washington Mutual Board of Directors Finance Committee Discussion, JPM_WM00302975-93, Hearing Exhibit 4/13-2a. 140 “Securitizations of Washington Mutual Subprime Home Loans,” chart prepared by the Subcommittee, Hearing Exhibit 4/13-1c. 141 4/2010 IG Report, at 9, Hearing Exhibit 4/16-82. 142 Id. at 9-10.
143 See 8/2006 Washington Mutual internal report, “Option ARM Credit Risk,” chart entitled, “Borrower-Selected Payment Behavior,” at 7, Hearing Exhibit 4/13-37. The WaMu report also stated: “Almost all Option ARM borrowers select the minimum payment every month with very high persistency, regardless of changes in the interest rates or payment adjustments.” Id. at 2. 144 4/2010 IG Report, at 9, Hearing Exhibit 4/16-82. 145 Id. at 10. 146 Id. 147 Id. at 11.

(1) Strategic Direction

In 2004, WaMu set the stage for its High Risk Lending Strategy by formally adopting aggressive financial targets for the upcoming five-year time period. The new earnings targets created pressure for the bank to shift from its more conservative practices toward practices that carried more risk. Mr. Killinger described those targets in a June 2004 “Strategic Direction” memorandum to WaMu’s Board of Directors: “Our primary financial targets for the next five years will be to achieve an average ROE [Return on Equity] of at least 18%, and average EPS [Earnings Per Share] growth of at least 13%.”148 predicted continuing growth opportunities for the bank:

In his memorandum to the Board, Mr. Killinger

“In a consolidating industry, it is appropriate to continually assess if shareholder value creation is best achieved by selling for a short-term change of control premium or to continue to build long-term value as an independent company. We believe remaining an independent company is appropriate at this time because of substantial growth opportunities we see ahead. We are especially encouraged with growth prospects for our consumer banking group. We would also note that our stock is currently trading at a price which we believe is substantially below the intrinsic value of our unique franchise.
This makes it even more important to stay focused on building long-term shareholder value, diligently protecting our shareholders from inadequate unsolicited takeover proposals and maintaining our long held position of remaining an independent company.”149

Mr. Killinger identified residential nonprime and adjustable rate mortgage loans as one of the primary bank businesses driving balance sheet growth.150 Mr. Killinger also stated in the memorandum: “Wholesale and correspondent will be nationwide and retooled to deliver higher margin products.”151

(2) Approval of Strategy

After 2002, Washington Mutual stopped acquiring lenders specializing in residential and embarked upon a new strategy to push the company’s growth, focused on

mortgages,152 increasing its issuance and purchase of higher risk home loans. OTS took note of this strategy in WaMu’s 2004 Report on Examination:

148 6/1/2004 Washington Mutual memorandum from Kerry Killinger to the Board of Directors, “Strategic Direction,” JPM_WM05385579 at 581. 149 Id. at 582. 150 Id. 151 Id. at 585. 152 The only new lender that Washington Mutual acquired after 2004 was Commercial Capital Bancorp in 2006.

“Management provided us with a copy of the framework for WMI’s 5-year (2005-2009) strategic plan [which] contemplates asset growth of at least 10% a year, with assets increasing to near $500 billion by 2009.”153

In response, in January 2005, WaMu management developed a document entitled,

OTS directed the bank to spell out its new lending strategy in a written document that had to be presented to and gain approval by the WaMu Board of Directors.154

“Higher Risk Lending Strategy” and presented it to its Board of Directors for approval to shift the bank’s focus from originating low risk fixed rate and government backed loans to higher risk subprime, home equity, and Option ARM loans.155 The Strategy disclosed that WaMu planned to increase both its issuance of higher risk loans and its offering of loans to higher risk borrowers. The explicit reasoning for the shift was the increased profitability of the higher risk loans, measured by actual bank data showing that those loans produced a higher “gain on sale” or profit for the bank compared to lower risk loans. For example, one chart supporting the Strategy showed that selling subprime loans garnered more than eight times the gain on sale as government backed loans.156

The WaMu submission to the Board noted that, in order for the plan to be successful,

WaMu would need to carefully manage its residential mortgage business as well as its credit risk, meaning the risk that borrowers would not repay the higher risk loans.157 During the Board’s discussion of the strategy, credit officers noted that losses would likely lag by several years.158

These documents show that WaMu knew that, even if loan losses did not immediately come to pass after initiating the High Risk Lending Strategy, it did not mean the strategy was free of problems.

153 See 3/15/2004 OTS Report of Examination, at OTSWMS04-0000001509, Hearing Exhibit 4/16-94 [Sealed Exhibit]. 154 6/30/2004 OTS Memo to Lawrence Carter from Zalka Ancely, OTSWME04-0000005357 at 61 (“Joint Memo #9

Subprime Lending Strategy”); 3/15/2004 OTS Report of Examination, at OTSWMS04-0000001483, Hearing Exhibit 4/16-94 [Sealed Exhibit]. See also 1/2005 “Higher Risk Lending Strategy Presentation,” submitted to Washington Mutual Board of Directors, at JPM_WM00302978, Hearing Exhibit 4/13-2a (“As we implement our Strategic Plan, we need to address OTS/FDIC 2004 Safety and Soundness Exam Joint Memos 8 & 9 . . . Joint Memo 9: Develop and present a SubPrime/Higher Risk Lending Strategy to the Board.”). 155 1/2005 “Higher Risk Lending Strategy Presentation,” submitted to Washington Mutual Board of Directors, at JPM_WM00302978, Hearing Exhibit 4/13-2a; see also 4/2010 “WaMu Product Originations and Purchases by Percentage – 2003-2007,” chart prepared by the Subcommittee, Hearing Exhibit 4/13-1i.
156 4/18/2006 Washington Mutual Home Loans Discussion Board of Directors Meeting, at JPM_WM00690894, Hearing Exhibit 4/13-3 (see chart showing gain on sale for government loans was 13 basis points; for 30-year, fixed rate loans was 19; for option loans was 109; for home equity loans was 113; and for subprime loans was 150.). 157 See 4/18/2006 Washington Mutual Home Loans Discussion Board of Directors Meeting, at JPM_WM00690899, Hearing Exhibit 4/13-3 (acknowledging that the risks of the High Risk Lending Strategy included managing credit risk, implementing lending technology and enacting organizational changes). 158 1/18/2005 Washington Mutual Inc. Washington Mutual Bank FA Finance Committee Minutes, JPM_WM06293964; see also 1/2005 “Higher Risk Lending Strategy Presentation,” submitted to Washington Mutual Board of Directors, at JPM_WM00302987, Hearing Exhibit 4/13-2a (“Lags in Effects of Expansion,” chart showing peak loss rates in 2007).

“For the purpose of establishing concentration limits, Higher Risk Lending strategies will be implemented in a ‘phased’ approach. Later in 2005 an expanded definition of Higher Risk Lending – encapsulating multiple risk layering and expanded underwriting criteria – and its corresponding concentration limit – will be presented for Board approval.

“The initial definition is ‘Consumer Loans to Higher Risk Borrowers’, which at 11/30/04 totaled $32 Billion or 151% of total risk-based capital, comprised of:

-Subprime loans, or all loans originated by Long Beach Mortgage or purchased through our Specialty Mortgage Finance program

-SFR [Single Family Residential] and Consumer Loans to Borrowers with low credit scores at origination.”160

(3) Definition of High Risk Lending

As part of the 2005 presentation to the Board of Directors outlining the strategy, OTS

recommended that WaMu define higher risk lending.159 contained a slide defining “Higher Risk Lending”:

The January 2005 presentation

While the January 2005 presentation promised to present a fuller definition of higher risk

A footnote on the slide defined “low credit scores” as less than a 620 FICO score for first lien single family residence mortgages, home equity loans, and home equity lines of credit. It defined low credit scores as less than 660 for second lien home equity loans (HEL) and home equity lines of credit (HELOC), and other consumer loans.161

loans for Board approval at some future date, a more complete definition had already been provided to the Board a few weeks earlier in a December 21, 2004 presentation entitled, “Asset Allocation Initiative: Higher Risk Lending Strategy and Increased Credit Risk Management.”162

This presentation contained the same basic definition of higher risk borrowers, but also provided a definition of higher risk loans.

Higher risk loans were defined as single family residence mortgages with a loan-to-value (LTV) ratio of equal to or greater than 90% if not credit enhanced, or a combined-loan-to-value (CLTV) ratio of 95%. These numbers are a notable departure from the 80% LTV ratio

159 6/30/2004 OTS Memo to Lawrence Carter from Zalka Ancely (“Joint Memo #8 - Loans to ‘Higher-Risk Borrowers’”), OTSWME04-0000005357 at 61.
160 1/2005 “Higher Risk Lending Strategy Presentation,” submitted to Washington Mutual Board of Directors, at JPM_WM00302979, Hearing Exhibit 4/13-2a. 161 Id. at JPM_WM00302979. 162 12/21/2004 “Asset Allocation Initiative: Higher Risk Lending Strategy and Increased Credit Risk Management,” Washington Mutual Board of Directors Presentation, at JPM_WM04107995-8008, Hearing Exhibit 4/13-2b.

-‘No Income’ loan documentation type -All Manufactured Housing loans …

“Expanded Criteria

Multiple Risk Layering in SF[R] and 1st lien HEL/HELOC loans

-Higher A- credit score or lacking LTV as strong compensating factor and -An additional risk factor from at least three of the following: -Higher uncertainty about ability to pay or ‘stated income’ documentation type -higher uncertainty about willingness to pay or collateral value[.]”165

traditionally required for a prime loan.163 For home equity loans and lines of credit, WaMu considered a first lien to be high risk if it had a greater than 90% LTV ratio, and considered a second lien to be high risk if had a greater than 80% CLTV ratio.164

expanded underwriting criteria and multiple risk layering:

The December 2004 presentation also defined higher risk lending on the basis of

Those assets fluctuated in

WaMu held billions of dollars in loans on its balance sheet.166

This document indicates that WaMu considered a mortgage to be higher risk if it lacked documentation regarding the borrower’s income, described as a “no income” or “stated income” loan.

value based on the changes in the interest rate. Fixed rate loans, in particular, incurred significant interest rate risk, because on a 30-year fixed rate mortgage, for example, WaMu agreed to receive interest payments at a certain rate for 30 years, but if the prevailing interest rate went up, WaMu’s cost of money increased and the relative value of the fixed mortgages on its balance sheet went down. WaMu used various strategies to hedge its interest rate risk. One way to incur less interest rate risk was for WaMu to hold loans with variable interest rates, such as Hybrid ARMs typical of WaMu’s subprime lending, or Option ARMs, WaMu’s flagship “prime” product. These adjustable rate mortgages paid interest rates that, after the initial fixed rate period expired, were typically pegged to the Cost of Funds Index (COFI) or the Monthly Treasury Average (MTA), two common measures of prevailing interest rates.

163 See, e.g., 10/8/1999 “Interagency Guidance on High LTV Residential Real Estate Lending,” http://www.federalreserve.gov/boarddocs/srletters/1993/SR9301.htm, and discussion of high LTV loans in section D(2)(b), below.
164 12/21/2004 “Asset Allocation Initiative: Higher Risk Lending Strategy and Increased Credit Risk Management,” Washington Mutual Board of Directors Presentation, JPM_WM04107995-8008 at 7999, Hearing Exhibit 4/13-2b. 165 Id. This slide lists only the two additional risk factors quoted, despite referring to “at least three of the following.” 166 See 9/25/2008 “OTS Fact Sheet on Washington Mutual Bank,” Dochow_Darrel-00076154_001 (“Loans held: $118.9 billion in single-family loans held for investment – this includes $52.9 billion in payment option ARMs and $16.05 billion in subprime mortgage loans”).

(4) Gain on Sale

WaMu’s internal documents indicate that the primary motivation behind its High Risk

Lending Strategy was the superior “gain on sale” profits generated by high risk loans.167 Washington Mutual management had calculated that higher risk loans were more profitable when sold or securitized. Prior to sale, higher risk loans also produced greater short term profits, because the bank typically charged the borrowers a higher rate of interest and higher fees.

Higher risk home loans placed for sale were more profitable for WaMu, because of the

higher price that Wall Street underwriters and investors were willing to pay for them. The profit that WaMu obtained by selling or securitizing a loan was known as the “gain on sale.” Gain on sale figures for the loans produced by the bank were analyzed and presented to the WaMu Board of Directors. On April 18, 2006, David Schneider, the President of WaMu Home Loans division, provided the Board of Directors a confidential presentation entitled, “Home Loans Discussion.”168 The third slide in the presentation was entitled, “Home Loans Strategic Positioning,” and stated: “Home Loans is accelerating significant business model changes to achieve consistent, long term financial objectives.”169 Beneath this heading the first listed objective was: “Shift from low-margin business to high-margin products,”170 profitable to more profitable loan products. The next slide in the presentation was entitled:
“Shift to Higher Margin Products,” and elaborated on that objective. The slide listed the actual gain on sale obtained by the bank, in 2005, for each type of loan WaMu offered, providing the “basis points” (bps) that each type of loan fetched on Wall Street:

meaning from less

2005 WaMu Gain on Sale

Margin by Product

in bps171

Government Fixed Hybrid/ARM Alt A Option ARM Home Equity Subprime

13 19 25 40 109 113 150

167 1/18/2005 Washington Mutual Inc. Washington Mutual Bank FA Finance Committee Minutes at JPM_WM06293964; see also 1/2005 “Higher Risk Lending Strategy Presentation,” submitted to Washington Mutual Board of Directors, at JPM_WM00302977, Hearing Exhibit 4/13-2a
168 4/18/2006 “Home Loans Discussion Board of Directors Meeting,” WaMu presentation, JPM_WM00690890-901, Hearing Exhibit 4/13-3.
169 Id. at 893 [emphasis in original removed]. 170 Id. 171 Id. at 894 [formatting as in the original].

Mr. Schneider told the Subcommittee that the numbers listed on the chart were not

projections, but the numbers generated from actual, historical loan data.172 As the chart makes clear, the least profitable loans for WaMu were government backed and fixed rate loans. Those loans were typically purchased by the government sponsored enterprises (GSEs) Fannie Mae and Freddie Mac which paid relatively low prices for them. Instead of focusing on those low margin loans, WaMu’s management looked to make profits elsewhere, and elected to focus on the most profitable loans, which were the Option ARM, home equity, and subprime loans. In 2005, subprime loans, with 150 basis points, were eight times more profitable than a fixed rate loan at 19 basis points and more than 10 times as profitable as government backed loans.

The gain on sale data WaMu collected drove not only WaMu’s decision to focus on

higher risk home loans, but also how the bank priced those loans for borrowers. In determining how much it would charge for a loan, the bank calculated first what price the loan would obtain on Wall Street. As Mr. Beck explained in his testimony before the Subcommittee:

“Because WaMu’s capital markets organization was engaged in the secondary mortgage market, it had ready access to information regarding how the market priced loan products. Therefore my team helped determine the initial prices at which WaMu could offer loans by beginning with the applicable market prices for private or agency-backed mortgage securities and adding the various costs WaMu incurred in the origination, sale, and servicing of home loans.”173

(5) Acknowledging Unsustainable Housing Price Increases

In 2004, before WaMu implemented its High Risk Lending Strategy, the Chief Risk

Officer Jim Vanasek expressed internally concern about the unsustainable rise in housing prices, loosening lending standards, and the possible consequences. On September 2, 2004, just months before the formal presentation of the High Risk Lending Strategy to the Board of Directors, Mr. Vanasek circulated a prescient memorandum to WaMu’s mortgage underwriting and appraisal staff, warning of a bubble in housing prices and encouraging tighter underwriting. The memorandum also captured a sense of the turmoil and pressure at WaMu. Under the subject heading, “Perspective,” Mr. Vanasek wrote:

“I want to share just a few thoughts with all of you as we begin the month of September.
Clearly you have gone through a difficult period of time with all of the changes in the mortgage area of the bank. Staff cuts and recent defections have only added to the stress.
Mark Hillis [a Senior Risk Officer] and I are painfully aware of the toll that this has taken on some of you and have felt it is important to tell you that we recognize it has been and continues to be difficult.

172 Subcommittee interview of David Schneider (2/16/2010). 173 April 13, 2010 Subcommittee Hearing at 53.

“In the midst of all this change and stress, patience is growing thin. We understand that.
We also know that loan originators are pushing very hard for deals. But we need to put all of this in perspective.

“At this point in the mortgage cycle with prices having increased far beyond the rate of increase in personal incomes, there clearly comes a time when prices must slow down or perhaps even decline. There have been so many warnings of a Housing Bubble that we all tend now to ignore them because thus far it has not happened. I am not in the business of forecasting, but I have a healthy respect for the underlying data which says ultimately this environment is no longer sustainable. Therefore I would conclude that now is not the time to be pushing appraisal values. If anything we should be a bit more conservative across the board. Kerry Killinger and Bill Longbrake [a Vice Chair of WaMu] have both expressed renewed concern over this issue.

“This is a point where we should be much more careful about exceptions. It is highly questionable as to how strong this economy may be; there is clearly no consensus on Wall Street. If the economy stalls, the combination of low FICOs, high LTVs and inordinate numbers of exceptions will come back to haunt us.”174

Mr. Vanasek was the senior-most risk officer at WaMu, and had frequent interactions with Mr. Killinger and the Board of Directors. While his concerns may have been heard, they were not heeded.

Mr. Vanasek told the Subcommittee that, because of his predictions of a collapse in the

housing market, he earned the derisive nickname “Dr. Doom.”175 But evidence of a housing bubble was overwhelming by 2005. Over the prior ten years, housing prices had skyrocketed in an unprecedented fashion, as the following chart prepared by Paulson & Co. Inc., based on data from the Bureau of Economic Analysis and the Office of Federal Housing Enterprise Oversight, demonstrates.176

174 9/2/2004 Washington Mutual memorandum from Jim Vanasek, “Perspective,” Hearing Exhibit 4/13-78b. 175 Subcommittee interview of Jim Vanasek (12/18/2009). 176 “Estimation of Housing Bubble,” PSI-Paulson&Co-02-00003, Hearing Exhibit 4/13-1j.

Mr. Vanasek shared his concerns with Mr. Killinger. At the Subcommittee’s hearing, Mr. Killinger testified: “Now, beginning in 2005, 2 years before the financial crisis hit, I was publicly and repeatedly warning of the risks of a potential housing downturn.”177 In March 2005, he engaged in an email exchange with Mr. Vanasek, in which both agreed the United States was in the midst of a housing bubble. On March, 10, 2005, Mr. Vanasek emailed Mr. Killinger about many of the issues facing his risk management team, concluding:

“My group is working as hard as I can reasonably ask any group to work and in several cases they are stretched to the absolute limit. Any words of support and appreciation would be very helpful to the morale of the group. These folks have stepped up to fixing any number of issues this year, many not at all of their own making.”178

Mr. Killinger replied:

“Thanks Jim. Overall, it appears we are making some good progress. Hopefully, the Regulators will agree that we are making some progress. I suspect the toughest thing for us will be to navigate through a period of high home prices, increased competitive conditions for reduced underwriting standards, and our need to grow the balance sheet. I

177 April 13, 2010 Subcommittee Hearing at 85. 178 3/2005 WaMu internal email chain, Hearing Exhibit 4/13-78.

have never seen such a high risk housing market as market after market thinks they are unique and for whatever reason are not likely to experience price declines. This typically signifies a bubble.”

Mr. Vanasek agreed:

“I could not agree more. All the classic signs are there and the likely outcome is probably not great. We would all like to think the air can come out of the balloon slowly but history would not lean you in that direction. Over the next month or so I am going to work hard on what I hope can be a lasting mechanism (legacy) for determining how much risk we can afford to take ….”

Despite Mr. Killinger’s awareness that housing prices were unsustainable, could drop suddenly, and could make it difficult for borrowers to refinance or sell their homes, Mr. Killinger continued to push forward with WaMu’s High Risk Lending Strategy.

(6) Execution of the High Risk Lending Strategy

WaMu formally adopted the High Risk Lending Strategy in January 2005.179

Over the

following two years, management significantly shifted the bank’s loan originations towards riskier loans as called for in the plan, but had to slow down the pace of implementation in the face of worsening market conditions. In retrospect, WaMu executives tried to portray their inability to fully execute the plan as a strategic choice rather than the result of a failed strategy.
For example, Mr. Killinger testified at the Subcommittee hearing that the bank’s High Risk Lending Strategy was only contemplated, but not really executed:

“First, we had an adjustment in our strategy that started in about 2004 to gradually increase the amount of home equity, subprime, commercial real estate, and multi-family loans that we could hold on the balance sheet. We had that long-term strategy, but … we quickly determined that the housing market was increasing in its risk, and we put most of those strategies for expansion on hold.”180

Mr. Killinger’s claim that the High Risk Lending Strategy was put “on hold” is contradicted, however, by WaMu’s SEC filings, its internal documents, and the testimony of other WaMu executives.

Washington Mutual’s SEC filings contain loan origination and acquisition data showing

that the bank did implement its High Risk Lending Strategy. Although rising defaults and the 2007 collapse of the subprime secondary market prevented WaMu from fully executing its plans, WaMu dramatically shifted the composition of the loans it originated and purchased, nearly

179 See 3/13/2006 OTS Report of Examination, at OTSWMS06-008 0001677, Hearing Exhibit 4/16-94 [Sealed Exhibit].
180 April 13, 2010 Subcommittee Hearing at 88.

doubling the percentage of higher risk home loans from 36% to 67%. The following chart, prepared by the Subcommittee using data from WaMu’s SEC filings, demonstrates the shift.181

In 2003, 64% of WaMu’s mortgage originations and purchases were fixed rate loans, and

only 19% were subprime, Option ARM, or home equity loans. In 2004, 31% of WaMu’s mortgage originations and purchases were fixed rate loans, and 55% were subprime, Option ARM, or home equity loans. In 2005, 31% of WaMu’s mortgage originations and purchases were fixed rate loans, and 56% were subprime, Option ARM, or equity loans. By 2006, only 25% of WaMu’s mortgage originations and purchases were fixed rate loans, and 55% were subprime, Option ARM, or home equity loans.182 Even after market forces began taking their toll in 2007, and WaMu ended all subprime lending in the fall of that year, its higher risk originations and purchases at 47% were double its fixed rate loans at 23%.183

181 4/2010 “WaMu Product Originations and Purchases by Percentage – 2003-2007,” chart prepared by the Subcommittee, Hearing Exhibit 4/13-1i. 182 Id. 183 Id.

Mr. Killinger’s annual “Strategic Direction” memoranda to the Board in 2005, 2006, and

2007, also contradict his testimony that the strategy of expanding high risk lending was put on hold. On the first page of his 2005 memorandum, Mr. Killinger wrote: “We continue to see excellent long-term growth opportunities for our key business lines of retail banking, mortgage banking, multi-family lending and sub-prime residential lending.”184 Rather than hold back on WaMu’s stated strategy of risk expansion, Mr. Killinger told the Board that WaMu should accelerate it:

“In order to reduce the impact of interest rate changes on our business, we have accelerated development of Alt-A, government and sub-prime loan products, as well as hybrid ARMs and other prime products, specifically for delivery through retail, wholesale and correspondent channels.”185

The 2005 strategic direction memorandum also targeted Long Beach for expansion:

“Long Beach is expected to originate $30 billion of loans this year, growing to $36 billion in 2006. To facilitate this growth, we plan to increase account managers by 100.
We expect Long Beach to have 5% of the sub-prime market in 2005, growing to [a] 6% share in 2006.”186

Despite warning against unsustainable housing prices in March 2005, Mr. Killinger’s

2006 “Strategic Direction” memorandum to the Board put even more emphasis on growth than the 2005 memorandum. After reviewing the financial targets set in the five-year plan adopted in 2004, Mr. Killinger wrote: “To achieve these targets, we developed aggressive business plans around the themes of growth, productivity, innovation, risk management and people development.”187 high risk home lending strategy was still operative in 2006. The memorandum stated:

His memorandum expressed no hesitation or qualification as to whether the

“Finally, our Home Loan Group should complete its repositioning within the next twelve months and it should then be in position to grow its market share of Option ARM, home equity, sub prime and Alt. A loans. We should be able to increase our share of these categories to over 10%.”188

Contrary to Mr. Killinger’s hearing testimony, the 2006 memorandum indicates an expansion of WaMu’s high risk home lending, rather than any curtailment:

“We are refining our home loans business model to significantly curtail low margin Government and conventional fixed rate originations and servicing, and to significantly

184 6/1/2005 Washington Mutual memorandum from Kerry Killinger to the Board of Directors, “Strategic Direction,” JPMC/WM - 0636-49 at 36, Hearing Exhibit 4/13-6c. 185 Id. at 644. 186 Id. at 646. 187 6/6/2006 Washington Mutual memorandum from Kerry Killinger to the Board of Directors, “Strategic Direction,” JPM_00808312-324 at 314, Hearing Exhibit 4/13-6d. 188 Id. at 315 [emphasis in original removed].

increase our origination and servicing of high margin home equity, Alt. A, sub prime and option ARMs. Action steps include merging Longbeach sub prime and the prime business under common management, merging correspondent activities into our correspondent channel, getting out of Government lending, curtailing conventional fixed rate production, expanding distribution of targeted high margin products through all distribution channels and potentially selling MSRs [Mortgage Servicing Rights] of low margin products. We expect these actions to result in significantly higher profitability and lower volatility over time.”189

The April 16, 2006 “Home Loans Discussion” presentation by Home Loans President

David Schneider, discussed above, also confirms WaMu’s ongoing efforts to shift its loan business toward high risk lending. Page four of that presentation, entitled, “Shift to Higher Margin Products,” shows two pie charts under the heading, “WaMu Volume by Product.”190 One chart depicts loan volume for 2005, and the second chart depicts projected loan volume for 2008:

WaMu Volume By Product

$ In Billions191

2005

Govt $8B 4%

Alt-A $1B 0%

Home Equity

$4B 2%

Subprime

$34B 16%

Option ARM

$63B 31%

Fixed $69B 33%

Hyb/ARM

$28B 13%

New Product

$13B 5%

Home Equity

$30B 13%

Alt A $24B
10%

2008

Fixed $4B 2%

Hyb/ARM

$38B 17%

Option ARM

$63B 23%

Subprime

$70B 30%

$206 Billion

$232 Billion

These charts demonstrate WaMu’s intention to increase its loan originations over three

years by almost $30 billion, focusing on increases in high risk loan products. Subprime originations, for example, were expected to grow from $34 billion in 2005 to $70 billion in 2008; Alt A originations were projected to grow from $1 billion in 2005 to $24 billion in 2008; and

189 Id. at 319. 190 4/18/2006 “Home Loans Discussion Board of Directors Meeting,” WaMu PowerPoint presentation, JPM_WM00690890-901 at 894, Hearing Exhibit 4/13-3.
191 Id. [formatted for clarity].

Home Equity originations were projected to grow from $4 billion in 2005 to $30 billion in 2008.
On the other hand, WaMu’s low risk originations were expected to be curtailed dramatically. Government backed loan originations, which totaled $8 billion in 2005, were projected to be eliminated by 2008. Fixed rate loan originations were projected to decline from $69 billion in 2005 to $4 billion in 2008.

The 2007 “Strategic Direction” memorandum to the Board is dated June 18, 2007, well

after U.S. housing prices had begun to decline, as Mr. Killinger acknowledged:

“For the past two years, we have been predicting the bursting of the housing bubble and the likelihood of a slowing housing market. This scenario has now turned into a reality.
Housing prices are declining in many areas of the country and sales are rapidly slowing.
This is leading to an increase in delinquencies and loan losses. The sub-prime market was especially rocked as many sub-prime borrowers bought houses at the peak of the cycle and now find their houses are worth less and they are having difficulties refinancing their initial low-rate loans.”192

While the memorandum’s section on home loan strategy no longer focused on overall growth, it continued to push the shift to high risk lending, despite problems in the subprime market:

“Home Loans is a large and important business, but at this point in the cycle, it is unprofitable. The key strategy for 2008 is to execute on the revised strategy adopted in

… We need to optimize the sub-prime and prime distribution channels with particular emphasis on growing the retail banking, home loan center and consumer direct channels. We also expect to portfolio more of Home Loans’ originations in 2008, including the new Mortgage Plus product. We will continue to emphasize higher-risk adjusted return products such as home equity, sub-prime first mortgages, Alt A mortgages and proprietary products such as Mortgage Plus.”193

The testimony of other WaMu executives further confirms the bank’s implementation of

its High Risk Lending Strategy. Ronald Cathcart, who joined WaMu in 2006, to become the company’s Chief Risk Officer, testified:

“The company’s strategic plan to shift its portfolios towards higher margin products was already underway when I arrived at WaMu. Basically, this strategy involved moving away from traditional mortgage lending into alternative lending programs involving adjustable-rate mortgages as well as into subprime products. The strategic shift to

192 6/18/2007 Washington Mutual memorandum from Kerry Killinger to the Board of Directors, “Strategic Direction,” JPM_WM03227058-67 at 60, Hearing Exhibit 4/13-6a. 193 Id. at 66 [emphasis in original removed]. See also 1/2007 Washington Mutual presentation, “Subprime Mortgage Program,” JPM_WM02551400, Hearing Exhibit 4/13-5 (informing potential investors in its subprime RMBS securities that: “WaMu is focusing on higher margin products”).

higher-margin products resulted in the bank taking on a higher degree of credit risk because there was a greater chance that borrowers would default.”194

Likewise, Steven Rotella, WaMu’s President and Chief Operating Officer, who began with the bank in January 2005, testified before the Subcommittee:

“In particular, I want to be very clear on the topic of high-risk lending, this Subcommittee’s focus today. High-risk mortgage lending in WaMu’s case, primarily Option ARMs and subprime loans through Long Beach Mortgage, a subsidiary of WaMu, were expanded and accelerated at explosive rates starting in the early 2000s, prior to my hiring in 2005…. In 2004 alone, the year before I joined, Option ARMs were up 124 [percent], and subprime lending was up 52 percent.”195

In his testimony, Mr. Rotella took credit for curtailing WaMu’s growth and high risk

Mr. Killinger replied by email the next day: “Regarding Longbeach, I think there is a

lending.196 Mr. Rotella’s own emails, however, show that he supported the High Risk Lending Strategy. On October 15, 2005, Mr. Rotella emailed Mr. Killinger about WaMu’s 2006 strategic plan: “I think our focus needs to be on organic growth of home eq, and subprime, and greater utilization of [the Home Loans division] as we know it today to facilitate that at lower acquisition costs and greater efficiency.”197

good opportunity to be a low cost provider and gain significant share when the industry implodes.”198 Responding to Mr. Rotella’s ideas about the Home Loans division, Mr. Killinger wrote: “It makes sense to leverage the home loans distribution channels with home equity, sub prime, and alt. A.”199 In this late 2005 email exchange, WaMu’s two senior-most executives contemplate reducing prime lending, not subprime. Mr. Killinger wrote: “If we can’t make a shift in our business model, we might be better off exiting the prime space.”200

Mr. Rotella replied to Mr. Killinger’s email later on October 16, 2005. He continued to emphasize the importance of focusing on high risk lending, referring to his previous experience as a mortgage banker at JPMorgan Chase:

“We did these kinds of analyses all the time at Chase which led us to run as fast as we could into home eq, alt a, subprime (our investment banking brethren stopped us from going too far here). We viewed prime as a source of scale benefits in servicing for the other areas and a conduit of higher margin product and aimed to hold our prime servicing

194 April 13, 2010 Subcommittee Hearing at 18-19. 195 Id. at 83. 196 See id., e.g., at 83-84.
197 10/15/2005-10/16/2005 email from Steve Rotella to Kerry Killinger, JPM_WM00665373-75. 198 Id. at JPM_WM00665374. 199 Id. 200 Id.

flat to down. I feel strongly that where we need to land is a new home loan unit that includes prime, heq, and subprime. It is a far superior model.”201

In July 2008, just two months before the collapse of WaMu, Home Loans President David Schneider prepared an internal presentation entitled, “Home Loans Story, External & Internal Views.”202 The presentation was retrospective, providing timelines of WaMu’s major strategy, policy, and personnel changes. The first substantive page of the presentation bears the heading, “Three fundamental business shifts occurred in Home Loans this millennium which shaped its performance and position in a volatile competitive landscape”:

“2001 to 2005 ‘Mono-line’ business model focused on generating high volume of low-margin, prime products ….

2006 Targeted production franchise toward higher margin products to become a market leader in specific product segments ….

2007 & Beyond Subprime mortgage implosion fuels credit and liquidity crisis and the non-agency secondary market disappears[.]”

Mr. Scheider’s retrospective presentation of the changes that occurred at WaMu is unambiguous: by 2006, WaMu had “[t]argeted production franchise toward higher margin products.”203 According to the same presentation, that model change also lowered earnings volatility for WaMu by lessening exposure to Mortgage Servicing Rights.204 Later slides provide more detail. A quarterly timeline is presented with the heading: “In an environment of internal and external large-scale change, Home Loans took bold actions to redefine its business into a sustainable model.” In the strategy section for the second quarter of 2006, Mr. Schneider wrote:
“New business model, high margin products.”205

Despite warnings by some within its management about unsustainable housing prices, WaMu pursued a High Risk Lending Strategy to generate short term profits from the favorable gain-on-sale margins offered by Wall Street for high risk loans and securitizations, for which the credit rating agencies continued to award AAA ratings. To succeed, the strategy was premised upon borrowers being able to refinance or sell their homes to pay off their loans in the event of a default. Stagnant or declining house prices made refinancing and home sales more difficult.

201 Id. at JPM_WM00665373. 202 7/2008 “Home Loans Story, External & Internal Views,” Washington Mutual PowerPoint presentation, Hearing Exhibit 4/13-80. 203 Id. at 1. 204 Id. 205 Id. at 4.

Effective implementation of the High Risk Lending Strategy also required robust risk management. But while WaMu was incurring significantly more credit risk than it had in the past, risk managers were marginalized, undermined, and subordinated to WaMu’s business units.
As a result, when credit risk management was most needed, WaMu found itself lacking in effective risk management and oversight.

D. Shoddy Lending Practices

At the same time they increased their higher risk lending, WaMu and Long Beach

engaged in a host of poor lending practices that produced billions of dollars in poor quality loans.
Those practices included offering high risk borrowers large loans; steering borrowers to higher risk loans; accepting loan applications without verifying the borrower’s income; using loans with low teaser rates to entice borrowers to take out larger loans; promoting negative amortization loans which led to many borrowers increasing rather than paying down their debt over time; and authorizing loans with multiple layers of risk. WaMu and Long Beach also exercised weak oversight over their loan personnel and third party mortgage brokers, and tolerated the issuance of loans with fraudulent or erroneous borrower information.

(1) Long Beach

Throughout the period reviewed by the Subcommittee, from 2004 until its demise in

September 2007, Long Beach was plagued with problems. Long Beach was one of the largest subprime lenders in the United States,206 but it did not have any of its own loan officers. Long Beach operated exclusively as a “wholesale lender,” meaning all of the loans it issued were obtained from third party mortgage brokers who had brought loans to the company to be financed. Long Beach “account executives” solicited and originated the mortgages that were initiated by mortgage brokers working directly with borrowers. Long Beach account executives were paid according to the volume of loans they originated, with little heed paid to loan quality.

Throughout the period reviewed by the Subcommittee, Long Beach’s subprime home

loans and mortgage backed securities were among the worst performing in the subprime industry. Its loans repeatedly experienced early payment defaults, its securities had among the highest delinquencies in the market, and its unexpected losses and repurchase demands damaged its parent corporation’s financial results. Internal documentation from WaMu shows that senior management at the bank was fully aware of Long Beach’s shoddy lending practices, but failed to correct them.

2003 Halt in Securitizations. For a brief period in 2003, Long Beach was required by

WaMu lawyers to stop all securitizations until significant performance problems were remedied.
While the problems were addressed and securitizations later resumed, many of the issues returned and lingered for several years.

206 See 1/2007 Washington Mutual Presentation, “Subprime Mortgage Program,” Hearing Exhibit 4/13-5 (slide showing Long Beach Annual Origination Volume).

The problems with Long Beach’s loans and securitizations predated the company’s purchase by WaMu in 1999, but continued after the purchase. An internal email at WaMu’s primary federal regulator, the Office of Thrift Supervision (OTS), observed the following with respect to Long Beach’s mortgage backed securities:

“Performance data for 2003 and 2004 vintages appear to approximate industry average while issues prior to 2003 have horrible performance. LBMC finished in the top 12 worst annualized NCLs [net credit losses] in 1997 and 1999 thru 2003. LBMC nailed down the worst spot at top loser … in 2000 and placed 3rd in 2001.”207

In 2003, Long Beach’s performance deteriorated to the point that WaMu’s legal department put a stop to all Long Beach securitizations until the company improved its operations.208 An internal review of Long Beach’s first quarter 2003 lending “concluded that 40% (109 of 271) of loans reviewed were considered unacceptable due to one or more critical errors.”209 According to a 2003 joint report issued by regulators from the FDIC and Washington State: “This raised concerns over LBMC’s ability to meet the representations and warrant[ies] made to facilitate sales of loan securitizations, and management halted securitization activity.”210
A Long Beach corporate credit review in August 2003 confirmed that “credit management and portfolio oversight practices were unsatisfactory.”211

As a result of the halt in securitizations, Long Beach had to hold loans on its warehouse

balance sheet, which increased by approximately $1 billion per month and reached nearly $5 billion by the end of November 2003. Long Beach had to borrow money from WaMu and other creditors to finance the surge.212 The joint visitation report noted that unless Long Beach executed a $3 billion securitization by January 2004, “liquidity will be strained.”213 WaMu initiated a review of Long Beach led by its General Counsel Faye Chapman.214 Her team evaluated the loans that had accumulated during the halt in securitizations. The joint visitation report noted that of 4,000 Long Beach loans reviewed by WaMu by the end of November 2003, less than one quarter, about 950, could be sold to investors, another 800 were unsaleable, and the rest – over half of the loans – had deficiencies that had to be remediated before a sale could take place.215

207 4/2005 OTS internal email, Hearing Exhibit 4/13-8(a). 208 Subcommittee interview of Faye Chapman, WaMu General Counsel (2/9/2010). See also 12/21/2005 OTS memorandum, “Long Beach Mortgage Corporation (LBMC),” OTSWMS06-007 0001010, Hearing Exhibit 4/16-31.
209 1/13/2004 report on “Joint Visitation Dated October 14, 2003,” jointly prepared by the FDIC and the State of Washington Department of Financial Institutions, FDIC-E_00102515, at 3, Hearing Exhibit 4/13-8b (citing a Long Beach quality assurance report). 210 Id. 211 Id. (citing a Long Beach Corporate Credit Review report).
212 Id. 213 Id. 214 Subcommittee interview of Fay Chapman (2/9/2010).
215 1/13/2004 report on “Joint Visitation Dated October 14, 2003,” jointly prepared by the FDIC and the State of Washington Department of Financial Institutions, FDIC-E_00102515, at 3, Hearing Exhibit 4/13-8b.

After a short hiatus, WaMu allowed Long Beach to resume securitizing subprime loans in An internal WaMu memorandum, later prepared by a WaMu risk officer who had been

2004.216 asked to review Long Beach in 2004, recalled significant problems:

“You’ve asked for a chronological recap of ERM [Enterprise Risk Management] market risk involvement with Longbeach and the sub prime conduit. … [In] 2004: I conducted an informal but fairly intensive market risk audit of Longbeach …. The climate was very adversarial. … We found a total mess.”217

A November 2004 email exchange between two WaMu risk officers provides a sense that

poor quality loans were still a problem. The first WaMu risk officer wrote:

“Just a heads-up that you may be getting some outreach from Carroll Moseley (or perhaps someone higher up in the chain) at Long Beach regarding their interest in exploring the transfer of … a small amount (maybe $10-20mm in UPB [unpaid principal balance]) of Piggieback ‘seconds’ (our favorite toxic combo of low FICO borrower and HLTV loan) from HFS [hold for sale portfolio] to HFI [hold for investment portfolio].

“As Carroll described the situation, these are of such dubious credit quality that they can’t possibly be sold for anything close to their ‘value’ if we held on to them. … I urged him to reach out to you directly on these questions. (E.g., it’s entirely possible we might want to make a business decision to keep a small amount of this crap on our books if it was already written down to near zero, but we would want all parties to be clear that no precedent was being set for the product as a whole, etc., etc.).”218

The second risk officer sent the email to the head of Long Beach, with the comment, “I think it would be prudent for us to just sell all of these loans.”

2005 Early Payment Defaults. Early in 2005, a number of Long Beach loans

experienced “early payment defaults,” meaning that the borrower failed to make a payment on the loan within three months of the loan being sold to investors. That a loan would default so soon after origination typically indicates that there was a problem in the underwriting process.
Investors who bought EPD loans often demanded that Long Beach repurchase them, invoking the representations and warranties clause in the loan sales agreements.

216 Subcommittee interview of Fay Chapman (2/9/2010). See also 12/21/2005 OTS memorandum, “Long Beach Mortgage Corporation (LBMC),” OTSWMS06-007 0001010, Hearing Exhibit 4/16-31 (“In 2003, adverse internal reviews of LBMC operations led to a decision to temporarily cease securitization activity. WMU’s Legal Department then led a special review of all loans in LBMC’s pipeline and held-for-sale warehouse in order to ensure file documentation adequately supported securitization representations and warranties and that WMI was not exposed to a potentially significant contingent liability. Securitization activity was reinstated in early 2004 after the Legal Department concluded there was not a significant liability issue.”).
217 Undated memorandum from Dave Griffith to Michelle McCarthy, “Sub Prime Chronology,” likely prepared in early 2007, JPM_WM02095572.
218 11/24/2004 email from Michael Smith to Mark Hillis and others, “LBMC Transfer of Piggiebacks from HFS to HFI,” JPM_WM01407692.

To analyze what happened, WaMu conducted a “post mortem” review of 213 Long

Beach loans that experienced first payment defaults in March, April, and May of 2005.219 review found that many early defaults were not only preventable, but that in some instances fraud should have been easily detected from the presence of “White Out” on an application or a borrower having two different signatures:

The

“First Payment Defaults (FPD’s) are preventable and / or detectable in nearly all cases (~99%)[.] Most FPD cases (60%) are failure of current control effectiveness[.] … High incident rate of potential fraud among FPD cases[.] … All roles in the origination process need to sharpen watch for misrepresentation and fraud[.] … Underwriting guidelines are not consistently followed and conditions are not consistently or effectively met[.] … Underwriters are not consistently recognizing non-arm’s length transactions and/or underwriting associated risk effectively[.] … Credit Policy does not adequately address certain key risk elements in layered high risk transactions[.] …

“66% of reviewed FPD cases had significant variances in the file[.] … Stated Income should be reviewed more closely ([fraud] incidence rate of 35%) …. Signatures should be checked – 14% Borrowers signature vary[.] Altered documents are usually detectable –5% White-out on documentation[.] … 92% of the Purchases reviewed are 100% CLTV [combined loan-to-value][.] … 52% are Stated Income.”220

A subsequent review conducted by WaMu’s General Auditor of the “root causes” of the

Long Beach loans with early payment defaults pointed not only to lax lending standards and a lack of fraud controls, but also to “a push to increase loan volume”:

“In 2004, LBMC [Long Beach] relaxed underwriting guidelines and executed loan sales with provisions fundamentally different from previous securitizations. These changes, coupled with breakdowns in manual underwriting processes, were the primary drivers for the increase in repurchase volume. The shift to whole loan sales, including the EPD provision, brought to the surface the impact of relaxed credit guidelines, breakdowns in manual underwriting processes, and inexperienced subprime personnel. These factors, coupled with a push to increase loan volume and the lack of an automated fraud monitoring tool, exacerbated the deterioration in loan quality.”221

Due to the early payment defaults, Long Beach was forced to repurchase loans totaling This

nearly $837 million in unpaid principal, and incurred a net loss of about $107 million.222

219 11/1/2005 “LBMC Post Mortem – Early Findings Read Out,” prepared by WaMu, JPM_WM03737297, Hearing Exhibit 4/13-9. 220 Id. 221 4/17/2006 WaMu memorandum to the Washington Mutual Inc. and WaMu Board of Directors’ Audit Committee, “Long Beach Mortgage Company - Repurchase Reserve Root Cause Analysis,” prepared by WaMu General Auditor, JPM_WM02533760-61, Hearing Exhibit 4/13-10. 222 Id. (Long Beach “experienced a dramatic increase in EPD’s [early payment defaults], during the third quarter of 2005 [which] … led to a large volume of required loan repurchases. The unpaid principal balance repurchased as a

loss overwhelmed Long Beach’s repurchase reserves, leading to a reserve shortfall of nearly $75 million.223 Due to its insufficient loss reserves, its outside auditor, Deloitte and Touche, cited Long Beach for a serious deficiency in its financial reporting.224 were significant enough that Washington Mutual Inc., Long Beach’s parent company, made special mention of them in its 2005 10-K filing:

These unexpected repurchases

“In 2004 and 2005, the Company’s Long Beach Mortgage Company subsidiary engaged in whole loan sale transactions of originated subprime loans in which it agreed to repurchase from the investor each ‘early payment default’ loan at a price equal to the loan’s face value plus the amount of any premium paid by the investor. An early payment default occurs when the borrower fails to make the first post-sale payment due on the loan by a contractually specified date. Usually when such an event occurs, the fair value of the loan at the time of its repurchase is lower than the face value. In the fourth quarter of 2005, the Company experienced increased incidents of repurchases of early payment default loans sold by Long Beach Mortgage Company and this trend is expected to continue in the first part of 2006.225

In addition to the early payment default problem, a September 2005 WaMu audit

observed that at Long Beach, policies designed to mitigate the risk of predatory lending practices were not always followed. The audit report stated: “In 24 of 27 (88%) of the refinance transactions reviewed, policies established to preclude origination of loans providing no net tangible benefit to the borrower were not followed.”226 In addition, in 8 out of 10 of the newly issued refinance loans that WaMu reviewed, Long Beach had not followed procedures designed to detect “loan flipping,” an industry term used to describe the practice of unscrupulous brokers or lenders quickly or repeatedly refinancing a borrower’s loan to reap fees and profits but provide no benefit to the borrower.227

2006 Purchase of Long Beach. In response to all the problems at Long Beach, at the end of 2005, WaMu fired Long Beach’s senior management and moved the company under the direct supervision of the President of WaMu’s Home Loans Division, David Schneider.228
Washington Mutual promised its regulator, OTS, that Long Beach would improve.229 The bank also filed a formal application, requiring OTS approval, to purchase Long Beach from its parent company, so that it would become a wholly owned subsidiary of the bank.230 WaMu told OTS that making Long Beach a subsidiary would give the bank greater control over Long Beach’s

result of the EPD provision for the year ended December 31, 2005 was $837.3 million. The net loss from these repurchases was approximately $107 million.”).
223 Id. 224 Id. 225 Washington Mutual Inc. 2005 10-K filing with the SEC. 226 9/21/2005 WaMu audit of Long Beach, JPM_WM04656627.
227 Id. 228 Subcommittee interview of David Schneider (2/17/2010). 229 See, e.g., 12/21/2005 OTS memorandum, “Long Beach Mortgage Corporation (LBMC),” OTSWMS06-007 0001009, Hearing Exhibit 4/16-31.
230 Id. at OTSWMS06-007 0001009 (stating WaMu filed a 12/12/2005 application to acquire Long Beach).

operations and allow it to strengthen Long Beach’s lending practices and risk management, as well as reduce funding costs and administrative expenses.231 In addition, WaMu proposed that it replace its current “Specialty Mortgage Finance” program, which involved purchasing subprime loans for its portfolio primarily from Ameriquest, with a similar loan portfolio provided by Long Beach.232 OTS had expressed a number of concerns about Long Beach in connection with the purchase request,233 but in December 2005, after obtaining commitments from WaMu to strengthen Long Beach’s lending and risk management practices, OTS agreed to the purchase.234
The actual purchase date was March 1, 2006.235

Immediately after the purchase, in April 2006, after reviewing Long Beach’s operations, WaMu President Rotella sent an email to WaMu CEO Killinger warning about the extent of the problems: “[D]elinquencies are up 140% and foreclosures close to 70%. … First payment defaults are way up and the 2005 vintage is way up relative to previous years. It is ugly.” would improve:

Mr. Rotella, however, expressed hope that operations

236

“Early changes by the new team from HL [Home Loans], who have deep subprime experience, indicate a solid opportunity to mitigate some of this. I would expect to see this emerge in 3 to 6 months. That said, much of the paper we originated in the 05 growth spurt was low quality. … I have the utmost confidence in the team overseeing this now and no doubt this unit will be more productive and better controlled, but I figured you should know this is not a pretty picture right now. We are all over it, but as we saw with repurchases, there was a lot of junk coming in.”

Despite the new management and direct oversight by WaMu’s Home Loans Division, Long Beach continued to perform poorly. Five months later, expected improvements had not materialized. In September 2006, Mr. Rotella sent another email to Mr. Killinger stating that Long Beach was still “terrible”:

“[Long Beach] is terrible, in fact negative right now. … We are being killed by the lingering movement of EPDs [early payment defaults] and other credit related issues ….
[W]e are cleaning up a mess. Repurchases, EPDs, manual underwriting, very weak servicing/collections practices and a weak staff. Other than that, well you get the picture.”237

231 Id. at OTSWMS06-007 0001010. 232 Id. at OTSWMS06-007 0001011. 233 See, e.g., 6/3/2005 OTS internal memorandum by OTS examiner to OTS Deputy Regional Director, at OTSWMS06-007 0002683, Hearing Exhibit 4/16-28. 234 See 12/21/2005 OTS memorandum, “Long Beach Mortgage Corporation (LBMC),” OTSWMS06-007 0001009, Hearing Exhibit 4/16-31.
235 “Washington Mutual Regulators Timeline,” chart prepared by the Subcommittee, Hearing Exhibit 4/16-1j. 236 4/27/2006 email from Steve Rotella to Kerry Killinger, JPM_WM05380911, Hearing Exhibit 4/13-11. 237 9/14/2006 WaMu internal email, Hearing Exhibit 4/13-12.

Again, he expressed hope that the situation would improve: “The good news is David and his team are pros and are all over it.”238 Two months later, in November 2006, however, the head of WaMu Capital Markets in New York, David Beck, relayed even more bad news to Mr. Schneider, the Home Loans President: “LBMC [Long Beach] paper is among the worst performing in the mkt [market] in 2006.”239

Despite the additional focus on improving its lending operations throughout 2006, Long

Beach was once again flooded with repurchase requests. According to a memorandum later written by an FDIC examination specialist, “[d]uring 2006, more than 5,200 LBMC loans were repurchased, totaling $875.3 million.”240 Even though, in January 2006, the bank had ceased executing whole loan sales which allowed an automatic repurchase in the event of an EPD, 46% of the repurchase volume was as a result of EPDs. Further, 43% of the repurchase volume resulted from first payment defaults (FPDs) in which the borrower missed making the first payment on the loan after it was sold.241 violations related to representation and warranties (R&W) not included in the EPD or FPD numbers, meaning the violations were identified only later in the life of the loan.

Another 10% of the repurchases resulted from

R&W repurchases generally pose a challenge for a bank’s loss reserves, because the

potential liability – the repurchase request – continues for the life of the loan. The FDIC memorandum observed:

“Management claims that R&W provisions are industry standard and indeed they may be.
However, I still found that the Mortgage Loan Purchase Agreement contains some representations and warranties worth noting. For example, not only must the loans be ‘underwritten in accordance with the seller’s underwriting guideline,’ but the ‘origination, underwriting, and collection practices used by the seller with respect to each mortgage loan have been in all material respects legal, proper, prudent, and customary in the subprime mortgage business.’ This provision elevates the potential that investors can put back a problem loan years after origination and not only must the loan have been underwritten in line with bank guidelines but must also have been underwritten in accordance with what is customary with other subprime lenders.”242

R&W repurchase requests and loss reserves continued to be an issue at Long Beach. The

fourth quarter of 2006 saw another spike in R&W repurchase requests, and in December the required amount of R&W loss reserves jumped from $18 million to $76 million.243

238 Id. 239 11/7/2006 WaMu internal email, Hearing Exhibit 4/13-50. 240 See 6/5/2007 memorandum by Christopher Hovik, Examination Specialist, sent to FDIC Dedicated Examiner Steve Funaro, “WaMu – Long Beach Mortgage Company (LMC) Repurchases,” at 1, FDIC_WAMU_000012348, Hearing Exhibit 4/13-13b. 241 Id.
242 Id.
243 Id. at 3.

On December 22, 2006, the FDIC Dedicated Examiner at WaMu, Steve Funaro, sent an email to Mr. Schneider, the Home Loans President, raising questions about the unexpected loan defaults and repurchase demands. He wrote that Long Beach had the “[s]ame issues as FPD last quarter … Current forecast of 35 to 50m [million] risk.” His email also noted potentially insufficient loss reserves related to WaMu’s own subprime conduit that purchased subprime loans from other lenders and mortgage brokers, some of which were going out of business and would be unable to shoulder any liability for defaulting loans. His email noted forecasts of early payment defaults totaling $15.6 million and loan delinquencies totaling $10.7 million, in addition to other problems, and asked: “Why the miss? … Who is accountable?”244

Mr. Schneider forwarded the email to his team and expressed frustration at Long Beach’s

continuing problems:

“Short story is this is not good. … There is [a] growing potential issue around Long Beach repurchases …. [W]e have a large potential risk from what appears to be a recent increase in repurchase requests. … We are all rapidly losing credibility as a management team.”245

Performance in 2007 Worsens. The following year, 2007, was no better as the

performance of WaMu’s loan portfolio continued to deteriorate. WaMu’s chief risk officer, Ron Cathcart, asked WaMu’s Corporate Credit Review team to assess the quality of Long Beach loans and RMBS securities in light of the slowdown and decline in home prices in some areas.246

In January 2007, he forwarded an email with the results of the review, which identified “key risk issues” related to recent loans and described deteriorating loan performance at Long Beach. The “top five priority issues” were:

“Appraisal deficiencies that could impact value and were not addressed[;]
Material misrepresentations relating to credit evaluation were confirmed[;]
Legal documents were missing or contained errors or discrepancies[;]
Credit evaluation or loan decision errors[; and]
Required credit documentation was insufficient or missing from the file.”247

The review also found: “[D]eterioration was accelerating in recent vintages with each vintage since 2002 having performed worse than the prior vintage.” Mr. Cathcart also expressed concern that problems were not being reported to senior management. He wrote: “Long Beach represents a real problem for WaMu. … I am concerned that Credit Review may seem to have been standing on the sidelines while problems continue. For instance, why have Cathcart, Schneider, Rotella and Killinger received NO report on any of this?”248

244 12/22/2006 email from Steve Funaro to David Schneider, Hearing Exhibit 4/13-13a. 245 12/2006 WaMu internal email, Hearing Exhibit 4/13-13a. 246 12/7/2006 email from Ron Cathcart to his colleagues, Hearing Exhibit 4/13-15. 247 1/2/2007 email from Ron Cathcart to Cory Gunderson, Hearing Exhibit 4/13-16. 248 Id.

In February 2007, WaMu senior managers discussed “how best to dispose” of $433 million in Long Beach performing second lien loans, due to “disarray” in the securitization market.249 was “not a viable exit strategy” and noted:

David Beck, head of WaMu’s Wall Street operation, wrote that securitizing the loans

“Investors are suffering greater than expected losses from subprime in general as well as subprime 2nd lien transactions. As you know, they are challenging our underwriting representations and warrants. Long Beach was able to securitize 2nd liens once in 2006 in May. We sold the BBB- bonds to investors at Libor +260. To date, that transaction has already experienced 7% foreclosures.”250

WaMu CEO Killinger complained privately to President Steve Rotella:

“Is this basically saying that we are going to lose 15 [percent] on over $400 million of this product or 60 million. That is a pretty bad hit that reflects poorly on credit and others responsibility for buying this stuff. Is this showing up in hits to compensation or personnel changes.”251

WaMu President Rotella responded:

“This is second lien product originated 7-10 months ago from Long Beach. … In 2006 Beck’s team started sprinkling seconds in deals as they could. And, we now have the % down to the low single digits, so that we can sell all into our deals (assuming the market doesn’t get even worse).”

Also in February 2007, early payment defaults again ticked up. A review of the first

He continued: “In terms of folks losing their jobs, the people largely responsible for bringing us this stuff are gone, the senior management of LB.”252

quarter of 2007 found: “First payment defaults (FPDs) rose to 1.96% in March but are projected to fall back to 1.87% in April based on payments received through May 5th.”253 It also reported that the findings from a “deep dive into February FPDs revealed” that many of the problems could have been eliminated had existing guidelines been followed:

“The root cause of over 70% of FPDs involved operational issues such as missed fraud flags, underwriting errors, and condition clearing errors. This finding indicates there may be opportunities to improve performance without further restricting underwriting guidelines.”254

249 2/2007 email chain among WaMu personnel, JPM_WM00673101-03, Hearing Exhibit 4/13-17. 250 Id. at JPM_WM00673103. 251 Id. at JPM_WM00673101.
252 Id.
253 “Quarterly Credit Risk Review SubPrime,” prepared by WaMu Home Loans Risk Management (1st Quarter, 2007), Hearing Exhibit 4/13-18. 254 Id.

In June 2007, WaMu decided to discontinue Long Beach as a separate entity, and instead

placed its subprime lending operations in a new WaMu division called “Wholesale Specialty Lending.” That division continued to purchase subprime loans and issue subprime securitizations.

Some months later, an internal WaMu review assessed “the effectiveness of the action

plans developed and implemented by Home Loans to address” the first payment default problem in the Wholesale Specialty Lending division.255 After reviewing 187 FPD loans from November 2006 through March 2007, the review found:

“The overall system of credit risk management activities and process has major weaknesses resulting in unacceptable level of credit risk. Exposure is considerable and immediate corrective action is essential in order to limit or avoid considerable losses, reputation damage, or financial statement errors.”256

In particular, the review found:

“Ineffectiveness of fraud detection tools – 132 of the 187 (71%) files were reviewed … for fraud. [The review] confirmed fraud on 115 [and 17 were] … ‘highly suspect’. …
Credit weakness and underwriting deficiencies is a repeat finding …. 80 of the 112 (71%) stated income loans were identified for lack of reasonableness of income[.] 133 (71%) had credit evaluation or loan decision errors …. 58 (31%) had appraisal discrepancies or issues that raised concerns that the value was not supported.”257

July 2007 was a critical moment not only for WaMu, but also for the broader market for mortgage securities. In that month, Moody’s and S&P downgraded the ratings of hundreds of RMBS and CDO securities, including 40 Long Beach subprime securities.258 downgrades caused many investors to immediately stop buying subprime RMBS securities, and the securities plummeted in value. Wall Street firms were increasingly unable to find investors for new subprime RMBS securitizations.

The mass

In August 2007, WaMu’s internal audit department released a lengthy audit report

criticizing Long Beach’s poor loan origination and underwriting practices.259 time, Long Beach had been rebranded as WaMu’s Wholesale Specialty Lending division, the subprime market had collapsed, and subprime loans were no longer marketable. The audit report nevertheless provided a detailed and negative review of its operations:

By that

255 9/28/2007 “Wholesale Specialty Lending-FPD,” WaMu Corporate Credit Review, JPM_WM04013925, Hearing Exhibit 4/13-21. 256 Id. at 2. 257 Id. at 3. 258 7/10/2007-7/12/2007 excerpts from Standard & Poor’s and Moody’s Downgrades, Hearing Exhibit 4/23-99. 259 8/20/2007 “Long Beach Mortgage Loan Origination & Underwriting,” WaMu audit report, JPM_WM02548939, Hearing Exhibit 4/13-19.

“[T]he overall system of risk management and internal controls has deficiencies related to multiple, critical origination and underwriting processes .… These deficiencies require immediate effective corrective action to limit continued exposure to losses. … Repeat Issue – Underwriting guidelines established to mitigate the risk of unsound underwriting decisions are not always followed …. Improvements in controls designed to ensure adherence to Exception Oversight Policy and Procedures is required …. [A]ccurate reporting and tracking of exceptions to policy does not exist.”260

In response, Mr. Rotella wrote to WaMu’s General Auditor: “This seems to me to be the ultimate in bayonetting the wounded, if not the dead.”261

Subprime Lending Ends. In September 2007, with investors no longer interested in buying subprime loans or securitizations, WaMu shut down all of its subprime operations.262
During the prior year, which was their peak, Long Beach and WaMu had securitized $29 billion in subprime loans; by 2007, due to the collapse of the subprime secondary market, WaMu’s volume for the year dropped to $5.5 billion. Altogether, from 2000 to 2007, Long Beach and WaMu had securitized at least $77 billion in subprime loans.263

When asked about Long Beach at the Subcommittee’s hearing, all of the WaMu former managers who testified remembered its operations as being problematic, and could not explain why WaMu failed to strengthen its operations. Mr. Vanasek, former Chief Risk Officer, testified that Long Beach did not have an effective risk management regime when he arrived at WaMu in 1999, and that it had not developed an effective risk management regime by the time he retired at the end of 2005.264 Likewise, Mr. Cathcart, who replaced Mr. Vanasek as Chief Risk Officer, testified that Long Beach never developed effective risk management during the course of his tenure.265

At the April 13 Subcommittee hearing, Senator Levin asked Mr. Vanasek: “Is it fair to say that WaMu is not particularly worried about the risk associated with Long Beach subprime mortgages because it sold those loans and passed the risk on to investors?” Mr. Vanasek replied:
“Yes, I would say that was a fair characterization.”266

Home Loans President David Schneider, who had direct responsibility for addressing the problems at Long Beach, testified that he tried to improve Long Beach, but “ultimately decided … Long Beach was an operation that we should shut down.”267 WaMu President Steve Rotella also acknowledged the inability of WaMu management to resolve the problems at Long Beach:

260 Id. at JPM_WM02548940-41. 261 8/21/2007 email from Steve Rotella to Randy Melby, JPM_WM04859837, Hearing Exhibit 4/13-20. 262 “Washington Mutual Regulators Timeline,” chart prepared by the Subcommittee, Hearing Exhibit 4/16-1j. 263 “Securitizations of Washington Mutual Subprime Home Loans,” chart prepared by the Subcommittee, Hearing Exhibit 4/13-1c. 264 April 13, 2010 Subcommittee Hearing at 22. 265 Id.
266 Id. at 23. 267 Id. at 55.

“We did bring the volume in Long Beach down substantially every quarter starting in the first quarter of 2006. As we went through that process, it became increasingly clear, as I have indicated in here, that the problems in Long Beach were deep and the only way we could address those were to continue to cut back volume and ultimately shut it down.”268

Community Impact. Long Beach’s poor quality loans not only proved unprofitable for

many investors, they were often devastating for the borrowers and their communities. Mr. Killinger testified at the Subcommittee hearing that WaMu, “entered the subprime business with our purchase of Long Beach Mortgage in 1999 to better serve an underserved market.”269 But the unfortunate result of many Long Beach loans was that they left communities reeling from widespread foreclosures and lost homes.

Those ten areas were, in order: Detroit, Cleveland, Stockton, Sacramento,

In November 2008, the Office of the Comptroller of the Currency (OCC) which oversees all nationally chartered banks, identified the ten metropolitan areas across the United States with the highest rates of foreclosure for subprime and Alt A mortgages originated from 2005 through 2007.270 Riverside/San Bernardino, Memphis, Miami/Fort Lauderdale, Bakersfield, Denver, and Las Vegas. The OCC then identified the lenders with the highest foreclosure rates in each of those devastated cities. Long Beach had the worst foreclosure rate in four of those areas, and was near the worst in five more, with the lone exception being Las Vegas. The OCC data also showed that, overall in the ten metropolitan areas, Long Beach mortgages had the second worst foreclosure rate of all the lenders reviewed, with over 11,700 foreclosures at the time of the report. Only New Century was worse.

(2) WaMu Retail Lending

Washington Mutual’s problems were not confined to its subprime operations; they also affected its retail operations. WaMu loosened underwriting standards as part of its High Risk Lending Strategy, and received repeated criticisms from its regulators, as outlined in the next chapter, for weak underwriting standards, risk layering, excessive loan error and exception rates, appraisal problems, and loan fraud. In August 2007, more than a year before the collapse of the bank, WaMu’s President Steve Rotella emailed CEO Kerry Killinger saying that, aside from Long Beach, WaMu’s prime home loan business “was the worst managed business I had seen in my career.”271

(a) Inadequate Systems and Weak Oversight

One reason for WaMu’s poor lending practices was its failure to adequately monitor the

hundreds of billions of dollars of residential loans being issued each year by its own loan

268 Id. at 90. 269 Id. at 86. 270 11/13/2008 “Worst Ten in the Worst Ten,” document prepared by the Office of the Comptroller of the Currency, http://www.occ.treas.gov/news-issuances/news-releases/2009/nr-occ-2009-112b.pdf, Hearing Exhibit 4/13-58. 271 8/23/2007 email from Mr. Rotella to Mr. Killinger, JPM_WM00675851, Hearing Exhibit 4/13-79.

personnel. From 1990 until 2002, WaMu acquired more than 20 new banks and mortgage companies, including American Savings Bank, Great Western Bank, Fleet Mortgage Corporation, Dime Bancorp, PNC Mortgage, and Long Beach. WaMu struggled to integrate dozens of lending platforms, information technology systems, staffs, and policies, whose inconsistencies and gaps exposed the bank to loan errors and fraud.

To address the problem, WaMu invested millions of dollars in a technology program

called Optis, which WaMu President Rotella described in the end as “a complete failure” that the bank “had to write off” and abandon.272 In 2004, an OTS Report of Examination (ROE), which was given to the bank’s Board of Directors, included this observation:

“Our review disclosed that past rapid growth through acquisition and unprecedented mortgage refinance activity placed significant operational strain on [Washington Mutual] during the early part of the review period. Beginning in the second half of 2003, market conditions deteriorated, and the failure of [Washington Mutual] to fully integrate past mortgage banking acquisitions, address operational issues, and realize expectations from certain major IT initiatives exposed the institution’s infrastructure weaknesses and began to negatively impact operating results.”273

The records reviewed by the Subcommittee showed that, from 2004 until its shuttering in 2008, WaMu constantly struggled with information technology issues that limited its ability to monitor loan errors, exception rates, and indicators of loan fraud.

From 2004 to 2008, WaMu’s regulators also repeatedly criticized WaMu’s failure to

exercise sufficient oversight of its loan personnel to reduce excessive loan error and exception rates that allowed the issuance of loans in violation of WaMu’s credit standards.274 Craig Chapman, then the President of WaMu Home Loans, visited a number of the bank’s loan centers around the country. Lawrence Carter, then OTS Examiner-in-Charge at WaMu, spoke with Mr. Chapman about what he found. Recalling that conversation in a later email, Mr. Carter wrote:

In 2004,

“Craig has been going around the country visiting home lending and fulfillment offices. His view is that band-aids have been used to address past issues and that there is a fundamental absence of process.”275

The regulators’ examination reports on WaMu indicate that its oversight efforts remained

weak. In February 2005, OTS stated that WaMu’s loan underwriting “has been an area of

272 Subcommittee interview of Steve Rotella (2/24/2010).
273 See 3/15/2004 OTS Report of Examination, at OTSWMS04-0000001482, Hearing Exhibit 4/16-94 [Sealed Exhibit]. See also, e.g., 12/17/2004 email exchange among WaMu executives, “Risks/Costs to Moving GSE Share to FH,” JPM_WM05501400, Hearing Exhibit 4/16-88 (noting that Fannie Mae “is well aware of our data integrity issues (miscoding which results in misdeliveries, expensive and time consuming data reconciliations), and has been exceedingly patient.”).
274 See, e.g., OTS examination reports cited in Chapter IV, below. 275 8/13/2004 email from Lawrence Carter to Michal Finn, Finn_Michael-00005331.

concern for several exams.”276 In June 2005, OTS expressed concern about the bank’s underwriting exceptions and policy compliance.277 In August of the same year, the OTS Report of Examination stated that, “the level of deficiencies, if left unchecked, could erode the credit quality of the portfolio,” and specifically drew attention to WaMu concentrations in higher risk loans that were a direct result of its High Risk Lending Strategy.278 2006 was no better. OTS repeatedly criticized the level of underwriting exceptions and errors.279

Another problem was the weak role played by WaMu’s compliance department. In March 2007, an OTS examiner noted that WaMu had just hired its “ninth compliance leader since 2000,” and that its “compliance management program has suffered from a lack of steady, consistent leadership.” The examiner added: “The Board of Directors should commission an evaluation of why smart, successful, effective managers can’t succeed in this position. …
(HINT: It has to do with top management not buying into the importance of compliance and turf warfare and Kerry [Killinger] not liking bad news.)”280

Still another problem was that WaMu failed to devote sufficient resources to overseeing the many loans it acquired from third party lenders and mortgage brokers. The 2010 Treasury and FDIC IG report found that, from 2003 to 2007, a substantial portion of WaMu’s residential loans – from 48% to 70% – came from third party lenders and brokers.281 found:

The IG report also

“The financial incentive to use wholesale loan channels for production was significant.
According to an April 2006 internal presentation to the WaMu Board, it cost WaMu about 66 percent less to close a wholesale loan ($1,809 per loan) than it did to close a retail loan ($5,273). Thus, WaMu was able to reduce its cost of operations through the use of third-party originators but had far less oversight over the quality of originations.”282

During its last five years, WaMu accepted loans from tens of thousands of third party

brokers and lenders across the country, not only through its wholesale and correspondent channels, but also through its securitization conduits that bought Alt A and subprime loans in bulk. Evidence gathered by the Subcommittee from OTS examination reports, WaMu internal

276 2/7/2005 OTS Letter to Washington Mutual Board of Directors on Matters Requiring Board Attention, OTSWMEF-0000047591, Hearing Exhibit 4/16-94 [Sealed Exhibit]. See the Regulator Chapter of this Report for more information. 277 6/3/2005 OTS Findings Memorandum, “Single Family Residential Home Loan review,” OTSWME05-004 0000392, Hearing Exhibit 4/16-26. For more information, see Chapter IV, below. 278 3/14/2005 OTS Report of Examination, OTSWMS05-004 0001794, Hearing Exhibit 4/16-94 [Sealed Exhibit]. (Examination findings were issued to WaMu on August 28, 2005.) 279 See, for example, 5/23/2006 OTS Exam Finding Memo, “Home Loan Underwriting, “ OTSWMS06-008 0001299, Hearing Exhibit 4/16-33; and 8/29/2006 OTS Report of Examination, OTSWMS06-008 0001690, Hearing Exhibit 4/16-94 [Sealed Exhibit]. 280 5/31/2007 Draft OTS Findings Memorandum, “Compliance Management Program,” Franklin_Benjamin- 00020408_001, Hearing Exhibit 4/16-9. 281 4/2010 IG Report, at 23, Hearing Exhibit 4/16-82. 282 Id. at 23.

documents, and oral testimony shows that WaMu exercised weak oversight over the thousands of brokers submitting loans. For example, a 2003 OTS report concluded that WaMu’s “annual review and monitoring process for wholesale mortgage brokers was inadequate, as management did not consider key performance indicators such as delinquency rates and fraud incidents.”283 A 2003 WaMu quality assurance review found an “error rate of 29 percent for wholesale mortgage loans, more than triple the acceptable error rate of 8 percent established by WaMu.”284 A 2004 OTS examination noted that 20,000 brokers and lenders had submitted loans to WaMu for approval during the year, a volume that was “challenging to manage.”285 A 2005 internal WaMu investigation of two high volume loan centers in Southern California that accepted loans from brokers found that “78% of the funded retail broker loans reviewed were found to contain fraud.”286 A 2006 internal WaMu inquiry into why loans purchased through its subprime conduit were experiencing high delinquency rates found the bank had securitized broker loans that were delinquent, not underwritten to standards, and suffering from “lower credit quality.”287

OTS examinations in 2006 and 2007 also identified deficiencies in WaMu’s oversight

efforts.288 For example, a 2007 OTS memorandum found that, in 2007, Washington Mutual had only 14 full-time employees overseeing more than 34,000 third party brokers submitting loans to the bank for approval,289 which meant that each WaMu employee oversaw more than 2,400 brokers. The OTS examination not only questioned the staffing level, but also criticized the scorecard WaMu used to rate the mortgage brokers, which did not include the rates at which significant lending or documentation deficiencies were attributed to the broker, the rate at which the broker’s loans were denied or produced unsaleable loans, or any indication of whether the broker was included on industry watch lists for prior or suspected misconduct.

In 2006, federal regulators issued Interagency Guidance on Nontraditional Mortgage Product Risks (NTM Guidance) providing standards on how banks “can offer nontraditional mortgage products in a safe and sound manner.”290 It focused, in part, on the need for banks to “have strong systems and controls in place for establishing and maintaining relationships” with third party lenders and brokers submitting high risk loans for approval. It instructed banks to monitor the quality of the submitted loans to detect problems such as “early payment defaults, incomplete documentation, and fraud.” If problems arose, the NTM Guidance directed banks to “take immediate action”:

283 Id.
284 Id. at 24. 285 Id.
286 11/16/2005 “Retail Fraud Risk Overview,” prepared by WaMu Credit Risk Management, at JPM_WM02481938, Hearing Exhibit 4/13-22b. 287 12/12/2006 WaMu Market Risk Committee Minutes, JPM_WM02095545, Hearing Exhibit 4/13-28. 288 4/2010 IG Report, at 24-25, Hearing Exhibit 4/16-82. 289 6/7/2007 OTS Asset Quality Memo 11, “Broker Credit Administration,” Hedger_Ann-00027930_001, Hearing Exhibit 4/16-10. 290 10/4/2006 “Interagency Guidance on Nontraditional Mortgage Product Risks,” (NTM Guidance), 71 Fed. Reg. 192 at 58609.

“Oversight of third party brokers and correspondents who originate nontraditional mortgage loans should involve monitoring the quality of originations so that they reflect the institution’s lending standards and compliance with applicable laws and regulations. … If appraisal, loan documentation, credit problems or consumer complaints are discovered, the institution should take immediate action.”291

WaMu did, at times, exercise oversight of its third party brokers. A 2006 credit review of its subprime loans, for example, showed that Long Beach – which by then reported to the WaMu Home Loans Division – had terminated relationships with ten brokers in 2006, primarily because their loans had experienced high rates of first payment defaults requiring Long Beach to repurchase them at significant expense.292 But terminating those ten brokers was not enough to cure the many problems with the third party loans WaMu acquired. The report also noted that, in 2006, apparently for the first time, Long Beach had introduced “collateral and broker risk” into its underwriting process.293

WaMu closed down its wholesale and subprime channels in 2007, and its Alt A and

subprime securitization conduits in 2008.

(b) Risk Layering

During the five-year period reviewed by the Subcommittee, from 2004 to 2008, WaMu

issued many loans with multiple higher risk features, a practice known as “risk layering.” At the April 13 Subcommittee hearing, Mr. Vanasek, its Chief Risk Officer from 2004 to 2005, testified about the dangers of this practice:

“It was the layering of risk brought about by these incremental changes that so altered the underlying credit quality of mortgage lending which became painfully evident once housing prices peaked and began to decline. Some may characterize the events that took place as a ‘perfect storm,’ but I would describe it as an inevitable consequence of consistently adding risk to the portfolio in a period of inflated housing price appreciation.”294

Stated Income Loans. One common risk layering practice at WaMu was to allow

borrowers to “state” the amount of their annual income in their loan applications without any direct documentation or verification by the bank. Data compiled by the Treasury and the FDIC IG report showed that, by the end of 2007, 50% of WaMu’s subprime loans, 73% of its Option ARMs, and 90% of its home equity loans were stated income loans.295 The bank’s acceptance of unverified income information came on top of its use of loans with other high risk features, such

291 Id. at 58615. 292 12/2006 “Home Loans – SubPrime Quarterly Credit Risk Review,” JPM_WM04107374, Hearing Exhibit 4/13-

293 Id. at JPM_WM04107375. 294 April 13, 2010 Subcommittee Hearing at 16. 295 4/2010 IG Report, at 10, Hearing Exhibit 4/16-82.

as borrowers with low credit scores or the use of low initial teaser interest rates followed by much higher rates.

Stated income loans were originally developed to assist self employed individuals that had good credit and high net worth to obtain loans they could afford. But from 2004 to 2008, stated income loans became much more widespread, including with respect to a wide variety of high risk loans.296

Mr. Cathcart testified at the Subcommittee hearing:

“[Stated income loans] originated as a product for self-employed individuals who didn’t have pay stubs and whose financial statements didn’t necessarily reflect what they made.
It was intended to be available for only the most creditworthy borrowers and it was supposed to be tested for reasonableness so that a person who said that they were a waiter or a lower-paid individual couldn’t say that they had an income of $100,000.

“I think that the standards eroded over time. At least I have become aware, reading all that has happened … standards eroded over time and that it became a competitive tool that was used by banks to gather business, so that if a loan consultant could send his loan to Bank A or Bank B, the consultant would say, well, why don’t you go to Bank B? You don’t have to state your income.

“I do think, thinking it through, that there was a certain amount of coaxing that was possible between the loan consultant and the individual, which would be something which would be invisible to a bank that received the application and the only test for that would be reasonableness, which as you have heard there were some issues within the portfolio.”297

WaMu required its loan personnel to determine whether a loan applicant’s stated income was reasonable, but evidence obtained by the Subcommittee indicates that requirement was not effectively implemented. A 2008 press report about a WaMu stated income loan is illustrative:

“As a supervisor at a Washington Mutual mortgage processing center, John D. Parsons was accustomed to seeing baby sitters claiming salaries worthy of college presidents, and schoolteachers with incomes rivaling stockbrokers. He rarely questioned them. A real estate frenzy was under way and WaMu, as his bank was known, was all about saying yes.

“Yet even by WaMu’s relaxed standards, one mortgage four years ago raised eyebrows.
The borrower was claiming a six-figure income and an unusual profession: mariachi singer.

296 See, e.g., NTM Guidance at 58614 (“Institutions increasingly rely on reduced documentation, particularly unverified income, to qualify borrowers for nontraditional mortgage loans.”). The NTM Guidance directed banks to use stated income loans “with caution,” but did not prohibit them or even issue guidance limiting their use. Id. at

297 April 13, 2010 Subcommittee Hearing at 41.

“Mr. Parsons could not verify the singer’s income, so he had him photographed in front of his home dressed in his mariachi outfit. The photo went into a WaMu file.
Approved.”298

Instead of verifying borrower income, WaMu loan personnel apparently focused instead

on borrower credit scores, as a proxy measure of a borrower’s creditworthiness. The problem with this approach, however, was that a person could have a high credit score – reflecting the fact that they paid their bills on time – and still have an income that was insufficient to support the mortgage amount being requested.

High LTV Ratios. A second risk-layering practice at WaMu involved loan-to-value (LTV) ratios. LTV ratios are a critical risk management tool, because they compare the loan amount to the estimated dollar value of the property. If an LTV ratio is too high and the borrower defaults, the sale of the property may not produce sufficient proceeds to pay off the loan. In interagency guidance, federal banking regulators noted that banks should generally avoid issuing loans with LTV ratios over 80%, and directed banks to ensure that loans with LTV ratios of 90% or more have additional credit support such as mortgage insurance or added collateral.299 The Treasury and the FDIC IG report found that WaMu held a “significant percentage” of home loans in which the LTV ratios exceeded 80%.300

These loans were the result of explicit WaMu policies allowing high LTV ratios to be

used in loans that already had other high risk features. In February 2005, for example, WaMu set up automated loan approval parameters to approve loans with a 90% LTV in Option ARM and interest-only loans providing financing of up to $1 million.301 added to these loans by permitting the borrowers to have credit scores as low as 620.

Still another layer of risk was

The Treasury and the FDIC IG report determined that 44% of WaMu’s subprime loans and 35% of its home equity loans had LTV ratios in excess of 80%.302 These loans resulted in part from a 2006 WaMu decision to combine home equity loans bearing high LTV ratios with borrowers bearing low credit scores. That initiative was discussed in a June 2006 email sent to Mr. Rotella, after he inquired about the project. He was informed:

298 “Saying Yes, WaMu Built Empire on Shaky Loans,” New York Times (12/27/08). When asked about this press report, WaMu told the Subcommittee that it had no record of this loan, but could not deny that the incident took place as reported. See also, in the following subsection, a WaMu loan issued to a “Sign Designer” who claimed earnings of $34,000 per month.
299 See 10/8/1999 “Interagency Guidance on High LTV Residential Real Estate Lending,” http://www.federalreserve.gov/boarddocs/srletters/1993/SR9301.htm.
300 4/2010 IG Report, at 10, Hearing Exhibit 4/16-82. 301 2/2005 email chain between Timothy Bates, Tony Meola, Mr. Rotella and others, JPM_WM00616783-84.
302 4/2010 IG Report, at 10, Hearing Exhibit 4/16-82. See also 3/1/2007 Washington Mutual Inc. 10-K filing with the SEC, at 52 (showing that, as of 12/31/2006, WaMu held $7.4 billion in home mortgages without private mortgage insurance or government guarantees with LTV ratios in excess of 80%, and $15 billion in home equity loans and lines of credit with LTV ratios in excess of 80%).

“$4 billion home equity investment program [was] approved … last Friday. High CLTVs [Combined Loan-to-Value ratios] (up to 100%) and lower FICOs (down to 600) permitted with some concentration limits.”303

In order to issue these loans as soon as possible in 2006, WaMu set up an underwriting team to provide “manual” approvals outside of its automated systems:

“Our team is currently focused on several HE [Home Equity] modeling initiatives to include higher risk lending …. [W]e are adjusting our decision engine rules for a July roll out to allow for 580-620 [FICO scores] and LT 80% CLTV [combined loan-to-value] loans to be referred to a manual ‘sub-prime’ underwriting team that we are putting in place. … [W]e see this 580-620 segment as the biggest opportunity where we aren’t lending today.”304

Also in 2006, WaMu began issuing so-called “80/20 loans,” in which a package of two loans are issued together, imposing an 80% LTV first lien and a 20% LTV second lien on the property, for a total combined LTV (CLTV) of 100%.305 Loans that provide financing for 100% of a property’s value are extremely high risk, because the borrower has no equity in the property, the borrower can stop payments on the loan without losing a personal investment, and a subsequent home sale may not produce sufficient funds to pay off the debt.306 Yet in 2006, Home Loans Division President David Schneider approved issuing 80/20 loans despite the risk and despite the fact that WaMu’s automatic underwriting system was not equipped to accept them, and loan officers initially had to use a manual system to issue the loans.307

Using Low Interest Rates to Qualify Borrowers. A third risk layering practice at

WaMu was allowing loan officers to qualify prospective borrowers for short term hybrid ARMs or Option ARMs based upon only the initial low rate and not the higher interest rate that would take effect later on. In a filing with the SEC, for example, Washington Mutual Inc. wrote that its “underwriting guidelines” allowed “borrowers with hybrid adjustable-rate home loans … where the initial interest rate is fixed for 2 to 5 years” to be “qualified at the payment associated with the fixed interest rate charged in the initial contractual period.”308 In addition, in 2005, WaMu personnel informed OTS that, since 2004, the bank had not been qualifying its Option ARM

303 6/13/2006 email from Cheryl Feltgen to David Schneider who forwarded it to Steve Rotella, JPM_WM01311922-23.
304 6/14/2006 email from Mark Hillis to Cheryl Feltgen, included in a longer email chain involving Mr. Rotella and Mr. Schneider, among others, JPM_WM01311922.
305 See, e.g., 6/2006 email chain between Mr. Rotella, Mr. Schneider, Mr. Hillis, and Ms. Feltgen, JPM_WM01311922-23.
306 See NTM Guidance at 58614. See also SEC v. Mozilo, Case No. CV09-03994 (USDC CD Calif.), Complaint (June 4, 2009), at ¶ 50 (quoting an email by Countrywide CEO Angelo Mozilo who, when discussing the 80/20 loans being issued by his bank, wrote: “In all my years in the business I have never seen a more toxic pr[o]duct.”).
307 Id.; Subcommittee interview of Cheryl Feltgen (2/6/2010). 2/2006 WaMu internal email chain, “FW: 80/20,” JPM_WM03960778. See also 3/19/2007 email from Ron Cathcart to David Schneider, JPM_WM02571598, Hearing Exhibit 4/16-75 (indicating WaMu issued loans with CLTVs in excess of 95% until ending the practice in March 2007). 308 See 3/1/2007 Washington Mutual Inc. 10-K filing with the SEC at 56.

borrowers using the “fully indexed rate.”309 Instead, WaMu was using a lower “administrative” rate that was “significantly less than the fully indexed rate.”310

Borrowers, loan officers, and WaMu executives often assumed that hybrid and Option

ARMs could be refinanced before the payments reset to higher levels – an expectation that eventually proved to be unfounded. In a November 30, 2007 email discussing loan modifications from Mr. Schneider to Mr. Killinger, Mr. Rotella and other senior executives, Mr. Schneider described WaMu’s faulty assumptions about the “start rate” and life span of these loans:

“I also think it is clear that the economic benefit of providing modifications for these borrowers is compelling for the following reasons:

None of these borrowers ever expected that they would have to pay at a rate greater than the start rate. In fact, for the most part they were qualified at the start rate
We need to provide incentive to these borrowers to maintain the home – especially if the home value has declined
When we booked these loans, we anticipated an average life of 2 years and never really anticipated the rate adjustments ….”311

Qualifying borrowers using the lower initial interest rate enabled banks to qualify more borrowers for those loans and enabled them to issue loans for larger amounts. Concerned that more banks were beginning to use this risky practice, federal banking regulators addressed it in the October 2006 NTM Guidance, which cautioned banks to use the fully indexed rate when qualifying borrowers for a loan, including loans with lower initial teaser rates.312 In addition, the Guidance provided that for negatively amortizing loans, banks should consider not only the “initial loan amount” but also “any balance increase that may accrue from the negative amortization provision.”313 that applying the new requirement to all of its loans would cause a 33% drop in its loan volume due to borrowers who would no longer qualify for its loans:

After the NTM Guidance was issued, a WaMu analyst calculated

“Implementing the NTM change for Purchase only drops additional 2.5% of volume …
If we implement the NTM changes to all loans, then we’ll see additional drop of 33% of volume.”314

309 9/15/2005 email from Darrel Dochow to OTS Examiner-In-Charge at WaMu, OTSWMS05-002 0000537, Hearing Exhibit 4/16-6. The “fully indexed rate” is the prevailing interest rate in the published index to which an adjustable rate mortgage is tied, plus the additional percentage points that the lender adds to the index value to calculate the loan’s interest rate. See NTM Guidance at 58614, n.5. 310 Id. 311 11/30/2007 email from David Schneider to John McMurray, Kerry Killinger and others, JPM_WM05382127-28. 312 NTM Guidance at 58614. 313 Id. 314 3/19/2007 email from Ron Cathcart to David Schneider, JPM_WM02571598, Hearing Exhibit 4/16-75.

In response to this information, WaMu’s chief risk officer wrote that the impact on the bank “argues in favor of holding off on implementation until required to act for public relations … or regulatory reasons.”

NTM Guidance, WaMu continued qualifying high risk borrowers using the lower interest rate, originating billions of dollars in new loans that would later suffer significant losses.

Because OTS gave the bank more than six months to come into compliance with the

WaMu’s risk-layering practices went beyond its use of stated income loans, high LTV

ratios, and the qualification of borrowers using low initial interest rates. The bank also allowed its loan officers to issue large volumes of high risk loans to borrowers who did not occupy the homes they were purchasing or had large debt-to-income ratios.315 concentrated its loans in a small number of states, especially California and Florida, increasing the risk that a downturn in those states would have a disproportionate impact upon the delinquency rates of its already high risk loans.

On top of those risks, WaMu

At one point in 2004, Mr. Vanasek made a direct appeal to WaMu CEO Killinger, urging

him to scale back the high risk lending practices that were beginning to dominate not only WaMu, but the U.S. mortgage market as a whole. Despite his efforts, he received no response:

“As the market deteriorated, in 2004, I went to the Chairman and CEO with a proposal and a very strong personal appeal to publish a full-page ad in the Wall Street Journal disavowing many of the then-current industry underwriting practices, such as 100 percent loan-to-value subprime loans, and thereby adopt what I termed responsible lending practices. I acknowledged that in so doing the company would give up a degree of market share and lose some of the originators to the competition, but I believed that Washington Mutual needed to take an industry-leading position against deteriorating underwriting standards and products that were not in the best interests of the industry, the bank, or the consumers. There was, unfortunately, never any further discussion or response to the recommendation.”316

Perhaps the clearest evidence of WaMu’s shoddy lending practices came when senior

management was informed of loans containing fraudulent information, but then did little to stop the fraud.

315 See, e.g., OTS document, “Hybrid ARM Lending Survey” (regarding WaMu), undated but the OTS Examiner-in- Charge estimated it was prepared in March or mid-2007, JPM_WM03190673 (“For Subprime currently up to 100% LTV/CLTV with 50% DTI is allowed for full Doc depending on FICO score. Up to 95% LTV/CLTV is allowed with 50% DTI for Stated Doc depending on FICO score. … For No Income Verification, No Income No Ratio, and No Income No Asset only up to 95% LTV/CLTV is allowed.”).
316 April 13, 2010 Subcommittee Hearing at 17.

Downey and Montebello Fraud Investigations. The most significant example involves

an internal WaMu investigation that, in 2005, uncovered substantial evidence of loan fraud involving two top producing loan offices in Southern California. WaMu management was presented with the findings, but failed to respond, leading to the same fraud allegations erupting again in 2007. According to the WaMu Home Loans Credit Risk Mitigation Team that conducted the 2005 internal investigation, it was initiated in response to “a sustained history of confirmed fraud findings over the past three years” involving the two offices, known as Downey and Montebello.317 Each office was located in a low-income area of Los Angeles and headed by a loan officer who had won repeated WaMu awards for high volume loan production.

To conduct its inquiry, the WaMu Risk Mitigation Team reviewed all of the loans

A November 2005 memorandum summarizing the review stated that it

produced by the two offices over a two-month period from August to September 2005, which totaled 751 loans. Analysts scored the loans using a standard electronic fraud detection program, and then reviewed all of the loans flagged for possible fraud, as well as ten percent of the remaining loans.318 found an “extensive level of loan fraud” caused primarily by employees “circumventing” bank policies:

“[A]n extensive level of loan fraud exists in the Emerging Markets [loan processing centers], virtually all of it stemming from employees in these areas circumventing bank policy surrounding loan verification and review. Of the 129 detailed loan review[s] … conducted to date, 42% of the loans reviewed contained suspect activity or fraud, virtually all of it attributable to some sort of employee malfeasance or failure to execute company policy. In terms of employee activity enabling this perpetration of fraud, the following categories of activity appeared most frequently: inconsistent application of credit policy, errors or negligence, process design flaws, intentional circumvention of established processes, and overriding automated decisioning recommendations. …
Based on the consistent and pervasive pattern of activity among these employees, we are recommending firm action be taken to address these particular willful behaviors on the part of the employees named.”319

A presentation prepared for WaMu management provided additional detail.320 It stated

that, out of the 751 loans produced, the Risk Mitigation Team had selected 180 loans for detailed review, of which 129 had been completed.321 It stated that 42% of the reviewed loans had “contained excessive levels of fraud related to loan qualifying data.”322 It also stated that the fraud findings did not differ between loans originated by WaMu’s own loan officers and loans

317 11/17/2005 WaMu internal memorandum, “So. CA Emerging Markets Targeted Loan Review Results,” JPM_WM01083051, Hearing Exhibit 4/13-22a. 318 Id. 319 Id. 320 11/16/2005 “Retail Fraud Risk Overview,” prepared by Credit Risk Management, JPM_WM02481934, Hearing Exhibit 4/13-22b.
321 Id. at JPM_WM02481940. 322 Id. at JPM_WM02481936.

originated by third party brokers and brought to the loan centers.323 that the fraud uncovered by the review was found to be “preventable with improved processes and controls.”

loan qualifying data,” including misrepresentations of income and employment, false credit letters and appraisal issues.324 including:

The presentation indicated that the loan fraud involved primarily “misrepresentation of

The presentation included a few examples of misrepresentations,

The presentation also stated

“Loan #0694256827[:] Misrepresentation [of] the borrower’s identification and qualifying information were confirmed in every aspect of this file, including: – Income – SSN – Assets – Alternative credit reference letters – Possible Strawbuyer or Fictitious borrower[.] The credit package was found to be completely fabricated. Throughout the process, red flags were over-looked, process requirements were waived, and exceptions to policy were granted.”325

The presentation noted that the loan delinquency rate for Luis Fragoso, the loan officer

heading the Montebello loan office, was “289% worse than the delinquency performance for the entire open/active retail channel book of business,” while the delinquency rate for Thomas Ramirez, the loan officer heading the Downey loan office was 157% worse.326 from the Risk Mitigation Team was clear that the two head loan officers were willfully flouting bank policy, issuing poor quality loans, and needed to be the subject of “firm action” by the bank.

The message

Three months prior to its formal presentation on the fraud, the Risk Mitigation Team

supplied a lengthy email with its fraud findings to colleagues in the credit risk department. The August 2005 email provided spreadsheets containing data collected on the loans from the two offices as well as figures about the types of loans reviewed and fraud found.327 Among other information, it indicated that at the Downey office, 83 loans had been reviewed, including 28 originated by the WaMu loan officer Thomas Ramirez, and 54 submitted to him by third party brokers; while at the Montebello office, 48 loans had been reviewed, including 19 originated by the WaMu loan officer Luis Fragoso and 29 submitted to him by third party brokers. The email was forwarded by a credit risk officer to WaMu’s Chief Risk Officer Jim Vanasek, with the following comment:

“As you requested in our Enterprise Fraud Committee meeting last Friday, the attached email contains a high-level summary of the investigations the Home Loans Risk Mit team has conducted on [the two offices] over the past year and a half, based on loans that were referred to them. … As you can see, among the referred cases there is an extremely high

323 Id. at JPM_WM02481936. 324 Id. at JPM_WM02481938.
325 Id. at JPM_WM02481943. 326 Id. at JPM_WM02481948. 327 8/29/2005 email from Jill Simons to Tim Bates, JPM_WM04026076-77, Hearing Exhibit 4/13-23b.

incidence of confirmed fraud (58% for Ramirez, 83% for Fragoso) …. [Additional analysis] will allow us to substantially validate what we suspect, which is that the incidence of fraud in this area is greater than with other producers.”328

At the Subcommittee hearing, Mr. Vanasek agreed these were “eye popping” rates of fraud.329

She asked

On November 18, 2005, Cheryl Feltgen, the Home Loans Chief Credit Officer, “had a very quick meeting” with Home Loans President David Schneider, the head of Home Loans sales, Tony Meola, and others in which she reviewed the memorandum and presentation on the fraud investigation.330 After the meeting, she sent an email to the Risk Mitigation Team stating:
“The good news is that people are taking this very seriously. They requested some additional information that will aid in making some decisions on the right course of action.”331 the Risk Mitigation Team to prepare a new spreadsheet with the loan information, which the team did over the weekend in anticipation of a Monday meeting.

The trail of documentation in 2005 about the fraud investigation ends there. Despite the year-long effort put into the investigation, the written materials prepared, the meetings held, and fraud rates in excess of 58% and 83% at the Downey and Montebello offices, no discernable actions were taken by WaMu management to address the fraud problem in those two offices. No one was fired or disciplined for routinely violating bank policy, no anti-fraud program was installed, no notice of the problem was sent to the bank’s regulators, and no investors who purchased RMBS securities containing loans from those offices were alerted to the fraud problem underlying their high delinquency rates. Mr. Vanasek retired from the bank in December 2005, and the new Chief Risk Officer Ron Cathcart was never told about the fraud investigation. Senior personnel, including Mr. Schneider, Mr. Meola, and Ms. Feltgen, failed to follow up on the matter.

Ramirez and Fragoso, continued to issue high volumes of loans332 and continued to win awards for their loan productivity, including winning trips to Hawaii as members of WaMu’s “President’s Club.” One of the loan officers even suggested to bank President Steve Rotella ways to further relax bank lending standards.333

provided mortgage insurance for some of WaMu’s residential mortgages, contacted the bank with concerns about material misrepresentations and fraudulent documents included in

In June 2007, however, the fraud problem erupted again. That month, AIG, which

Over the next two years, the Downey and Montebello head loan officers, Messrs.

328 8/30/2005 email from Tim Bates to Jim Vanasek and others, JPM_WM04026075, Hearing Exhibit 4/13-23b. 329 April 13, 2010 Subcommittee Hearing at 28. 330 11/18/2005 email from Cheryl Feltgen to Nancy Gonseth on the Risk Mitigation Team and Tim Bates, JPM_WM03535695, Hearing Exhibit 4/13-23a. 331 Id. 332 At the Subcommittee’s hearing, Mr. Vanasek testified that as much as $1 billion in loans originated out of these two offices per year. April 13, 2010 Subcommittee Hearing at 27. 333 See, e.g., 3/2006 WaMu email chain, JPM_WM03985880-83.

mortgages being issued by Mr. Fragoso, the loan officer heading the Montebello office.334 When no one responded to its concerns, in September 2007, AIG filed a Suspected Fraud Claim with the California Department of Insurance which, in turn, notified OTS of the problem.335 The OTS Examiner-in-Charge at WaMu at the time, Benjamin Franklin, asked the bank to conduct an investigation into the matter.336 WaMu’s legal department asked the WaMu Corporate Fraud Investigation (CFI) group and the Audit department to conduct a joint inquiry.

memorandum with their findings.337 in the Montebello office, citing a loan file review that found a fraud rate of 62%, it also uncovered the 2005 investigation that had identified the problem two years earlier, but was ignored by management. The 2008 memorandum stated:

Seven months later, in April 2008, CFI and the Audit department issued a 12-page

The memorandum not only confirmed the presence of fraud

“In 2005, HL [Home Loans] Risk Mitigation provided Senior HL Management with an assessment of fraud and loan performance in the Retail Broker Program and two Southern California Emerging Markets [loan centers] for the period of September 2003 through August 2005. This assessment identified excessive levels of fraud related to loan qualifying data …. It also highlighted the Downey and Montebello [loan centers] as the primary contributors of these fraudulent loan documents based upon volume and articulated strategies to mitigate fraud. The report also stated that delinquency performance on these [loan centers] … were significantly worse that the delinquency performance for the entire open/active retail channel book of business. In 2007, HL Risk Mitigation mirrored their 2005 review with a smaller sample of loans and found that, for the September and October 2007 sampled time period, the volume of misrepresentation and suspected loan fraud continued to be high for this [loan center] (62% of the sampled loans).”338

Examples of fraudulent loan information uncovered in the 2007 review included falsified income documents, unreasonable income for the stated profession, false residency claims, inflated appraisal values, failure of the loan to meet bank guidelines, suspect social security numbers, misrepresented assets, and falsified credit information.339

The memorandum reported that one individual

The memorandum found that, in 2005, the WaMu Risk Mitigation Team had reported its findings to several WaMu managers whom it “felt were very aware of high volumes of fraud” in the loans issued by the two loan officers.340 believed that David Schneider “was made aware of these findings” and wanted Risk Mitigation

334 4/4/2008 WaMu Memorandum of Results, “AIG/UG and OTS Allegation of Loan Frauds Originated by [name redacted],” at 1, Hearing Exhibit 4/13-24.
335 Id.
336 Subcommittee interview of Benjamin Franklin (2/18/2010). 337 4/4/2008 WaMu Memorandum of Results, “AIG/UG and OTS Allegation of Loan Frauds Originated by [name redacted],” at 1, Hearing Exhibit 4/13-24. 338 Id. at 2. 339 Id. at 3. 340 Id. at 7.

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to “monitor the situation.”341 But no one knew “of additional monitoring that was done, or efforts to bring additional attention to” the fraudulent loans from the Downey and Montebello offices. The memorandum also noted that no personnel action had been taken against either of the loan officers heading the two offices.342 David Schneider was interviewed and “recalled little about the 2005 fraud findings or actions taken to address them.”343 was handled or resolved.” The WaMu memorandum concluded:

He “thought the matter

“Outside of training sessions … in late 2005, there was little evidence that any of the recommended strategies were followed or that recommendations were operationalized.
There were no targeted reviews conducted … on the Downey or Montebello loan portfolios between 2005 and the actions taken in December 2007.”344

After the memorandum was issued, WaMu initially resisted providing a copy to OTS,

claiming it was protected by attorney-client privilege.345 Benjamin Franklin told the Subcommittee that he insisted on seeing the memorandum. After finally receiving it and reading about the substantial loan fraud occurring at the two loan offices since 2005, he told the Subcommittee that it was “the last straw” that ended his confidence that he could rely on WaMu to combat fraudulent practices within its own ranks.

The OTS Examiner-in-Charge

The 2008 WaMu memorandum and a subsequent OTS examination memorandum346

included a number of recommendations to address the fraud problem at the Downey and Montebello offices. The recommendations in the WaMu memorandum included actions to “[d]etermine appropriate disciplinary actions for employees”; “[e]nhance Code of Conduct training to stress each employee’s role as a corporate steward and the consequences for passively facilitating the placement of loans into the origination process that could be suspect”; enhance WaMu compensation incentives “to support loan quality”; and determine if further analysis was required of the loans originated by the Montebello office or “the broader loan population (bank owned and securitized)” including “if actions are needed to address put backs or sales to investors of loans that contain misrepresentation[s] or other fraud findings.”347

By the time WaMu issued the April 2008 memorandum on the Downey and Montebello fraud problem, however, the bank was already experiencing serious liquidity problems and was cutting back on its loan operations and personnel. On April 30, 2008, WaMu put an end to its wholesale loan channel which had accepted loans from third party mortgage brokers, closed 186

341 Id. 342 Id.
343 Id. at 8. 344 Id. at 9. 345 Subcommittee interview of Benjamin Franklin (2/18/2010). 346 1/7/2008 OTS Asset Quality Memo 22, “Loan Fraud Investigation,” JPM_WM02448184, Hearing Exhibit 4/13-

347 4/4/2008 WaMu Memorandum of Results, “AIG/UG and OTS Allegation of Loan Frauds Originated by [name redacted],” at 4, Hearing Exhibit 4/13-24.

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stand-alone loan centers, and reduced its workforce by 3,000.348 The Downey and Montebello offices were closed as part of that larger effort. The two loan officers heading those offices left the bank and found other jobs in the mortgage industry that involve making loans to borrowers.

Other Fraud Problems. The loan fraud problems at the Downey and Montebello offices

were not the only fraud problems plaguing WaMu. The Subcommittee uncovered three additional examples that demonstrate the problem was not isolated.

The first example involves the Westlake Village loan office outside of Los Angeles. On April 1, 2008, WaMu’s Risk Mitigation Team sent 13 home loans with early payment defaults to the WaMu Corporate Fraud Investigations (CFI) group for further examination.349 All 13, whose unpaid loan balances totaled about $14.3 million, had been issued in 2007, by the Westlake Village loan office which was one of WaMu’s top loan producers. Two loan officers, Chris O’Brien and Brian Minkow, who worked in tandem, had won multiple awards for their loan production and had a team of 14 sales associates assisting them.350 CFI reviewed the referred loans which contained a variety of fraud indicators, including “fabricated asset statements, altered statements, income misrepresentation and one altered statement that is believed to have been used in two separate loans.”351 personnel at the WaMu “loan fulfillment center” (LFC) that processed Westlake Village loan applications.

CFI then interviewed the loan officers, sales associates, and

In one egregious example of document “manufacturing,” a sales associate confessed that if “it was too late to call the borrower,” the “sales associates would take [bank] statements from other [loan] files and cut and paste the current borrower’s name and address” onto the old bank statements.352 The same sales associate “admitted that during that crunch time some of the Associates would ‘manufacture’ asset statements from previous loan docs,” because end-of- month loans would often get funded without full documentation. The pressure to get the necessary documentation was “tremendous” and they had been told to get the loans funded “with whatever it took.”353

The LFC loan processor in charge of handling Westlake Village’s loan applications was fired, as was the sales associate who confessed to manufacturing false documents. The rest of the employees were also let go, when the office itself was closed on April 30, 2008, in

348 Subcommittee interview of Brian Minkow (2/16/2010); 5/27/2008 “Internal Investigative Report” on Westlake Home Loan Center, JPM_WM03171384, Hearing Exhibit 4/13-31. See also “Washington Mutual Exits Wholesale Lending Business, Will Close Home-Loan Centers,” Mercury News, 4/7/2008, http://blogs.mercurynews.com/realestate/2008/04/07/washington-mutual-exits-wholesale-lending-business-will- close-home-loan-centers.
349 5/12/2008 “WaMu Significant Incident Notification (SIN),” JPM_WM05452386, Hearing Exhibit 4/13-30. 350 Subcommittee interview of Brian Minkow (2/16/2010). See also 2005 “President’s Club 2005 - Maui, Awards Night Show Script,” Washington Mutual, Home Loans Group, Hearing Exhibit 4/13-63a (stating Mr. O’Brien and Mr. Minkow had produced $1.2 billion in loans in 2005). 351 Id. 352 5/27/2008 “Internal Investigative Report” on Westlake Home Loan Center, JPM_WM03171384, Hearing Exhibit 4/13-31. 353 5/12/2008 “WaMu Significant Incident Notification (SIN),” JPM_WM05452386, Hearing Exhibit 4/13-30.

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connection with WaMu’s reorganization and downsizing. One of the loan officers who headed the office told the Subcommittee, however, that he had been offered another job within the bank, but declined it due to lower compensation.354 arranging residential loans.

He went on to work in the mortgage industry

The second example involves 25 Home Equity Lines of Credit (HELOCs) totaling $8.5

million that were originated in 2008 by a WaMu loan officer at the Sunnyvale loan office in California. Before all of the loans were funded, they were referred to the Risk Mitigation Team because of fraud indicators. On May 1, 2008, the loan files were sent on to the CFI group for further inquiry. An internal document summarizing the CFI investigation stated:

“The review found that the borrowers indicated they owned the property free and clear when in fact existing liens were noted on the properties. The properties are located in California, Arizona and Washington. … WaMu used … Abbreviated Title reports [that] … do not provide existing lien information on the subject property.”355

Of the 25 loan applications, 22 were ultimately terminated or declined. The employee involved in originating the loans was terminated as part of the April 30, 2008 reorganization.

The third example involves a review of 2006 and 2007 WaMu loans conducted by Radian

Guaranty Inc., a company which provided mortgage insurance for those loans.356 Radian’s objectives were to test WaMu’s “compliance with Radian’s underwriting guidelines and eligible loan criteria,” assess the quality of WaMu’s underwriting decisions, “rate the risk of the individual loans insured,” and identify any errors in the loan data transmitted to Radian.357 The review looked at a random selection of 133 loans and found enough problems to give WaMu an overall rating of “unacceptable.”358

The Radian review identified a number of problems in the loan files it deemed ineligible

for insurance. In one, WaMu issued a $484,500 loan to a “Sign Designer” who claimed to be making $34,000 in income every month.359 The Radian review observed: “Borrower’s stated monthly income of $34,000 does not appear reasonable for a ‘Sign Designer.’” The review also noted several high risk elements in the loan, which was an 85% LTV loan given to a borrower with a 689 credit score who used the loan to refinance an existing loan and “cash-out” the equity in the house. The review noted that the borrower received $203,000 at the loan closing. In addition, the review stated that WaMu had appraised the house at $575,000, but an automated appraisal verification program assigned the house a probable value of only $321,000, less than the amount of the loan.

354 Subcommittee interview of Brian Minkow (2/16/2010). 355 5/15/2008 “WaMu Significant Incident Notification (SIN),” JPM_WM05452389, Hearing Exhibit 4/13-32b.
356 2/7/2008 Radian Guaranty Inc. review of Washington Mutual Bank loans, JPM_WM02057526, Hearing Exhibit 4/13-33. 357 Id. at 1. 358 Id. 359 Id. at 5.

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Extent of Fraud. At the Subcommittee hearing, when asked about these matters, Mr.

Vanasek, WaMu’s Chief Risk Officer from 2004 to 2005, attributed the loan fraud to compensation incentives that rewarded loan personnel and mortgage brokers according to the volume of loans they processed rather than the quality of the loans they produced:

“Because of the compensation systems rewarding volume versus quality and the independent structure of the originators, I am confident at times borrowers were coached to fill out applications with overstated incomes or net worth to meet the minimum underwriting requirements. Catching this kind of fraud was difficult at best and required the support of line management. Not surprisingly, loan originators constantly threatened to quit and to go to Countrywide or elsewhere if the loan applications were not approved.”360

When asked by Senator Coburn if he thought the type of fraud at the Downey and Montebello loan offices extended beyond those two offices, Mr. Vanasek replied: “Yes, Senator.”361

the bank’s failure, found that loans marked as containing fraudulent information had nevertheless been securitized and sold to investors. The report blamed ineffective controls that had “existed for some time”:

Another sobering internal WaMu report, issued in September 2008, a few weeks before

“The controls that are intended to prevent the sale of loans that have been confirmed by Risk Mitigation to contain misrepresentations or fraud are not currently effective. There is not a systematic process to prevent a loan in the Risk Mitigation Inventory and/or confirmed to contain suspicious activity from being sold to an investor. … Of the 25 loans tested, 11 reflected a sale date after the completion of the investigation which confirmed fraud. There is evidence that this control weakness has existed for some time.”362

Loans not meeting the bank’s credit standards, deliberate risk layering, sales associates

manufacturing documents, offices issuing loans in which 58%, 62%, or 83% contained evidence of loan fraud, and selling fraudulent loans to investors are evidence of deep seated problems that existed within WaMu’s lending practices. Equally disturbing is evidence that when WaMu senior managers were confronted with evidence of substantial loan fraud, they failed to take corrective action. WaMu’s failure to strengthen its lending practices, even when problems were identified, is emblematic of how lenders and mortgage brokers produced billions of dollars in high risk, poor quality home loans that contributed to the financial crisis.

360 April 13, 2010 Subcommittee Hearing at 17. 361 Id. at 30. 362 9/8/2008 “WaMu Risk Mitigation and Mortgage Fraud 2008 Targeted Review,” JPM_WM00312502, Hearing Exhibit 4/13-34.

(d) Steering Borrowers to High Risk Option ARMs

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In addition to subprime loans, Washington Mutual made a variety of high risk loans to

“prime” borrowers, including its flagship product, the Option Adjustable Rate Mortgage (Option ARM). Washington Mutual’s Option ARMs typically offered borrowers an initial teaser rate, sometimes as low as 1% for the first month, which later adjusted to a much higher floating interest rate linked to an index, but gave borrowers the choice each month of paying a higher or lower amount. These loans were called “Option” ARMs, because borrowers were typically given four options: (1) paying the fully amortizing amount needed to pay off the loan in 30 years; (2) paying an even higher amount to pay off the loan in 15 years; (3) paying only the interest owed that month and no principal; or (4) making a “minimum payment” that covered only a portion of the interest owed and none of the principal.363 If the borrower selected the minimum payment option, unpaid interest would be added to the loan principal. If the borrower repeatedly selected the minimum payment, the loan principal would increase rather than decrease over time, creating a negatively amortizing loan.

Negative amortization created additional credit risk for WaMu and posed a challenge to

risk managers. At the April 13 Subcommittee hearing, Mr. Vanasek testified:

“We had concerns from the standpoint of negative amortization that was accumulating and we had been reassured that in the past, borrowers would negatively amortize during difficult times and then make up for the lost payments in good times. But the percentage and the potential percentage for negative amortization was very large, and, of course the attendant payment shock was also very large, which was a concern to credit.”364

Few executives at WaMu shared Mr. Vansek’s concern about the Option ARM. To the extent that risk managers expressed concern, it was outweighed by the product’s favorable gain-on- sale margin.

As part of its High Risk Lending Strategy, WaMu determined to increase its issuance of

its Option ARM loans. To do that, WaMu had to convince customers to forego a simple, low risk conventional loan in favor of the complex and higher risk Option ARM. In late 2003, WaMu conducted two focus group studies to “explore ways to increase sales of Option ARMs, Washington Mutual’s most profitable mortgage loan products.”365 examined the views of WaMu loan consultants and third party mortgage brokers. The second focus group examined the views of WaMu Option ARM customers.

The first focus group

The report following the first focus group with WaMu loan consultants and mortgage

brokers identified a number of impediments to selling Option ARMs. It noted that Option ARM

363 See 8/2006 “Option ARM Credit Risk,” WaMu presentation, at 3, Hearing Exhibit 4/13-37; 10/17/2006 “Option ARM” draft presentation to the WaMu Board of Directors, JPM_WM02549027, Hearing Exhibit 4/13-38. 364 April 13, 2010 Subcommittee Hearing at 49. 365 9/17/2003 “Option ARM Focus Groups – Phase II, WaMu Option ARM Customers,” WaMu research report, at 3, Hearing Exhibit 4/13-35.

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loans had to be “sold” to customers asking for a 30-year fixed loan, and training was needed to overcome the feeling of “many” WaMu loan consultants that Option ARMs were “bad” for their customers. The report also recommended increasing commissions so salespersons would take the “hour” needed to sell an Option ARM, and increasing loan processing times so salespersons and brokers were not inconvenienced. The report stated in part:

“Option ARMs are sold to customers and few walk through the door and ask for them. …

unenthusiastic about the product. The focus group report stated:

“In general, people do not seem to have a good understanding of their mortgage and its terms. What understanding they do have is framed by the concept of a 30-year fixed mortgage. Option ARMs are very complicated and need to be explained in simple, easy

366 8/14/2003 “Option ARM Focus Groups – Phase I, WaMu Loan Consultants and Mortgage Brokers,” WaMu research report, at 2, Hearing Exhibit 4/13-36 [emphasis in original].

If salespeople don’t understand Option ARMs, they won’t sell them. Many felt that more training would be needed to better educate salespeople about this type of loan, and to change the mindset of current Loan Consultants. Some felt there were many within Washington Mutual who simply felt these loans were ‘bad’ for customers, probably from a lack of understanding the product and how it could benefit customers. …

It is critical that salespeople fully understand a customer’s financial situation and motivation for the loan. By taking into account these factors, they can recommend the loan that will best fit their customers’ needs. Given today’s low interest rate environment, it can be challenging to get salespeople to take the time to do this.
Currently it is easier to give customers what they ask for (a 30 year fixed loan) than to sell them an Option ARM. They can take 20 minutes and sell a 30 fixed-rate loan, or spend an hour trying to sell an Option ARM.

Commission caps make it unappealing for Mortgage Brokers to sell Washington Mutual Option ARMs. Most would not sell loans to customers with prepayment penalties, and given the low commission rate for selling them without the prepayment penalty, many simply go to another company or product where they can make more money.

Slow ARM processing times (up to 90 days) can cause Mortgage Brokers to take business elsewhere. …

Improving collateral would help salespeople better explain Option ARMs to customers and take away some of the mystery. … They also would like improved brochures which talk to the customer in simple, easy to understand terms about features and benefits.
They liked the current sample statements they are provided.”366

The second focus group with existing Option ARM customers showed they were also

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to understand terms, prospective borrowers need to be educated about the loan – this is not a product that sells itself.”367

The focus group identified several reasons that borrowers were leery of Option ARMs

and suggested ways to address the unease: “Helping prospective borrowers understand payment and interest rate caps may mitigate fears of wild monthly payment swings .… Similarly, fears about negative amortization, a concept also not very well understood by the participants, could be reduced or eliminated by showing how much residential properties in the local market have appreciated over time.”368

The main findings of the focus group included:

“Few participants fully understood the Option ARM and its key benefits. A number of them were not familiar with the payment options or how they could be used. …
Additionally, most did not understand how their interest rate was derived, how often their payments would change, and what, if any, were the interest and/or payment caps.

Perhaps the best selling point for the Option ARM loan was being shown how much lower their monthly payment would be by choosing an Option ARM versus a fixed-rate loan.

Many participants did not know what happened to their loan at the end of the fixed interest rate period. Most of them assumed they would have to sell or refinance because of a potential balloon payment or a steep jump in their payments. Because of these misperceptions, most participants expect to refinance their loans within the next three to five years.”369

To increase Option ARM sales, WaMu increased the compensation paid to its loan

personnel and outside mortgage brokers for the loans.370 The bank also qualified borrowers for Option ARMs by using a monthly payment amount that was less than what the borrower would likely pay once the loan recast.371

The Option ARM was also frequently featured in sales promotion efforts communicated to loan officers through WaMu’s internal alert email system known as, “e-Flash.” For example, a June 5, 2006 e-Flash from Steve Stein, the Director of Retail Lending in the Home Loans division, to the entire retail sales team announced:

367 9/17/2003 “Option ARM Focus Groups – Phase II, WaMu Option ARM Customers,” WaMu research report, at 4, Hearing Exhibit 4/13-35. 368 Id. 369 Id. at 5 [emphasis in original]. 370 Subcommittee interview of David Schneider (2/17/2010). 371 See April 13, 2010 Subcommittee Hearing at 50.

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“We are beginning to focus on higher-margin products like our flagship product, the Option ARM. This is a fantastic product for almost any borrower. To help our sales force feel more comfortable with selling the Option ARM to a wide variety of borrowers, we are rolling out a comprehensive skills assessment and training initiative. … This initiative is not about selling the Option ARM to everyone. We will always stay true to our values and provide the right loan for every customer. … Through the skills assessment, training, role playing and a best-practices selling tips video, I think this retail sales team will be unstoppable with the Option ARM. … The Option ARM is our product and we can sell it better than anyone. I have great confidence that we’ll improve our Option ARM market share quickly, like the experts that we are.”372

One month later, Mr. Stein announced increased compensation incentives for selling

Option ARMs. In another e-Flash to the entire retail sales team, Mr. Stein wrote:

“You’ve seen and heard a lot recently about our refined business model and focus on higher margin products, especially Option ARMs. To further drive this focus, I’m pleased to announce the 2006 Option ARM Blitz – Quarterly Incentive Campaign. This will allow eligible Loan Consultants to earn 5 additional basis points on all Option ARM volume funded during the 3rd quarter 2006.”373

Under the rules of the Option ARM Blitz, loan consultants who increased the percentage of Option ARMs they sold by at least 10% would receive an additional bonus. In August 2006, an e-Flash announced that the underwriting guidelines for Option ARMs had been loosened, allowing higher loan amounts for “condos and co-ops” and greater loan-to-value ratios for “low- doc” second home mortgages.374 Also in August, an e-Flash announced that the “Option ARM Sales Mastery Program” that was launched in June, would now become part of the mandatory loan originator training curricula.375

consumer direct channel which waived all closing costs for Option ARMs except for an appraisal deposit.376 In the fourth quarter of 2006, the consumer direct channel also held a contest called the “Fall Kickoff Contest.” For each of the 13 weeks in the quarter, the loan consultant who scored the most points would receive a $100 gift card. An Option ARM sale was a “touchdown” and worth seven points; jumbo-fixed, equity, and nonprime mortgages were only “field goals” worth three points. At the end of the quarter the top five point winners were awarded with a $1,000 gift card.377

In September 2006, WaMu introduced pricing incentives for Option ARMs in the

In addition, from November 2006 through January 2007, e-Flashes sent to

372 6/5/2006 “e-Flash” from Steve Stein to Retail Production Sales, JPM_WM03246053.
373 7/3/2006 “e-Flash” from Steve Stein to Retail Production Sales, JPM_WM04471136-37.
374 8/17/2006 “e-Flash” from Steve Stein, Arlene Hyde, and John Schleck to Production and Operations, JPM_WM03277786-87. 375 8/18/2006 “e-Flash” from Allen Myers to Retail Production Sales Managers, JPM_WM03277758.
376 8/31/2006 “e-Flash” from Mary Ann Kovach to Consumer Direct, JPM_WM03077747.
377 10/12/2006 “e-Flash” from Mary Ann Kovach to Consumer Direct, JPM_WM03627448-49.

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consumer direct originators promoted Option ARM sales specials offering $1,000 off closing costs for loans under $300,000 and a waiver of all fees for loans greater than $300,000.378

Judging by sales of Option ARMs in 2004, after the completion of the focus groups,

WaMu’s strategy to push sales of Option ARM loans was successful. In 2003, WaMu originated $30.1 billion in Option ARMs; in 2004 WaMu more than doubled its Option ARM originations to $67.5 billion. Although sales of Option ARMs declined thereafter because of challenges in the market, in 2006, WaMu still originated $42.6 billion in Option ARMs. According to its internal documents, by 2006, Washington Mutual was the second largest Option ARM originator in the country.379

As WaMu’s Option ARM portfolio grew, and as the wider economy worsened, the

prevalence of negative amortization in the Option ARMs increased. While WaMu risk managers viewed negative amortization as a liability, WaMu accountants, following generally accepted accounting practices, treated negative amortization as an asset. In 2003, WaMu recognized $7 million in earnings from deferred interest due to negative amortization.380 By 2006, capitalized interest recognized in earnings that resulted from negative amortization surpassed $1 billion; by 2007 it exceeded $1.4 billion.381 In other words, as WaMu customers stopped paying down their mortgages, WaMu booked billions of dollars in earnings from the increasing unpaid balances.
By another measure, in 2003, $959 million in Option ARM loans that WaMu held in its investment portfolio experienced negative amortization; in 2007, the figure was more than $48 billion.382

According to data compiled by the Treasury and the FDIC Inspectors General, in 2005,

WaMu borrowers selected the minimum monthly payment option for 56% of the value of the Option ARM loans in its investment portfolio. By the end of 2007, 84% of the total value of the Option ARMs in WaMu’s investment portfolio was negatively amortizing.383 To avoid having their loans recast at a higher interest rate, Option ARM borrowers typically refinanced the outstanding loan balance. Some borrowers chose to refinance every year or two.384 The Treasury and the FDIC IG report determined that a significant portion of Washington Mutual’s Option ARM business consisted of refinancing existing loans.385

One WaMu loan officer, Brian Minkow, told the Subcommittee that he expected the vast

As long as home prices were appreciating, most borrowers were able to refinance if

majority of Option ARMs borrowers to sell or refinance their homes before their payments increased.386

378 See, e.g., 11/13/2006 “e-Flash” from Mary Ann Kovack to Consumer Direct, JPM_WM03077089-90.
379 2007 “Home Loans Product Strategy,” WaMu presentation at JPM_WM03097203, Hearing Exhibit 4/13-60a (only Countrywide ranked higher). 380 2005 Washington Mutual Inc. 10-K filing with the SEC at 27. 381 Id.
382 Id. at 55; 3/2007 Washington Mutual Inc. 10-K filing with the SEC at 57. 383 4/2010 IG Report, at 9, Hearing Exhibit 4/16-82. 384 Subcommittee interview of Brian Minkow (2/16/2010). 385 4/2010 IG Report, Hearing Exhibit 4/16-82. 386 Subcommittee interview of Brian Minkow (2/16/2010).

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they chose to. According to Mr. Minkow, who was one of WaMu’s top loan consultants and in some years originated more than $1 billion in loans, 80% of his business was in Option ARMs, and 70% of his business consisted of refinances.387 however, refinancing became difficult. At recast, many people found themselves in homes they could not afford, and began defaulting in record numbers.

Once housing prices stopped rising,

WaMu was one of the largest originators of Option ARMs in the country. In 2006 alone,

WaMu securitized or sold $115 billion in Option ARMs.388 Like Long Beach securitizations, WaMu Option ARM securitizations performed badly starting in 2006, with loan delinquency rates between 30 and 50%, and rising.389

(e) Marginalization of WaMu Risk Managers

WaMu knowingly implemented a High Risk Lending Strategy, but failed to establish a

corresponding system for risk management. Instead, it marginalized risk managers who warned about and attempted to limit the risk associated with the high risk strategy.

At the time it formally adopted its High Risk Lending Strategy, WaMu executives

acknowledged the importance of managing the risks it created. For example, the January 2005 “Higher Risk Lending Strategy ‘Asset Allocation Initiative’” presentation to the Board of Directors Finance Committee stated in its overview:

“In order to generate more sustainable, consistent, higher margins within Washington Mutual, the 2005 Strategic Plan calls for a shift in our mix of business, increasing our Credit Risk tolerance while continuing to mitigate our Market and Operational Risk positions.

“The Corporate Credit Risk Management Department has been tasked, in conjunction with the Business Units, to develop a framework for the execution of this strategy. Our numerous activities include:

-Selecting best available credit loss models -Developing analytical framework foundation -Identifying key strategy components per Regulatory Guidance documents

“A strong governance process will be important as peak loss rates associated with this higher risk lending strategy will occur with a several year lag and the correlation between high risk loan products is important. For these reasons, the Credit Department will pro-

387 Id. 388 10/17/2006 “Option ARM” draft presentation to the WaMu Board of Directors, JPM_WM02549027, Hearing Exhibit 4/13-38, chart at 2. 389 See wamusecurities.com (subscription website maintained by JPMorgan Chase with data on Long Beach and WaMu mortgage backed securities showing, as of January 2011, delinquency rates for particular mortgage backed securities, including WMALT 2006 OA-3 – 57.87% and WAMU 2007-OA4 – 48.43%).

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actively review and manage the implementation of the Strategic Plan and provide quarterly feedback and recommendations to the Executive Committee and timely reporting to the Board.”390

The robust risk management system contemplated by in the January 2005 memorandum,

which was critical to the success of the High Risk Lending Strategy, was never meaningfully implemented. To the contrary, risk managers were marginalized, undermined, and often ignored.
As former Chief Risk Manager Jim Vanasek testified at the April 13 Subcommittee hearing:

“I made repeated efforts to cap the percentage of high-risk and subprime loans in the portfolio. Similarly, I put a moratorium on non-owner-occupied loans when the percentage of these assets grew excessively due to speculation in the housing market. I attempted to limit the number of stated income loans, loans made without verification of income. But without solid executive management support, it was questionable how effective any of these efforts proved to be.”391

Later in the hearing, Mr. Vanasek had the following exchange with Senator Coburn:

Senator Coburn: Did you ever step in and try to get people to take a more conservative approach at WaMu?

Mr. Vanasek: Constantly.

Senator Coburn: Were you listened to?

Mr. Vanasek: Very seldom.

Senator Coburn: [Had] you ever felt that your opinions were unwelcomed, and could you be specific?

Mr. Vanasek: Yes. I used to use a phrase. It was a bit of humor or attempted humor. I used to say the world was a very dark and ugly place in reference to subprime loans. I cautioned about subprime loans consistently.392

Mr. Vanasek’s description of his efforts is supported by contemporaneous internal

documents. In a February 24, 2005 memorandum to the Executive Committee with the subject heading, “Critical Pending Decisions,” for example, Mr. Vanasek cautioned against expanding WaMu’s “risk appetite”:

390 1/2005 “Higher Risk Lending Strategy ‘Asset Allocation Initiative,’” Washington Mutual Board of Directors Finance Committee Discussion, JPM_WM00302975, Hearing Exhibit 4/13-2a [emphasis in original]. 391 April 13, 2010 Subcommittee Hearing at 17. 392 Id. at 32.

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“My credit team and I fear that we are considering expanding our risk appetite at exactly the wrong point and potentially walking straight into a regulatory challenge and criticism from both the Street and the Board. Said another way I fear that the timing of further expansion into higher risk lending beyond what was contemplated in the ’05 Plan and most especially certain new products being considered is ill-timed given the overheated market and the risk [of] higher interest rates ….

So we come down to the basic question, is this the time to expand beyond the ’05 Plan and/or to expand into new categories of higher risk assets? For my part I think not. We still need to complete EDE [Enterprise Decision Engine, an automated underwriting system], reduce policy exception levels, improve the pricing models, build our sub-prime collection capability, improve our modeling etc. We need to listen to our instincts about the overheated housing market and the likely outcome in our primary markets. We need to build further credibility with the regulators about the control exercised over our SFR underwriting and sub-prime underwriting particularly in LBMC.”393

Mr. Vanasek retired in December 2005, in part, because the management support for his risk policies and culture was lacking.394 When Mr. Vanasek left WaMu, the company lost one of the few senior officers urging caution regarding the high risk lending that came to dominate the bank. After his departure, many of his risk management policies were ignored or discarded. For example, by the end of 2007, stated income loans represented 73% of WaMu’s Option ARMs, 50% of its subprime loans, and 90% of its home equity loans.395

Ronald Cathcart was hired in December 2005 to replace Mr. Vanasek, and became the

Chief Enterprise Risk Officer. He had most recently been the Chief Risk Officer for Canadian Imperial Bank of Commerce’s retail bank.396 Although the High Risk Lending Strategy was well underway, after Mr. Vanasek’s departure, risk management was in turmoil. Mr. Cathcart testified at the Subcommittee hearing: “When I arrived at WaMu, I inherited a Risk Department that was isolated from the rest of the bank and was struggling to be effective at a time when the mortgage industry was experiencing unprecedented demand for residential mortgage assets.” In early 2006, the bank reorganized WaMu’s risk management.397 Under the new system, much of the risk management was subordinated to the WaMu business divisions, with each business division’s Chief Risk Officer reporting to two bosses, Mr. Cathcart and the head of the business unit to which the division’s Chief Risk Officer was assigned. WaMu referred to this system of reporting as a “Double-Double.”398

393 2/24/2005 Washington Mutual memorandum from Jim Vanasek to the Executive Committee, “Critical Pending Decisions,” JPM_WM01265462-64. 394 Subcommittee interview of Jim Vanasek (12/18/2009 and 1/19/2010). 395 4/2010 IG Report, at 10, Hearing Exhibit 4/16-82. 396 Subcommittee interview of Ronald Cathcart (2/23/2010). 397 Id.
398 Id.; Subcommittee interviews of David Schneider (2/17/2010) and Cheryl Feltgen (2/6/2010).

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Cheryl Feltgen, for example, was the Chief Risk Officer for the Home Loans division.
She reported both to Mr. Cathcart and to Mr. Schneider, the Home Loans President, setting up a tension between the two.399 Mr. Schneider had hired Ms. Feltgen from Citi Mortgage, where she had been the Chief Marketing Officer, not a risk manager. Mr. Cathcart told the Subcommittee that he would not have hired her for the role, because of her lack of risk management experience.400

Ms. Feltgen told the Subcommittee that, although she was the Home Loans Chief Risk

Officer, she also had responsibility to meet business goals. She indicated that she did not see her role as one of risk minimization, but rather of risk optimization.401 Her 2007 performance evaluation reflected her dual responsibilities, but clearly subordinated her risk management duties to the achievement of business growth objectives. For example, the evaluation identified a series of goals and assigned each a percentage weighting to determine their precedence. Instead of assigning priority to her performance in the area of managing risk, Ms. Feltgen’s number one performance goal for 2007 was “GROWTH” in home loans, given a weighting of 35%, followed by “RISK MANAGEMENT,” given a weighting of only 25%.402 Her performance review even listed specific sales targets:

“Employee Goals

GROWTH 35%

Achieve Net Income - $340 MM for 2007
HL [Home Loan] Product Sales (Incl. Conduit)
Customer Satisfaction (Total HL) – 55%”403
Home Equity - $18B
Subprime - $32B
Option ARM - $33B
Alt A - $10B

By conditioning her evaluation on whether her division hit pre-determined sales figures, the performance evaluation made her compensation more dependent upon the Home Loans division hitting revenue growth and product sales than upon her contributions to risk management.

Further complicating matters were Ms. Feltgen’s two supervisors. In an interview, Ms. Feltgen stated that Ron Cathcart, her supervisor on risk matters, was “not well respected” and did not have “a strong voice.” 404

On the other hand, she described David Schneider, her

399 See April 13, 2010 Subcommittee Hearing at 34; Subcommittee interviews of Mr. Cathcart (2/23/2010), Mr. Schneider (2/17/2010), and Ms. Feltgen (2/6/2010). 400 Subcommittee interview of Ronald Cathcart (2/23/2010). 401 Subcommittee interview of Cheryl Feltgen (2/6/2010). 402 “Performance Review Form: Leadership,” Hearing Exhibit 4/13-64 (the form is not dated, but Ms. Feltgen confirmed that it is the 2007 review).
403 Id. 404 Subcommittee interview of Cheryl Feltgen (2/6/2010).

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supervisor on loan origination matters, as having a strong voice and acting more as her boss.
This arrangement again de-emphasized the importance of her risk duties.

Ms. Feltgen’s dedication to the growth of the Home Loans business is apparent in her

communications with her staff. For example, on December 26, 2006, she sent a year-end email to her staff. Under the subject line, “Year-End 2006 Message for the Home Loans Risk Management Team,” Ms. Feltgen wrote:

“As we approach the close of 2006, it is fitting to reflect on the challenges and accomplishments of this past year and to look forward to 2007 and beyond. Earlier this year David Schneider and the leadership team of Home Loans articulated a new business strategy that included: (1) a shift to higher margin products (Alt-A, subprime and home equity); (2) reducing market risk … and taking on more credit risk and (3) aggressively attacking the cost structure. We have made great strides as a business on all of those fronts and you have all been a part of those accomplishments. You have partnered successfully with the business units of Home Loans in pursuit of our collective goal to drive profitable growth with the right balance of risk and return.”405

The email continued with a list of “accomplishments of the Home Loans Risk

Management Team in support of business goals,” that included the following accomplishment: “Our appetite for credit risk was invigorated with the expansion of credit guidelines for various product segments including the 620 to 680 FICO, low docs and also for home equity.”406 The email continued with Ms. Feltgen stating her commitment to the High Risk Lending Strategy and emphasizing revenue and sales despite an acknowledgement of the worsening condition of the mortgage market:

“The year 2007 will be another challenging year for the mortgage industry with mortgage origination volumes down, the inverted yield curve putting pressure on profitability and gain on sale margins at lower level than prior years. The focus on the three key elements of our 2006 strategy remains important: shift to higher margin products, reduce market risk and increase credit risk and attack the cost structure. … In 2007, we must find new ways to grow our revenue. Home Loans Risk Management has an important role to play in that effort.

David Schneider has encouraged us to ‘BE BOLD’…. Recognize that ‘we are all in sales’ passionately focused on delivering great products and service to our customers.”407

Ms. Feltgen’s year-end bonus was based upon her performance review.408

According to Mr. Cathcart, in 2007, the bank made bonus distributions more dependent on the performance of

405 1/3/2007 email from Cheryl Feltgen, “Year-End 2006 Message for the Home Loans Risk Management Team,” Hearing Exhibit 4/13-73. 406 Id. 407 Id. 408 Subcommittee Interview of Ronald Cathcart (2/23/2010).

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each business line, rather than the performance of the bank as a whole, which largely removed his control over compensation of his risk managers. Mr. Cathcart told the Subcommittee that he disagreed with this change because it made his risk managers, who reported to him and to the heads of the business units, more beholden to the business heads. Mr. Cathcart said he approached the head of Human Resources, and strongly objected to the change, but was told to take it up with Mr. Killinger. Mr. Cathcart told the Subcommittee that he voiced his objection to Mr. Killinger, but Mr. Killinger told him to talk to Mr. Rotella. He said that he took his objection to Mr. Rotella, but was unsuccessful at preventing the policy change.

Mr. Cathcart told the Subcommittee that this change created further separation between

him and his risk managers, and compromised the independence of risk management.409 testified at the Subcommittee hearing:

Mr. Cathcart: The chairman adopted a policy of what he called double reporting, and in the case of the Chief Risk Officers, although it was my preference to have them reporting directly to me, I shared that reporting relationship with the heads of the businesses so that clearly any of the Chief Risk Officers reporting to me had a direct line to management apart from me.

Senator Coburn: And was that a negative or a positive in terms to the ultimate outcome in your view?

Mr. Cathcart: It depended very much on the business unit and on the individual who was put in that double situation. I would say that in the case of home loans, it was not satisfactory because the Chief Risk Officer of that business favored the reporting relationship to the business rather than to risk.410

The subordination of risk management to sales was apparent at WaMu in many other

ways as well. Tony Meola, the head of home loans sales, reported directly to David Schneider.
He had direct access to Mr. Schneider and often pushed for more lenient lending standards.
According to Ms. Feltgen, the sales people always wanted more lenient standards and more mortgage products, and Mr. Meola advocated for them.411

One example was the 80/20 loan, which consisted of a package of two loans issued

together, an 80% LTV first lien and a 20% LTV second lien, for a total CLTV of 100%. Ms. Feltgen said she was nervous about the product, as a 100% CLTV was obviously very risky.
WaMu’s automatic underwriting system was not set up to accept such loans, but Mr. Meola wanted permission to “side step” the systems issue.412 Ms. Feltgen ultimately signed off on it. She told the Subcommittee that it was a high risk

Mr. Schneider approved the product, and

409 Id.
410 April 13, 2010 Subcommittee Hearing at 34.
411 Subcommittee Interview of Cheryl Feltgen (2/6/2010). 412 See 2/2006 WaMu internal email chain, “FW: 80/20,” JPM_WM03960778.

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product, but was priced accordingly, and that it might have been successful if housing prices had not declined.413

When the housing market began to collapse, a time in which prudent risk management

became even more critical, Mr. Cathcart, the Chief Enterprise Risk Manager, was accorded even less deference and authority. Mr. Cathcart testified at the April 13 Subcommittee hearing:

“Financial conditions … deteriorated further in 2007 and 2008. As head of risk, I began to be excluded from key management decisions. By February 2008, I had been so fully isolated that I initiated a meeting with the Director, where I advised that I was being marginalized by senior management to the point that I was no longer able to discharge my responsibilities as Chief Enterprise Risk Officer of WaMu. Within several weeks, I was terminated by the Chairman.”414

During his interview with the Subcommittee Mr. Cathcart provided additional details

He said that he initially had extensive

Mr. Cathcart told the Subcommittee that regulators were also given out-of-date loss

about his marginalization by senior management.415 interaction with the WaMu Board of Directors and presented to the full Board every six months.
According to Mr. Cathcart, he attended all of the Board meetings until the end of 2007 or the beginning of 2008, at which time he was no longer invited. Mr. Cathcart felt he was excluded from Board meetings and calls with investment bankers because he was forthright about WaMu’s mortgage loss rates, whereas senior management used older, more favorable numbers.
According to Mr. Cathcart, during one of the last Board meetings he attended, after a presentation on expected mortgage losses, he interjected that the loan loss data being presented were already out of date, and the real figures would be much worse. He also recalled speaking up in a 2007 conference call with investment bankers to correct an overly optimistic loss figure.
According to Mr. Cathcart, he was chastised for his corrections by WaMu management and told to leave the credit discussions to another senior manager.

projections as the situation worsened, because Mr. Killinger and Mr. Rotella wanted to prevent a negative reaction. Mr. Cathcart said that the loss rates were increasing every week, and the regulators were being provided with three-week old information. Mr. Cathcart told the Subcommittee that in February or March 2008, he discovered that Mr. Killinger had provided the Director of OTS, John Reich, with out-of-date loss rates. Mr. Cathcart said that he called a meeting with Mr. Dochow, head of the OTS West Regional Office, and provided him with the current numbers. Mr. Cathcart said that Mr. Killinger found out about the meeting and was upset. In April, Mr. Killinger fired Mr. Cathcart.

413 Subcommittee Interview of Cheryl Feltgen (2/6/2010). See also 2/2006 WaMu internal email chain, “FW: 80/20,” JPM_WM03960778.
414 April 13, 2010 Subcommittee Hearing at 19. 415 Subcommittee interview of Ronald Cathcart (2/23/2010).

E. Polluting the Financial System

Washington Mutual, as the nation’s largest thrift, was a leading issuer of home loans.

When many of those loans began to go bad, they caused significant damage to the financial system.

Washington Mutual originated or acquired billions of dollars of home loans through

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multiple channels, including loans originated by its own loan officers, loans brought to the bank by third party mortgage brokers, and loans purchased in bulk from other lenders or firms. Its subprime lender, Long Beach, originated billions of dollars in home loans brought to it by third party mortgage brokers across the country. According to a 2007 WaMu presentation, by 2006, Washington Mutual was the second largest nonagency issuer of mortgage backed securities in the United States, behind Countrywide.416

Washington Mutual and Long Beach sold or securitized the vast majority of their subprime home loans. Initially, Washington Mutual kept most of its Option ARMs in its proprietary investment portfolio, but eventually began selling or securitizing those loans as well. With respect to other loans, such as fixed rate 30-year, Alt A, home equity, and jumbo loans, WaMu kept a portion for its own investment portfolio, and sold the rest either to Wall Street investors, usually after securitizing them, or to Fannie Mae or Freddie Mac.

By securitizing billions of dollars in poor quality loans, WaMu and Long Beach were able to decrease their risk exposure while passing along risk to others in the financial system. They polluted the financial system with mortgage backed securities which later incurred high rates of delinquency and loss. At times, WaMu securitized loans that it had identified as likely to go delinquent, without disclosing its analysis to investors to whom it sold the securities, and also securitized loans tainted by fraudulent information, without notifying purchasers of the fraud that was discovered and known to the bank.

(1) WaMu and Long Beach Securitizations

From 2000 to 2007, Washington Mutual and Long Beach securitized at least $77 billion

in subprime and home equity loans.417 WaMu also sold or securitized at least $115 billion in Option ARM loans.418 Between 2000 and 2008, Washington Mutual sold over $500 billion in loans to Fannie Mae and Freddie Mac, accounting for more than a quarter of every dollar in loans WaMu originated.419

416 See 6/11/2007 chart entitled, “Rate of Growth Exceeds the Industry,” JPM_WM03409860, Hearing Exhibit 4/13- 47c. 417 6/2008 “WaMu Wholesale Specialty Lending Securitization Performance Summary,” JPM_WM02678980, Hearing Exhibit 4/13-45. 418 10/17/2006 “Option ARM” draft presentation to the WaMu Board of Directors, JPM_WM02549027, Hearing Exhibit 4/13-38 (see chart at 2). See also 8/2006 “Option ARM Credit Risk,” WaMu presentation, at JPM_WM00212644, Hearing Exhibit 4/13-37 (see chart at 5).
419 See chart in section E(4), below, using loan data from Inside Mortgage Finance.

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According to a 2007 WaMu presentation at a securities investor meeting in New York, in

2004, WaMu issued $37.2 billion in RMBS securitizations and was the sixth largest RMBS issuer in the United States.420 In 2005, it doubled its production, issuing $73.8 billion in securitizations, and became the third largest issuer. In 2006, it issued $72.8 billion and was the second largest issuer, behind Countrywide.421

WaMu and Long Beach’s securitizations produced only RMBS securities. Although

WaMu considered issuing CDO securities as well, it never did so.422 From 2004 to 2006, WaMu and Long Beach securitized dozens of pools of prime, subprime, Alt A, second lien, home equity, and Option ARM loans.423 WaMu and Long Beach also sold “scratch and dent” pools of nonperforming loans, including nonperforming primary mortgages, second lien, and Option ARMs.424

At first, Washington Mutual worked with Wall Street firms to securitize its home loans,

but later built up its own securitization arm, Washington Mutual Capital Corporation (WCC), which gradually took over the securitization of both WaMu and Long Beach loans. WCC was a private Washington State corporation that WaMu acquired from another bank in 2001, and renamed.425 WCC became a wholly owned subsidiary of Washington Mutual Bank. In July 2002, WaMu announced that WCC would act as an institutional broker-dealer handling RMBS securities and would work with Wall Street investment banks to market and sell WaMu and Long Beach RMBS securities.426

It also conducted whole loan sales and credit card

WCC was initially based in Seattle, and by 2003, had between 30 and 40 employees.427
In 2004, due to increasing securitizations, WaMu decided to move the headquarters of WCC to Manhattan.428 In 2004, for the first time, WCC acted as the lead manager of a WaMu securitization. That same year, WCC initiated a “conduit program” to buy Alt A and subprime loans in bulk for securitization.429 WCC issued its first Alt A securitization in 2005, and its first subprime securitization in 2006.430

420 See 6/11/2007 chart entitled, “Rate of Growth Exceeds the Industry,” JPM_WM03409860, Hearing Exhibit 4/13- 47c.
421 Id. WaMu attributed its rapid rise in the issuer rankings over the three-year period to its establishment of a Conduit Program, which began buying loans in bulk in 2004. Id. 422 See 12/15/2006 Enterprise Risk Management Committee, JPM_WM02656967. See also 10/25/2006 Asset- Liability Management Committee Meeting Agenda, JPM_WM02406624. 423 See 6/2008 “WaMu Wholesale Specialty Lending Securitization Performance Summary,” JPM_WM02678980, Hearing Exhibits 4/13-45 and 46; 6/11/2007 chart entitled, “WaMu Capital Corp Sole/Lead Underwriter,” JPM_WM03409861, Hearing Exhibit 4/13-47c. 424 See, e.g., undated “List of WaMu-Goldman Loans Sales and Securitizations,” Hearing Exhibit 4/13-47b; 2/2007 internal WaMu email chain, JPM_WM00652762.
425 See 6/11/2007 chart entitled, “Capital Markets Division Growth,” JPM_WM03409858, Hearing Exhibit 4/13- 47c. 426 Id. 427 Subcommittee interview of David Beck (3/2/2010). 428 Id.
429 See 6/11/2007 chart entitled, “Capital Markets Division Growth,” JPM_WM03409858, Hearing Exhibit 4/13- 47c. 430 Id.

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securitizations.431 At its peak, right before the collapse of the subprime securitization market, WCC had over 200 employees and offices in Seattle, New York, Los Angeles, and Chicago. The majority of WCC employees were based in New York.432 WCC was headed by Tim Maimone, WCC President, who reported to David Beck, Executive Vice President in charge of WaMu’s Capital Markets Division. Mr. Beck reported to the President of WaMu’s Home Loans Division, David Schneider.433

At the Subcommittee hearing on April 13, 2010, Mr. Beck explained the role of WCC in

WaMu and Long Beach securitizations as follows:

“WaMu Capital Corp. acted as an underwriter of securitization transactions generally involving Washington Mutual Mortgage Securities Corp. or WaMu Asset Acceptance Corp. Generally, one of the two entities would sell loans into a securitization trust in exchange for securities backed by the loans in question, and WaMu Capital Corp. would then underwrite the securities consistent with industry standards. As an underwriter, WaMu Capital Corp. sold mortgage-backed securities to a wide variety of institutional investors.434

WCC sold WaMu and Long Beach loans and RMBS securities to insurance companies, pension funds, hedge funds, other banks, and investment banks.435 Mae and Freddie Mac. WCC personnel marketed WaMu and Long Beach loans both in the United States and abroad.

It also sold WaMu loans to Fannie

Before WCC was able to act as a sole underwriter, WaMu and Long Beach worked with

The QSPE then issued RMBS securities secured by future cash

a variety of investment banks to arrange, underwrite, and sell its RMBS securitizations, including Bank of America, Credit Suisse, Deutsche Bank, Goldman Sachs, Lehman Brothers, Merrill Lynch, Royal Bank of Scotland, and UBS. To securitize its loans, WaMu typically assembled and sold a pool of loans to a qualifying special-purpose entity (QSPE) that it established for that purpose, typically a trust.436 flows from the loan pool. Next, the QSPE – working with WCC and usually an investment bank – sold the RMBS securities to investors, and used the sale proceeds to repay WaMu for the cost

431 Id. 432 Subcommittee interview of David Beck (3/2/2010). 433 Id. 434 April 13, 2010 Subcommittee Hearing at 53. Washington Mutual Mortgage Securities Corp. (WMMSC) and WaMu Asset Acceptance Corp. (WAAC) served as warehouse entities that held WaMu loans intended for later securitization. Mr. Beck explained in his prepared statement: “WMMSC and WAAC purchased loans from WaMu, and from other mortgage originators, and held the loans until they were sold into the secondary market. WCC was a registered broker-dealer and acted as an underwriter of securitization deals for a period of time beginning in 2004 and ending in the middle of 2007. In addition to buying and selling mortgage loans, WMMSC acted as a ‘master servicer’ of securitizations. The master servicer collects and aggregates the payments made on loans in a securitized pool and forwards those payments to the Trustee who, in turn, distributes those payments to the holders of the securities backed by that loan pool.” Id. at 163. 435 See 6/11/2007 chart entitled, “Origination Through Distribution,” JPM_WM03409859, Hearing Exhibit 4/13- 47c; Subcommittee interview of David Beck (3/2/2010). 436 See 3/2007 Washington Mutual Inc. 10-K filing with the SEC, at 45 (describing securitization process).

of the loan pool. Washington Mutual Inc. generally retained the right to service the loans.
WaMu or Long Beach might also retain a senior, subordinated, residual, or other interest in the loan pool.

The following two diagrams created for a 2005 Long Beach securitization, LBMC 2005-

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2, demonstrate the complex structures created to issue the RMBS securities, as well as the “waterfall” constructed to determine how the mortgage payments being made into the securitization pool would be used.437

437 See “LBMC 2005-2 Structure” and “LBMC 2005-2 Cash Flow Waterfall,” FDIC_WAMU_000012358-59, Hearing Exhibit 47a.

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In that particular securitization, Goldman Sachs served as the lead underwriter, WCC served as the securities dealer, Deutsche Bank served as the trustee of the trust set up to hold the securities, and Long Beach served as the mortgage servicer.

Another document, prepared by Goldman Sachs, shows the variety of relationships that WaMu engaged in as part of its securitization efforts.438 That document, which consists of a list of various loan pools and related matters, shows that WaMu worked with Goldman Sachs to make whole loan sales; securitize loans insured by the Federal Home Administration or Veterans Administration; and securitize prime, subprime, Alt A, second lien, and scratch and dent nonperforming loans. It also shows that Goldman Sachs asked WaMu and Long Beach to repurchase more than $19.7 million in loans it had purchased from the bank.439

Goldman Sachs handled a number of securitizations for Long Beach. At one point in

2006, Goldman Sachs made a pitch to also handle loans issued by WaMu. One Goldman Sachs broker explained to a colleague in an email: “They have possibly the largest subprime portfolio on the planet.”440

(2) Deficient Securitization Practices

Over the years, both Long Beach and Washington Mutual were repeatedly criticized by

the bank’s internal auditors and reviewers, as well as its regulators, OTS and the FDIC, for deficient lending and securitization practices. Their mortgage backed securities were among the worst performing in the marketplace due to poor quality loans that incurred early payment defaults, fraud, and high delinquency rates.

recounted eight years of abysmal performance by Long Beach securities, noting that loan delinquencies and losses occurred in pools containing both fixed rate and adjustable rate mortgages:

Long Beach Securitizations. In April 2005, an internal email sent by an OTS regulator

“[Securitizations] prior to 2003 have horrible performance …. For FRM [fixed rate mortgage] losses, LBMC finished in the top 12 worst annual NCLs [net credit losses] in 1997 and 1999 thru 2003. LBMC nailed down the number 1 spot as top loser with an NCL of 14.1% in 2000 and placed 3rd in 2001 with 10.5% …. For ARM losses, LBMC really outdid themselves with finishes as one of the top 4 worst performers for 1999 thru

For specific ARM deals, LBMC made the top 10 worst deal list from 2000 thru
LBMC had an extraordinary year in 2001 when their securitizations had 4 of the top 6 worst NCLs (range: 11.2% to 13.2%).

438 Undated “List of WaMu-Goldman Loans Sales and Securitizations,” Hearing Exhibit 4/13-47b. 439 Id. 440 3/24/2005 email from Kevin Gasvoda of Goldman Sachs to Christopher Gething, others, Hearing Exhibit 4/27- 167b.

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“Although underwriting changes were made from 2002 thru 2004, the older issues are still dragging down overall performance. Despite having only 8% of UPB [unpaid balances] in 1st lien FRM pools prior to 2002 and only 14.3% in 2002 jr. lien pools, LBMC still had third worst delinquencies and NCLs for most of [the] period graphed from 11/02 thru 2/05 and was 2nd worst in NCLs in 2005 out of 10 issuers graphed. …
At 2/05, LBMC was #1 with a 12% delinquency rate. Industry was around 8.25%. At 3/05, LBMC had a historical NCL rate of 2% smoking their closest competitor by 70bp and tripling the industry average.”441

This email, which is based upon a 2005 Fitch analysis of Long Beach, shows that,

from 1997 to March 2005, due to loan delinquencies and losses, Long Beach securities were among the very worst performing in the entire subprime industry.442

Long Beach’s performance did not improve after 2005. In April 2006, for

example, Nomura Securities issued an analysis of the ABX Index that tracked a basket of 20 subprime RMBS securities and identified Long Beach as the worst performer:

“Long Beach Mortgage Loan Trust appears to be the poorest performing issuer, with its three deals averaging 15.67% in 60+ day delinquency and 12.75% in 90+ day delinquency. Unsurprisingly, all three deals issued by LBMLT have exceeded their delinquency trigger limits.”443

In November 2006, while attending the Asset Backed Securities East Conference

for the securitization industry, the head of WaMu’s Capital Markets Division, David Beck, emailed WaMu’s Home Loans President, David Schneider, that with respect to RMBS securities carrying noninvestment grade ratings, “LBMC [Long Beach] paper is among the worst performing paper in the mkt [market] in 2006. Subordinate buyers want answers.”444

In March 2007, an analysis by JPMorgan Chase again singled out Long Beach securities for having the worst delinquency rates among the subprime securities tracked by the ABX Index:

“Washington Mutual Inc.’s subprime bonds are suffering from some of the worst rates of delinquency among securities in benchmark indexes, according to JPMorgan Chase & Co. research. … Delinquencies of 60 days or more on loans supporting WaMu’s Long Beach LBMLT 2006-1 issue jumped … to 19.44 percent … the highest among the 20

441 4/14/2005 email from Steve Blelik to David Henry, “Fitch – LBMC Review,” Hearing Exhibit 4/13-8a. 442 Id. 443 4/19/2006 “ABX Index – The Constituent Breakdown,” prepared by Nomura Securities International Inc., http://www.scribd.com/doc/19606903/Nomura-ABX-Index-The-Constituent-Breakdown.
444 11/7/2006 email from David Beck to David Schneider, Hearing Exhibit 4/13-50. See also 4/19/2006 “ABX Index – The Constituent Breakdown,” prepared by Nomura Securities International Inc., http://www.scribd.com/doc/19606903/Nomura-ABX-Index-The-Constituent-Breakdown.

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bonds in the widely watched ABX-HE 06-2 index of bonds backed by residential loans to risky borrowers.”445

In July 2007, Moody’s and S&P downgraded the credit ratings of hundreds of subprime RMBS and CDO securities, due to rising mortgage delinquencies and defaults. Included were approximately 40 Long Beach securities.446 A July 12, 2007 presentation prepared by Moody’s to explain its ratings action shows that Long Beach was responsible for only 6% of all the subprime RMBS securities issued in 2006, but received 14% of the subprime RMBS ratings downgrades that day.447

Only Fremont had a worse ratio.

Over time, even AAA rated Long Beach securities performed terribly. Of the 75 Long

Beach mortgage backed security tranches rated AAA by Standard and Poor’s in 2006, all 75 have been downgraded to junk status, defaulted, or been withdrawn.448 In most of the 2006 Long Beach securitizations, the underlying loans have delinquency rates of 50% or more.449

The problems were not confined to Long Beach loans. In early 2008, for example, an investment adviser posted information on his personal blog about a WaMu-sponsored RMBS securitization known as WMALT 2007-OC1. Formed in May 2007, this pool contained about 1,700 Alt A loans with a total outstanding balance of about $515 million. WaMu was the sole underwriter. The credit rating agencies gave AAA and other investment grade ratings to more than 92% of the securitization, but within eight months, 15% of the pool was in foreclosure. The posting suggested that the poor performance of WaMu securities was systemic.

When informed by David Schneider of the complaint about the negative publicity

surrounding the pool, David Beck responded:

“Yes (ughh!) we are doing some peer group performance and looking at the servicing data … and putting together an analysis. … The collateral is full of limited doc layered risk alt a paper and at least half is TPO [third party originated]. The performance is not great but my opinion is not a WaMu specific issue.”450

445 “WaMu subprime ABS delinquencies top ABX components,” Reuters (3/27/2007), Hearing Exhibit 4/13-52. 446 7/10/2007-7/12/2007 excerpts from Standard & Poor’s and Moody’s Downgrades, Hearing Exhibit 4/23-99. 447 7/12/2007 “Moody’s Structured Finance Teleconference and Web Cast: RMBS and CDO Rating Actions,” MOODYS-PSI2010-0046902, Hearing Exhibit 4/23-106. 448 See Standard and Poor’s data at www.globalcreditportal.com. 449 See, e.g., wamusecurities.com (subscription website maintained by JPMorgan Chase with data on Long Beach and WaMu mortgage backed securities showing, as of March 2011, delinquency rates for particular mortgage backed securities, including LBMLT 2006-1 – 58.44%; LBMLT 2006-6 – 60.06%; and LBMLT 2005-11 – 54.32%).
450 2/2/2008 email from David Beck to David Schneider and others, JPM_WM02445758, Hearing Exhibit 4/13-51.

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Home Loans President David Schneider replied: “Ok – thanks .… Are we sure there isn’t a reporting issue?” Today, those securities have all been downgraded to junk status and more than half of the underlying loans are delinquent or in foreclosure.451

Despite their poor performance, it is unclear that any investment bank refused to do

business with either Long Beach or WaMu. As long as investors expressed interest in purchasing the securities, banks continued selling them until the entire subprime market collapsed. Before the market collapsed, WaMu earned hundreds of millions of dollars a year from its home loans sales and securitizations.452

Securitizing Fraudulent Loans. WaMu and Long Beach securitized not just poor

quality loans, but also loans that its own personnel had flagged as containing fraudulent information. That fraudulent information included, for example, misrepresentations of the borrower’s income and of the appraised value of the mortgaged property. In September 2008, WaMu’s Corporate Credit Review team released a report which found that internal controls intended to prevent the sale of fraudulent loans to investors were ineffective:

In other words, even loans marked with a red flag indicating fraud were being sold to investors.
The review identified several factors contributing to the problem, including insufficient resources devoted to anti-fraud work, an absence of automated procedures to alert personnel to fraud indicators, and inadequate training on fraud awareness and prevention. The 2008 review warned: “Exposure is considerable and immediate corrective action is essential in order to limit or avoid considerable losses, reputation damage, or financial statement errors.”454

(3) Securitizing Delinquency-Prone Loans

The Subcommittee uncovered an instance in 2007 in which WaMu securitized certain

types of loans that it had identified as most likely to go delinquent, but did not disclose its analysis to investors who bought the securities. Investors who purchased these securities without the benefit of that analysis quickly saw the value of their purchases fall.

451 As of December 2010, the total loan delinquency rate of the WMALT 2007-OC1 series was 57.37%. See wamusecurities.com. 452 See 3/1/2007 Washington Mutual Inc. 10-K filing with the SEC, at 82, 87.
453 9/8/2008 “Risk Mitigation and Mortgage Fraud 2008 Targeted Review,” WaMu Corporate Credit Review, JPM_WM00312502, Hearing Exhibit 4/13-34. 454 Id.

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WaMu securitization agreements prohibited the bank from using an “adverse selection”

process when including loans within a securitized pool. On March 22, 2007, WaMu filed a prospectus for WMALT Series 2007-OA3, in which Washington Mutual Bank and Washington Mutual Mortgage Securities Corp. co-sponsored a securitization of a $2.3 billion pool of Option ARM loans. In the section entitled, “Representations and Warranties Regarding the Mortgage Loans,” the prospectus stated:

“Washington Mutual Mortgage Securities Corp. and Washington Mutual Bank, as applicable, used no adverse selection procedures in selecting the mortgage loans from among the outstanding adjustable rate conventional mortgage loans owned by it which were available for sale and as to which the representations and warranties in the mortgage loan sale agreement could be made.”455

On the following page of the prospectus, under the section heading, “Criteria for

Selection of Mortgage Loans,” it stated:

“Each co-sponsor selected the mortgage loans it sold to the depositor from among its portfolio of mortgage loans held for sale based on a variety of considerations, including type of mortgage loan, geographic concentration, range of mortgage interest rates, principle balance, credit scores and other characteristics described in Appendix B to this prospectus supplement, and taking into account investor preferences and the depositor’s
objective of obtaining the most favorable combination of ratings on the certificates.”456

WaMu emails and memoranda obtained by the Subcommittee indicate that, prior to

assembling the loan pool used in the WMALT 2007-OA3 securitization, WaMu identified delinquency-prone Option ARM mortgages in its “Held for Investment” loan portfolio and transferred those loans to its portfolio of mortgages available for sale or securitization. WaMu then used its “Held for Sale” loan portfolio to select the loans for the loan pool used in the WMALT 2007-OA3 securitization. The prospectus provides a list of criteria used to select the loans in the WMALT 2007-OA3 loan pool, but omits any mention of the fact that some of the loans were selected using statistical analysis designed to identify Option ARM loans likely to go delinquent quickly. The internal emails demonstrate that WaMu selected delinquency-prone loans for sale in order to move risk from the bank’s books to the investors in WaMu securities, and profit from its internal analysis, which was not available to the market.

WCC, sent David Beck, head of WaMu’s Capital Markets Division, with copies to others, an email regarding “Tom Casey visit,” with the importance marked “high.” Tom Casey was then the Chief Financial Officer of Washington Mutual Bank. In the email Mr. Drastal relayed Mr. Casey’s concern about WaMu’s exposure to Option ARM loans:

On Thursday, September 14, 2006, John Drastal, then Senior Managing Director of

455 3/22/2007 WaMu Prospectus Supplement, “Washington Mutual Mortgage Pass-Through Certificates, WMALT Series 2007-OA3,” at S-102, Hearing Exhibit 4/13-86b.
456 Id. at S-103.

“David,

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“Tom just stopped by after the Lehman investor conference. He says equity investors are totally freaking about housing now. He asked how we could prepare for this. A few items ….

“2. On the portfolio side, he asked about exposure on option ARMs. We talked about looking to potentially sell ’06 production Option ARMs in portfolio. He even said looking at this quarter. I don’t think that this is possible but we should look at what the credit composition of this product is and see if we can sell quickly if it’s the right thing to do (see Nagle’s message). He doesn’t for[e]see a tainting issue if we are doing it for credit issues. Youyi, can you get me a collateral strat from the portfolio?”457

Three months later, on Wednesday, February 14, 2007, a WaMu portfolio analyst and

trader, Michael Liu, sent an email to a senior official in WaMu’s portfolio management department, Richard W. Ellson, with the subject line: “Option ARM MTA and Option ARM MTA Delinquency.” The email included the abbreviations “MTA,” which stands for “Monthly Treasury Average,” and “PPD,” which stands for “Payment Past Due.” The email provided a description of Option ARM loans in WaMu’s investment portfolio that were delinquent in the fourth quarter of 2006:

“Hi Rick,

“Attached is the spreadsheet with the total Option ARM MTA … and Option ARM MTA

=1 PPD summary. Some points for the Option ARM MTA >=1PPD:

• $105mm in Nonaccrual is between FICO 501-540. • $222mm in Nonaccrual between LTV 61-80. • CA [California] represents the greatest amount of Delinquency (1PPD, 2PPD, 3PPD, nonaccrual)[.] • Loans originated in 2004 and 2005 represent the highest amount of 3 PPD and nonaccrual[.]”458

On the same day, Mr. Ellson forwarded the email to the Division Executive for Portfolio

Management and Research, Youyi Chen, with the following comments:

“Youyi – attached is a description of the Option ARMs that were delinquent in the 2006q4 [fourth quarter]. You can see that it is very much a function of FICOs and Low Doc loans. We are in the process of updating the optimum pricing matrix. Mike did the work. Your comments are appreciated.”459

457 9/14/2006 email from John Drastal to David Beck, with Youyi Chen and Doug Potolsky copied, “Tom Casey visit,” Hearing Exhibit 4/13-40a. 458 2/2007 WaMu internal email chain, Hearing Exhibit 4/13-40b. 459 Id.

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Mr. Chen, in turn, forwarded the email to the head of WaMu’s Capital Markets Division, David Beck. Mr. Chen’s introductory comments indicated that the research had been performed in response to a question from WaMu Home Loans President David Schneider and was intended to identify criteria for the loans driving delinquencies in the Option ARM portfolio:

“This answers partially [David] Schneider’s questions on break down of the option arm delinquencies.

The details (1PPD tab) shows Low fico, low doc, and newer vintages are where most of the delinquency comes from, not a surprise.”460

On the same day, February 14, Mr. Beck forwarded the entire email chain to David

Schneider and WaMu Home Loans Risk Officer Cheryl Feltgen, adding his own view:

“Please review. The performance of newly minted option arm loans is causing us problems. Cheryl can validate but my view is our alt a (high margin) option arms [are] not performing well.

We should address selling 1Q [first quarter] as soon as we can before we loose [sic] the oppty. We should have a figure out how to get this feedback to underwriting and fulfillment.”461

Mr. Beck’s message indicated that recently issued Option ARM loans were not

performing well, and suggested selling them before the bank lost the opportunity. WaMu would lose the opportunity to sell those loans if, for example, they went delinquent, or if the market realized what WaMu analysts had already determined about their likelihood of going delinquent.
Mr. Beck’s email proposed selling the loans during the first quarter of the year, already six weeks underway, and “as soon as we can.”

requesting Ms. Feltgen’s thoughts. Later that day, Ms. Feltgen responded with additional analysis and an offer to help further analyze the Option ARM delinquencies:

Four days later, on Sunday, February 18, Mr. Schneider replied to the email chain by

“The results described below are similar to what my team has been observing.
California, Option ARMs, large loan size ($1 to $2.5 million) have been the fastest increasing delinquency rates in the SFR [Single Family Residence] portfolio. Although the low FICO loans have … higher absolute delinquency rates, the higher FICOs have been increasing at a faster pace than the low FICOs. Our California concentration is getting close to 50% and many submarkets within California actually have declining house prices according to the most recent OFHEO [Office of Federal Housing Enterprise Oversight] data from third quarter of 2006. There is a meltdown in the subprime market which is creating a ‘flight to quality’. I was talking to Robert Williams just after his

460 Id. 461 Id.

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return from the Asia trip where he and Alan Magleby talked to potential investors for upcoming covered bond deals backed by our mortgages. There is still strong interest around the world in USA residential mortgages. Gain on sale margins for Option ARMs are attractive. This seems to me to be a great time to sell as many Option ARMs as we possibly can. Kerry Killinger was certainly encouraging us to think seriously about it at the MBR [Monthly Business Review] last week. What can I do to help? David, would your team like any help on determining the impact of selling certain groupings of Option ARMs on overall delinquencies? Let me know where we can help. Thanks.”462

As Chief Risk Officer in WaMu’s Home Loans division, Ms. Feltgen pointed out some

counterintuitive features of the latest delinquencies, noting that the fastest increases in delinquencies occurred in large loans and loans with high FICO scores. She also noted that the subprime meltdown had led to a “flight to quality,” and that foreign investors still had a strong interest in U.S. residential mortgages, suggesting that WaMu might be able to sell its likely-to-go delinquent Option ARMs to those foreign investors. From her perspective as a risk manager, she urged selling “as many Option ARMs as we can.”

Her email also indicated that the topic of selling more Option ARMs had come up during

the prior week at the monthly business review meeting, in which WaMu CEO Killinger expressed interest in exploring the idea.463 Finally, Ms. Feltgen offered help in analyzing the impact of selling “certain groupings of Options ARMs” on overall delinquencies. Removing those problematic loans from the larger pool of Option ARM loans in the bank’s investment portfolio would reduce loan delinquencies otherwise affecting the value of the portfolio as a whole.

Mr. Schneider sent a second email at 11:00 at night that same Sunday providing

instructions for moving forward:

“Let[’]s do the following:

db [David Beck] - please select the potential sample portfolios - along the lines we discussed at the mbr [Monthly Business Review]
cf [Cheryl Feltgen] - please run credit scenarios
db - coordinate with finance on buy/sell analysis
db/cf – recommendation[.]”464

On Tuesday morning, February 20, 2007, Mr. Beck replied with additional analysis:

“Here’s how I see this going.

462 Id. 463 At the end of 2006, WaMu held about $63.5 billion in Option ARM mortgages, then comprising about 28% of its investment portfolio. See 3/2007 Washington Mutual Inc. 10-K filing with the SEC, at 52. 464 2/2007 WaMu internal email chain, Hearing Exhibit 4/13-40b.

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From the MBR [Monthly Business Review], my notes indicate two portfolios we discussed for sale; the 2007 high margin production (Jan and Feb so far) and the seasoned COFI book.465

I will supply to Cheryl the loan level detail on both pools and the pricing assumptions for losses. Cheryl, you need to run scenario analysis and on losses versus pricing AND reserving assumptions. I can supply pricing assumptions but would like you to pull the ALLL [Allowance for Loan and Lease Losses] against these pools.”466

Later that day, Ms. Feltgen forwarded the email chain to her team, changing the subject

line to read: “URGENT NEED TO GET SOME WORK DONE IN THE NEXT COUPLE DAYS: Option ARM MTA and Option ARM MTA Delinquency.” Clearly, time was of the essence:

“See the attached string of emails. We are contemplating selling a larger portion of our Option ARMs than we have in the recent past. Gain on sale is attractive and this could be a way to address California concentration, rising delinquencies, falling house prices in California with a favorable arbitrage given that the market seems not to be yet discounting a lot for those factors. David Schneider has set a meeting for Friday morning with David Beck and me to hear our conclusions and recommendations. See the comments below about the information that we need to provide for this analysis. We will get the pools by tomorrow at the latest. We will need to coordinate with Joe Mattey and get input from him in order to make a judgment regarding the ALLL impact. …

In addition to the specific information that David Beck asks for, I would like your input on portions of the Option ARM portfolio that we should be considering selling. We may have a different view than David Beck’s team as to the most desirable to sell and we should provide that input. Our suggestion, for instance, might include loans in California markets where housing prices are declining. There may be other factors.

I will need to get from you by Thursday, February 22 end of day a summary of our conclusions and recommendations.”467

465 Option ARMs were considered a “high margin” product within WaMu, because they produced a relatively high gain on sale when sold. See 4/18/2006 Washington Mutual Home Loans Discussion Board of Directors Meeting, at JPM_WM00690894, Hearing Exhibit 4/13-3 (chart showing gain on sale margin by product). “COFI” stands for “Cost of Funds Index” which is an index used to set variable interest rates. “Seasoned” means the loans are older production. 466 2/2007 WaMu internal email chain, Hearing Exhibit 4/13-40b. 467 Id.

that were driving delinquencies in the Option ARM portfolio:

A WaMu risk analyst, Robert Shaw, replied the same day and identified specific factors

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“Cheryl,

between 1/06 - 1/07 [January 6 and 7]. The results of this

I reviewed the HFI [Hold for Investment] prime loan characteristics that contributed to rising 60+ delinquency rates468 analysis show that seven combined factors contain $8.3 billion HFI Option ARM balances which experienced above-average increases in the 60+ delinquency rate during the last 12 months (a 821% increase, or 10 times faster than the average increase of 79%).
I recommend that we select loans with some or all of these characteristics to develop a HFS [Hold for Sale] pool.

Below, I have listed the factors (layered), their percentage change in 60+ delinquency rate over the last 12 months, and HFI balances as of January 2007.469

1) HFI Option ARMs – 79% increase (.56% to 1.0%), $60.6 billion 2) Above + Vintages 2004-2007 – 179% increase (.33% to .92%), $47.8 billion 3) Above + CA – 312% increase (.16 to .66%), $23.7 billion 4) Above + NY/NJ/CT – 254% increase (.21 to .76%), $29.3 billion 5) Above + $351k-1mil – 460% increase (.12 to .70%), $17.2 billion 6) Above + FICO 700-739 – 1197% increase (.03% to .40%), $4.2 billion 7) Above + FICO 780+ – 1484% increase (.02% to .38%), $5.2 billion 8) Above + FICO 620-659 – 821% increase (.07 to .67%), $8.3 billion[.]”470

Essentially, the key factors identified Option ARMs that were in certain states, like California, had certain FICO scores or certain loan amounts, or were issued during the period 2004-2007.

and Mr. Ellson. Her email carried the subject line: “Some thoughts on target population for potential Option ARM MTA loan sale.” She wrote:

Later that same day, Ms. Feltgen forwarded Mr. Shaw’s email to Mr. Beck, Mr. Chen,

“David, Youyi and Rick:

My team and I look forward to receiving the loan level detail on the pools of Option ARMs we are considering for sale. I thought it might be helpful insight to see the information Bob Shaw provides below about the components of the portfolio that have been the largest contributors to delinquency in recent times. I know this is mostly an exercise about gain on sale, but we might also be able to accomplish the other purpose of reducing risk and delinquency at the same time. Talk to you soon.”471

468 A “60+ delinquency rate” applies to loans in which a payment is late by 60 days or more. 469 2/2007 WaMu internal email chain, Hearing Exhibit 4/13-40b. 470 2/20/2007 email from Robert Shaw to Cheryl Feltgen, Hearing Exhibit 4/13-41. 471 2/20/2007 email from Cheryl Feltgen to David Beck, Youyi Chen, and Richard Ellson, Hearing Exhibit 4/13-41.

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A week later, on Sunday, February 25, 2007, Mr. Beck sent an email with the subject

heading, “HFI Option Arms redirect to HFS,” to much of WaMu’s top management, including Mr. Schneider, Mr. Rotella, Mr. Casey, as well as the FDIC Examiner-In-Charge Steve Funaro, and others. The email indicated that a decision had been made to sell $3 billion in recent Option ARM loans, with as many as possible to be sold before the end of the quarter, which was four weeks away:

“David [Schneider] and I spoke today. He’s instructed me to take actions to sell all marketable Option Arms that we intend to transfer to portfolio in 1Q[first quarter], 2007.
That amounts to roughly 3B [$3 billion] option arms availab[l]e for sale. I would like to get these loans into HFS [the Hold for Sale portfolio] immediately so that [I] can sell as many as possible in Q1.

John [Drastal], we are only targeting to sell Option Arms destined for portfolio since year end at this point. I’ll need direction from you on any special accounting concerns or documentation you will need to get these loans in the warehouse without tainting the HFI [Hold for Investment] book.472

Michelle, I believe this action requires MRC [Market Risk Committee] approval. Please advise.

This week I’ll work to get the necessary governance sign offs in place. Cheryl, please direct me on what form the approval request should take and what committees should review and authorize the request. I can pull all of the data.

We continue to work with Cheryl and the credit risk team to analyze emerging credit risks in our prime portfolio and recommend actions to mitigate them.

Thanks for your help, DJB”473

Two days later, on Tuesday, February 27, 2007, Mr. Chen sent an email with the subject line, “HFI selection criteria changes,” to Michelle McCarthy, who was head of WaMu’s Market Risk Management department474 as well as chair of both its Market Risk Committee and Asset Liability Committee.475 that the implementation of the plan was underway:

The email was copied to Mr. Beck, Ms. Feltgen and others, and showed

472 Loans in a bank’s Hold for Investment portfolio receive different accounting treatment than loans in the bank’s Hold for Sale portfolio, and generally accepted accounting principles (GAAP) frown upon frequent transfers between the two portfolios. The GAAP principles were a key reason for Mr. Beck’s instruction that the transfer of the Option ARM loans from WaMu’s HFI to HFS portfolios proceed “without tainting the HFI book.” 473 2/25/2007 email from David Beck to himself, David Schneider, Steve Rotella, Ron Cathcart, Tom Casey, Cheryl Feltgen, others, Hearing Exhibit 4/13-42b.
474 12/28/2007 WaMu internal report, “Disclosure Management,” JPM_WM02414318.
475 3/9/2007 WaMu Market Risk Committee Meeting Minutes, Hearing Exhibit 4/13-43.

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“After careful review with David and the teams, David suggested me to make the following recommendations to MRC [Market Risk Committee] on the existing prime HFI/HFS selection criteria

Effective March 7th 2007, modify the portfolio option ARM and COFI ARM

retention criteria (see attached ‘existing HFI descriptions’, ‘section 1.01 to 1.11 and section 2.01 to 2.08’) to include only following loans for the portfolio (HFI)

a. Super jumbo of size greater or equal to $ 3 MM (Risk based pricing applied,

but difficult to sale)

b. Advantage 90 (high LTV loans without MI, very little production as 80/10/10

c. Foreign Nationals (Risk based pricing applied, but difficult to sale due to FICO

d. FICO less than 620, except employee loans in which case FICO can be re-

gets popularity)

problems)

stated after closing.

e. 3-4 units (excessive S & P level hit calls for portfolio execution)

Further more, we would like to request, transferring from HFI to HFS, all the MTA option ARMs and COFI ARMs, funded or locked between January 1st, 2007 to Mach [sic] 7th, 2007, and DO NOT fit the criteria listed above, and DO NOT fit the criteria section 3.02 to 4.07 in the attached ‘existing HFI descriptions’)

As a result of this change, we expected to securitize and settle about $ 2 billion more option/COFI ARMs in Q1-07 (mostly margin greater than 295), and going forward $ 1 billion per month potential incremental volume into HFS. For your information, the impact to gain on sale for the year is estimated to be about $180 MM pretax based on current market, and the impacts to 2007 portfolio NII is estimated to be about - $ 80 MM pretax.

Also included in the attachment, is a pool of $1.3 billion option/COFI ARMs funded to portfolio between January 1st and February 22nd that will be re-classified as HFS based on the above recommendations. We understand that this population of loans will be growing from now to March 7th until the portfolio selection criteria are officially modified.

We expected to start marketing the deal on March 12th, your prompt response will be greatly appreciated as the TSG [Technology Solutions Group] and QRM [Quantitative Risk Management] teams also need time to implement the coding changes.”476

476 2/27/2007 email from Youyi Chen to Michelle McCarthy, with copies to David Beck, Cheryl Feltgen, Steve Fortunato, and others, “HFI selection criteria changes,” Hearing Exhibit 4/13-42a [emphasis in original].

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This email proposed several significant changes to WaMu’s treatment of its Option

ARMs. First, WaMu decided to require most of its Option ARMs to go directly into its Hold for Sale portfolio instead of going into its Held for Investment portfolio. In light of its analysis that Option ARM loans were rapidly deteriorating, the bank no longer wanted to treat them as investments it would keep, but immediately sell them. Second, the only Option ARMs that it would automatically direct into its investment portfolio were those that the bank considered to be so obviously of poor quality that they were “non-salable,” according to another internal email.477

Third, WaMu proposed transferring all Option ARM loans originated in 2007 from the investment portfolio to the sale portfolio. Since these three changes in how WaMu would treat its Option ARMs had compliance, accounting, and tax consequences, they had to be approved by the Market Risk Committee. That Committee was composed of senior risk officers throughout the bank as well as senior managers in the bank’s finance, treasury, and portfolio management departments. The email indicated that the changes needed to be implemented within about a week so that marketing of some of the Option ARMs could begin by March 12.

proposal. The minutes of that meeting describe the changes that had been proposed:

On March 9, 2007 the Market Risk Committee met and approved the Option ARM

“- Change the Held for Investment (HFI) ARM and COFI ARM retention criteria to include only the following loans for HFI effective March 12, 2007; Super jumbo ≥ $3.0 million, Advantage 90, Foreign Nationals, FICO < 620 except employee loans in which case FICO can be re-stated after closing, and 3 to 4 units.

Increase Prime Option ARM’s (including Second Liens) from $26.0 billion to $37.0 billion.
Transfer up to $3.0 billion of saleable Option ARM and COFI ARM loans originated between January 1, 2007 and March 12, 2007 from HFI to HFS (excluding HFI loans described above).”478

The minutes also recorded an exchange between Ms. McCarthy and another Committee

member, Mr. Woods, who was the Chief Financial Officer of WaMu’s Home Loans division:

“A second part of the proposal requests approval to transfer up to $3.0 billion of saleable Option ARM and COFI ARM loans originated since January 1, 2007 from HFI to Held for Sale (HFS). In response to a question from Mr. Woods, Ms. McCarthy explained that there are other Option ARM loans not included in the criteria that we are retaining in portfolio. Ms. McCarthy noted that Ms. Feltgen ha[d] reviewed and approved this proposal. Mr. Woods noted that Deloitte has reviewed the proposal as well.”479

477 2/27/2007 email from Youyi Chen to David Griffith, “Option ARM,” JPM_WM03117796 (“David, we sell all 295+ margin and other OA and COFI, and KEEP the 4 categories going forward due mostly to non-salable reasons.”). 478 3/9/2007 WaMu Market Risk Committee Meeting Minutes, Hearing Exhibit 4/13-43. 479 Id.

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This exchange acknowledges that not all of the saleable Option ARM loans were diverted from the HFI to the HFS portfolio. WaMu chose to keep some Option ARMs and make other Option ARMs available for sale. The internal WaMu documents and communications reviewed by the Subcommittee strongly suggest that the decision to transfer the most recently originated Option ARMs from the Held-for-Investment portfolio to the Held-for-Sale portfolio was part of an effort to sell loans thought to be prone to delinquency, before they became delinquent. None of the hearing witnesses recalled how these loans were specifically selected for securitization, nor did any deny that they may have been selected for their propensity toward delinquency.480

The Subcommittee investigation determined that WaMu carried out the plan as approved, and transferred at least $1.5 billion Option ARMs originated in the first quarter of 2007, from the HFI to HFS portfolio. Of these loans, about 1,900 with a total value of a little over $1 billion were assembled into a pool and used in the WMALT 2007-OA3 securitization in March 2007.481
WMALT 2007-OA3 securities were issued with WaMu as the sole underwriter and sold to investors.482

None of the materials associated with the sale of the WMALT 2007-OA3 securities informed investors of the process used to select the delinquency-prone Option ARMs from WaMu’s investment portfolio and include them in the securitization.483 Nor did WaMu inform investors of the internal analysis it performed to identify the delinquency-prone loans. Senator Levin questioned Mr. Beck about this point at the April 13 Subcommittee hearing:

Senator Levin. When you said that investors were told of the characteristics of loans, they were told of all the characteristics of loans. Did they know, were they informed that loans with those or some of those characteristics had a greater propensity towards delinquency in WaMu’s analysis? Were they told that?

Mr. Beck. They were not told of the WaMu analysis.484

Predictably, the securitization performed badly. Approximately 87% of the securities

received AAA ratings.485 Within 9 months, by January 2008, those ratings began to be downgraded.486

As of February 2010, more than half of the loans in WMALT Series 2007-OA3

480 Mr. Schneider and Mr. Beck were asked about this matter at the hearing. See April 13, 2010 Subcommittee Hearing at 75-82. 481 4/10/2010 Subcommittee email from Brent McIntosh, Sullivan & Cromwell LLP, Counsel for JPMorgan Chase [Sealed Exhibit]. 482 3/22/2007 WaMu Prospectus Supplement, “Washington Mutual Mortgage Pass-Through Certificates, WMALT Series 2007-OA3,” at S-102, Hearing Exhibit 4/13-86b. 483 See, e.g., id. See also April 13, 2010 Subcommittee Hearing at 80. 484 April 13, 2010 Subcommittee Hearing at 82. 485 4/11/2007 “New Issue: Washington Mutual Mortgage Pass-Through Certificates WMALT Series 2007-OA3 Trust,” S&P’s Global Credit Portal, www.globalcreditportal.com. 486 See 1/14/2008 “Moody’s takes negative rating actions on certain WaMu Option Arm deals issued in 2007,” Moody’s, http://www.moodys.com/viewresearchdoc.aspx?lang=en&cy=global&docid=PR_147683.

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were delinquent, and more than a quarter were in foreclosure.487 ratings have been downgraded to junk status, and the investors have incurred substantial losses.

All of the investment grade

(4) WaMu Loan Sales to Fannie Mae and Freddie Mac

Washington Mutual had longstanding relationships with a number of government

sponsored enterprises (GSEs), including the Federal National Mortgage Association (Fannie Mae) and Federal Home Loan Mortgage Corporation (Freddie Mac).488 Between 2000 and 2008, Washington Mutual sold over $500 billion in loans to Fannie Mae and Freddie Mac, accounting for more than a quarter of every dollar in loans WaMu originated.489 While the majority of those loans involved lower risk, fixed rate mortgages, WaMu also sold Fannie and Freddie billions of dollars in higher risk Option ARMs.

Relationships with Fannie and Freddie. Fannie Mae and Freddie Mac purchase

residential mortgages that meet specified underwriting standards and fall below a specified dollar threshold, so-called “conforming loans.” They often enter into multi-year contracts with large mortgage issuers to purchase an agreed-upon volume of conforming loans at agreed-upon rates.
Prior to 2005, Washington Mutual sold most of its conforming loans to Fannie Mae, with relatively little business going to Freddie Mac.490 From at least 1999 through 2004, WaMu sold those loans to Fannie Mae through a long term “Alliance Agreement,”491 that resulted in its providing more than 85% of its conforming loans to Fannie Mae.492 In 2004, WaMu calculated that it “contributed 15% of Fannie Mae’s 2003 mortgage business,”493 and was “Fannie Mae’s 2nd largest provider of business (behind Countrywide).”494 Among the advantages that WaMu believed it gained from its relationship with Fannie Mae were help with balance sheet

487 “Select Delinquency and Loss Data for Washington Mutual Securitizations,” chart prepared by the Subcommittee, Hearing Exhibit 4/13-1g. 488 See 9/29/2005 “GSE Forum,” internal presentation prepared by WaMu, Hearing Exhibit 4/16-91 at JPM_WM02575608. As mentioned earlier, GSEs are Congressionally chartered, nongovernment owned financial institutions created for public policy purposes. At the time of the financial crisis, the GSEs included Fannie Mae, Freddie Mac, and the Federal Home Loan Bank System (FHLBS), all of which were created by Congress to strengthen the availability of capital for home mortgage financing.
489 See chart, below, using loan data from Inside Mortgage Finance. 490 See 4/12/2004 “Pre-Meeting for Fannie Mae,” internal presentation prepared by WaMu, at JPM_WM02405463, Hearing Exhibit 4/16-86 (“At current level, alternative executions, e.g., Freddie Mac, FHLB, and private investors, do not win a significant level of business.”). 491 See 4/12/2004 “Pre-Meeting for Fannie Mae,” internal presentation prepared by WaMu, at JPM_WM02405462, Hearing Exhibit 4/16-86 (chart entitled, “Timeline of the Alliance Agreement”). 492 See 4/12/2004 “Pre-Meeting for Fannie Mae,” internal presentation prepared by WaMu, at JPM_WM02405461, Hearing Exhibit 4/16-86 (“Under this Alliance Agreement with Fannie Mae, WaMu has agreed to deliver no less than 75% of eligible, conforming loans to Fannie Mae.”); 2/23/2005 email exchange between David Beck and WaMu executives, Hearing Exhibit 4/16-85 (“5 years of 85%+ share with Fannie”). 493 4/12/2004 “Pre-Meeting for Fannie Mae,” internal presentation prepared by WaMu, at JPM_WM02405459, Hearing Exhibit 4/16-86. 494 Id. at JPM_WM02405467, Subcommittee Hearing Exhibit 4/16-86.

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management, underwriting guidance, and support for WaMu’s Community Reinvestment Act initiatives.495

The following slide, created by Washington Mutual in March 2004, provides an overview

of the GSEs’ impact on the mortgage market at the time as well as the status of WaMu’s relationship with Fannie Mae in early 2004.496

495 Id. at JPM_WM02405461, Subcommittee Hearing Exhibit 4/16-86. The Community Reinvestment Act (CRA) was passed by Congress to encourage banks to make loans in low- and moderate-income neighborhoods. See website of the Federal Financial Institutions Examination Council, “Community Reinvestment Act,” http://www.ffiec.gov/cra/history.htm. Regulators, including the Office of Thrift Supervision, periodically reviewed banks’ CRA activities and took them into account if a bank applied for deposit facilities or a merger or acquisition.
Id. A 2005 presentation prepared by WaMu stated that its relationship with Freddie Mac helped the bank meet its CRA goals by purchasing more than $10 billion in qualifying loans. See 9/29/2005 “GSE Forum,” presentation prepared by WaMu Capital Markets, at JPM_WM02575611, Hearing Exhibit 4/16-91. Between 1991 and 2006, WaMu was evaluated 20 times by OTS and the FDIC, achieving the highest possible CRA rating of “Outstanding” in each evaluation. See website of the Federal Financial Institutions Examination Council, ratings search for “Washington Mutual,” http://www.ffiec.gov/craratings/default.aspx. Regulations state that an “outstanding” institution is one that not only meets the needs of its surrounding community, but utilizes “innovative or flexible lending practices.” See 12 C.F.R. 345, Appendix A, http://www.fdic.gov/regulations/laws/rules/2000- 6600.html#fdic2000appendixatopart345. 496 Id. at JPM_WM02405459, Subcommittee Hearing Exhibit 4/16-86.

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Despite Fannie Mae’s long history with WaMu, in 2005, the bank made a major change

and shifted the majority of its conforming loan business to Freddie Mac. WaMu made the change in part because its long term contract with Fannie Mae was up for renegotiation,497 and Freddie Mac offered better terms. According to WaMu, Freddie Mac had purchased $6 billion of its Option ARM loans in 2004, without a contract in place, and WaMu wanted to sell more of those loans.498 WaMu conducted detailed negotiations with both firms that lasted more than six months.499 Internally, it considered a number of issues related to switching the majority of its conforming loans to Freddie Mac.500 The deciding factor was Freddie Mac’s offer to purchase 100% of WaMu’s conforming Option ARM mortgages which were among the bank’s most profitable loans.501 Freddie, WaMu wrote:

In January 2005, in a document comparing the proposals from Fannie and

“The Freddie Mac Business Relationship [proposal] dated 12/21/2004 establishes another execution opportunity that diversifies WaMu’s execution risk and confers material financial benefits for the Option ARM product. The key to the Freddie proposal is that it provides significant liquidity for our Option ARM originations, with more advantageous credit parameters, competitive g-fees and preferred access to their balance sheet relative to our current agreement with Fannie. Fannie has made it very clear to us that we should not expect to retain the same pricing and credit parameters for Option ARMs in our 2005 pricing agreement that we have enjoyed during 2004. For fixed rate loans and hybrids, g- fe[e]s adjusted for MAP Pricing and credit parameters are roughly equivalent to the Fannie Agreement.”502

497 See 4/12/2004 “Pre-Meeting for Fannie Mae,” internal presentation prepared by WaMu, at JPM_WM02405468, Hearing Exhibit 4/16-86. 498 See, e.g., 2/23/2005 email exchange between David Beck and WaMu executives, Hearing Exhibit 4/16-85 (reporting that Freddie Mac was “very aggressive in 2004 buying 6B of option arm without a share agreement in place.”).
499 See, e.g., 4/12/2004 “Pre-Meeting for Fannie Mae,” internal presentation prepared by WaMu, Hearing Exhibit 4/16-86; 12/17/2004 email exchange among WaMu executives, “Risks/Costs to Moving GSE Share to FH [Freddie Mac],” JPM_WM05501399, Hearing Exhibit 4/16-88; 1/5/2005 “Business Relationship Proposal Issues,” document prepared by WaMu, Hearing Exhibit 4/16-90 (describing multiple issues negotiated with both firms); 2/23/2005 email exchange between David Beck and WaMu executives, Hearing Exhibit 4/16-85 (David Beck wrote:
“Fannie negotiated hard for our business especially in the 11th hour.” CEO Killinger responded: “Good work David. It appears we got a good economic outcome and haven’t burnt any bridges for the future.”).
500 See 12/17/2004 email exchange among WaMu executives, “Risks/Costs to Moving GSE Share to FH [Freddie Mac],” at JPM_WM05501401, Hearing Exhibit 4/16-88 (listing multiple issues including whether Fannie Mae would “be less supportative [sic] of using their balance sheet to support our quarter-end liquidity needs”). 501 Id. at JPM_WM05501399 (describing Fannie Mae’s offer to purchase two-thirds of WaMu’s Option ARM production); 2/23/2005 email exchange between David Beck and WaMu executives, Hearing Exhibit 4/16-85 (“I reviewed the most recent proposals from Freddie and Fannie today with Steve. We agreed that the Freddie 65% minimum share (100% of option arms) proposal offers us between 26MM and 37MM of benefit depending on volume … 39% of our 2005 home loans gain on sale comes from conforming option arm sales. FH [Freddie Mac] stepped up with 21B of committed balance sheet and aggressive forward pricing for OA [Option ARMs] that result in the financial benefit over FN [Fannie Mae].”). WaMu originated both conforming and nonconforming Option ARMs, depending upon whether the loan exceeded the GSEs’ dollar limit for the loans they would purchase.
502 1/5/2005 “Business Relationship Proposal Issues,” document prepared by WaMu, Hearing Exhibit 4/16-90.

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In April 2004, at the conclusion of its negotiations with Fannie and Freddie, WaMu entered into a one-year contract with Freddie Mac, switching the lion’s share of the bank’s conforming loans to that company and away from Fannie Mae.503 According to WaMu, Freddie Mac’s share of its conforming loans “went from 20% in Q1 [first quarter of 2005] to 81% in Q2 [second quarter of 2005].”504 WaMu reported internally that, as a result of the new contract, it became the second largest seller of mortgages to Freddie Mac behind Wells Fargo, and that “[f]orty percent of FRE’s [Freddie Mac’s] portfolio growth in ’05 can be attributed to WM’s $8 billion sale of option ARMS.”505

As the 2005 contract’s expiration date neared, WaMu developed a list of issues to be

negotiated with Freddie Mac for a new contract, noting that Freddie Mac “does not want to be a ‘one-year’ wonder.”506 WaMu also observed that “FRE is not likely to outbid FNM by such a wide margin on option ARMS like in the current contract.”507 relationship” with Freddie Mac, WaMu indicated, among other issues, that it would press Freddie Mac to buy more subprime and “lower quality loans”:

In a list of “asks … to cement our

 “Credit …

 Non-prime

• WM [WaMu] wants FRE [Freddie Mac] to expand the eligibility of lower

quality loans to ensure WM is ‘market competitive’. …

• Potential securitization of SMF [Specialty Mortgage Finance] assets ($1.5 - $10 bil) that will create liquidity for WM and create a positive affordability profile for FRE;

• Expansion of credit profile into subprime; (Keith Johnson wants to keep this

point very general); …

 Liquidity – we want to understand how we can best help the FRE portfolio

w/Product.

• Longer term portfolio commitment on option ARMS; • Broader deliverability guidelines w/respect to option ARMs.”508

WaMu wrote that it also expected Freddie Mac to discuss trends related to accepting “lower documentation standards.”509

In April 2006, WaMu signed a new, two-year contract with Freddie Mac, again agreeing WaMu President Steve Rotella

to sell the majority of its conforming loans to that company.510

503 See 7/5/2006 “Freddie Mac – WaMu Meeting,” document prepared by WaMu, JPM_WM03200453, Hearing Exhibit 4/16-87 (“WM executed a majority share arrangement w/FRE [Freddie Mac], effective 4/1/05 thru 3/31/06; included in that arrangement was a market-leading opportunity to sell up to $21 billion of option ARMs to the FRE portfolio.”). 504 Id.
505 Id.
506 Id.
507 Id.
508 Id. [italics in original omitted]. 509 Id. at JPM_WM03200454.

wrote: “Congratulations to the team for getting this done and with terrific results for the company.”511 In a document describing the “highlights” of the new agreement, a Wamu employee wrote:

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“Aligns WM with the stronger GSE over the next 12-18 months; we fully expect once FNM [Fannie Mae] gets its financial house in order to become a very aggressive competitor – just when this contract is coming up for renewal.”512

WaMu’s reference to the “stronger GSE” was in response to accounting scandals that, over the prior year, had weakened both Freddie Mac and Fannie Mae. In 2003, Freddie Mac announced that it had misstated its earnings by at least $4.5 billion, mostly by under-reporting its earnings in order to smooth the volatility of its quarterly earnings reports, and would be restating its earnings for the prior three years. fine to settle civil charges of accounting fraud brought by its regulator, the Office of Federal Housing Enterprise Oversight (OFHEO).514 In September 2004, OFEHO issued a report finding that Fannie Mae had also violated accounting rules to smooth its earnings reports.515 Fannie Mae later filed a $6.3 billion restatement of earnings and paid a $400 million fine.516 Both GSEs also changed their senior management.

513 Later that year, Freddie Mac paid a $125 million civil

When asked at the Subcommittee hearing to define Washington Mutual’s relationship

with Fannie Mae and Freddie Mac, Mr. Rotella provided the following response:

“Well, like all big mortgage lenders, Senator, Fannie Mae and Freddie Mac were important …. [T]here was a substantial amount of production that was sold off to either Fannie or Freddie. … [A]ny mortgage lender that is in the mortgage business, given the government advantages and the duopoly that Fannie and Freddie had, needed to do business with them. It would be very difficult to be a mortgage player without them.”517

510 See 4/28/2006 email exchange between WaMu executives, JPM_WM02521921, Hearing Exhibit 4/16-89 (celebrating contract that “David Schneider signed today”). 511 Id. 512 Id. 513 See “Freddie Mac Raises its Estimate of Errors,” Associated Press (9/26/2003). 514 See “Freddie to Settle with Fat Civil Fine,” Associated Press (12/11/2003). In 2007, Freddie Mac paid an additional $50 million civil fine to the SEC to settle civil charges of securities fraud, without admitting or denying wrongdoing. “Freddie Mac to Pay $50 million,” Associated Press (9/28/2007). 515 9/17/2004 Office of Federal Housing Enterprise Oversight Report of Findings to Date, “Special Examination of Fannie Mae,” available at http://www.fhfa.gov/Preview- FHFAWWW/webfiles/748/FNMfindingstodate17sept04.pdf. 516 See 2004 10-K filing with the SEC. Fannie Mae paid the $400 million civil fine in May 2006, to settle accounting fraud charges brought by OFHEO and SEC. See also “Fannie Settles Fraud Charges,” National Mortgage News (5/29/2006).
517 April 13, 2010 Subcommittee Hearing at 105, Senator Coburn question to Mr. Rotella.

Loan Sales to Fannie and Freddie. During the years examined by the Subcommittee,

WaMu sold a variety of loans to both Fannie Mae and Freddie Mac, including 15, 20, and 30- year fixed rate mortgages; Option ARMs; interest-only ARMs; and hybrid ARMs.518

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A September 2005 chart prepared by WaMu, identifying the loans it sold to Fannie Mae

and Freddie Mac during the first part of that year, details the types and volumes of loans involved.519 The chart showed, for example, that the largest category of loans that WaMu sold to Fannie and Freddie at that point in 2005 was fixed rate loans, which together totaled nearly 140,000 loans with a collective, total loan amount of about $24.3 billion.520 The next largest category of loans was Option ARMs, which WaMu sold only to Freddie Mac and which consisted of 35,421 loans with a total loan amount of about $7.9 billion.521 The third largest category was interest-only ARMs, totaling about 8,400 loans with a total loan amount of about $2 billion.522 The fourth largest category was hybrid ARMs, totaling 6,500 loans with a total loan amount of about $1.4 billion.523 WaMu also sold other loans to Fannie and Freddie which included 6,020 loans of various types bearing a total loan amount of about $2 billion.524

The chart showed that, altogether by September 2005, WaMu had sold Fannie and

Freddie about 196,000 loans with a total loan amount of $36.5 billion.525 About 70% were fixed rate loans;526 about 20% were Option ARMs;527 and other types of loans made up the final 10%.
In addition to those single family mortgages, WaMu had an active business with Fannie and Freddie regarding loans related to multifamily apartment buildings.528 The 2005 loan data indicates that WaMu sold twice as many loans to Fannie and Freddie as it did to all other buyers combined.529 Most of those loans were fixed rate mortgages, but they also included the higher

518 See 9/29/2005 “GSE Forum,” internal presentation prepared by WaMu, at JPM_WM02575611, Hearing Exhibit 4/16-91 (chart entitled, “WaMu’s Deliveries – Contract to Date 2005”). For more information on these types of loans, see Chapter II, above. WaMu did not sell loans directly to Ginnie Mae which, instead, guaranteed certain government backed mortgages when they were securitized by one of its approved securitizers. The WaMu chart showed that, in 2005, WaMu originated 35,291 loans with a total loan amount of about $4.6 billion that were securitized with Ginnie Mae guarantees. Id. 519 Id. 520 Id. The WaMu chart showed that WaMu sold 31,460 fixed rate loans with a total loan amount of about $5.2 billion to Fannie Mae, and 108,246 loans with a total loan amount of about $19.1 billion to Freddie Mac. 521 Id.
522 Id. The WaMu chart showed that WaMu sold 5,350 interest-only ARMs with a total loan amount of about $1.3 billion to Fannie Mae, and 3,016 interest-only ARMs with a total loan amount of $724 million to Freddie Mac.
523 Id. The WaMu chart showed that WaMu sold 3,250 hybrid ARMs with with a total loan amount of nearly $700 million to Fannie Mae, and 3,303 hybrid ARMs with a total loan amount of nearly $700 million to Freddie Mac. 524 Id. See chart for more detail. 525 Id. The chart showed that, altogether, WaMu sold about 45,000 loans with a total loan amount of $7.9 billion to Fannie Mae and 151,000 loans with a total loan amount of about $28.6 billion to Freddie Mac.
526 By loan number, the percentage is 71%; by loan amount, the percentage is 67%. 527 By loan number, the percentage is 18%; by loan amount, the percentage is 22%. 528 See, e.g., 4/12/2004 “Pre-Meeting for Fannie Mae,” internal presentation prepared by WaMu, at JPM_WM02405461, JPM_WM02405467, Hearing Exhibit 4/16-86 (chart entitled, “Overview of the Alliance,” and “WaMu was responsible for 34.7% of Fannie Mae’s Multifamily business”). 529 See 9/29/2005 “GSE Forum,” internal presentation prepared by WaMu, at JPM_WM02575611, Hearing Exhibit 4/16-91 (chart entitled, “WaMu’s Deliveries – Contract to Date 2005”). During the same time period in 2005, WaMu sold about 99,000 loans with a total loan amount of about $35 billion to buyers other than Fannie and

2000 2001 2002 2003 2004 2005 2006 2007 2008

(in billions) $ 0 $ 1.4 $ 0.2 $ 2.2 $ 1.1 $ 34.6 $ 32.3 $ 31.8 $ 20.8 $ 124.4 Source: Inside Mortgage Finance

TOTAL

Percent of Total WaMu Originations Sold to GSEs

14% 20% 29% 40% 10% 20% 23% 29% 70% 27.3%

$ 7.1 $ 35.3 $ 95.7 $ 174.3 $ 25.9 $ 20.3 $ 11.2 $ 8.2 $ 2.1 $ 380.1

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risk Option ARMs. In 2005, for example, WaMu sold three times as many Option ARMs to Freddie Mac than to all of its other buyers combined.530

The amount and variety of the loans that WaMu sold to the GSEs fluctuated over time.

For example, the following chart, which is taken from data compiled by Inside Mortgage Finance, presents the total dollar volume of loans sold by WaMu to Fannie and Freddie from 2000 until 2008 when WaMu was sold, as well as the percentage those loans represented compared to WaMu’s total loan originations.531

Year

Sold to Freddie Mac

Sold to Fannie Mae

(in billions)

The data indicates that, in total, WaMu sold more than half a trillion dollars in loans to the two GSEs in the nine years leading up to the bank’s collapse, accounting for more than a quarter of all of the loans WaMu originated.

The documents obtained by the Subcommittee indicate that, from 2004 to 2008, Fannie Mae and Freddie Mac competed to purchase billions of dollars in WaMu’s residential mortgage loans, and WaMu used that competition to negotiate better terms for its loan sales. Twice during that period, WaMu successfully played one GSE off the other to sell more high risk Option ARM loans under better terms to Freddie Mac.

Freddie. The two largest categories of loans sold to buyers other than Fannie or Freddie were jumbo loans (43,758 loans with a total loan amount of $26.9 billion) and government backed loans in securities guaranteed by Ginnie Mae (35,291 loans with a total loan amount of $4.6 billion). Id.
530 Id. The chart indicates that WaMu sold over 17,000 loans with a total loan amount of nearly $4 billion to Freddie Mac, but only 5,841 Option ARMs with a total loan amount of $1.2 billion to all other buyers. It is possible, however, that the data on Option ARMs sold to other buyers is understated if some portion of the loans categorized on the chart as “jumbo” loans were, in fact, also Option ARMs. See, e.g., Id. at JPM_WM02575611, Hearing Exhibit 4/16-91 (interpretive note below chart); 8/2006 WaMu chart entitled, “WaMu Originations Product Mix,” at JPM_WM00212644, Hearing Exhibit 4/13-37 (showing that WaMu used Option ARMs in both conforming and jumbo loans). In addition to selling Option ARMs to Freddie Mac and others, WaMu kept a portion of the Option ARMs it originated in its investment portfolio and securitized still others. 531 “Historical Data from Inside Mortgage Finance, Inside Mortgage Finance, www.imfpubs.com/data.

F. Destructive Compensation Practices

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Washington Mutual and Long Beach’s compensation practices contributed to and

deepened its high risk lending practices. Loan officers and processors were paid primarily on volume, not primarily on the quality of their loans, and were paid more for issuing higher risk loans. Loan officers and mortgage brokers were also paid more when they got borrowers to pay higher interest rates, even if the borrower qualified for a lower rate – a practice that enriched WaMu in the short term, but made defaults more likely down the road. Troubling compensation practices went right to the top. In 2008, when he was asked to leave the bank that failed under his management, CEO Kerry Killinger received a severance payment of $15 million.532

(1) Sales Culture

WaMu’s compensation policies were rooted in the bank culture that put loan sales ahead

of loan quality. As early as 2004, OTS expressed concern about WaMu’s sales culture: “The overt causes for past underwriting concerns were many, but included: (1) A sales culture focused heavily on market share via loan production, (2) extremely high lending volumes.”533 In early 2005, WaMu’s Chief Credit Officer complained to Mr. Rotella that: “[a]ny attempts to enforce [a] more disciplined underwriting approach were continuously thwarted by an aggressive, and often times abusive group of Sales employees within the organization.”534 The aggressiveness of the sales team toward underwriters was, in his words, “infectious and dangerous.”535

In late 2006, as home mortgage delinquency rates began to accelerate and threaten the

viability of WaMu’s High Risk Lending Strategy, Home Loans President David Schneider presided over a “town hall” meeting to rally thousands of Seattle based employees of the WaMu Home Loans Group.536 At the meeting, Mr. Schneider made a presentation, not just to WaMu’s sales force, but also to the thousands of risk management, finance, and technology staff in

532 See “Washington Mutual CEO Kerry Killinger: $100 Million in Compensation, 2003-2008,” chart prepared by the Subcommittee, Hearing Exhibit 4/13-1h. 533 5/12/2004 OTS Safety & Soundness Examination Memo 5, “SFR Loan Origination Quality,” at 1, Hearing Exhibit 4/16-17. 534 Undated draft WaMu memorandum, “Historical Perspective HL – Underwriting: Providing a Context for Current Conditions, and Future Opportunities,” JPM_WM00783315 (a legal pleading states this draft memorandum was prepared for Mr. Rotella by WaMu’s Chief Credit Officer in or about February or March 2005; FDIC v. Killinger, Case No. 2:2011cv00459 (W.D. Wash.), Complaint (March 16, 2011), at ¶ 35). 535 Undated draft WaMu memorandum, “Historical Perspective HL – Underwriting: Providing a Context for Current Conditions, and Future Opportunities,” JPM_WM00783315, at JPM_WM00783322. 536 Mr. Schneider told the Subcommittee that this meeting was held in early 2007, but Ms. Feltgen’s end of 2006 email to her staff quotes Mr. Schneider’s language from this presentation. 1/3/2007 email from Ron Cathcart to Cheryl Feltgen, Hearing Exhibit 4/13-73.

attendance.537 The title and theme of his presentation was: “Be Bold.”538 One slide demonstrates the importance and pervasiveness of the sales culture at WaMu:539

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When asked about this presentation, Mr. Schneider told the Subcommittee it was an appropriate message, even for WaMu’s risk managers.540

The sales culture was also promoted through WaMu’s “President’s Club,” which

sponsored an annual all-expense-paid gala and retreat in an exotic locale, such as Hawaii or the Bahamas, where the top producing loan officers were feted and lavished with gifts and plaudits.541 Only a limited number of top producing loan officers were made members of the club, and the President’s Club trips were used to incentivize sales volume. Loan officers were encouraged to look up their sales rankings on the company’s intranet to see if they would qualify for a trip.

In November 2006, as subprime mortgages began to incur delinquencies, Mr. Schneider sent a letter about the President’s Club to WaMu loan consultants. Under a photo of the Grand Hyatt Kauai in Hawaii and the banner headline, “President’s Club – Take the Lead!,” Mr. Schneider wrote:

537 Subcommittee interview of David Schneider (2/17/2010). 538 “Way2Go, Be Bold!,” WaMu presentation prepared by David Schneider, Home Loans President, at 28, Hearing Exhibit 4/13-4. 539 Id. at 30 [recreated by the Subcommittee staff from an image]. 540 Subcommittee interview of David Schneider (2/17/2010). 541 Subcommittee interviews of Brian Minkow (2/16/2010), David Schneider (2/17/2010), and Kerry Killinger (2/5/2010).

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“I attended WaMu’s President’s Club last year for the first time and had an awesome time getting to know the stars of our sales force. You work hard, but you know how to have a good time too ….

“At the first-class awards dinner, I looked around the room and felt honored to be with so many talented people. Congratulations to those of you who were repeat President’s Club honorees. Of those of you who have not yet reached the President’s Club, I want each and every one of you to believe you have the potential to achieve this great reward. “Now is the time to really kick it into high gear and drive for attending this awesome event! Rankings are updated and posted monthly on the DashBoards (under reports) and on WaMu.net: President’s Club Rankings. Where do you rank? What can you do to take your business [to] the next level? Your management team is here to help.”542

At the April 13 Subcommittee hearing, Mr. Schneider testified:

“As housing prices peaked, the economy softened, and credit markets tightened, WaMu adopted increasingly conservative credit policies and moved away from loan products with greater credit risk. … During my time at WaMu, we reduced and then entirely stopped making Alt A loans and Option ARM loans.”543

However, his November 2006 letter to WaMu loan consultants showed no reticence about the High Risk Lending Strategy. The letter went on to say:

“As you know, growth is a key area of focus for WaMu and Home Loans. I am extremely proud of the achievements in Production so far this year – and I know it’s been tough. I’m especially pleased with your ability to change with the market and responsibly sell more higher-margin products – Option ARM, Home Equity, Non-prime, and Alt A. I also know that you – truly the best sales team in the industry – are up to the challenge of doing even more by year end. …

“I hope to see you in Kauai!”544

The 2005 President’s Club retreat had taken place in Maui. The awards night was hosted

by Magic Johnson. An excerpt of the script from the evening gives a sense of the proceedings:

“VOICE-OVER ANNOUNCER

Good evening ladies and gentleman and welcome to your President’s Club 2005 Awards Night program!

Please welcome the host of President’s Club, the President of the Washington Mutual Home Loans Group, Mr. David Schneider!

542 11/2006 “President’s Club - Take the Lead!,” WaMu Home Loans flier, Hearing Exhibit 4/13-62. 543 Prepared statement of David Schneider, April 13, 2010 Subcommittee Hearing. 544 11/2006 “President’s Club - Take the Lead!,” WaMu Home Loans flier, Hearing Exhibit 4/13-62.

WALK-UP MUSIC FOR DAVID SCHNEIDER

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DAVID SCHNEIDER

Thank you ladies and gentlemen, and welcome to this very special Awards Evening.

Wow, could you feel the energy and excitement tonight out on the Red Carpet?!
Talk about star power!

And it was great fun to learn so much more about some of you during the interviews … and at the bar.

But don’t worry. I’m told that the age-old tradition here at Washington Mutual is, ‘What happens at President’s Club stays at President’s Club.’ And who am I to mess with tradition?

Tonight we are gathered together to pay the highest respects and honors to those who deserve them the most, the President’s Club Class of 2005. …

And of course I want to pay special homage to all of you astonishing returning champions of President’s Club. You multiple award-winning superstars clearly lead our entire industry as the standard others can only attempt to match. You folks really do make this feel like the academy awards tonight because everywhere I turn I see another star of another box office sensation.”545

This 2005 awards ceremony was attended by WaMu loan officers Luis Fragoso and Thomas Ramirez at the same time they were under investigation for fraud. Both were members of the President’s Club in 2005 and 2006.

When asked about the sales culture at the bank, Mr. Vanasek testified at the hearing that he tried in vain to counter it. He recalled one occasion at an annual management retreat in 2004, in which the bank was promoting a new advertising slogan called, “The Power of Yes”:

“I stood in front of thousands of senior Washington Mutual managers and executives in an annual management retreat in 2004 and countered the senior executive ahead of me on the program who was rallying the troops with the company’s advertising line, ‘The power of yes.’ The implication of that statement was that Washington Mutual would find some way to make a loan. The tag line symbolized the management attitude about mortgage lending more clearly than anything I can tell you.

545 2005 “President’s Club 2005 - Maui, Awards Night Show Script,” Washington Mutual Home Loans Group, Hearing Exhibit 4/13-63a.

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“Because I believed this sent the wrong message to the loan originators, I felt compelled to counter the prior speaker by saying to the thousands present that the power of yes absolutely needed to be balanced by the wisdom of no. This was highly unusual for a member of the management team to do, especially in such a forum. In fact, it was so far out of the norm for meetings of this type that many considered my statement exceedingly risky from a career perspective.”546

The President’s Club annual trip was the pinnacle of WaMu awards to its top producing

loan consultants. One loan consultant interviewed by the Subcommittee described it as an incredible experience, with first class airfare, daily gifts, lavish food, and top entertainment for both employees and their spouses.547 including Mr. Killinger, Mr. Rotella, and Mr. Schneider. It sent a powerful message about the priority that WaMu placed on loan volume and sales of higher risk loans.

It was also an opportunity to meet WaMu’s top executives,

(2) Paying for Speed and Volume

The Long Beach and Washington Mutual compensation systems encouraged high volumes of risky loans but provided little or no incentive to ensure high quality loans that complied with the bank’s credit requirements. WaMu loan officers or their sales associates typically interacted directly with customers interested in obtaining loans. Some also were allowed to accept loans brought to them by third party lenders or mortgage brokers. Long Beach account executives dealt only with third party lenders or mortgage brokers; they did not deal directly with customers. After reaching agreement on a loan, the WaMu or Long Beach loan officers or executives completed the loan application and sent it to a loan processing center where the application was reviewed by an underwriter and, if approved, underwent further processing and brought to a loan closing.

Long Beach and Washington Mutual loan officers received more money per loan for

originating higher risk loans and for exceeding established loan targets. Loan processing personnel were compensated according to the speed and number of the loans they processed.
Loan officers and their sales associates received still more compensation if they charged borrowers higher interest rates or points than required in bank rate sheets specifying loan prices, or included prepayment penalties in the loan agreements. That added compensation created incentives to increase loan profitability, but not loan quality. A 2008 OTS review elaborated:

“[T]he review defines an origination culture focused more heavily on production volume rather than quality. An example of this was a finding that production personnel were allowed to participate in aspects of the income, employment, or asset verification process, a clear conflict of interest. … Prior OTS examinations have raised similar issues

546 April 13, 2010 Subcommittee Hearing at 16-17. 547 Subcommittee interview of Brian Minkow (2/16/2010).

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Despite the years of internal and external audits that found a lack of internal controls at

including the need to implement incentive compensation programs to place greater emphasis on loan quality.”548

(a) Long Beach Account Executives

Long Beach that led to some of the worst rates of loan delinquency in the subprime industry, Long Beach continued to incentivize production volume over sound lending. The Subcommittee obtained a presentation of the Long Beach 2004 Incentive Plan.549 The plan outlines four compensation tiers based on volume, creating a system where the largest producers not only make more money by issuing more loans, but rather, as producers climb more of the tiers, they earn a higher rate of commission as well. Tier 1 Long Beach account executives, those who closed 1-6 loans or funded up to $899,000 in loans per month, received 40 basis points (bps) commission for each broker sourced loan.550 Tier 2 Long Beach account executives, those who closed 7-12 loans or funded between $900,000 and $2,499,999 in loans per month, received 50 bps commission for each broker sourced loan plus $30 per loan in additional compensation. Tier 3 Long Beach account executives, those who closed 13-26 loans or funded between $2,500,000 and $4,999,999 in loans per month, received 55 bps commission for each broker sourced loan plus $30 additional per loan. Tier 4 Long Beach account executives, those who closed more than 26 loans or funded more than $5,000,000 in loans per month, received 60 bps commission for each broker sourced loan.551

called, “Long Term Cash Incentive Program,” which provided bonuses tied to the performance of WaMu stock and could be converted to cash over a three-year period. Top producing Long Beach account executives received the Long Term Cash Incentive bonus calculated as a small percentage of overall volume. Like the tier system, as volume increased so did the percentage used to calculate the bonus. Account executives ranked in the top 25% in volume received a five bps bonus on their total production, account executives in the top 15% received a 7.5 bps bonus, and account executives in the top 5% received a 10 bps bonus. These bonuses could add up to tens of thousands, if not hundreds of thousands of dollars.552

In addition, in 2004, the top 40 Long Beach account executives were rewarded with a trip to the President’s Club. Long Beach used a point system to calculate the top account executives for this purpose. Three points were awarded for each loan funded for first mortgages, two points

548 6/19/2008 OTS Findings Memorandum, “Loan Fraud Investigation,” JPM_WM02448184, Hearing Exhibit 4/13-

549 Documents regarding Long Beach compensation, Hearing Exhibit 4/13-59a. 550 Id. The “units” referred to in the document are “loans.” Subcommittee interview of Brian Minkow (2/16/2010).
By awarding “basis points” the compensation system ensured that the account executives got a percentage of the loan amounts that they successfully issued after receiving loan information from a broker, incentivizing them to maximize the dollar amount of the loans they issued. Some were also paid a per loan fee, incentivizing them to sell as many loans as possible. 551 Id. 552 Id.

The 2004 Long Beach Incentive Plan also introduced a contingent compensation program

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were awarded for each purchase loan funded (as opposed to a refinance), and two points were awarded for each $100,000 funded. The point system created a competition that focused primarily on volume. The 2004 incentive plan makes no reference to loan quality.553

Long Beach regularly made changes to the compensation plan, but the basic volume incentives remained. In the 2007 incentive plan, which took effect after the collapse of the subprime market, the volume requirements were even greater than 2004 requirements. In 2007, the Tier 1 represented 1-9 qualified loans and up to $1,499,999 funded; Tier 2 was 10-13 qualified loans and between $1,500,000 and $2,399,000 funded; Tier 3 was 14-35 qualified loans and between $2,400,000 and $5,999,999 funded; Tier 4 was 36 or more loans and $6,000,000 or more funded.554

(b) WaMu Loan Consultants

Like Long Beach, at WaMu loan officers were compensated for the volume of loans

closed and loan processors were compensated for speed of loan closing rather than a more balanced scorecard of timeliness and loan quality. According to the findings and recommendations from an April 2008 internal investigation into allegations of loan fraud at WaMu:

“A design weakness here is that the loan consultants are allowed to communicate minimal loan requirements and obtain various verification documents from the borrower that [are] need[ed] to prove income, employment and assets. Since the loan consultant is also more intimately familiar with our documentation requirements and approval criteria, the temptation to advise the borrower on means and methods to game the system may occur. Our compensation and reward structure is heavily tilted for these employees toward production of closed loans.”555

An undated presentation obtained by the Subcommittee entitled, “Home Loans Product

Strategy, Strategy and Business Initiatives Update,” outlines WaMu’s 2007 Home Loans Strategy and shows the decisive role that compensation played, while providing still more evidence of WaMu’s efforts to execute its High Risk Lending Strategy:

“2007 Product Strategy Product strategy designed to drive profitability and growth

-Driving growth in higher margin products (Option ARM, Alt A, Home Equity, Subprime) …

553 Id.
554 Documents regarding Long Beach compensation, Hearing Exhibit 4/13-59b. 555 4/4/2008 WaMu Memorandum of Results, “AIG/UG and OTS Allegation of Loan Frauds Originated by [name redacted],” at 11, Hearing Exhibit 4/13-24.

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-Recruit and leverage seasoned Option ARM sales force, refresh existing training including top performer peer guidance

-Maintain a compensation structure that supports the high margin product strategy”556

In order to promote high risk, high margin products, WaMu paid its loan consultants

The presentation goes on to explain the Retail Loan Consultant incentive plan: “Incentive Tiers reward high margin products … such as the Option ARM, Non-Prime referrals and Home Equity Loans …. WaMu also provides a 15 bps ‘kicker’ for selling 3 year prepayment penalties.”557

more to sell them. WaMu divided its products into four categories: “W,” “A,” “M,” and “U.”
WaMu paid the highest commissions for “W” category products, and in general, commissions decreased though the other categories. “W” products included new Option ARMs, “Non-prime” referrals, and home equity loans. “A” products included Option ARM refinancings, new hybrid ARMs, new Alt A loans, and new fixed rate loans. Like Long Beach, WaMu also created four compensation tiers with increasing commissions based on volume. The tiers were called: “Bronze,” “Silver,” “Gold,” and “Platinum.”558 continued to incentivize volume and high risk mortgage products.

Even in 2007, WaMu’s compensation plan

In 2007, WaMu also adopted a plan to pay “overages,” essentially a payment to loan officers who managed to sell mortgages to clients with higher rates of interest than the clients qualified for or were called for in WaMu’s daily rate sheets. The plan stated:

“Overages … [give a] Loan Consultant [the] [a]bility to increase compensation [and] [e]nhance compensation/incentive for Sales Management …. Major national competitors have a similar plan in place in the market. ”559

Under the 2007 plan, if a loan officer sold a loan that charged a higher rate of interest than WaMu would have accepted according to its rate sheet, WaMu would split the additional profit with the loan officer.560 This compensation practice, often referred to as awarding “yield spread premiums,” has been barred by the Dodd-Frank Act implementing financial reforms.561

556 2007 WaMu Home Loans Product Strategy, “Strategy and Business Initiatives Update,” JPM_WM03097217, Hearing Exhibit 4/13-60a [emphasis in original]. 557 Id. 558 Id. 559 12/6/2006 WaMu Home Loan Credit Risk F2F, JPM_WM02583396-98, Hearing Exhibit 4/13-60b (The proposal to pay overages, adopted in 2007, increased compensation for loan officers who sold loans with a higher interest rate or more points than required on WaMu’s daily rate sheet.) 560 Subcommittee interview of David Schneider (2/17/2010). 561 Section 1403 of the Dodd-Frank Act (prohibiting “steering incentives”).

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At Long Beach and WaMu, volume incentives were not limited to the sales people. Back

office loan processors and quality control personnel were also compensated for volume. While WaMu executives and senior managers told the Subcommittee that quality control was emphasized and considered as part of employee compensation, the back office staff said otherwise.562 Diane Kosch worked as a Quality Assurance Controller in a Long Beach Loan Fulfillment Center (LFC) in Dublin, California, east of San Francisco Bay. She told the Subcommittee that the pressure to keep up with the loan volume was enormous. Each month the LFC would set volume goals, measured in dollar value and the number of loans funded. At the end of each month the pressure to meet those goals intensified. Ms. Kosch said that at month’s end, she sometimes worked from 6 a.m. until midnight reviewing loan files. Monthly rallies were held, and prizes were awarded to the underwriters and loan processors who had funded the most loans.563

September 2004 email sent to all Dublin LFC employees with the subject line, “Daily Productivity – Dublin,” by the area manager uses creative formatting to express enthusiasm:

Documents obtained by the Subcommittee confirm Ms. Kosch’s recollections. A

“Less than 1 week and we have a long way to go to hit our 440M!
including today, we have 4 days of fundings to end the Quarter with a bang! With all the new UW changes, we will be swamped next month, so don’t hold any back!

4 days…..it’s time for the mad dash to the finish line! Who is in the running……

Loan Set Up – Phuong is pulling away with another 18 files set up yesterday for 275 MTD! 2nd place is held by Jean with 243…can you catch Phuong? Get ready Set Up – come October, it’s going to get a little crazy!

Underwriting – Michelle did it! She broke the 200 mark with 4 days left to go! Nice job Michelle! 2nd place is held by Andre with 176 for the month! Way to go Andre! Four other UW’s had solid performances for the day as well including Mikhail with 15! Jason and Chioke with 11 and June with 10 – The double digit club!”564

562 Subcommittee interview of Mark Brown (2/19/2010). Mr. Brown, WaMu National Underwriting Director, told the Subcommittee that incentives for loan processors were based on quality standards and monthly volume. 563 Subcommittee interview of Diane Kosch (2/18/2010). 564 9/2004 Long Beach processing center internal email, Hearing Exhibit 4/13-61. In the email, “UW” stands for Underwriting or Underwriter, and “SLC” stands for Senior Loan Coordinator.

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Ms. Kosch told the Subcommittee that from late 2005 until early 2007, loan volume

increased and loan quality remained very poor. She said that just about every loan she reviewed was a stated income loan, sloppy, or appeared potentially fraudulent. Yet she was not given the resources or support to properly review each loan. Ms. Kosch said that she was told by a Quality Control manager that she should spend 15 minutes on each file, which she felt was insufficient.
Yet, because Quality Assurance Controllers received a bonus on the basis of the number of loans they reviewed, she said some of her colleagues spent only ten minutes on each file.565

Ms. Kosch found that often, when she tried to stop the approval of a loan that did not meet quality standards, it would be referred to management and approved anyway. She said good Quality Assurance Controllers were treated like “black sheep,” and hated because they got in the way of volume bonuses. She said certain brokers were identified as “elite,” and the Dublin LFC employees were told to, “take care of them.” Ms. Kosch even suspected some underwriters were getting kickbacks, in part, because of the clothes they wore and cars they drove, which she believed would have been unaffordable to even the top back office employees. She reported her suspicions to her supervisor, but she was not aware of any action taken as a result.

As it turns out, Ms. Kosch’s concerns about fraud were not unfounded. The September 2004 Daily Productivity email also lauds the work of a Senior Loan Coordinator (SLC) named John Ngo:

“SLC – This one is still tight with Sandy holding on to the first place slot! Sandy funded 4 more on Friday for a MTD total of 46! 2nd place is John Ngo with 4 fundings on Friday and 44 MTD – only 2 back!”

About a year after this email was sent, the FBI began to question Mr. Ngo about a scheme to buy houses in Stockton, California with fake documents and stolen identities. According to court records, the FBI had uncovered documents that showed Mr. Ngo had received more than $100,000 in payments from a mortgage broker, allegedly bribes to approve bad loans. Mr. Ngo’s estranged wife told the FBI that she didn’t know how he could afford their $1.4 million home for which he made a down payment of $350,000. At the time, his salary at Long Beach was $54,000. 566

Mr. Ngo later pled guilty to perjury and agreed to testify against his Long Beach sales associate, Joel Blanford. Long Beach paid Mr. Blanford more than $1 million in commissions each year from 2003-2005. According to the Department of Justice:

“NGO admitted in his plea agreement that most of the payments were to ensure that fraudulent loan applications were processed and funded. NGO also admitted he received payments from Long Beach Mortgage sales representatives to push applications through the funding process. He knew many of these applications were fraudulent, and he and

565 Subcommittee interview of Diane Kosch (2/18/2010). 566 “At Top Subprime Mortgage Lender, Policies Were an Invitation to Fraud,” Huffington Post Investigative Fund (12/21/2009), http://www.huffingtonpost.com/2009/12/21/at-long-beach-mortgage-a_n_399295.html.

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others took steps to ‘fix’ applications by creating false documents or adding false information to the applications or the loan file.”567

(3) WaMu Executive Compensation

Questionable compensation practices did not stop in the loan offices, but went all the way to the top of the company. WaMu’s CEO received millions of dollars in pay, even when his high risk loan strategy began unraveling, even when the bank began to falter, and even when he was asked to leave his post. From 2003 to 2007, Mr. Killinger was paid between $11 million and $20 million each year in cash, stock, and stock options. In addition, WaMu provided him with four retirement plans, a deferred bonus plan, and a separate deferred compensation plan. In 2008, when he was asked to leave to leave the bank, Mr. Killinger was paid $25 million, including $15 million in severance pay. Altogether, from 2003 to 2008, Washington Mutual paid Mr. Killinger nearly $100 million, on top of multi-million-dollar corporate retirement benefits.568

As WaMu began losing billions of dollars due to the declining value of its loans and mortgage backed securities, top management paid significant attention to ensuring that they would be well compensated despite the crisis. In January 2008, Mr. Killinger sent Mr. Rotella an email with the subject “comp,” seeking input on formulating compensation recommendations for the Board of Directors’ Human Resources Committee. The email discussed compensation for WaMu’s top executives. Mr Killinger wrote: “Our current thinking is to recommend that equity grants be in options this year. … I am considering an additional restricted stock grant which would help a bit on retention and to help offset the low bonus for 2007.” 569

bonuses in cash:

Mr. Rotella responded that he thought WaMu executives would want more of their

“[T]he feeling people will have about this is tied to the level of pain on the cash bonus side …. Unfortunately more than a few feel that our stock price will not easily recover, that it is highly dependent on housing and credit and they can’t influence that at all. This will come on the heels of what will be a terrible fourth qtr, and likely very poor results in the first half along with continued bad news in the environment. So we will have some people thinking, ‘this is nice but I don’t see the upside in a time frame that works.’ Also, as you know folks feel very burned by the way their paper was tied to performance targets that they now see as unrealistic and tied to housing and have a jaundiced view of paper. … People want more certainty now with some leverage, not a high dose of leverage with low cash.”570

567 6/19/2008 Department of Justice press release, “Federal Authorities Announce Significant Regional Federal Mortgage Fraud Investigations and Prosecutions Coinciding with Nationwide ‘Operation Malicious Mortgage’ Takedown,” 568 “Washington Mutual CEO Kerry Killinger: $100 Million in Compensation, 2003-2008,” chart prepared by the Subcommittee, Hearing Exhibit 4/13-1h. 569 1/3/2008 email chain between Kerry Killinger and Steve Rotella, JPM_WM01335818, Hearing Exhibit 4/13-65. 570 Id.

http://sacramento.fbi.gov/dojpressrel/pressrel08/sc061908a.htm.

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Mr. Killinger replied: “In short, the success of the comp program is up to you and me. I think we are putting the right economics and opportunities on the table. But we have to convince our folks that they will all make a lot of money by being with WaMu.”571

In February 2008, the Human Resources Committee approved a bonus plan for executive officers that tried to shield the executive bonuses from any impact caused by WaMu’s mounting mortgage losses. The Committee established a formula consisting of four weighted performance measures, but took steps to exclude mortgage losses. The first performance measure, for example, set a goal for WaMu’s 2008 net operating profit, but adjusted the profit calculation to exclude: “(i) loan loss provisions other than related to our credit card business and (ii) expenses related to foreclosed real estate assets.”572 The second performance measure set a target limiting WaMu’s 2008 noninterest expense, but excluded expenses related to: “(i) business resizing or restructuring and (ii) foreclosed real estate assets.”573

mortgage related losses and expenses in the plan attracted notice from shareholders and the press. One March 5, 2008 article entitled, “WaMu Board Shields Executives’ Bonuses,” reported: “The board of Washington Mutual Inc. has set compensation targets for top executives that will exclude some costs tied to mortgage losses and foreclosures when cash bonuses are calculated this year.”574 WaMu employees circulated the article through company email.575

Investors and analysts raised concerns.

Mr. Killinger sought to respond to the controversy in a way that would placate investors without alienating executives. His solution was to eliminate bonuses for the top five executives, and make cash payments to the other executives, without making that fact public. In July, Mr. Killinger emailed Steve Frank, the Chairman of the Board of Directors, with his proposal:

WaMu filed its executive compensation plan with the SEC, as required. The exclusion of

“We would like to have the HR [Human Resources] committee approve excluding the exec com [Executive Committee] from the 2008 bonus and to approve the cash retention grants to the non NEOs [Named Executive Officers]. This would allow me to respond to questions next week regarding the bonus plan on the analyst call. And it would help calm down some of the EC [Executive Committee] members.”576

In other words, WaMu would announce publicly that none of the Executive Committee members would receive bonuses in 2008, while quietly paying “retention grants” rather than “bonuses” to the next tier of executives. Mr. Frank replied, “Sounds OK to me.” Mr. Killinger followed up with the explanation: “We would disclose the exclusion of EC [Executive Committee] members from the bonus plan. There would be no disclosure of the retention cash payments. Option

571 Id. 572 2/28/2008 email from David Schneider, “FW: 2008 Leadership Bonus,” JPM_WM02446549.
573 Id.
574 “WaMu Board Shields Executives’ Bonuses,” Wall Street Journal (3/5/2008), Hearing Exhibit 4/13-67. 575 Id. 576 7/16/2008 email from Kerry Killinger, JPM_WM01240144, Hearing Exhibit 4/13-66.

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grants would be held off until whenever other comp. actions were done.”577 At WaMu’s annual meeting with shareholders, the Board indicated that it had “reversed” the decision to exclude mortgage losses when calculating executive bonuses and made no mention of the cash retention payments planned for some executives.578

When WaMu failed, shareholders lost all of their investments. Yet in the waning days of

the company, top executives were still well taken care of. On September 8, 2008, Mr. Killinger walked away with $25 million, including $15 million in severance pay. His replacement, Allen Fishman, received a $7.5 million signing bonus for taking over the reins from Mr. Killinger in September 2008.579 Eighteen days later, WaMu failed, and Mr. Fishman was out of a job.
According to his contract, he was eligible for about $11 million in severance pay when the bank failed.580

It is unclear how much of the severance he received.

G. Preventing High Risk Lending

Washington Mutual was a $300 billion, 120-year-old financial institution that was destroyed by high risk lending practices. By 2007, stated income loans – loans in which Washington Mutual made no effort to verify the borrower’s income or assets – made up 50% of its subprime loans, 73% of its Option ARMs, and 90% of its home equity loans. Nearly half of its loans were Option ARMs of which 95% of the borrowers were making minimum payments and 84% were negatively amortizing. Numerous loans had loan-to-value ratios of over 80%, and some provided 100% financing. Loans issued by two high volume loan offices in the Los Angeles area were found to have loan fraud rates of 58, 62, and even 83%. Loan officer sales assistants were manufacturing borrower documentation. The bank’s issuance of hundreds of billions of dollars in high risk, poor quality loans not only destroyed confidence in the bank, but also undermined the U.S. financial system.

The consequences of WaMu’s High Risk Lending Strategy and the proliferation of its RMBS structured finance products incorporating high risk, poor quality loans provide critical lessons that need to be learned to protect the U.S. financial system from similar financial disasters. A number of developments over the past two years hold promise in helping to address many of the problems identified in the Washington Mutual case history.

(1) New Developments

The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act),

P.L. 111-203, which the President signed into law on July 21, 2010, contains a number of changes in law that will be implemented over the course of 2011. The Dodd-Frank Act changes

577 7/16/2008 email from Kerry Killinger, JPM_WM01240144, Hearing Exhibit 4/13-66. 578 See, e.g., “Shareholders Score at WaMu,” Bloomberg BusinessWeek (4/15/2008) (“And perhaps most notable:
WaMu reversed a much-criticized decision to leave out the company’s mortgage related losses when calculating profits that determine executive bonuses for the year ahead.”). 579 “WaMu Creditors could Challenge Payments to Killinger, Others,” Seattle Times (10/1/2008), Hearing Exhibit 4/13-68. 580 “WaMu CEO: 3 Weeks Work, $18M,” CNNMoney.com (9/26/2008).

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include banning stated income loans; restricting negative amortization loans; requiring lenders to retain an interest in high risk loan pools that they sell or securitize; prohibiting lenders from steering borrowers to poor quality, high risk loans; and re-evaluating the role of high risk, structured finance products in bank portfolios.

Ban on Stated Income Loans. Multiple witnesses at the Subcommittee’s April 16, 2010

hearing on the role of bank regulators expressed support for banning stated income loans. The FDIC Chairman Sheila Bair testified: “We are opposed to stated income. … We think you should document income.”581 When asked for his opinion of stated income loans, the FDIC Inspector General Jon Rymer responded: “I do not think they should be allowed,”582 stressing the fraud risk: “I really can see no practical reason from a banker’s perspective or a lender’s perspective to encourage that. … That is just, to me, an opportunity to essentially encourage fraud.” 583 Treasury Inspector General Eric Thorson also criticized stated income loans, explaining: “[T]he problem is, you can’t assess the strength of the borrower and that has got to be at the foundation of underwriting, risk assessment, risk management.”584 Even the former head of OTS called stated income loans an “anathema” and expressed regret that OTS had allowed them.585

The Dodd-Frank Act essentially bans stated income loans by establishing minimum standards for residential mortgages in Title XIV of the law. Section 1411 establishes a new Section 129C of the Truth in Lending Act (TILA) prohibiting lenders from issuing a residential mortgage without first conducting a “good faith and reasonable” determination, based upon “verified and documented information,” that a borrower has a “reasonable ability to repay the loan” and all applicable taxes, insurance, and assessments. Subsection 129C(a)(4) states the lender “shall verify” the borrower’s income and assets by reviewing the borrower’s W-2 tax form, tax returns, payroll receipts, financial institution records, or “other third-party documents that provide reasonably reliable evidence” of the borrower’s income or assets. In addition, Section 1412 of the Dodd-Frank Act adds a new Subsection 129C(b) to TILA establishing a new category of “qualified mortgages” eligible for more favorable treatment under federal law. It states that, in all “qualified mortgages,” the “income and financial resources” of the borrower must be “verified and documented.”

These statutory requirements, by prohibiting lenders from issuing a residential mortgage without first verifying the borrower’s income and assets, essentially put an end to stated income loans.586

581 April 16, 2010 Subcommittee Hearing at 88. 582 Id. at 27. 583 Id. at 15. 584 Id. 585 Id. at 42, 142. 586 The Federal Reserve is charged with issuing regulations to implement Section 1411. Federal Reserve regulations issued in July 2008, under the authority of the Home Ownership and Equity Protection Act (HOEPA) of 1994, which took effect in October 2009, already require lenders issuing certain high cost mortgages to verify a borrower’s ability to repay the loan. 73 Fed. Reg. 147, at 44543 (7/30/2008). Since the Dodd-Frank Act applies to all types of

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Restrictions on Negative Amortization Loans. Witnesses at the Subcommittee’s April 16 hearing also criticized WaMu’s heavy reliance on Option ARM loans. These loans provided borrowers with a low initial interest rate, which was followed at a later time by a higher variable rate. Borrowers were generally qualified for the loans by assuming they would pay the lower rather than the higher rate. In addition, borrowers were allowed to select one of four types of monthly payments, including a “minimum payment” that was less than the interest and principal owed on the loan. If the borrower selected the minimum payment, the unpaid interest was added to the unpaid loan principal, which meant that the loan debt could increase rather than decrease over time, resulting in negative amortization.

At the Subcommittee hearing, the FDIC Inspector General Jon Rymer warned that

negative amortization loans are “extraordinarily risky” for both borrowers and banks.587 FDIC Chairman Sheila Bair testified:

The

“We are opposed to teaser rate underwriting. You need to underwrite at the fully indexed rate. You should document the customer’s ability to repay, not just the initial introductory rate, but if it is an adjustable product, when it resets, as well.”588

The Dodd-Frank Act does not ban negatively amortizing loans, but does impose new

restrictions on them. Section 1411 amends TILA by adding a new Section 129C(6) that requires, for any residential mortgage that allows a borrower “to defer the repayment of any principal or interest,” that the lender vet potential borrowers based upon the borrower’s ability to make monthly loan payments on a fully amortizing schedule – meaning a schedule in which the loan would be fully repaid by the end of the loan period – instead of evaluating the borrower’s ability to make payments at an initial teaser rate or in some amount that is less than the amount required at a fully amortized rate. The law also requires the lender, when qualifying a borrower, to “take into consideration any balance increase that may accrue from any negative amortization provision.” This provision essentially codifies the provisions in the 2006 Nontraditional Mortgage Guidance regarding qualification of borrowers for negatively amortizing loans.

In addition, Section 1414 of the Dodd-Frank Act adds a new Section 129C(c) to TILA

prohibiting lenders from issuing a mortgage with negative amortization without providing certain disclosures to the borrower prior to the loan. The lender is required to provide the borrower with an explanation of negative amortization in a manner prescribed by regulation as well as describe its impact, for example, how it can lead to an increase in the loan’s outstanding principal balance. In the case of a first-time home buyer, the lender must also obtain documentation that the home buyer received homeownership counseling from a HUD-certified organization or counselor. Finally, Section 1412 of the Dodd-Frank Act, establishing the new favored category of “qualified mortgages,” states those mortgages cannot negatively amortize.

mortgage loans, the Federal Reserve is expected to issue revised regulations during 2011, expanding the verification requirement to all mortgage loans. 587 April 16, 2010 Subcommittee Hearing at 16. 588 Id. at 88.

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Together, these borrower qualification and disclosure requirements, if well implemented,

should reduce, although not eliminate, the issuance of negative amortization mortgages.

Risk Retention. One of the root causes of the financial crisis was the ability of lenders like Washington Mutual to securitize billions of dollars in high risk, poor quality loans, sell the resulting securities to investors, and then walk away from the risky loans it created. At the April 16 Subcommittee hearing, the FDIC Chairman Bair testified:

“[W]e support legislation to require that issuers of mortgage securitizations retain some ‘skin in the game’ to provide added discipline for underwriting quality. In fact, the FDIC Board will consider … a proposal to require insured banks to retain a portion of the credit risk of any securitizations that they sponsor.”589

Section 941(b) of the Dodd-Frank Act adds a new section 15G to the Securities Exchange

Act of 1934 to require the federal banking agencies, SEC, Department of Housing and Urban Development, and Federal Housing Finance Agency jointly to prescribe regulations to “require any securitizer to retain an economic interest in a portion of the credit risk for any residential mortgage asset that the securitizer, through the issuance of an asset-backed security, transfers, sells, or conveys to a third party.”590 The retained economic interest must be “not less than 5 percent of the credit risk” of the assets backing the security, with an exception made for “qualified residential mortgages,” to be further defined by the regulators. The regulators issued a proposed rule early in 2011, which is currently the subject of a public comment period.

In the meantime, the FDIC has issued a new regulation, effective September 30, 2010,

that imposes a range of disclosure, risk retention, and other obligations on all insured banks that issue asset backed securitizations.591 requirement on all asset backed securitizations issued by an insured bank, whether backed by mortgages or other assets. The provision states that the bank sponsoring the securitization must:

One of the provisions imposes a 5% risk retention

“retain an economic interest in a material portion, defined as not less than five (5) percent, of the credit risk of the financial assets. This retained interest may be either in the form of an interest of not less than five (5) percent in each of the credit tranches sold or transferred to the investors or in a representative sample of the securitized financial assets equal to not less than five (5) percent of the principal amount of the financial assets at transfer. This retained interest may not be sold or pledged or hedged, except for the hedging of interest rate or currency risk, during the term of the securitization.”592

The provision also states that this risk retention requirement applies only until the “effective date” of the regulations to be issued under Section 941 of the Dodd-Frank Act.

589 Id. at 81. 590 Section 941(b) also imposes risk retention requirements on other types of asset backed securities and collateralized debt obligations. 591 12 CFR § 360.6. 592 12 CFR § 360.6(b)(5)(i).

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The FDIC risk retention requirement, followed by the risk retention requirement to be developed under the Dodd-Frank Act, should, if well implemented, end the ability of banks to magnify risk through issuing asset backed securities and then walking away from that risk.
Instead, banks will be required to keep “skin in the game” until each securitization concludes.

Ban on Steering. The Washington Mutual case history also exposed another problem:

compensation incentives that encouraged loan officers and mortgage brokers to steer borrowers to higher risk loans. Compensation incentives called “overages” at WaMu and “yield spread premiums” at other financial institutions also encouraged loan officers and mortgage brokers to charge borrowers higher interest rates and points than the bank would accept, so that the loan officer or mortgage banker could split the extra money taken from the borrower with the bank.

To ban these compensation incentives, Section 1403 of the Dodd-Frank Act creates a new

Section 129B(c) in TILA prohibiting the payment of any steering incentives, including yield spread premiums. It states: “no mortgage originator shall receive from any person and no person shall pay to a mortgage originator, directly or indirectly, compensation that varies based on the terms of loan (other than the amount of the principal).” It also states explicitly that no provision of the section should be construed as “permitting any yield spread premium or other similar compensation.” In addition, it directs the Federal Reserve to issue regulations to prohibit a range of abusive and unfair mortgage related practices, including prohibiting lenders and brokers from steering borrowers to mortgages for which they lack a reasonable ability to repay.

The Dodd-Frank provisions were enacted into law shortly before the Federal Reserve, in September 2010, promulgated new regulations prohibiting a number of unfair or abusive lending practices, including certain payments to mortgage originators.593 In its notice, the Federal Reserve noted that its new regulations prohibit many of the same practices banned in Section 1403 of the Dodd Frank Act, but that it will fully implement the new Dodd-Frank measures in a future rulemaking.594

High Risk Loans. Still another problem exposed by the Washington Mutual case history

is the fact that, in the years leading up to the financial crisis, many U.S. insured banks held highly risky loans and securities in their investment and sale portfolios. When those loans and securities lost value in 2007, many banks had to declare multi-billion-dollar losses that triggered shareholder flight and liquidity runs.

Section 620 of the Dodd-Frank Act requires the federal banking regulators, within 18

months, to prepare a report identifying the activities and investments that insured banks and their affiliates are allowed to engage in under federal and state law, regulation, order, and guidance, and analyzing the risks associated with those activities and investments. The federal banking agencies are also asked to make recommendations on whether each allowed activity or investment is appropriate, could negatively affect the safety and soundness of the banking entity or the U.S. financial system, and should be restricted to reduce risk.

593 75 Fed. Reg. 185 (9/24/2010). 594 Id. at 58509.

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(2) Recommendations
To further strengthen standards and controls needed to prevent high risk lending and safeguard the Deposit Insurance Fund, this Report makes the following recommendations.

Ensure “Qualified Mortgages” Are Low Risk. Federal regulators should use their regulatory authority to ensure that all mortgages deemed to be “qualified residential mortgages” have a low risk of delinquency or default.
Require Meaningful Risk Retention. Federal regulators should issue a strong risk retention requirement under Section 941 by requiring the retention of not less than a 5% credit risk in each, or a representative sample of, an asset backed securitization’s tranches, and by barring a hedging offset for a reasonable but limited period of time.
Safeguard Against High Risk Products. Federal banking regulators should safeguard taxpayer dollars by requiring banks with high risk structured finance products, including complex products with little or no reliable performance data, to meet conservative loss reserve, liquidity, and capital requirements.
Require Greater Reserves for Negative Amortization Loans. Federal banking regulators should use their regulatory authority to require banks issuing negatively amortizing loans that allow borrowers to defer payments of interest and principal, to maintain more conservative loss, liquidity, and capital reserves.
Safeguard Bank Investment Portfolios. Federal banking regulators should use the Section 620 banking activities study to identify high risk structured finance products and impose a reasonable limit on the amount of such high risk products that can be included in a bank’s investment portfolio.

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IV. REGULATORY FAILURE:

CASE STUDY OF THE OFFICE OF THRIFT SUPERVISION

Washington Mutual Bank (WaMu), with more than $300 billion in assets, $188 billion in

deposits, over 2,300 branches in 15 states, and 43,000 employees, was by late 2008 the largest thrift under the supervision of the Office of Thrift Supervision (OTS) and among the eight largest financial institutions insured by the Federal Deposit Insurance Corporation (FDIC). The bank’s collapse in September 2008 came on the heels of the Lehman Brothers bankruptcy filing, accelerating the unraveling of the financial markets. WaMu’s collapse marked one of the most spectacular failures of federal bank regulators in recent history.

In 2007, many of WaMu’s home loans, especially those with the highest risk profile,

began experiencing increased rates of delinquency, default, and loss. After the subprime mortgage backed securities market collapsed in September 2007, Washington Mutual was unable to sell or securitize subprime loans and its loan portfolio began falling in value. By the fourth quarter of 2007, the bank recorded a loss of $1 billion, and then in the first half of 2008, WaMu lost $4.2 billion more. WaMu’s stock price plummeted against the backdrop of these losses and a worsening financial crisis elsewhere on Wall Street, which was witnessing the forced sales of Countrywide Financial Corporation and Bear Stearns, the government takeover of IndyMac, Fannie Mae and Freddie Mac, the bankruptcy of Lehman Brothers, the taxpayer bailout of AIG, and the conversion of Goldman Sachs and Morgan Stanley into bank holding companies. From 2007 to 2008, WaMu’s depositors withdrew a total of over $26 billion in deposits from the bank, triggering a liquidity crisis. On September 25, 2008, OTS placed Washington Mutual Bank into receivership, and the FDIC, as receiver, immediately sold it to JPMorgan Chase for $1.9 billion.
Had the sale not gone through, Washington Mutual’s failure could have exhausted the FDIC’s entire $45 billion Deposit Insurance Fund.

OTS records show that, during the five years prior to its collapse, OTS examiners

repeatedly identified significant problems with Washington Mutual’s lending practices, risk management, and asset quality, and requested corrective action. Year after year, WaMu promised to correct the identified problems, but failed to do so. OTS, in turn, failed to respond with meaningful enforcement action, choosing instead to continue giving the bank inflated ratings for safety and soundness. Until shortly before the thrift’s failure in 2008, OTS regularly gave WaMu a CAMELS rating of “2” out of “5,” which signaled to the bank and other regulators that WaMu was fundamentally sound.

Federal bank regulators are charged with ensuring that U.S. financial institutions operate in a safe and sound manner. However, in the years leading up to the financial crisis, OTS failed to prevent Washington Mutual’s increasing use of high risk lending practices and its origination and sale of tens of billions of dollars in poor quality home loans. The agency’s failure to adequately monitor and regulate WaMu’s high risk lending stemmed in part from an OTS regulatory culture that viewed its thrifts as “constituents,” relied on them to correct the problems identified by OTS with minimal regulatory intervention, and expressed reluctance to interfere with even unsound lending and securitization practices. OTS displayed an unusual amount of

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deference to WaMu’s management, choosing to rely on the bank to police itself. The reasoning appeared to be that if OTS examiners simply identified the problems at the bank, OTS could then rely on WaMu’s assurances that problems were corrected, with little need for tough enforcement actions. It was a regulatory approach with disastrous results.

Over the five-year period reviewed by the Subcommittee, OTS examiners identified over 500 serious deficiencies in WaMu operations. Yet OTS did not once, from 2004 to 2008, take a public enforcement action against Washington Mutual, even when the bank failed to correct major problems. Only in late 2008, as the bank incurred mounting losses, did OTS finally take two informal, nonpublic enforcement actions, requiring WaMu to agree to a Board Resolution in March and a Memorandum of Understanding in September, but neither action was sufficient to prevent the bank’s failure. OTS officials resisted calls by the FDIC, the bank’s backup regulator, for stronger measures and even impeded FDIC oversight efforts at the bank. Hindered by a culture of deference to management, demoralized examiners, and agency infighting, OTS officials allowed the bank’s short term profits to excuse its risky practices and failed to evaluate the bank’s actions in the context of the U.S. financial system as a whole.

OTS not only failed to prevent Washington Mutual from engaging in unsafe and unsound lending practices, it gave its tacit approval and allowed high risk loans to proliferate. As long as Washington Mutual was able to sell off its risky loans, neither OTS nor the FDIC expressed concerns about the impact of those loans elsewhere. By not sounding the alarm, OTS and the FDIC enabled WaMu to construct a multi-billion-dollar investment portfolio of high risk mortgage assets, and also permitted WaMu to sell hundreds of billions of dollars in high risk, poor quality loans and securities to other financial institutions and investors in the United States and around the world. Similar regulatory failings by OTS, the FDIC, and other agencies involving other lenders repeated these problems on a broad scale. The result was a mortgage market saturated with risky loans, and financial institutions that were supposed to hold predominantly safe investments but instead held portfolios rife with high risk, poor quality mortgages. When those loans began defaulting in record numbers and mortgage related securities plummeted in value, financial institutions around the globe suffered hundreds of billions of dollars in losses, triggering an economic disaster. The regulatory failures that set the stage for these losses were a proximate cause of the financial crisis.

A. Subcommittee Investigation and Findings of Fact

To analyze regulatory oversight of Washington Mutual, the Subcommittee subpoenaed

documents from OTS, the FDIC, and WaMu, including bank examination reports, legal pleadings, reports, internal memoranda, correspondence, and email. The Subcommittee also conducted over two dozen interviews with OTS, FDIC, and WaMu personnel, including the FDIC Chairman, OTS Director, OTS and the FDIC senior examiners assigned to Washington Mutual, and senior WaMu executives. The Subcommittee also spoke with personnel from the Offices of the Inspector General (IG) at the FDIC and the Department of Treasury, who were engaged in a joint review of WaMu’s failure. In addition, the Subcommittee spoke with nearly a dozen experts on a variety of banking, accounting, regulatory, and legal issues. On April 16, 2010, the Subcommittee held a hearing at which OTS, the FDIC, and IG officials provided

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testimony; released 92 hearing exhibits; and released the FDIC and Treasury IGs’ joint report on Washington Mutual.595

“Federal bank regulators are supposed to ensure the safety and soundness of individual U.S. financial institutions and, by extension, the U.S. banking system. Washington Mutual was just one of many financial institutions that federal banking regulators allowed to engage in such high risk home loan lending practices that they resulted in bank failure and damage to financial markets. The ineffective role of bank regulators was a major contributor to the 2008 financial crisis that continues to afflict the U.S. and world economy today.”

On March 16, 2011, the FDIC sued the three top former executives of Washington

Mutual for pursuing a high risk lending strategy without sufficient risk management practices and despite their knowledge of a weakening housing market.596 The FDIC complaint stated:

“Chief Executive Officer Kerry K. Killinger (“Killinger”), Chief Operating Officer Stephen J. Rotella (“Rotella”), and Home Loans President David C. Schneider (“Schneider”) caused Washington Mutual Bank (“WaMu” or “the Bank”) to take extreme and historically unprecedented risks with WaMu’s held-for-investment home loans portfolio. They focused on short term gains to increase their own compensation, with reckless disregard for WaMu’s longer term safety and soundness. Their negligence, gross negligence and breaches of fiduciary duty caused WaMu to lose billions of dollars. The FDIC brings this Complaint to hold these three highly paid senior executives, who were chiefly responsible for WaMu’s higher risk home lending program, accountable for the resulting losses.”

595 See “Wall Street and the Financial Crisis: Role of the Regulators,” before the U.S. Senate Permanent Subcommittee on Investigations, S.Hrg. 111-672 (April 16, 2010) (hereinafter “April 16, 2010 Subcommittee Hearing”). 596 The Federal Deposit Insurance Corporation v. Kerry K. Killinger, Stephen J. Rotella, David C. Schneider, et al., Case No. 2:11-CV-00459 (W.D. Wash.), Complaint (March 16, 2011), at http://graphics8.nytimes.com/packages/pdf/business/conformedcomplaint.pdf (hereinafter “FDIC Complaint Against WaMu Executives”).

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The Levin-Coburn memorandum contained joint findings of fact regarding the role of federal regulators in the Washington Mutual case history. Those findings of fact, which this Report reaffirms, are as follows.

Largest U.S. Bank Failure. From 2003 to 2008, OTS repeatedly identified

significant problems with Washington Mutual’s lending practices, risk management, and asset quality, but failed to force adequate corrective action, resulting in the largest bank failure in U.S. history.

Shoddy Lending and Securitization Practices. OTS allowed Washington Mutual and its affiliate Long Beach Mortgage Company to engage year after year in shoddy lending and securitization practices, failing to take enforcement action to stop its origination and sale of loans with fraudulent borrower information, appraisal problems, errors, and notoriously high rates of delinquency and loss.
Unsafe Option ARM Loans. OTS allowed Washington Mutual to originate hundreds of billions of dollars in high risk Option Adjustable Rate Mortgages, knowing that the bank used unsafe and unsound teaser rates, qualified borrowers using unrealistically low loan payments, permitted borrowers to make minimum payments resulting in negatively amortizing loans (i.e., loans with increasing principal), relied on rising house prices and refinancing to avoid payment shock and loan defaults, and had no realistic data to calculate loan losses in markets with flat or declining house prices.
Short Term Profits Over Long Term Fundamentals. OTS abdicated its

responsibility to ensure the long term safety and soundness of Washington Mutual by concluding that short term profits obtained by the bank precluded enforcement action to stop the bank’s use of shoddy lending and securitization practices and unsafe and unsound loans.

Impeding FDIC Oversight. OTS impeded FDIC oversight of Washington Mutual

by blocking its access to bank data, refusing to allow it to participate in bank examinations, rejecting requests to review bank loan files, and resisting the FDIC recommendations for stronger enforcement action.

FDIC Shortfalls. The FDIC, the backup regulator of Washington Mutual, was

unable to conduct the analysis it wanted to evaluate the risk posed by the bank to the Deposit Insurance Fund, did not prevail against unreasonable actions taken by OTS to limit its examination authority, and did not initiate its own enforcement action against the bank in light of ongoing opposition by the primary federal bank regulators to FDIC enforcement authority.

Recommendations Over Enforceable Requirements. Federal bank regulators

undermined efforts to end unsafe and unsound mortgage practices at U.S. banks by issuing guidance instead of enforceable regulations limiting those practices, failing to

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prohibit many high risk mortgage practices, and failing to set clear deadlines for bank compliance.

Failure to Recognize Systemic Risk. OTS and the FDIC allowed Washington

Mutual and Long Beach to reduce their own risk by selling hundreds of billions of dollars of high risk mortgage backed securities that polluted the financial system with poorly performing loans, undermined investor confidence in the secondary mortgage market, and contributed to massive credit rating downgrades, investor losses, disrupted markets, and the U.S. financial crisis.

Ineffective and Demoralized Regulatory Culture. The Washington Mutual case

history exposes the regulatory culture at OTS in which bank examiners are frustrated and demoralized by their inability to stop unsafe and unsound practices, in which their supervisors are reluctant to use formal enforcement actions even after years of serious bank deficiencies, and in which regulators treat the banks they oversee as constituents rather than arms-length regulated entities.

B. Background

At the time of its collapse, Washington Mutual Savings Bank was a federally chartered thrift with over $188 billion in federal insured deposits. Its primary federal regulator was OTS. Due to its status as an insured depository institution, it was also overseen by the FDIC.

(1) Office of Thrift Supervision

The Office of Thrift Supervision was created in 1989, in response to the savings and loan crisis, to charter and regulate the thrift industry.597 Thrifts are required by their charters to hold most of their assets in mortgage lending, and have traditionally focused on the issuance of home loans.598 OTS was part of the U.S. Department of the Treasury and headed by a presidentially appointed director. Like other bank regulators, OTS was charged with ensuring the safety and soundness of the financial institutions it oversaw. Its operations were funded through semiannual fees assessed on the institutions it regulated, with the fee amount based on the size, condition, and complexity of each institution’s portfolio. Washington Mutual was the largest thrift overseen by OTS and, from 2003 to 2008, paid at least $30 million in fees annually to the agency, which comprised 12-15% of all OTS revenue.599

597 Twenty years after its establishment, OTS was abolished by the Dodd-Frank Wall Street Reform and Consumer Protection Act, P.L. 111-203, (Dodd-Frank Act) which has transferred the agency’s responsibilities to the Office of the Comptroller of the Currency (OCC), and directed the agency to cease all operations by 2012. This Report focuses on OTS during the time period 2004 through 2008. 598 6/19/2002 OTS Regulatory Bulletin, “Thrift Activities Regulatory Handbook Update” (some educational loans, SBLs, and credit card loans also count towards qualifying as a thrift), http://files.ots.treas.gov/74081.pdf.
599 See April 16, 2010 Subcommittee Hearing at 11 (testimony of Treasury IG Eric Thorson).

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In 2009, OTS oversaw about 765 thrift-chartered institutions.600

OTS supervised its thrifts through four regional offices, each led by a Regional Director, Deputy Director, and Assistant Director. Regional offices assigned an Examiner-in-Charge to each thrift in its jurisdiction, along with other supporting examination personnel. Approximately three-quarters of the OTS workforce reported to its four regional offices, while the remaining quarter worked at OTS headquarters in Washington, D.C. Washington Mutual, whose headquarters were located in Seattle, was supervised by the Western Region Office which, through the end of 2008, was based in Daly City, California.

During the years reviewed by the Subcommittee, the OTS Executive Director was John

Reich; the Deputy Director was Scott Polakoff; the Western Region Office Director was Michael Finn and later Darrel Dochow; and the Examiners-in-Charge at WaMu were Lawrence Carter and later Benjamin Franklin.

(2) Federal Deposit Insurance Corporation WaMu’s secondary federal regulator was the FDIC. The FDIC’s mission is to maintain stability and public confidence in the nation’s financial system by insuring deposits, examining and supervising financial institutions for safety and soundness and consumer protection, and managing failed institutions placed into receivership.601 The FDIC administers the Deposit Insurance Fund, which is the primary mechanism used to protect covered deposits at U.S. financial institutions from loss. The Deposit Insurance Fund is financed through fees assessed on the insured institutions, with assessments based on the amount of deposits requiring insurance, the amount of assets at each institution, and the degree of risk posed by each institution to the insurance fund.

To minimize withdrawals from the Deposit Insurance Fund, the FDIC is assigned backup

supervisory authority over approximately 3,000 federally insured depository institutions whose primary regulators are the Federal Reserve, OCC, and, until recently, OTS. Among other measures, the FDIC is authorized to conduct a “special examination” of any insured institution “to determine the condition of such depository institution for insurance purposes.” facilitate and coordinate its oversight obligations with those of the primary bank regulators and ensure it is able to protect the Deposit Insurance Fund, the FDIC has entered into an inter-agency agreement with the primary bank regulators.603 The 2002 version of that agreement, which was in effect until 2010, stated that the FDIC was authorized to request to participate in examinations of large institutions or higher risk financial institutions, recommend enforcement actions to be taken by the primary regulator, and if the primary regulator failed to act, take its own enforcement action with respect to an insured institution.

602 To

600 2009 OTS Annual Report, “Agency Profile,” http://www.ots.treas.gov/_files/482096.pdf. 601 See “FDIC Mission, Vision, and Values,” http://www.fdic.gov/about/mission/index.html.
602 12 U.S.C. § 1820(b)(3). 603 The interagency agreement is entitled, “Coordination of Expanded Supervisory Information Sharing and Special Examinations.” During the time period of the Subcommittee’s investigation, the 2002 version of the interagency agreement, signed by the FDIC, Federal Reserve, OCC, and OTS, was in effect. In July 2010, the federal financial regulators agreed to adopt a stronger version, discussed later in this Report.

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For the eight largest insured institutions at the time, the FDIC assigned at least one

Dedicated Examiner to work on-site at the institution. The examiner’s obligation is to evaluate the institution’s risk to the Deposit Insurance Fund and work with the primary regulator to lower that risk. During the period covered by this Report, Washington Mutual was one of the eight and had an FDIC-assigned Dedicated Examiner who worked with OTS examiners to oversee the bank.

During the years examined by the Subcommittee, the FDIC Chairman was Sheila Bair; the Acting Deputy Director for the FDIC’s Division of Supervision and Consumer Protection’s Complex Financial Institution Branch was John Corston; in the San Francisco Region, the Director was John Carter and later Stan Ivie, and the Assistant Director was George Doerr. At WaMu, the FDIC’s Dedicated Examiner was Stephen Funaro.

(3) Examination Process
The stated mission of OTS was “[t]o supervise savings associations and their holding

companies in order to maintain their safety and soundness and compliance with consumer laws, and to encourage a competitive industry that meets America’s financial services needs.” The OTS Examination Handbook required “[p]roactive regulatory supervision” with a focus on evaluation of “future needs and potential risks to ensure the success of the thrift system in the long term.”604 OTS, like other bank regulators, had special access to the financial information of the thrifts under its regulation, which was otherwise kept confidential from the market and other parties.

To carry out its mission, OTS traditionally conducted an examination of each of the thrifts within its jurisdiction every 12 to 18 months and provided the results in a Report of Examination (ROE). In 2006, OTS initiated a “continuous exam” program for its largest thrifts, requiring its examiners to conduct a series of specialized examinations during the year with the results from all of those examinations included in an annual ROE. The Examiner-in-Charge led the examination activities which were organized around the CAMELS rating system used by all federal bank regulators. The CAMELS rating system evaluates a bank’s: (C) capital adequacy, (A) asset quality, (M) management, (E) earnings, (L) liquidity, and (S) sensitivity to market risk.
A CAMELS rating of 1 is the best rating, while 5 is the worst. In the annual ROE, OTS provided its thrifts with an evaluation and rating for each CAMELS component, as well as an overall composite rating on the bank’s safety and soundness.

605

At Washington Mutual, OTS examiners conducted both on-site and off-site activities to

review bank operations, and maintained frequent communication with bank management through emails, telephone conferences, and meetings. During certain periods of the year, OTS examiners

604 2004 OTS Examination Handbook, Section 010.2, OTSWMEF-0000031969, Hearing Exhibit 4/16-2. 605 A 1 composite rating in the CAMELS system means “sound in every respect”; a 2 rating means “fundamentally sound”; a 3 rating means “exhibits some degree of supervisory concern in one or more of the component areas”; a 4 rating means “generally exhibits unsafe and unsound practices or conditions”; and a 5 rating means “exhibits extremely unsafe and unsound practices or conditions” and is of “greatest supervisory concern.” See chart in the prepared statement of Treasury IG Eric Thorson at 7, reprinted in April 16, 2010 Subcommittee Hearing at 107.

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had temporary offices at Washington Mutual for accessing bank information, collecting data from bank employees, performing analyses, and conducting other exam activities. Washington Mutual formed a Regulatory Relations office charged with overseeing its interactions and managing its relationships with personnel at OTS, the FDIC, and other regulators.

During the year, OTS examiners issued “findings memoranda,” which set forth particular

examination findings, and required a written response and corrective action plan from WaMu management. The memoranda contained three types of findings. The least severe was an “observation,” defined as a “weakness identified that is not of regulatory concern, but which may improve the bank’s operating effectiveness if addressed. … Observations may or may not be reviewed during subsequent examinations.” The next level of finding was a “recommendation,” defined as a “secondary concern requiring corrective action. … They may be included in the Report of Examination … Management’s actions to address Recommendations are reviewed at subsequent or follow-up examinations.” The most severe type of finding was a “criticism,” defined as a “primary concern requiring corrective action … often summarized in the ‘Matters Requiring Board Attention’ … section of the Report of Examination. … They are subject to formal follow-up by examiners and, if left uncorrected, may result in stronger action.”606

The most serious OTS examination findings were elevated to Washington Mutual Bank’s

Board of Directors by designating them as a “Matter Requiring Board Attention” (MRBA).
MRBAs were set forth in the ROE and presented to the Board in an annual meeting attended by OTS and FDIC personnel. Washington Mutual tracked OTS findings, along with its own responses, through an internal system called Enterprise Risk Issue Control System (ERICS).
ERICS was intended to help WaMu manage its relationship with its regulators by storing the regulators’ findings in one central location. In one of its more unusual discoveries, the Subcommittee learned that OTS also came to rely largely on ERICS to track its dealings with WaMu. OTS’ reliance on WaMu’s tracking system was a unique departure from its usual practice of separately tracking the status of its past examination findings and a bank’s responses.

607

The FDIC also participated in the examinations of Washington Mutual. Because WaMu

was one of the eight largest insured banks in the country, the FDIC assigned a full-time Dedicated Examiner to oversee its operations. Typically, the FDIC examiners worked with the primary regulator and participated in or relied upon the examinations scheduled by that regulator, rather than initiating separate FDIC examinations. At least once per year, the FDIC examiner performed an evaluation of the institution’s risk to the Deposit Insurance Fund, typically relying primarily on the annual Report on Examination (ROE) issued by the primary regulator and the ROE’s individual and composite CAMELS ratings for the institution. After reviewing the ROE as well as other examination and financial information, the FDIC examiner reviewed the CAMELS ratings for WaMu to ensure they were appropriate.

606 Descriptions of these terms appeared in OTS findings memoranda. See, e.g., 6/19/2008 OTS Findings Memorandum of Washington Mutual Bank, at Bisset_John-00046124_002, Hearing Exhibit 4/16-12a. 607 See April 16, 2010 Subcommittee Hearing at 21 (information supplied by Treasury IG Thorson for the record).

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In addition, for institutions with assets of $10 billion or more, the FDIC had established a Large Insured Depository Institutions (LIDI) Program to assess and report on emerging risks that may pose a threat to the Deposit Insurance Fund. Under that program, the FDIC Dedicated Examiner and other FDIC regional case managers performed ongoing analysis of emerging risks within each covered institution and assigned it a quarterly risk rating, using a scale of A to E, with A being the best rating and E the worst. In addition, senior FDIC analysts within the Complex Financial Institutions Branch analyzed specific bank risks and developed supervisory strategies. If the FDIC viewed an institution as imposing an increasing risk to the Deposit Insurance Fund, it could perform one or more “special examinations” to take a closer look.

C. Washington Mutual Examination History

For the five-year period, from 2004 to 2008, OTS repeatedly identified significant

problems with Washington Mutual’s lending practices, risk management, appraisal procedures, and issued securities, and requested corrective action. WaMu promised to correct the identified deficiencies, but failed to do so. OTS failed, in turn, to take enforcement action to ensure the corrections were made, until the bank began losing billions of dollars. OTS also resisted and at times impeded FDIC examination efforts at Washington Mutual.

(1) Regulatory Challenges Related to Washington Mutual Washington Mutual was a larger and more complex financial institution than any other thrift overseen by OTS, and presented numerous regulatory challenges. By 2007, Washington Mutual had over $300 billion in assets, 43,000 employees, and over 2,300 branches in 15 states, including a securitization office on Wall Street, a massive loan portfolio, and several lines of business, including home loans, credit cards, and commercial real estate.

Integration Issues. During the 1990s, as described in the prior chapter, WaMu

embarked upon a strategy of growth through acquisition of smaller institutions, and over time became one of the largest mortgage lenders in the United States. One consequence of its acquisition strategy was that WaMu struggled with the logistical and managerial challenges of integrating a variety of lending platforms, information technology systems, staff, and policies into one system.

OTS was concerned about and critical of WaMu’s integration efforts. In a 2004 Report

on Examination (ROE), OTS wrote:

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certain major IT initiatives exposed the institution’s infrastructure weaknesses and began to negatively impact operating results.”608

Long Beach. One of WaMu’s acquisitions, in 1999, was Long Beach Mortgage

Company (Long Beach), a subprime lender that became a source of significant management, asset quality, and risk problems. Long Beach’s headquarters were located in Long Beach, California, but as a subsidiary of Washington Mutual Inc., the parent holding company of Washington Mutual Bank, it was subject to regulation by the State of Washington Department of Financial Institutions and the FDIC. Long Beach’s business model was to purchase subprime loans from third party mortgage brokers and lenders and then sell or securitize the loans for sale to investors.

For the first seven years, from 1999 to 2006, OTS had no direct jurisdiction over Long

Beach, since it was a subsidiary of WaMu’s parent holding company, but not a subsidiary of the bank itself. OTS was limited to reviewing Long Beach indirectly by examining its effect on the holding company and WaMu. In late 2003, OTS examiners took greater notice of Long Beach after WaMu’s legal department halted Long Beach’s securitizations while it helped the company strengthen its internal controls. As many as 4,000 Long Beach loans were of such poor quality that three quarters of them could not be sold to investors. In 2005, Long Beach experienced a surge in early payment defaults, was forced to repurchase a significant number of loans, lost over $107 million, and overwhelmed its loss reserves. Washington Mutual requested permission to make Long Beach a division of the bank, so that it could assert greater control over Long Beach’s operations, and in March 2006, OTS approved the purchase with conditions. In 2006, Long Beach experienced another surge of early payment defaults and was forced to repurchase additional loans. When Long Beach loans continued to have problems in 2007, Washington Mutual eliminated Long Beach as a separate operation and rebranded it as a Washington Mutual “Wholesale Specialty Lending” division. In August 2007, after the collapse of the subprime secondary market, WaMu stopped offering subprime loans and discontinued the last vestiges of the Long Beach operation.

High Risk Lending. In 2004, Washington Mutual shifted its strategy toward the

issuance and purchase of higher risk home loans. OTS took note of the strategic shift in WaMu’s 2004 ROE:

608 See 3/15/2004 OTS Report of Examination, at OTSWMS04-0000001482, Hearing Exhibit 4/16-94 [Sealed Exhibit]. See also, e.g., 12/17/2004 email exchange among WaMu executives, “Risks/Costs to Moving GSE Share to FH,” JPM_WM05501400, Hearing Exhibit 4/16-88 (noting that Fannie Mae “is well aware of our data integrity issues (miscoding which results in misdeliveries, expensive and time consuming data reconciliations), and has been exceedingly patient.”).
609 See 3/15/2004 OTS Report of Examination, at OTSWMS04-0000001509, Hearing Exhibit 4/16-94 [Sealed Exhibit].

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The result was the bank’s January 2005 High Risk Lending Strategy, discussed in the

OTS recommended, and the bank agreed, to spell out its new lending strategy in a written document that had to be approved by the WaMu Board of Directors.610

prior chapter, in which WaMu management obtained the approval of its Board to shift its focus from originating lower risk fixed rate and government backed loans to higher risk subprime, home equity, and Option ARM loans.611 The High Risk Lending Strategy also outlined WaMu’s plans to increase its issuance of higher risk loans to borrowers with a higher risk profile. The purpose of the shift was to maximize profits by originating loans with the highest profit margins, which were usually the highest risk loans. According to actual loan data analyzed by WaMu, higher risk loans, such as subprime, Option ARM, and home equity loans, produced a higher “gain on sale” or profit for the bank compared to lower risk loans. For example, a presentation supporting the High Risk Lending Strategy indicated that selling subprime loans garnered more than eight times the gain on sale as government backed loans.612

The WaMu submission to the Board noted that, in order for the plan to be successful,

WaMu would need to carefully manage its residential mortgage business as well as its credit risk, meaning the risk that borrowers would not repay the higher risk loans.613 During the Board’s discussion of the strategy, credit officers noted that losses would likely lag by several years.614 WaMu executives knew that even if loan losses did not immediately materialize, the strategy presented potentially significant risks down the road. OTS did not object to the High Risk Lending Strategy, even though OTS noted that the bank’s five-year plan did not articulate a robust plan for managing the increased risk.615

610 6/30/2004 OTS Memo to Lawrence Carter from Zalka Ancely, OTSWME04-0000005357 at 61 (“Joint Memo #9

Subprime Lending Strategy”); 3/15/2004 OTS Report of Examination, at OTSWMS04-0000001483 [Sealed Exhibit]. See also 1/2005 “Higher Risk Lending Strategy Presentation,” submitted to Washington Mutual Board of Directors, at JPM_WM00302978, Hearing Exhibit 4/13-2a (“As we implement our Strategic Plan, we need to address OTS/FDIC 2004 Safety and Soundness Exam Joint Memos 8 & 9 . . . Joint Memo 9: Develop and present a SubPrime/Higher Risk Lending Strategy to the Board.”). 611 1/2005 “Higher Risk Lending Strategy Presentation,” submitted to Washington Mutual Board of Directors, at JPM_WM00302978, Hearing Exhibit 4/13-2a; see also “WaMu Product Originations and Purchases by Percentage – 2003-2007,” chart prepared by the Subcommittee, Hearing Exhibit 4/13-1i. 612 4/18/2006 Washington Mutual Home Loans Discussion Board of Directors Meeting, at JPM_WM00690894, Hearing Exhibit 4/13-3 (see chart showing gain on sale for government loans was 13 basis points (bps); for 30-year, fixed rate loans was 19 bps; for Option ARMs was 109 bps; for home equity loans was 113 bps; and for subprime loans was 150 bps.) 613 The Home Loans presentation to the Board acknowledged that risks of the High Risk Lending Strategy included managing credit risk, implementing lending technology and enacting organizational changes. 4/18/2006 Washington Mutual Home Loans Discussion Board of Directors Meeting, at JPM_WM00690899, Hearing Exhibit 4/13-3. 614 1/18/2005 Washington Mutual Inc. Washington Mutual Bank FA Finance Committee Minutes, JPM_WM06293964-68 at 67; see also 1/2005 Washington Mutual, Higher Risk Lending Strategy Presentation, at JPM_WM00302987, Hearing Exhibit 4/13-2a (chart showing peak loss rates in 2007).
615 See 3/15/2004 OTS Report of Examination, at OTSWMS04-0000001509, Hearing Exhibit 4/16-94 [Sealed Exhibit].

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Even before it received formal Board approval, Washington Mutual had begun shifting its loan originations toward higher risk loans. By 2007, rising defaults and the collapse of the subprime secondary market prevented WaMu from fully implementing its plans, but it did have time to shift the composition of the loans it originated and purchased, increasing the percentage of higher risk home loans from at least 19% in 2003, to over 47% in 2007.616 2007

Home Equity

2003

Subprime

Option ARM 7%

Other ARM

17%

Home Equity 24%

Fixed 64%

Subprime

Option ARM 18%

Fixed 23%

Other ARM 30%

Over the course of nearly three years, from 2005 to 2007, WaMu issued and securitized

hundreds of billions of high risk loans, including $49 billion in subprime loans617 and $59 billion in Option ARMs.618 Data compiled by the Treasury and the FDIC Inspectors General showed that, by the end of 2007, Option ARMs constituted about 47% of all home loans on WaMu’s balance sheet, of which about 56% of the borrowers were making the minimum payment amounts.619 The data also showed that 84% of the total value of the Option ARMs was negatively amortizing, meaning that the borrowers were going into deeper debt rather than paying off their loan balances.620 which the bank had not verified the borrower’s income – represented 73% of WaMu’s Option

In addition, by the end of 2007, stated income loans – loans in

616 “WaMu Product Originations and Purchases by Percentage – 2003-2007,” chart prepared by the Subcommittee, Hearing Exhibit 4/13-1i. 617 “Securitizations of Washington Mutual and Long Beach Subprime Home Loans,” chart prepared by the Subcommittee, Hearing Exhibit 4/13-1c. 618 4/2010 “Evaluation of Federal Regulatory Oversight of Washington Mutual Bank,” report prepared by the Offices of Inspector General at the Department of the Treasury and Federal Deposit Insurance Corporation (hereinafter “Treasury and FDIC IG Report”), at 9, Hearing Exhibit 4/16-82. 619 Id. An August 2006 WaMu internal presentation indicated that over 95% of its Option ARM borrowers were making minimum payments. See 8/2006 chart, “Borrower-Selected Payment Behavior,” in WaMu internal presentation entitled, “Option ARM Credit Risk,” JPM_WM00212646, Hearing Exhibit 4/13-37. 620 See Treasury and FDIC IG Report, at 9, Hearing Exhibit 4/16-82.

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ARMs, 50% of its subprime loans, and 90% of its home equity loans.621 WaMu also originated numerous loans with high loan-to-value (LTV) ratios, in which the loan amount exceeded 80% of the value of the underlying property. The Inspectors General determined, for example, that 44% of WaMu’s subprime loans and 35% of its home equity loans had LTV ratios in excess of 80%.622 Still another problem was that WaMu had high concentrations of its home loans in California and Florida, states that ultimately suffered above-average home value depreciation.623

WaMu issued loans through its own retail loan offices, through Long Beach, which

issued subprime loans initiated by third party mortgage brokers, and through correspondent and conduit programs in which the bank purchased loans from third parties. The Treasury and the FDIC Inspectors General observed that, from 2003 to 2007, 48 to 70% of WaMu’s residential mortgages came from third party mortgage brokers, and that only 14 WaMu employees were responsible for overseeing more than 34,000 third party brokers, employee to oversee more than 2,400 third party brokers.

requiring each WaMu

624

When the subprime market collapsed in July 2007, Washington Mutual was left holding a

portfolio saturated with high risk, poorly performing loans. Prior to the collapse, WaMu had sold or securitized the majority of the loans it had originated or purchased, undermining the U.S. home loan mortgage market with hundreds of billions of dollars in high risk, poor quality loans.
OTS documentation shows that WaMu’s regulators saw what was happening, identified the problems, but then took no enforcement actions to protect either Washington Mutual or the U.S. financial system from the bank’s shoddy lending practices.

(2) Overview of Washington Mutual’s Ratings History and Closure

An overview of Washington Mutual’s ratings history shows how OTS and the FDIC were

required to work together to oversee Washington Mutual, which the two agencies did with varying levels of success. At times, the relationship was productive and useful, while at others they found themselves bitterly at odds over how to proceed. As Washington Mutual’s problems intensified, the working relationship between OTS and the FDIC grew more dysfunctional.

From 2004 to 2006, Washington Mutual was a profitable bank and enjoyed a 2 CAMELS

rating from both agencies, signifying it was a fundamentally sound institution. In late 2006, as housing prices began to level off for the first time in years, subprime loans began to experience delinquencies and defaults. In part because borrowers were unable to refinance their loans, those delinquencies and defaults accelerated in 2007. The poorly performing loans began to affect the payments supporting subprime mortgage backed securities, which began to incur losses. In July 2007, the subprime market was performing so poorly that the major credit rating agencies suddenly downgraded hundreds of subprime mortgage backed securities, including over 40 issued by Long Beach. The subprime market slowed and then collapsed, and Washington Mutual was suddenly left with billions of dollars in unmarketable subprime loans and securities

621 Id. at 10. 622 Id. 623 Id. at 11. 624 See Thorson prepared statement, at 5, April 16, 2010 Subcommittee Hearing at 105.

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that were plummeting in value. WaMu stopped issuing subprime loans. In the fourth quarter of 2007, WaMu reported a $1 billion loss.

As housing prices slowed and even began declining in some parts of the country, high risk prime loans, including hybrid adjustable rate mortgages, Alt A, and Option ARMs, also began incurring delinquencies and defaults.625 By March 2008, the total delinquency rate for prime/Alt A loans underlying WaMu and Long Beach securitizations was 8.57%, more than twice the industry average.626 In 2008, WaMu did not issue any new high risk, nonconforming mortgage securitizations due to, in the words of OTS, “continued market illiquidity, deterioration in the financial condition of the market, and the poor performance of WaMu’s outstanding securitizations.”627

In the first quarter of 2008, WaMu continued to incur losses as the value of its loan

portfolio and mortgage backed securities continued to drop. In February 2008, OTS downgraded Washington Mutual for the first time, changing its CAMELS rating from a 2 to a 3, signifying that the bank was in trouble. Unfortunately, OTS did not follow up with a suitable enforcement action. Consistent with its own practice, OTS should have required WaMu to enter into a public Memorandum of Understanding specifying the measures WaMu would take to remedy its problems. Instead, in March, OTS allowed WaMu to issue a nonpublic Board Resolution in which the WaMu Board generally promised to address various problems, but did not identify any specific actions or deadlines.

628

Also in March 2008, at the urging of the FDIC, OTS required Washington Mutual to

allow potential buyers of the bank to conduct due diligence of its assets and operations.

Several institutions participated, and JPMorgan Chase made an offer to buy the bank which Washington Mutual turned down. By the end of the first quarter of 2008, Washington Mutual had lost another $1 billion. In April 2008, to reassure the market and its depositors, the holding company raised additional capital of $7 billion from the private sector and provided $3 billion of those funds to the bank. But by the end of the second quarter, WaMu lost another $3.2 billion.
Its stock price plummeted, and depositors began withdrawing substantial sums from the bank.

629

In June 2008, as a result of the bank’s financial and deposit losses, the FDIC downgraded WaMu to its lowest internal LIDI rating, an E, indicating “serious concern” that the bank would

625 WaMu’s Chief Credit Officer informed the Board of Directors that WaMu was “heavily concentrated” in residential mortgages and high risk products as well as in “highly stressed” geographic markets, which negatively affected WaMu’s portfolio performance. See 2/25/2008 Credit Risk Overview Report to the Board of Directors, prepared by John McMurray, WaMu Chief Credit Officer, JPM_WM02548447, at 28-29. He reported that WaMu’s mortgages were 1366% of its common tangible equity, the highest percentage of any of the top 20 banks. He also informed the Board that the bank’s residential mortgages “performed very poorly” and WaMu had “generally retained higher risk products (e.g., Option ARMS, 2nd Liens, Subprime, Low Doc).” 626 OTS Fact Sheet 12, “Securitizations,” Dochow_Darrel-00001364_001. 627 Id. 628 3/17/2008 letter from Kerry Killinger to Darrel Dochow with enclosed Board Resolution, OTSWMS08-015

See also Treasury and FDIC IG Report at 31. 629 Subcommittee interviews of WaMu Chief Financial Officer Tom Casey (2/20/2010); WaMu Controller Melissa Ballenger (2/14/2010); and OTS Western Region Office Director Darrel Dochow (3/3/2010); 4/2010 “Washington Mutual Regulators Timeline,” prepared by the Subcommittee, Hearing Exhibit 4/16-1j.

cause a loss to the Deposit Insurance Fund. It also initiated a special insurance examination of WaMu, which it conducted concurrently with ongoing OTS examination efforts.630

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Other financial institutions were also failing, compounding the concern of those who

worried whether the Deposit Insurance Fund had sufficient funds. In July 2008, IndyMac Bank, 631 In response, another thrift with high risk loans, failed and was taken over by the FDIC. Washington Mutual depositors began to withdraw more funds from the bank, eventually removing over $10 billion.632 The Federal Home Loan Bank of San Francisco also began to limit WaMu’s borrowing, further straining its liquidity.633 an additional $2 billion in capital to the bank.

The parent holding company supplied

In the final three months before WaMu’s collapse, tensions increased further between

OTS and the FDIC as they disagreed on the course of action. On July 3, 2008, the head of OTS sent an email to the CEO of WaMu informing him that the agency had decided to require the bank to issue a nonpublic Memorandum of Understanding (MOU). FDIC met with the WaMu Board of Directors to discuss the latest examination findings and formally advise the Board of the OTS decision to require the MOU. On July 21, 2008, the FDIC sent a letter to OTS urging it to take tough supervisory action in the MOU, including by requiring WaMu to increase its loan loss reserves, begin providing regular financial updates, and raise an additional $5 billion in capital.635 OTS rejected the FDIC’s advice.636 On July 31, 2008, both OTS and FDIC officials met with WaMu’s Board. An FDIC official suggested at the Board meeting that WaMu look for a strategic partner to buy or invest in the bank; OTS expressed anger that the FDIC had raised the issue without first clearing it with OTS.637

634 On July 15, OTS and the

On August 1, 2008, the FDIC informed OTS that it thought WaMu should be

638 OTS strongly disagreed.639

downgraded to a 4 CAMELS rating, signaling it was a troubled bank exhibiting unsafe and unsound practices. the proposed MOU. The proposed MOU would require the bank to correct lending and risk management deficiencies identified in a June 30 examination report, develop a capital contingency plan (rather than, as the FDIC originally urged, raise additional capital), submit a 3- year business plan, and engage a consultant to review its underwriting, risk management,

Also on August 1, OTS provided WaMu with

630 See 7/21/2008 letter from FDIC to OTS, FDIC_WAMU_000001730, Hearing Exhibit 4/16-59. 631 For more information on IndyMac Bank, see section E(2), below. 632 See undated charts prepared by FDIC on “Daily Retail Deposit Change,” FDIC-PSI-01-000009. 633 See, e.g., 12/1/2008 “WaMu Bank Supervisory Timeline,” prepared by OTS Examiner-in-Charge Benjamin Franklin, at Franklin_Benjamin-00035756_001, at 032 (7/22/2008 entry: “Although they have $60 billion in borrowing capacity, the FHLB is not in a position to fund more than about $4 to $5 billion a week”). See also FDIC LIDI Report for the Second Quarter of 2008, at FDIC_WAMU_000014991 [Sealed Exhibit]. 634 7/3/2008 email from John Reich to Kerry Killinger, “MOU vs. Board Resolution,” Hearing Exhibit 4/16-44. 635 7/21/2008 letter from FDIC to OTS, FDIC_WAMU_000001730, Hearing Exhibit 4/16-59. 636 7/22/2008 letter from OTS to FDIC, OTSWMS08-015 0001312, Hearing Exhibit 4/16-60. 637 See 8/1/2008 email exchange among FDIC colleagues, FDIC-EM_00246958, Hearing Exhibit 4/16-64. 638 8/1/2008 email exchange among OTS officials, Hearing Exhibit 4/16-62. The FDIC had performed a capital analysis earlier in the summer and had been pushing for a downgrade for weeks. See 7/21/2008 letter from FDIC to OTS, FDIC_WAMU_000001730, Hearing Exhibit 4/16-59. 639 8/1/2008 email from OTS Director John Reich to FDIC Chairman Sheila Bair, Hearing Exhibit 416-63.

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management, and board oversight. On August 4, WaMu asked OTS to drop the requirement that the consultant review the Board’s oversight efforts, and OTS agreed.

On August 6, the FDIC Chairman asked the OTS Director to discuss contingency plans for an emergency closure of the bank. The OTS Director reacted negatively and sent an email criticizing the FDIC Chairman for acting as if it were the primary regulator of the bank.640 As the agencies argued amongst themselves, the bank’s condition continued to deteriorate.

By August 25, OTS and WaMu reached agreement on the terms of the MOU, but it was 641 Apart from the capitalization plan, OTS Deputy

not actually signed until September 7, 2008. Director Scott Polakoff described the final MOU as a “benign supervisory document,”642 meaning it would not bring about meaningful change at WaMu.643

On September 10, 2008, the FDIC Chairman, Sheila Bair, informed WaMu that there was

a ratings disagreement between the FDIC and OTS, and that the FDIC was likely to downgrade WaMu to a 4. When she informed the OTS Director, John Reich, of her conversation with WaMu, he sent an internal email to his deputy, Scott Polakoff, venting his frustration that she had not discussed the matter with him first and allowed OTS to break the news to the bank: “I cannot believe the continuing audacity of this woman.”

644

Six days later, on September 16, 2008, Lehman Brothers declared bankruptcy, triggering

another run on Washington Mutual. Over the next eight days, depositors pulled $17 billion in 645 On September 18, the FDIC cash from WaMu’s coffers, leading to a second liquidity crisis. downgraded the bank to a 4 rating, and OTS agreed to the lower rating. Within days, because of the bank’s accelerating liquidity problems, portfolio losses, share price decline, and other problems, OTS and the FDIC decided they had to close the bank.646

Due to the bank’s worsening liquidity crisis, the regulators abandoned their customary practice of waiting until markets closed on Friday, and on Thursday, September 25, 2008, OTS closed Washington Mutual Bank and appointed the FDIC as receiver. The FDIC immediately sold the bank to JPMorgan Chase for $1.9 billion. If the sale had not gone through, Washington Mutual’s $300 billion failure might have exhausted the entire $45 billion Deposit Insurance Fund.

640 See 8/6/2008 email from John Reich, OTS Director, to Sheila Bair, FDIC Chairman, “Re: W,” FDIC- EM_00110089, Hearing Exhibit 4/16-66. 641 9/11/2008 OTS document, “WaMu Ratings,” Hearing Exhibit 4/16-48. 642 7/28/2008 email from OTS Deputy Director Scott Polakoff to Timothy Ward, “Re: WAMU MOU,” Polakoff_Scott-00060660_001, Hearing Exhibit 4/16-45. 643 Subcommittee interview of Tim Ward, OTS Deputy Director of Examinations, Supervision and Consumer Protection (2/12/2010). 644 9/10/2008 email from OTS Director John Reich to OTS Deputy Director Scott Polakoff, Polakoff_Scott- 00065461_001, Hearing Exhibit 4/16-68. 645 See undated charts prepared by FDIC on “Daily Retail Deposit Change,” FDIC-PSI-01-000009. 646 See IG Report at 13.

(3) OTS Identification of WaMu Deficiencies

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During the five-year period reviewed by the Subcommittee, from 2004 through 2008, OTS examiners identified over 500 serious deficiencies in Washington Mutual’s lending, risk management, and appraisal practices.647 OTS examiners also criticized the poor quality loans and mortgage backed securities issued by Long Beach, and received FDIC warnings regarding the bank’s high risk activities. When WaMu failed in 2008, it was not a case of hidden problems coming to light; the bank’s examiners were well aware of and had documented the bank’s high risk, poor quality loans and deficient lending practices.

(a) Deficiencies in Lending Standards From 2004 to 2008, OTS Findings Memoranda and annual Reports of Examination

(ROE) repeatedly identified deficiencies in WaMu’s lending standards and practices. Lending standards, also called “underwriting” standards, determine the types of loans that a loan officer may offer or purchase from a third party mortgage broker. These standards determine, for example, whether the loan officer may issue a “stated income” loan without verifying the borrower’s professed income, issue a loan to a borrower with a low FICO score, or issue a loan providing 90% or even 100% of the appraised value of the property being purchased.

When regulators criticize a bank’s lending or “underwriting” standards as weak or

unsatisfactory, they are expressing concern that the bank is setting its standards too low, issuing risky loans that may not be repaid, and opening up the bank to later losses that could endanger its safety and soundness. When they criticize a bank for excessively high lending or underwriting “errors,” regulators are expressing concern that the bank’s loan officers are failing to comply with the bank’s standards, such as by issuing a loan that finances 90% of a property’s appraised value when the bank’s lending standards prohibit issuing loans that finance more than 80% of the appraised value.

In addition to errors, regulators may express concern about the extent to which a bank allows its loan officers to make “exceptions” to its lending standards and issue a loan that does not comply with some aspects of its lending standards. Exceptions that are routinely approved can undermine the effectiveness of a bank’s formal lending standards. Another common problem is inadequate loan documentation indicating whether or not a particular loan complies with the bank’s lending standards, such as loan files that do not include a property’s appraised value, the source of the borrower’s income, or key analytics such as the loan-to-value or debt-to- income ratios. In the case of Washington Mutual, from 2004 to 2008, OTS examiners routinely found all four sets of problems: weak standards, high error and exception rates, and poor loan documentation.

2004 Lending Deficiencies. In 2004, OTS examiners identified a variety of problems with WaMu’s lending standards. In May of that year, an OTS Findings Memorandum stated:

647 See IG Report at 28.

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“Several of our recent examinations concluded that the Bank’s single family loan underwriting was less than satisfactory due to excessive errors in the underwriting process, loan document preparation, and in associated activities.”648

After reviewing an OTS examination of a loan sample, the FDIC examiner wrote that the loans:

“reflected inconsistencies with underwriting and documentation practices, particularly in the brokered channel. Additionally, examiners noted that Washington Mutual’s SFR [Single Family Residential] portfolio has an elevated level of risk to a significant volume of potential negative amortization loans, high delinquency and exception rates, and a substantial volume of loans with higher risk characteristics, such as low FICO scores.”649

A few months later, in September, an OTS review of a sample of 2003 WaMu loans

found “critical error rates as high as 57.3%”:

“[Residential Quality Assurance]’s review of 2003 originations disclosed critical error rates as high as 57.3 percent of certain loan samples, thereby indicating that SFR [Single Family Residential] underwriting still requires much improvement. While this group has appropriately identified underwriting deficiencies, it has not been as successful in effecting change.”650

The same OTS Report of Examination observed that one of the three causes of underwriting deficiencies was “a sales culture focused on building market share.” It also stated:

“Notwithstanding satisfactory asset quality overall, some areas still require focused management and Board attention. Most important is the need to address weaknesses in single-family residential (SFR) underwriting, which is an ongoing issue from prior exams.”651

The OTS ROE concluded: “Underwriting of SFR loans remains less than satisfactory.”

652

The next month, when OTS conducted a field visit to follow up on some of the problems

identified earlier, it concluded:

“The level of SFR [Single Family Residential] underwriting exceptions in our samples has been an ongoing examination issue for several years and one that management has found difficult to address. The institution instituted a major organizational/staffing

648 5/12/2004 OTS Memo 5, “SFR Loan Origination Quality,” OTSWME04-0000004883. 649 5/20/2004 FDIC-DFI Memo 3, “Single Family Residential Review,” OTSWME04-0000004889. 650 9/13/2004 OTS Report of Examination, at OTSWMS04-0000001498, Hearing Exhibit 4/16-94 [Sealed Exhibit]. 651 9/13/2004 OTS Report of Examination, at OTSWMS04-0000001492, Hearing Exhibit 4/16-94 [Sealed Exhibit]. 652 9/13/2004 OTS Report of Examination, at OTSWMS04-0000001497, Hearing Exhibit 4/16-94 [Sealed Exhibit].

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realignment in September 2003 and has continued to make additional adjustments since that time to address accumulating control issues.”653

2005 Lending Deficiencies. In early 2005, OTS elevated the problems with the bank’s

lending standards to the attention of the WaMu Board of Directors. In a letter to the Board, OTS wrote:

“SFR Loan Underwriting – This has been an area of concern for several exams. As management continues to make change in organization, staffing, and structure related to SFR loan underwriting, delays in meeting target dates become inevitable. The board should closely monitor these delays to ensure they do not become protracted.”654

OTS officials attended a Board meeting to address this and other concerns. Yet a few months later, in June, an OTS examiner wrote: “We continue to have concerns regarding the number of 655
underwriting exceptions and with issues that evidence lack of compliance with Bank policy.” The examination findings memorandum also noted that, while WaMu tried to make changes, those changes produced “only limited success” and loan underwriting remained “less than satisfactory.”656

had not been resolved:

In August 2005, the OTS ROE for the year indicated that the lending standards problem

“[W]e remain concerned with the number of underwriting exceptions and with issues that evidence lack of compliance with bank policy …. [T]he level of deficiencies, if left unchecked, could erode the credit quality of the portfolio. Our concerns are increased with the risk profile of the portfolio is considered, including concentrations in Option ARM loans to higher-risk borrowers, in low and limited documentation loans, and loans with subprime or higher-risk characteristics. We are concerned further that the current market environment is masking potentially higher credit risk.”657 2006 Lending Deficiencies. The same problems continued into 2006. In March 2006,

OTS issued the same strong warning about WaMu’s loan portfolio that it had provided in August 2005:

“We believe the level of delinquencies, if left unchecked, could erode the credit quality of the portfolio. Our concerns are increased when the risk profile of the portfolio is considered, including concentrations in Option ARMS to higher-risk borrowers, in low and limited documentation loans, and loans with subprime or higher-risk characteristics.

653 10/18/2004 OTS Field Visit Report of Examination, at OTSWMEF-0000047576-78, Hearing Exhibit 4/16-94 [Sealed Exhibit]. 654 2/7/2005 OTS Letter to Washington Mutual Board of Directors on Matters Requiring Board Attention, OTSWMEF-0000047591 [Sealed Exhibit]. 655 6/3/2005 OTS Findings Memorandum, “Single Family Residential Home Loan Review,” OTSWME05-004 0000392, Hearing Exhibit 4/16-26. 656 Id. at OTSWME05-004 0000392. 657 8/29/2005 OTS Report of Examination, at OTSWMS05-004 0001794, Hearing Exhibit 4/16-94 [Sealed Exhibit].

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We are concerned further that the current market environment is masking potentially higher credit risk.”658 Two months later, in May 2006, an OTS examiner wrote:
“During the prior examination, we noted numerous instances of underwriters exceeding underwriting guidelines, errors in income calculations, errors in debt-to-income (DTI) calculations, lack of sufficient mitigating factors for credit-quality related issues, and insufficient title insurance coverage on negative amortization loans. … [U]nderwriting errors [] continue to require management’s attention.”659 While OTS was documenting its concerns, however, it is apparent in hindsight that the

agency tempered its criticism. The OTS examiner who authored the memo found that in his review, none of the negatively amortizing loans he analyzed for safety and soundness carried an “exception,” meaning it “probably should not have been made.” Many of the loans made in this time period would later default.

660

Another OTS Findings Memorandum the same month concluded: “Overall, we

concluded that the number and severity of underwriting errors noted remain at higher than acceptable levels.”

661

The 2006 OTS ROE for the year concluded:
“[S]ubprime underwriting practices remain less than satisfactory. … [T]he number and severity of underwriting exceptions and errors remain at higher than acceptable levels.
… The findings of this judgmental sample are of particular concern since loans with risk layering … should reflect more, rather than less, stringent underwriting.”662 2007 Lending Deficiencies. In 2007, the problems with WaMu’s lending standards were

no better, and the acceleration of high risk loan delinquencies and defaults threatened serious consequences.

By July 2007, the major credit rating agencies had begun mass ratings downgrades of

hundreds of mortgage backed securities, the subprime secondary market froze, and WaMu was left holding billions of dollars worth of suddenly unmarketable subprime and other high risk loans. In September, the OTS ROE for the year concluded:

“Underwriting policies, procedures, and practices were in need of improvement, particularly with respect to stated income lending. Based on our current findings, and the

658 3/14/2006 OTS Report of Examination, at 19, OTSWMEF-0000047030, Hearing Exhibit 4/16-94 [Sealed Exhibit]. 659 5/23/2006 OTS Findings Memorandum, “Home Loan Underwriting,” OTSWMS06-008 0001299, Hearing Exhibit 4/16-33. 660 Id. 661 5/25/2006 OTS Findings Memorandum, “Loan Underwriting Review - Long Beach Mortgage,” OTSWMS06- 008 0001243, Hearing Exhibit 4/16-35. 662 8/26/2006 OTS Report of Examination, at OTSWMS06-008 0001680, Hearing Exhibit 4/16-94 [Sealed Exhibit].

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fact that a number of similar concerns were raised at prior examinations, we concluded that too much emphasis was placed on loan production, often at the expense of loan quality.”663

The ROE also reported on an unsatisfactory review of loans that had been originated by Long Beach and warned that, if the problems were not promptly corrected, “heightened supervisory action would be taken”:

“Based on our review of 75 subprime loans originated by [Long Beach], we concluded that subprime underwriting practices remain less than satisfactory …. Given that this is a repeat concern and MRBA [Matter Requiring Board Attention], we informed management that underwriting must be promptly corrected, or heightened supervisory action would be taken, including limiting the Bank’s ability to continue SFR subprime underwriting.”664 In the fourth quarter of 2007, WaMu’s loan portfolio lost $1 billion in value. Despite that loss, and the strong language in the 2007 examinations, OTS took no enforcement action against the bank that would result in WaMu’s tightening its lending standards or strengthening compliance with the standards it had.

2008 Lending Deficiencies. In the first six months of 2008, WaMu continued to incur billions of dollars in losses, as its high risk loan portfolio lost value and its share price fell. In July 2008, about two months before the bank failed, OTS met with the WaMu Board of Directors to discuss, among other matters, the bank’s deficient lending standards. While the presentation to the Board reiterated the concerns from past years, it failed to convey a sense of urgency to a bank on the verge of collapse. Instead, the presentation focused on long term corrective action that WaMu should take. The OTS written presentation to the Board included the following: “High SFR [Single Family Residential] losses due in part to downturn in real estate market but exacerbated by: geographic concentrations[,] risk layering[,] liberal underwriting policy[,] poor underwriting. … Discontinuing higher risk lending and tightened underwriting policy should improve asset quality; however, actions should have been taken sooner. … Significant underwriting and process weaknesses noted again in the Home Loans Group[.] … Reducing higher risk lending products and practices should have been done sooner.”665 Failure to Correct Deficient Lending Practices. In various reports for nearly five

consecutive years, OTS criticized WaMu’s lending standards, error and exception rates, and loan documentation, and directed the bank to improve its performance. When WaMu failed to improve during that span, OTS failed to take action, such as requiring a board resolution,

663 9/18/2007 OTS Report of Examination, at OTSWMEF-0000046679, Hearing Exhibit 4/16-94 [Sealed Exhibit]. 664 9/18/2007 OTS Report of Examination, at OTSWMEF-0000047146, Hearing Exhibit 4/16-94 [Sealed Exhibit]. 665 7/15/2008 OTS Presentation to WaMu Board of Directors based on Comprehensive Examinations, Polakoff_Scott-00061303_007, 012, 027, Hearing Exhibit 4/16-12b.

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memorandum of understanding, or cease and desist order compelling WaMu to tighten its lending standards and increase oversight of its loan officers to reduce underwriting error and exception rates and improve loan documentation. The result was that WaMu originated or purchased hundreds of billions of dollars of high risk loans, including stated income loans without verification of the borrower’s assets or ability to repay the loan; loans with low FICO scores and high loan-to-value ratios; loans that required interest-only payments; and loan payments that did not cover even the interest owed, much less the principal.

(b) Deficiencies in Risk Management

Over the same five-year period, from 2004 to 2008, in addition to identifying deficiencies

associated with WaMu’s lending practices, OTS repeatedly identified problems with WaMu’s risk management practices. Risk management involves identifying, evaluating, and mitigating the risks that threaten the safety, soundness, and profitability of an institution. At thrifts, the primary risk issues include setting lending standards that will produce profitable loans, enforcing those standards, evaluating the loan portfolio, identifying home loans that may default, establishing adequate reserves to cover potential losses, and advising on measures to lower the identified risks. When regulators criticize a bank’s risk management practices as weak or unsatisfactory, they are expressing concern that the bank is failing to identify the types of risk that threaten the bank’s safety and soundness and failing to take actions to reduce and manage those risks.

Within WaMu, from 2004-2005, oversight of risk management practices was assigned to

a Chief Risk Officer. In 2006, it was assigned to an Enterprise Risk Management (ERM) Department headed by a Chief Enterprise Risk Officer. ERM employees reported, not only to the department, but also to particular lines of business such as the WaMu Home Loans Division, and reported both to the Chief Risk Officer and to the head of the business line, such as the president of the Home Loans Division. WaMu referred to this system of reporting as a “Double- Double.”666

As with the bank’s poor lending standards, OTS allowed ongoing risk management

problems to fester without taking enforcement action. From 2004 to 2008, OTS explicitly and repeatedly alerted the WaMu Board of Directors to the need to strengthen the bank’s risk management practices.

2004 Risk Management Deficiencies. In 2004, prior to the bank’s adoption of its High

Risk Lending Strategy, OTS expressed concern about the bank’s risk management practices, highlighted the issue in the annual ROE, and brought it to the attention of the WaMu Board of Directors. The 2004 ROE stated:

666 Subcommittee interviews of Ronald Cathcart (2/23/2010), David Schneider (2/17/2010), and Cheryl Feltgen (2/6/2010).

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“Board oversight and management performance has been satisfactory … but … increased operational risks warrant prompt attention. These issues limit the institution’s flexibility and may threaten its ability to remain competitive and independent.”667

668

Another OTS examination that focused on WaMu’s holding company identified multiple

At another point, the ROE warned: “Ensure cost-cutting measures are not impacting critical risk management areas.”

risks associated with Long Beach: “[P]rimary risks associated with Long Beach Mortgage Company remain regulatory risk, reputation risk, and liquidity of the secondary market in subprime loans.”

requirement that WaMu commit its high risk lending strategy to paper and gain explicit approval from the Board of Directors.

Its concern about WaMu’s risk management practices prompted, in part, OTS’

669

2005 Risk Management Deficiencies. In 2005, after adoption of the High Risk Lending

Strategy, OTS again highlighted risk management issues in its examination reports and again brought the matter to the attention of WaMu’s Board of Directors.

In March 2005, OTS observed that WaMu’s five-year strategy, which increased credit

risk for the bank, did not “clearly articulate the need to first focus on addressing the various operational challenges before embarking on new and potentially more risky growth initiatives.”670 OTS also wrote: “We discussed the lack of a clear focus in the plan on resolving operational challenges with CEO Killinger and the Board.”671 concerns about the bank’s weak risk management practices for the rest of the year, yet took no concrete enforcement action to compel the bank to address the issue. In June 2005, OTS described risk management weaknesses within WaMu’s Corporate Risk Oversight group, a sub- group within the ERM Department responsible for evaluating credit and compliance risk. OTS wrote that it had deemed its comments as “criticisms” of the bank, because of the significance of the risk management function in addressing ongoing problems with the bank’s lending standards and loan error rates:

OTS continued to express

“Most of the findings are considered ‘criticisms’ due to the overall significance of CRO [Corporate Risk Oversight] activities and the fact that we have had concerns with quality assurance and underwriting processes within home lending for several years.”672

In August 2005, in its annual Report on Examination, OTS urged the WaMu Board to

obtain progress reports from the ERM Department and ensure it had sufficient resources to

667 9/13/2004 OTS Report of Examination, at OTSWMS04-0000001504, Hearing Exhibit 4/16-94 [Sealed Exhibit].
668 Id. at OTSWMS04-000001488.
669 4/5/2004 OTS Report of Examination, at OTSWMEF-0000047477, Hearing Exhibit 4/16-94 [Sealed Exhibit]. 670 3/15/2004 OTS Report of Examination, at OTSWMS04-0000001509, Hearing Exhibit 4/16-94 [Sealed Exhibit]. 671 Id. 672 6/1/2005 OTS Findings Memorandum, “Corporate Risk Oversight,” OTSWMS05-005 0002046, Hearing Exhibit 4/16-23.

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become an effective counterweight to the increased risk-taking entailed in the High Risk Lending Strategy:

“Monitor and obtain reports from management on status of [Enterprise Risk Management] in terms of effectiveness and resource adequacy. … ERM provides an important check and balance on the company’s profit-oriented units and warrants ongoing strong Board commitment given the institution’s current strategic direction.”673

The same ROE noted that the bank did not have effective procedures in place to evaluate the many exceptions being granted to allow loan officers to issue loans that failed to comply with the bank’s lending standards, and urged attention to the risks being established:

“Until full exception data collection, reporting, and follow-up processes are in place and stabilized, senior management and the Board cannot fully assess whether quality assurance processes are having a meaningful impact on line activities, including loan underwriting. We are particularly concerned with the establishment of good quality assurance process for SFR underwriting, which has been an issue for the past several examinations.”674

A follow-up field examination, conducted in September 2005, stated:

“We criticized the lack of Trend and Dashboard Report to senior management and the board, without which it is impossible to determine whether line functions are performing acceptably and, more specifically, whether the quality assurance process is having a meaningful impact on improving loan underwriting.”675 2006 Risk Management Deficiencies. In 2006, OTS again expressed concern about WaMu’s risk management practices, but took no further steps to compel improvements. The annual ROE urged the Board of Directors to:

“[c]ontinue to monitor and obtain reports from management on the status of ERM to ensure its effectiveness and adequacy of resources. . . . ERM should provide an important check and balance on profit-oriented units … particularly given the bank’s current strategy involving increased credit risk.” 676

The 2006 ROE also commented that: “[w]ithin ERM, fraud risk management at the enterprise level is in the early stage of development. … Currently, fraud management is decentralized and does not provide a streamlined process to effectively track fraud events across all business lines.
In addition, consistent fraud reporting capabilities are not in place to consolidate data for analysis, reporting, and risk management at the enterprise level.”

677

673 8/29/2005 OTS Report of Examination, at OTSWMS05-003 0001783, Hearing Exhibit 4/16-94 [Sealed Exhibit]. 674 Id. at OTSWMS05-004 0001792. 675 10/3/2005 OTS Field Visit Report of Examination, at OTSWMEF-0000047602, Hearing Exhibit 4/16-94 [Sealed Exhibit].
676 8/29/2006 OTS Report of Examination, at OTSWMS06-008 0001671, Hearing Exhibit 4/16-94 [Sealed Exhibit]. 677 Id. at OTSWMS06-008 0001687, 91.

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2007 Risk Management Deficiencies. In 2007, as high risk loan delinquencies and

defaults accelerated and WaMu began to incur losses, OTS examiners used harsher language to describe the deficiencies in WaMu’s risk management practices, criticizing the bank’s failure to institute stronger risk controls and procedures at an earlier date, as recommended.

In June 2007, for example, OTS examiners completed a review critical of WaMu

procedures to oversee the loans it purchased from third party mortgage brokers.678 From 2003 to 2007, 48 to 70% of WaMu’s loans were purchased from third parties.679 An OTS memorandum noted that Washington Mutual had only 14 full-time employees overseeing more than 34,000 third party brokers submitting loans to the bank for approval. OTS also criticized the scorecard used to rate those brokers which, among other problems, did not include the rate at which significant lending or documentation deficiencies were attributed to the broker, the rate at which its loans were denied or produced unsaleable loans, or an indication of whether the broker was included in industry watchlists for misconduct. After describing these and other problems, rather than lower WaMu’s safety and soundness scores for its poor oversight, however, the OTS memorandum made only the following observation: “Given the . . . increase in fraud, early payment defaults, first payment defaults, subprime delinquencies, etc., management should re- assess the adequacy of staffing.”680 WaMu management agreed with the finding, but provided no corrective action plan, stating only that “[s]taffing needs are evaluated continually and adjusted as necessary.”681

In the September 2007 annual ROE, OTS wrote:

“Risk management practices in the HLG (Home Loans Group) during most of the review period were inadequate …. We believe that there were sufficient negative credit trends that should have elicited more aggressive action by management with respect to limiting credit exposure. In particular, as previously noted, the risk misrepresentation in stated income loans has been generally reported for some time. This information should have led management to better assess the prudence of stated income lending and curtail riskier products well before we indicated during this examination that we would limit the Bank’s ability to continue such lending.” 682

The ROE also faulted management and Board inaction:

“Board oversight and management’s performance was less than satisfactory. …
Contributing factors should have been more proactively managed by the Board and management. The most significant of these factors include Matters Requiring Board

678 6/7/2007 OTS Asset Quality Memo 11, “Broker Credit Administration,” Hedger_Ann-00027930_001, Hearing Exhibit 4/16-10. 679 Prepared statement of Treasury IG Thorson, April 16, 2010 Subcommittee Hearing, at 5. 680 6/7/2007 OTS Asset Quality Memo 11, “Broker Credit Administration,” Hedger_Ann-00027930_001, Hearing Exhibit 4/16-10. 681 Id. at 011.
682 9/18/2007 OTS Report of Examination, at OTSWMEF-0000046681, Hearing Exhibit 4/16-94 [Sealed Exhibit].

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Attention that were noted in prior examinations but were not adequately addressed, including … an ERM function that was not fully effective.”683

The ROE concluded: “The ERM function has been less than effective for some time. … ERM has not matured in a timely manner and other ERM functions have been generally ineffective.”

684

A separate OTS examination of WaMu’s compliance function observed that WaMu had

hired nine different compliance officers in the past seven years, and that “[t]his amount of turnover is very unusual for an institution of this size and is a cause for concern.”

685

Despite these harsh assessments in 2007, OTS again refrained from taking any enforcement action against the bank such as developing a nonpublic Memorandum of Understanding or a public Cease and Desist Order with concrete plans for strengthening WaMu’s risk management efforts.

2008 Risk Management Deficiencies. In 2008, as WaMu continued to post billions of

dollars in losses, OTS continued to express concerns about its risk management practices. In February 2008, OTS downgraded WaMu to a 3 CAMELS rating and required the bank to issue a Board Resolution committing to certain strategic initiatives including “a more disciplined framework for the identification and management of compliance risks.”686

In June 2008, OTS issued a Findings Memorandum reacting to a WaMu internal review

that found significant levels of loan fraud at a particular loan office, and expressed concern “as to The memorandum whether similar conditions are systemic throughout the organization.” noted that “a formalized process did not exist to identify, monitor, resolve, and escalate third party complaints” about loan fraud, expressed concern about “an origination culture focused more heavily on production volume rather than quality”; noted that the WaMu review had found the “loan origination process did not mitigate misrepresentation/fraud”; and described the “need to implement incentive compensation programs to place greater emphasis on loan quality.”

687

As referenced above, in July 2008, two months before the bank’s failure, OTS made a presentation to the WaMu Board which, among other problems, criticized its risk management efforts:

“An adequate [Enterprise Risk Management] function still does not exist although this has been an MRBA [Matter Requiring Board Attention] for some time. Critical as a check and balance for profit oriented units[.] Necessary to ensure that critical risks are

683 Id. at OTSWMEF-0000046690. 684 Id. at OTSWMEF-0000046691. 685 5/31/2007 Draft OTS Findings Memorandum, “Compliance Management Program,” Franklin_Benjamin- 00020408_001, Hearing Exhibit 4/16-9. 686 3/11/2008 WaMu presentation, “Summary of Management’s Action to Address OTS Concerns,” JPM_WM01022322; 3/17/2008 letter from Kerry Killinger to Darrel Dochow with enclosed Board Resolution, OTSWMS08-015 0001216 (committing to initiatives outlined by management).
687 6/19/2008 OTS Asset Quality Memo 22, Bisset_John-00046124_002, Hearing Exhibit 4/16-12a.

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identified, measured, monitored and communicated[.] Even more critical given increased credit, market, and operational risk.”688

Failure to Correct Poor Risk Management. By neglecting to exercise its enforcement authority, OTS chronicled WaMu’s inadequate risk management practices over a period of years, but ultimately failed to change its course of action. During a hearing of the Subcommittee, the Department of the Treasury Inspector General, Eric Thorson, whose office conducted an in-depth review of WaMu’s regulatory oversight, testified:

“Issues related to poor underwriting and weak risk controls were noted as far back as 2003, but the problem was OTS did not ensure that WaMu ever corrected those weaknesses. We had a hard time understanding why OTS would allow these satisfactory ratings to continue given that, over the years, they found the same things over and over.”689

(c) Deficiencies in Home Appraisals Still another area in which OTS failed to take appropriate enforcement action involves

WaMu’s appraisal practices. OTS failed to act even after other government entities accused WaMu of systematically inflating property values to justify larger and more risky home loans.

Appraisals provide estimated dollar valuations of property by independent experts. They play a key role in the mortgage lending process, because a property’s appraised value is used to determine whether the property provides sufficient collateral to support a loan. Lending standards at most banks require loans to meet, for example, certain loan-to-value (LTV) ratios to ensure that, in the event of a default, the property can be sold and the proceeds used to pay off any outstanding debt.

From 2004 to mid-2006, WaMu conducted its own property appraisals as part of the loan

approval process. During that period, OTS repeatedly expressed concerns about WaMu’s appraisal efforts.690 In May 2005, OTS criticized WaMu – the most severe type of finding – regarding its practice of allowing sellers to estimate the value of their property. OTS directed WaMu to stop including an Owner’s Estimate of Value in documents sent to appraisers since it biased the review; this criticism had been repeatedly noted in prior examinations, yet WaMu did not satisfactorily address it until the end of 2005.691 A second finding criticized WaMu’s use of automated appraisal software, noting “significant technical document weaknesses.”692 OTS ultimately determined that none of WaMu’s automated appraisals complied with standard appraisal practices and some even had “highly questionable value conclusions.”693

688 7/15/2008 OTS presentation to WaMu Board of Directors based on Comprehensive Examinations, Polakoff_Scott-00061303-028, Hearing Exhibit 4/16-12b. 689 See April 16, 2010 Subcommittee Hearing at 25.
690 See, e.g., 10/3/2005 OTS Report of Examination, at OTSWMEF-0000047601, Hearing Exhibit 4/16-94 [Sealed Exhibit]. 691 5/20/2005 OTS Memo 4, “Safety and Soundness Examination,” at OTSWME06-039 0000214.
692 Id. 693 3/14/2005 OTS Report of Examination, at OTSWMEN-000001794, Hearing Exhibit 4/16-94 [Sealed Exhibit].

Despite this

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dramatic criticism, OTS found in the next year’s examination that WaMu had continued to use noncompliant automated appraisals.694 management agreed to cease using automated appraisals by October 2006.

Before any enforcement action was taken, WaMu

To address the issue, WaMu decided in mid-2006 to outsource its appraisal function to

695 Calling the move “Project two vendors: eAppraiseIT and Lender Service Incorporated (LSI). Cornerstone,” WaMu fired all of its residential staff appraisers, reducing a staff of about 400 to 30,696 and eAppraiseIT and LSI were tasked with conducting appraisals of homes purchased with WaMu loans.697 WaMu assigned oversight of the outside appraisals to a new Appraisal Business Oversight (ABO) group, a unit within the WaMu Home Loans Risk Management division.

The Decision to Outsource. WaMu’s decision to outsource the appraisal function

698 Though the bank had repeatedly delayed taking action or failed to respond

received minimal attention from OTS. Documentation obtained by the Subcommittee indicates only a few meetings took place between OTS examiners and the WaMu staff tasked with the outsourcing. During a Subcommittee interview, the key OTS appraisal expert, Bruce Thorvig, explained that it was his first time supervising a large institution that decided to outsource the appraisal function. to OTS recommendations and criticisms in the appraisal area in the past, the OTS appraisal expert told the Subcommittee that he saw nothing to indicate that WaMu management could not competently handle a large appraisal outsourcing project of this scale.699 In one of the few meetings that did occur between WaMu and OTS staff on appraisal issues, the bank’s management came away with what they thought was full OTS approval for the outsourcing project,700 though OTS’ appraisal expert disputed that he was even in a position to grant approval and was instead simply receiving notification of WaMu’s plans.701

Appraisal Problems. Problems began almost immediately after WaMu outsourced the

appraisal function. Whether appraisals are conducted internally by the bank or through a vendor, the bank must take responsibility for establishing a standard process to ensure accurate, unbiased home appraisal values. One, for example, was a repeat problem from when WaMu did its own appraisals: “WaMu allowed a homeowner’s estimate of the value of the home to be included on the form sent from WaMu to third party appraisers, thereby biasing the appraiser’s evaluation” toward a higher home value, in violation of standard residential appraisal methods. seasoned appraisal compliance manager, who oversaw WaMu as an FDIC examiner prior to coming to work for the bank, drafted a February 2007 Residential Appraisal Department Review which included a long list of issues. Problems included: “undefined” appraisal standards and processes; “loosely defined” vendor management; “unreasonable and imprudent sales force

702

694 5/23/2006 OTS Memo 2, “Safety and Soundness Examination,” at OTSWME06-039 0000205. 695 Undated OTS internal memo, OTSWMSP-00000001936-51 at 39 [Sealed Exhibit]. 696 Undated OTS internal memo, OTSWMEN-0000015926-31 at 28 [Sealed Exhibit]. 697 Undated OTS internal memo, OTSWMSP-00000001936-51 at 39 [Sealed Exhibit]. 698 Subcommittee Interview of Bruce Thorvig (2/24/2010). 699 Id.
700 5/22/2006 WaMu internal email, OTSWMEN-0000020983. 701 Subcommittee Interview of Bruce Thorvig (2/24/2010). 702 IG Report, at 11, Hearing Exhibit 4/16-82.

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influence over the appraisal function;” and a “broken” third party appraisal risk control process that “may be contributing to the increasing incidence of mortgage fraud.”703

These problems continued without resolution or enforcement action from OTS

throughout 2007. In an April 2007 memorandum, OTS detailed its concerns, both old and new, with WaMu’s appraisal operations. OTS found that WaMu had failed to update and revise its appraisal manual after outsourcing, which put the bank at risk of regulatory violations. In addition, an OTS review of 54 WaMu appraisals identified a number of concerns:

“Primary appraisal issues (red flags requiring attention by the underwriter or review appraiser) included seller paid closing costs and concession, misstatements/ contradictions, inadequate/incomplete explanations and support for the value conclusion, reconciliation of the sales comparison approach, and weakness in the appraisal review process.”704

Despite the extent of these concerns, OTS issued a “recommendation” to the bank that it address the identified problems, rather than the stronger “criticism” which would have elevated the issue to the bank’s senior management or Board of Directors.

705

Attorney General Complaint. On November 1, 2007, the New York Attorney General issued a complaint against WaMu’s appraisal vendors, LSI and eAppraiseIT, alleging fraud and collusion with WaMu to systematically inflate real estate values.

The complaint stated in part:

706

“[F]irst American and eAppraiseIT have abdicated their role in providing ‘third-party, unbiased valuations’ for eAppraiseIT’s largest client, WaMu. Instead, eAppraiseIT improperly allows WaMu’s loan production staff to hand-pick appraisers who bring in appraisal values high enough to permit WaMu’s loans to close, and improperly permits WaMu to pressure eAppraiseIT appraisers to change appraisal values that are too low to permit loans to close.”

707

Though OTS had been aware of the Attorney General’s investigation in May 2007, it took no action until after the Attorney General issued the complaint. Even then, OTS did not initiate its own investigation until after an internal WaMu investigation was already underway.
The OTS Western Region Director advised: “I believe OTS needs to open up its own special investigation. WaMu started their own special investigation a few days ago when this broke.”

708

703 2/21/2007 draft internal WaMu report, “Residential Appraisal Department Review,” OTSWMEN-0000000274 (drafted by Mark Swift).
704 4/5/2007 OTS Asset Quality Memo 2, OTSWME07-067 0001082.
705 Id. 706 11/1/2007 New York Attorney General press release, http://www.ag.ny.gov/media_center/2007/nov/nov1a_07.html. Both companies appraised property in New York, which provided jurisdiction for the complaint.
707 New York v. First American Corporation, et al., (N.Y. Sup.), Complaint (November 1, 2007), at 3. 708 11/7/2007 email from Darrel Dochow to Benjamin Franklin, Randy Thomas, others, OTSWMS07-011 0001294.

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It took nearly a month for OTS to launch its own investigation into the allegations set out

in the New York Attorney General’s complaint.709 OTS, John Reich, was presented with his agency’s investigation plan, he responded:

In November 2007, when the director of

“This appears to be a comprehensive (and impressive) review schedule. It doesn’t appear, on the surface anyway, to leverage off of WaMu’s own review. Do you think we might be totally reinventing the wheel and possibly taking too long to complete our review?”

710

Despite his concerns about how long the planned investigation might take, the OTS investigation proceeded as proposed. It took over 10 months, until September 2008, for OTS to gather, analyze, and reach conclusions about WaMu’s appraisal practices.

The OTS investigation uncovered many instances of improper appraisals. After

reviewing 225 loan files, the OTS appraisal expert found that “[n]umerous instances were identified where, because of undue influence on the appraiser, values were increased without supporting documentation.”711 OTS also found that WaMu had violated the agency’s appraisal regulations by failing to comply with appraisal independence procedures after they outsourced the function.712 The OTS investigation concluded that WaMu’s appraisal practices constituted “unsafe or unsound banking practices.”713 The OTS investigation also concluded that WaMu was not in compliance with the Uniform Standards of Professional Appraisal Practice and other minimum appraisal standards.714

Failure to Correct Appraisal Deficiencies. Shortly before WaMu was sold, OTS’ staff

prepared a draft recommendation that the agency issue a cease and desist order to bar the bank from engaging in any activity that would lead to further violation of the appraisal regulations. A cease and desist order would have been the first public enforcement action against WaMu regarding its lending practices. Ultimately, the legal staff submitted the memorandum to OTS’ Deputy Director and Chief Counsel on October 3, 2008, more than a week after the bank collapsed and was sold.716 moot.

By this point, the recommendation was too late and the issue was

715

709 See undated OTS internal memo to John Bowman, OTSWMSP-0000001936 [Sealed Exhibit]. 71011/16/2007 email from OTS Director John Reich to OTS Operations Director Scott Polakoff, Reich_John- 00040045_001. 711 7/28/2008 Draft Memo to Hugo Zia from Bruce Thorvig, OTSWMEN-0000015851 [Sealed Exhibit]. 712 See 12 CFR Part 564. 713 Undated OTS internal memo, OTSWMSP-00000001936-51 at 47 [Sealed Exhibit]. 714 Id. at 37 [Sealed Exhibit]. The Subcommittee found no evidence that anyone in OTS senior management disputed the conclusions of the investigation.
715 Id.
716 OTS internal document, OTS Enforcement Status of Formal Investigations, Quigley_Lori-00231631_001.

(d) Deficiencies Related to Long Beach

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In 1999, WaMu’s parent holding company, Washington Mutual Inc., purchased Long

Beach Mortgage Company (Long Beach). Long Beach’s business model was to issue subprime loans initiated by third party mortgage lenders and brokers and then sell or package those loans into mortgage backed securities for sale to Wall Street firms. Beginning in 1999, Washington Mutual Bank worked closely with Long Beach to sell or securitize its subprime loans and exercised oversight over its lending and securitization operations. Because Long Beach was a subsidiary of Washington Mutual Inc., the holding company, however, and not a subsidiary of Washington Mutual Bank, OTS did not have direct regulatory authority over the company, but could review its operations to the extent they affected the holding company or the bank itself.

OTS was aware of ongoing problems with Long Beach’s management, lending and risk standards, and issuance of poor quality loans and mortgage backed securities. OTS reported, for example, that Long Beach’s “early operations as a subsidiary of [Washington Mutual Inc.] were characterized by a number of weaknesses” including “loan servicing weaknesses, documentation exceptions, high delinquencies, and concerns regarding compliance with securitization-related representations and warranties.”717 OTS also reported that, in 2003, “adverse internal reviews of [Long Beach] operations led to a decision to temporarily cease securitization activity” until a “special review” by the WaMu legal department ensured that file documentation “adequately supported securitization representations and warranties” made by Long Beach.718 OTS was aware of an examination report issued by a state regulator and the FDIC after a review of 2003 Long Beach loans, which provides a sense of the extent of problems with those loans at the time:

“An internal residential quality assurance (RQA) report for [Long Beach]’s first quarter 2003 … concluded that 40% (109 of 271) of loans reviewed were considered unacceptable due to one or more critical errors. This raised concerns over [Long Beach]’s ability to meet the representations and warranty’s made to facilitate sales of loan securitizations, and management halted securitization activity. A separate credit review report … disclosed that [Long Beach]’s credit management and portfolio oversight practices were unsatisfactory. … Approximately 4,000 of the 13,000 loans in the warehouse had been reviewed … of these, approximately 950 were deemed saleable, 800 were deemed unsaleable, and the remainder contained deficiencies requiring remediation prior to sale. … [O]f 4,500 securitized loans eligible for foreclosure, 10% could not be foreclosed due to documentation issues.” Despite these severe underwriting and operational problems, Long Beach resumed

719

securitization of its subprime loans in 2004. In April 2005, OTS examiners circulated an internal email commenting on the poor quality of Long Beach loans and mortgage backed securities compared to its peers:

717 12/21/2005 OTS internal memorandum by OTS examiners to OTS Deputy Regional Director, OTSWMS06-007 0001010, Hearing Exhibit 4/16-31.
718 Id. 719 1/13/2004 FDIC-Washington State joint visitation report, FDIC-EM_00102515-20, Hearing Exhibit 4/13-8b.
OTS held a copy of this report in its files, OTSWME04-0000029592.

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“Performance data for 2003 and 2004 vintages appear to approximate industry average while issues prior to 2003 have horrible performance. . . . [Long Beach] finished in the top 12 worst annualized [Net Credit Losses] in 1997 and 1999 thru 2003. [Long Beach nailed down the number 1 spot as top loser with an [Net Credit Loss] of 14.1% in 2000 and placed 3rd in 2001 with 10.5%. … For ARM [adjustable rate mortgage] losses, [Long Beach] really outdid themselves with finishes as one of the top 4 worst performers from 1999 through 2003. For specific ARM deals, [Long Beach] made the top 10 worst deal list from 2000 thru 2002. … Although underwriting changes were made from 2002 thru 2004, the older issues are still dragging down overall performance. … At 2/05, [Long Beach] was #1 with a 12% delinquency rate. Industry was around 8.25%.”720

Six months later, after conducting a field visit, an OTS examiner wrote: “Older securitizations of [Long Beach] continue to have some issues due to previously known underwriting issues in some vintages. The deterioration in these older securitizations is not unexpected.”

721

Purchase of Long Beach. In 2005, Washington Mutual Bank proposed purchasing Long

Beach from its holding company so that Long Beach would become a wholly owned subsidiary of the bank. In making the case for the purchase, which required OTS approval, WaMu contended that making Long Beach a subsidiary would give the bank greater control over Long Beach’s operations and allow it to strengthen Long Beach’s lending practices and risk management, as well as reduce funding costs and administrative expenses. In addition, WaMu proposed that it could replace its current “Specialty Mortgage Finance” program, which involved purchasing subprime loans for its portfolio primarily from Ameriquest, with a similar loan portfolio provided by Long Beach.

722

In June 2005, an OTS examiner expressed concerns about the purchase in an internal

memorandum to OTS regional management and recommended that the purchase be conditioned on operational improvements:

“At the start of this examination, it was our intent to perform a review of the operation of [Long Beach] with the expectation that [Washington Mutual Inc.] or the bank would be requesting approval to move [Long Beach] as an operating subsidiary of the bank. Such a move would obviously place the heightened risks of a subprime lending operation directly within the regulated institution structure. Because of the high profile nature of the business of [Long Beach] and its problematic history, we believe that any and all concerns regarding the subprime operation need to be fully addressed prior to any move.”723

720 4/14/2005 OTS internal email, OTSWME05-012 0000806, Hearing Exhibit 4/16-19. 721 10/3/2005 OTS Holding Company Field Visit Report of Examination, at OTSWMS06-010 00002532, Hearing Exhibit 4/16-94 [Sealed Exhibit]. 722 See 12/21/2005 OTS internal memorandum by OTS examiners to OTS Deputy Regional Director, at OTSWMS06-007 0001011, Hearing Exhibit 4/16-31. 723 6/3/2005 OTS memorandum from Rich Kuczek to Darrel Dochow, “Long Beach Mortgage Corporation (LBMC) Review,” OTSWMS06-007 0002683, Hearing Exhibit 4/16-28.

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The memorandum identified several matters that required resolution prior to a WaMu purchase of Long Beach, including the establishment of pre- and post-funding loan quality reviews that were already in place at the bank. The memorandum also stated that Long Beach management had “worked diligently to improve its operation and correct significant deficiencies … reported in prior years,” and observed, “there is definitely a new attitude and culture.”724

OTS continued to review Long Beach’s lending practices and found additional

deficiencies throughout the year. Those deficiencies included errors in loan calculations of debt- to-income ratios, lack of documentation to support the reasonableness of borrower income on stated income loans, and lack of explanation of a borrower’s ability to handle payment shock on loans with rising interest rates. portfolio of subprime loans “had attributes that could result in higher risk” than WaMu’s existing subprime loan portfolio.726

725 OTS also determined that Long Beach’s newly created

Nevertheless, in December 2005, OTS examiners wrote that, even though Long Beach

was “engaged in a high-risk lending activity and we are not yet fully satisfied with its practices,” 727
they recommended approving WaMu’s purchase of the company with certain conditions. Those conditions included WaMu’s reconsidering its high risk lending concentration limits, including “stated income loans with low FICOs and high LTV ratios”; WaMu’s assurance that Long Beach would comply with certain loan guidance; a WaMu commitment to continue to bring down its loan exception and error rates; and a WaMu commitment to ensure its Enterprise Risk Management division would provide a “countervailing balance” to “imprudent” desires to expand Long Beach’s subprime lending.728

About the same time as this memorandum was completed, OTS learned that, during the

fourth quarter of 2005, Long Beach had been required to repurchase tens of millions of dollars of loans it had sold to third parties due to early payment defaults. By December, this unexpected wave of repurchases had overwhelmed Long Beach’s repurchase reserves, leading to a reserve shortfall of nearly $75 million. Altogether in the second half of 2005, Long Beach had to repurchase loans with about $837 million in unpaid principal, and incurred a net loss of about

729

724 Id. See also 5/19/2005 OTS email, “LBMC Fair Lending,” OTSWMS05-005 0002002, Hearing Exhibit 4/16-20 (“I would not … feel comfortable with their moving [Long Beach] under the thrift without some conditions”). 725 See 12/21/2005 OTS internal memorandum by OTS examiners to OTS Deputy Regional Director Darrel Dochow, OTSWMS06-007 0001009-16, Hearing Exhibit 4/16-31. 726 Id. at OTSWMS06-007 0001011. 727 See 12/21/2005 OTS internal memorandum by OTS examiners to OTS Deputy Regional Director Darrel Dochow, OTSWMS06-007 0001009-16, Hearing Exhibit 4/16-31. 728 Id. at OTSWMS06-007 0001015-16. 729 See 10/3/2005 OTS Report of Examination, OTSWMS06-010 0002530, Hearing Exhibit 4/16-94 [Sealed Exhibit] (noting that, after a field visit to Long Beach that concluded in December 2005, OTS learned that loan repurchases had surged: “Subsequent to our on-site field visit, management informed us that loan repurchases had increased considerably. … Management indicated that approximately $0.6 billion in loans were repurchased during the fourth quarter of 2005 out of approximately $13.2 billion in total whole loan sales. The gross financial impact at December 31, 2005, was $72.3 million.”); 1/20/2006 email from Darrel Dochow to Michael Finn and others, with chart, OTSWMS06-007 0001020 to 1021 (describing Long Beach repurchases).

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$107 million.730 In response, its auditor, Deloitte and Touche, cited Long Beach for a Significant Deficiency in its financial reporting. Despite the sudden evidence of Long Beach’s poor quality loans, inadequate repurchase reserves, and negative earnings impact on its parent company, Washington Mutual Inc., OTS approved the bank’s application to purchase Long Beach. OTS explained its decision to the Subcommittee by contending that the change in status gave WaMu more control over Long Beach to ensure its improvement.731

WaMu ultimately purchased Long Beach on March 1, 2006.

732 After the purchase, Long Beach’s practices did not improve, but continued to exhibit numerous problems, as described in the prior chapter. A May 2006 OTS examination of Long Beach loans concluded, for example, “that the number and severity of underwriting errors noted remain at higher than acceptable levels.”733 wrote:

In a June 2006 internal email to his colleagues, the OTS Regional Deputy Director

“We gave them the benefit of doubt based on commitments and some progress when we allowed them to bring [Long Beach] into the bank, but … we have the same type of concerns remaining 6 months later.”

734

In the annual 2006 ROE and again in the annual 2007 ROE, OTS found that Long

Beach’s lending practices “remain[ed] less than satisfactory.” Subcommittee on April 13, 2010, WaMu’s chief credit risk officers from 2004 to 2008 uniformly condemned Long Beach’s poor performance and testified that it had never developed an effective risk management system.736

735 At a hearing of the

730 See 4/17/2006 memorandum by WaMu General Auditor to Board of Directors’ Audit Committees of Washington Mutual Inc. and Washington Mutual Bank, “Long Beach Repurchase Reserve Root Cause Analysis,” JPM_WM02533760, Hearing Exhibit 4/13-10 (Long Beach “experienced a dramatic increase in EPD’s [early payment defaults], during the third quarter of 2005 [which] … led to a large volume of required loan repurchases.
The unpaid principal balance repurchased as a result of the EPD provision for the year ended December 31, 2005 was $837.3 million. The net loss from these repurchases was approximately $107 million.”).
731 Subcommittee interview of Benjamin Franklin (2/18/2010). 732 See “Washington Mutual Regulators Timeline,” chart prepared by the Subcommittee, Hearing Exhibit 4/16-1j. 733 5/25/2006 OTS Findings Memorandum, “Loan Underwriting Review - Long Beach Mortgage,” OTSWMS06- 008 0001243, Hearing Exhibit 4/16-35. See also 1/20/2006 email from Darrel Dochow to Michael Finn, et al., “LBMC EDP Impact,” OTSWMS06-007 0001020 (emphasis added).
734 6/9/2006 email from Darrel Dochow to Richard Kuczek, Lawrence Carter, and Benjamin Franklin, “Findings Memos,” OTSWMS06-008 0001253, Hearing Exhibit 4/16-36.
735 8/29/2006 OTS Report of Examination, at OTSWMS06-008 0001680, Hearing Exhibit 4/16-94 [Sealed Exhibit]; 9/18/2007 OTS Report of Examination, OTSWMEF-0000047146, Hearing Exhibit 4/16-94 (“Based on our review of 75 subprime loans originated by LBMC, we concluded that subprime underwriting practices remain less than satisfactory . . . . Given that this is a repeat concern and MRBA, we informed management that underwriting must be promptly corrected, or heightened supervisory action would be taken, including limiting the Bank’s ability to continue SFR subprime underwriting.”) [Sealed Exhibit]. 736 April 13, 2010 Subcommittee Hearing at 22.

(e) Over 500 Deficiencies in 5 Years

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As part of their review of Washington Mutual, the Treasury and the FDIC Inspectors

General determined that, over a five-year period, 2004-2008, OTS examiners identified a total of over 540 criticisms, observations, and recommendations related to WaMu operations.737 At the Subcommittee hearing, when asked whether those 540 findings constituted “serious criticisms” of the bank, Treasury IG Eric Thorson responded: “Absolutely.”738 General, Jon Rymer, agreed:

The FDIC Inspector

“[T]he examiners, from what I have seen here, were pointing out the problems, underwriting problems, riskier products, concentrations, distributions, and markets that may display more risk – they were all significant problems and they were identified. At the end of the day, though, I don’t think forceful enough action was taken.”

739

As WaMu accumulated hundreds of infractions from OTS, longstanding problems with

asset quality in the bank’s portfolio continued. While some observers have blamed WaMu’s failure on its liquidity troubles in late 2008, years of unresolved problems festered below the surface.

The consequences of WaMu’s failure to address its underwriting problems, risk

concentrations, risk layering, and other problems were exponential increases in its loss rates.
The FDIC later calculated the loss rates for several WaMu products. In WaMu’s held-for- investment Option ARM portfolio, delinquency rates nearly doubled every year, rising from 0.48% at the end of 2005 to 0.90% a year later, to 2.63% at year end 2007, and up to 4.63% by June 30, 2008.740 In its subprime portfolio, its delinquency rate increased from 7.39% in 2005 to 25.20% in June 2008.741 The delinquency rate in its HELOC portfolio rose from 0.58% in 2005 to 4.00% in June 2008.742 As a result, net charge-offs for WaMu’s Option ARM portfolio rose from $15 million at year end 2005 to $37 million in 2006, to $147 million in 2007, and to $777 million by June 2008.743 HELOC net charge-offs likewise increased, rising from $21 million in 2005, to $23 million in 2006, to $424 million in 2007, and to $1.19 billion by June 2008.744
Subprime net charge-offs expanded even more rapidly, rising from $47 million in 2005, to $134 million in 2006, to $550 million in 2007, and $956 million by June 2008.745 To account for these losses, WaMu’s loss provisions jumped from $218 million in 2006 to over $2 billion in 2007, and an additional $6 billion by June 2008.746

737 Id. at 20. See also IG Report at 28. 738 April 16, 2010 Subcommittee Hearing at 17. 739 Id. at 18. 740 See FDIC Complaint Against WaMu Executives at ¶ 79.
741 Id. 742 Id. 743 Id. at ¶ 81. 744 Id. 745 Id. 746 Id. at ¶ 82.

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The joint report of the Treasury and the FDIC Inspectors General specifically identified WaMu’s poor quality loans and poor risk management practices as the real cause of its failure, rather than the liquidity crisis that hit the bank in 2008.747 During the Subcommittee’s hearing, when asked why WaMu failed, a senior FDIC official put it this way: “Asset quality. Weak asset quality. It brought on the liquidity problems.”748

He explained:

“If you have strong asset quality, you will not have liquidity issues because your assets – you can borrow either against them or you can sell them. If you have weak asset quality, then you are going to have liquidity issues at some point.”

(4) OTS Turf War Against the FDIC

749

As WaMu approached the end, tensions between OTS and the FDIC that had built up

over two years evolved into a turf war. OTS examination and regional officials began to express distrust of their FDIC counterparts. The conflict was elevated to the top leaders of both agencies, who came to take different views of what to do with WaMu – the FDIC becoming more aggressive and OTS becoming more protective. When the bank’s imminent collapse was no longer a question, the result was a hasty seizure and sale. Had the two government agencies acted in concert, rather than as adversaries, it is likely that WaMu’s problems would have been resolved earlier and with less collateral damage. During an interview, the chairman of the FDIC, Sheila Bair, stated pointedly that WaMu “could have sold themselves in July if they had tried.”750 other options remained, and OTS worked with the FDIC to make it happen.

The same outcome was not accomplished until two months later in September when no

As mentioned earlier, OTS was the primary, but not the only, federal bank regulator that oversaw Washington Mutual. Since WaMu was also an insured institution, the FDIC served as a backup examiner responsible for evaluating the risk that the bank posed to the Deposit Insurance Fund. Because WaMu was one of the eight largest insured institutions in the country, the FDIC had assigned a Dedicated Examiner whose full time responsibility was to determine whether the bank was operating in a safe and sound manner. The FDIC Examiner reviewed all OTS ROEs and examination findings, participated on many occasions in OTS examinations, and reviewed bank documents. The FDIC reviewed the CAMELS ratings for the bank, as well as LIDI ratings under its Large Insured Depository Institutions Program.

For many years, FDIC examiners worked cooperatively with OTS examiners to conduct oversight of WaMu. But beginning in 2006, OTS management expressed increasing reluctance to allow FDIC examiners to participate in WaMu examinations and review bank documents.
Claiming that joint efforts created confusion about which agency was WaMu’s primary

747 IG Report at 8.
748 April 16, 2010 Subcommittee Hearing at 76. John Corston was the Acting Deputy Director of the FDIC’s Division of Supervision and Consumer Protection, Complex Financial Institution Branch. 749 Id.
750 Subcommittee interview of Sheila Bair (4/5/2010).

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OTS officials employed a variety of tactics to limit the FDIC oversight of the bank,

regulator,751 including restricting its physical access to office space at the bank, its participation in bank examinations, and its access to loan files. In addition, as the FDIC began to express greater concern about the bank’s viability, recommend ratings downgrades, and urge enforcement action, OTS officials displayed increasing resistance to its advice. In the end, OTS not only undermined years of cooperative oversight efforts, but at times actively impeded FDIC oversight of one of the largest insured banks in the country.

Resisting FDIC Advice. During the period 2004-2008, internal FDIC evaluations of

Washington Mutual were consistently more negative than those of OTS, at times creating friction between the two agencies. OTS also resisted the FDIC’s advice to subject WaMu to stronger enforcement actions, downgrade its CAMELS rating, and solicit buyers for the bank.

As early as 2005, the FDIC examination team expressed concerns about WaMu’s high risk lending strategy, even though the bank’s management expressed confidence that the risks were manageable. In an internal memorandum, for example, the FDIC team identified multiple negative impacts on WaMu’s loan portfolio if housing prices were to stop climbing. The memorandum stated in part:

“Washington Mutual Bank’s (WMB) single-family residential (SRF) loan portfolio has embedded risk factors that increase exposure to a widespread decline in housing prices.
The overall level of risk is moderate, but increasing. … A general decline in housing prices would adversely impact: a) The SRF loan portfolio; b) The home equity loan portfolio; and c) Mortgage banking revenue. … In January 2005, management developed a higher-risk lending (HRL) strategy and defined company-wide higher-risk loans as … sub prime loans … SFR loans with FICO scores below 620, … consumer loans with FICO scores below 660, and … [the] Long Beach … portfolio. Management intends to expand the HRL definition and layer additional risk characteristics in the future. …
Management acknowledges the risks posed by current market conditions and recognizes that a potential decline in housing prices is a distinct possibility. Management believes, however that the impact on WMB would be manageable, since the riskiest segments of production are sold to investors, and that these investors will bear the brunt of a bursting housing bubble.”752

751 See, e.g., April 16, 2010 Subcommittee Hearing at 61 (testimony of OTS Director Reich: “[F]irst of all, the primary regulator is the primary Federal regulator, and when another regulator enters the premises, when the FDIC enters the premises, confusion develops about who is the primary regulator, who really is calling the shots, and who do we report to, which agency.”) 752 Undated draft memorandum from the WaMu examination team at the FDIC to the FDIC Section Chief for Large Banks, FDIC-EM_00251205-10, Hearing Exhibit 4/16-51a (likely mid-2005). In an interview, when shown the draft memorandum, FDIC Assistant Regional Director George Doerr, who was a member of the WaMu examination team, told the Subcommittee that this type of analysis was prepared for a select group of mortgage lenders, including WaMu, to understand where the mortgage market was headed and how it would affect those insured thrifts. He did not have a copy of the final version of the memorandum, but said the FDIC’s analysis was discussed with OTS.
Subcommittee interview of George Doerr (3/30/2010).

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In mid-2005, an internal FDIC memorandum discussed the increased risk associated with

the new types of higher risk mortgage loans being issued in the U.S. housing market:

“Despite the favorable history, we believe recent lending practices and buyer behavior have elevated the risk of residential lending. Concerns are compounded by significantly increased investor activity and new loan products that allow less creditworthy borrowers to obtain mortgages. The new loan products of most concern include Option Adjustment Rate Mortgage (ARM) Loans, Interest Only (IO) Loans, and Piggyback Home Equity Loans.”753

WaMu offered all three types of loans, in addition to subprime loans through Long Beach.

In 2007, an FDIC memorandum again identified WaMu’s high risk home loans as

its “primary risk,” singling out both its subprime and Option ARM loans:

“SFR [Single Family Residential loan] credit risk remains the primary risk. The bank has geographic concentrations, moderate exposure to subprime assets, and significant exposure to mortgage products with potential for payment shock. …
The bank’s credit culture emphasized home price appreciation and the ability to perpetually refinance. … In the past, the bank relied on quarterly sales of delinquent residential loans to manage its non performing assets. The bank’s underwriting standards were lax as management originated loans under an originate to sell model. When the originate to sell model collapsed in July 2007 for private and subprime loans, management was no longer able to sell non performing assets. Consequently, non performing assets are now mounting, and the bank’s credit risk mitigation strategy is no longer effective.”754

From 2004 to 2008, the FDIC assigned LIDI ratings to WaMu that indicated a higher

degree of risk at the bank than portrayed by the bank’s CAMELS ratings. LIDI ratings are intended to convey the degree of risk that a bank might cause loss to the Deposit Insurance Fund, 755 The FDIC IG explained the difference between with A being the best rating and E the worst. LIDI and CAMELS ratings as follows: “LIDI ratings consider future risks at an institution, where CAMELS rating, in practice, are more point-in-time measures of performance.”756

753 7/5/2005 memorandum from FDIC Associate Director John H. Corston to FDIC Associate Director Michael Zamorski, “Insured Institutions’ Exposures to a Housing Slowdown,” FDIC_WAMU_000015114, Hearing Exhibit 4/16-51b. 754 FDIC Washington Mutual Bank LIDI Report, Q307, FDIC_WAMU_000014851, Hearing Exhibit 4/16-94 [Sealed Exhibit].
755 An A rating indicates a “low risk” of concern that an institution will cause a loss to the Deposit Insurance Fund, a B rating indicates an “ordinary level of concern,” a C rating indicates a “more than an ordinary level of concern,” a D rating conveys a “high level of concern,” and an E rating conveys “serious concerns.” See prepared statement of FDIC IG Rymer at 5 (chart showing FDIC LIDI ratings descriptions), April 16, 2010 Subcommittee Hearing, at 124 (showing FDIC LIDI ratings description). 756 Id.

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early as 2004, the FDIC viewed WaMu as having higher levels of risk than indicated by its CAMELS ratings. This chart shows the comparable ratings over time:

WaMu CAMELS and LIDI Ratings, 2004-2008757

Assessment

Period January 2004 July 2004 January 2005 July 2005 January 2006 July 2006 March 2007 June 2007 September 2007 December 2007 March 2008 June 2008 September 2008

CAMELS

Composite Rating

2 2 2 2 2 2 2 2 2 2 3 3 4

LIDI
Rating

B B/C B/C B/C B/C B/C B/C C C C D E E

FDIC IG Rymer explained that the B/C rating meant that the FDIC viewed WaMu as posing a “somewhat more than ordinary risk” to the Deposit Insurance Fund, the C rating meant it “posed more than an ordinary risk,” D meant the FDIC had “a high level of concern,” and E meant that the FDIC had “serious concerns” that WaMu would cause a loss to the Fund.758

Despite assigning lower LIDI ratings to the bank, indicating the increasing risk it posed

to the Deposit Insurance Fund, the FDIC – like OTS – continued to support a 2 CAMELS rating throughout 2007. The result of both regulators delaying a downgrade in WaMu’s rating had a direct impact on FDIC operations. According to the FDIC Inspector General, WaMu’s CAMELS rating of 2 prevented the FDIC from charging higher premiums for the Deposit Insurance Fund until February 2008, when its rating was dropped to a 3. Higher premiums are one of the tools used by the FDIC to signal to financial institutions that they should better control their risk. Unfortunately, in this case, that tool was not available in 2005, 2006, or 2007.

759

OTS downgraded the bank to a 3 CAMELS rating in February 2008, after WaMu

incurred substantial losses. OTS also required WaMu to issue a nonpublic Board Resolution making general commitments to strengthen its operations. The FDIC undertook a special insurance examination of the bank, analyzed its capital, and concluded that the bank should raise

757 See prepared statement of FDIC IG Rymer at 6 (chart showing WaMu ratings and insurance assessments), April 16, 2010 Subcommittee Hearing at 125. 758 Id. 759 Prepared statement of FDIC IG Rymer at 6-7, April 16, 2010 Subcommittee Hearing, at 125-26. See also IG Report at 40-42.

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additional capital.760 The FDIC staff attempted to engage OTS staff in discussions about increasing the bank’s capital and downgrading its CAMELS ratings, but OTS was not persuaded.761

In July 2008, tensions between the FDIC and OTS flared after the FDIC sent a letter to

OTS urging it to take additional enforcement action: “As we discussed, we believe that [WaMu’s] financial condition will continue to deteriorate unless prompt and effective supervisory action is taken.” included requiring the bank to raise $5 billion in additional capital and provide quarterly reports on its financial condition. OTS not only rejected that advice, but also expressed the hope that the FDIC would refrain from future “unexpected letter exchanges.”763 Polakoff, a senior OTS official called the FDIC letter “inappropriate and disingenuous”:

762 The letter urged OTS to impose a “corrective program” that

In a separate email, Scott

“I have read the attached letter from the FDIC regarding supervision of Wamu and am once again disappointed that the FDIC has confused its role as insurer with the role of the Primary Federal Regulator. Its letter is both inappropriate and disingenuous. I would like to see our response to the FDIC, which I assume will remind it that we, as the PFR, will continue to effectively supervise the entity and will continue to consider the FDIC’s views.”

764

Two weeks later, on July 31, both OTS and the FDIC met with the WaMu Board of Directors to discuss the bank’s problems. At that meeting, the FDIC Dedicated Examiner suggested that the bank look for a “strategic partner” who could buy or invest in the bank. The OTS director, John Reich, later expressed anger at the FDIC for failing to clear that suggestion first with OTS as the bank’s primary regulator. An FDIC examiner wrote to his colleagues:

“Major ill will at WAMU meeting yesterday caused by FDIC suggestion in front of WAMU management that they find a strategic partner. [OTS Director] Reich reportedly indicated that was totally inappropriate and that type of conversation should have occurred amongst regulatory agencies before it was openly discussed with management.”765 The next day, on August 1, 2008, due to WaMu’s increasing financial and deposit losses, the FDIC Chairman, Sheila Bair, suggested that the bank’s condition merited a downgrade in its CAMELS rating to a 4, signaling a troubled bank. The head of OTS sent an email to the head of the FDIC responding that “rating WaMu a 4 would be a big error”:

766

“In my view rating WaMu a 4 would be a big error in judging the facts in this situation.
It would appear to be a rating resulting from fear and not a rating based on the condition

760 See 7/21/2008 letter from FDIC to OTS, FDIC_WAMU_000001730, Hearing Exhibit 4/16-59. 761 Subcommittee interview of Steve Funaro (3/18/2010).
762 7/21/2008 letter from the FDIC to OTS, FDIC_WAMU_000001730, Hearing Exhibit 4/16-59. 763 7/22/2008 letter from OTS to the FDIC, OTSWMS08-015 0001312, Hearing Exhibit 4/16-60. 764 7/22/2008 email from OTS Deputy Director Scott Polakoff to OTS colleagues, Hearing Exhibit 4/16-59. 765 8/1/2008 email from David Promani to FDIC colleagues, FDIC-EM_00246958, Hearing Exhibit 4/16-64. 766 See 8/1/2008, email from Darrell Dochow to OTS senior officials, Hearing Exhibit 4/16-62.

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of the institution. WaMu has both the capital and the liquidity to justify a 3 rating. It seems based on email exchanges which have taken place that FDIC supervisory staff in San Francisco is under pressure by the fear in Washington to downgrade this institution.
… [P]rior to such action I would request a[n FDIC] Board meeting to consider the proper rating on this institution.”767

The FDIC Chairman responded: “We will follow the appropriate procedures if the staff cannot agree.”

768

A few days later, Ms. Bair sent an email to Mr. Reich requesting a discussion of

“contingency planning” for WaMu, including making “discrete inquiries” to determine whether any institution would be willing to buy the bank. The OTS Director responded with a lengthy email criticizing the request and stating in part:

“I do not under any circumstances want to discuss this on Friday’s conference call …. I should not have to remind you the FDIC has no role until the PFR [Primary Federal Regulator] (i.e. the OTS) rules on solvency …. You personally, and the FDIC as an agency, would likely create added instability if you pursue what I strongly believe would be a precipitous and unprecedented action. … It seems as though the FDIC is behaving as some sort of super-regulator – which you and it are not.”769 In September 2008, Ms. Bair informed WaMu that there was a likely ratings

disagreement between the FDIC and OTS, and that the FDIC intended to lower the bank’s rating to a 4. After the FDIC Chairman informed the OTS Director by email of her conversation with WaMu, Mr. Reich forwarded the exchange to his OTS Deputy Director, upset that she had not come to him first with that information: “I cannot believe the continuing audacity of this woman.”

Two weeks later, the bank failed.

770

Restricting Office Space and Information. Throughout the period examined by the

Subcommittee, OTS not only rebuffed the FDIC’s analysis and advice, it began to actively impede FDIC oversight efforts at WaMu. OTS even went so far as to limit the FDIC’s physical access to office space, as well as to needed information, at WaMu’s new headquarters. Prior to 2006, OTS had always provided the FDIC examiners with space in its on-site offices at the bank, making it easy for FDIC examiners to participate in OTS examinations. In the summer of 2006, however, following WaMu’s move to a new headquarters in Seattle, OTS did not provide any of its desks for the FDIC examiners. OTS also restricted the FDIC’s access to an important database that all examiners used to review WaMu documents, referred to as the “examiner’s library.” From July until November 2006, a period of about four months, the FDIC examiners were denied access to both office space on the bank’s premises and the examiner’s library. The

767 8/1/2008 email from OTS Director John Reich to FDIC Chairman Sheila Bair, Hearing Exhibit 416-63. 768 Id. 769 8/6/2008 email from OTS Director John Reich to FDIC Chairman Sheila Bair, “Re: W,” FDIC-EM_00110089, Hearing Exhibit 4/16-66. 770 9/10/2008 email from OTS Director John Reich to OTS Deputy Director Scott Polakoff, Polakoff_Scott- 00065461_001, Hearing Exhibit 4/16-68.

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FDIC had to make multiple requests, taking the issue up through the OTS hierarchy in Washington, D.C. headquarters, to regain the access it had enjoyed for years at WaMu.

In an October 2006 email to the FDIC Assistant Regional Director, George Doerr, the

FDIC Dedicated Examiner at WaMu, described in exasperation how he had been promised permanent space at the bank, but still did not have it. Demonstrating how poisoned the relationship was at that point, the FDIC examiner blamed the lack of cooperation on “stalling tactics and misrepresentations:”

“Our issue is with OTS management (Finn and Dochow) and how they have apparently mislead RD [Regional Director] Carter, DRD [Deputy Regional Director] Villalba, you, and me. This regards space for the dedicated examiner and access to information …. I met with OTS examiners yesterday and they have not made arrangements for permanent space for me at the new location and protocols for information sharing have not been developed …. In July RD Carter [from FDIC] talked with Finn [from OTS] and he agreed to space and access. On 8/17 you and DRD Villalba had a telephone conversation with Dochow and he agreed it was not necessary to fix what was not broken and he promised access to space and information. On 9/15 I met with Dochow and he agreed to space and information sharing …. I am prepared for more of Dochow’s stalling tactics and misrepresentations.”771

Mr. Doerr forwarded the “info about OTS denying us space and access to information” to other FDIC officials stating: “The situation has gone from bad to worse.”

772

At the Subcommittee hearing, when asked why OTS took four months to restore FDIC

access to office space and WaMu documents, Mr. Doerr of the FDIC responded:

Mr. Doerr: I can’t explain what the reason was. I personally think they didn’t want us there. I mean, we were denied physical access and the access to this examiner library … of electronic materials that WaMu puts together for the regulators …. [Y]ou shouldn’t have to go 4 months without having to have that. …

Senator Levin: And it was essential that Mr. Funaro [the FDIC Dedicated Examiner] have access to that library in order to get information about the Washington Mutual? Mr. Doerr: Absolutely.773

By November 2006, when OTS relented and provided desk space and database access to the FDIC Dedicated Examiner, it did little to ameliorate the situation. Its actions contributed to a

771 10/13/2006 email chain from Vanessa Villalba to J. George Doerr, John F. Carter, and John H. Corston, “Re: wamu quarterly,” FDIC_WAMU_000014449, Hearing Exhibit 4/16-53. See also 9/6/2006 FDIC internal email chain, “OTS re: WAMU,” FDIC-EM_00252239, Hearing Exhibit 4/16-51c (“He absolutely agreed you’d have access to the Examiner Library. And he hasn’t arranged that.”). 772 Id. 773 April 16, 2010 Subcommittee Hearing at 72-73.

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worsening relationship between the two agencies, impeded FDIC oversight efforts, and weakened oversight of WaMu’s activities.774

Restricting FDIC Examinations. At the same time OTS was withholding office space and database access from the FDIC examination team, it also, for the first time, refused an FDIC request to participate in an OTS examination of WaMu.

Although the FDIC has a broad statutory right to participate in examinations of insured

depository institutions,775 it had agreed to spell out how it would exercise that statutory authority in a 2002 Interagency Agreement with the Federal Reserve, OCC, and OTS.776 The Interagency Agreement authorized the FDIC to conduct “special examinations” of insured institutions that “represent a heightened risk” to the Deposit Insurance Fund, defined as institutions with a 3, 4, or 5 rating on the CAMELS scale or which were “undercapitalized as defined under Prompt Corrective Action” standards.777 Other FDIC bank examinations had to be authorized by the primary regulator. Prior to 2006, OTS had routinely authorized joint OTS-FDIC examinations without regard to the CAMELS ratings, but in January 2006, OTS suddenly changed its policy.
The change was signaled in an email sent by a senior OTS official to his colleagues:

“The message was crystal clear today. Absolutely no FDIC participation on any OTS 1 and 2 rated exams. . . . We should also deny FDIC requests to participate on HC [holding company] or affiliate exams.

Permission for FDIC to join us on WaMu … will stand for now, but they should not be [in] direct contact with thrift management or be requesting info directly from the thrift.”778

This email signaled the beginning of a much more restrictive policy toward the FDIC participation in OTS examinations, even though in January 2006, OTS indicated it would allow an exception for the FDIC examiners to continue participating in its scheduled examination of WaMu. The reasons for this change in policy were never made clear, but in several interviews, OTS and FDIC officials attributed it to certain senior OTS officials who were reluctant to share thrift oversight responsibilities with the FDIC.

In August 2006, the FDIC made what it viewed as a routine request to join in the next

OTS examination of WaMu, which was designed to focus, in part, on WaMu’s subprime lending.
To the surprise and consternation of the FDIC, the OTS Regional Director Michael Finn sent a letter denying the request and stating that OTS would instead “share our exam findings with the

774 See also IG Report at 42-45 (“It appears that 2006 was a turning point in the relationship between FDIC and OTS in terms of information sharing that carried through to 2008.”). 775 See 12 U.S.C. § 1820(b)(3). 776 See “Coordination of Expanded Supervisory Information Sharing and Special Examinations,” PSI-FDIC-10-

777Id. 778 1/24/2006 email from OTS senior official Michael Finn to Edwin Chow and Darrel Dochow, OTSWM06-006 0000129, Hearing Exhibit 4/16-49.

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FDIC, as we have in the past.”779 and FDIC had not shown “any concerns regarding our past or planned examination activities, and our continued commitment to share all appropriate information, the FDIC has not shown the regulatory need to participate in the upcoming Washington Mutual examination.”

Mr. Finn wrote that because WaMu’s CAMELS rating was a 2

After discussing the Finn letter in an internal email, the FDIC Assistant Regional

Director, George Doerr, wrote to his colleagues:

“Obviously, we have a major problem here. OTS is taking the approach we need to establish a ‘regulatory need to participate’ on an exam, and that the basis would have to be disagreement on exam findings. Mr. Finn is totally missing the point on our need for timely accurate information to properly categorize WAMU for deposit insurance premium purposes, more so now than ever in the past.”780

In October 2006, John Carter with the FDIC sent Michael Finn of OTS a letter repeating

the FDIC’s request to participate in the WaMu examination:

“I have received your response to our August 14 2006 letter in which we request permission to participate in aspects of the upcoming examination of Washington Mutual Bank. Regarding your reasoning for rejecting our participation in these target reviews, you are correct that our request is not predicated on any current disagreement related to examination findings or concerns regarding supervisory activities at Washington Mutual.
Such criteria are not prerequisite for requesting – or for the OTS granting – FDIC staff participation in target examination activities.

As you are aware, the FDIC and the OTS have a long, cooperative, and productive working relationship with respect to the examination of Washington Mutual Bank, which we hope to continue. Past experience has proven that our participation in targeted reviews is beneficial to our respective Agencies, as well as to the Bank. … The 2002 Agreement clearly allows for FDIC staff participation in examination activities to evaluate the risk of a particular banking activity to the deposit insurance fund.

Washington Mutual Bank is very large insured financial institution, and in our view participation on the upcoming targeted reviews is necessary to fulfill our responsibilities to protect the deposit insurance fund.”781

On November 10, 2006, Mr. Finn responded with a letter that, again, refused to allow the

FDIC to participate in the WaMu examination:

“OTS does not seek to have FDIC staff actively participate in our examination activities and conclusions at Washington Mutual. We do understand your need for access to

779 9/6/2006 FDIC internal email chain, “OTS re: WAMU,” FDIC-EM_00252239-40, Hearing Exhibit 4/16-51c. 780 Id. at FDIC-EM_00252240. 781 10/6/2006 letter from FDIC senior official John Carter to OTS senior official Michael Finn, FDIC_WAMU_000014445-46, Hearing Exhibit 4/16-52a.

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examination information and your need to meet with OTS staff to discuss our supervisory activities at Washington Mutual. To facilitate this information sharing and discussions, we have agreed to allow your Dedicated Examiner … to conduct his FDIC risk assessment activities on site at Washington Mutual when our examination team is on site.
All FDIC requests for information should continue to be funneled through our examiner- in-charge.”782

The OTS letter also restricted the ability of the FDIC to place more than one examiner on site at WaMu, even though the bank, with $300 billion in assets, was one of the largest insured institutions in the country and was engaged in a high risk lending strategy:

“We also understand that the FDIC may occasionally request OTS permission to have FDIC examination staff assist [its Dedicated Examiner] on site at Washington Mutual in his risk assessment activities. We will consider these limited requests to send additional FDIC staff to Washington Mutual on a case-by-case basis.”783

Despite the negative tone of the OTS letter, the FDIC persisted in its request, and OTS

eventually allowed the FDIC examiners to participate in some WaMu examinations in 2006 and 2007, though it continued to press the FDIC to limit its requests and personnel.

784

During the Subcommittee hearing, the FDIC staff described their surprise at the new OTS

policy and frustration at its seemingly circular reasoning – that the FDIC needed to specify a “basis” and “disagreement” with OTS to justify joining an OTS examination, but the FDIC was also barred from participating in the very examinations that could develop that basis and disagreement.

785

Restricting Access to Loan Files. Even after OTS reluctantly allowed the FDIC to

participate in some OTS examinations, it held firm in its refusal to allow the FDIC to directly review WaMu loan files, insisting that the FDIC instead rely on the findings and conclusions of OTS examiners who conducted the loan file reviews.

In September 2006, when OTS first refused to give the FDIC direct access to WaMu loan

files, an FDIC senior official commented: “The OTS must really be afraid of what we might come across, but bottom line is we need access to the information.”786 the Subcommittee that it needed direct access to the loan files to assess the higher risk loans WaMu was issuing, both to evaluate what insurance fees should be imposed on Washington Mutual and to assess the extent of any threat to the Deposit Insurance Fund.

The FDIC explained to

782 11/10/2006 letter from OTS senior official Michael Finn to FDIC Regional Director John Carter, OTSWMS06- 008 0001827, Hearing Exhibit 4/16-52b. 783 Id. 784 See, e.g., 1/22/2007 letter from Michael Finn to John Carter, Hearing Exhibit 4/16-52d.
785 See, e.g., April 16, 2010 Subcommittee Hearing at 73-74. 786 9/7/2006 email from FDIC senior official John Carter to George Doerr, FDIC-EM_00252239, Hearing Exhibit 4/16-51c.

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In February 2007, OTS refused an FDIC request to review WaMu loan files to evaluate

the bank’s compliance with recently issued federal guidance on how to handle nontraditional mortgages, such as subprime, stated income, and negatively amortizing loans. Even though Washington Mutual was issuing exactly those types of loans under its High Risk Lending Strategy, OTS indicated that it did not plan to evaluate WaMu’s compliance with the guidance and did not want the FDIC to perform that evaluation either. In a February email, the FDIC Dedicated Examiner at WaMu informed the FDIC Assistant Regional Director: “OTS is restricting FDIC on the current examination in the SFR [single family residential loan] review segment. OTS will not allow us to review SFR loan files.”787 The Assistant Regional Director relayed the development to the Regional Director: “John, here we go again. … OTS wants to draw a distinction between loan file review as an examination activity (that they object to) vs. risk assessment (which they do not object to). I don’t fathom the distinction.”788

Two months later, in April 2007, the FDIC continued to press for permission to review

WaMu loan files. The FDIC Assistant Regional Deputy wrote in an email to a colleague:

“[OTS Regional Director] Finn pushed back on his previous approval of our participation in the 2007 exam targets, specifically as to our ability to work loan files alongside OTS examiner, and we were particularly interested in WAMU’s compliance with nontraditional mortgage guidance. … Mr. Finn and his examiner, Ben Franklin, stated that OTS did not intend to look at files for purposes of testing nontraditional mortgage guidance until after the bank made a few changes they had agreed to. I asked if we could then join the file review whenever ots did look at this, and he said, ‘No.’”789

At the Subcommittee hearing, when asked about these incidents, the FDIC Chairman

Sheila Bair testified:

“[I]n 2005 … OTS management determined that FDIC should not actively participate in OTS examinations at WaMu, citing the 2002 interagency agreement. In subsequent years, FDIC faced repeated resistance to its efforts to fully participate in examinations of WaMu. Even as late as 2008, as problems at WaMu were becoming more apparent, OTS management sought to limit the number of FDIC examiners involved in the examination and did not permit the FDIC to review loan files.”790

Both the Treasury and the FDIC Inspectors General were critical of OTS’ actions. In response to a question about “[w]hether or not OTS should have allowed the FDIC to help” with the examinations of WaMu, FDIC IG Rymer responded:

“[I]t is clear to me that they [OTS] should have. … [T]hey [the FDIC] had concerns and those concerns were principally driven by its own LIDI analysis. … [T]here is no question in my mind that the FDIC’s request for back-up authority, simply given the

787 2/6/2007 email from Stephen Funaro to George Doerr, Hearing Exhibit 4/16-55. 788 2/6/2007 email from George Doerr to John Carter and others, Hearing Exhibit 4/16-55. 789 4/30/2007 email from George Doerr to David Collins, FDIC_WAMU 000014457, Hearing Exhibit 4/16-57.
790 April 16, 2010 Subcommittee Hearing at 80-81 (testimony of Sheila Bair).

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sheer size of WaMu, was, to me, enough reason for FDIC to ask for back-up authority.”791

Treasury IG Thorson agreed:

“I agree with Mr. Rymer. … [T]he sheer size of the bank would say that there should be a maximum of cooperation, not to mention the fact that it is dictated by statute, as well.
… [A]s a matter of policy, I think they [OTS] should have allowed that. No matter what their reasoning was, as a matter of policy, they should have, yes.”792 OTS Turf War. At the Subcommittee hearing, John Reich, the OTS Director, was asked

about the friction between the two agencies. In response to a question about the August 2008 email in which he wrote that the FDIC had “no role” at WaMu until OTS “rules on solvency,” Mr. Reich stressed that the key point he was trying to convey was that OTS was WaMu’s primary federal regulator:

793

Mr. Reich: I think basically and fundamentally it was who was the primary Federal regulator.

Senator Levin: It was turf, in a word.

Mr. Reich: I think OTS had the responsibility as the primary Federal regulator.

Senator Levin: Turf.

Mr. Reich: We had the statutory responsibility.

Senator Levin: Instead of going at this as partners –

Mr. Reich: I have more than most – an understanding of the role of the FDIC and their need to participate. I have been there.794 The evidence shows that OTS senior officials not only resisted, but resented the FDIC

participation in the oversight of Washington Mutual Bank and deliberately took actions that limited the FDIC oversight, even in the face of a deteriorating $300 billion institution whose failure could have exhausted the entire Deposit Insurance Fund. After contrasting OTS’ hard- edged treatment of the FDIC with the collaborative approach it took towards WaMu, Senator Levin observed:

“About the only time OTS showed backbone was against another agency’s moving, in your view, into your turf. Boy, that really got your dander up. That got your blood pressure up. I do not see your blood pressure getting up against a bank which is engaged

791 April 16, 2010 Subcommittee Hearing at 34. 792 Id. at 35. 793 See 8/6/2008 email from OTS Director John Reich to FDIC Chairman Sheila Bair, “Re: W,” FDIC- EM_00110089, Hearing Exhibit 4/16-66 (“I should not have to remind you the FDIC has no role until the PFR [Primary Federal Regulator] (i.e. the OTS) rules on solvency.”). 794 April 16, 2010 Subcommittee Hearing at 64.

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in the kind of dangerous practices that the bank engaged in, dangerous to their solvency, dangerous to their investors, dangerous to their depositors, dangerous to this economy.”795

Because OTS has been abolished, its turf war with the FDIC is over. But witnesses from the FDIC told the Subcommittee that the remaining banking regulators also sometimes resist its participation in bank oversight. In particular, a senior FDIC official told the Subcommittee that, although the FDIC has the statutory authority to take an enforcement action against a bank, the FDIC has never used that authority because the other regulators would view it as “an act of war.”
The WaMu case history demonstrates how important it is for our federal regulators to view each other as partners rather than adversaries in the effort to ensure the safety and soundness of U.S. financial institutions.

D. Regulatory Failures

In a market economy, the purpose of regulation within the financial markets is to provide

a level playing field that works for everyone involved, from the financial institutions, to the investors, to the consumers and businesses that rely on well functioning financial systems. When financial regulators fail to enforce the rules in an effective and even handed manner, they not only tilt the playing field in favor of some and not others, but also risk creating systemic problems that can damage the markets and even the entire economy.

At the April 16, 2010 hearing of the Subcommittee, Senator Coburn had the following

exchange with Inspectors General Thorson and Rymer, which explains in part why OTS failed as a regulator to address WaMu’s harmful lending policies:

Senator Coburn: As I sat here and listened to both the opening statement of the Chairman and to your statements, I come to the conclusion that actually investors would have been better off had there been no OTS because, in essence, the investors could not get behind the scene to see what was essentially misled by OTS because they had faith the regulators were not finding any problems, when, in fact, the record shows there are tons of problems, just there was no action taken on it. … I mean, we had people continually investing in this business on the basis—as a matter of fact, they raised an additional $7 billion before they collapsed, on the basis that OTS said everything was fine, when, in fact, OTS knew everything was not fine and was not getting it changed. Would you agree with that statement or not?

Mr. Thorson: Yes, sir. I think … basically assigning a ‘satisfactory’ rating when conditions are not is contradictory to the very purpose for which regulators use a rating system. I think that is what you are saying.

Senator Coburn: Any comments on that Mr. Rymer?

Mr. Rymer: I would agree with Mr. Thorson. …

795 Id. at 66.

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Senator Coburn: [To Mr. Thorson] By your statement, it would imply almost that OTS is an enabler of this effort rather than an enabler of making sure that the American people’s taxpayer dollars and the trust in institutions that are supposed to be regulated by an agency of the Federal Government can be trusted.

Mr. Thorson: Right.

In trying to understand why OTS failed to make use of its enforcement tools to compel

WaMu to operate in a safe and sound manner, the Subcommittee investigation has identified factors that have resonance not only in the recent financial crisis, but are critical for regulators and policymakers to address in order to avoid future financial disasters as well.

(1) OTS’ Failed Oversight of WaMu

During the five-year period of the Subcommittee’s inquiry, from 2004 to 2008, OTS

identified over 500 serious operational deficiencies at WaMu and Long Beach. At WaMu, the problems included weak lending standards, high loan exception and error rates, noncompliance with bank loan policy, weak risk management, poor appraisal practices, and poor quality loans.
At Long Beach, OTS identified many of the same problems and added on top of those, weak management, poor quality mortgage backed securities, and inadequate repurchase reserves. The problems are described in examination report after examination report, and OTS raised many of the same concerns, in writing and in person, with WaMu’s Board of Directors.

But for all those years, OTS did little beyond describing the problems and asking bank

executives to make improvements. When the reforms failed to materialize, the problems continued, and the risk increased, OTS stood on the sidelines. Subcommittee interviews found that, until 2008, OTS regulators never even held internal discussions about taking an enforcement action against the bank. In 2008, in the face of mounting losses, OTS took two informal, nonpublic enforcement actions, which contained few mandatory measures or deadlines and were together insufficient to save the bank.

In trying to understand the agency’s years of inaction, the Subcommittee’s investigation

concluded that the lack of enforcement reflected an OTS culture of deference to bank management, demoralized examiners whose oversight efforts were unsupported by their supervisors, and a narrow regulatory focus that allowed short term profits to excuse high risk activities and disregarded systemic risk. Inflated CAMELS ratings may have further reduced the pressure to act, while conflicts of interest may have also tempered OTS’ willingness to take tough enforcement action against WaMu.

(a) Deference to Management

Part of the reason that OTS declined to take enforcement action against Washington

Mutual was a posture of deference to the management of the institutions it regulated. Ronald Cathcart, WaMu’s chief enterprise risk officer from 2006-2008, described OTS as essentially believing in “self-regulation”:

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“I … have actually operated in banks under three regulators, in Canada under the Office of the Supervisor of Financial Institutions, at Bank One under the OCC, and then at Washington Mutual under the OTS[.] … [T]he approach that the OTS took was much more light-handed than I was used to. It seemed as if the regulator was prepared to allow the bank to work through its problems and had a higher degree of tolerance that I had … seen with the other two regulators. … I would say that the OTS did believe in self- regulation.”796

A former OTS regulator who later took a job with WaMu, was quoted in a press report as saying that OTS provided “by far the softest” oversight of any federal bank regulator.

797

Evidence of OTS’ unusually deferential approach can be found in its internal documents,

starting at the top. In a May 2007 email, for example, cancelling lunch with a colleague so he could instead have lunch with WaMu’s CEO, Kerry Killinger, OTS Director, John Reich, described the bank as “my largest constituent.” defended using the term, testifying that referring to others as constituents was a “habit” he had picked up while working on Capitol Hill.799 One Senator pointed out that OTS’ true constituents were not the banks it regulated, but “the American people it was supposed to protect from unsafe and unsound banking practices.”800

798 At the Subcommittee hearing, Mr. Reich

On another occasion in July 2008, Mr. Reich sent an email to Mr. Killinger informing

him that OTS had decided to issue a Memorandum of Understanding (MOU) to address issues of concern at the bank. In the email, the OTS Director apologized twice for his method of communication, but also sounded a note of regret for his decision to take a tougher approach:

“Kerry,

I’m sorry to communicate by email – I’ve left a couple of messages on your office phone, but I’m guessing you may be off for a long weekend.

I’ve been wrestling with the issue of an MOU versus a Board Resolution as a result of our conversation in my office last week. And I’ve decided that an MOU is the right approach for OTS to do in this situation ….

We almost always do an MOU for 3-rated institutions, and if someone were looking over our shoulders, they would probably be surprised we don’t already have one in place. …

So as much as I would like to be able to say a Board Resolution is the appropriate regulatory response, I don’t really believe it is. I do believe we need to do an MOU. We

796 April 13, 2010 Subcommittee Hearing, at 39-40 (Testimony of Ronald J. Cathcart, former WaMu Chief Enterprise Risk Officer, 2006-2008). 797 “Lax Regulators Helped Doom Washington Mutual,” Associated Press (4/16/2010). 798 5/2/2007 email from OTS Director John Reich to Shelley Hymes, “Re: Lunch Friday,” Reich_John- 00025837_001, Hearing Exhibit 4/16-78. 799 April 16, 2010 Subcommittee Hearing at 36. 800 Id. at 5 (opening statement of Senator Levin).

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don’t consider it a disclosable event, and we also think the investment community won’t be surprised if they learn of it, and would probably only be surprised to learn one didn’t already exist.

Again, I’m sorry to communicate this decision by email, but I’m scheduled to be out of the office next week myself and wanted you to have this information.

Best regard, Kerry, John”801

The email does not convey a message from an arms-length regulator concerned about a

failing bank. To the contrary, the email conveys a sense of familiarity and discloses that the head of OTS knew his agency had already been providing preferential treatment to the bank by failing to impose an MOU after its downgrade to a 3 rating five months earlier, in February

Mr. Reich stated that others “looking over our shoulders … would probably be surprised” an MOU was not already in place at WaMu.

When asked about this email at the Subcommittee hearing, the Treasury and the FDIC

Inspectors General both expressed discomfort with its language and tone:

Mr. Thorson: Again, he sort of apologizes in the previous document that this could become known. This gets right to the heart of what you were talking about, the culture. … [T]here is not an acceptance of the fact that a strong regulatory control helps them.

Senator Levin: This is far too cozy?

Mr. Thorson: Absolutely, as far as I am concerned, yes.

Senator Levin: Mr. Rymer, do you have any reaction to this? Mr. Rymer: It does indicate a level of familiarity that makes me uncomfortable.802

Equally telling is the fact that, even after sending the email, OTS delayed imposing the MOU on WaMu for another two months, waiting until September 2008, just three weeks before the bank’s failure.

803

Like the head of the agency, OTS examiners also took a deferential approach to WaMu.

In a January 2006 email discussing WaMu’s desire to purchase Long Beach, for example, the OTS Examiner-in-Charge indicated that, rather than insist the bank clean up Long Beach

801 7/3/2008 email from OTS Director John Reich to WaMu CEO Kerry Killinger, OTSWMS08-014 0000912-13, Hearing Exhibit 4/16-44. 802 April 16, 2010 Subcommittee Hearing at 34. 803 See also id. at 46 (When asked why OTS took so long to complete the MOU, former OTS Director John Reich testified: “I don’t know, to tell you the truth. I do not know why it took so long to implement the MOU. … I regret [the] … delay.”).

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problems before the purchase, OTS would have to rely on its “relationship” with WaMu to get the job done:

“The letter [from WaMu] seems okay. They obviously want to leave it a little squishy, of course, on the growth plans, but at least they make a firm commitment to clean up the underwriting issues. At some level, it seems we have to rely on our relationship and their understanding that we are not comfortable with current underwriting practices and don’t want them [Long Beach] to grow significantly without having the practices cleaned up first.”804 On another occasion in June 2006, the same OTS Examiner-in-Charge sent a lengthy email to his Regional Director discussing plans for the annual WaMu Report on Examination (ROE). His email expressed concern about losing credibility with the bank if OTS pressed too hard on certain reforms, twice noted the bank’s size and complexity, and stressed that the bank was making progress in fixing identified problems:

“[W]e still have some strong feelings on some items that I’d like to ‘push back’ … some on. Generally we feel that we are quite balanced and do not have any gloves on in our approach to our findings and conclusions at WAMU. We have some concern that if we press forward with some things … we may run the risk of losing some credibility in terms of understanding the size and complexity of their business and looking as though we do not have a balanced perspective. My own fear is that we may not have done enough to communicate to you [the Regional Director] why we feel that the few negative things we have brought up through findings memos and meetings, while important to keep in front of management, are not so serious they wipe out all the right things the institution is doing in all those areas we reviewed and did not have any issues, nor should they negate the ongoing good progress in making improvements in a manner that seems reasonable given the size, complexity, and status of the institution.”805 The Examiner-in-Charge then listed three areas of concern, problems at Long Beach which he seemed to downplay, the need to limit the number of corrective actions listed in the ROE, and the need to review how OTS cited the bank for compliance violations. In the Long Beach discussion, he wrote that improvements “will take time because of size and complexity …. We don’t feel demanding more than providing us with an acceptable action plan with realistic timelines is appropriate or necessary at this time.” On the corrective actions, he wrote that the list had to be limited or “more important findings will get lost. … We feel strongly that we should not cite all findings and corrective actions within the body of the ROE … [which] is already not getting read I believe.” He also expressed concern that OTS was “starting to ‘over- meeting’ the institution” and suggested that “the exit meeting” with the bank to discuss the ROE findings had “become almost unnecessary.”

804 1/27/2006 email from Lawrence Carter to Darrel Dochow, OTSWMS06-008 0001082, Hearing Exhibit 4/16-32.
805 6/15/2006 email from Lawrence Carter to Darrel Dochow, Dochow_Darrel-00022908_001, Hearing Exhibit 4/16-7.

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After urging patience on WaMu reforms, suggesting a limit on the corrective actions

listed in the ROE, and recommending fewer meetings with WaMu management, the curious final line in the email is: “My management class this week has made me feel empowered! Can you tell? Please don’t fire me!”

Additional evidence of OTS deference is its reliance on WaMu to track its own

compliance with OTS findings calling for corrective action. At all other thrifts, OTS tracked the extent to which the thrift implemented OTS findings, using its own systems. But at WaMu, OTS did not keep its own records, but relied on WaMu’s Enterprise Risk Issue Control System (ERICS). The Treasury and the FDIC Inspectors General criticized this arrangement, noting that they were unable to use WaMu’s system to determine the status of multiple OTS findings.806 In addition, they noted that, in 2006, ERICS discontinued its practice of identifying “repeat findings,” making it difficult to identify and track those findings.807 recommends against OTS’ relying on a bank’s systems in the future to track compliance.

Their report explicitly

Finally, the actual language used by OTS in its reports and memoranda that described deficiencies demonstrated a passive approach to dealing with management. Common phrases noted that the bank’s practices were “less than satisfactory,” error rates were at “higher than acceptable levels,” and “management’s actions did not improve underwriting to a satisfactory level.” OTS reports rarely used more assertive language that, for example, called the bank’s efforts unsatisfactory, inadequate, or ineffective. An exchange at the Subcommittee hearing between Senator Levin and the OTS Examiner-in-Charge at WaMu from 2004 to 2006, Lawrence Carter, captured the issue:

Mr. Carter: I think that what I said here is that we could not conclude that their progress was wholly inadequate, because they did make some progress.

Senator Levin: … Can you use the words, ‘Folks, your progress was inadequate?’ Are you able to tell them that?

Mr. Carter: For their progress on this specific action plan, I did not conclude we could tell them that.

Senator Levin: That it was inadequate?

Mr. Carter: That is right.

Senator Levin: You could tell them it was not wholly adequate.

Mr. Carter: Yes.

Senator Levin: But not inadequate.

Mr. Carter: I do not think I could say it was wholly inadequate.

806 See, e.g., IG Report at 30. 807 See Thorson prepared statement, April 16, 2010 Subcommittee Hearing at 12.

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Senator Levin: I did not use the word ‘wholly.’ You could tell them it was not wholly adequate, but you could not tell them it was inadequate. That is what you are telling us.

Mr. Carter: Yes.

Senator Levin: That is the kind of bureaucratic speech which I think sends the message to people you regulate that, hey, folks, you are making progress, instead of telling them it is inadequate.808

At times, WaMu took advantage of its special relationship with OTS and lobbied for leniency. In one instance from May 2006, a WaMu official from the Regulatory Relations division sent an email to his colleagues stating that he was able to convince the agency to reduce an audit “criticism” to the less serious category of a “recommendation”: “OTS confirmed today 809 His that they will re-issue this memo without the ‘Criticism.’ It will be a ‘Recommendation.’” colleague forwarded the email to bank executives noting: “Good news - John was able to get the OTS to see the light and revise the Underwriting rating to a Recommendation.”810

A more serious incident involved WaMu’s 2005 discovery, after almost a year-long

investigation by an internal Home Loans Risk Mitigation Team, of substantial loan fraud taking place at two high volume loan offices in California, known as Downey and Montebello. The WaMu investigators found that 83% of the loans reviewed from the Downey office and 58% of the loans reviewed from the Montebello office contained fraudulent information, either with respect to the borrower or the appraised value of the property. The investigators wrote up their 811 findings and presented them to WaMu’s Chief Risk Officer and the President of Home Loans. No one, however, informed OTS, and WaMu took no action to stop the fraudulent loans.

Two years later, in 2007, after a mortgage insurer refused to insure any more loans issued by the lead loan officer in the Montebello office, OTS directed WaMu to investigate the matter.
WaMu’s internal auditors launched an investigation, confirmed the loan fraud problem at the Montebello office, and also uncovered the 2005 investigation whose fraud findings had been WaMu ignored. WaMu took until April 2008 to produce a report documenting its findings. also initially resisted providing the report to OTS, claiming it was protected by attorney-client

812

808 April 16, 2010 Subcommittee Hearing at 60-61. 809 5/30/2006 email from John Robinson, WaMu VP of Regulatory Relations, to colleagues, JPM_WM02619435.
Hearing Exhibit 4/16-34. 810 5/30/2006 email from Wayne Pollack, WaMu SVP, to David Schneider, et al., JPM_WM02619434, Hearing Exhibit 4/16-34. 811 See 11/17/2005 WaMu internal memorandum, “re So. CA Emerging Markets Targeting Loan Review Results,” JPM_WM01083051, Hearing Exhibit 4/13-22a; 11/16/2005 WaMu internal PowerPoint presentation, “Retail Fraud Risk Overview,” JPM_WM02481934-49, Hearing Exhibit 4/13-22b; 11/19/2005 email from Cheryl Feltgen to colleagues, “Re: Retail Fraud Risk Overview,” JPM_WM03535694-95, Hearing Exhibit 4/13-23a; 8/29/2005 email from Jill Simons to Timothy Bates, “Risk Mit Loan review data ‘Confidential,’” JPM_WM04026076-77, Hearing Exhibit 4/13-23b. 812 4/4/2008 WaMu internal memorandum, from June Thoreson-Rogers, Corporate Fraud Investigations, and Michele Snyer, Deputy General Auditor, to Stewart Landefeld, Acting Chief Legal Officer, and others, Hearing Exhibit 4/13-24.

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privilege.813 The OTS Examiner-in-Charge at the time told the Subcommittee that he insisted on seeing the report. After finally receiving it and reading about the substantial loan fraud occurring at the two loan offices since 2005, he told the Subcommittee that it was “the last straw” that ended his confidence that he could rely on WaMu to combat fraudulent practices within its own ranks.

OTS’ deference to WaMu management appeared to be the result of a deliberate posture of reliance on the bank to take the steps needed to ensure that its personnel were engaged in safe and sound practices. The reasoning appeared to be that if OTS examiners simply identified the problems at the bank, OTS could then rely on WaMu’s own self interest, competence, and discipline to ensure the problems were corrected, with no need for tough enforcement action. It was a regulatory approach with disastrous results. While OTS may have hoped that it could accomplish its regulatory responsibilities by simply identifying problems without the threat of enforcement action, that approach proved ineffective.

(b) Demoralized Examiners

For five years, OTS examiners identified serious problems with WaMu’s lending

practices and risk management, but OTS senior officials failed to support their efforts by using the agency’s enforcement tools to compel the bank to correct the identified problems. WaMu’s chief risk officer from 2004 to 2005, James Vanasek, remarked at the Subcommittee hearing on how OTS examiners seemed to receive little support from more senior officials in terms of enforcement:

“[T]he OTS Examiner-in-Charge during the period time in which I was involved … did an excellent job of finding and raising the issues. Likewise, I found good performance from … the FDIC Examiner-in-Charge. … What I cannot explain is why the superiors in the agencies didn’t take a tougher tone with the banks given the degree of … negative findings. My experience with the OTS, versus with the OCC, was completely different.
So there seemed to be a tolerance there or a political influence on senior management of those agencies that prevent them from taking a more active stance. By a more active stance, I mean putting the banks under letters of agreement and forcing change.”814

Internal OTS documents and emails indicate that the result was a cadre of OTS examiners who were skeptical of their ability to effect meaningful change at WaMu, who were too often rebuffed by their own management when they tried to reduce risk or strengthen bank controls, and whose leaders worked to weaken rather than strengthen the standards used by examiners to hold banks accountable.

813 Subcommittee interview of OTS Examiner-in-Charge Benjamin Franklin (2/17/2010). 814 April 13, 2010 Subcommittee Hearing at 39 (testimony of James G. Vanasek, former WaMu Chief Risk Officer, 2004-2005).

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Low Expectations. The documents show that OTS examiners had low expectations that

WaMu would actually implement recommended changes at the bank. Ultimately, OTS examiners adapted to the situation, they gave up trying to make the bank act more quickly, and WaMu was able to delay needed changes for long periods of time if it wished.

In 2003, for example, one OTS examiner wrote to the Examiner-in-Charge:

“It is clear from my experience that changes seem to progress slowly at WaMu so I don’t know if we can expect faster progress …. If any target is missed, as happens at WaMu, then we may not be in a position to determine the effectiveness of the corrective actions.”815

In 2005, another OTS examiner wrote: “They agree to take all action required to correct the problem. The Target Completion Dates are not real timely but fine for WaMu.”

816

Other examiners were more critical. In 2007, for example, one OTS examiner wrote: “Regulatory Relations [the WaMu office established to work with regulators] is a joke. The purpose of this group seems to be how can we give the regulators the bare minimum without them raising a fuss.”817

The examiner also wrote:

“WaMu’s compliance management program has suffered from a lack of steady, consistent leadership. Dick Stevenson, who took over as Chief Compliance Officer on March 2, 2007, is the bank’s ninth compliance leader since 2000. … The OTS is very concerned that this lack of consistent, stable leadership leaves the program vulnerable. This amount of turnover is very unusual for an institution of this size and is a cause for concern. The Board of Directors should commission an evaluation of why smart, successful, effective managers can’t succeed in this position. If you would like my opinion, just ask. (HINT: It has to do with top management not buying into the importance of compliance and turf warfare and Kerry [Killinger] not liking bad news.)”818 In an interview, OTS examiner Benjamin Franklin, who worked at the agency for 24

years, told the Subcommittee that the thrifts he oversaw generally did not “collaborate” with the agency but would “fight” OTS reviews and resist OTS recommendations. He said that at WaMu,

815 6/27/2003 email from Dennis Fitzgerald, OTS Examiner, to Lawrence Carter, OTSWEM04-0000006748, Hearing Exhibit 4/16-15. 816 6/8/2005 email from Verlin Campbell, OTS Examiner, to Zalka Ancely, OTS Examiner, OTSWME05-003 0000634, Hearing Exhibit 4/16-29.
817 5/31/2007 Draft Compliance Memo from Susie Clark, OTS Compliance Specialist, Franklin_Benjamin- 00020408_002, Hearing Exhibit 4/16-9. 818 Id. at Franklin_Benjamin-00020408_001.

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“for the most part” OTS examiners were “butting heads” with bank personnel and it was difficult to effect change.819

Weak Standards. The documents show that the OTS examiners were also frustrated by the agency’s weak standards, which made it difficult to cite WaMu for violations or require the bank to strengthen its operations.

In 2007, for example, an examiner critical of WaMu’s compliance procedures wanted to downgrade the bank’s compliance rating from 2 to 3, but told the OTS Examiner-in-Charge that, due to the lack of standards on compliance matters, she didn’t believe she could win a battle with the bank:

“I’m not up for the fight or the blood pressure problems. … It doesn’t matter that we are right, what matters is how it is framed. … They [Washington Mutual] aren’t interested in our ‘opinions’ of the [compliance] program. They want black and white, violations or not. … [O]ur training always emphasizes ‘Best Practices’ but when it comes down to it, we don’t have the resources to show the risk.”820 At another point, when discussing standards for calculating acceptable loan error rates, an

OTS examiner wrote:

“We will need additional discussion of acceptable error rates and how we view their [WaMu’s] standard. … [A] 2.5 percent error rate would mean that approximate[ly] $600.0 million could be originated and be within acceptable guidelines. A 20.0 percent medium error rate means that $4.8 billion of loans with these types of errors could be originated without a criticism. The latter seem[s] especially high when you consider that their medium criteria includes loans that we don’t think should be made.”821

The OTS Examiner-in-Charge responded with a lengthy email criticizing outdated, unclear OTS standards on the acceptable loan error rate for a portfolio of subprime loans:

“Unfortunately, our sampling standards are 10 years old and we have no standards of acceptance really. It depends on our own comfort levels, which differ. … Moreover, our guidance requires that an exception be SIGNIFICANT, which … we have over time interpreted as loans that should not have been made. … While we may (and have) questioned the reasonableness of these standards, they are all we have at this time. If our tolerance for some reason is now a lot lower than our handbook standards, it would be nice to have this clarified. I have always used these standards as rough benchmarks and not absolutes myself, upping my expectations for higher risk portfolios. … It would be

819 Subcommittee interview of Benjamin Franklin (2/17/2010). 820 6/3/2007 email from OTS examiner Mary Clark to Examiner-in-Charge Benjamin Franklin, “Compliance Rating,” OTSWMS07-013 0002576, Hearing Exhibit 4/16-39. 821 11/21/2005 email exchange between OTS examiner Benjamin Franklin and Examiner-in-Charge Lawrence Carter and others, OTSEMS05-004 0001911-12, Hearing Exhibit 4/16-30.

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nice if they [higher risk loan portfolios] could meet even higher expectations, but that would require us to agree on what the standard should be.”822 At another point, the same Examiner-in-Charge wrote a long email discussing issues related to a decision by WaMu to qualify borrowers for adjustable rate mortgages using an interest rate that was less than the highest rate that could be charged under the loan. He
complained that it was difficult to force WaMu to comply with the OTS “policy of underwriting at or near the fully indexed rate,” when “in terms of policy, I am not sure we have ever had a really hard rule that institutions MUST underwrite to the fully indexed rate.” He also noted that OTS sometimes made an exception to that rule for loans held for sale.

823

NTM Guidance. While some OTS examiners were complaining about the agency’s weak standards, other OTS officials worked to ensure that new standards being developed for high risk mortgages would not restrain WaMu’s lending practices. The effort began in 2006 with an aim to address concerns about lax lending standards and the risks posed by subprime, negatively amortizing, and other exotic home loans. The federal banking agencies convened a joint effort to reduce the risk associated with those mortgages by issuing interagency guidance for “nontraditional mortgage” products (NTM Guidance). Washington Mutual filed public comments on the proposed NTM Guidance and argued that Option ARM and Interest-Only loans were “considered more safe and sound for portfolio lenders than many fixed rate mortgages,” so 824 It also stated that regulators should “not discourage lenders from offering these products.” calculating a potential borrower’s “DTI [debt-to-income ratio] based on the potential payment shock from negative amortization would be highly speculative” and “inappropriate to use in lending decisions.”825 During subsequent negotiations to finalize that guidance, OTS argued for less stringent lending standards than other regulators were advocating and bolstered its points using data supplied by Washington Mutual.826

In one July 2006 email, for example, an OTS official expressed the view that early

827 He also wrote that OTS needed to

In August, several OTS officials discussed over email how to prevent the

versions of the new guidance focused too much on negative amortization loans, which were popular with several thrifts and at WaMu in particular, and failed to also look closely at other high risk lending products more common elsewhere. address this issue and “should consider going on the offensive, rather than defensive to refute the OCC’s positions” on negatively amortizing loans, defending the loans using WaMu Option ARM loan data.828

822 Id. 823 9/15/2005 email from OTS Examiner-in-Charge Lawrence Carter to OTS Western Region Deputy Director Darrel Dochow, OTSWMS05-002 0000535, Hearing Exhibit 4/16-6. 824 3/29/2006 letter from Washington Mutual Home Loans President David C. Schneider to OTS Chief Counsel, Proposed Guidance – Interagency Guidance on Nontraditional Mortgage Products 70 Fed. Reg. 77249, JPM_WM04473292.
825 Id. at JPM_WM04473298. 826 Subcommittee interviews of Sheila Bair (4/5/2010) and George Doerr (3/30/2010). The Subcommittee was told that OTS was the “most sympathetic to industry” concerns of the participating agencies and was especially protective of Option ARMs. 827 7/27/2006 email from Steven Gregovich to Grovetta Gardineer and others, “NTM Open Issues,” OSWMS06-008 0001491-495, Hearing Exhibit 4/16-71. 828 Id.

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proposed restrictions on negatively amortizing loans from going farther than they believed necessary, noting in part the “profitable secondary market” for Option ARMs and the fact that “hybrid IO [interest only] ARMs are a huge product for Wamu.” One OTS official wrote:

“We have dealt with this product [negatively amortizing loans] longer than any other regulator and have a strong understanding of best practices. I just don’t see us taking a back seat on guidance that is so innate to the thrift industry.”829

OTS officials argued variously that the new proposal would wrongly put the focus on “products” instead of “underwriting,” as well as that it would hurt the business of large thrifts like WaMu.

830

The NTM Guidance was finally issued on October 4, 2006.

The final version did not fully reflect the recommendations of OTS on negatively amortizing loans. Among other matters, it called on banks to:

831

• evaluate a borrower’s ability to fully repay a prospective loan, including any balance

increase from negative amortization;

• qualify borrowers using the higher interest rate that would apply after any teaser or

introductory interest rate;

• avoid loans whose repayment was dependent solely upon the value of the collateral or

the borrower’s ability to refinance the loan; and

•

implement strong quality control and risk mitigation procedures for loans containing layers of risk, including loans with no documentation requirements, no verification of the borrower’s income or assets, or high loan-to-value ratios.

The Guidance also called for capital levels commensurate with risk and adequate allowances for loan losses.

The Guidance was not promulgated as a bank regulation that could be enforced in court,

and it contained no explicit deadline for compliance. Instead, it provided policies and procedures that regulators could use as benchmarks during examinations. Agencies could penalize noncompliance with the standards through lower CAMELS ratings or enforcement actions.
FDIC officials told the Subcommittee that the FDIC expected banks to come into immediate

829 8/14/2006 email from Kurt Kirch to David Henry and Steven Gregovich, “Latest AMP Guidance,” Hearing Exhibit 4/16-72. 830 7/27/2006 email from Steven Gregovich to Grovetta Gardineer, et al., “NTM Open Issues,” OSWMS06-008 0001491-495, Hearing Exhibit 4/16-71. 831 10/4/2006 “Interagency Guidance on Nontraditional Mortgage Product Risks,” (NTM Guidance), 71 Fed. Reg. 192 at 58609.

compliance with the Guidance, and that no agency should have been telling a bank that it did not have to comply with the new standards.832

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A few days after the NTM Guidance went into effect, WaMu officials met with OTS

about implementation and reported back that OTS had indicated that compliance was something 833 According to a written summary by institutions “should” do, not something they “must” do. WaMu of its October 12, 2006 meeting with OTS to discuss the new rules, OTS told the bank that it “view[ed] the guidance as flexible” and “specifically pointed out that the language in the guidance says ‘should’ vs. ‘must’ in most cases and they [were] looking to WaMu to establish our position on how the guidance impacts our business processes.”834

In 2007, OTS conducted a review of WaMu’s Option ARM activities and compliance

efforts and found that three months after the NTM Guidance had become effective, the bank was 835 The OTS review not yet complying with the new standards when issuing Option ARMs. noted that as of January 31, 2007, the bank had a total of $62 billion in outstanding Option ARMs in its investment portfolio, of which 80% were negatively amortizing.836 The review stated that, as of December 31, 2006, WaMu was not in compliance with the NTM Guidance, because it continued not to consider potential negative amortization amounts when qualifying borrowers for Option ARMs; placed too much reliance on FICO scores instead of income verification to qualify borrowers for nontraditional mortgages; failed to consider amortizing payments or payment shocks when qualifying borrowers for interest only loans; and placed too much reliance on collateral, rather than borrower income, as the primary repayment source in the event of a loan default.837 WaMu changed its procedures.

The review contained no recommendations for actions to ensure

In April 2007, the FDIC asked OTS for permission to conduct its own review of WaMu 838 OTS refused, however,

loan files to evaluate the bank’s compliance with the NTM Guidance. to provide the FDIC with access to the relevant loan files and effectively blocked the review.839 The FDIC Assistant Regional Director George Doerr told the Subcommittee that when he

832 Subcommittee interviews of Sheila Bair (4/5/2010) and George Doerr (3/30/2010).
833 See 10/2006 OTS Meeting, “Washington Mutual Alternative Mortgage Guidance Implementation Plan,” JPM_WM02549033, Hearing Exhibit 4/16-73. 834 Id. at JPM_WM02549037. Subcommittee interview of Darrel Dochow (3/3/2010) (indicating that the NTM Guidance used “should” instead of “must” to avoid being a “one-size-fits-all” set of requirements). See also Subcommittee interview of John Bowman (4/6/2010) (indicating that guidance is not enforceable and that giving banks more time to comply was a reasonable approach).
835 See undated OTS document, “Option ARM Neg Am Review Workprogram 212A(1) & Nontraditional Mortgage Guidance Review,” OTSWMEF-0000009888, Hearing Exhibit 4/16-74. The document quotes Option ARM data from March 31, 2007, indicating that the document was prepared after that date. 836 Id. at OTSWMEF-0000009890. 837 Id. at OTSWMEF-0000009893-94. 838 See, e.g., 4/30/2007 email from FDIC Western Region Assistant Director George Doerr to FDIC official David Collins, FDIC_WAMU 000014457, Hearing Exhibit 4/16-57.
839 See April 16, 2010 Subcommittee Hearing at 33 (Testimony of FDIC IG John Rymer: “OTS did grant FDIC greater access at WaMu, but limited FDIC’s review of WaMu’s residential loan files. The FDIC wanted to review these files to assess underwriting and WaMu’s compliance with the Non-Traditional Mortgage Guidance.”); See also April 16, 2010 Subcommittee Hearing at 187 (Testimony of George Doerr, FDIC).

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contacted OTS official Mike Finn about the FDIC’s request to review WaMu loan files to test NTM compliance, Mr. Finn said that OTS was giving its institutions more time to comply with the guidance, even though it had taken effect more than six months earlier.840 The FDIC Chairman Sheila Bair told the Subcommittee that the FDIC had not known until then that OTS was allowing institutions to delay compliance with the NTM Guidance and were “surprised” by the agency’s actions. She said that normally, if an institution needs more time to comply with new standards, a regulator required it to provide a written plan with milestones for achieving compliance.841

Documents uncovered by the Subcommittee show how WaMu took advantage of the

delay to continue its high risk lending practices. The NTM Guidance directed banks, for example, to evaluate a borrower’s ability to repay a mortgage using the highest interest rate that would be charged under the loan and the fully amortized payment amount rather than any smaller or minimum payment amount. After determining that those new requirements could lead to a 33% drop in Option ARM loan volume due to borrowers who would no longer qualify for the loans, WaMu’s Chief Enterprise Risk Officer, Ron Cathcart, advised “holding off on implementation until required to act for public relations (CFC [Countrywide] announces unexpectedly) or regulatory reasons.” had already allowed Washington Mutual to delay its compliance with the Guidance for six months, resulting in the bank’s originating billions of dollars in new Option ARM loans that would later suffer significant losses.843 strengthen WaMu’s lending standards and reduce its loan risk, OTS chose to delay its implementation.

842 When he made that suggestion in March 2007, OTS

Instead of using the NTM Guidance as an opportunity to

In addition, in May 2007, when an OTS official attempted to stop WaMu from issuing

mortgages without verifying borrower incomes, relying on the NTM Guidance and other rules as justification, OTS senior management rebuffed the official’s efforts. Instead, OTS senior managers interpreted its standards as allowing thrifts to continue issuing “stated income loans,” also called “No Income No Asset” (NINA) or “no doc” loans, because they permitted lenders to provide credit without verifying the borrower’s income or assets. On May 15, 2007, after reviewing a summary of WaMu’s loans, an OTS official in Washington, Bill Magrini, sent an email to the OTS Examiner-in-Charge with responsibility for WaMu stating:

“I note that WAMU makes a significant amount of No-doc loans. OTS policy states that no-doc loans are unsafe and unsound. I assume they mean no doc regarding NINA or no income-no asset loans.

840 Subcommittee interview of George Doerr (3/30/2010). 841 Subcommittee interview of Sheila Bair (4/5/2010). 842 3/19/2007 email from Ron Cathcart to David Schneider, JPM_WM02571598, Hearing Exhibit 4/16-75.
843 See wamusecurities.com. (subscription website maintained by JPMorgan Chase with data on Long Beach and WaMu mortgage backed securities showing, as of January 2011, delinquency rates for particular mortgage backed securities, including WMALT 2006 OA-3 – 57.87%).

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Without even asking for income or assets/liabilities, the loans are collateral-dependent.
This is imprudent … [T]he interagency NTM Guidance states specifically that collateral dependent loans are unsafe and unsound. …

Does WAMU have any plans to amend its policies per no doc loans?”844 The Examiner-in-Charge, Benjamin Franklin, relayed the inquiry to the then Director of the OTS Western Region Office, Darrel Dochow, and stated that, while WaMu had not issued “true NINAs” in the past, the bank had begun “doing NINA’s in 2006 through their conduit program. As such, all these loans are held for sale.” He estimated WaMu then had about $90 million of NINA loans held for sale, had originated about $600 million in 2006, and would originate the same amount again in 2007.

845

Mr. Dochow responded that he was already in regular contact with OTS officials in

Washington about WaMu and “there is no need to duplicate with Bill Magrini as far as I know.”

Later the same day, Mr. Dochow wrote:

846

“I am being told that Bill’s views may not necessarily represent OTS policy in these matters. I value Bill’s input, but we should be careful about relaying his views to others as being OTS policy, absent collaborating written guidance. [His] views … are somewhat inconsistent with NTM guidance and industry practice. I also understand Grovetta [another OTS official] promised to clarify section 212 of the handbook in several areas as a result of the NTM roundtable discussion in Wash DC last month.”

847

That same day, another OTS official, Mark Reiley, sent an email indicating his belief that

sections of the OTS handbook barred WaMu from issuing NINA loans, even when those loans were originated for sale to Wall Street:

“The Handbook guidance Section 212 states that no-doc loans (NINAs) are unsafe and unsound loans (Pg. 212.7). Furthermore, even if the no-doc (NINA) loans are originated and held for sale the guidance indicates (pg. 212.8) the association must use prudent underwriting and documentation standards and we have already concluded they are unsafe and unsound. Even if the institution holds the loans for a short period of time. … [T]his is a hot topic in DC and we are getting a significant amount of push back from the

844 See 5/15/2007 email from OTS Examiner-in-Charge Benjamin Franklin to OTS Western Region Director Darrel Dochow, Franklin_Benjamin-00020449_001, Hearing Exhibit 4/16-79 (quoting email from Bill Magrini). See also 3/27/2007 email from OTS official Bill Magrini to OTS colleagues, Quigley_Lori-00110324, Hearing Exhibit 4/16- 76 (“I noted that several of our institutions make NINA loans. That, in my humble opinion is collateral dependent lending and deemed unsafe and unsound by all the agencies. … It is not at all surprising that delinquencies are up, even among Alt-A. In my opinion, credit standards have gone too low.”). See also undated OTS document, “Option ARM Neg Am Review Workprogram 212A(1) & Nontraditional Mortgage Guidance Review,” at OTSWMEF-0000009891, Hearing Exhibit 4/16-74 (determining that 73% of the Option ARMs in WaMu’s portfolio were “low doc” loans).
845 5/16/2007 email from OTS Western Region Director Darrel Dochow to OTS Examiner-in-Charge Benjamin Franklin, Franklin_Benjamin-00020449_001, Hearing Exhibit 4/16-79. 846 Id. 847 Id.

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industry. … At this point I don’t think a memo is the best avenue, I think we need to request in writing that WAMU respond to us on how the NINA’s comply with the handbook guidance?”

The WaMu Examiner-in-Charge, Benjamin Franklin, responded:

“I didn’t intend to send a memo until I got a blessing from [the Western Region Director] or DC on what our official policy is on this. … [M]any of our larger institutions now do NINAs (including Countrywide) .… Apparently [OTS policy official] Bill Magrini is the lone ranger in his view that NINA’s are imprudent. West region position seems to be that FICO, appraisal, and other documentation … is sufficient to assess the borrower’s ability to repay in all but subprime loans. While I probably fall more into the Magrini camp (until we get empirical data to support NINAs are not imprudent) we will just document our findings … until the ‘official’ policy on this has been worked out.”848 A year later, in October 2008, after WaMu’s failure, the same Examiner-in-Charge,

Benjamin Franklin, wrote to a colleague:

“[N]ot one regulatory agency had a rule or guideline saying you couldn’t do stated income lending, even to this day. That, I find incredible. We criticized stated income lending at WaMu but they never got it completely fixed. … [I]n hindsight, I’m convinced that it is just a flawed product that can’t be fixed and never should have been allowed in the first place. How do you really assess underwriting adequacy when you allow the borrower to tell you what he makes without verification. We used to have documentation requirements for underwriting in the regs, but when those were taken out, the industry slowly migrated to an anything goes that got us into this mess. … When I told Scott Polakoff [OTS Deputy Director] that stated income subprime should not be made under any circumstance, I was corrected by Mike Finn [OTS Western Region head] that that was not the West Region’s position. I rest my case.”849 Data compiled by the Treasury and FDIC Inspectors General shows that, by the end of

2007, stated income loans – loans in which the bank did not verify the borrower’s income – represented 50% of WaMu’s subprime loans, 73% of its Option ARMs, and 90% of its home equity loans. loans as unsafe and unsound.851 OTS Director John Reich testified that he regretted not doing more to prevent supervised thrifts from issuing stated income loans.852

850 At the Subcommittee hearing, virtually every witness condemned stated income

Subcommittee interviews with OTS examiners who worked at WaMu found those

examiners to be demoralized and frustrated at their inability to effect change at the bank. They

848 Id. 849 10/7/2008 email exchange between OTS Examiner-in-Charge Benjamin Franklin and OTS examiner Thomas Constantine, “West Region Update,” Franklin_Benjamin-00034415_001, Hearing Exhibit 4/16-14.
850 4/2010 “Evaluation of Federal Regulatory Oversight of Washington Mutual Bank,” prepared by the Offices of Inspector General at the Department of the Treasury and Federal Deposit Insurance Corporation, at 10, Hearing Exhibit 4/16-82. 851 See, e.g., April 16, 2010 Subcommittee Hearing at 14-15, 41-42. 852 Id. at 42 (“In hindsight, I regret it.”).

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had identified serious deficiencies at the bank year after year, with no enforcement consequences; some tried to interpret OTS standards in ways that would reduce risk, only to be rebuffed by their leaders; and others were told that the NTM Guidance being enforced by other agencies did not have standards that could be enforced by OTS examiners. Days after WaMu’s failure, one OTS examiner had this to say about OTS leadership:

“My examination history here is filled with the editing and removal of my comments as well as predictions (that turned out to be true) by EICs [Examiners-in-Charge]. No system in place to keep that from happening. Instead we put whitewashers and scaredity cats in charge of the most problematic shops. I don’t know what happened to you at WAMU, but I was critical of their accounting at Card Services and the AP. Fortunately, I think I made the ‘don’t let him come back here’ list. … [O]ur leadership screwed us and can’t acknowledge it. They should resign.”853 (c) Narrow Regulatory Focus

In addition to a policy of deference to management, weak standards, and demoralized examiners, OTS employed an overly narrow regulatory focus that allowed WaMu’s short term profits to excuse its risky practices and that ignored systemic risk. For a time, its short term profits masked the problems at Washington Mutual, and regulators allowed practices which they knew to be risky and problematic to continue. Because it mishandled its responsibilities, OTS gave the illusion to investors, economists, policy makers, and others that the bank was sound, when in reality, it was just the opposite. Unfortunately, the truth of the matter was not revealed until it was too late, and the bank collapsed.

Using Short Term Profits to Excuse Risk. OTS justified not taking enforcement action

against WaMu in part by pointing to Washington Mutual’s profits and low loss rates during the height of the mortgage boom, claiming they made it difficult to require the bank to reduce the risks threatening its safety and soundness. In 2005, when faced with underwriting problems at WaMu, the OTS Examiner-in-Charge put it this way:

“It has been hard for us to justify doing much more than constantly nagging (okay, ‘chastising’) through ROE [Reports of Examination] and meetings, since they [WaMu] have not been really adversely impacted in terms of losses. It has been getting better and has not recently been bad enough to warrant any ratings downgrade.”854

The OTS Handbook was explicit, however, in stating that profits should not be used to

overlook or excuse high risk activities:

853 10/7/2008 emails from OTS examiner Thomas Constantine to OTS Examiner-in-Charge Benjamin Franklin, “West Region Update,” Franklin_Benjamin-00034415_002, Hearing Exhibit 4/16-14. 854 9/15/2005 email from Examiner-in-Charge Lawrence Carter to Western Region Deputy Director Darrel Dochow, OTSWMS05-002 0000535, Hearing Exhibit 4/16-6.

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“If an association has high exposure to credit risk, it is not sufficient to demonstrate that the loans are profitable or that the association has not experienced insignificant losses in the near term.”855

But in the case of Washington Mutual, profits did make a difference. At the

Subcommittee hearing, when asked by Senator Kaufman to identify one or two reasons why no regulatory action was taken against WaMu, the FDIC IG Jon Rymer testified as follows:

“[L]et me start by saying I think the problem in 2005, 2006, and into 2007, the problem was the bank was profitable. I think there was a great reluctance to [take action], even though problems were there in underwriting, the product mix, the distribution process, the origination process, all in my view extraordinarily risky .… [T]he people in [agency] leadership positions have to be willing to make the tough calls and be experienced enough to know that today’s risky practices may show today profitability, but to explain to management and enforce with regulatory action that risky profitability is going to have a cost. It either has a cost in control processes an institution would have to invest in now, or it is going to have a cost ultimately to the bank’s profitability and perhaps eventually to the Deposit Insurance Fund.”856

In his prepared statement, the Treasury Inspector General, Eric Thorson, noted

that OTS examiners told his staff they did not lower WaMu’s CAMELS ratings because “even though underwriting and risk management practices were less than satisfactory, WaMu was making money and loans were performing.”

857

This problem was not isolated within OTS, however, but applied to other regulatory

agencies as well. The FDIC Inspector General noted, for example, that the bank’s profitability also tempered the FDIC views of the bank. He explained that, prior to 2008, the FDIC did not challenge WaMu’s 2 CAMELS ratings, because “the risks in WaMu’s portfolio had not manifested themselves as losses and nonperforming loans, and therefore did not impact WaMu’s financial statements.” long list of “embedded risk factors” in WaMu’s home loans that, despite the bank’s profitability, exposed the bank to losses in the event of “a widespread decline in housing prices.”859

858 At the same time, an internal FDIC analysis of the bank identified a

In the financial industry, high risk activities are undertaken by financial institutions to

earn higher marginal returns. The role of the regulator is to enforce rules that ensure the risks an institution undertakes do not unfairly transfer that risk to others or threaten the safety and soundness of the economy, despite any short term profits. In the case of the FDIC, the judgment

855 11/2004 Office of Thrift Supervision Examination Handbook, at 070.8, OTSWMEF-0000032053; 2/2011 Office of Thrift Supervision Examination Handbook, at 070.9, http://www.ots.treas.gov/_files/422008.pdf (quote is the same in updated version of handbook). See also April 16, 2010 Subcommittee Hearing at 19 (testimony of FDIC and Treasury Inspectors General). 856 April 16, 2010 Subcommittee Hearing at 24-26. 857 Thorson prepared statement at 10, April 16, 2010 Subcommittee Hearing at 110. 858 Rymer prepared statement at 10, April 16, 2010 Subcommittee Hearing at 129.
859 Undated draft memorandum from the WaMu examination team at the FDIC to the FDIC Section Chief for Large Banks, FDIC-EM_00251205-10, Hearing Exhibit 4/16-51a (likely mid-2005).

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includes whether the risk threatens loss to the Deposit Insurance Fund. Any firm that decides to take a risk should be the only firm, along with its investors, to bear the brunt of the problem if it turns out to have been a mistake. Regulators that, when faced with short term profits, stop evaluating or downplay attendant risks that could produce later losses fail in their obligation to ensure the safety and soundness of the financial institutions they are regulating. In the case of WaMu, both OTS and the FDIC allowed the bank’s success in the short term to paper over its underlying problems.

In October 2008, after Washington Mutual failed, the OTS Examiner-in-Charge at the

bank, Benjamin Franklin, deplored OTS’ failure to prevent its thrifts from engaging in high risk lending because “the losses were slow in coming”:

“You know, I think that once we (pretty much all the regulators) acquiesced that stated income lending was a reasonable thing, and then compounded that with the sheer insanity of stated income, subprime, 100% CLTV [Combined Loan-to-Value], lending, we were on the figurative bridge to nowhere. Even those of us that were early opponents let ourselves be swayed somewhat by those that accused us of being ‘chicken little’ because the losses were slow in coming, and let[’]s not forget the mantra that ‘our shops have to make these loans in order to be competitive’. I will never be talked out of something I know to be fundamentally wrong ever again!!”860

Failure to Consider Financial System Impacts. A related failing was that OTS took a narrow view of its regulatory responsibilities, evaluating each thrift as an individual institution without evaluating the effect of thrift practices on the financial system as a whole. The U.S. Government Accountability Office, in a 2009 evaluation of how OTS and other federal financial regulators oversaw risk management practices, concluded that none of the regulators took a systemic view of factors that could harm the financial system:

“Even when regulators perform horizontal examinations across institutions in areas such as stress testing, credit risk practices, and the risks of structured mortgage products, they do not consistently use the results to identify potential system risks.”861

Evidence of this narrow regulatory focus includes the fact that OTS examiners carefully evaluated risk factors affecting home loans that WaMu kept on its books in a portfolio of loans held for investment, but paid less attention to the bank’s portfolio of loans held for sale. OTS apparently reasoned that the loans held for sale would soon be off WaMu’s books so that little analysis was necessary. From 2000 to 2007, WaMu securitized about $77 billion in subprime

860 10/7/2008 email from OTS Examiner-in-Charge Benjamin Franklin to OTS Examiner Thomas Constantine, Franklin_Benjamin-00034415, Hearing Exhibit 4/16-14. 861 3/18/2009 Government Accountability Office, “Review of Regulators’ Oversight of Risk Management Systems at a Limited Number of Large, Complex Financial Institutions,” Testimony of Orice M. Williams, Hearing Exhibit 4/16-83 (GAO reviewed risk management practices of OTS, as well as the Federal Reserve, the Office of the Comptroller of the Currency, the SEC, and self-regulatory organizations.).

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loans, mostly from Long Beach, as well as about $115 billion in Option ARM loans.862 documents indicate that OTS did not consider the problems that could result from widespread defaults of poorly underwritten mortgage securities from WaMu and other thrifts.

Internal

Numerous documents show that OTS and the FDIC were, in fact, aware that WaMu was

issuing high risk loans that led to poor quality securitizations:

2005 OTS email describing poor quality Long Beach mortgage backed securities:
“Performance data for 2003 and 2004 vintages appear to approximate industry average while issues [of securities] prior to 2003 have horrible performance. … [Long Beach] finished in the top 12 worst annualized [net credit losses] in 1997 and 1999 thru 2003. …
At 2/05, [Long Beach] was #1 with a 12% delinquency rate. Industry was around 8.25%.”863 2005 FDIC analysis of WaMu high risk loans: “Management acknowledges the risks posed by current market conditions and recognizes that a potential decline in housing prices is a distinct possibility. Management believes, however that the impact on [WaMu] would be manageable, since the riskiest segments of production are sold to 864 investors, and that these investors will bear the brunt of a bursting housing bubble.”

865

2005 OTS email discussing allowing lower standards for loans held for sale: “[L]oans held for sale could be underwritten to secondary market standards …. I believe we would still find that secondary market requirements are more lax than our policy on underwriting to fully indexed rates. … [I]f you allow them [WaMu] the exception for loans held for sale … they probably do not have a ton of loans that fall far outside our policy guidance.” 2006 OTS email discussing Long Beach loans that had to be repurchased from buyers:
“The primary reasons for the problem were … [g]eneral lower quality 2005 production due to economy and lowered standards …. The $4.749 billion in loans on [Long Beach] books at 12/31/05 are largely comprised of the same 2005 vintage production that was sold in the whole loan sales and are now subject to the increased repurchases. …
Management is balancing the probability that these loans will perform worse than expected and priced for, versus the increased income they generate … in considering whether to [sell] some or all of the portfolio.”

866

862 “Securitizations of Washington Mutual and Long Beach Subprime Home Loans,” chart prepared by the Subcommittee, Hearing Exhibit 4/13-1c; 10/17/2006 “Option ARM” draft presentation to the WaMu Board of Directors, JPM_WM02549027, chart at 2, Hearing Exhibit 4/13-38. 863 4/14/2005 email from OTS examiner to colleagues, OTSWME05-0120000806, Hearing Exhibit 4/13-8a.
864 Undated draft memorandum from WaMu examination team to the FDIC Section Chief for Large Banks, FDIC- EM_00251205-10, Hearing Exhibit 4/16-51a (likely mid-2005). 865 9/16/2005 email from OTS Examiner-in-Charge at WaMu, OTSWMS05-002 0000535, Hearing Exhibit 4/16-6. 866 1/20/2006 email from Darrel Dochow to Michael Finn and others, OTSWMS06-007 0001020.

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2008 OTS email after WaMu’s failure: “We were satisfied that the loans were originated for sale. SEC and FED [were] asleep at the switch with the securitization and repackaging of the cash flows, irrespective of who they were selling to.”867

2005 WaMu audit of Loan Sales and Securitization planned no further audit for three years. In March 2007, OTS informally suggested that more frequent audits would be appropriate given the high volume and high risk nature of WaMu’s securitization activity and “data integrity issues surrounding the creation of securitization trusts, resulting in loan repurchases from those trusts.” secondary market for subprime securities collapsed four months later.

OTS was two years too late, however; the

868

Neither OTS nor the FDIC saw preventing WaMu’s sale of high risk mortgages into U.S. securitization markets as part of its regulatory responsibilities.

(d) Inflated CAMELS Ratings Still another possible explanation for OTS’ inaction may have been the overly positive

CAMELS ratings it assigned WaMu. From 2004 until early 2008, WaMu held a 2 rating, which meant that it was “fundamentally sound,” had “satisfactory risk management,” and had “only moderate weaknesses that [were] within the board’s and management’s capability and willingness to correct.”869 actions that OTS and the FDIC could have taken, because it would have required changes from WaMu.

A lower CAMELS rating would have represented one of the strongest

Both the Treasury and the FDIC Inspector General criticized the assignment of the 2

ratings as inaccurate and inappropriate, highlighting how those inflated ratings masked the true problems. risk home loans:

Treasury IG Thorson focused in particular on the 2 rating assigned to WaMu’s high

870

“[W]e find it difficult to understand how OTS could assign WaMu a satisfactory asset quality 2-rating for so long. Assigning a satisfactory rating when conditions are not satisfactory sends a mixed and inappropriate supervisory message to the institution and its board. It is also contrary to the very purpose for which regulators use the CAMELS rating system.”

871

Inspector General Thorson also criticized the 2 rating assigned to WaMu’s management,

which signaled “satisfactory performance by management and the Board of Directors and

867 10/7/2008 email from OTS examiner Thomas Constantine to OTS colleague Benjamin Franklin, Franklin_Benjamin-00034415_001, Hearing Exhibit 4/16-14. 868 See 3/5/2007 WAMU Examination “Review of Securitization,” OTSWME07-075 0000780-791 at 789 (data gathered from WaMu’s Market Risk Committee minutes, Dec. 2006 and Jan. 2007). 869 Thorson prepared statement at 7, April 16, 2010 Subcommittee Hearing at 107.
870 See, e.g., Treasury and FDIC IG Report at 16.
871 Thorson prepared statement at 10, April 16, 2010 Subcommittee Hearing at 110. See also id. at 8, April 16, 2010 Subcommittee Hearing at 108.

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satisfactory risk management practices.”872 rating until June 2008, despite the bank’s ongoing failure to correct the many deficiencies identified by OTS examiners and the fact that management problems at WaMu were longstanding. At the Subcommittee hearing, the FDIC Inspector General Rymer also criticized the 2 rating assigned to WaMu’s management:

He noted that OTS gave management this positive

“[T]he management piece should be, in my view, downgraded if management has not demonstrated that it has built the adequate systems and control processes and governance processes to help manage problems when they eventually do occur in assets. … I find it difficult to understand why the management rating at a minimum was not lowered much earlier on.”

873

The FDIC Inspector General also noted that, from 2004 to 2008, the FDIC had assigned

LIDI ratings to WaMu that indicated a higher degree of risk at the bank than portrayed by the bank’s CAMELS ratings. He observed that LIDI ratings, which are intended to convey the degree of risk that a bank might cause loss to the Deposit Insurance Fund, are designed to be more forward-looking and incorporate consideration of future risks to a bank, as compared to CAMELS ratings, which are designed to convey the state of an institution at a particular point in time.

874

WaMu kept its 2 rating despite the five-year litany of lending, risk management,

appraisal, and Long Beach deficiencies identified by OTS examiners from 2004 to 2008. It was only in February 2008, after the bank began to incur substantial losses, that OTS downgraded the bank to a 3. When the FDIC urged a further downgrade to a 4 rating in the summer of 2008, OTS disagreed. In September 2008, however, while still resisting the ratings downgrade, OTS acknowledged internally that WaMu’s poor quality loans and poor risk management were the source of its problems:

“The bank’s overall unsatisfactory condition is primarily the result of the poor asset quality and operating performance in the bank’s major Home Loans Group area of business. … The deteriorating asset quality in the Home Loans Group is accompanied by inadequacies in risk management, internal controls, and oversight that made more vulnerable to the current housing and economic downturn. The examination criticized past liberal home loan underwriting practices and concentrated delivery of nontraditional mortgage products to higher risk geographic markets.”875

It was only on September 18, 2008, after the bank began to run out of the cash needed to conduct its affairs and the FDIC independently downgraded the bank to a 4, that OTS finally agreed to the downgrade. One week later, OTS placed the bank into receivership.

872 See Thorson prepared statement at 11, April 16, 2010 Subcommittee Hearing at 111. 873 April 16, 2010 Subcommittee Hearing at 24-26. 874 See, e.g., Rymer prepared statement at 5. 875 9/11/2008 OTS document, “WaMu Ratings of 3/343432,” Polakoff_Scott-00065325, Hearing Exhibit 4/16-48.

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Hindsight establishes that the CAMELS ratings assigned to Washington Mutual Bank were inflated. Whether the ratings inflation was attributable to the OTS culture of deference to management, examiners who were too intimidated to downgrade the agency’s largest institution, an overly narrow regulatory focus that was blinded by WaMu’s short term profits and ignored systemic risk, or an absence of forward-looking risk analysis, the WaMu collapse suggests that the CAMELS rating system did not work as it should.

(e) Fee Issues

During the investigation, when asked why OTS senior officials were not tougher on

Washington Mutual Bank, several persons brought up the issue of fees – that WaMu supplied $30 million or nearly 15% of the fees per year that paid for OTS’ operating expenses. WaMu’s former Chief Risk Officer James Vanasek offered this speculation:

“I think you have to look at the fact that Washington Mutual made up a substantial portion of the assets of the OTS and one wonders if the continuation of the agency would have existed had Washington Mutual failed.”876

The issue was also raised by Treasury IG Thorson who warned that OTS should have been “very clear from top to bottom” that WaMu’s payment of $30 million in fees per year to OTS was “not a factor. It just [was] not.”

877

The OCC and OTS are the only federal banking regulators reliant on fees paid by their regulated entities to fund their operations. At OTS, Washington Mutual was far larger than any other thrift overseen by the agency and was a far larger and more important contributor to the agency’s budget. It is possible that the agency’s oversight was tempered by recognition of the thrift’s unique importance to the agency’s finances and a concern that tough regulation might cause WaMu to convert its charter and switch to a different regulator. Its dependence on WaMu fees may have given OTS the incentive to avoid subjecting WaMu to regulatory enforcement actions and ultimately compromised its judgments.

Conclusion. WaMu is the largest bank failure in the history of the United States. When

OTS seized it, WaMu had $307 billion in assets. By comparison, the next largest U.S. bank failure was Continental Illinois, which had $40 billion in assets when it collapsed in 1984. OTS’ failure to act allowed Washington Mutual to engage in unsafe and unsound practices that cost borrowers their homes, led to a loss of confidence in the bank, and sent hundreds of billions of dollars of toxic mortgages into the financial system with its resulting impact on financial markets at large. Even more sobering is the fact that WaMu’s failure was large enough that, if the bank had not been purchased by JPMorgan Chase, it could have exhausted the entire Deposit Insurance Fund which then contained about $45 billion. Exhausting the Deposit Insurance Fund

876 April 13, 2010 Subcommittee Hearing at 40 (Testimony of James Vanasek).
877 See April 16, 2010 Subcommittee Hearing at 25.

could have triggered additional panic and loss of confidence in the U.S. banking system and financial markets.

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(2) Other Regulatory Failures

Washington Mutual was not the only failed thrift overseen by OTS. In 2008, OTS closed

the doors of five thrifts with combined assets of $354 billion.878 Another seven thrifts holding collective assets of $350 billion were sold or declared bankruptcy.879 Virtually all of these thrifts conducted high risk lending, accumulated portfolios with high risk assets, and sold high risk, poor quality mortgages to other financial institutions and investors. At the Subcommittee hearing, the Treasury Inspector General testified that, after completing 17 reviews and working on another 33 reviews of a variety of failed financial institutions, he could say that OTS’ lack of enforcement action was “not unique to WaMu” and lax enforcement by the relevant federal banking regulator was “not unique to OTS.”880

Mortgage lenders other than banks also failed. Many of these mortgage lenders had

operated as private firms, rather than as depository institutions, and were not overseen by any federal or state bank regulator. Some were overseen by the SEC; others were not overseen by any federal financial regulator. Some became large companies handling billions of dollars in residential loans annually, yet operated under minimal and ineffective regulatory oversight.
When residential loans began to default in late 2006, and the subprime securitization market dried up in 2007, these firms were unable to sell their loans, developed liquidity problems, and went out of business. Together, these failed mortgage lenders, like the failed thrifts, contributed to systemic risk that damaged the U.S. banking system, U.S. financial markets, and the U.S. economy as a whole.

(a) Countrywide

Countrywide Financial Corporation, now a division of Bank of America and known as

Bank of America Home Loans, was formerly the largest independent mortgage lender in the United States and one of the most prolific issuers of subprime mortgages.881 For a number of years, Countrywide operated as a national bank under the OCC. In March 2007, it converted to a thrift charter and operated for its last 18 months under the regulatory supervision of OTS.882 At its height, Countrywide had approximately $200 billion in assets, 62,000 employees, and issued in excess of $400 billion in residential mortgages each year. In 2008, Countrywide originated

878 1/2009 Center for Responsible Lending report, “The Second S&L Scandal,” at 1, Hearing Exhibit 4/16-84. 879 Id. 880 April 16, 2010 Subcommittee Hearing at 18 (Testimony of Treasury IG Thorson). The Treasury IG also reviewed, for example, failed banks overseen by the OCC. 881 See, e.g., “Mortgage Lender Rankings by Residential Originations,” charts prepared by MortgageDaily.com, http://www.mortgagedaily.com/MortgageLenderRanking.asp (indicating Countrywide was one of the top three issuers of U.S. residential mortgages from 2003 to 2008); “A Mortgage Crisis Begins to Spiral, and the Casualties Mount,” New York Times (3/5/2007).
882 3/5/2007 OTS press release, “OTS Approves Countrywide Application,” http://www.ots.treas.gov/_files/777014.html.

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nearly 20% of all mortgages in the United States.883 But in August 2008, after the collapse of the subprime secondary market, Countrywide could no longer sell or securitize its subprime loans and was unable to obtain replacement financing, forcing the bank into a liquidity crisis.884 By the end of the summer of 2008, it would have declared bankruptcy, but for its sale to Bank of America for $2.8 billion.885

Neither the OCC nor OTS ever filed a public enforcement action against the bank. In June 2009, the SEC filed suit against the three most senior Countrywide executives, the chief executive officer, the chief operating officer and president, and the chief financial officer, charging them with fraudulently misleading investors by representing that Countrywide had issued loans primarily to “prime” or low risk borrowers, when it had actually written increasingly risky loans that senior executives knew would result in substantial defaults and delinquencies. disclosure obligations and engaged in insider trading.887

886 In addition, the SEC charged that CEO Angelo Mozilo had violated his federal

The SEC complaint detailed the bank’s increasingly risky underwriting and lending practices from 2005 to 2007, including its use of stated income loans, loan-to-value ratios in excess of 95%, loans to borrowers with low FICO scores, frequent use of loan exceptions, and willingness to match the loan terms of any competitor. Like WaMu, from 2003 to 2007, the bank switched from issuing primarily low risk, 30-year loans, to subprime and other high risk mortgages.

888

The complaint also described how Mr. Mozilo was internally alarmed and critical of the

increased credit risks that Countrywide was incurring, while at the same time telling investors 889 The SEC complaint cited, for example, that the bank was more prudent than its competitors. an April 2006 email from Mr. Mozilo discussing Countrywide’s issuance of subprime 80/20 loans, which are loans that have no down payment and are comprised of a first loan for 80% of the home’s value and a second loan for the remaining 20% of the value, resulting in a loan-to- value ratio of 100%. Mr. Mozilo wrote: “In all my years in the business I have never seen a more toxic pr[o]duct.”890 In another email that same month, after being informed that most borrowers were making the minimum payments allowed on Option ARM loans, Mr. Mozilo wrote: “Since over 70% have opted to make the lower payment it appears it is just a matter of time that we will be faced with much higher resets and therefore much higher delinquencies.”891

http://www.occ.gov/static/publications/annrpt/2009AnnualReport.pdf.

883 OCC, “Annual Report: Fiscal Year 2009,” 884 See, e.g., SEC v. Mozilo, Case No. CV09-03994 (USDC CD Calif.), Complaint (June 4, 2009), at ¶¶ 102-104
(hereinafter “SEC Complaint against Countrywide Executives”). 885 “Countrywide Financial Corporation,” New York Times (10/15/2010). 886 SEC Complaint against Countrywide Executives. 887 Id. 888 See, e.g., SEC Complaint against Countrywide Executives, at ¶¶ 17-19. 889 See, e.g., id. at ¶¶ 6-7. 890 Id. at ¶ 50. 891 Id. at ¶ 63.

Later he warned that the bank was “flying blind” on the ultimate delinquency rate and should consider selling the loans.892

The SEC complaint also stated:

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“Mozilo went on to write that he had ‘personally observed a serious lack of compliance within our origination system as it relates to documentation and generally a deterioration in the quality of loans originated versus the pricing of those loan[s].’ Mozilo noted that, ‘In my conversations with Sambol [Countrywide’s chief operating officer] he calls the 100% sub prime seconds as the ‘milk’ of the business. Frankly, I consider that product line to be the poison of ours.” On October 15, 2010, the SEC announced a record settlement with the three Countrywide

894 Mr. Mozilo agreed to pay $22.5 million to settle the disclosure fraud allegations

executives. and $45 million to settle the insider trading allegations, bringing his total settlement to $67.5 million.895 publicly traded corporation. Countrywide’s former chief operating officer paid $5.5 million and agreed to a three-year bar. The chief financial officer paid $130,000 and agreed to a one-year bar on practicing before the SEC.

He also agreed to be permanently barred from serving as an officer or director of a

893

In June 2010, in a case brought by the Federal Trade Commission, Countrywide agreed to

pay penalties of $108 million for charging inflated mortgage servicing fees to homeowners in delinquency, including excessive fees to inspect property or mow lawns for people struggling to 896 In August 2010, Countrywide and some former executives agreed to pay keep their homes. $600 million to settle several class action lawsuits.897

(b) IndyMac

IndyMac Bank was established in 1985 by Countrywide co-founders Angelo Mozilo and David Loeb. While its lines of business changed over time, in 2000, it became a chartered thrift overseen by OTS, and grew to become the country’s ninth-largest originator of residential mortgage loans.898 did not require verification or documentation of the borrower’s income, assets or employment; and Option ARM loans which allowed borrowers to pay less than the fully amortized cost of the mortgage. From 2004 to 2006, Option ARMs made up 75% of IndyMac’s home loans and, in 2006, IndyMac allowed 75% of its Option ARM borrowers to make only the minimum payment

IndyMac specialized in two types of high risk home loans, Alt A loans which

892 Id. at ¶ 68-69. 893 Id. at ¶ 49. 894 10/15/2010 SEC Press Release, “Former Countrywide CEO Angelo Mozilo to Pay SEC’s Largest-Ever Financial Penalty Against a Public Company’s Senior Executive,” http://www.sec.gov/news/press/2010/2010-197.htm. 895 Id. 896 6/7/2010 U.S. Federal Trade Commission press release, “Countrywide Will Pay $108 Million for Overcharging Struggling Homeowners; Loan Servicer Inflated Fees, Mishandled Loans of Borrowers in Bankruptcy,” http://www.ftc.gov/opa/2010/06/countrywide.shtm. 897 See, e.g., “$600 Million Countrywide Settlement,” Associated Press (8/3/2010). 898 2/26/2009 Office of Inspector General, Dept. of the Treasury Audit Report, “Safety and Soundness: Material Loss Review of IndyMac Bank,” at 40, http://www.treasury.gov/about/organizational- structure/ig/Documents/oig09032.pdf (hereinafter “IG Report on IndyMac Bank”).

required by the loan, triggering negative amortization. In addition to originating loans, IndyMac packaged them into securities and sold them on the secondary market.899

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In July 2007, after the credit rating agencies downgraded the ratings on most subprime

mortgage backed securities and the subprime secondary market collapsed, IndyMac – like WaMu – was left holding a large inventory of poor quality mortgage loans it could not sell. As delinquencies increased and the value of the mortgages fell, IndyMac incurred substantial losses, and its depositors began withdrawing funds. The withdrawals continued throughout 2007 and 900 In into 2008, eventually reaching $1.55 billion and triggering a liquidity crisis at the bank. July 2008, IndyMac collapsed and was seized by the FDIC, which had to pay more than $10 billion from the Deposit Insurance Fund to protect insured deposits and pay related expenses.901

As it did with WaMu, OTS gave IndyMac high CAMELS ratings until shortly before the

thrift’s failure, despite the fact that OTS had identified numerous problems with IndyMac’s 902 Those problems included adopting an overly narrow subprime mortgage business practices. definition of “subprime,” so that IndyMac could maintain a lower level of capital reserves;903 poor underwriting and sloppy property appraisal practices;904 and improper risk mitigation.905

Neither OTS nor the FDIC ever took a public enforcement action against the bank.

After IndyMac’s failure, the Treasury Inspector General conducted a review and issued a

906 The report attributed IndyMac’s collapse to its report evaluating OTS’ oversight efforts. strategy of rapid growth; originating and securitizing nontraditional, high risk loans; lack of verification of borrowers’ income or assets; lax underwriting; and reliance on high interest loans for its own operations.907 The Treasury IG found that OTS was aware of IndyMac’s problems, but did not take sufficient enforcement action to correct them.908

According to the Inspector

899 Id. at 7. 900 Id. at 3. 901 Id. at 1.
902 Id. at 8. 903 Id. at 18. 904 Id. at 21-31. 905 Id. 906 Id. In addition to the Material Loss Review, the Treasury Inspector General investigated OTS’ conduct in permitting thrifts, including IndyMac to backdate certain capital infusions. See 12/22/2008 Office of the Inspector General, Dept. of the Treasury, Letter to Ranking Member Charles Grassley, Senate Committee on Finance,
http://media.washingtonpost.com/wp- srv/business/documents/Indymac_Thorson_122308pdf.pdf?sid=ST2008122202386. Darrel Dochow was removed from his position as Director of the OTS West Division for having allowed IndyMac to backdate a capital contribution of $18 million, which made it appear stronger than it really was in the relevant financial statement.
Then Acting OTS Director Scott Polakoff was also placed on leave during the backdating investigation, but he disputed that he directed anyone to allow backdated capital injections and asserted that the real impetus for his being placed on leave was his Congressional testimony critical of the agency’s conduct related to AIG. Subcommittee interview of Scott Polakoff (3/16/10). 907 3/31/2009 Office of the Inspector General, Dept. of the Treasury, “Semiannual Report to Congress,” at 15, http://www.treasury.gov/about/organizational-structure/ig/Documents/sar042009.pdf. 908 Id. at 31.

General, OTS typically relied on the “cooperation of IndyMac management to obtain needed improvements” – which was usually not forthcoming – to remedy identified problems.909

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In February 2011, the SEC charged three former senior IndyMac executives with

securities fraud for misleading investors about the company’s deteriorating financial 910 The SEC alleged that the former CEO and two former CFOs participated in the condition. filing of false and misleading disclosures about the financial stability of IndyMac and its main subsidiary, IndyMac Bank F.S.B. One of the executives – S. Blair Abernathy, former CFO – has agreed to settle the SEC’s charges without admitting or denying the allegations for approximately $125,000. The SEC’s complaint against former CEO Michael W. Perry and former CFO A. Scott Keys seeks, among other things, disgorgement, financial penalties, and a bar on their acting as an officer or director of a publicly traded corporation.911

IndyMac was the third-largest bank failure in U.S. history and the largest collapse of a

912 At the time of its collapse, IndyMac had $32 FDIC-insured depository institution since 1984. billion in assets and $19 billion in deposits, of which approximately $18 billion were insured by the FDIC.913 IndyMac’s failure cost the FDIC $10.7 billion,914 a figure which, at the time, represented over 10% of the federal Deposit Insurance Fund.915

New Century Financial Corporation is an example of a failed mortgage lender that

operated largely without federal or state oversight, other than as a publicly traded corporation overseen by the SEC. New Century originated, purchased, sold, and serviced billions of dollars in subprime residential mortgages, operating not as a bank or thrift, but first as a private corporation, then as a publicly traded corporation, and finally, beginning in 2004, as a publicly traded Real Estate Investment Trust (REIT).916 By 2007, New Century had approximately 7,200 employees, offices across the country, and a loan production volume of $51.6 billion, making it

909 Id. at 38. 910 2/11/2011 SEC press release, “SEC Charges Former Mortgage Lending Executives With Securities Fraud,” http://www.sec.gov/news/press/2011/2011-43.htm. 911 Id. 912 “The Fall of IndyMac,” CNNMoney.com (7/13/2008). 913 Id. 914 3/31/2010 Office of Inspector General, Dept. of the Treasury, “Semiannual Report to Congress,” http://www.treasury.gov/about/organizational- structure/ig/Documents/March%202010%20SAR%20Final%20%20(04-30-10).pdf. 915 “Crisis Deepens as Big Bank Fails; IndyMac Seized in Largest Bust in Two Decades,” Wall Street Journal (7/12/2008). 916 See SEC v. Morrice, Case No. SACV09-01426 (USDC CD Calif.), Complaint (Dec. 7, 2009), ¶¶ 12-13 (hereinafter “SEC Complaint against New Century Executives”). See also In re New Century, Case No. 2:07-cv- 00931-DDP (USDC CD Calif.), Amended Consolidated Class Action Complaint (March 24, 2008), at ¶¶ 55-58 (hereinafter “New Century Class Action Complaint”).

236 the second largest subprime lender in the country.917 insured accounts, it was not overseen by any federal or state bank regulator.

Because it did not accept deposits or have

In 2007, after the company announced its intent to restate its 2006 financial results,

918 In February 2008, the bankruptcy examiner released a

investors lost confidence in the company, its stock plummeted, and New Century collapsed. In April 2007, it filed for bankruptcy. detailed report that found New Century was responsible for “significant improper and imprudent practices related to its loan originations, operations, accounting and financial reporting processes.”919 practices, including “increasing loan originations, without due regard to the risks associated with that business strategy”; risk layering in which it issued high risk loans to high risk borrowers, including originating in excess of 40% of its loans on a stated income basis; allowing multiple exceptions to underwriting standards; and utilizing poor risk management practices that relied on the company’s selling or securitizing its high risk mortgages rather than retaining them.

Like WaMu, New Century had engaged in a number of harmful mortgage

After New Century’s bankruptcy, a 2007 class action complaint was filed by the New York State Teachers’ Retirement System and others alleging that New Century executives had 920 Among other matters, the complaint violated federal securities laws and committed fraud. alleged that the company sold poor quality loans that incurred early payment defaults, received numerous demands from third party buyers of the loans to repurchase them, and built up a huge backlog of hundreds of millions of dollars in repurchase requests that the company deliberately delayed paying to make its 2005 and 2006 financial results appear better than they actually were.921 The complaint also alleged that New Century issued loans using lax underwriting standards to maximize loan production,922 and “routinely and increasingly lent money to people who were unable to repay the debt shortly after the loans were closed.”923 The suit took note of a news article stating: “Loans made by New Century, which filed for bankruptcy protection in March, have some of the highest default rates in the industry.”924

In December 2009, the SEC filed a civil complaint charging three former New Century

executives, the CEO, CFO, and controller, with fraudulent accounting that misled investors about the company’s finances. painted a picture that the company’s performance exceeded that of its peers, its executives had failed to disclose material negative information, such as significant increases in its loans’ early

The SEC alleged that, while the company’s financial disclosures

925

917 In re New Century TRS Holdings, Inc., Case No. 07-10416 (KJC) (US Bankruptcy Court, Del.), 2/29/2008 Final Report of Michael J. Missal, Bankruptcy Court Examiner, at 2, http://graphics8.nytimes.com/packages/pdf/business/Final_Report_New_Century.pdf (hereinafter “New Century Bankruptcy Report”). See also New Century Class Action Complaint at ¶ 59-60. 918 In re New Century TRS Holdings, Inc., Case No. 07-10416 (KJC) (US Bankruptcy Court, Del.).
919 New Century Bankruptcy Report.
920 New Century Class Action Complaint. 921 Id. at ¶¶ 75-79. 922 Id. at ¶ 112. See also ¶¶ 126-130. 923 Id. at ¶ 113. See also ¶¶ 114-116. 924 Id. at ¶ 123. 925 SEC Complaint against New Century Executives; See also 12/7/2009 SEC Press Release, “SEC Charges Former Offices of Subprime Lender New Century With Fraud.”

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payment defaults and a backlog of loan repurchases, which had the effect of materially overstating the company’s financial results. The SEC complaint also stated that, although New Century had represented itself as a prudent subprime lender, it “soon became evident that its lending practices, far from being ‘responsible,’ were the recipe for financial disaster.”926 The complaint detailed a number of high risk lending practices, including the issuance of interest only loans; 80/20 loans with loan-to-value ratios of 100%; and stated income loans in which the borrower’s income and assets were unverified.927 The complaint charged the New Century executives with downplaying the riskiness of the company’s loans and concealing their high delinquency rates.

In July 2010, the three former New Century executives settled the SEC complaint for

928 Each also agreed to be barred about $1.5 million, without admitting or denying wrongdoing. from serving as an officer or director of any publicly traded corporation for five years. A larger group of about a dozen former New Century officers and directors settled several class action and other shareholder lawsuits for $88.5 million.929

In 2007, New Century reported publicly that it was under criminal investigation by the

U.S. Attorney’s Office for the Central District of California, but no indictment of the company or any executive has been filed.

930

(d) Fremont

Fremont Investment & Loan was once the fifth largest subprime mortgage lender in the United States.931 At its peak in 2006, it had $13 billion in assets, 3,500 employees, and nearly two dozen offices.932 Fremont Investment & Loan was neither a bank nor a thrift, but an “industrial loan company” that issued loans and held insured deposits.933 It was owned by Fremont General Credit Corporation which was owned, in turn, by Fremont General Corporation. In 2007, the bank was the subject of an FDIC cease and desist order which identified multiple problems with its operations and ordered the bank to cease its subprime lending.934 In 2008, due to insufficient capital, the FDIC ordered Fremont General Corporation to either recapitalize the bank or sell it. The bank was then sold to CapitalSource, Inc.935

In June

926 SEC Complaint against New Century Executives at 3. 927 See, e.g., SEC Complaint against New Century Executives at ¶¶ 24-32. 928 See 7/30/2010 SEC Litigation Release No. 21609, “SEC Settles With Former Officers of Subprime Lender New Century, “ http:www.sec.gov/litigation/litreleases/2010/lr21609.htm. 929 See, e.g., “New Century Ex-leaders to Pay $90 Million in Settlements,” Los Angeles Times (7/31/2010). 930 See 3/12/2007 New Century Financial Corporation Form 8-K, Item 8.01.
931 “Fremont Ordered by FDIC to Find Buyer; Curbs Imposed,” Bloomberg (3/28/2010), http://www.bloomberg.com/apps/news?pid=newsarchive&sid=atIgi9otRZ3k. 932 3/2006 Fremont General Corporation Form 10-K filed with the SEC. 933 Id. 934 In re Fremont Investment & Loan, Order to Cease and Desist, Docket No. FDIC-07-035b (March 7, 2007) (hereinafter “Fremont Cease and Desist Order”). 935 In re Fremont Investment & Loan, Supervisory Prompt Corrective Action Directive, Docket No. FDIC-08-069 PCAS (March 26, 2008); “CapitalSource, Inc.,” Hoover’s Company Records. See also “CapitalSource to Acquire Fremont’s Retail Arm,” New York Times (4/14/2008).

2008, Fremont General Corporation declared bankruptcy under Chapter 11 and has since reorganized as Signature Group Holdings, Inc.936

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As a California based industrial loan company, Fremont Investment & Loan was

overseen by the California Department of Financial Institutions, a state bank regulator. Since it 937 The March had deposits that were federally insured, Fremont was also regulated by the FDIC. 2007 FDIC cease and desist order required the bank to end its subprime lending business, due to “unsafe and unsound banking practices and violations of law,” including operating with “a large volume of poor quality loans”; “unsatisfactory lending practices”; “excessive risk”; and inadequate capital.938 The FDIC also determined that the bank lacked effective risk management practices, lacked adequate mortgage underwriting criteria, and was “approving loans with loan- to-value ratios approaching or exceeding 100 percent of the value of the collateral.”939

Many of the specific practices cited in the cease and desist order mirror the FDIC and

OTS criticisms of WaMu. For example, the FDIC determined that Fremont was “marketing and extending adjustable-rate mortgage (‘ARM’) products to subprime borrowers in an unsafe and unsound manner that greatly increase[d] the risk that borrowers will default”; “qualifying borrowers for loans with low initial payments based on an introductory or ‘start’ rate that will expire after an initial period”; “approving borrowers without considering appropriate documentation and/or verification of the their income”; and issuing loans with “features likely to require frequent refinancing to maintain an affordable monthly payment and/or to avoid foreclosure.” mortgages it had sold to investors.941

940 Fremont later reported receiving default notices on $3.15 billion in subprime

One year later, in March 2008, the FDIC filed another public enforcement action against

the bank, for failing to provide an acceptable capital restoration plan or obtaining sufficient capital, and ordered the bank’s parent company to either adequately capitalize the bank within 60 days or sell it.

The bank was then sold to CapitalSource, Inc.

942

The FDIC took action against Fremont much earlier – in March 2007 – than other

regulators did with respect to other financial institutions, including OTS’ nonpublic enforcement actions against WaMu in March and September 2008; the FDIC’s seizure of IndyMac in July 2008; the SEC’s action against Countrywide in June 2009; and the SEC’s action against New

936 In re Fremont General Corporation, Case No. 8:08-bk-13421-ES (US Bankruptcy Court, CD Calif.), First Status Report (July 30, 2010) (included in 7/30/2010 Fremont General Corporation 8K filing with the SEC). 937 2006 Fremont 10-K Statement with the SEC. 938 Fremont Cease and Desist Order at 1-3. See also 3/7/2007 FDIC press release, “FDIC Issues Cease and Desist Order Against Fremont Investment & Loan, Brea, California, and its Parents.” 939 Fremont Cease and Desist Order at 2-4.
940 Id. at 3. 941 See 3/4/2008 Fremont General Corporation press release, “Fremont General Corporation Announces Receipt of Notice of Covenant Default With Respect to Guaranties Issued in Connection With Certain Prior Residential Sub- Prime Loan Sale Transactions,” http://media.corporate-ir.net/media_files/irol/10/106265/08-03- 04N%20FGCAnnouncesDefaultNoticewithRRELoanTransactions.pdf. See also “CapitalSource to Acquire Fremont’s Retail Arm,” New York Times (4/14/2008).
942 In re Fremont Investment & Loan, Supervisory Prompt Corrective Action Directive, Docket No. FDIC-08-069 PCAS ( March 26, 2008).

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Century in December 2009. By putting an early end to Fremont’s subprime lending, the FDIC stopped it from selling additional poor quality mortgage backed securities into U.S. securitization markets.

In November 2008, the OCC researched the ten metropolitan areas with the highest

foreclosure rates and identified the ten lenders in each area with the most foreclosed loans; Long Beach, Countrywide, IndyMac, New Century, and Fremont all made the list of the “Worst Ten in the Worst Ten.”943 Moody’s, the credit rating agency, later calculated that, in 2006 alone, Long Beach, New Century, and Fremont were responsible for 24% of the residential subprime mortgage backed securities issued, but 50% of the subsequent credit rating downgrades of those securities.944 quality home loans. By allowing these lenders, for years, to sell and securitize billions of dollars in poor quality, high risk home loans, regulators permitted them to contaminate the secondary market and introduce systemic risk throughout the U.S. financial system.

The fact is that each of these lenders issued billions of dollars in high risk, poor

E. Preventing Regulatory Failures

Regulators stood on the sidelines as U.S. mortgage lenders introduced increasingly high risk mortgage products into the U.S. mortgage market. Stated income loans, NINA loans, and so-called “liar loans” were issued without verifying the borrower’s income or assets. Alt A loans also had reduced documentation requirements. Interest-only loans, Option ARMs, and hybrid ARMs involved charging low introductory interest rates on loans that could be refinanced before much higher interest rates took effect. Negative amortization loans – loans that became bigger rather than smaller over time – became commonplace. Home equity loans and lines of credit, piggybacks and silent seconds, 100% financing – all involved loans that required the borrower to make virtually no down payment or equity investment in the property, relying instead on the value of the property to ensure repayment of the loan. All of these loans involved higher risks than the 30-year and 15-year fixed rate mortgages that dominated the U.S. mortgage market prior to 2004. When property values stopped climbing in late 2006, these higher risk loans began incurring delinquencies, losses, and defaults at record rates.

A number of new developments have occurred in the past several years to address the

problems highlighted throughout this Report.

(1) New Developments

The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act),

which the President signed into law on July 21, 2010, contains many changes in the law that will be implemented over the next year. The Dodd-Frank changes include abolishing OTS, banning stated income loans, and restricting negative amortization loans. Other developments include a revised interagency agreement strengthening the FDIC’s ability to conduct examinations of

943 See 11/13/2008 “Worst Ten in the Worst Ten,” document prepared by the OCC, Hearing Exhibit 4/13-58. 944 7/12/2007 “Moody’s Structured Finance Teleconference and Web Cast: RMBS and CDO Rating Actions,” prepared by Moody’s Investors Service, Hearing Exhibit 4/23-106.

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insured depository institutions and a new FDIC deposit insurance pricing system that requires higher risk institutions to pay higher insurance fees.

OTS Abolished. One significant new change brought about by the Dodd-Frank Act is the abolishment of the Office of Thrift Supervision. Title III of the Dodd-Frank Act reassigned OTS’ duties and personnel to other agencies, primarily the Office of the Comptroller of the Currency (OCC).945 partner with the OCC, the statute is clear in its intent to abolish OTS, rather than effect a merger of equals.

Although some OTS officials claim the law intended OTS to be a merger

Revised Interagency Agreement. A second important change is that the interagency

946

agreement that guides when the FDIC can examine an insured institution was altered to give the FDIC increased authority. Under federal law, the FDIC can conduct an examination of an insured depository institution “whenever the [FDIC] Board of Directors determines a special examination … is necessary to determine the condition of such depository institution for insurance purposes.” Despite this broad statutory grant of examination authority, in 2002, the FDIC agreed to limit the circumstances in which it would examine banks subject to regulation by another agency. The resulting interagency agreement essentially required the FDIC to establish that an institution was at “heightened risk” of causing loss to the Deposit Insurance Fund before the FDIC could compel another banking regulator to allow the FDIC to participate in an examination of its operations. OTS used that agreement to impede the FDIC’s participation in examinations of WaMu.

947

Compared to the 2002 version, the revised agreement explicitly provides

In 2010, the FDIC renegotiated that agreement with the other financial regulators, and they signed a revised version that will facilitate more cooperation on a less bureaucratic and more timely basis. for special examinations of a broader scope of insured depository institutions. It also streamlined the process for resolving differences in CAMELS ratings between financial regulators. In the case of WaMu, this new process would have helped facilitate a quicker response to WaMu’s deteriorating condition. Additionally, the new agreement establishes a continuous on-site FDIC presence, with five or more examiners, at certain large institutions, including those that receive ratings under the FDIC’s Large Insured Depository Institutions Program. This new provision ensures the FDIC has consistent access to information about big banks that, by virtue of their size, pose the most risk to the Deposit Insurance Fund. Finally, after first discussing it with the primary federal regulator, the FDIC is permitted to gather information directly from financial institutions. These provisions will help ensure that the FDIC can obtain the information needed to safeguard the Deposit Insurance Fund.

945 See, e.g., Section 312 of the Dodd-Frank Act. 946 12 U.S.C. § 1820(b)(3).
947 9/17/2010 letter from FDIC Chairman Sheila C. Bair to the Subcommittee, PSI-FDIC-13-000001 (“Enclosed please find a signed copy of a revised and much-strengthened memorandum of understanding among the FDIC and other bank regulators which will greatly enhance our ability to continually access and monitor information related to our risks as deposit insurer. I believe this is a very strong agreement and one which we accomplished due in no small part to the work of your Subcommittee in identifying weaknesses in the supervisory processes leading up to the failure of Washington Mutual.”).

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Risk Factors in Insurance Fees. Under a new FDIC deposit insurance pricing system that takes effect in 2011, large depository institutions with higher risk activities will be required to pay higher fees into the Deposit Insurance Fund.948 This new assessment system is designed to “better capture risk at the time large institutions assume the risk, to better differentiate among institutions for risk and take a more forward-looking view of risk, [and] to better take into account the losses that the FDIC may incur if such an insured depository institution fails.”949 It is the product of both past FDIC revisions and changes to the insurance fund assessment system made by the Dodd-Frank Act.950 It is intended to impose higher assessments on large banks “with high-risk asset concentrations, less stable balance sheet liquidity, or potentially higher loss severity in the event of failure,” and impose those higher assessments when the banks “assume these risks rather than when conditions deteriorate.”951 higher risk activities will be assessed higher fees, not only to safeguard the insurance fund and allocate insurance costs more fairly, but also to help discourage high risk activities.

Under this new system, banks with

Financial Stability Oversight Council. The Dodd-Frank Act has also established a new

intra-governmental council, the Financial Stability Oversight Council (FSOC), to identify systemic risks and respond to emerging threats to the stability of the U.S. financial system. The council is comprised of ten existing regulators in the financial services sector, including the Chairman of the Federal Reserve Board of Governors, the Chairman of the FDIC, and the Comptroller of the Currency, and is chaired by the Secretary of the Treasury. This Council is intended to ensure that U.S. financial regulators consider the safety and soundness of not only individual financial institutions, but also of U.S. financial markets and systems as a whole.

952

(2) Recommendations To further strengthen oversight of financial institutions to reduce risk, protect U.S. financial markets and the economy, and safeguard the Deposit Insurance Fund, this Report makes the following recommendations.

Complete OTS Dismantling. The Office of the Comptroller of the Currency (OCC)

should complete the dismantling of the Office of Thrift Supervision (OTS), despite attempts by some OTS officials to preserve the agency’s identity and influence within the OCC.

Strengthen Enforcement. Federal banking regulators should conduct a review of

948 See 2/7/2011 FDIC Final Rule of Assessments, Dividends, Assessment Base and Large Bank Pricing, RIN 3064.
949 Id. 950 See Sections 331, 332 and 334 of the Dodd-Frank Act. 951 2/7/2011 FDIC press release, “FDIC Approves Final Rule of Assessments, Dividends, Assessment Base and Large Bank Pricing,” http://www.fdic.gov/news/news/press/2011/pr11028.html. 952 See Title I, Subtitle A, of the Dodd-Frank Act establishing the Financial Stability Oversight Council, including Section 112(a) which provides its purposes and duties.

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Strengthen CAMELS Ratings. Federal banking regulators should undertake a

Evaluate Impacts of High Risk Lending. The Financial Stability Oversight Council

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V. INFLATED CREDIT RATINGS: CASE STUDY OF MOODY’S AND STANDARD & POOR’S

Moody’s Investors Service, Inc. (Moody’s) and Standard & Poor’s Financial Services

LLC (S&P), the two largest credit rating agencies (CRAs) in the United States, issued the AAA ratings that made residential mortgage backed securities (RMBS) and collateralized debt obligations (CDOs) seem like safe investments, helped build an active market for those securities, and then, beginning in July 2007, downgraded the vast majority of those AAA ratings to junk status.953 plummeting, precipitated the collapse of the RMBS and CDO secondary markets, and perhaps more than any other single event triggered the financial crisis.

The July mass downgrades sent the value of mortgage related securities

In the months and years of buildup to the financial crisis, warnings about the massive

problems in the mortgage industry were not adequately addressed within the ratings industry. By the time the rating agencies admitted their AAA ratings were inaccurate, it took the form of a massive ratings correction that was unprecedented in U.S. financial markets. The result was an economic earthquake from which the aftershocks continue today.

Between 2004 and 2007, taking in increasing revenue from Wall Street firms, Moody’s

and S&P issued investment grade credit ratings for the vast majority of the RMBS and CDO securities issued in the United States, deeming them safe investments even though many relied on subprime and other high risk home loans. In late 2006, high risk mortgages began to go delinquent at an alarming rate. Despite signs of a deteriorating mortgage market, Moody’s and S&P continued for six months to issue investment grade ratings for numerous subprime RMBS and CDO securities. In July 2007, as mortgage defaults intensified and subprime RMBS and CDO securities began incurring losses, both companies abruptly reversed course and began downgrading at record numbers hundreds and then thousands of their RMBS and CDO ratings, some less than a year old. Investors like banks, pension funds, and insurance companies were suddenly forced to sell off their RMBS and CDO holdings, because they had lost their investment grade status. RMBS and CDO securities held by financial firms lost much of their value, and new securitizations were unable to find investors. The subprime RMBS market initially froze and then collapsed, leaving investors and financial firms around the world holding unmarketable subprime RMBS securities plummeting in value. A few months later, the CDO market collapsed as well.

Traditionally, investments holding AAA ratings have had a less than 1% probability of incurring defaults. But in the financial crisis, the vast majority of RMBS and CDO securities with AAA ratings incurred substantial losses; some failed outright. Investors and financial institutions holding those AAA securities lost significant value. Those widespread losses led, in turn, to a loss of investor confidence in the value of the AAA rating, in the holdings of major U.S. financial institutions, and even in the viability of U.S. financial markets. Inaccurate AAA

953 S&P issues ratings using the “AAA” designation; Moody’s equivalent rating is “Aaa.” For ease of reference, this Report will refer to both ratings as “AAA.”

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credit ratings introduced systemic risk into the U.S. financial system and constituted a key cause of the financial crisis.

The Subcommittee’s investigation uncovered a host of factors responsible for the

inaccurate credit ratings issued by Moody’s and S&P. One significant cause was the inherent conflict of interest arising from the system used to pay for credit ratings. Credit rating agencies were paid by the Wall Street firms that sought their ratings and profited from the financial products being rated. The rating companies were dependent upon those Wall Street firms to bring them business and were vulnerable to threats that the firms would take their business elsewhere if they did not get the ratings they wanted. Rating standards weakened as each credit rating agency competed to provide the most favorable rating to win business and greater market share. The result was a race to the bottom.

Additional factors responsible for the inaccurate ratings include rating models that failed to include relevant mortgage performance data, unclear and subjective criteria used to produce ratings, a failure to apply updated rating models to existing rated transactions, and a failure to provide adequate staffing to perform rating and surveillance services, despite record revenues.
Compounding these problems were federal regulations that required the purchase of investment grade securities by banks and others, thereby creating pressure on the credit rating agencies to issue investment grade ratings. Still another factor were the Securities and Exchange Commission’s (SEC) regulations which required use of credit ratings by Nationally Recognized Statistical Rating Organizations (NRSRO) for various purposes but, until recently, resulted in only three NRSROs, thereby limiting competition.954

Evidence gathered by the Subcommittee shows that credit rating agencies were aware of problems in the mortgage market, including an unsustainable rise in housing prices, the high risk nature of the loans being issued, lax lending standards, and rampant mortgage fraud. Instead of using this information to temper their ratings, the firms continued to issue a high volume of investment grade ratings for mortgage backed securities. If the credit rating agencies had issued ratings that accurately exposed the increasing risk in the RMBS and CDO markets and appropriately adjusted existing ratings in those markets, they might have discouraged investors from purchasing high risk RMBS and CDO securities, slowed the pace of securitizations, and as a result reduced their own profits. It was not in the short term economic self interest of either Moody’s or S&P to provide accurate credit ratings for high risk RMBS and CDO securities, because doing so would have hurt their own revenues. Instead, the credit rating agencies’ profits became increasingly reliant on the fees generated by issuing a large volume of investment grade ratings.

954 See, e.g., 1/2003 “Report on the Role and Function of Credit Rating Agencies in the Operation of the Securities Markets,” prepared by the SEC, at 5-6 (explaining how the SEC came to rely on NRSRO credit ratings); 9/3/2009 “Credit Rating Agencies and Their Regulation,” report prepared by the Congressional Research Service, Report No. R40613 (revised report issued 4/9/2010) (finding that, prior to the 2006 Credit Rating Agency Reform Act, “[t]he SEC never defined the term NRSRO or specified how a CRA might become one. Its approach has been described as essentially one of ‘we know-it-when-we-see-it.’ The resulting limited growth in the pool of NRSROs was widely believed to have helped to further entrench the three dominant CRAs: by some accounts, they have about 98% of total ratings and collect 90% of total rating revenue.” 9/3/2009 version of the report at 2-3).

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Looking back after the first shock of the crisis, one Moody’s managing director offered

this critical self analysis:

“[W]hy didn’t we envision that credit would tighten after being loose, and housing prices would fall after rising, after all most economic events are cyclical and bubbles inevitably burst. Combined, these errors make us look either incompetent at credit analysis, or like we sold our soul to the devil for revenue, or a little bit of both.”955

A. Subcommittee Investigation and Findings of Fact For more than one year, the Subcommittee conducted an in-depth investigation of the role

of credit rating agencies in the financial crisis, using as case histories Moody’s and S&P. The Subcommittee subpoenaed and reviewed hundreds of thousands of documents from both companies including reports, analyses, memoranda, correspondence, and email, as well as documents from a number of financial institutions that obtained ratings for RMBS and CDO securities. The Subcommittee also collected and reviewed documents from the SEC and reports produced by academics and government agencies on credit rating issues. In addition, the Subcommittee conducted nearly two dozen interviews with current and former Moody’s and S&P executives, managers, and analysts, and consulted with credit rating experts from the SEC, Federal Reserve, academia, and industry. On April 23, 2010, the Subcommittee held a hearing and released 100 hearing exhibits.956

In connection with the hearing, the Subcommittee released a joint memorandum from Chairman Levin and Ranking Member Coburn summarizing the investigation into the credit rating agencies and the problems with the credit ratings assigned to RMBS and CDO securities.
The memorandum contained joint findings regarding the role of the credit rating agencies in the Moody’s and S&P case histories, which this Report reaffirms. The findings of fact are as follows.

Inaccurate Rating Models. From 2004 to 2007, Moody’s and S&P used credit rating models with data that was inadequate to predict how high risk residential mortgages, such as subprime, interest only, and option adjustable rate mortgages, would perform.
Competitive Pressures. Competitive pressures, including the drive for market share and need to accommodate investment bankers bringing in business, affected the credit ratings issued by Moody’s and S&P.
Failure to Re-evaluate. By 2006, Moody’s and S&P knew their ratings of RMBS

and CDOs were inaccurate, revised their rating models to produce more accurate ratings, but then failed to use the revised model to re-evaluate existing RMBS and

955 9/2007 anonymous Moody’s Managing Director after a Moody’s Town Hall meeting on the financial crisis, at 763, Hearing Exhibit 4/23-98. 956 “Wall Street and the Financial Crisis: The Role of Credit Rating Agencies,” before the U.S. Senate Permanent Subcommittee on Investigations, S.Hrg. 11-673 (4/23/2010) (hereinafter “April 23, 2010 Subcommittee Hearing”).

CDO securities, delaying thousands of rating downgrades and allowing those securities to carry inflated ratings that could mislead investors.

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Failure to Factor in Fraud, Laxity, or Housing Bubble. From 2004 to 2007,

Moody’s and S&P knew of increased credit risks due to mortgage fraud, lax underwriting standards, and unsustainable housing price appreciation, but failed adequately to incorporate those factors into their credit rating models.

Inadequate Resources. Despite record profits from 2004 to 2007, Moody’s and

S&P failed to assign sufficient resources to adequately rate new products and test the accuracy of existing ratings.

Mass Downgrades Shocked Market. Mass downgrades by Moody’s and S&P,

including downgrades of hundreds of subprime RMBS over a few days in July 2007, downgrades by Moody’s of CDOs in October 2007, and actions taken (including downgrading and placing securities on credit watch with negative implications) by S&P on over 6,300 RMBS and 1,900 CDOs on one day in January 2008, shocked the financial markets, helped cause the collapse of the subprime secondary market, triggered sales of assets that had lost investment grade status, and damaged holdings of financial firms worldwide, contributing to the financial crisis.

Failed Ratings. Moody’s and S&P each rated more than 10,000 RMBS securities from 2006 to 2007, downgraded a substantial number within a year, and, by 2010, had downgraded many AAA ratings to junk status.
Statutory Bar. The SEC is barred by statute from conducting needed oversight into

the substance, procedures, and methodologies of the credit rating models.

Legal Pressure for AAA Ratings. Legal requirements that some regulated entities, such as banks, broker-dealers, insurance companies, pension funds, and others, hold assets with AAA or investment grade credit ratings, created pressure on credit rating agencies to issue inflated ratings making assets eligible for purchase by those entities.

(1) Credit Ratings Generally Credit ratings, which first gained prominence in the late 1800s, are supposed to provide

The United States has three major credit rating agencies: Moody’s, S&P, and Fitch

independent assessments of the creditworthiness of particular financial instruments, such as a corporate bond, mortgage backed security, or CDO. Essentially, credit ratings predict the likelihood that a debt will be repaid.957

Rating Ltd., each of which is a NRSRO. By some accounts, these three firms issue about 98% of total credit ratings and collect 90% of total credit rating revenue.

charging subscription fees to investors who were considering investing in the financial instruments being rated. This method of payment was known as the “subscriber-pays” model.
Following the 1929 crash, the credit rating agencies fell out of favor. As one academic expert has explained:

Paying for Ratings. Prior to the 1929 crash, credit rating agencies made money by

958

“Investors were no longer very interested in purchasing ratings, particularly given the agencies’ poor track record in anticipating the sharp drop in bond values beginning in late

… The rating business remained stagnant for decades.”959

B. Background

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Credit Ratings. Credit ratings use a scale of letter grades, from AAA to C, with AAA

In 1970, the credit rating agencies changed to an “issuer-pays” model and have used it since.960

In this model, the party seeking to issue a financial instrument, such as a bond or security, pays the credit rating agency to analyze the credit risk and assign a credit rating to the financial instrument.

ratings designating the safest investments and the other grades designating investments at greater risk of default.961 Investments with AAA ratings have historically had low default rates. For example, S&P reported that its cumulative RMBS default rate by original rating class (through September 15, 2007) was 0.04% for AAA initial ratings and 1.09% for BBB.962

957 9/3/2009 “Credit Rating Agencies and Their Regulation,” report prepared by the Congressional Research Service, Report No. R40613 (revised report issued 4/9/2010). 958 Id.
959 “How and Why Credit Rating Agencies Are Not Like Other Gatekeepers,” Frank Partnoy, University of San Diego Law School Legal Studies Research Paper Series (5/2006), at 63. 960 9/3/2009 “Credit Rating Agencies and Their Regulation,” report prepared by the Congressional Research Service, Report No. R40613 (revised report issued 4/9/2010). A few small credit rating agencies use the “subscriber-pays” model. However, 99% of outstanding credit ratings are issued by agencies using the “issuer-pays” model. 1/2011 “Annual Report on Nationally Recognized Statistical Rating Organizations,” report prepared by the SEC, at 6.
961 The Moody’s rating system is similar in concept but with a slightly different naming convention. For example its top rating scale is Aaa, Aa1, Aa2, Aa3, A1, A2, A3. 962 Prepared statement of Vickie A. Tillman, Executive Vice President, Standard & Poor’s Credit Market Services, “The Role of Credit Rating Agencies in the Structured Finance Market,” before U.S. House of Representatives Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises, Cong.Hrg. 110-62

Financial

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instruments bearing AAA through BBB- ratings are generally called “investment grade,” while those with ratings below BBB- (or Baa3) are referred to as “below investment grade” or sometimes as “junk” investments. Financial instruments that default receive a D rating from S&P, but no rating at all by Moody’s.

former senior credit analyst at Moody’s explained that investors use ratings to:

Investors often rely on credit ratings to gauge the safety of a particular investment. A

“satisfy any number of possible needs: institutional investors such as insurance companies and pension funds may have portfolio guidelines or requirements, investment fund portfolio managers may have risk-based capital requirements or investment committee requirements. And of course, private investors lacking the resources to do separate analysis may use the published ratings as their principal determinant of the risk of the investment.”963

The rationale behind these legal requirements is to require or

Legal Requirements. Some state and federal laws restrict the amount of below

investment grade bonds that certain investors can hold, such as pension funds, insurance companies, and banks. Banks, for example, are limited by law in the amount of non-investment grade bonds they can hold, and are sometimes required to post additional capital for those higher risk instruments.964 Broker-dealers and money market funds that register with the SEC operate under similar restrictions.965 provide economic incentives for banks and other financial institutions to purchase investments that have been identified as liquid and “safe” by an independent third party with a high level of market expertise, such as a credit rating agency. Because so many federal and state statutes and regulations require the purchase of investment grade ratings, issuers of securities and other instruments work hard to obtain favorable credit ratings to ensure regulated financial institutions can buy their products. As a result, those legal requirements not only increased the demand for investment grade ratings, but also created pressure on credit rating agencies to issue top ratings in order to make the rated products eligible for purchase by regulated financial institutions. The legal requirements also generated more work and greater profits for the credit rating agencies.

(9/27/2007), S&P SEN-PSI 0001945-71, at 51. See also 1/2007 S&P document, “Annual 2006 Global Corporate Default Study and Ratings Transitions.”
963 Prepared statement of Richard Michalek, Former VP/Senior Credit Officer, Moody’s Investors Service, April 23, 2010 Subcommittee Hearing, at 2. See also 8/29/2006 email from Greg Lippmann, (Deutsche Bank), to Paolo Pellegrini (Paulson & Co.) and others, DBSI_PSI_EMAIL01625848 at 52 (“Since a CDO without a triple-A-rated senior tranche would be unmarketable, their imprimatur is indispensable.”); 11/13/2007 email from Ralph Silva (Goldman Sachs), GS MBS-E-010023525, Tri-Lateral Combined Comments Attachment, GS MBS-E-01035693- 715, at 713 (“Investors in subprime related securities, especially higher rated bonds, have historically relied significantly on bond ratings particularly when securities are purchased by structured investing vehicles.”); M&T Bank Corporation v. Gemstone CDO VII, Ltd., Index No. 200800764 (N.Y. Sup.), Complaint, (June 16, 2008) at 12.
964 See, e.g., Section 28 (d) and (e) of the Federal Deposit Insurance Act, codified at 12 U.S.C. § 1831e(d)-(e).
965 See, e.g., Rule 15c3-1 of the Securities Exchange Act of 1934 (allowing broker-dealers to avoid “haircuts” for net capital requirements provided they hold instruments with investment grade credit ratings); and Rule 2a-7 of the Investment Company Act of 1940 (limiting money market funds to investments in “high quality” securities).

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CRA Oversight and Accountability. The credit rating agencies are currently subject to regulation by the SEC. In September 2006, Congress enacted the Credit Rating Agency Reform Act, P.L. 109-291, to require SEC oversight of the credit rating industry. Among other provisions, the law charged the SEC with designating NRSROs and defined that term for the first time. By 2008, the SEC had granted NRSRO status to ten credit rating agencies (CRA).966 The Act also directed the SEC to conduct examinations of the CRAs, while at the same time prohibiting the SEC from regulating the substance, criteria, or methodologies used in credit rating models.967

Prior to the 2006 Reform Act, CRAs had been subject to uneven or limited regulatory

oversight by state and federal agencies. The SEC had developed the NRSRO system, for example, but had no clear statutory basis for establishing that system or exercising regulatory authority over the credit rating agencies. Because the requirements for the NRSRO designation were not defined in law, the SEC had designated only three rating agencies, limiting competition.
No government agency conducted routine examinations of the credit rating agencies or the procedures they used to rate financial products.

In addition, private investors have generally been unable to hold CRAs accountable for

poor quality ratings or other malfeasance through civil lawsuits.968 The CRAs have successfully won dismissal of investor lawsuits, claiming that they are in the financial publishing business and their opinions are protected under the First Amendment.969 In addition, the CRAs have attempted to avoid any legal liability for their ratings by making disclaimers to investors who potentially may rely on their opinions. For example, S&P’s disclaimer reads in part as follows:

“Standard & Poor’s Ratings
Analytic services provided by Standard & Poor’s Ratings Services (‘Ratings Services’) are the result of separate activities designed to preserve the independence and objectivity of ratings opinions. The credit ratings and observations contained herein are solely statements of opinion and not statements of fact or recommendations to purchase, hold, or sell any securities or make any other investment decisions. Accordingly, any user of the information contained herein should not rely on any credit rating or other opinion contained herein in making any investment decision. Ratings are based on information received by Ratings Services.”970

966 The ten NRSROs are Moody’s; Standard & Poor’s; Fitch; A.M. Best Company, Inc.; DBRS Ltd.; Egan-Jones Rating Company; Japan Credit Rating Agency, Ltd.; LACE Financial Corp.; Rating and Investment Information, Inc.; and Realpoint LLC. 9/25/2008 “Credit Rating Agencies – NRSROs,” SEC, available at http://www.sec.gov/answers/nrsro.htm. 967 See Sections 15E(c)(2) and 17(a)(1) of the Securities Exchange Act of 1934, as amended by the Credit Rating Agency Reform Act of 2006, codified at 15 U.S.C. § 78o-7(c)(2) and § 78q(a)(1).
968 “How and Why Credit Rating Agencies Are Not Like Other Gatekeepers,” Frank Partnoy, University of San Diego Law School Legal Studies Research Paper Series (5/2006), at 61. 969 Id. 970 Standard & Poor’s ClassicDirect website, https://www.eclassicdirect.com/NASApp/cotw/CotwLogin.jsp.

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RMBS and CDO Ratings. Over the last ten years, Wall Street firms have devised ever

more complex financial instruments for sale to investors, including the RMBS and CDO securities that played a key role in the financial crisis. Because of the complexity of the instruments, investors often relied heavily on credit ratings to determine whether they could or should buy the products. For a fee, Wall Street firms helped design the RMBS and CDO securities, worked with the credit rating agencies to obtain ratings, and sold the securities to investors like pension funds, insurance companies, university endowments, municipalities, and hedge funds.971 more difficult time selling these products to investors, because each investor would have had to perform its own due diligence review of the financial instrument. Credit ratings simplified the review and enhanced sales. Here’s how one federal bank regulatory handbook put it:

Without investment grade ratings, Wall Street firms would have had a much

“The rating agencies perform a critical role in structured finance – evaluating the credit quality of the transactions. Such agencies are considered credible because they possess the expertise to evaluate various underlying asset types, and because they do not have a financial interest in a security’s cost or yield. Ratings are important because investors generally accept ratings by the major public rating agencies in lieu of conducting a due diligence investigation of the underlying assets and the servicer.”

972

In addition to making structured finance products easier to sell to investors, Wall Street firms used financial engineering to create high risk assets that were given AAA ratings – ratings which are normally reserved for ultra-safe investments with low rates of return. Firms combined high risk assets, such as the BBB tranches from subprime mortgage backed securities paying a relatively high rate of return, in a new financial instrument, such as a CDO, that issued securities with AAA ratings and were purportedly safe investments. Higher rates of return, combined with AAA ratings, made subprime RMBS and related CDO securities especially attractive investments.

(2) The Rating Process

Prior to the massive ratings downgrade in mid-2007, the RMBS and CDO rating process followed a generally well-defined pattern. It began with the firm designing the securitization –
the arranger – sending a detailed proposal to the credit rating agency. The proposal contained information on the mortgage pools involved and how the security would be structured. The rating agency examined the proposal and provided comments and suggestions, before ultimately agreeing to run the securitization through one of its models. The results from the model were used by a rating committee within the agency to determine a final rating, which was then published.

971 See 9/2009 “The Financial Crisis of 2007-2009: Causes and Circumstances,” report prepared by the Task Force on the Cause of the Financial Crisis, Banking Law Committee, Section of Business Law, American Bar Association.
972 11/1997 Comptroller of the Currency Administrator of National Banks Comptroller’s Handbook, “Asset Securitization,” at 11.

To create that hierarchy, the arranger placed the pool’s

Arrangers. For RMBS, the “arranger” – typically an investment bank – initiated the

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In addition to data on the assets, the arranger provided a proposed capital structure for the

rating process by sending to the credit rating agency information about a prospective RMBS and data about the mortgage loans included in the prospective pool. The data typically identified the characteristics of each mortgage in the pool including: the principal amount, geographic location of the property, FICO score, loan to value ratio of the property, and type of loan. In the case of a CDO, the process also included a review of the underlying assets, but was based primarily on the ratings those assets had already received.

financial instrument, identifying, for example, how many tranches would be created, how the revenues being paid into the RMBS or CDO would be divided up among those tranches, and how many of the tranches were designed to receive investment grade ratings. The arranger also identified one or more “credit enhancements” for the pool to create a financial cushion that would protect the designated investment grade tranches from expected losses.973

Credit Enhancements. Arrangers used a variety of credit enhancements. The most

common was “subordination” in which the arranger “creates a hierarchy of loss absorption among the tranche securities.”974 tranches in an order, with the lowest tranche required to absorb any losses first, before the next highest tranche. Losses might occur, for example, if borrowers defaulted on their mortgages and stopped making mortgage payments into the pool. Lower level tranches most at risk of having to absorb losses typically received noninvestment grade ratings from the credit rating agencies, while the higher level tranches that were protected from loss typically received investment grade ratings. One key task for both the arrangers and the credit rating agencies was to calculate the amount of “subordination” required to ensure that the higher tranches in a pool were protected from loss and could be given AAA or other investment grade ratings.

credit enhancement, the arranger ensured that the revenues expected to be produced by the assets in a pool exceeded the revenues designated to be paid out to each of the tranches. That excess amount provided a financial cushion for the pool and was used to create an “equity” tranche, which was the first tranche in the pool to absorb losses if the expected payments into the pool were reduced. This equity tranche was subordinate to all the other tranches in the pool and did not receive any credit rating. The larger the excess, the larger the equity tranche, and the larger the cushion created to absorb losses and protect the more senior tranches in the pool. In some pools, the equity tranche was also designed to pay a relatively higher rate of return to the party or parties who held that tranche due to its higher risk.

which involved designating an amount of revenue to pay the pool’s monthly expenses and other liabilities, but ensuring that the amount was slightly more than what was likely needed for that

Still another common form of credit enhancement was the creation of “excess spread,”

A second common form of credit enhancement was “over-collateralization.” In this

973 See, e.g., 7/2008 “Summary Report of Issues Identified in the Commission Staff’s Examination of Select Credit Rating Agencies,” report prepared by the SEC, at 6-10. 974 Id. at 6.

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The major RMBS credit rating model at Moody’s was called the Mortgage Metrics

Credit Rating Models. After the arranger submitted the pool information, proposed

To derive the default or loss rate for an RMBS pool of residential mortgages, the CRA

purpose. Any funds not actually spent on expenses would provide an additional financial cushion to absorb losses, if necessary.

capital structure, and proposed credit enhancements to the CRA, a CRA analyst was assigned to evaluate the proposed financial instrument. The first step that most CRA analysts took was to use a credit rating model to evaluate the rate of probable defaults or expected losses from the asset pool. Credit rating models are mathematical constructs that analyze a large number of data points related to the likelihood of an asset defaulting. RMBS rating models typically use statistical analyses of past mortgage performance data to calculate expected RMBS default rates and losses. In contrast, rather than statistics, CDO models use assumptions to build simulations that can be used to project likely CDO defaults and losses.

Model (M3), while the S&P model was called the Loan Evaluation and Estimate of Loss System (LEVELS). Both models used large amounts of statistical data related to the performance of residential mortgages over time to develop criteria to analyze and rate submitted mortgage pools.
CRA analysts relied on these quantitative models to predict expected loss (Moody’s) or the probability of default (S&P) for a pool of residential loans.

analyst typically fed a “loan tape” – most commonly a spreadsheet provided by the arranger with details on each loan – into the credit rating model. The rating model then automatically assessed the expected credit performance of each loan in the pool and aggregated that information. To perform this function, the model selected certain data points from the loan tape, such as borrower credit scores or loan-to-value ratios, and compared that information to past mortgage data using various assumptions, to determine the likely “frequency of foreclosure” and “loss severity” for the particular types of mortgages under consideration. It then projected the level of “credit enhancement,” or cushion needed to protect investment grade tranches from loss.

from losses. For example, the model might project that 30% of the pool’s incoming revenue would need to be set aside to ensure that the remaining 70% of incoming revenues would be protected from any losses. Tranches representing the 70% of the incoming revenues could then receive AAA ratings, while the remaining 30% of incoming revenues could be assigned to support the payment of expenses, an equity tranche, or one or more of the subordinated tranches.

qualitative factors in their analysis of expected default and loss rates. For example, Moody’s analysts considered the quality of the originators and servicers of the loans included in a pool.
Originators known for issuing poor quality loans or servicers known for providing poor quality servicing could increase the loss levels calculated for a pool by a significant degree, up to a total

For riskier loans, the model required a larger cushion to protect investment grade tranches

In addition to using quantitative models, Moody’s analysts also took into account

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Credit Analysis. After obtaining the model’s projections for the cushion or

In addition to evaluating an RMBS pool’s expected default and loss rates, credit

of 20%.975 Moody’s only began incorporating that type of analysis into its M3 ratings process in December 2006, only six months before the mass downgrades began.976 In contrast, S&P analysts did not conduct this type of analysis of mortgage originators and servicers during the time period examined in this Report.977

subordination needed to protect the pool’s investment grade tranches from loss, the CRA analyst compared that projection to the tranches and credit enhancements actually proposed for the particular pool to evaluate their sufficiency.

enhancements, and capital structure, CRA analysts conducted a cash flow analysis of the interest and principal payments to be made into the proposed pool to determine that the revenue generated would be sufficient to pay the rates of return projected for each proposed tranche.
CRA analysts also reviewed the proposed legal structure of the financial instrument to understand how it worked and how revenues and losses would be allocated. Some RMBS and CDO transactions included complex “waterfalls” that allocated projected revenues and expected losses among an array of expenses, tranches, and parties. The CRA analyst was expected to evaluate whether the projected revenues were sufficient for the designated purposes. The CRA review also included a legal analysis “ensuring that there was no structural risk presented due to a failure to fulfill minimally necessary legal requirements … and confirming that the deal documentation accurately and faithfully described the structure modeled by the Quant [quantitative analyst].”978

analysts used CDO rating models to predict the CDO’s expected defaults and losses. However, unlike RMBS statistical models that used past performance data to predict RMBS default and loss rates, the CDO models relied primarily on the underlying ratings of the assets as well as on a set of assumptions, such as asset correlation, and ran multiple simulations to predict how the CDO pool would perform. The CDO simulation model at Moody’s was called “CDOROM,” while the S&P CDO model was called the “CDO Evaluator,” which was repeatedly updated, eventually to “Evaluator 3” or “E3.” Both companies’ CDO models analyzed the likely rates of loss for assets within a particular CDO, but neither model re-analyzed any underlying RMBS

The process for assigning credit ratings to cash CDOs followed a similar path. CRA

975 See 2008 SEC Examination Report for Moody’s Investor Services Inc., PSI-SEC (Moodys Exam Report)-14- 0001-16, at 2-3, footnote 5. 976 Id. See also 7/2008 “Summary Report of Issues Identified in the Commission Staff’s Examination of Select Credit Rating Agencies,” report prepared by the Securities and Exchange Commission, at 35, n.70. 977 In November 2008, after the time period examined in this Report, S&P published enhanced criteria requiring the quality of mortgage originators and their underwriting processes to be factored into its RMBS rating analyses. 6/24/2010 supplemental letter from S&P to the Subcommittee, Hearing Exhibit 4/23-108, Exhibit W, 11/25/2008 “Standard &Poor’s Enhanced Mortgage Originator and Underwriting Review Criteria for U.S. RMBS.” 978 Prepared statement of Richard Michalek at 4, April 23, 2010 Subcommittee hearing.

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Rating Recommendations. After completing analysis of a proposed financial

After calculating the CDO’s default and loss rates and the cushion or subordination

Evidence gathered by the Subcommittee indicates that it was common for a CRA analyst

securities included within a CDO. Instead, both models simply relied on the credit rating already assigned to those securities.979

needed to protect the pool’s investment grade tranches from loss, the CRA analyst examined the CDO’s capital structure, credit enhancements, cash flow, and legal structure, in the same manner as for an RMBS pool.

to speak with the arranger or issuer of an RMBS or CDO to gather additional information and discuss how a proposed financial instrument would work. Among other tasks, the analyst worked with the arranger or issuer to evaluate the cash flows, the number and size of the tranches, the size and nature of the credit enhancements, and the rating each tranche would receive. Documents obtained by the Subcommittee show that CRA analysts and investment bankers often negotiated over how specific deal attributes would affect the credit ratings of particular tranches.

instrument, the CRA analyst developed a rating recommendation for each proposed RMBS or CDO tranche that would be used to issue securities, and presented the recommended ratings internally to a rating committee composed of other analysts and managers within the credit rating agency. The rating committee reviewed and then voted on the analyst’s recommendations. Once the committee approved the ratings, a rating committee memorandum was prepared memorializing the actions taken, and the ratings were provided to the arranger. If the arranger indicated that the issuer accepted the ratings, the credit rating agency made the ratings available publicly. If dissatisfied, the arranger could appeal a ratings decision.980 process typically took several weeks, sometimes longer for novel or complex transactions.

responsible for rating RMBS and CDOs. In 2007, Moody’s RMBS ratings were issued by the RMBS Group, which had about 25 analysts, while it had about 50 derivatives analysts in its Derivatives Group, whose responsibilities included rating CDOs.981 rating these products was headed by a Team Managing Director who reported to a Group Managing Director. Both the RMBS Group and the Derivatives Group were housed in the Structured Finance Group. The setup was similar at S&P. At S&P, RMBS ratings were issued by the RMBS Group, which had about 90 analysts in 2007, while CDO ratings were issued by

RMBS and CDO Groups. Moody’s and S&P had separate groups and analysts

The entire rating

Each group responsible for

979 Synthetic CDOs, on the other hand, involved a different type of credit analysis. Unlike RMBS and cash CDOs, synthetic CDOs do not contain any cash producing assets, but simply reference them. The revenues paid into synthetic CDOs do not come from mortgages or other assets, but from counterparties betting that the referenced assets will lose value or suffer a specified credit event.
980 7/2008 “Summary Report of Issues Identified in the Commission Staff’s Examination of Select Credit Rating Agencies,” report prepared by the Securities and Exchange Commission, at 9.
981 3/11/2008 compliance letter from Moody’s to SEC, SEC_OCIE_CRA_011212; SEC_OCIE_CRA_011214; and SEC_OCIE_CRA_011217.

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During the years reviewed by the Subcommittee, at Moody’s, the CEO and Chairman of

the Global CDO Group, with about 85 analysts.982 Each group was headed by a Managing Director, and housed in the Structured Finance Ratings Group which was headed by a Senior Managing Director.

the Board was Raymond W. McDaniel, Jr.; the Senior Managing Director of the Structured Finance Group was Brian Clarkson; the head of the RMBS Group was Pramila Gupta; and the heads of the Derivatives CDO analysts were Gus Harris and Yuri Yoshizawa. At S&P, the President was Kathleen A. Corbet; the Senior Managing Director of the Structured Finance Ratings Group was Joanne Rose; the head of the RMBS Group was Frank Raiter and then Susan Barnes; and the head of the Global CDO Group was Richard Gugliada.

Surveillance. Following an initial credit rating, both Moody’s and S&P conducted

ongoing surveillance of all rated securities to evaluate a product’s ongoing credit risk and to determine whether its credit rating should be affirmed, upgraded, or downgraded over the life of the security. Both used automated surveillance tools that, on a monthly basis, flagged securities whose performance indicated their rating might need to be adjusted to reflect the current risk of default or loss. Surveillance analysts investigated the flagged securities and presented recommendations for rating changes to a ratings committee.

surveillance analysts and 24 derivatives surveillance analysts, respectively.983 S&P maintained a Structured Finance Surveillance Group that included an RMBS Surveillance Group and a CDO Surveillance Group, with about 20 analysts in each group in 2007.984 Each of these groups was headed by a Managing Director who reported to the head of the Structured Finance Group. The Managing Director for Moody’s surveillance analysts was Nicolas Weill. At S&P, the Managing Director of the Structured Finance Surveillance Group was Peter D’Erchia.

after surveillance, is to forecast a security’s probability of default (S&P) or expected loss (Moody’s). If the security has an extremely low likelihood of default, credit rating agencies grant it AAA status. For securities with a higher probability of default, they provide lower credit ratings.

When asked about the meaning of an AAA rating, Moody’s CEO Raymond McDaniel

explained that it represented the safest type of investment and had the same significance across various types of financial products.985 While all credit rating agencies leave room for error by designing procedures to downgrade or upgrade ratings over time, Moody’s and S&P told the Subcommittee that their ratings are designed to take into account future performance. Prior to

Meaning of Ratings. The purpose of a credit rating, whether stated at first issuance or

Within both the RMBS and Derivatives Groups, in 2007, Moody’s had 15 RMBS

982 3/14/2008 compliance letter from S&P to SEC, SEC_OCIE_CRA_011218-59, at 32-34, and at 43-44. 983 3/11/2008 compliance letter from Moody’s to SEC, SEC_OCIE_CRA_011212; SEC_OCIE_CRA_011214; and
SEC_OCIE_CRA_011217.
984 3/14/2008 compliance letter from S&P to SEC, SEC_OCIE_CRA_011218-59, at 48-49, and at 56-57. 985 Subcommittee interview of Raymond McDaniel (4/6/2010).

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the financial crisis, the numbers of downgrades and upgrades for structured finance ratings were substantially lower.986

Revenues increased dramatically over time as well. Moody’s gross revenues from

(3) Record Revenues From 2004 to 2007, Moody’s and S&P produced a record number of ratings and a record amount of revenues in structured finance, primarily because of RMBS and CDO ratings. A 2008 S&P submission to the SEC indicates, for example, that from 2004 to 2007, S&P issued more than 5,500 RMBS ratings and more than 835 mortgage related CDO ratings.987 The number of ratings it issued increased each year, going from approximately 700 RMBS ratings in 2002, to more than 1,600 in 2006. Its mortgage related CDO ratings increased tenfold, going from 34 in 2002, to over 340 in 2006.988 Moody’s experienced similar growth. According to a 2008 Moody’s submission to the SEC, from 2004 to 2007, it issued over 4,000 RMBS ratings and over 870 CDO ratings.989 Moody’s also increased the ratings it issued each year, going from approximately 540 RMBS and 45 CDO ratings in 2002, to more than 1,200 RMBS and 360 CDO ratings in 2006.990

Both companies charged substantial fees to rate a product. To obtain an RMBS or CDO rating during the height of the market, for example, S&P charged issuers generally from $40,000 to $135,000 to rate tranches of an RMBS and from $30,000 to $750,000 to rate the tranches of a CDO.991 Surveillance fees, which may be imposed at the initial rating or annually, ranged generally from $5,000 to $50,000 for these mortgage backed securities.992

RMBS and CDO ratings more than tripled in five years, from over $61 million in 2002, to over $260 million in 2006.993 RMBS and mortgage related CDO ratings was over $64 million and increased to over $265

986 See, e.g., 3/26/2010 “Fitch Ratings Global Structured Finance 2009 Transition and Default Study,” prepared by Fitch.
987 3/14/2008 compliance letter from S&P to SEC, SEC_OCIE_CRA_011218-59, at 20. These numbers represent the RMBS or CDO pools that were presented to S&P which then issued ratings for multiple tranches per RMBS or CDO pool.
988 Id.
989 3/11/2008 compliance letter from Moody’s to SEC, SEC_OCIE_CRA_011212 and SEC_OCIE_CRA_011214.
These numbers represent the RMBS or CDO pools that were presented to Moody’s which then issued ratings for multiple tranches per RMBS or CDO pool. The data Moody’s provided to the SEC on CDOs represented ABS CDOs, some of which may not be mortgage related. However, by 2004, most, but not all, CDOs relied primarily on mortgage related assets such as RMBS securities. Subcommittee interview of Gary Witt, former Managing Director of Moody’s RMBS Group (10/29/2009).
990 Id.
991 See, e.g., “U.S. Structured Ratings Fee Schedule Residential Mortgage-Backed Financings and Residential Servicer Evaluations,” prepared by S&P, S&P-PSI 0000028-35; and “U.S. Structured Ratings Fee Schedule Collateralized Debt Obligations Amended 3/7/2007,” prepared by S&P, S&P-PSI 0000036-50. 992 Id.
993 3/11/2008 compliance letter from Moody’s to SEC, SEC_OCIE_CRA_011212 and SEC_OCIE_CRA_011214.
The 2002 figure does not include gross revenue from CDO ratings as this figure was not readily available due to the transition of Moody’s accounting systems.

S&P’s revenue increased even more. In 2002, S&P’s gross revenue for

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million in 2006.994 In that same period, revenues from S&P’s structured finance group tripled from about $184 million in 2002 to over $561 million in 2007.995 In 2002, structured finance ratings contributed 36% to S&P’s bottom line; in 2007, they made up 49% of all S&P revenues from ratings.996 In addition, from 2000 to 2007, operating margins at the CRAs averaged 53%.997 Altogether, revenues from the three leading credit rating agencies more than doubled from nearly $3 billion in 2002 to over $6 billion in 2007.998

significant price increase that Moody’s shares experienced as a result of increased revenues during the years of explosive growth in the ratings of both RMBS and CDOs.999 Moody’s percentage gain in share price far outpaced the major investment banks on Wall Street from 2002 to 2006.

Both companies also saw their share prices shoot up. The chart below reflects the

994 3/14/2008 compliance letter from S&P to SEC, SEC_OCIE_CRA_011218-59, at 18-19.
995 Id. at 19.
996 Id.
997 “Debt Watchdogs: Tamed or Caught Napping?” New York Times (12/7/2008). The operating margin is a ratio used to measure a company’s operating efficiency and is calculated by dividing operating income by net sales. 998 “Revenue of the Three Credit Rating Agencies: 2002-2007,” chart prepared by Subcommittee using data from thismatter.com/money, Hearing Exhibit 4/23-1g. 999 “How and Why Credit Rating Agencies Are Not Like Other Gatekeepers,” Frank Partnoy, University of San Diego Law School Legal Studies Research Paper Series (5/2006), at 67.

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Standard & Poor’s is a division of The McGraw-Hill Companies (NYSE: MHP), whose share price also increased significantly during this time period.1000

Top CRA executives received millions of dollars each year in compensation. Moody’s CEO, Raymond McDaniel, for example, earned more than $8 million in total compensation in 2006.1001 Brian Clarkson, the head of Moody’s structured finance group, received $3.8 million in total compensation in the same year.1002 Upper and middle managers also did well. Moody’s managing directors made between $385,000 to about $460,000 in compensation in 2007, before

1000 See “The McGraw-Hill Companies, Inc.,” Google Finance, 1001 3/19/2008 Moody’s 2008 Proxy Statement, “Summary Compensation Table.” 1002 Id.

http://www.google.com/finance?q=mcgraw+hill.

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stock options. Including stock options, their total compensation ranged from almost $700,000 to over $930,000.1003 S&P managers received similar compensation.1004

C. Mass Credit Rating Downgrades In the years leading up to the financial crisis, Moody’s and S&P together issued

investment grade ratings for tens of thousands of RMBS and CDO securities, earning substantial sums for issuing these ratings. In mid-2007, however, both credit rating agencies suddenly reversed course and began downgrading hundreds, then thousands of RMBS and CDO ratings.
These mass downgrades shocked the financial markets, contributed to the collapse of the subprime RMBS and CDO secondary markets, triggered sales of assets that had lost investment grade status, and damaged holdings of financial firms worldwide. Perhaps more than any other single event, the sudden mass downgrades of RMBS and CDO ratings were the immediate trigger for the financial crisis.

To understand why the credit rating agencies suddenly reversed course and how their

RMBS and CDO ratings downgrades impacted the financial markets, it is useful to review trends in the housing and mortgage backed security markets in the years leading up to the crisis.

(1) Increasing High Risk Loans and Unaffordable Housing
The years prior to the financial crisis saw increasing numbers of borrowers buying not only more homes than usual, but higher priced homes, requiring larger and more frequent loans that were constantly refinanced. By 2005, about 69% of Americans had purchased homes, the largest percentage in American history.1005 In the five-year period running up to 2006, the median home price, adjusted for inflation, increased 50 percent.1006 The pace of home price appreciation was on an unsustainable trajectory, as is illustrated by the chart below.1007

1003 4/27/2007 email from Yuri Yoshizawa to Noel Kirnon, PSI-MOODYS-RFN-000044 (Attachment, PSI- MOODYS-RFN-000045).
1004 See S&P’s “Global Compensation Guidelines 2007/2008,” S&P-SEC 067708, 067733, 067740, and 067747. 1005 See 3/1/2006 “Housing Vacancies and Homeownership Annual Statistics: 2005,” U.S. Census Bureau.
1006 “Housing Bubble Trouble,” The Weekly Standard (4/10/2006). 1007 1/25/2010, “Estimation of Housing Bubble: Comparison of Recent Appreciation vs. Historical Trends,” chart prepared by Paulson & Co. Inc., Hearing Exhibit 4/23-1j.

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Subprime lending fueled the overall growth in housing demand and housing price

increases that began in the late 1990s and ran through mid-2006.1008 “Between 2000 and 2007, backers of subprime mortgage-backed securities – primarily Wall Street and European investment banks – underwrote $2.1 trillion worth of [subprime mortgage backed securities] business, according to data from trade publication Inside Mortgage Finance.”1009 By 2006, subprime lending made up 13.5% of mortgage lending in the United States, a fivefold increase from 2001.1010 The graph below reflects the unprecedented growth in subprime mortgages between 2003 and 2006.1011

1008 See 3/2009 U.S. Department of Housing and Urban Development Interim Report to Congress, “Root Causes of the Foreclosure Crisis,” at 36. See also “A Brief History of Credit Rating Agencies: How Financial Regulation Entrenched this Industry’s Role in the Subprime Mortgage Debacle of 2007 – 2008,” Mercatus on Policy (10/2009), at 2.
1009 “The Roots of the Financial Crisis: Who is to Blame?” The Center for Public Integrity (5/6/2009), http://www.publicintegrity.org/investigations/economic_meltdown/articles/entry/1286.
1010 3/2009 U.S. Department of Housing and Urban Development Interim Report to Congress, “Root Causes of the Foreclosure Crisis,” at 7. 1011 1/25/2010, “Mortgage Subprime Origination,” chart prepared by Paulson & Co. Inc., PSI-Paulson&Co-02-0001- 21, at 4.

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To enable subprime borrowers to buy homes that they would not traditionally qualify for, lenders began using exotic mortgage products that reduced or eliminated the need for large down payments and allowed monthly mortgage payments that reflected less than the fully amortized cost of the loan. For example, some types of mortgages allowed borrowers to obtain loans for 100% of the cost of a house; make monthly payments that covered only the interest owed on the loan; or pay artificially low initial interest rates on loans that could be refinanced before higher interest rates took effect. In 2006, Barron’s reported that first-time home buyers put no money down 43% of the time in 2005; interest only loans made up approximately 33% of new mortgages and home equity loans in 2005, up from 0.6% in 2000; by 2005, 15% of borrowers owed at least 10% more than their home was worth; and more than $2.5 trillion in adjustable rate mortgages were due to reset to higher interest rates in 2006 and 2007.1012

These new mortgage products were not confined to subprime borrowers; they were also offered to prime borrowers who used them to purchase expensive homes. Many borrowers also used them to refinance their homes and take out cash against their homes’ increased value.
Lenders also increased their issuance of home equity loans and lines of credit that offered low

1012 “The No-Money-Down Disaster,” Barron’s (8/21/2006).

initial interest rates or interest-only features, often taking a second lien on an already mortgaged home.1013

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Subprime loans, Alt A mortgages that required little or no documentation, and home

equity loans all posed a greater risk of default than traditional 30-year, fixed rate mortgages. By 2006, the combined market share of these higher risk home loans totaled nearly 50% of all mortgage originations.

1014

At the same time housing prices and high risk loans were increasing, the National

Association of Realtors’ housing affordability index showed that, by 2006, housing had become less affordable than at any point in the previous 20 years, as presented in the graph below. The “affordability index” measures how easy it is for a typical family to afford a typical mortgage. Higher numbers mean that homes are more affordable, while lower numbers mean that homes are generally less affordable.

1015

By the end of 2006, the concentration of higher risk loans for less affordable homes had set the stage for an unprecedented number of credit rating downgrades on mortgage related securities.

1013 3/2009 U.S. Department of Housing and Urban Development Interim Report to Congress, “Root Causes of the Foreclosure Crisis,” at 8.
1014 Id. 1015 11/7/2007 “Would a Housing Crash Cause a Recession?” report prepared by the Congressional Research Service, at 3-4.

(2) Mass Downgrades

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Although ratings downgrades for investment grade securities are supposed to be

relatively infrequent, in 2007, they took place on a massive scale that was unprecedented in U.S. financial markets. Beginning in July 2007, Moody’s and S&P downgraded hundreds and then thousands of RMBS and CDO ratings, causing the rated securities to lose value and become much more difficult to sell, and leading to the subsequent collapse of the RMBS and CDO secondary markets. The massive downgrades made it clear that the original ratings were not only deeply flawed, but the U.S. mortgage market was much riskier than previously portrayed.

Housing prices peaked in 2006. In late 2006, as the increase in housing prices slowed or

leveled out, refinancing became more difficult, and delinquencies in subprime residential mortgages began to multiply. By January 2007, nearly 10% of all subprime loans were delinquent, a 68% increase from January 2006.1016 exposing more borrowers who had purchased homes that they could not afford and could no longer refinance. Subprime lenders also began to close their doors, which the U.S. Department of Housing and Urban Development marked as the beginning of economic trouble:

Housing prices then began to decline,

“Arguably, the first tremors of the national mortgage crisis were felt in early December 2006 when two sizeable subprime lenders, Ownit Mortgage Solutions and Sebring Capital, failed. The Wall Street Journal described the closing of these firms as ‘sending shock waves’ through the mortgage-bond market. … By late February 2007 when the number of subprime lenders shuttering their doors had reached 22, one of the first headlines announcing the onset of a ‘mortgage crisis’ appeared in the Daily Telegraph of London.”1017

During the first half of 2007, despite the news of failing subprime lenders and increasing subprime mortgage defaults, Moody’s and S&P continued to issue AAA credit ratings for a large number of RMBS and CDO securities. In the first week of July 2007 alone, S&P issued over 1,500 new RMBS ratings, a number that almost equaled the average number of RMBS ratings it issued in each of the preceding three months.1018 From July 5 to July 11, 2007, Moody’s issued approximately 675 new RMBS ratings, nearly double its weekly average in the prior month.1019

The timing of this surge of new ratings on the eve of the mass downgrades is troubling, and raises serious questions about whether S&P and Moody’s quickly pushed these ratings through to avoid losing revenues before the mass downgrades began.

1016 1/25/2010 “60 Day+Delinquency and Foreclosure,” chart prepared by Paulson & Co. Inc., PSI-Paulson&Co-02- 0001-21, at 15. Subcommittee interview of Sihan Shu (2/24/2010). 1017 3/2009 U.S. Department of Housing and Urban Development Interim Report to Congress, “Root Causes of the Foreclosure Crisis,” at 2 [citations omitted]. 1018 6/24/2010 supplemental response from S&P to the Subcommittee, at 12, Hearing Exhibit 4/23-108.
1019 Data compiled by the Subcommittee using 6/14/2007 “Structured Finance New Ratings: May 28, 2007 through June 13, 2007,” Moody’s; 6/28/2007 “Structured Finance New Ratings: June 11, 2007 through June 27, 2007,” Moody’s; 7/5/2007 “Structured Finance New Ratings: June 18, 2007 through July 4, 2007,” Moody’s; and 7/12/2007 “Structured Finance New Ratings: June 25, 2007 through July 11, 2007,” Moody’s.

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In the second week of July 2007, S&P and Moody’s initiated the first of several mass

rating downgrades, shocking the financial markets. On July 10, S&P placed on credit watch, the ratings of 612 subprime RMBS with an original value of $7.35 billion,1020 and two days later downgraded 498 of these securities.1021 On July 10, Moody’s downgraded 399 subprime RMBS with an original value of $5.2 billion.1022 By the end of July, S&P had downgraded more than 1,000 RMBS and almost 100 CDO securities.1023 unprecedented in U.S. financial markets.

This volume of rating downgrades was

The downgrades created significant turmoil in the securitization markets, as investors were required to sell off RMBS and CDO securities that had lost their investment grade status, RMBS and CDO securities in the investment portfolios of financial firms lost much of their value, and new securitizations were unable to find investors. The subprime RMBS secondary market initially froze and then collapsed, leaving financial firms around the world holding suddenly unmarketable subprime RMBS securities that were plummeting in value.1024

Neither Moody’s nor S&P produced any meaningful contemporaneous documentation

explaining their decisions to issue mass downgrades in July 2007, disclosing how the mass downgrades by the two companies happened to occur two days apart, or analyzing the possible impact of their actions on the financial markets. When Moody’s CEO, Raymond McDaniel, was asked about the July downgrades, he indicated that he could not recall any aspect of the decision- making process.1025 He told the Subcommittee that he was merely informed that the downgrades would occur, but was not personally involved in the decision.1026

1020 6/24/2010 supplemental response from S&P to the Subcommittee, Exhibit H, Hearing Exhibit 4/23-108 (7/11/2007 “S&PCORRECT: 612 U.S. Subprime RMBS Classes Put On Watch Neg; Methodology Revisions Announced,” S&P RatingsDirect (correcting the original version issued on 7/10/2007)).
1021 6/24/2010 supplemental response from S&P to the Subcommittee, Exhibit I, Hearing Exhibit 4/23-108 (7/12/2007 “Various U.S. First-Lien Subprime RMBS Classes Downgraded,” S&P’s RatingsDirect).
1022 7/30/2010 supplemental response from Moody’s to the Subcommittee, Hearing Exhibit 4/23-106 (7/12/2007 Moody’s Structured Finance Teleconference and Web Cast, “RMBS and CDO Rating Actions,” at MOODYS- PSI2010-0046899-900). The $5.2 billion also included the original value of 32 tranches that were put on review for possible downgrade that same day.
1023 6/24/2010 supplemental response from S&P to the Subcommittee, at 3, 6, Hearing Exhibit 4/23-108. According to this letter, the July downgrades were not the first to take place during 2007. The letter reports that, altogether in the first six months of 2007, S&P downgraded 739 RMBS and 25 CDOs. These downgrades, however, took place on multiple days over a six-month period. Prior to July, Moody’s had downgraded approximately 480 RMBS during the first six months of 2007 (this figure was calculated by the Subcommittee based on information from Moody’s “Structured Finance: Changes & Confirmations” reports for that time period).
1024 See 3/19/2007 “Subprime Mortgages: Primer on Current Lending and Foreclosure Issues,” report prepared by the Congressional Research Service, Report No. RL33930; 5/2008 “The Subprime Lending Crisis: Causes and Effects of the Mortgage Meltdown,” report prepared by CCH, at 13.
1025 Subcommittee interview of Ray McDaniel (4/6/2010).
1026 Id. At S&P, no emails were produced that explained the decision-making process, but a few indicated that, prior to the mass downgrades, the RMBS Group was required to make a presentation to the chief executive of its parent company about “how we rated the deals and are preparing to deal with the fallout (downgrades).” 3/18/2007 email from Michael Gutierrez to William LeRoy, Hearing Exhibit 4/23-52a; 3/2007 S&P internal email chain, “Pre- empting bad press on the subprime situation,” Hearing Exhibit 4/23-52c.

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Although neither Moody’s nor S&P produced documentation on its internal decision-

making process related to the mass downgrades, one bank, UBS, produced an email in connection with a court case indicating that Moody’s was meeting with a series of investment banks to discuss the upcoming downgrades. In an email dated July 5, 2007, five days before the mass downgrades began, a UBS banker sent an email to a colleague about a meeting with Moody’s:

“I just got off the phone with David Oman …. Apparently they’re meeting w/ Moodys to discuss impacts of ABS subprime downgrades, etc. Has he been in contact with the [UBS] Desk? It sounds like Moodys is trying to figure out when to start downgrading, and how much damage they’re going to cause – they’re meeting with various investment banks.”1027

It is unclear how much notice Moody’s or S&P provided to investment banks regarding their planned actions.

One senior executive at S&P, Ian Bell, the head of European structured finance ratings, provided his own views in a post-mortem analysis a few days after the initial downgrades. He expressed frustration and concern that S&P had mishandled its public explanation of the mass downgrades, writing:

“[O]ne aspect of our handling of the subprime that really concerns me is what I see as our arrogance in our messaging. Maybe it is because I am away from the center of the action and so have more of an ‘outsider’s’ point of view. …

I listened to the telecon TWICE. That guy [who asked a question about the timing of the mass downgrades] was not a ‘jerk’. He asked an entirely legitimate question that we should have anticipated. He then got upset when we totally fluffed our answer. We did sound like the Nixon White House. Instead of dismissing people like him or assuming some dark motive on their part, we should ask ourselves how we could have so mishandled the answer to such an obvious question.

I have thought for awhile now that if this company suffers from an Arthur Andersen event, we will not be brought down by a lack of ethics as I have never seen an organisation more ethical, nor will it be by greed as this plays so little role in our motivations; it will be arrogance.”1028

In August 2007, Eric Kolchinsky, a managing director of Moody’s CDO analysts, sent an urgent email to his superiors about the pressures to rate still more new CDOs in the midst of the mass downgrades:

1027 7/5/2007 email from David Goldsteen (UBS) to Dayna Corlito (UBS), “ABS Subprime & Moody’s downgrades,” UBS-CT 021485, Hearing Exhibit 4/23-94o. 1028 7/13/2007 internal S&P email from Ian Bell to Tom Gillis and Joanne Rose, Hearing Exhibit 4/23-54a.

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“[E]ach of our current deals is in crisis mode. This is compounded by the fact that we have introduced new criteria for ABS CDOs. Our changes are a response to the fact that we are already putting deals closed in the spring on watch for downgrade. This is unacceptable and we cannot rate the new deals in the same away [sic] we have done before. … [B]ankers are under enormous pressure to turn their warehouses into CDO notes.”1029

Both Moody’s and S&P continued to rate new CDO securities despite their companies’ accelerating downgrades.

In October 2007, Moody’s began downgrading CDOs on a daily basis, using the month to downgrade more than 270 CDO securities with an original value of $10 billion.1030 In December 2007, Moody’s downgraded another $14 billion in CDOs, and placed another $105 billion on credit watch. Moody’s calculated that, overall in 2007, “8725 ratings from 2116 deals were downgraded and 1954 ratings from 732 deals were upgraded,” which means it issued four times as many downgrades as upgrades.1031 S&P calculated that, during the second half of 2007, it downgraded over 9,000 RMBS ratings.1032

The downgrades continued into 2008. On January 30, 2008, S&P took action on over

6,300 subprime RMBS securities and over 1,900 CDO securities – meaning it either downgraded their ratings or placed the securities on credit watch with negative implications. The affected RMBS and CDO securities represented issuance amounts of approximately $270.1 billion and $263.9 billion, respectively.1033

The rating downgrades affected a wide range of RMBS and CDO securities. Some of the

downgraded securities had been rated years earlier; others had received AAA ratings less than 12 months before. For example, in April 2007, both Moody’s and S&P gave AAA ratings to three tranches of approximately $1.5 billion in a cash CDO known as Vertical ABS CDO 2007-1. Six months later, the majority of the CDO’s tranches were downgraded to junk status; in 2008, the CDO’s ratings were withdrawn, it assets were liquidated, and the AAA rated securities became worthless. In another case, in February and March 2007, Moody’s and S&P gave AAA ratings to 5 tranches of about a $1 billion RMBS securitization known as GSAMP Trust 2007-FM2. In late 2007, both credit rating agencies began downgrading the securities; by 2008, they began

1029 8/22/2007 email from Moody’s Eric Kolchinsky, “Deal Management,” Hearing Exhibit 4/23-42. 1030 7/30/2010 supplemental response from Moody’s to the Subcommittee, at 9, Hearing Exhibit 4/23-106. In an email sent in the midst of these CDO downgrades, one Moody’s analyst commented to a colleague: “You’re right about CDOs as WMD – but it’s only CDOs backed by subprime that are WMD.” 11/27/2007 email from William May to Deepali Advani, Hearing Exhibit 4/23-58. 1031 2/2008 “Structured Finance Ratings Transitions, 1983-2007,” Credit Policy Special Comment prepared by Moody’s, at 4. 1032 6/24/2010 supplemental response from S&P to the Subcommittee, at 6, Hearing Exhibit 4/23-108.
1033 6/24/2010 supplemental response from S&P to the Subcommittee, Exhibit N, Hearing Exhibit 4/23-108 (1/30/2008 “S&P Takes Action on 6,389 U.S. Subprime RMBS Ratings and 1,953 CDO Ratings,” S&P’s RatingsDirect).

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downgrading the AAA rated securities, and by August 2009 S&P had downgraded all its tranches to noninvestment grade or junk status.

One more striking example involved a $1.6 billion hybrid CDO known as Delphinus

CDO 2007-1, Ltd., which was downgraded a few months after its rating was issued. Moody’s gave AAA ratings to seven of its tranches and S&P to six tranches in July and August 2007, respectively, but began downgrading its securities by the end of the year, and by the end of 2008, had fully downgraded its AAA rated securities to junk status.1034

Analysts have determined that, by 2010, over 90% of subprime RMBS securities issued

in 2006 and 2007 and originally rated AAA had been downgraded to junk status by Moody’s and S&P.1035

Percent of the Original AAA Universe

Currently Rated Below Investment Grade Option ARM 50% 76% 97% 97%

Prime ARM 9% 58% 90% 90%

Alt-A ARM 17% 81% 98% 96%

Alt-A Fixed 10% 73% 96% 98%

Vintage Prime Fixed 3% 39% 81% 92%

2004 2005 2006 2007

Subprime

11% 53% 93% 91%

Source: BlackRock Solutions as of February 8, 2010.
Prepared by the U.S. Senate Permanent Subcommittee on Investigations, April 2010.

D. Ratings Deficiencies

The Subcommittee’s investigation uncovered a host of factors responsible for the

inaccurate credit ratings assigned by Moody’s and S&P to RMBS and CDO securities. Those factors include the drive for market share, pressure from investment banks to inflate ratings, inaccurate rating models, and inadequate rating and surveillance resources. In addition, federal regulations that limited certain financial institutions to the purchase of investment grade financial instruments encouraged investment banks and investors to pursue and credit rating agencies to provide those top ratings. All these factors played out against the backdrop of an ongoing conflict of interest that arose from how the credit rating agencies earned their income. If the

1034 For more details about these three examples, see “Fact Sheet for Three Examples of Failed AAA Ratings,” prepared by the Subcommittee based on information from S&P and Moody’s websites. 1035 See “Percent of the Original AAA Universe Currently Rated Below Investment Grade,” chart prepared by the Subcommittee using data from BlackRock Solutions, Hearing Exhibit 4/23-1i. See also 3/2008 “Understanding the Securitization of Subprime Mortgage Credit,” report prepared by Federal Reserve Bank of New York staff, no. 318, at 58 and table 31 (“92 percent of 1st-lien subprime deals originated in 2006 as well as … 91.8 percent of 2nd-lien deals originated in 2006 have been downgraded.”). See also “Regulatory Use of Credit Ratings: How it Impacts the Behavior of Market Constituents,” University of Westminster - School of Law International Finance Review (2/2009), at 65-104 (citations omitted) (“As of February 2008, Moody’s had downgraded at least one tranche of 94.2% of the subprime RMBS issues it rated in 2006, including 100% of the 2006 RMBS backed by second-lien loans, and 76.9% of the issues rated in 2007. In its rating transition report, S&P wrote that it had downgraded 44.3% of the subprime tranches it rated between the first quarter of 2005 and the third quarter of 2007.”)

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credit rating agencies had issued ratings that accurately exposed the increasing risk in the RMBS and CDO markets, they may have discouraged investors from purchasing those securities, slowed the pace of securitizations, and as a result reduced their own profits. It was not in the short term economic self-interest of either Moody’s or S&P to provide accurate credit risk ratings for high risk RMBS and CDO securities.

(1) Awareness of Increasing Credit Risks The evidence shows that analysts within Moody’s and S&P were aware of the increasing risks in the mortgage market in the years leading up to the financial crisis, including higher risk mortgage products, increasingly lax lending standards, poor quality loans, unsustainable housing prices, and increasing mortgage fraud. Yet for years, neither credit rating agency heeded warnings – even their own – about the need to adjust their processes to accurately reflect the increasing credit risk.

Moody’s and S&P began issuing public warnings about problems in the mortgage market

as early as 2003, yet continued to issue inflated ratings for RMBS and CDO securities before abruptly reversing course in July 2007. Moody’s CEO testified before the House Committee on Oversight and Government Reform, for example, that Moody’s had been warning the market continuously since 2003, about the deterioration in lending standards and inflated housing prices.

“Beginning in July 2003, we published warnings about the increased risks we saw and took action to adjust our assumptions for the portions of the residential mortgage backed securities (“RMBS”) market that we were asked to rate.”1036

Both S&P and Moody’s published a number of articles indicating the potential for deterioration in RMBS performance.1037 For example, in September 2005, S&P published a report entitled, “Who Will Be Left Holding the Bag?” The report contained this strong warning:

“It’s a question that comes to mind whenever one price increase after another – say, for ridiculously expensive homes – leaves each succeeding buyer out on the end of a longer

1036Prepared statement of Raymond W. McDaniel, Moody’s Chairman and Chief Executive Officer, “Credit Rating Agencies and the Financial Crisis,” before the U.S. House of Representatives Committee on Oversight and Government Reform, Cong.Hrg. 110-155 (10/22/2008), at 1 (hereinafter “10/22/2008 McDaniel prepared statement”).
1037 See, e.g., 6/24/2010 supplemental response from S&P to the Subcommittee, Hearing Exhibit 4/23-108 (4/20/2005 Subprime Lenders: Basking in the Glow of A Still-Benign Economy, but Clouds Forming on the Horizon” S&P; 9/13/2005 “Simulated Housing Market Decline Reveals Defaults Only in Lowest-Rated U.S. RMBS Transactions,” S&P; and 1/19/2006 “U.S. RMBS Market Still Robust, But Risks Are Increasing and Growth Drivers Are Softening” S&P). “Housing Market Downturn in Full Swing,” Moody’s Economy.com (10/4/2006); 1/18/2007 “Special Report: Early Defaults Rise in Mortgage Securitization,” Moody’s ; and 9/21/2007 “Special Report: Moody’s Subprime Mortgage Servicer Survey on Loan Modifications,” Moody’s. See 10/22/2008 McDaniel prepared statement at 13-14. In addition, in March 2007 Moody’s warned of the possible effect that downgrades of subprime mortgage backed securities might have on its structured finance CDOs. See 3/2007 “The Impact of Subprime Residential Mortgage-Backed Securities on Moody’s-Rated Structured Finance CDOs: A Preliminary Review,” Moody’s.

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and longer limb: When the limb finally breaks, who’s going to get hurt? In the red-hot U.S. housing market, that’s no longer a theoretical riddle. Investors are starting to ask which real estate vehicles carry the most risk – and if mortgage defaults surge, who will end up suffering the most.”1038

Internal Moody’s and S&P emails further demonstrate that senior management and

ratings personnel were aware of the deteriorating mortgage market and increasing credit risk. In June 2005, for example, an outside mortgage broker who had seen the head of S&P’s RMBS Group, Susan Barnes, on a television program sent her an email warning about the “seeds of destruction” in the financial markets. He noted that no one at the time seemed interested in fixing the looming problems:

“I have contacted the OTS, FDIC and others and my concerns are not addressed. I have been a mortgage broker for the past 13 years and I have never seen such a lack of attention to loan risk. I am confident our present housing bubble is not from supply and demand of housing, but from money supply. In my professional opinion the biggest perpetrator is Washington Mutual. 1) No income documentation loans. 2) Option ARMS (negative amortization) … 5) 100% financing loans. I have seen instances where WAMU approved buyers for purchase loans; where the fully indexed interest only payments represented 100% of borrower’s gross monthly income. We need to stop this madness!!!”1039

Several email chains among S&P employees in the Servicer Evaluation Group in

Structured Finance demonstrate a clear awareness of mortgage market problems. One from September 2006, for example, with the subject line “Nightmare Mortgages,” contains an exchange with startling frankness and foresight. One S&P employee circulated an article on mortgage problems, stating: “Interesting Business Week article on Option ARMs, quoting anecdotes involving some of our favorite servicers.” Another responded: “This is frightening. It wreaks of greed, unregulated brokers, and ‘not so prudent’ lenders.” commenting on the same article said: “I’m surprised the OCC and FDIC doesn’t come downharder [sic] on these guys - this is like another banking crisis potentially looming!!”1041

1040 Another employee

Another email chain that same month shows that at least some employees understood the significance of problems within the mortgage market nine months before the mass downgrades began. One S&P employee wrote: “I think [a circulated article is] telling us that underwriting fraud; appraisal fraud and the general appetite for new product among originators is resulting in loans being made that shouldn’t be made. … [I]f [Eliot] Spitzer [then-New York Attorney General] could prove coercion this could be a RICO offense!” A colleague responded that the

1038 “Economic Research: Who Will be Left Holding the Bag?” S&P’s RatingsDirect (9/12/2005).
1039 7/22/2005 email from Michael Blomquist (Resource Realty) to Susan Barnes (S&P), “Washington Mutual,” Hearing Exhibit 4/23-45. 1040 9/2/2006 email from Robert Mackey to Richard Koch, “Nightmare Mortgages,” Hearing Exhibit 4/23-46a. 1041 9/5/2006 email from Michael Gutierrez to Richard Koch and Edward Highland, “RE: Nightmare Mortgages,” Hearing Exhibit 4/23-46b.

head of the S&P Surveillance Group “told me that broken down to loan level what she is seeing in losses is as bad as high 40’s – low 50% I’d love to be able to publish a commentary with this data but maybe too much of a powder keg.”1042

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In a third email chain from August 2006, commenting on an article about problems in the

mortgage market, a director in the S&P Servicer Evaluation Group wrote: “I’m not surprised; there has been rampant appraisal and underwriting fraud in the industry for quite some time as 1043 Another S&P director in the same pressure has mounted to feed the origination machine.” group wrote in an October 2006 internal email about a news article entitled, “More Home Loans Go Sour – Though New Data Show Rising Delinquencies, Lenders Continue to Loosen Mortgage Standards”: “Pretty grim news as we suspected – note also the ‘mailing in the keys and walking away’ epidemic has begun – I think things are going to get mighty ugly next year!”1044 Still another S&P email the same month circulated an article entitled, “Home Prices Keep Sliding; Buyers Sit Tight,” and remarked: “[J]ust curious…are there ever any positive repo[r]ts on the housing market?”1045

An email among several S&P employees a few months later circulated an article entitled,

“The Mortgage Mess Spreads” with one person noting ominously: “This is like watching a hurricane from FL [Florida] moving up the coast slowly towards us. Not sure if we will get hit in full or get trounced a bit or escape without severe damage ….”

1046

     Government Warnings.   At the same time the credit rating agencies were publishing  reports and circulating articles internally about the deteriorating mortgage market, several  government agencies issued public warnings about lax lending standards and increasing  mortgage fraud.  A 2004 quarterly report by the FDIC, for example, sounded an alarm over the  likelihood of more high risk loan delinquencies: 

“[I]t is unlikely that home prices are poised to plunge nationwide, even when mortgage rates rise …. The greater risk to insured institutions is the potential for increased credit delinquencies and losses among highly leveraged, subprime, and ARM borrowers. These

1042 9/29/2006 email from Michael Gutierrez, Director at S&P, PSI-S&P-RFN-000029.
1043 8/7/2006 email from Richard Koch, Director at S&P, Hearing Exhibit 4/23-1d. 1044 10/20/2006 email from Michael Gutierrez to Richard Koch and others, Hearing Exhibit 4/23-47. 1045 10/26/2006 email from Ernestine Warner to Robert Pollsen, Hearing Exhibit 4/23-48. 1046 3/9/2007 email from KP Rajan, Hearing Exhibit 4/23-51. See also 2/14/2006 email from Robert Pollsen, PSI- S&P-RFN-000038 (forwarding “Coming Home to Roost,” Barron’s (2/13/2006), which includes the sentences “The red-hot U.S. housing market may be fast approaching its date with destiny …. much anxiety is being focused on a looming ‘reset problem.’”); see also 3/25/2007 S&P internal email chain, PSI-S&P-RFN-000006 (forwarding “Slow-Motion Train Wreck Picks Up Speed,” Barron’s (3/26/2007)). 3/26/2007 Moody’s internal email, PSI-S&P- RFN-000003 (forwarding “Slow-Motion Train Wreck Picks Up Speed,” Barron’s (3/26/2007)); 10/19/2006 Moody’s internal email, PSI-MOODYS-RFN-000009 (forwarding “More Home Loans Go Sour—Though New Data Show Rising Delinquencies, Lenders Continue to Loosen Mortgage Standards,” The Wall Street Journal (10/19/2006)); 9/6/2006 Moody’s internal email, PSI-MOODYS-RFN-000001 (forwarding “The No-Money-Down Disaster.” Barron’s (8/21/2006)).

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high-risk segments of mortgage lending may drive overall mortgage loss rates higher if home prices decline or interest rates rise.”1047

In 2005, in its 11th Annual Survey on Credit Underwriting Practices, the Office of the Comptroller of the Currency (OCC), which oversees nationally chartered banks, described a significant lowering of retail lending standards, noting it was the first time in the survey’s history that a net lowering of retail lending practices had been observed. The OCC wrote:

“Retail lending has undergone a dramatic transformation in recent years as banks have aggressively moved into the retail arena to solidify market positions and gain market share. Higher credit limits and loan-to-value ratios, lower credit scores, lower minimum payments, more revolving debt, less documentation and verification, and lengthening amortizations - have introduced more risk to retail portfolios.”1048

Starting in 2004, federal law enforcement agencies also issued multiple warnings about

fraud in the mortgage marketplace. For example, the Federal Bureau of Investigation (FBI) made national headlines when it warned that mortgage fraud had the potential to be a national epidemic,1049 and issued a 2004 report describing how mortgage fraud was becoming more prevalent. The report noted: “Criminal activity has become more complex and loan frauds are expanding to multitransactional frauds involving groups of people from top management to industry professionals who assist in the loan application process.”1050 The FBI also testified about the problem before Congress:

“The potential impact of mortgage fraud on financial institutions and the stock market is clear. If fraudulent practices become systemic within the mortgage industry and mortgage fraud is allowed to become unrestrained, it will ultimately place financial institutions at risk and have adverse effects on the stock market.”1051

In 2006, the FBI reported that the number of Suspicious Activity Reports describing mortgage fraud had risen significantly since 2001.1052

1047 “Housing Bubble Concerns and the Outlook for Mortgage Credit Quality,” FDIC Outlook (Spring 2004), available at http://www.fdic.gov/bank/analytical/regional/ro20041q/na/infocus.html. 1048 6/2005 “Survey of Credit Underwriting Practices,” report prepared by the Office of the Comptroller of the Currency, at 6, available at http://www.occ.gov/publications/publications-by-type/survey-credit-underwriting/pub- survey-cred-under-2005.pdf. 1049 “FBI: Mortgage Fraud Becoming an ‘Epidemic,’” USA Today (9/17/2004).
1050 FY 2004 “Financial Institution Fraud and Failure Report,” prepared by the Federal Bureau of Investigation, available at http://www.fbi.gov/stats-services/publications/fiff_04. 1051 Prepared statement of Chris Swecker, Assistant Director of the Criminal Investigative Division, Federal Bureau of Investigation, “Mortgage Fraud and Its Impact on Mortgage Lenders,” before the U.S. House of Representatives Financial Services Subcommittee on Housing and Community Opportunity, Cong.Hrg. 108-116 (10/7/2004), at 2. 1052 “Financial Crimes Report to the Public: Fiscal Year 2006, October 1, 2005 – September 30, 2006,” prepared by the Federal Bureau of Investigation, available at http://www.fbi.gov/stats- services/publications/fcs_report2006/financial-crimes-report-to-the-public-2006-pdf/view.

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The FBI’s fraud warnings were repeated by industry analysts. The Mortgage Bankers

Association’s Mortgage Asset Research Institute (MARI), for example, had been reporting increasing fraud in mortgages for years. In April 2007, MARI reported a 30% increase in 2006 in loans with suspected mortgage fraud. The report also noted that while 55% of overall fraud incidents reported to MARI involved loan application fraud, the percentage of subprime loans with loan application fraud was even higher at 65%.1053

Press Reports. Warnings in the national press concerning the threat posed by

deteriorating mortgages and unsustainable housing prices were also prevalent. A University of Florida website has collected dozens of these articles, many of which were published in 2005.
The headlines include: “Fed Debates Pricking the U.S. Housing ‘Bubble’,” New York Times, May 31, 2005; “Yale Professor Predicts Housing ‘Bubble’ Will Burst,” NPR, June 3, 2005; “Cover Story: Bubble Bath of Doom” [warning of overheated real estate market], Washington Post, July 4, 2005; “Housing Affordability Hits 14-Year Low,” The Wall Street Journal, December 22, 2005; “Foreclosure Rates Rise Across the U.S.,” NPR, May 30, 2006; “For Sale Signs Multiply Across U.S.,” The Wall Street Journal, July 20, 2006; and “Housing Gets Ugly,” New York Times, August 25, 2006.

1054

Had Moody’s and S&P heeded their own warnings as well as the warnings in government

reports and the national press, they might have issued more conservative, including fewer AAA, ratings for RMBS and CDO securities from 2005 to 2007; required additional credit enhancements earlier; and issued ratings downgrades earlier and with greater frequency, gradually letting the air out of the housing bubble instead of puncturing it with the mass downgrades that began in July 2007. The problem, however, was that neither company had a financial incentive to assign tougher credit ratings to the very securities that for a short while increased their revenues, boosted their stock prices, and expanded their executive compensation.
Instead, ongoing conflicts of interest, inaccurate credit rating models, and inadequate rating and surveillance resources made it possible for Moody’s and S&P to ignore their own warnings about the U.S. mortgage market. In the longer run, these decisions cost both companies dearly.
Between January 2007 and January 2009, the stock price for both The McGraw-Hill Companies (S&P’s parent company) and Moody’s fell nearly 70%, and neither share price has fully recovered.

(2) CRA Conflicts of Interest In transitioning from the fact that the rating agencies issued inaccurate ratings to the question of why they did, one of the primary issues is the conflicts of interest inherent in the “issuer-pays” model. Under this system, the firm interested in profiting from an RMBS or CDO security is required to pay for the credit rating needed to sell the security. Moreover, it requires the credit rating agencies to obtain business from the very companies paying for their rating

1053 4/2007 “Ninth Periodic Mortgage Fraud Case Report to Mortgage Bankers Association,” prepared by the Mortgage Asset Research Institute, LLC, at 10. 1054 “Business Library – The Housing Bubble,” University of Florida George A. Smathers Libraries, http://www.uflib.ufl.edu/cm/business/cases/housing_bubble.htm.

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judgment. The result is a system that creates strong incentives for the rating agencies to inflate their ratings to attract business, and for the issuers and arrangers of the securities to engage in “ratings shopping” to obtain the highest ratings for their financial products.

The conflict of interest inherent in an issuer-pay setup is clear: rating agencies are

incentivized to offer the highest ratings, as opposed to offering the most accurate ratings, in order to attract business. It is much like a person trying to sell a home and hiring a third-party appraiser to make sure it is worth the price. Only, with the credit rating agencies, it is the seller who hires the appraiser on behalf of the buyer – the result is a misalignment of interests. This system, currently permitted by the SEC, underlies the “issuers-pay” model.

The credit rating agencies assured Congress and the investing public that they could

“manage” these conflicts, but the evidence indicates that the drive for market share and increasing revenues, ratings shopping, and investment bank pressures have undermined the ratings process and the quality of the ratings themselves. Multiple former Moody’s and S&P employees told the Subcommittee that, in the years leading up to the financial crisis, gaining market share, increasing revenues, and pleasing investment bankers bringing business to the firm assumed a higher priority than issuing accurate RMBS and CDO credit ratings.

(a) Drive for Market Share

Prior to the explosive growth in revenues generated from the ratings of mortgage backed

securities, the credit rating agencies had a reputation for exercising independent judgment and taking pride in requiring the information and performing the analysis needed to issue accurate credit ratings. A journalist captured the rating agency culture in a 1995 article when she wrote:
“Ask a [company’s] treasurer for his opinion of rating agencies, and he’ll probably rank them somewhere between a trip to the dentist and an IRS audit. You can’t control them, and you can’t escape them.”1055

But a number of analysts who worked for Moody’s during the 1990s and into the new

decade told the Subcommittee that a major cultural shift took place at the company around 2000.
They told the Subcommittee that, prior to 2000, Moody’s was academically oriented and conservative in its issuance of ratings. That changed, according to those interviewed, with the rise of Brian Clarkson who worked at Moody’s from 1990 to 2008, and rose from Group Managing Director of the Global Asset Backed Finance Group to President and Chief Operating Officer of Moody’s. These employees indicated that during Mr. Clarkson’s tenure Moody’s began to focus less on striving for accurate credit ratings, and more on increasing market share and “servicing the client,” who was identified as the investment banks that brought business to the firm.

This testimonial evidence that increasing revenues gained importance is corroborated by documents obtained by the Subcommittee during the course of its investigation. For example, in a March 2000 email, the head of Moody’s Structured Finance Group in Paris wrote that she was

1055 “Rating the Rating Agencies,” Treasury and Risk Management (7/1995).

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leaving the firm, because she was uncomfortable with “the lack of a strategy I can clearly understand, other than maximize the market share and the gross margin with insufficient resources.”1056 A 2002 Moody’s survey of the Structured Finance Group (SFG) also documents the shift, finding that most employees who responded to the survey indicated that SFG business objectives included: generating increased revenue; increasing market share; fostering good relationships with issuers and investors; and delivering high quality ratings and research.
According to the survey results: “When asked about how business objectives were translated into day-to-day work, most agreed that writing deals was paramount, while writing research and developing new products and services received less emphasis. Most agreed that there was a strong emphasis on relationships with issuers and investment bankers.”1057

A 2003 email sent by Mr. Clarkson to one of his senior managers about the performance

of the Structured Finance Real Estate and Derivatives Group further demonstrates the firm’s emphasis on market share. Mr. Clarkson wrote:

“Noel and his team handled the increase and met or exceeded almost every financial and market share objective and goal for his Group. … Through November total revenue for Noel’s Group has grown 16% compared with budgeted growth of 10% with CMBS [Commercial Mortgage Backed Securities] up 19% and Derivatives up 14%. This was achieved by taking advantage of increased CMBS issuance volumes and by meeting or slightly exceeding market share objectives for the Group. The Derivatives team has achieved a year to date 96% market share compared to a target share of 95%. This is down approximately 2% from 2002 primarily due to not rating Insurance TRUP CDO’s and rating less subordinated tranches. Noel’s team is considering whether we need to refine our approach to these securities. The CMBS team was able to meet their target share of 75%. However this was down from 84% market share in 2002 primarily due to competitor’s [sic] easing their standards to capture share.”1058

This performance analysis notes that the team being reviewed put up a strong performance despite competitors “easing their standards to capture [market] share.” It also notes that for certain CDOs and “less subordinated tranches,” Moody’s might “need to refine our approach.”
The clear emphasis of the analysis is increasing revenues and meeting “market share objectives,” and appears silent with regard to issuing accurate ratings.

One former Moody’s senior vice president, Mark Froeba, told the Subcommittee that Mr.

Clarkson used fear and intimidation tactics to make analysts spend less time on the ratings process and work more cooperatively with investment bankers.1059 At the Subcommittee hearing, another former Moody’s senior analyst, Richard Michalek, described a meeting that he

1056 3/19/2000 email from Catherine Gerst to Debra Perry, Moody’s Chief Administrative Officer, PSI-MOODYS- RFN-000039.
1057 5/2/2002 Moody’s SFG 2002 Associate Survey, prepared by Metrus Group, at 4, Hearing Exhibit 4/23-92a. 1058 12/1/2003 email from Brian Clarkson to Noel Kirnon, Managing Director of Real Estate and Derivatives Group, Hearing Exhibit 4/23-15. 1059 Subcommittee interview of Mark Froeba (10/27/2010). See also 6/2/2010 statement of Mark Froeba submitted by request to the Financial Crisis Inquiry Commission.

had with Mr. Clarkson shortly after he was promoted to head of the Structured Finance Group.
Mr. Michalek stated:

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“In my ‘discussion,’ I was told that he [Mr. Clarkson] had met with the investment banks to learn how our Group was working with the various clients and whether there were any analysts who were either particularly difficult or particularly valuable. I was named … as two of the more ‘difficult’ analysts who had a reputation for making ‘too many’ comments on the deal documentation.

The conversation was quite uncomfortable, and it didn’t improve when he described how he had previously had to fire [another analyst], a former leader of the Asset-Backed group who he otherwise considered a ‘good guy.’ He described how, because of the numerous complaints he had received about [that analyst’s] extreme conservatism, rigidity and insensitivity to client perspective, he was left with no choice. … He then asked me to convince him why he shouldn’t fire me. … [T]he primary message of the conversation was plain: further complaints from the ‘customers’ would very likely abruptly end my career at Moody’s.”1060

Several former Moody’s employees have testified that Moody’s employees were fired when they challenged senior management with a more conservative approach to rating RMBS and CDO securities. According to Mr. Froeba:

“[T]he fear was real, not rare and not at all healthy. You began to hear of analysts, even whole groups of analysts, at Moody’s who had lost their jobs because they were doing their jobs, identifying risks and describing them accurately.”1061

A former Managing Director, Eric Kolchinsky, one of the senior managers in charge of the business line which rated subprime backed CDOs at Moody’s stated:

“Managers of rating groups were expected by their supervisors and ultimately the Board of Directors of Moody’s to build, or at least maintain, market share. It was an unspoken understanding that loss of market share would cause a manager to lose his or her job.”1062

He described how market share concerns were addressed:

“Senior management would periodically distribute emails detailing their departments’ market share. These emails were limited to Managing Directors only. Even if the market share dropped by a few percentage points, managers would be expected to justify

1060 Prepared statement of Richard Michalek at 13-14, April 23, 2010 Subcommittee hearing. 1061 6/2/2010 statement of Mark Froeba, submitted by request to the Financial Crisis Inquiry Commission, at 4. 1062 Prepared Statement of Eric Kolchinsky, Former Managing Director at Moody’s Investor Service, April 23, 2010 Subcommittee Hearing, at 1.

‘missing’ the deals which were not rated. Colleagues have described enormous pressure from their superiors when their market share dipped.”1063

A Moody’s email sent in early October 2007 to Managing Directors of the CDO Group

illustrates the intense pressure placed on CDO analysts to retain or increase market share, even in the midst of the onset of the financial crisis.1064

This email reported that for CDOs:

“Market share by deal count [had] dropped to 94%, though by volume it’s 97%. It’s lower than the 98+% in prior quarters. Any reason for concern, are issuers being more selective to control costs (is Fitch cheaper?) or is it an aberration[?]”1065

This email was sent during the same period when Moody’s began downgrading CDOs on a daily basis, eventually downgrading almost 1,500 CDO securities with an original value likely in the tens of billions in the last three months of 2007 alone. Despite the internal recognition at Moody’s that previously rated CDOs were at substantial risk for downgrades, the email shows management pressing the CDO Managing Directors about losing a few points of market share in the middle of an accelerating ratings disaster.

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The drive for market share was similarly emphasized at S&P. One former S&P

Managing Director in charge of the RMBS Ratings Group described it as follows:

“By 2004 the structured finance department at S&P was a major source of revenue and profit for the parent company, McGraw-Hill. Focus was directed at collecting market share and revenue data on a monthly basis from the various structured finance rating groups and forwarded to the finance staff at S&P.”1066

Numerous internal emails illustrate not only S&P’s drive to maintain or increase market share, but also how that pressure negatively impacted the ratings process, placing revenue concerns ahead of ratings quality. For example, in a 2004 email, S&P management discussed the possibility of changing its CDO ratings criteria in response to an “ongoing threat of losing deals”:

“We are meeting with your group this week to discuss adjusting criteria for rating CDOs of real estate assets this week because of the ongoing threat of losing deals.”1067

1063 Id. at 2.
1064 10/5/2007 email from Sunil Surana to Yuri Yoshizawa, and others, “RE: 3Q Market Coverage-CDO,” Hearing Exhibit 4/23-24a. 1065 Id. 1066 Prepared statement of Frank Raiter, Former Managing Director at S&P, April 23, 2010 Subcommittee Hearing, at 5. 1067 8/17/2004 email from S&P manager, “RE: SF CIA: CDO methodology invokes reactions,” Hearing Exhibit 4/23-3 [emphasis in the original].

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On another occasion, in response to a 2005 email stating that S&P’s ratings model

A 2004 email chain among members of the S&P Analytical Policy Board, which set

needed to be adjusted to account for the higher risks associated with subprime loans, a director in RMBS research, Frank Parisi, wrote that S&P could have released a different ratings model, LEVELS 6.0, months ago “if we didn’t have to massage the sub-prime and Alt-A numbers to preserve market share.”1068 This same director wrote in an email a month later: “Screwing with criteria to ‘get the deal’ is putting the entire S&P franchise at risk – it’s a bad idea.”1069

standards to ensure integrity for the ratings process, provides additional evidence of how market share concerns affected the credit ratings process. In that chain of emails, a senior S&P manager, Gale Scott, openly expressed concern about how a criteria change could impact market share and cause S&P to lose business. Ms. Scott wrote: “I am trying to ascertain whether we can determine at this point if we will suffer any loss of business because of our decision and if so, how much? We should have an effective way of measuring the impact of our decision over time.”1070 business, she reiterated her concerns, noting, “I think the criteria process must include appropriate testing and feedback from the marketplace.”

After a colleague reassured her that he did not believe it would cause a loss of

On another occasion, an August 2006 email reveals the frustration that at least one S&P

employee in the Servicer Evaluation Group felt about the dependence of his employer on the issuers of structured finance products, going so far as to describe the rating agencies as having “a
kind of Stockholm syndrome” – the phenomenon in which a captive begins to identify with the captor:

“They’ve become so beholden to their top issuers for revenue they have all developed a kind of Stockholm syndrome which they mistakenly tag as Customer Value creation.”1071

In October 2007, Moody’s Chief Credit Officer explicitly raised concerns at the highest

levels of the firm that it was losing market share “[w]ith the loosening of the traditional duopoly” between Moody’s and S&P, noting that Fitch was becoming an “acceptable substitute.”1072 In a memorandum entitled, “Credit Policy issues at Moody’s suggested by the subprime/liquidity crisis,” the author set out to answer the question, “how do rating agencies compete?” 1073 The candid reflection noted that in an ideal situation “ratings quality” would be paramount, but the need to maintain, and even increase, market share, coupled with pressures exerted by the companies seeking credit ratings, were also affecting the quality of its ratings. Moody’s Chief Credit Officer wrote the following lament:

1068 3/23/2005 email from Frank Parisi to Thomas Warrack, and others, Hearing Exhibit 4/23-5. 1069 6/14/2005 email from Frank Parisi to Frank Bruzese, and others, Hearing Exhibit 4/23-6. 1070 11/9/2004 email from Gale Scott to Perry Inglis, Hearing Exhibit 4/23-4. 1071 8/8/2006 email from Michael Gutierrez to Richard Koch, “RE: Loss Severity vs gross/net proceeds,” Hearing Exhibit 4/23-14.
1072 10/21/2007 Moody’s internal email, Hearing Exhibit 4/23-24b. Although this email is addressed to and from the CEO, the Chief Credit Officer told the Subcommittee that he wrote the memorandum attached to the email.
Subcommittee interview of Andy Kimball (4/15/2010).
1073 Id.

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“Analysts and MDs [Managing Directors] are continually ‘pitched’ by bankers, issuers, investors – all with reasonable arguments – whose views can color credit judgment, sometimes improving it, other times degrading it (we ‘drink the kool-aid’). Coupled with strong internal emphasis on market share & margin focus, this does constitute a ‘risk’ to ratings quality.”1074

By the time his memorandum was written, both Moody’s and S&P were already issuing thousands of RMBS and CDO rating downgrades, admitting that their prior investment grade ratings had not accurately reflected the risk that these investments would fail.

(b) Investment Bank Pressure

At the same time Moody’s and S&P were pressuring their RMBS and CDO analysts to increase market share and revenues, the investment banks responsible for bringing RMBS and CDO business to the firms were pressuring those same analysts to ease rating standards. Former Moody’s and S&P analysts and managers interviewed by the Subcommittee described, for example, how investment bankers pressured them to get their deals done quickly, increase the size of the tranches that received AAA ratings, and reduce the credit enhancements protecting the AAA tranches from loss. They also pressed the CRA analysts and managers to ignore a host of factors that could be seen as increasing credit risk. Sometimes described as “ratings shopping,” the analysts described how some investment bankers threatened to take their business to another credit rating agency if they did not get the favorable treatment they wanted. The evidence collected by the Subcommittee indicates that the pressure exerted by investment banks frequently impacted the ratings process, enabling the banks to obtain more favorable treatment than they otherwise would have received.

email in which a UBS banker warned an S&P senior manager not to use a new, more conservative rating model for CDOs. He wrote:

The type of blatant pressure exerted by some investment bankers is captured in a 2006

“[H]eard you guys are revising your residential mbs [mortgage backed security] rating methodology - getting very punitive on silent seconds. [H]eard your ratings could be 5 notches back of [Moody’s] equivalent. [G]onna kill your resi[dential] biz. [M]ay force us to do moodyfitch only cdos!”1075

When asked by his colleague about the change in the model, an S&P senior manager, Thomas Warrack, noted that the new model “took a more conservative approach” that would result in “raising our credit support requirements going forward,” but Mr. Warrack was also quick to add:
“We certainly did [not] intend to do anything to bump us off a significant amount of deals.”1076

1074 Id. 1075 5/3/2006 email from Robert Morelli (UBS) to Peter Kambeseles (S&P), Hearing Exhibit 4/23-11. 1076 Id.

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In another instance in May 2007, an S&P analyst reported to her colleagues about

attempting to apply a default stress test to a CDO transaction proposed by Lehman Brothers. She wrote:

“[T]hey claim that their competitor investment banks are currently doing loads of deals that are static in the US and where no such stress is applied. … [W]e’d initially calculated some way of coming up with the stresses, by assuming the lowest rated assets default first …. [T]hey claim that once they have priced the whole thing, it is possible that the spreads would change …. We suggested that it was up to them to build up some cushion at the time they price, but they say this will always make their structures uneconomic and is basically unmanageable => I understand that to mean they would not take us on their deals.”1077

Her supervisor responded in part: “I would recommend we do something. Unless we have too many deals in US where this could hurt.”

their ratings profitable rather than just accurate, especially when their competitor employed lower rating standards:

On still another occasion in 2004, several S&P employees discussed the pressure to make

“We just lost a huge Mizuho RMBS deal to Moody’s due to a huge difference in the required credit support level. It’s a deal that six analysts worked through Golden Week so it especially hurts. What we found from the arranger was that our support level was at least 10% higher than Moody’s. … Losing one or even several deals due to criteria issues, but this is so significant that it could have an impact in the future deals. There’s no way we can get back on this one but we need to address this now in preparation for the future deals.”1078

Other emails illustrate the difficulty of upgrading the ratings models, because of the potential disruption to securitizations in the process of being rated. Some investment banks applied various types of pressure to maintain the status quo, despite the fact that the newer models were considered more accurate. In a February 2006 email to an S&P analyst, for example, an investment banker from Citigroup wrote:

“I am VERY concerned about this E3 [new CDO rating model]. If our current struc[ture], which we have been marketing to investors … doesn’t work under the new assumptions, this will not be good. Happy to comply, if we pass, but will ask for an exception if we fail.”1079

1077 5/23/2007 email from Claire Robert to Lapo Guadagnuolo, and others, Hearing Exhibit 4/23-31. 1078 5/25/2004 email from Yu-Tsung Chang to Joanne Rose and Pat Jordan, “Competition with Moody’s,” Hearing Exhibit 4/23-2. 1079 2/16/2006 email from Edward Tang (Citigroup) to Lina Kharnak (S&P), Hearing Exhibit 4/23-8.

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In another instance from May 2005, an investment banker from Nomura in the middle of

finalizing a securitization raised concerns that S&P was not only failing to provide the desired rating, but that a new model could make the situation worse. He wrote:

“My desire is to keep S&P on all of my deals. I would rather not drop S&P from the upcoming deal, particularly if it ends up being for only a single deal until the new model is in place. Can you please review the approval process on this deal?”1080

Initially hesitant, S&P analysts ultimately decided to recommend approval of the deal in line with the banker’s proposal.

example, a SunTrust Bank employee told Moody’s:

The same pressure was applied to Moody’s analysts. In an April 2007 email, for

“SunTrust is disconcerted by the dramatic increase in Moody’s loss coverage levels given initial indications. … Our entire team is extremely concerned. … Each of the other agencies reduced their initial levels, and the material divergence between Moody’s levels and the other agencies seems unreasonable and unwarranted given our superior collateral and minimal tail risk.”1081

On another occasion in March 2007, a Moody’s analyst emailed a colleague about

problems she was having with someone at Deutsche Bank after Moody’s suggested adjustments to the deal: “[The Deutsche Bank investment banker] is pushing back dearly saying that the deal has been marketed already and that we came back ‘too late’ with this discovery .… She claims it’s hard for them to change the structure at this point.”1082

Special Treatment. Documents obtained by the Subcommittee indicate that investment

bankers who complained about rating methodologies, criteria, or decisions were often able to obtain exceptions or other favorable treatment. In many instances, the decisions made by the credit rating agencies appeared to cross over from the healthy give and take involved in complex analysis to concessions made to prevent the loss of business. While the former facilitates efficient transactions, the second distorts the market and hurts investors.

In a February 2007 email directed to Moody’s, for example, a Chase investment banker complained that a transaction would receive a significantly lower rating than the same product was slated to receive from another rating agency: “There’s going to be a three notch difference when we print the deal if it goes out as is. I’m already having agita about the investor calls I’m going to get.” Upon conferring with a colleague, the Moody’s manager informed the banker that Moody’s was able to make some changes after all: “I spoke to Osmin earlier and confirmed that

1080 5/6/2005 email from Robert Gartner (Nomura) to Thomas Warrack (S&P), PSI-S&P-RFN-000024-28, at 28.
1081 4/12/2007 email from Patrick DellaValle (SunTrust) to David Teicher (Moody’s), and others, PSI-MOODYS- RFN-000032. 1082 3/8/2007 email from Karen Ramallo to Yakov Krayn, Hearing Exhibit 4/23-22.

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Jason is looking into some adjustments to his [Moody’s] methodology that should be a benefit to you folks.”1083

In another instance, a difference of opinion arose between Moody’s and UBS over how to rate a UBS transaction known as Lancer II. One senior Moody’s analyst wrote to her colleagues that, given the “time line for closing” the deal, they should side with the investment bank: “I agree that what the [Moody’s rating] committee was asking is reasonable, but given the other modeling related issues and the time line for closing, I propose we let them go with the CDS Cp criteria for this deal.”1084

S&P made similar concessions while rating three deals for Bear Stearns in 2006. An

analyst wrote:

“Bear Stearns is currently closing three deals this month which ha[ve] 40 year mortgages (negam) …. There was some discrepancy in that they were giving some more credit to recoveries than we would like to see. … [I]t was agreed that for the deals this month we were OK and they would address this issue for deals going forward.”1085

While the rating process involved some level of subjective discretion, these electronic communications make it clear that in many cases, close calls were made in favor of the customer.

An exception made one time often turned into further exceptions down the road. In August 2006, for example, an investment banker from Morgan Stanley tried to leverage past exceptions into a new one, couching his request in the context of prior deals:

“When you went from [model] 2.4 to 3.0, there was a period of time where you would rate on either model. I am asking for a similar ‘dual option’ window for a short period. I do not think this is unreasonable.”

A frustrated S&P manager resisted, saying: “You want this to be a commodity relationship and this is EXACTLY what you get.” But even in the midst of his defense, the same S&P manager reminded the banker how often he had granted exceptions in other transactions: “How many times have I accommodated you on tight deals? Neer, Hill, Yoo, Garzia, Nager, May, Miteva, Benson, Erdman all think I am helpful, no?”1086

1083 2/20/2007 email from Mark DiRienz (Moody’s) to Robert Miller (Chase), PSI-MOODYS-RFN-000031. See also 4/27/2006 email from Karen Ramallo to Wioletta Frankowicz and others, Hearing Exhibit 4/23-18 (“For previous synthetic deals this wasn’t as much of an issue since the ARM % wasn’t as high, and … at this point, I would feel comfortable keeping the previously committed levels since such a large adjustment would be hard to explain to Bear .… So unless anybody objects, Joe and I will tell Bear that the levels stand where they were previously.”). 1084 5/23/2007 email from Yvonne Fu to Arnaud Lasseron, PSI-MOODYS-RFN-000013. 1085 2/23/2006 email from Errol Arne to Martin Kennedy, and others, “Request for prioritization,” PSI-S&P-RFN-

1086 8/1/2006 email from Elwyn Wong (S&P) to Shawn Stoval (Morgan Stanley) and Belinda Ghetti (S&P), Hearing Exhibit 4/23-13.

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Some rating analysts who granted exceptions to firm policies, and then tried to limit those exceptions in future deals, found it difficult to do. In June 2007, for example, a Moody’s analyst agreed to an exception, while warning that no exceptions would be made in future transactions:

“This is an issue we feel strongly about and it is a published Moody’s criteria. We are making an exception for this deal only. … Going forward this has to be effective date level. I would urge you to let your colleagues know as well since we will not be in a position to give in on this issue in future deals.”1087

     A similar scenario played out at S&P.  A Goldman Sachs banker strongly objected to a  rating decision on a CDO called Abacus 2006-12:   

“I would add that this scenario is very different from an optional redemption as you point out below since the optional redemption is at Goldman’s option and a stated maturity is not. We therefore cannot settle for the most conservative alternative as I believe you are suggesting.”

The S&P director pushed back, saying that what Goldman wanted was “a significant departure from our current criteria,” but then suggested an exception could be made if it were limited to the CDO at hand and did not apply to future transactions:

“As you point out, it is a conservative position for S&P to take, but it is one we’ve taken with all Dealers. Since time is of the essence, this may be another issue that we table for 2006-12 [the CDO under consideration], but would have to be addressed in future trades.”1088

But a Moody’s analyst showed how difficult it was to allow an exception once and

demand different conduct in the future:

“I am worried that we are not able to give these complicated deals the attention they really deserve, and that they [Credit Suisse] are taking advantage of the ‘light’ review and the growing sense of ‘precedent’.

As for the precedential effects, we had indicated that some of the ‘fixes’ we agreed to in Qian’s deal were ‘for this deal only’…. When I asked Roland if they had given further thought to a more robust approach, he said (unsurprisingly) that they had no success and could we please accept the same [stopgap] measure for this deal.”1089

1087 6/28/2007 email from Pooja Bharwani (Moody’s) to Frank Li (Citigroup), and others, PSI-MOODYS-RFN-

1088 4/23/2006 email from Chris Meyer (S&P) to Geoffrey Williams and David Gerst (Goldman Sachs), and others, PSI-S&P-RFN-000002. See also 5/1/2006 email from Matthew Bieber (Goldman Sachs) to Malik Rashid (S&P), and others, PSI-S&P-RFN-000008-11, at 9 (“GS has not agreed to this hold back provision in any of our previous transactions (including the ABACUS deal that just closed last week) - and we cannot agree to it in this deal.”). 1089 5/1/2006 email from Richard Michalek to Yuri Yoshizawa, Hearing Exhibit 4/23-19; see also 5/23/2007 email from Eric Kolchinsky to Yuri Yoshizawa and Yvonne Fu, PSI-MOODYS-RFN-000011 (“In that case, should we

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Linking a Rating to a Fee. On at least one occasion, an investment bank seeking a

credit rating attempted to link the ratings it would receive with the amount of fees it would pay.
In June 2007, Merrill Lynch was seeking a rating from Moody’s for a CDO known as Belden Point.1090 Moody’s agreed to rate the CDO, but only for a higher than usual fee using a “complex CDO fee schedule.”1091 Merrill Lynch responded: “[N]o one here has ever heard or seen this fee structure applied for any deal in the past. Could you point us to a precedent deal where we have approved this?”1092

Moody’s replied:

“[W]e do not view this transaction as a standard CDO transaction and the rating process so far has already shown that the analysis for this deal is far more involved and will continue to be so. We have spent significant amount of resource[s] on this deal and it will be difficult for us to continue with this process if we do not have an agreement on the fee issue.”1093

The next day, Merrill Lynch wrote:

“We are okay with the revised fee schedule for this transaction. We are agreeing to this under the assumption that this will not be a precedent for any future deals and that you will work with us further on this transaction to try and get to some middle ground with respect to the ratings.”1094

Moody’s responded:

“We agree that this will not be a precedent for future deals by default and we will discuss with you on a case by case basis if [the] Complex CDO rating application should be applied to future deals. We will certainly continue working with you on this transaction, but analytical discussions/outcomes should be independent of any fee discussions.”1095

Vertical CDO. A transaction known as Vertical ABS CDO 2007-1 helps illustrate how

imbalanced the relationship between investment bankers and rating analysts became. In connection with that CDO, an investment banker from UBS failed to cooperate with S&P rating analysts requesting information to analyze the transaction.

On March 30, 2007, an S&P analyst wrote that UBS wanted to close the deal in ten days,

but was not providing the information S&P needed:

exclude any mention of the one notch rule from the general communication? Instead, we should give comm[ittee] chairs the discretion to apply the rule as they see fit. In this way, there is less of a chance of it getting back to the bankers as a ‘general rule’. They are more likely to know it as something that only applies, as a concession, on the deal that they are working on.”). 1090 See 6/11/2007 email exchange between Merrill Lynch and Moody’s, Hearing Exhibit 4/23-23. 1091 Id. 1092 Id.
1093 Id. 1094 Id. 1095 6/12/2007 email from Moody’s to Merrill Lynch, Hearing Exhibit 4/23-23 Addendum.

“Sarah and I have been working with James Yao from UBS but we have not been getting cooperation from him. He has told me that I am jeopardizing the deal. … This is the third time that he refuses to model the cashflow according to the Indenture and Criteria.”1096

A few days later, in an April 5, 2007 instant message, one S&P analyst wrote: “[W]hat happened? … [I] heard some fury.” His colleague responded that it was Mr. Yao, the UBS banker.1097

Later the same day, an S&P manager wrote that the three analysts:

“[w]ould like to give us a heads-up with respect to the lack of responsiveness/cooperation from UBS … on Vertical 2007-1. There seems to be a general lack of interest to work WITH us, incorporate our comments, or modeling to our criteria. Based on their collective difficult experience so far, our analysts estimate a smooth closing is unlikely.
(The behavior is not limited to this deal either.)” 1098

“Vertical is politically closely tied to B of A – and is mostly a marketing shop – helping to take risk off books of B o A. Don’t see why we have to tolerate lack of cooperation.
Deals likely not to perform.”1099

An S&P senior director responded:

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Despite the uncooperative investment banker and prediction that the CDO was unlikely to perform, S&P analysts continued to work hard on the rating. One of the analysts sent an email to her colleagues describing their efforts to get the CDO to pass tests for issuing investment grade ratings:

“Just wanted to let you know that this deal is closing and going Effective next Tuesday, but our rated Equity tranche (BBB) is failing in our cashflow modeling.

“Sarah tried a lot of ways to have the model passed. Unfortunately we are still failing by 1bp [basis point], without any stress runs and without modeling certain fees (anticipated to be minimal).

“In addition, we already incorporated the actual ramped up portfolio, and not a hypothetical one, for this exercise.”1100

After another day of work, the analyst reported she had found a “mistake” that, when

corrected, would allow Vertical to get the desired investment grade credit ratings:

1096 3/30/2007 email from Lois Cheng, “Vertical ABS CDO 2007-1, Ltd. UBS,” Hearing Exhibit 4/23-94c. 1097 4/5/2007 instant message exchange between Brian Trant and Shannon Mooney, Hearing Exhibit 4/23-94a. 1098 4/5/2007 email from Bujiang Hu to Peter Kambeseles, and others, Hearing Exhibit 4/23-94b [emphasis in the original].
1099 4/5/2007 email from James Halprin to Bujiang Hu and others, Hearing Exhibit 4/23-94b. 1100 4/5/2007 email from Lois Cheng to Brian O’Keefe and Peter Kambeseles, and others, Hearing Exhibit 4/23-94c.

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“Just wanted to update you guys on Vertical. The model is passing now. We found a mistake in the waterfall modeling that was more punitive than necessary. James Yao [the UBS investment banker] has been notified and is probably having a chuckle at our expense. I still feel that his attitude toward our rating process and our team still needs to be addressed in some way.”1101

These emails show S&P analysts expending great effort to provide favorable ratings to the UBS CDO, despite concerns about its creditworthiness.1102

On April 10, 2007, just three months before the July 2007 mass downgrades of subprime RMBS, S&P issued ratings for the Vertical securitization. All but one of the nine tranches were given investment grade ratings, with the top three receiving AAA. Moody’s issued similar ratings.1103

Four months later in August 2007, all but the top three tranches were put on credit

watch.1104 Two months after that, in October, Moody’s downgraded all but one of the Vertical securities to junk status.1105 In 2008, the CDO was liquidated.1106 The chart below shows how the various tranches were originally rated by S&P, only to be downgraded to a D – the rating given to securities in default.

1101 4/6/2007 email from Lois Cheng to Brian O’Keefe and Peter Kambeseles, and others, Hearing Exhibit 4/23-94c. 1102 For a similar situation involving an RMBS, see 2/8/2006 email exchange among S&P analysts, “EMC Compares,” PSI-SP-000362, Hearing Exhibit 4/23-7 (describing how an analyst worked to find a way to reduce the size of the cushion that an RMBS had to set aside to protect its investment grade tranches from loss, and found that changing the way first loan payment dates were reported in LEVELS would produce a slight reduction; a colleague responded: “I don’t think this is enough to satisfy them. What’s the next step?”). 1103 4/2007 Moody’s internal memorandum from Saiyid Islam and Peter Hallenbeck to the Derivatives Rating Committee, Hearing Exhibit 4/23-94d. Moody’s gave investment grade ratings to seven of the eight tranches it rated, including AAA ratings to the top three tranches. 1104 Moody’s downgrade of Vertical ABS CDO 2007-1, Hearing Exhibit 4/23-94k. 1105 Id.; 10/25/2007 “Moody’s Downgrades Vertical ABS CDO 2007-1 Notes; Further Downgrades Possible,” Moody’s; 1/14/2008 and 6/23/2008 “Moody’s downgrades ratings of Notes issued by Vertical ABS CDO 2007-1, Ltd.,” Moody’s; 9/11/2008 “Moody’s withdraws ratings of Notes issued by 34 ABS CDOs,” Moody’s. Moody’s downgraded all but the super senior Vertical tranche to junk status in October 2007, just six months after giving investment grade ratings to seven of the eight tranches it rated. See 10/24/2007 email from Jonathan Polansky to Moody’s colleagues, Hearing Exhibit 4/23-94f. S&P followed suit on November 14, 2007, downgrading all but two of Vertical’s tranches, with five falling to junk status. 11/14/2007 “112 Ratings Lowered on 21 U.S. Cash Flow, Hybrid CDOs of ABS; $4.689B In Securities Affected,” S&P. 1106 9/11/2008 “Moody’s Withdraws Ratings of Notes Issued by 34 ABS CDOs,” Moody’s.

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One of the purchasers of Vertical securities, a hedge fund called Pursuit Partners, sued UBS, S&P, and Moody’s over the quick default. Both credit rating agencies filed successful motions to be dismissed from the lawsuit, but the court ordered UBS to set aside $35 million for a possible award to the investor. The investor had found internal UBS emails calling the investment grade Vertical securities “crap.”1107

Barring Analysts. Rating analysts who insisted on obtaining detailed information about transactions sometimes became unpopular with investment bankers who pressured the analysts’ directors to have them barred from rating their deals. One Moody’s analyst, Richard Michalek, testified before the Subcommittee that he was prohibited from working on RMBS transactions for several banks because he scrutinized deals too closely. He stated:

“During my tenure at Moody’s, I was explicitly told that I was ‘not welcome’ on deals structured by certain banks. … I was told by my then-current managing director in 2001 that I was ‘asked to be replaced’ on future deals by … CSFB [Credit Suisse First Boston], and then at Merrill Lynch. Years later, I was told by a different managing director that a CDO team leader at Goldman Sachs also asked, while praising the thoroughness of my work, that after four transactions he would prefer another lawyer be given an opportunity to work on his deals.”1108

At the Subcommittee’s April 23 hearing, Yuri Yoshizawa, the Senior Managing Director

This analyst’s claim was corroborated by the Moody’s Managing Director who was his superior at the time.1109

of Moody’s Derivatives Group testified that the relationship between CDO analysts and investment banks “could get very contentious and very abusive.”1110 She testified that she did get complaints from investment banks who wanted analysts removed from conducting their ratings, because they were unhappy with those analysts. She testified that “[t]here was always pressure from banks, including [removing analysts from transactions].”1111 She stated that she did, in fact, remove analysts from rating certain banks’ transactions, but claimed she did so to protect the analysts from abuse rather than to appease the complaining bank.1112 When asked whether she ever protected her analysts by instead banning the abusive bank employee from Moody’s interactions, she could not recall taking that action.

1107 8/28/2007 email from Evan Malik (UBS) to Hugh Corcoran (UBS) regarding Pursuit Partners’ purchase of Vertical securities, Hearing Exhibit 4/23-94n. 1108 Prepared statement of Richard Michalek at 16, April 23, 2010 Subcommittee hearing.
1109 Prepared statement of Gary Witt, Former Managing Director, Moody’s Investors Service, submitted by request to the Financial Crisis Inquiry Commission (6/2/2010) at 6-7. 1110 April 23, 2010 Subcommittee Hearing at 64. Employees from both Moody’s and S&P confirmed this abusive conduct in interviews with the Subcommittee, which was also corroborated in emails. Subcommittee interviews of Richard Michalek (1/18/2010) and Eric Kolchinsky (10/7/2009). See also, e.g., 4/6/2007 email from Lois Cheng to Brian O’Keefe and Peter Kambeseles, and others, Hearing Exhibit 4/23-94c.
1111 April 23, 2010 Subcommittee Hearing at 65. 1112 Id. at 64, 66.

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Ratings Shopping. It is not surprising that credit rating agencies at times gave into

pressure from the investment banks and accorded them undue influence in the ratings process.
The rating companies were directly dependent upon investment bankers to bring them business and were vulnerable to threats that the investment bankers would take their business elsewhere if they did not get the ratings they wanted. Moody’s Chief Credit Officer told the Subcommittee staff that ratings shopping, the practice in which investment banks chose the credit rating agency offering the highest rating for a proposed transaction, was commonplace prior to 2008.1113

Ratings shopping inevitably weakens standards as each credit rating agency seeks to

provide the most favorable rating to win business. It is a conflict of interest problem that results in a race to the bottom – with every credit rating agency competing to produce credit ratings to please its paying clients. Moody’s CEO described the problem this way: “What happened in ’04 and ’05 with respect to subordinated tranches is that our competition, Fitch and S&P, went nuts.
Everything was investment grade. It didn’t really matter.”1114

All of the witnesses who were questioned about ratings shopping during the

Subcommittee’s hearing confirmed its existence:

Senator Levin: Ms. Yoshizawa [Senior Managing Director, Moody’s Derivatives Group], we were advised by Moody’s Chief Credit Officer that it was common knowledge that ratings shopping occurred in structured finance. In other words, investment bankers sought ratings from credit rating agencies who would give them their highest ratings. Would you agree with that?

Ms. Yoshizawa: I agree that credit shopping does exist, yes.

Senator Levin: Ms. Barnes [Managing Director, S&P RMBS Group], would you agree that the same thing existed in your area?

Ms. Barnes: Yes, Mr. Chairman.1115

Moody’s CEO, Ray McDaniel echoed this concern during the hearing:

Senator Levin: There are a lot of interesting things there that your Chief Credit Officer, Mr. Kimball, wrote in October of 2007 …. One of the things he wrote, and this is under market share, he says in paragraph five, ‘Ideally, competition would be primarily on the basis of ratings quality’ – that is ideally – ‘with a second component of price and a third

1113 Subcommittee interview of Andy Kimball (4/15/2010). See also 2007 Moody’s draft “2007 Operating Plan: Public Finance, Global Structured Finance and Investor Services,” prepared by Brian Clarkson, MIS-OCIE-RMBS- 0419014-53, at 25. In a draft presentation Clarkson wrote: “Challenges for 2007 … Competitive issues (ex. Rating inflation, successful rating shopping ….).” He also noted in the presentation “increased ‘rating shopping’ by market participants.”
1114 9/10/2007 Transcript of Raymond McDaniel at Moody’s MD Town Hall Meeting, at 63, Hearing Exhibit 4/23-

1115 April 23, 2010 Subcommittee Hearing at 66-67.

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component of service. Unfortunately, of the three competitive factors, rating quality is proving the least powerful.’ … ‘It turns out that ratings quality has surprisingly few friends; issuers want high ratings; investors don’t want rating downgrades; short-sighted bankers labor short-sightedly to game the rating agencies for a few extra basis points on execution.’ Would you agree with that?

Mr. McDaniel: In this section, he is talking about the issue of rating shopping, and I agree that that existed then and exists now.1116

(3) Inaccurate Models

        The conflict of interest problem was not the only reason that Moody’s and S&P issued  inaccurate RMBS and CDO credit ratings.  Another problem was that the credit rating models  they used were flawed.  Over time, from 2004 to 2006, S&P and Moody’s revised their rating  models, but never enough to produce accurate forecasts of the coming wave of mortgage  delinquencies and defaults.  Key problems included inadequate performance data for the higher  risk mortgages flooding the mortgage markets and inadequate correlation factors.   

In addition, the companies failed to provide their ratings personnel with clear, consistent,

and comprehensive criteria to evaluate complex structured finance deals. The absence of effective criteria was particularly problematic, because the ratings models did not conclusively determine the ratings for particular transactions. Instead, modeling results could be altered by the subjective judgment of analysts and their supervisors. This subjective factor, while unavoidable due to the complexity and novelty of the transactions being rated, rendered the process vulnerable to improper influence and inflated ratings.

(a) Inadequate Data

CRA analysts relied on their firm’s quantitative rating models to calculate the probable default and loss rates for particular pools of assets. These models were handicapped, however, by a lack of relevant performance data for the high risk residential mortgages supporting most RMBS and CDO securities, by a lack of mortgage performance data in an era of stagnating or declining housing prices, by the credit rating agencies’ unwillingness to devote sufficient resources to update their models, and by the failure of the models to incorporate accurate correlation assumptions predicting how defaulting mortgages might affect other mortgages.

Lack of High Risk Mortgage Performance Data. The CRA models failed, in part,

because they relied on historical data to predict how RMBS securities would behave, and the models did not use adequate performance data in the development of criteria to rate subprime and other high risk mortgages that proliferated in the housing market in the years leading up to the financial crisis. From 2004 through 2007, many RMBS and CDO securities were comprised of residential mortgages that were not like those that had been modeled in the past. As one S&P email observed:

1116 April 23, 2010 Subcommittee Hearing at 100-101.

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“[T]he assumptions and the historical data used [in the models] … never included the performance of these types of residential mortgage loans .… The data was gathered and computed during a time when loans with over 100% LTV or no stated income were rare.”1117

In contrast to decades of actual performance data for 30-year mortgages with fixed interest rates, the new subprime, high risk products had little to no track record to predict their rates of default.
In fact, Moody’s RMBS rating model was not even used to rate subprime mortgages until December 2006; prior to that time, Moody’s used a system of “benchmarking” in which it rated a subprime mortgage pool by comparing it to other subprime pools Moody’s had already rated.1118

Lack of Data During Era of Stagnant or Falling Home Prices. In addition, the models operated with subprime data for mortgages that had not been exposed to stagnant or falling housing prices. As one February 2007 presentation from a Deutsche Bank investment banker explained, the models used to calculate “subprime mortgage lending criteria and bond subordination levels are based largely on performance experience that was mostly accumulated since the mid-1990s, when the nation’s housing market has been booming.”1119 A former managing director in Moody’s Structured Finance Group put it this way: “[I]t was ‘like observing 100 years of weather in Antarctica to forecast the weather in Hawaii.”1120 In September 2007, after the crisis had begun, an S&P executive testified before Congress that:

“[W]e are fully aware that, for all our reliance on our analysis of historically rooted data that sometimes went as far back as the Great Depression, some of that data has proved no longer to be as useful or reliable as it has historically been.”1121

The absence of relevant data for use in RMBS modeling left the credit rating agencies

unable to accurately predict mortgage default and loss rates when housing prices stopped climbing. The absence of relevant performance data for high risk mortgage products in an era of stagnant or declining housing prices impacted the rating of not only RMBS transactions, but also CDOs, which typically included RMBS securities and relied heavily on RMBS credit ratings.

Lack of Investment. One reason that Moody’s and S&P lacked relevant loan

performance data for their RMBS models was not simply that the data was difficult to obtain, but

1117 9/30/2007 email from Belinda Ghetti to David Tesher, and others, Hearing Exhibit 4/23-33. 1118 See 2008 SEC Examination Report for Moody’s Investor Services Inc., PSI-SEC (Moodys Exam Report)-14- 0001-16, at 3. 1119 2/2007 “Shorting Home Equity Mezzanine Tranches,” Deutsche Bank Securities Inc., DBSI_PSI_EMAIL01988773-845, at 776. See also 6/4/2007 FDIC memorandum from Daniel Nuxoll to Stephen Funaro, “ALLL Modeling at Washington Mutual,” FDIC_WAMU_000003743-52, at 47 (“Virtually none of the data is drawn from an episode of severe house price depreciation. Even introductory statistics textbooks caution against drawing conclusions about possibilities that are outside the data. A model based on data from a relatively benign period in the housing market cannot produce reliable inferences about the effects of a housing price collapse.”). 1120 “Triple-A Failure,” New York Times (4/27/2008). 1121 Prepared statement of Vickie Tillman, S&P Executive Vice President, “The Role of Credit Rating Agencies in the Structured Finance Market,” before U.S. House of Representatives Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises, Cong.Hrg. 110-62 (9/27/2007), S&P SEN-PSI 0001945-71, at 46-47.

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that both companies were reluctant to devote the resources needed to improve their modeling, despite soaring revenues.

Moody’s senior managers even expressed skepticism about whether new loan data was needed and, in fact, generally did not purchase new loan data for a four-year period, from 2002 to 2006.1122 In a 2000 internal email exchange, the head of Moody’s Structured Finance Group at the time, Brian Clarkson, wrote the following regarding the purchasing of data for Moody’s RMBS model:

“I have a wild thought also – let[’]s not even consider BUYING anymore data, programs, software or companies until we figure out what we have and what we intend to do with what we have. From what I have heard and read so far we have approaches (MBS, Tranching and Spread) few use or understand (let alone being able to explain it to the outside) and new data that we are unable to use. We want more data when most of the time we rate MBS deals using arbitrary rule of thumb?!! …

“I suggest we spend less time asking for more data and software (I have not seen anything that sets forth the gains in revenue from such spending – it is easy to ask for $$ – much harder to justify it against competing projects) and more time figuring out how to utilize what we have by way of good analysis, a solid approach to this market a proper staffing model.”1123

In response to Brian Clarkson’s email, a managing director wrote:

“As you know, I don’t think we need to spend a lot of $ or resources to improve the model from an analytic perspective; but I’d need to defer to people more in the loop (looks like you’re that person) on whether the marketing component mandates some announcement of model and data improvement. …

Make sure you talk to Noel and maybe Fons about the decision to buy the data; I was invited to the original meeting so that the powers that be (at the time) could understand the data originally used. I felt that the arguments for buying the data and re-inventing the model were not persuasive .… The most convincing argument for buying the data was that it would be a cornerstone for marketing, that S&P touted the size of their database as a competitive advantage and that this was why they had the market share advantage.”1124

Moody’s advised the Subcommittee that, in fact, it generally did not obtain any new loan

data for its RMBS model development for four years, from 2002 until 2006, although it continued to improve its RMBS model in other ways.1125

In 2005, a Moody’s employee survey

1122 2/24/2011 Response from Moody’s to Subcommittee questions. The Subcommittee asked Moody’s to provide information on any new data it had received or purchased for its models from 2002 to 2007.
1123 11/3/2000 email from Brian Clarkson to David Zhai and others, PSI-MOODYS-RFN-000007.
1124 11/13/2000 email from Jay Siegel to Brian Clarkson, PSI-MOODYS-RFN-000007.
1125 2/17/2011 and 2/24/2011 Responses from Moody’s to Subcommittee questions.

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found that the company’s employees felt that Moody’s should have been spending more resources on improving its models.1126 In 2006, Moody’s obtained new loan level data for use in its new subprime model, M3 Subprime.1127

In contrast to Moody’s, S&P did purchase new loan data on several occasions from 2002 to 2006, but told the Subcommittee that this data did not provide meaningful results that could be used in its RMBS model prior to 2006.1128 In 2002, for example, S&P said that it purchased data on approximately 640,000 loans, including ARM and hybrid loans. S&P told the Subcommittee that it developed an equation from that data set which predicted a lower default rate for ARM and hybrid loans than for fixed rate loans. S&P considered this counter-intuitive and chose not to incorporate it into its model.1129 In 2005, S&P purchased data on another 2.9 million loans that included first and second liens for prime, subprime, Alt A, high LTV, and home equity loans.1130 S&P claimed that it made “concerted efforts to analyze” this data, “both by employing external consultants and dedicating resources within Standard & Poor’s to analyze the data for criteria development.”1131

Contrary to S&P’s claim, the former head of the S&P RMBS Ratings Group, Frank

Raiter, who worked at S&P until 2005, told the Subcommittee that management did not provide him with sufficient resources to analyze the data and develop improved criteria for the RMBS model.1132 Mr. Raiter told the Subcommittee that he personally informed S&P’s senior management about the need to update S&P’s model with better loan data several years before the crisis.1133 Mr. Raiter also testified that the “analysts at S&P had developed better methods for determining default which did capture some of the variations among products that were to become evident at the advent of the crisis,”1134 but those methods were not incorporated into the RMBS model before he left in 2005. Mr. Raiter said that “[i]t is my opinion that had these models been implemented we would have had an earlier warning about the performance of many of the new products that subsequently lead [sic] to such substantial losses.”1135

1126 4/7/2006 “Moody’s Investor Service, BES-2005: Presentation to Derivatives Team,” Hearing Exhibit 4/23-92b. 1127 2/24/2011 Response from Moody’s to Subcommittee questions. Moody’s also advised the Subcommittee that it “generally receives, as part of the surveillance process, updated loan performance statistics on a monthly basis for the collateral pools of the transactions it has rated.” Moody’s told the Subcommittee that its surveillance data tracked the deterioration in the RMBS market, and its rating committee members were able to incorporate that information into their rating considerations. 2/17/2011 Response from Moody’s to Subcommittee questions.
1128 2/10/2011 Response from S&P to Subcommittee questions. 1129 Id. 1130 Id. 1131 Id. S&P also told the Subcommittee that, between 2001 and 2008, it updated its RMBS model multiple times, using other types of data and analytical improvements. 2/2010 Standard & Poor’s Presentation on LEVELS, PSI- Standard&Poor’s-04-0001–0025, at 6. 1132 Subcommittee interviews of Frank Raiter (7/15/2009 and 4/8/2010). 1133 Id. See also prepared statement of Frank Raiter, “Credit Rating Agencies and the Financial Crisis,” before the U.S. House of Representatives Committee on Oversight and Government Reform, Cong.Hrg. 110-155 (10/22/2008), at 5. 1134 Prepared statement of Frank Raiter, “Credit Rating Agencies and the Financial Crisis,” before the U.S. House of Representatives Committee on Oversight and Government Reform, Cong.Hrg. 110-155 (10/22/2008), at 5-6. 1135 Id.

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According to Mr. Raiter, even though S&P revenues had increased dramatically and were

generated in large part by the RMBS Group, senior management had no interest in committing the resources needed to update the RMBS model with improved criteria from the new loan data.
Mr. Raiter said that S&P did not spend sufficient money on better analytics, because S&P already dominated the RMBS ratings market: “[T]he RMBS group enjoyed the largest ratings market share among the three major rating agencies (often 92% or better), and improving the model would not add to S&P’s revenues.”1136

Poor Correlation Risk Assumptions. In addition to using inadequate loan performance data, the S&P and Moody’s credit rating models also incorporated inadequate assumptions about the correlative risk of mortgage backed securities. Correlative risk measures the likelihood of multiple negative events happening simultaneously, such as the likelihood of RMBS assets defaulting together. It examines the likelihood, for example, that two houses in the same neighborhood will default together compared to two houses in different states. If the neighborhood houses are more likely to default together, they would have a higher correlation risk than the houses in different states.

The former head of S&P’s Global CDO Group, Richard Gugliada, told the Subcommittee

that the inaccurate RMBS and CDO ratings issued by his company were due, in part, to wrong assumptions in the S&P models about correlative risk.1137 Mr. Gugliada explained that, because CDOs held fewer assets than RMBS, statistical analysis was less helpful, and the modeling instead required use of significant performance assumptions, including on correlative risk. He explained that the primary S&P CDO model, the “CDO Evaluator,” ran 100,000 simulations to determine how a pool would perform. These simulations ran on a set of assumptions that took the place of historical performance data, according to Mr. Gugliada, and included assumptions on the probability of default and the correlation between assets if one or more assets began to default. He said that S&P believed that RMBS assets were more likely to default together than, for example, corporate bonds held in a CDO. He said that S&P had set the probability of corporate correlated defaults at 30 out of 100, and set the probability of RMBS correlated defaults at 40 out of 100. He said that the financial crisis has now shown that the RMBS correlative assumptions were far too low and should have been set closer to 80 or 90 out of 100.1138

On one occasion in 2006, an outside party also highlighted a problem with the S&P model’s consideration of correlative risk. On March 20, 2006, a senior managing director at Aladdin Capital Management, LLC sent an email to S&P expressing concern about a later version of its CDO model, Evaluator 3:

“Thanks for a terrific presentation at the UBS conference. I mentioned to you a possible error in the new Evaluator 3.0 assumptions:

1136 Id. at 6.
1137 Subcommittee interview of Richard Gugliada, Former Head of S&P’s CDO Ratings Group (10/9/2009). 1138 Id.

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Two companies in the same Region belonging to two different local Sectors are assumed to be correlated (by 5%), while if they belong to the same local Sector then they are uncorrelated.

I think you probably didn’t mean that.”1139

Apparently, this problem with the model had already been identified within S&P. Two S&P employees discussed the problem on the same email, with one saying:

“I have already brought this issue up and it was decided that it would be changed in the future, the next time we update the criteria. … [T]he correlation matrix is inconsistent.”

Despite this clear problem resulting in the understatement of correlative risk for assets in the same region, S&P in this instance did not immediately take the steps needed to repair its CDO model.

At Moody’s, a former Managing Director of the CDO Group, Gary Witt, observed a

different set of correlation problems with Moody’s CDO model. Mr. Witt, who was responsible for managing Moody’s CDO analysts as well as its CDO modeling, told the Subcommittee that he had become uncomfortable with the lack of correlation built into the company’s methodology.1140 Expansion Technique (BET),” addressed correlation by having a diversity score at a time when CDOs had diverse assets such as credit cards or aircraft lease revenues, in addition to RMBS securities. By 2004, however, Mr. Witt said that most CDOs contained primarily RMBS assets, lacked diversity, and made little use of the diversity score.

According to Mr. Witt, Moody’s model, which then used the “Binomial

Mr. Witt told the Subcommittee that, from 2004 to 2005, he worked on modifying the

BET model to improve its consideration of correlation factors. According to Mr. Witt, modeling changes like the one he worked on had to be done on an employee’s own time – late nights and weekends – because there was no time during the work week due to the volume of deals. Indeed, during his eighteen month tenure as a Managing Director in the CDO Group, Mr. Witt “spent a huge amount of time working on methodology because the ABS CDO market especially was in transition from multi-sector to single sector transactions [RMBS]” which he felt necessitated an update of Moody’s model.1141 Mr. Witt indicated that, in June 2005, Moody’s CDO model was changed to incorporate part of his suggested improvements, but did not go as far as he had proposed. When asked about this 2005 decision, Mr. Witt indicated that he did not feel that Moody’s was getting the ratings wrong for CDOs with RMBS assets, but he did “think that we [Moody’s] were not allocating nearly enough resources to get the ratings right.”1142

1139 3/20/2006 email from Isaac Efrat (Aladdin Capital Management LLC) to David Tesher (S&P), Hearing Exhibit 4/23-26 [emphasis in original]. 1140 Subcommittee interview of Gary Witt, Former Managing Director, Moody’s Investors Service (10/29/2009).
1141 6/2/2010 Statement of Gary Witt, Former Managing Director, Moody’s Investors Service, submitted by request to the Financial Crisis Inquiry Commission, at 11.
1142 Id. at 21.

The lack of performance data for high risk residential mortgage products, the lack of mortgage performance data in an era of stagnating or declining housing prices, the failure to expend resources to improve their model analytics, and incorrect correlation assumptions meant that the RMBS and CDO models used by Moody’s and S&P were out of date, technically deficient, and could not provide accurate default and loss predictions to support the credit ratings being issued. Yet Moody’s and S&P analysts told the Subcommittee that their analysts relied heavily on their model outputs to project the default and loss rates for RMBS and CDO pools and rate RMBS and CDO securities.

(b) Unclear and Subjective Ratings Process Obtaining expected default and loss analysis from the Moody’s and S&P credit rating

models was only one aspect of the work performed by RMBS and CDO analysts. Equally important was their effort to analyze a proposed transaction’s legal structure, cash flow, allocation of revenues, the size and nature of its tranches, and its credit enhancements.
Analyzing each of these elements involved often complex judgments about how a transaction would work and what impact various factors would have on credit risk. Although both Moody’s and S&P published a number of criteria, methodologies, and guidance on how to handle a variety of credit risk factors, the novelty and complexity of the RMBS and CDO transactions, the volume and speed of the ratings process, and inconsistent applications of the various rules, meant that CRA analysts were continuously faced with issues that were difficult to resolve about how to analyze a transaction and apply the company’s standards. Evidence obtained by the Subcommittee indicates that, at times, ratings personnel acted with limited guidance, unclear criteria, and a limited understanding of the complex deals they were asked to rate.

Many documents obtained by the Subcommittee disclosed confusion and a high level of

frustration from RMBS and CDO analysts about how to handle ratings issues and how the ratings process actually worked. In May 2007, for example, one S&P employee wrote: “[N]o body gives a straight answer about anything around here …. [H]ow about we come out with new [criteria] or a new stress and ac[tu]ally have clear cut parameters on what the hell we are supposed to do.”1143 decision wrote:

Two years earlier, in May 2005, an S&P analyst complaining about a rating

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“Chui told me that while the three of us voted ‘no’, in writing, that there were 4 other ‘yes’ votes. … [T]his is a great example of how the criteria process is NOT supposed to work. Being out-voted is one thing (and a good thing, in my view), but being out-voted by mystery voters with no ‘logic trail’ to refer to is another. … Again, this is exactly the kind of backroom decision-making that leads to inconsistent criteria, confused analysts, and pissed-off clients.”1144

1143 5/8/2007 instant message exchange between Shannon Mooney and Andrew Loken, Hearing Exhibit 4/23-30b. 1144 5/12/2005 email from Michael Drexler to Kenneth Cheng and others, Hearing Exhibit 4/23-10c. In a similar email, S&P employees discuss questionable and inconsistent application of criteria. 8/7/2007 email from Andrew Loken to Shannon Mooney, Hearing Exhibit 4/23-96a (“Back in May, the deal had 2 assets default, which caused it to fail. We tried some things, and it never passed anything I ran. Next thing I know, I’m told that because it had

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When asked by the SEC to compile a list of its rating criteria in 2007, S&P was unable to

identify all of its criteria for making rating decisions. The head of criteria for the structured finance department, for example, who was tasked with gathering information for the SEC, wrote in an email to colleagues:

“[O]ur published criteria as it currently stands is a bit too unwieldy and all over the map in terms of being current or comprehensive. … [O]ur SF [Structured Finance] rating approach is inherently flexible and subjective, while much of our written criteria is detailed and prescriptive. Doing a complete inventory of our criteria and documenting all of the areas where it is out of date or inaccurate would appear to be a huge job ….”1145

The confused and subjective state of S&P criteria, including when the criteria had to be

applied, is also evident in a May 2007 email sent by an S&P senior director to colleagues discussing whether to apply a default stress test to certain CDOs:

“[T]he cash-flow criteria from 2004 (see below), actually states [using a default stress test when additional concerns about the CDO are raised] … in the usual vague S&P’s way …. Still, consistency is key for me and if we decide we do not need that, fine but I would recommend we do something. Unless we have too many deals in [the] US where this could hurt.”1146

Moody’s ratings criteria were equally subjective, changeable, and inconsistent. In an

October 2007 internal email, for example, Moody’s Chief Risk Officer wrote:

“Methodologies & criteria are published and thus put boundaries on rating committee discretion. (However, there is usually plenty of latitude within those boundaries to register market influence.)”1147

Another factor was that ratings analysts were also under constant pressure to quickly

analyze and rate complex RMBS and CDO transactions. To enable RMBS or CDO transactions to meet projected closing dates, it was not uncommon, as shown above, for CRA analysts to grant exceptions to established methodologies and criteria, put off analysis of complex issues to later transactions, and create precedents that investment banks invoked in subsequent

gone effective already, it was surveillance’s responsibility, and I never heard about it again. Anyway, because of that, I never created a new monitor.”).
1145 3/14/2007 email from Calvin Wong to Tom Gillis, Hearing Exhibit 4/23-29. See also 2008 SEC Examination Report for Standard and Poor’s Ratings Services, Inc., PSI-SEC (S&P Exam Report)-14-0001-24, at 6-7 (“[C]ertain significant aspects of the rating processes and the methodologies used to rate RMBS and CDOs were not always disclosed, or were not fully disclosed …. [S]everal communications by S&P employees to outside parties related to the application of unpublished criteria, such as ‘not all our criteria is published. [F]or example, we have no published criteria on hybrid deals, which doesn’t mean that we have no criteria,’” citing an 8/2006 email from the S&P Director of the Analytical Pool for the Global CDO Group.). 1146 5/24/2007 email from Lapo Guadagnuolo to Belinda Ghetti, and others, Hearing Exhibit 4/23-31. 1147 10/21/2007 Moody’s internal email, Hearing Exhibit 4/23-24b. Although this email is addressed to and from the CEO, the Chief Credit Officer told the Subcommittee that he wrote the memorandum attached to the email.
Subcommittee interview of Andy Kimball (4/15/2010).

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securitizations. CRA analysts were then compelled to decide whether to follow an earlier exception, revert to the published methodology and criteria, or devise still another compromise.
The result was additional confusion over how to rate complex RMBS and CDO securities.

Publication of the CRAs’ ratings methodologies and criteria was also inconsistent.
According to an October 2006 email sent by an investment banker at Morgan Stanley to an analyst at Moody’s, for example, key methodology changes had not been made public: “Our problem here is that nobody has told us about the changes that we are later expected to adhere to.
Since there is no published criteria outlining the change in methodology how are we supposed to find out about it?”1148 On another occasion, a Moody’s analyst sought guidance from senior managers because of the lack of consistency in applying certain criteria. He wrote: “Over time, different chairs have been giving different guidelines at different point[s] of time on how much over-enhancement we need for a bond to be notched up to Aaa.”1149 In a November 2007 email, another senior executive described the criteria problem this way: “It seems, though, that the more of the ad hoc rules we add, the further away from the data and models we move and the closer we move to building models that ape analysts expectations, no?”1150

The rating agency models were called by some a “black box,” because they were difficult to understand and not always predictable. Issuers and investors alike vented frustrations toward the black box and basing decisions on a computer program few understood or could replicate.
This email from June 20, 2006, recounts the conversation one Moody’s employee had with another over frustrations they had heard from an outside issuer.

“Managers are tired of large ‘grids.’ They would rather prefer a model based test like what S&P and Fitch do. Pascale disagrees with these managers. As a wrapper, she hates that the credit quality of what she wraps is linked to a black box. Also, she hates the fact that the black box can change from time to time.”1151

A January 2007 email from BlackRock to S&P (and other rating agencies) also complained about the “black box” problem:

“What steps are you taking to better communicate and comfort investors about your ratings process? In other w[o]rds, how do we break the ‘black box’ that determines enhancement levels?”1152

1148 10/19/2006 email from Graham Jones (Morgan Stanley) to Yuri Yoshizawa (Moody’s) and others, Hearing Exhibit 4/23-37. See 2008 SEC Examination Report for Moody’s Investor Services Inc., PSI-SEC (Moodys Exam Report)-14-0001-16, at 5 (“[C]ertain significant aspects of the rating processes and the methodologies used to rate RMBS and CDOs were not always disclosed, or were not fully disclosed .…”).
1149 6/28/2007 email from Yi Zhang to Warren Kornfeld and others, Hearing Exhibit 4/23-39.
1150 11/28/2007 email from Roger Stein to Andrew Kimball and Michael Kanef, Hearing Exhibit 4/23-44. 1151 6/20/2006 email from Paul Mazataud to Noel Kirnon, MIS-OCIE-RMBS-0035460 [emphasis in original]. 1152 1/16/2007 email from Kishore Yalamanchili (BlackRock) to Scott Mason (S&P), Glenn Costello (Fitch Ratings), and others, PSI-S&P-RFN-000044.

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At times, some CRA analysts openly questioned their ability to rate some complex

securities. In a December 2006 email chain regarding a synthetic CDO squared, for example, S&P analysts appeared challenged by a modeling problem and questioned their ability to rate the product. One analyst wrote: “Rating agencies continue to create and [sic] even bigger monster –
the CDO market. Let’s hope we are all wealthy and retired by the time this house of cards falters.”1153 In an email written in a similar vein, an S&P manager preparing for a presentation wrote to her colleagues: “Can anyone give me a crash course on the ‘hidden risks in CDO’s of RMBS’?”1154 In an April 2007 instant message, an S&P analyst offered this cynical comment:
“[W]e rate every deal[.] [I]t could be structured by cows and we would rate it.”1155

(4) Failure to Retest After Model Changes Another key factor that contributed to inaccurate credit ratings was the failure of

Moody’s and S&P to retest outstanding RMBS and CDO securities after improvements were made to their credit rating models. These model improvements generally did not derive from data on new types of high risk mortgages, but were intended to improve the models’ predictive capability,1156 but even after they were made, CRA analysts failed to utilize them to downgrade artificially high RMBS and CDO credit ratings.

Key model adjustments were made in 2006 to both the RMBS and CDO models to

improve their ability to predict expected default and loss rates for higher risk mortgages. Both Moody’s and S&P decided to apply the revised models to rate new RMBS and CDO transactions, but not to retest outstanding subprime RMBS and CDO securities, even though many of those securities contained the same types of mortgages and risks that the models were recalibrated to evaluate. Had they retested the existing RMBS and CDO securities and issued appropriate rating downgrades starting in 2006, the CRAs could have signaled investors about the increasing risk in the mortgage market, possibly dampened the rate of securitizations, and possibly reduced the impact of the financial crisis.

conduct ongoing surveillance of the RMBS and CDO securities they rated to ensure the ratings remained valid over the life of the rated securities. In fact, both companies charged annual surveillance fees to the issuers of the securities to pay for the surveillance costs, and each had established a separate division to carry out surveillance duties. Due to the huge numbers of RMBS and CDO securities issued in the years leading up to the financial crisis, those surveillance divisions were responsible for reviewing tens of thousands of securities. The issue of whether to retest the outstanding securities using the revised credit rating models was, thus, a significant issue affecting numerous securities and substantial company resources.

Surveillance Obligations. Both Moody’s and S&P were obligated by contract to

1153 12/15/2006 email from Chris Meyer to Belinda Ghetti and Nicole Billick, Hearing Exhibit 4/23-27. 1154 1/17/2007 email from Monica Perelmuter to Kyle Beauchamp, and others, Hearing Exhibit 4/23-28. 1155 4/5/2007 instant message exchange between Shannon Mooney and Rahul Dilip Shah, Hearing Exhibit 4/23-30a. 1156 These model improvements still significantly underestimated subprime risk as is evidenced by the sheer number of downgrades that occurred after the model improvements for securities issued in 2006 and 2007.

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Increased Loss Protection. In July 2006, S&P made significant adjustments to its subprime RMBS model. S&P had determined that, to avoid an increasing risk of default, subprime RMBS securities required additional credit enhancements that would provide 40% more protection to keep the investment grade securities from experiencing losses.1157 Moody’s made similar adjustments to its RMBS model around the same time, settling on parameters that required 30% more loss protection. As Moody’s explained to the Senate Banking Committee in September 2007:

“In response to the increase in the riskiness of loans made during the last few years and the changing economic environment, Moody’s steadily increased its loss expectations and subsequent levels of credit protection on pools of subprime loans. Our loss expectations and enhancement levels rose by about 30% over the 2003 to 2006 time period, and as a result, bonds issued in 2006 and rated by Moody’s had more credit protection than bonds issued in earlier years.”1158

The determination that RMBS pools required 30-40% more credit enhancements to

protect higher rated tranches from loss reflected calculations by the updated CRA models that these asset pools were exposed to significantly more risk of delinquencies and defaults.
Requiring increased loss protection meant that Moody’s and S&P analysts had to require more revenues to be set aside in each pool to provide AAA ratings greater protection than before the model adjustments. Requiring increased loss protection also meant RMBS pools would have a smaller pool of AAA securities to sell to investors. That meant, in turn, that RMBS pools would produce fewer profits for issuers and arrangers. Requiring increased loss protection had a similar impact on CDOs that included RMBS assets.

Retesting RMBS Securities. Even though S&P and Moody’s had independently revised

their RMBS models and, by 2006, determined that additional credit enhancements of 30-40% were needed to protect investment grade tranches from loss, in 2006 and the first half of 2007, neither company used its revised models to evaluate existing rated subprime RMBS securities as part of its surveillance efforts.1159 announcing that no retests would be done:

Instead S&P, for example, sent out a June 2006 email

1157 3/19/2007 “Structured Finance Ratings - Overview and Impact of the Residential Subprime Market,” S&P Monthly Review Meeting, at S&P SEC-PSI 0001473, Hearing Exhibit 4/23-52b. 1158 Prepared statement of Michael Kanef, Group Managing Director of Moody’s Asset Backed Finance Rating Group, “The Role and Impact of Credit Rating Agencies on the Subprime Credit Markets,” before the U.S. Senate Committee on Banking, Housing, and Urban Affairs, S.Hrg. 110-931 (9/26/2007), at 17.
1159 6/2006 S&P internal email exchange, Hearing Exhibit 4/23-72; and 3/31/2008 Moody’s Structured Finance Credit Committee Meeting Notes, Hearing Exhibit 4/23-80. See also 7/16/2007 Moody’s email from Joseph Snailer to Qingyu Liu, and others, PSI-MOODYS-RFN-000029 (when an analyst sought guidance on whether to use the new or old methodology for testing unrated tranches of outstanding deals, she was advised: “The ratings you are generating should reflect what we would have rated the deals when they were issued knowing what we knew then and using the methodology in effect then (ie, using the OC model we built then.”); 6/1/2007 email from Moody’s Senior Director in Structured Finance, “RE: Financial Times inquiry on transparency of assumptions,” MIS-OCIE- RMBS-0364942-46, at 43.

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“Simply put – although the RMBS Group does not ‘grandfather’ existing deals, there is not an absolute and direct link between changes to our new ratings models and subsequent rating actions taken by the RMBS Surveillance Group. As a result, there will not be wholesale rating actions taken in July or shortly thereafter on outstanding RMBS transactions, absent a deterioration in performance and projected credit support on any individual transaction.”1160

Moody’s and S&P each advised the Subcommittee that it had decided not to retest any

existing rated RMBS securities, because it felt that actual performance data for the pools in question would provide a better indicator of future defaults and loss than application of its statistical model. But actual loan performance data for the subprime mortgages in the pools – the fact that, for example, timely loan payments had been made in the past on most of those loans – provided an incomplete picture regarding whether those payments would continue to be made after home prices stopped climbing, refinancings became difficult, and higher interest rates took effect in many of the mortgages. By focusing only on actual past performance, the ratings ignored foreseeable problems and gave investors false assurances about the creditworthiness of the RMBS and CDO securities.

Some CRA employees expressed concern about the limitations placed on their ability to

alter ratings to reflect expected performance of the rated securities. In a July 2007 email just before the mass ratings downgrades began, for example, an S&P senior executive raised concerns about these to the head of the RMBS Surveillance Group as follows:

“Overall, our ratings should be based on our expectations of performance, not solely the month to month performance record, which will only be backward looking. … Up to this point, Surveillance has been ‘limited’ in when we can downgrade a rating (only after it has experienced realized losses), how far we can adjust the rating (no more than 3 notches at a time is preferred), and how high up the capital structure we can go (not downgrading higher rated classes, if they ‘pass’ our stressed cash flow runs).”1161

In addition, many of the RMBS loans were less than a year old, making any performance data less significant and difficult to analyze. In others words, the loans were too unseasoned or new to offer any real predictive performance value.

1160 6/23/2006 email from Thomas Warrack to Pat Jordan and Rosario Buendia, Hearing Exhibit 4/23-72 [emphasis in original]. Despite this 2006 email, the former head of S&P’s RMBS Group, Frank Raiter, told a House Committee: “At S&P, there was an ongoing, often heated discussion that using the ratings model in surveillance would allow for re-rating every deal monthly and provide significantly improved measures of current and future performance.” Prepared statement of Frank L. Raiter, “Credit Rating Agencies and the Financial Crisis,” before the U.S. House of Representatives Committee on Oversight and Government Reform, Cong.Hrg. 110-155 (10/22/2008), at 7. 1161 7/3/2007 S&P email from Cliff Griep to Ernestine Warner and Stephen Anderberg, Hearing Exhibit 4/23-32 [emphasis in original].

Some internal S&P emails suggest alternative explanations for the decision not to retest.
In October 2005, for example, an S&P analytic manager in the Structured Finance Ratings Group sent an email to his colleagues asking: “How do we handle existing deals especially if there are material changes [to a model] that can cause existing ratings to change?” His email then laid out what he believed was S&P’s position at that time:

•

“I think the history has been to only re-review a deal under new assumptions/criteria when the deal is flagged for some performance reason. I do not know of a situation where there were wholesale changes to existing ratings when the primary group changed assumptions or even instituted new criteria. The two major reasons why we have taken the approach is (i) lack of sufficient personnel resources and (ii) not having the same models/information available for surveillance to relook at an existing deal with the new assumptions (i.e. no cash flow models for a number of assets). The third reason is concerns of how disruptive wholesale rating changes, based on a criteria change, can be to the market.

• CDO is current[ly] debating the issue and appropriate approach as they change the

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methodology.”1162

This email suggests the reason retesting did not occur was, not because S&P thought actual performance data would produce more accurate ratings for existing pools, but because S&P did not have the resources to retest, and lower ratings on existing deals might have disrupted the marketplace, upsetting investment banks and investors. Several S&P managers and analysts confirmed in Subcommittee interviews that these were the real reasons for the decision not to retest existing RMBS securities.1163 Moody’s documents also suggest that resource constraints may lay behind its decision not to retest.1164

rushed to have deals rated before the CRAs implemented more stringent revised models. In an attempt to explain why one RMBS security from the same vintage and originator was pricing better than another, a CDO trader wrote:

The Subcommittee also found evidence suggesting that investment banks may have

“Only reasons I can think for my guys showing you a tighter level is that we are very short this one and that the June 06 deals have a taint that earlier months don[’]t due to the theory that late June deals were crammed with bad stuff in order to beat the S & P [model] revisions.1165

1162 10/6/2005 email from Roy Chun, Hearing Exhibit 4/23-62. 1163 Prepared statement of Frank Raiter, Former Managing Director at Standard & Poor’s, April 23, 2010 Subcommittee Hearing, at 2; and Subcommittee interviews of S&P confidential sources (2/24/2010) and (4/9/2010).
1164 See, e.g., 3/31/2008 Moody’s Structured Finance Credit Committee Meeting Notes, Hearing Exhibit 4/23-80
(“Currently, following a methodology change, Moody’s does not re-evaluate every outstanding, affected rating.
Instead, it reviews only those obligations that it considers most prone to multi-notch rating changes, in light of the revised rating approach. This decision to selectively review certain ratings is made due to resource constraints.”). 1165 10/20/2006 email from Greg Lippmann (Deutsche Bank) to Craig Carlozzi (Mast Capital), DBSI_PSI_EMAIL01774820.

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Retesting CDO Securities. The debate over retesting existing CDO securities followed

a similar path to the debate over retesting RMBS securities. The CDO Group at S&P first faced the retest question in the summer of 2005, when it made a major change to its CDO model, then Evaluator 3 (E3).1166 The S&P CDO Group appeared ready to announce and implement the improved model that summer, but then took more than a year to implement it as the group struggled to rationalize why it would not retest existing CDO securities with the improved assumptions.1167 Internal S&P emails indicate that the primary considerations were, again, resource limitations and possible disruption to the CDO market, rather than concerns over accuracy. For instance, in a June 2005 email sent to an S&P senior executive, the head of the CDO Group wrote:

“The overarching issue at this point is what to do with currently rated transactions if we do release a new version of Evaluator. Some of [us] believe for both logistical and market reasons that the existing deals should mainly be ‘grand fathered’. Others believe that we should run all deals using the new Evaluator. The problem with running all deals using E3 is twofold: we don’t have the model or resource capacity to do so, nor do we all believe that even if we did have the capability, it would be the responsible thing to do to the market.”1168

Several months later the S&P CDO Ratings Group was still deliberating the issue. In

November 2005, an investment banker at Morgan Stanley who had concerns about whether E3 would be used to retest existing deals and those in the pipeline expressed frustration at the delay:

“We are in a bit of a pickle here. My legal staff is not letting me send anything out to any investor on anything with an S&P rating right now. We are waiting for you to tell us … that you approve the disclaimer or are grandfathering [not retesting with E3] our existing and pipeline deals. My business is on ‘pause’ right now.”1169

One S&P senior manager, frustrated by an inability to get an answer on the retesting issue, sent an email to a colleague complaining: “Lord help our f**king scam … this has to be the stupidest place I have worked at.”1170

1166 The CDO models were simulation models dependent upon past credit ratings for the assets they included plus various performance and correlation assumptions. See earlier discussion of these models. 1167 7/12/2005 S&P internal email, “Delay in Evaluator 3.0 incorporation in EOD/CDOi platform,” PSI-S&P-RFN-

1168 6/21/2005 email from Pat Jordan to Cliff Griep, “RE: new CDO criteria,” Hearing Exhibit 4/23-60. See also 3/21/2006 email from an S&P senior official, Hearing Exhibit 4/23-71. (“FYI. Just sat on a panel with Frderic Drevon, my opposite number at Moody’s who fielded a question on what happens to old transactions when there is a change to rating methodologie[s]. The official Moody’s line is that there is no ‘grandfathering’ and that old transactions are reviewed using the new criteria. However, the ‘truth is that we do not have the resources to review thousands of transactions, so we focus on those that we feel are more at risk.’”).
1169 11/23/2005 email from Brian Neer (Morgan Stanley) to Elwyn Wong (S&P), Hearing Exhibit 4/23-64. 1170 11/23/2005 email from Elwyn Wong to Andrea Bryan, Hearing Exhibit 4/23-64.

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In May 2006, S&P circulated a draft policy setting up what seemed to be an informal

screening process “prior to transition date” to see how existing CDOs would be affected by the revised CDO model. The draft offered a convoluted approach in an apparent attempt to avoid retesting all existing CDOs, which included allowing the use of the prior “E2” model and review “by a special E3 committee.” The draft policy read in part as follows:

“PRIVILEGED AND CONFIDENTIAL - S&P DISCUSSION PURPOSES ONLY Prior to Transition Date (in preparation for final implementation of E3 for cash CDOs):

• A large majority of the pre- E3 cash flow CDOs will be run through E3 in batch

processes to see how the ratings look within the new model …

•

Ratings falling more than 3 notches +/- from the current tranche rating in the batch process will be reviewed in detail for any modeling, data, performance or other issues

If any transactions are found to be passing/failing E3 by more than 3 notches due to performance reasons they will be handled through the regular surveillance process to see if the ratings are stable under current criteria (i.e., if they pass E2.4.3 using current cash flow assumptions the ratings will remain unchanged)

If any transactions are found to be passing/failing E3 by more than 3 notches due to a model gap between E2.4.3 and E3, they will be reviewed by a special E3 committee ….”1171

Questions continued to be raised internally at S&P about the retesting issue. In March

It is unclear whether this screening actually took place.

2007, almost a year after the change was made in the CDO model, an S&P senior executive wrote to the Chief Criteria Officer in the structured finance department:

“Why did the criteria change made in mid 2006 not impact any outstanding transactions at the time we changed it, especially given the magnitude of the change we are highlighting in the article? Should we apply the new criteria now, given what we now know? If we did, what would be the impact?”1172

But by then, residential mortgages were already defaulting in

In July 2007, the same senior executive raised the issue again in an email asking the S&P Analytic Policy Board to address the alignment of surveillance methodology and new model changes at a “special meeting.”1173 record numbers, and the mass downgrades of RMBS and CDO ratings had begun.

1171 5/19/2006 email from Stephen Anderberg to Pat Jordan, David Tesher, and others, PSI-S&P-RFN-000021 [emphasis in original]. 1172 3/12/2007 email from Cliff Griep to Tom Gillis, and others, PSI-S&P-RFN-000015.
1173 7/15/2007 email from Tom Gillis to Valencia Daniels, “Special APB meeting,” Hearing Exhibit 4/23-74.

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Consequences for Investors. During the April 23 Subcommittee hearing, credit ratings expert, Professor Arturo Cifuentes, explained to the Subcommittee the importance of retesting existing rated deals when there is a model change.

Senator Levin: If a ratings model changes its assumptions or criteria, for instance, if it becomes materially more conservative, how important is it that the credit rating agency use the new assumptions or criteria to re-test or re-evaluate securities that are under surveillance?

Mr. Cifuentes: Well, it is very important for two reasons: Because if you do not do that, you are basically creating two classes of securities, a low class and an upper class, and that creates a discrepancy in the market. At the same time, you are not being fair because you are giving an inflated rating then to a security or you are not communicating to the market that the ratings given before were of a different class.1174

Moody’s and S&P updated their RMBS and CDO models with more conservative criteria

in 2006, but then used the revised models to evaluate only new RMBS and CDO transactions, bypassing the existing RMBS and CDO securities that could have benefited from the new credit analysis. Even with respect to the new RMBS and CDOs, investment banks sought to delay use of the revised models that required additional credit enhancements to protect investment grade tranches from loss. For example, in May 2007, Morgan Stanley sent an email to a Moody’s Managing Director with the following:

“Thanks again for your help (and Mark’s) in getting Morgan Stanley up-to-speed with your new methodology. As we discussed last Friday, please find below a list of transactions with which Morgan Stanley is significantly engaged already (assets in warehouses, some liabilities placed). We appreciate your willingness to grandfather these transactions [under] Moody’s old methodology.”1175

When asked about the failure of Moody’s and S&P to retest existing securities after their

model updates in 2006, the global head trader for CDOs from Deutsche Bank told the Subcommittee that he believed the credit rating agencies did not retest them, because to do so would have meant significant downgrades and “they did not want to upset the apple cart.”1176

Instead, the credit rating agencies waited until 2007, when the high risk mortgages underlying the outstanding RMBS and CDO securities incurred record delinquencies and defaults and then, based upon the actual loan performance, instituted mass ratings downgrades. Those sudden mass downgrades caught many financial institutions and other investors by surprise, leaving them with

1174 April 23, 2010 Subcommittee Hearing at 35. 1175 5/2/2007 email from Zach Buchwald (Morgan Stanley Executive Director) to William May (Moody’s Managing Director), and others, Hearing Exhibit 4/23-76. See also 4/11/2007 email from Moody’s Managing Director to Calyon, PSI-MOODYS-RFN-000040. 1176 Subcommittee interview of Greg Lippmann, Former Managing Director and Global Head of Trading of CDOs for Deutsche Bank (10/18/2010). Mr. Lippmann said he thought the agencies’ decision not to retest existing securities was “ridiculous.”

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billions of dollars of suddenly unmarketable securities. The RMBS secondary market collapsed soon after, and the CDO secondary market followed.

(5) Inadequate Resources In addition to operating with conflicts of interest, models containing inadequate

performance data, subjective and inconsistent rating criteria, and a policy against using improved models to retest outstanding RMBS and CDO securities, and despite the increasing numbers of ratings issued each year and record revenues as a result, neither Moody’s nor S&P hired sufficient staff or devoted sufficient resources to ensure that the initial rating process and the subsequent surveillance process produced accurate credit ratings.

Instead, both Moody’s and S&P forced their staffs to churn out new ratings and conduct

required surveillance with limited resources. Over time, the credit rating agencies’ profits became increasingly connected to issuing a high volume of ratings. By not devoting sufficient resources to handle the high volume of ratings, the strain on resources negatively impacted the quality of the ratings and their surveillance.

High Speed Ratings. From 2000 to 2007, Moody’s and S&P issued record numbers of

RMBS and CDO ratings. Each year the number of ratings issued by each firm increased.
According to SEC examinations of the firms, from 2002 to 2006, “the volume of RMBS deals rated by Moody’s increased by 137%, and the number of CDO deals … increased by 700%.”1177
At S&P, the SEC determined that over the same time period, “the volume of RMBS deals rated by S&P increased by 130%, and the number of CDO deals … increased by over 900%.”1178 In addition to the rapid growth in numbers, the transactions themselves grew in complexity, requiring more time and talent to analyze.

The former head of the S&P RMBS Group, Frank Raiter, described the tension between

profits and resources this way: “Management wanted increased revenues and profit while analysts wanted more staff, data and IT support which increased expenses and obviously reduced profit.”1179

Moody’s CEO, Ray McDaniel, readily acknowledged during the Subcommittee’s April

23 hearing that resources were stressed and that Moody’s was short staffed.1180 He testified:
“People were working longer hours than we wanted them to, working more days of the week than we wanted them to.” He continued: “It was not for lack of having open positions, but with

1177 2008 SEC Examination Report for Moody’s Investor Services Inc., PSI-SEC (Moodys Exam Report)-14-0001- 16, at 4.
1178 2008 SEC Examination Report for Standard and Poor’s Ratings Services, Inc., PSI-SEC (S&P Exam Report)- 14-0001-24, at 3. 1179 Prepared statement of Frank Raiter, Former Managing Director at Standard & Poor’s, April 23, 2010 Subcommittee Hearing, at 1-2.
1180 April 23, 2010 Subcommittee Hearing at 96-97.

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the pace at which the market was growing, it was difficult to fill positions as quickly as we would have liked.”1181

Moody’s staff, however, had raised concerns about personnel shortages impacting their work quality as early as 2002. A 2002 survey of the Structured Finance Group staff reported, for example:

“[T]here is some concern about workload and its impact on operating effectiveness. …
Most acknowledge that Moody’s intends to run lean, but there is some question of whether effectiveness is compromised by the current deployment of staff.”1182

Similar concerns were expressed three years later in a 2005 employee survey:

“We are over worked. Too many demands are placed on us for admin[istrative] tasks … and are detracting from primary workflow …. We need better technology to meet the demand of running increasingly sophisticated models.”1183

In 2006, Moody’s analyst Richard Michalek worried that investment bankers were taking advantage of the fact that analysts did not have the time to understand complex deals. He wrote:

“I am worried that we are not able to give these complicated deals the attention they really deserve, and that they (CS) [Credit Suisse] are taking advantage of the ‘light’ review and the growing sense of ‘precedent’.”1184

Moody’s managers and analysts interviewed by the Subcommittee stated that staff

shortages impacted how much time could be spent analyzing a transaction. One analyst responsible for rating CDOs told the Subcommittee that, during the height of the boom, Moody’s analysts didn’t have time to understand the complex deals being rated and had to set priorities on what issues would be examined:

“When I joined the [CDO] Group in 1999 there were seven lawyers and the Group rated something on the order of 40 – 60 transactions annually. In 2006, the Group rated over 600 transactions, using the resources of approximately 12 lawyers. The hyper-growth years from the second half of 2004 through 2006 represented a steady and constant adjustment to the amount of time that could be allotted to any particular deal’s analysis, and with that adjustment, a constant re-ordering of the priority assigned to the issues to be raised at rating Committees.”1185

1181 Id. at 97. 1182 5/2/2002 “Moody’s SFG 2002 Associate Survey: Highlights of Focus Groups and Interviews,” Hearing Exhibit 4/23-92a at 6.
1183 4/7/2006 “Moody’s Investor Service, BES-2005: Presentation to Derivatives Team,” Hearing Exhibit 4/23-92b. 1184 5/1/2006 email from Richard Michalek to Yuri Yoshizawa, Hearing Exhibit 4/23-19.
1185 Prepared statement of Richard Michalek at 20, April 23, 2010 Subcommittee hearing.

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A Moody’s managing director responsible for supervising CDO analysts put it this way in a 2007 email: “Unfortunately, our analysts are o[v]erwhelmed .…”1186 Moody’s CEO testified at the Subcommittee’s hearing, “[w]e had stress on our resources in this period, absolutely.”1187
Senator Levin asked him if Moody’s was profitable at the time, and he responded, “[w]e were profitable, yes.”1188

S&P also experienced significant resource shortages. In 2004, for example, a managing director in the RMBS Group wrote a lengthy email about the resource problems impacting credit analysis:

“I am trying to put my hat on not only for ABS/RMBS but for the department and be helpful but feel that it is necessary to re-iterate that there is a shortage in resources in RMBS. If I did not convey this to each of you I would be doing a disservice to each of you and the department. As an update, December is going to be our busiest month ever in RMBS. I am also concerned that there is a perception that we have been getting all the work done up until now and therefore can continue to do so.

“We ran our Staffing model assuming the analysts are working 60 hours a week and we are short resources. We could talk about the assumptions and make modifications but the results would be similar. The analysts on average are working longer than this and we are burning them out. We have had a couple of resignations and expect more. It has come to my attention in the last couple of days that we have a number of staff members that are experiencing health issues.”1189

A May 2006 internal email from an S&P senior manager in the Structured Finance Real

Estate Ratings Group expressed similar concerns:

“We spend most of our time keeping each other and our staff calm. Tensions are high. Just too much work, not enough people, pressure from company, quite a bit of turnover and no coordination of the non-deal ‘stuff’ they want us and our staff to do ….”1190

The head of the S&P CDO Ratings Group sent a 2006 email to the head of the Structured Finance Department to make a similar point. She wrote:

“While I realize that our revenues and client service numbers don’t indicate any ill [e]ffects from our severe understaffing situation, I am more concerned than ever that we are on a downward spiral of morale, analytical leadership/quality and client service.”1191

1186 5/23/2007 email from Eric Kolchinsky to Yvonne Fu and Yuri Yoshizawa, Hearing Exhibit 4/23-91. 1187 April 23, 2010 Subcommittee Hearing at 97. 1188 Id. 1189 12/3/2004 email from Gail McDermott to Abe Losice and Pat Jordan, PSI-S&P-RFN-000034. 1190 5/2/2006 email from Gale Scott to Diane Cory, “RE: Change in scheduling/Coaching sessions/Other stuff,” PSI- S&P-RFN-000012.
1191 10/31/2006 S&P internal email, “A CDO Director resignation,” PSI-S&P-RFN-000001.

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Some of the groups came up with creative ways to address their staffing shortages. For

example, the head of the S&P RMBS Ratings Group between 2005 and 2007, Susan Barnes, advised the Subcommittee that her group regularly borrowed staff from the S&P Surveillance Group to assist with new ratings. She said that almost half the surveillance staff provided assistance on issuing new ratings during her tenure, and estimated that each person in the surveillance group might have contributed up to 25% of his or her time to issuing new ratings.1192

The Subcommittee investigation discovered a cadre of professional RMBS and CDO rating analysts who were rushed, overworked, and demoralized. They were asked to evaluate increasing numbers of increasingly complex financial instruments at high speed, using out-of- date rating models and unclear ratings criteria, while acting under pressure from management to increase market share and revenues and pressure from investment banks to ignore credit risk.
These analysts were short staffed even as their employers collected record revenues.

credit rating agencies to conduct surveillance on outstanding rated RMBS and CDO securities to evaluate their credit risk. The credit rating agencies were contractually obligated to monitor the accuracy of the ratings they issued over the life of the rated transactions. CRA surveillance analysts were supposed to evaluate each rating on an ongoing basis to determine whether the rating should be affirmed, upgraded, or downgraded. To support this analysis, both companies collected substantial annual surveillance fees from the issuers of the financial instruments they rated, and set up surveillance groups to review the ratings. In the case of RMBS and CDO securities, the Subcommittee investigation found evidence that these surveillance groups may have lacked the resources to properly monitor the thousands of rated products.

were responsible for tracking over 13,000 rated CDO securities:

Resource-Starved Surveillance. Resource shortages also impacted the ability of the

At Moody’s, for example, a 2007 email disclosed that about 26 surveillance analysts

“Thanks for sharing the draft of the CDO surveillance piece you’re planning to publish later this week. … In the section about your CDO surveillance infrastructure, we were struck by the data point about the 26 professionals who are dedicated to monitoring CDO ratings. While this is, no doubt, a strong team, we wanted to at least raise the question about whether the company’s critics could twist that number – e.g., by comparing it to the 13,000+ CDOs you’re monitoring – and once again question if you have adequate resources to do your job effectively. Given that potential risk, we thought you might consider removing any specific reference to the number of people on the CDO surveillance team.”1193

The evidence of surveillance shortages at S&P was particularly telling. Although during an interview with the Subcommittee, the head of S&P’s RMBS Surveillance Group from 2001 to 2008, Ernestine Warner, said she had adequate resources to conduct surveillance of rated RMBS

1192 Subcommittee interview of Susan Barnes (3/18/2010). 1193 7/9/2007 email to Yuri Yoshizawa, “FW: CDO Surveillance Note 7_071.doc,” PSI-MOODYS-RFN-000022.

securities during her tenure, her emails indicate otherwise.1194 period, she repeatedly described and complained about a lack of resources that was impeding her group’s ability to complete its work. In the spring of 2006, she emailed her colleague about her growing anxiety:

In emails sent over a two-year

“RMBS has an all time high of 5900 transactions. Each time I consider what my group is faced with, I become more and more anxious. The situation with Lal [a surveillance analyst], being off line or out of the group, is having a huge impact.”1195

In June 2006, she wrote that the problems were not getting better:

“It really feels like I am repeating myself when it comes to completing a very simple project and addressing some of the other surveillance needs. … The inability to make a decision about how the project is going to be resourced is causing undue stress. I have talked to you and Peter [D’Erchia, head of global structured finance surveillance,] about each of the issues below and at this point I am not sure what else you need from me. …

To rehash the points below:

In addition to the project above that involves some 863 deals, I have a back log of deals that are out of date with regard to ratings. … We recognize that I am still understaffed with these two additional bodies. … [W]e may be falling further behind at the rate the deals are closing. If we do not agree on the actual number, certainly we can agree that I need more recourse if I am ever going to be near compliance.”1196

In December 2006, she wrote:

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“In light of the current state of residential mortgage performance, especially sub-prime, I think it would be very beneficial for the RMBS surveillance team to have the work being done by the temps to continue. It is still very important that performance data is loaded on a timely basis as this has an impact on our exception reports. Currently, there are nearly 1,000 deals with data loads aged beyond one month.”1197

In February 2007, she expressed concerns about having adequate resources to address

potential downgrades in RMBS:

“I talked to Tommy yesterday and he thinks that the [RMBS] ratings are not going to hold through 2007. He asked me to begin discussing taking rating actions earlier on the

1194 During an interview, the head of RMBS surveillance advised that she believed she was adequately resourced and prioritized her review of outstanding securities by focusing on 2006 and 2007 vintages that had performance problems. Subcommittee interview of Ernestine Warner (3/11/2010). 1195 4/28/2006 email from Ernestine Warner to Roy Chun, and others, Hearing Exhibit 4/23-82. 1196 6/1/2006 emails from Ernestine Warner to Roy Chun, Hearing Exhibit 4/23-83. 1197 12/20/2006 email from Ernestine Warner to Gail Houston, Roy Chun, others, Hearing Exhibit 4/23-84.

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poor performing deals. I have been thinking about this for much of the night. We do not have the resources to support what we are doing now. A new process, without the right support, would be overwhelming. … My group is under serious pressure to respond to the burgeoning poor performance of sub-prime deals. … we are really falling behind. … I am seeing evidence that I really need to add staff to keep up with what is going on with sub prime and mortgage performance in general, NOW.”1198

In April 2007, a managing director at S&P in the Structured Finance Group wrote an

email confirming the staffing shortages in the RMBS Surveillance Group:

“We have worked together with Ernestine Warner (EW) to produce a staffing model for RMBS Surveillance (R-Surv). It is intended to measure the staffing needed for detailed surveillance of the 2006 vintage and also everything issued prior to that. This model shows that the R-Surv staff is short by 7 FTE [Full Time Employees] - about 3 Directors, 2 AD’s, and 2 Associates. The model suggests that the current staff may have been right sized if we excluded coverage of the 2006 vintage, but was under titled lacking sufficient seniority, skill, and experience.”1199

The global head of the S&P Structured Finance Surveillance Group, Peter D’Erchia, told

the Subcommittee that, in late 2006, he expressed concerns to senior management about surveillance resources and the need to downgrade subprime in more significant numbers in light of the deteriorating subprime market.1200 director of the Global Structured Finance Ratings Group, Joanne Rose, disagreed with him about the need to issue significantly more downgrades in subprime RMBS and this disagreement continued into the next year. He also told the Subcommittee that after this disagreement with her, he received a disappointing 2007 performance evaluation. He wrote the following in the employee comment section of his evaluation:

According to Mr. D’Erchia, the executive managing

“Even more offensive – and flatly wrong – is the statement that I am not working for a good outcome for S&P. That is all I am working towards and have been for 26 years. It is hard to respond to such comments, which I think reflect Joanne’s [Rose] personal feelings arising from our disagreement over subprime debt deterioration, not professional assessment. … Such comments, and others like it, suggest to me that this year-end appraisal, in contrast to the mid-year appraisal, has more to do with our differences over subprime deterioration than an objective assessment of my overall performance.”1201

In 2008, Mr. D’Erchia was removed from his surveillance position, where he oversaw

more than 314 employees, as part of a reduction in force. He was subsequently rehired as a managing director in U.S. Public Finance at S&P, a position without staff to supervise.

1198 2/3/2007 email from Ernestine Warner to Peter D’Erchia, Hearing Exhibit 4/23-86 [emphasis in original]. 1199 4/24/2007 email from Abe Losice to Susan Barnes, “Staffing for RMBS Surveillance,” Hearing Exhibit 4/23-88. 1200 Subcommittee interview of Peter D’Erchia (4/13/2010). 1201 2007 Performance Evaluation for Peter D’Erchia, S&P SEN-PSI 0007442; See also April 23, 2010 Subcommittee Hearing at 74-75.

Similarly, Ernestine Warner, the head of RMBS Surveillance, lost her managerial position and was reassigned to investor relations in the Structured Finance Group.

On July 10, 2007, amid record mortgage defaults, S&P abruptly began downgrading its

outstanding RMBS and CDO ratings. In July alone, it downgraded the ratings of more than 1,000 RMBS and 100 CDO securities. Both credit rating agencies continued to issue significant downgrades throughout the remainder of 2007. On January 30, 2008, S&P took action on over 8,200 RMBS and CDO ratings – meaning it either downgraded their ratings or placed the securities on credit watch with negative implications. These and other downgrades, matched by equally substantial numbers at Moody’s, paint a picture of CRA surveillance teams acting at top speed in overwhelming circumstances to correct thousands of inaccurate RMBS and CDO ratings. When asked to produce contemporaneous decision-making documents indicating how and when the ratings were selected for downgrade, neither S&P nor Moody’s produced meaningful documentation. The facts suggest that CRA surveillance analysts with already substantial responsibilities and limited resources were forced to go into overdrive to clean up ratings that could not “hold.”

(6) Mortgage Fraud
A final factor that contributed to inaccurate credit ratings involves mortgage fraud.

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Although the credit rating agencies were clearly aware of increased levels of mortgage fraud, they did not factor that credit risk into their quantitative models or adequately factor it into their qualitative analyses. The absence of that credit risk meant that the credit enhancements they required were insufficient, the tranches bearing AAA ratings were too large, and the ratings they issued were too optimistic.

Reports of mortgage fraud were frequent and mounted yearly prior to the financial crisis.
As noted above, as early as 2004, the FBI began issuing reports on increased mortgage fraud.1202
The FBI was also quoted in Congressional testimony and in the popular press about the mortgage fraud problem. CNN reported that “[r]ampant fraud in the mortgage industry has increased so sharply that the FBI warned Friday of an ‘epidemic’ of financial crimes which, if not curtailed, could become ‘the next S&L crisis.’”1203 In 2006, the FBI reported that the number of Suspicious Activity Reports on mortgage fraud had increased sixfold, from about 6,800 in 2002, to about 36,800 in 2006, while pending mortgage fraud cases nearly doubled from 436 in FY 2003 to 818 in FY 2006.1204 The Mortgage Asset Research Institute, LLC (MARI) also reported increasing mortgage fraud over several years, including a 30% increase in 2006 alone.1205

1202 FY 2004 “Financial Institution Fraud and Failure Report,” prepared by the Federal Bureau of Investigation, available at 1203 “FBI warns of mortgage fraud ‘epidemic’,” CNN.com (9/17/2004), http://articles.cnn.com/2004-09- 17/justice/mortgage.fraud_1_mortgage-fraud-mortgage-industry-s-1-crisis?_s=PM:LAW. 1204 “Financial Crimes Report to the Public: Fiscal Year 2006, October 1, 2005 – September 30, 2006,” prepared by the Federal Bureau of Investigation, available at http://www.fbi.gov/stats- services/publications/fcs_report2006/financial-crimes-report-to-the-public-2006-pdf/view. 1205 4/2007 “Ninth Periodic Mortgage Fraud Case Report to Mortgage Bankers Association,” prepared by Mortgage Asset Research Institute, LLC.

http://www.fbi.gov/stats-services/publications/fiff_04.

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Published reports, as well as internal emails, demonstrate that analysts within both Moody’s and S&P were aware of the serious mortgage fraud problem in the industry.1206
Despite being on notice about the problem and despite assertions about the importance of loan data quality in the ratings process for structured finance securities,1207 neither Moody’s nor S&P established procedures to account for the possibility of fraud in its ratings process. For example, neither company took any steps to ensure that the loan data provided for specific RMBS loan pools had been reviewed for accuracy.1208 The former head of S&P’s RMBS Group, Frank Raiter, stated in his prepared testimony for the Subcommittee hearing that the S&P rating process did not include any “due diligence” review of the loan tape or any requirement for the provider of the loan tape to certify its accuracy. He stated: “We were discouraged from even using the term ‘due diligence’ as it was believed to expose S&P to liability.”1209 Fraud was also not factored into the RMBS or CDO quantitative models.1210

securities in July 2007, they directed some of the blame for the rating errors on the volume of mortgage fraud. On July 10, 2007, when S&P announced that it was placing 612 U.S. subprime RMBS on negative credit watch, S&P noted the high incidence of fraud reported by MARI,
“misrepresentations on credit reports,” and that “[d]ata quality concerning some of the borrower and loan characteristics provided during the rating process [had] also come under question.” 1211 In October 2007, the CEO of Fitch Ratings, another ratings firm, said in an interview that “the blame may lie with fraudulent lending practices, not his industry.”1212 Moody’s made similar observations. In 2008, Moody’s CEO Ray McDaniel told a panel at the World Economic Forum:

Yet when Moody’s and S&P initiated the mass downgrades of RMBS and CDO

“In hindsight, it is pretty clear that there was a failure in some key assumptions that were supporting our analytics and our models. … [One reason for the failure was that the]

1206 See, e.g., 9/2/2006 email chain between Richard Koch, Robert Mackey, and Michael Gutierrez, “Nightmare Mortgages,” Hearing Exhibit 4/23-46a; 9/5/2006 email chain between Edward Highland, Michael Gutierrez, and Richard Koch, “Nightmare Mortgages,” Hearing Exhibit 4/23-46b; and 9/29/2006 email from Michael Gutierrez, Director of S&P, PSI-S&P-RFN-000029.
1207 See, e.g., 6/24/2010 supplemental response from S&P to the Subcommittee, Exhibit H, Hearing Exhibit 4/23- 108 (7/11/2007 “S&PCORRECT: 612 U.S. Subprime RMBS Classes Put On Watch Neg; Methodology Revisions Announced,” S&P’s RatingsDirect (correcting the original version issued on 7/10/2007)).
1208 See, e.g., 2008 SEC Examination Report for Moody’s Investor Services Inc., PSI-SEC (Moodys Exam Report)- 14-0001-16, at 7; and 2008 SEC Examination Report for Standard and Poor’s Ratings Services, Inc., PSI-SEC (S&P Exam Report)-14-0001-24, at 11 (finding with respect to each credit rating agency that it “did not engage in any due diligence or otherwise seek to verify the accuracy and quality of the loan data underlying the RMBS pools it rated”). 1209 Prepared statement of Frank Raiter, Former Managing Director at Standard & Poor’s, April 23, 2010 Subcommittee Hearing, at 3. 1210 Subcommittee interviews of Susan Barnes (3/18/2010) and Richard Gugliada (10/9/2009). 1211 6/24/2010 supplemental response from S&P to the Subcommittee, Exhibit H, Hearing Exhibit 4/23-108 (7/11/2007 “S&PCORRECT: 612 U.S. Subprime RMBS Classes Put On Watch Neg; Methodology Revisions Announced,” S&P’s RatingsDirect (correcting the original version issued on 7/10/2007)).
1212 10/12/2007 Moody’s internal email, PSI-MOODYS-RFN-000035 (citing “Fitch CEO says fraudulent lending practices may have contributed to problems with ratings,” Associated Press, and noting: “After S&P, Fitch is now blaming fraud for the impact on RMBS, at least partially.”).

‘information quality’ [given to Moody’s,] both the complete[ness] and veracity, was deteriorating.”1213

In 2007, Fitch Ratings decided to conduct a review of some mortgage loan files to

evaluate the impact of poor lending standards on loan quality. On November 28, 2007, Fitch issued a report entitled, “The Impact of Poor Underwriting Practices and Fraud in Subprime RMBS Performance.” After reviewing a “sample of 45 subprime loans, targeting high CLTV [combined loan to value] [and] stated documentation loans, including many with early missed payments,” Fitch reported that it decided to summarize information about the impact of fraud, as well as lax lending standards, on the mortgages. Fitch explained: “[t]he result of the analysis was disconcerting at best, as there was the appearance of fraud or misrepresentation in almost every file.”1214

To address concerns about fraud and lax underwriting standards generally, S&P

considered a potential policy change in November 2007 that would give an evaluation of the quality of services provided by third parties more influence in the ratings process. An S&P managing director wrote:

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“We believe our analytical process and rating opinions will be enhanced by an increased focus on the role third parties can play in influencing loan default and loss performance.
… [W]e’d like to set up meetings where specific mortgage originators, investment banks and mortgage servicers are discussed. We would like to use these meetings to share ideas with a goal of determining whether loss estimates should be altered based upon your collective input.”1215

An S&P employee who received this announcement wrote to a colleague: “Should have been doing this all along.” 1216

S&P later decided that its analysts would also review specific loan originators that supplied loans for the pool. Loans issued by originators with a reputation for issuing poor quality loans, including loans marked by fraud, would be considered a greater credit risk and ratings for the pool containing the loans would reflect that risk. S&P finalized that policy in November 2008.1217 As part of its ratings analysis, S&P now ranks mortgage originators based on the past historical performance of their loans and factors the assessment of the originator into credit enhancement levels for RMBS.1218

1213 “Moody’s: They Lied to Us,” New York Times (1/25/2008), http://norris.blogs.nytimes.com/2008/01/25/moodys-they-lied-to-us/. 1214 11/28/2007 “The Impact of Poor Underwriting Practices and Fraud in Subprime RMBS Performance,” report prepared by Fitch Ratings, at 4, Hearing Exhibit 4/23-100. 1215 11/15/2007 email from Thomas Warrack to Michael Gutierrez, and others, Hearing Exhibit 4/23-34. 1216 11/15/2007 email from Robert Mackey to Michael Gutierrez, and others, Hearing Exhibit 4/23-34.
1217 6/24/2010 supplemental letter from S&P to the Subcommittee, Exhibit W, Hearing Exhibit 4/23-108 (11/25/2008 “Standard & Poor’s Enhanced Mortgage Originator and Underwriting Review Criteria for U.S. RMBS,” S&P’s RatingsDirect). 1218 Id.

In September 2007, Moody’s solicited industry feedback on proposed enhancements to

its evaluation of nonprime RMBS securitizations, including the need for third-party due diligence reviews of the loans in a securitization. Moody’s wrote: “To improve the accuracy of loan information upon which it relies, Moody’s will look for additional oversight by a qualified third party.”1219 In November 2008, Moody’s issued a report detailing its enhanced approach to RMBS originator assessments.1220

E. Preventing Inflated Credit Ratings

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Weak credit rating agency performance has long been a source of concern to financial

regulators. Many investors rely on credit ratings to identify “safe” investments. Many regulated financial institutions, including banks, broker-dealers, insurance companies, pension funds, mutual funds, money market funds, and others have been required to operate under restrictions related to their purchase of “investment grade” versus “noninvestment grade” financial instruments. When credit agencies issue inaccurate credit ratings, both retail investors and regulated financial institutions may mistakenly purchase financial instruments that are riskier than they intended or are permitted to buy. The recent financial crisis has demonstrated how the unintended purchase of high risk financial products by multiple investors and financial institutions can create systemic risk and endanger, not only U.S. financial markets, but the entire U.S. economy.

(1) Past Credit Rating Agency Oversight Even before the recent financial crisis, the SEC and Congress had been reviewing the need for increased regulatory oversight of the credit rating industry. In 1994, for example, the SEC “issued a Concept Release soliciting public comment on the appropriate role of ratings in the federal securities laws, and the need to establish formal procedures for recognizing and monitoring the activities of [credit rating agencies].”1221

Enron Corporation, focusing in part on how the credit rating agencies assigned investment grade credit ratings to the company “until a mere four days before Enron declared bankruptcy.”1222 The Committee issued a report finding, among other things, that the credit rating agencies:

In 2002, the Senate Committee on Governmental Affairs examined the collapse of the

1219 “Moody’s Proposes Enhancements to Non-Prime RMBS Securitization,” Moody’s (9/25/2007). 1220 “Moody’s Enhanced Approach to Originator Assessments for U.S. Residential Mortgage Backed Securities (RMBS),” Moody’s, Hearing Exhibit 4/23-106 (originally issued 11/24/2008 but due to minor changes was republished on 10/5/2009).
1221 1/2003 “Report on the Role and Function of Credit Rating Agencies in the Operation of the Securities Markets,” prepared by the SEC, at 5. 1222 10/8/2002 “Financial Oversight of Enron: The SEC and Private-Sector Watchdogs,” prepared by the U.S. Senate Committee on Governmental Affairs, at 6. See also “Rating the Raters: Enron and the Credit Rating Agencies,” before the U.S. Senate Committee on Governmental Affairs, S.Hrg. 107-471 (3/20/2002). The Committee has since been renamed as the Committee on Homeland Security and Governmental Affairs.

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“failed to detect Enron’s problems – or take sufficiently seriously the problems they were aware of – until it was too late because they did not exercise the proper diligence. … [T]he agencies did not perform a thorough analysis of Enron’s public filings; did not pay appropriate attention to allegations of financial fraud; and repeatedly took company officials at their word … despite indications that the company had misled the rating agencies in the past.”1223

The report also found the credit rating “analysts [did] not view themselves as accountable for their actions,” since the rating agencies were subject to little regulation or oversight, and their liability for poor quality ratings was limited by regulatory exemptions and First Amendment protections.1224 The report recommended “increased oversight for these rating agencies in order to ensure that the public’s trust in these firms is well-placed.”1225

In 2002, the Sarbanes-Oxley Act required the SEC to conduct a study into the role of credit rating agencies in the securities markets, including any barriers to accurately evaluating the financial condition of the issuers of securities they rate.1226 In response, the SEC initiated an in-depth study of the credit rating industry and released its findings in a 2003 report. The SEC’s oversight efforts “included informal discussions with credit rating agencies and market participants, formal examinations of credit rating agencies, and public hearings, where market participants were given the opportunity to offer their views on credit rating agencies and their role in the capital markets.”1227 The report expressed a number of concerns about CRA operations, including “potential conflicts of interest caused by the [issuer-pays model].”1228

was designed to address some of the shortcomings identified by Congress and the SEC. The Act made it clear that the SEC had jurisdiction to conduct oversight of the credit rating industry, and formally charged the agency with designating companies as NRSROs.1229 The statute also required NRSROs to meet certain criteria before registering with the SEC. In addition, the statute instructed the SEC to promulgate regulations requiring NRSROs to establish policies and procedures to prevent the misuse of nonpublic information and to disclose and manage conflicts of interest.1230

In the summer of 2007, after the mass downgrades of RMBS and CDO ratings had begun and as the financial crisis began to intensify, the SEC initiated its first examinations of the major

The Credit Rating Agency Reform Act, which was signed into law in September 2006,

Those regulations were designed to take effect in September 2007.

1223 10/8/2002 “Financial Oversight of Enron: The SEC and Private-Sector Watchdogs,” prepared by the U.S. Senate Committee on Governmental Affairs, at 6, 108. 1224 Id. at 122. 1225 Id. at 6. 1226 Section 702 of the Sarbanes-Oxley Act of 2002. 1227 1/2003 “Report on the Role and Function of Credit Rating Agencies in the Operation of the Securities Markets,” prepared by the SEC, at 4. 1228 Id. at 19. 1229 9/3/2009 “Credit Rating Agencies and Their Regulation,” report prepared by the Congressional Research Service, Report No. R40613 (revised report issued 4/9/2010). 1230 Id.

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credit rating agencies. According to the SEC, “[t]he purpose of the examinations was to develop an understanding of the practices of the rating agencies surrounding the rating of RMBS and CDOs.”1231 The examinations reviewed CRA practices from January 2004 to December 2007.
In 2008, the SEC issued a report summarizing its findings. The report found that “there was a substantial increase in the number and in the complexity of RMBS and CDO deals,” “significant aspects of the ratings process were not always disclosed,” the ratings policies and procedures were not fully documented, “the surveillance processes used by the rating agencies appear to have been less robust than the processes used for initial ratings,” and the “rating agencies’ internal audit processes varied significantly.”1232 In addition, the report raised a number of conflict of interest issues that influenced the ratings process, noted that the rating agencies failed to verify the accuracy or quality of the loan data used to derive their ratings, and raised questions about the factors that were or were not used to derive the credit ratings.1233

(2) New Developments

Although the Credit Rating Agency Reform Act of 2006 strengthened oversight of the

credit rating agencies, Congress passed further reforms in response to the financial crisis to address weaknesses in regulatory oversight of the credit rating industry. The Dodd-Frank Act dedicated an entire subtitle to those credit rating reforms which substantially broadened the powers of the SEC to oversee and regulate the credit rating industry and explicitly allowed investors, for the first time, to file civil suits against credit rating agencies.1234 The major reforms include the following:

a. establishment of a new SEC Office of Credit Ratings charged with overseeing the

credit rating industry, including by conducting at least annual NRSRO examinations whose reports must be made public;

b. SEC authority to discipline, fine, and deregister a credit rating agency and associated

personnel for violating the law;

c. SEC authority to deregister a credit rating agency for issuing poor ratings; d. authority for investors to file private causes of action against credit rating agencies

that knowingly or recklessly fail to conduct a reasonable investigation of a rated product;

e. requirements for credit rating agencies to establish internal controls to ensure high quality ratings and disclose information about their rating methodologies and about each issued rating;

1231 7/2008 “Summary Report of Issues Identified in the Commission Staff’s Examinations of Select Credit Rating Agencies,” prepared by the SEC, at 1. The CRAs examined by the SEC were not formally subject to the Credit Rating Agency Reform Act of 2006 or its implementing SEC regulations until September 2007. 1232 Id. at 1-2. 1233 Id. at 14, 17-18, 23-29, 31-37. 1234 See Title IX, Subtitle C – Improvements to the Regulation of Credit Rating Agencies of the Dodd-Frank Act.

f. amendments to federal statutes removing references to credit ratings and credit rating

agencies in order to reduce reliance on ratings;

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g. a GAO study to evaluate alternative compensation models for ratings that would

create financial incentives to issue more accurate ratings; and

h. an SEC study of the conflicts of interest affecting ratings of structured finance

products, followed by the mandatory development of a plan to reduce ratings shopping.1235

The Act stated that these reforms were needed, “[b]ecause of the systemic importance of

credit ratings and the reliance placed on credit ratings by individual and institutional investors and financial regulators,” and because “credit rating agencies are central to capital formation, investor confidence, and the efficient performance of the United States economy.”

        (3)  Recommendations

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To further strengthen the accuracy of credit ratings and reduce systemic risk, this Report

makes the following recommendations.

Rank Credit Rating Agencies by Accuracy. The SEC should use its regulatory

authority to rank the Nationally Recognized Statistical Rating Organizations in terms of performance, in particular the accuracy of their ratings.

Help Investors Hold CRAs Accountable. The SEC should use its regulatory

Strengthen CRA Operations. The SEC should use its inspection, examination, and regulatory authority to ensure credit rating agencies institute internal controls, credit rating methodologies, and employee conflict of interest safeguards that advance rating accuracy.
Ensure CRAs Recognize Risk. The SEC should use its inspection, examination, and

1235 See id. at §§ 931-939H; “Conference report to accompany H.R. 4173,” Cong. Report No. 111-517 (June 29, 2010). 1236 See Section 931 of the Dodd-Frank Act.

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Strengthen Disclosure. The SEC should exercise its authority under the new Section

Reduce Ratings Reliance. Federal regulators should reduce the federal government’s

reliance on privately issued credit ratings.

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VI. INVESTMENT BANK ABUSES: CASE STUDY OF GOLDMAN SACHS AND DEUTSCHE BANK

A key factor in the recent financial crisis was the role played by complex financial

instruments, often referred to as structured finance products, such as residential mortgage backed securities (RMBS), collateralized debt obligations (CDOs), and credit default swaps (CDS), including CDS contracts linked to the ABX Index. These financial products were envisioned, engineered, sold, and traded by major U.S. investment banks.

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Those fees contributed substantial revenues to the investment banks which set

From 2004 to 2008, U.S. financial institutions issued nearly $2.5 trillion in RMBS securities and over $1.4 trillion in CDOs securitizing primarily mortgage related products. 1237 Investment banks charged fees ranging from $1 to $8 million to act as the underwriter of an RMBS securitization, and from $5 to $10 million to act as the placement agent for a CDO securitization. up structured finance groups, and a variety of RMBS and CDO origination and trading desks within those groups, to handle mortgage related securitizations. Investment banks placed these securities with investors around the world, and helped develop a secondary market where private RMBS and CDO securities could be bought and sold. The investment banks’ trading desks participated in those secondary markets, buying and selling RMBS and CDO securities either for their customers or for themselves.

Some of these financial products allowed investors to profit, not only from the success of an RMBS or CDO securitization, but also from its failure. CDS contracts, for example, allowed counterparties to wager on the rise or fall in the value of a specific RMBS security or on a collection of RMBS and other assets contained or referenced in a CDO. Major investment banks also developed standardized CDS contracts that could be traded on a secondary market. In

See “Banks’ Self-Dealing Super-Charged Financial Crisis,” ProPublica (8/26/2010),

3/4/2011 “U.S. Mortgage-Related Securities Issuance” and 1/1/2011 “Global CDO Issuance,” charts prepared

1237 by Securities Industry and Financial Markets Association, www.sifma.org/research/statistics.aspx. The RMBS total does not include about $6.6 trillion in RMBS securities issued by government sponsored enterprises like Fannie Mae and Freddie Mac. 1238 See, e.g., 2/2011 chart, “Goldman Sachs Expected Profit from RMBS Securitizations,” prepared by the U.S. Senate Permanent Subcommittee on Investigations using Goldman-produced documents for securitizations from 2005-2007 (underlying documents retained in Subcommittee file); 3/21/2011 letter from Deutsche Bank counsel, PSI-Deutsche_Bank-32-0001. 1239 http://www.propublica.org/article/banks-self-dealing-super-charged-financial-crisis (“A typical CDO could net the bank that created it between $5 million and $10 million – about half of which usually ended up as employee bonuses. Indeed, Wall Street awarded record bonuses in 2006, a hefty chunk of which came from the CDO business.”). Fee information obtained by the Subcommittee is consistent with this range of CDO fees. For example, Deutsche Bank received nearly $5 million in fees for Gemstone 7, and the head of its CDO Group said that Deutsche Bank received typically between $5 and 10 million in fees, while Goldman Sachs charged a range of $5 to $30 million in fees for Camber 7, Fort Denison, and the Hudson Mezzanine 1 and 2 CDOs. 12/20/2006 Gemstone 7 Securitization Credit Report, DB_PSI_00237655-71 and 3/15/2007 Gemstone CDO VII Ltd. Closing Memorandum, DB_PSI_00133536- 41; Subcommittee interview of Michael Lamont (9/29/2010); and Goldman Sachs response to Subcommittee QFRs at PSI-QFR-GS0249.

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addition, they established the ABX Index which allowed counterparties to wager on the rise or fall in the value of a basket of subprime RMBS securities, and which could be used to reflect the state of the subprime mortgage market as a whole.

Investment banks sometimes matched up parties who wanted to take opposite sides in a

structured finance transaction, and other times took one or the other side of a transaction to accommodate a client. At still other times, investment banks used these financial instruments to make their own proprietary wagers. In extreme cases, some investments banks set up structured finance transactions which enabled them to profit at the expense of their clients.

Two case studies, involving Goldman Sachs and Deutsche Bank, illustrate a variety of

troubling and sometimes abusive practices involving the origination or use of RMBS, CDO, CDS, and ABX financial instruments. Those practices included at times constructing RMBS or CDOs with assets that senior employees within the investment banks knew were of poor quality; underwriting securitizations for lenders known within the industry for issuing high risk, poor quality mortgages or RMBS securities; selling RMBS or CDO securities without full disclosure of the investment bank’s own adverse interests; and causing investors to whom they sold the securities to incur substantial losses.

In the case of Goldman Sachs, the practices included exploiting conflicts of interest with

the firm’s clients. For example, Goldman used CDS and ABX contracts to place billions of dollars of bets that specific RMBS securities, baskets of RMBS securities, or collections of assets in CDOs would fall in value, while at the same time convincing customers to invest in new RMBS and CDO securities. In one instance, Goldman took the entire short side of a $2 billion CDO known as Hudson 1, selected assets for the CDO to transfer risk from Goldman’s own holdings, allowed investors to buy the CDO securities without fully disclosing its own short position, and when the CDO lost value, made a $1.7 billion gain at the expense of the clients to whom it had sold the securities. While Goldman sometimes told customers that it might take an adverse investment position to the RMBS or CDO securities it was selling them, Goldman did not disclose that, in fact, it already had significant proprietary investments that would pay off if the particular security it was selling or if RMBS and CDO securities in general fell in value. In another instance, Goldman marketed a CDO known as Abacus 2007-AC1 to clients without disclosing that it had allowed the sole short party in the CDO, a hedge fund, to play a major role in selecting the assets. The Abacus securities quickly lost value, and the three long investors together lost $1 billion, while the hedge fund profited by about the same amount. In still other instances, Goldman took on the role of a collateral put provider or liquidation agent in a CDO, and leveraged that role to obtain added financial benefits to the fiscal detriment of the clients to whom it sold the CDO securities.

In the case of Deutsche Bank, during 2006 and 2007, the bank’s top CDO trader, Greg

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was asked to buy a specific CDO security and responded that it “rarely trades,” but he “would take it and try to dupe someone” into buying it. He also disparaged RMBS securities that, at the same time, were being included in Gemstone 7, a CDO being assembled by the bank for sale to investors. Gemstone 7 included or referenced 115 RMBS securities, many of which carried BBB, BBB-, or even BB credit ratings, making them among the highest risk RMBS securities sold to the public, yet received AAA ratings for its top three tranches. Deutsche Bank sold $700 million in Gemstone securities to eight investors who saw their investments rapidly incur delinquencies, rating downgrades, and losses. Mr. Lippmann at times referred to the industry’s ongoing CDO marketing efforts as a “CDO machine” or “ponzi scheme,” and predicted that the U.S. mortgage market as a whole would eventually plummet in value. Deutsche Bank’s senior management disagreed with his negative views, and used the bank’s own funds to make large proprietary investments in mortgage related securities that, in 2007, had a notional or face value of $128 billion and a market value of more than $25 billion. At the same time, Deutsche Bank allowed Mr. Lippmann to develop for the bank a $5 billion proprietary short position in the RMBS market, which it later cashed in for a profit of approximately $1.5 billion. Despite that gain, in 2007, due to its substantial long investments, Deutsche Bank incurred an overall loss of about $4.5 billion from its mortgage related proprietary investments.

The two case studies illustrate how investment banks engaged in high intensity sales efforts to market new CDOs in 2007, even as U.S. mortgage delinquencies climbed, RMBS securities incurred losses, the U.S. mortgage market as a whole deteriorated, and investors lost confidence. They demonstrate how these investment banks benefitted from structured finance fees, and had little incentive to stop producing and selling high risk, poor quality structured finance products. They also illustrate how the development of complex structured finance products, such as synthetic CDOs and naked credit default swaps, amplified market risk by allowing investors with no ownership interest in the “reference obligations” to place unlimited side bets on their performance. Finally, the two case histories demonstrate how proprietary trading led to dramatic losses in the case of Deutsche Bank and to conflicts of interest in the case of Goldman Sachs.

Investment banks were a major driving force behind the structured finance products that provided a steady stream of funding for lenders to originate high risk, poor quality loans and that magnified risk throughout the U.S. financial system. The investment banks that engineered, sold, traded, and profited from mortgage related structured finance products were a major cause of the financial crisis.

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A. Background

(1) Investment Banks In General

Historically, investment banks helped raise capital for business and other endeavors by helping to design, finance, and sell financial products like stocks or bonds. When a corporation needed capital to fund a large construction project, for example, it often hired an investment bank either to arrange a bank loan or to raise capital by designing, financing, and marketing an issue of shares or corporate bonds for sale to investors. Investment banks performed these services in exchange for fees.

Today, investment banks also participate in a wide range of other financial activities, including providing broker-dealer and investment advisory services, and trading commodities and derivatives. Investment banks also often engage in proprietary trading, meaning trading with their own money and not on behalf of a customer. Many investment banks are structured today as affiliates of one or more banks.

Under the Glass-Steagall Act of 1933, certain types of financial institutions had been

prohibited from commingling their services. For example, with limited exceptions, only broker- dealers could provide brokerage services; only banks could offer banking; and only insurers could offer insurance. Each financial sector had its own primary regulator who was generally prohibited from regulating services outside of its jurisdiction. Glass-Steagall also contained One reason for keeping the sectors separate was to prohibitions against proprietary trading. ensure that banks with federally insured deposits did not engage in the type of high risk activities that might be the bread and butter of a broker-dealer or commodities trader. Another reason was to avoid the conflicts of interest that might arise, for example, from a financial institution pressuring its clients to obtain all of its financial services from the same firm. A third reason was to avoid the conflicts of interest that arise when a financial institution is allowed to act for its own benefit in a proprietary capacity, while at the same time acting on behalf of customers in an agency or fiduciary capacity.

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Glass-Steagall was repealed in 1999, after which the barriers between banks, broker- dealers, and insurance firms fell. U.S. financial institutions not only began offering a mix of financial services, but also intensified their proprietary trading activities. The resulting changes in the way financial institutions were organized and operated made it more difficult for regulators to distinguish between activities intended to benefit customers versus the financial institution itself. The expanded set of financial services investment banks were allowed to offer also contributed to the multiple and significant conflicts of interest that arose between some investment banks and their clients during the financial crisis.

Federal law has never established a “super-regulator” with jurisdiction to police compliance and conduct across

1240 banking, brokerage, investment advisory, and insurance sectors, and that remains the case today. 1241

See Section 16 of the Banking Act of 1933, Pub. L. 73-66 (also known as the Glass-Steagall Act).

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(2) Roles and Duties of an Investment Bank: Market Maker, Underwriter, Placement Agent, Broker-Dealer

Investment banks typically play a variety of significant roles when dealing with their

clients, including that of market maker, underwriter, placement agent, and broker-dealer. Each role brings different legal obligations under federal securities law.

Market Maker. A “market maker” is typically a dealer in financial instruments that

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stands ready to buy and sell for its own account a particular financial instrument on a regular and continuous basis at a publicly quoted price. A major responsibility of a market maker is filling orders on behalf of customers. Market markers do not solicit customers; instead they maintain, buy, and sell quotes in a public setting, demonstrating their readiness to either buy or sell the specified security, and customers come to them. For example, a market maker in a particular stock typically posts the prices at which it is willing to buy or sell that stock, attracting customers based on the competitiveness of its prices. This activity by market makers helps provide liquidity and efficiency in the trading market for the security. It is common for a particular security to have multiple market makers who competitively quote the security.

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Market makers generally use the same inventory of assets to carry out both their market- making and proprietary trading activities. Market makers are allowed, in certain circumstances specified by the SEC, to sell securities short in situations to satisfy market demand when they do not have the securities in their inventory in order to provide liquidity. Market makers have among the most narrow disclosure obligations under federal securities law, since they do not actively solicit clients or make investment recommendations to them. Their disclosure obligations are generally limited to providing fair and accurate information related to the execution of a particular trade. market manipulation. In addition, they are subject to legal requirements relating to the handling of customer orders, for example using best execution efforts when placing a client’s buy or sell order.1245

Market makers are also subject to the securities laws’ prohibitions against fraud and

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Underwriter and Placement Agent. If an investment bank agrees to act as an

“underwriter” for the issuance of a new security to the public, such as an RMBS, it typically

1242 Section 3(a)(38) of the Securities Exchange Act of 1934 states: “The term “market maker” means any specialist permitted to act as a dealer, any dealer acting in the capacity of block positioner, and any dealer who, with respect to a security, holds himself out (by entering quotations in an inter-dealer communications system or otherwise) as being willing to buy and sell such security for his own account on a regular or continuous basis.” See also SEC website, http://www.sec.gov/answers/mktmaker.htm; FINRA website, FAQs, “What Does a Market Maker Do?” http://finra.atgnow.com/finra/categoryBrowse.do. 1243 Maker Do?” http://finra.atgnow.com/finra/categoryBrowse.do. 1244 Exchange Commission, at 55, http://www.sec.gov/news/studies/2011/913studyfinal.pdf. 1245

1/2011 “Study on Investment Advisers and Broker-Dealers,” study conducted by the U.S. Securities and

http://www.sec.gov/answers/mktmaker.htm; FINRA website, FAQs, “What Does a Market

See Responses to Questions for the Record from Goldman Sachs at PSI_QFR_GS0046.

See SEC website,

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purchases the securities from the issuer, holds them on its books, conducts the public offering, and bears the financial risk until the securities are sold to the public. By law, securities sold to the public must be registered with the SEC. Underwriters help issuers prepare and file the registration statements filed with the SEC, which explain to potential investors the purpose of a proposed public offering, the issuer’s operations and management, key financial data, and other important facts. Any offering document, or prospectus, given to the investing public in connection with a registered security must also be filed with the SEC.

If a security is not offered to the general public, it can still be offered to investors through

a “private placement.” Investment banks often act as the “placement agent,” performing intermediary services between those seeking to raise money and investors. Placement agents often help issuers design the securities, produce the offering materials, and market the new securities to investors. Offering documents in connection with private placements are exempt from SEC registration and are not filed with the SEC.

In the years leading up to the financial crisis, RMBS securities were registered with the SEC, while CDOs were sold to investors through private placements. Both of these securities were also traded in a secondary market by market makers. Investment banks sold both types of securities primarily to large institutional investors, such as other banks, pension funds, insurance companies, municipalities, university endowments, and hedge funds.

Whether acting as an underwriter or placement agent, a major part of the investment

bank’s responsibility is to solicit customers to buy the new securities being offered. Under the securities laws, investment banks that act as an underwriter or placement agent for new securities are liable for any material misrepresentation or omission of a material fact made in connection with a solicitation or sale of those securities to investors.

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The obligation of an underwriter and placement agent to disclose material facts to every

investor it solicits comes from two sources: the duties as an underwriter specifically, and the duties as a broker-dealer generally. With respect to duties relating to being an underwriter, the U.S. Court of Appeals for the First Circuit observed that underwriters have a “unique position” in the securities industry:

See Sections 11 and 12 of Securities Act of 1933. See also Rule 10b-5 of the Securities Exchange Act of 1934.

1246 See also, e.g., SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 201 (1963) (“Experience has shown that disclosure in such situations, while not onerous to the advisor, is needed to preserve the climate of fair dealing which is so essential to maintain public confidence in the securities industry and to preserve the economic health of the country.”). See also SEC Study on Investment Advisers and Broker-Dealers at 51 (citations omitted) (“Under the so- called ‘shingle’ theory …, a broker-dealer makes an implicit representation to those persons with whom it transacts business that it will deal fairly with them, consistent with the standards of the profession. … Actions taken by the broker-dealer that are not fair to the customer must be disclosed in order to make this implied representation of fairness not misleading.”).

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“[T]he relationship between the underwriter and its customer implicitly involves a favorable recommendation of the issued security. … Although the underwriter cannot be a guarantor of the soundness of any issue, he may not give it his implied stamp of approval without having a reasonable basis for concluding that the issue is sound.”

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In addition, Section 11 of the Securities Act of 1933 makes underwriters liable to any investor in any registered security if any part of the registration statement “contained an untrue statement of a material fact or omitted to state a material fact required to be stated therein or necessary to make the statements therein not misleading.”1248

Broker-Dealer. Broker-dealers also have affirmative disclosure obligations to their

clients. With respect to the duties of a broker-dealer, the SEC has held:

“[W]hen a securities dealer recommends a stock to a customer, it is not only obligated to avoid affirmative misstatements, but also must disclose material adverse facts to which it is aware. That includes disclosure of ‘adverse interests’ such as ‘economic self interest’ that could have influenced its recommendation.”

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To help broker-dealers understand when they are obligated to disclose material adverse facts to investors, the Financial Industry Regulatory Authority (FINRA) has further defined the term “recommendation”:

“[A] broad range of circumstances may cause a transaction to be considered recommended, and this determination does not depend on the classification of the transaction by a particular member as ‘solicited’ or ‘unsolicited.’ In particular a transaction will be considered to be recommended when the member or its associated person brings a specific security to the attention of the customer through any means, including, but not limited to, direct telephone communication, the delivery of promotional material through the mail, or the transmission of electronic messages.”1250

There is no indication in any law or regulation that the obligation to disclose material adverse facts is diminished or waived in relation to the level of sophistication of the potential investor.1251

SEC v. Tambone, 550 F.3d 106 (1st Cir. 2008) [citations omitted]. Section 11 of the Securities Act of 1933, codified at 15 U.S.C. § 77a. In the Matter of Richmark Capital Corporation, Securities Exchange Act Rel. No. 48758 (Nov. 7, 2003) (citing

1247 1248 1249 Chasins v. Smith Barney & Co., Inc., 438 F.3d 1167, 1172 (2d Cir. 1970) (“The investor … must be permitted to evaluate overlapping motivations through appropriate disclosures, especially where one motivation is economic self- interest”)). 1250 1251 correspondence may not “omit any material fact or qualification if the omission, in the light of the context of the material presented, would cause the communications to be misleading.”). See also FINRA Rule 2310 and IM-2310-

FINRA Notice No. 96-60. See FINRA Rules 2210(d)(1)(A) and 2211(a)(3) and (d)(1) (by rule all institutional sales material and

(3) Structured Finance Products

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Over time, investment banks have devised, marketed, and sold increasingly complex financial instruments to investors, often referred to as “structured finance” products. These products include residential mortgage backed securities (RMBS), collateralized debt obligations (CDOs), and credit default swaps (CDS), including CDS contracts linked to the ABX Index, all of which played a central role in the financial crisis.

RMBS and CDO Securities. RMBS and CDO securities are two common types of structured finance products. RMBS securities contain pools of mortgage loans, while CDOs contain or reference pools of RMBS securities and other assets. RMBS concentrate risk by including thousands of subprime and other high risk home loans, with similar characteristics and risks, in a single financial instrument. Mortgage related CDOs concentrate risk even more by including hundreds or thousands of RMBS securities, with similar characteristics and risks, in a single financial instrument. In addition, while some CDOs included only AAA rated RMBS securities, others known as “mezzanine” CDOs contained RMBS securities that carried the riskier BBB, BBB-, and even BB credit ratings and were more susceptible to losses if the underlying mortgages began to incur delinquencies or defaults.

Some investment banks went a step farther and assembled CDO securities into pools and

resecuritized them as so-called “CDO squared” instruments, which further concentrated the risk in the underlying CDOs. not contain any actual RMBS securities or other assets, but merely referenced them. Some devised “hybrid CDOs,” which contained a mix of cash and synthetic assets.

Some investment banks also assembled “synthetic CDOs,” which did

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The securitization process generated billions of dollars in funds that allowed investment banks to supply financing to lenders to issue still more high risk mortgages and securities, which investment banks and others then sold or securitized in exchange for still more fees. This cycle was repeated again and again, introducing more and more risk to a wider and wider range of investors.

Credit Default Swaps. Some investment banks modified still another structured finance

product, a derivative known as a credit default swap (CDS), for use in the mortgage market. Much like an insurance contract, a CDS is a contract between two parties in which one party guarantees payment to the other if the assets referenced in the contract lose value or experience a negative credit event. The party selling the insurance is referred to as the “long” party, since it profits if the referenced asset performs well. The party buying the insurance protection is referred to as the “short” party, because it profits if the referenced asset performs poorly.

3 (suitability obligation to institutional customers). 1252 use the term “CDO^2.”

CDO squared transactions will generally be referred to in this Report as “CDO .” Some Goldman materials also

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The short party, or CDS buyer, typically pays periodic premiums, similar to insurance

premiums, to the long party or CDS seller, who has guaranteed the referenced assets against a loss in value or a negative credit event such as a credit rating downgrade, default, or bankruptcy. If the loss or negative credit event occurs, the CDS seller is required to pay an agreed upon amount to the CDS buyer. Many CDS contracts also tracked the changing value of the referenced assets over time, and required the long and short parties to post cash collateral with each other to secure payment of their respective contractual obligations.

CDS contracts that reference a single, specific security or bond for protection against a

loss in value or negative credit event have become known as “single name” CDS contracts. Other CDS contracts have been designed to protect a broader basket of securities, bonds, or other assets.

By 2005, investment banks had standardized CDS contracts that referred to a “single

name” RMBS or CDO security. Some investment banks and investors, which held large inventories of RMBS and CDO securities, purchased those single name CDS contracts as a hedge against possible losses in the value of their holdings. Other investors, including investment banks, began to purchase single name CDS contracts, not as a hedge to offset losses from the RMBS or CDO securities they owned, but as a way to profit from particular RMBS or CDO securities they predicted would lose value or fail. CDS contracts that paid off on securities that were not owned by the CDS buyer became known as “naked credit default swaps.” Naked CDS contracts enabled investors to bet against mortgage related assets, using the minimal capital needed to make the periodic premium payments and collateral calls required by a CDS contract.

The key significance of the CDS product for the mortgage market was that it offered an

alternative to investing in RMBS and CDO securities that would perform well. Single name CDS contracts instead enabled investors to place their dollars in financial instruments that would pay off if specific RMBS or CDO securities lost value or failed.

ABX Index. In January 2006, a consortium of investment banks, led by Goldman Sachs and Deutsche Bank, launched still another type of structured finance product, linked to a newly created “ABX Index,” to enable investors to bet on multiple subprime RMBS securities at once. The ABX Index was administered by a private company called the Markit Group and consisted of five separate indices, each of which tracked the performance of a different basket of 20 designated subprime RMBS securities. The values of the securities in each basket were aggregated into a single composite value that rose and fell over time. Investors could then arrange, through a broker-dealer, to enter into a CDS contract with another party using the ABX basket of subprime RMBS securities as the “reference obligation” and the relevant ABX Index value as the agreed

1253

Each of the five indices tracked a different basket of subprime RMBS securities. One index tracked a basket of

1253 20 AAA rated RMBS securities; the second a basket of AA rated RMBS securities; and the remaining indices tracked baskets of A, BBB, and BBB- rated RMBS securities. Every six months, a new set of RMBS securities was selected for each index. See 3/2008 Federal Reserve Bank of New York Staff Report No. 318, “Understanding the Securitization of Subprime Mortgage Credit,” at 26. Markit Group Ltd. administered the ABX Index which issued indices in 2006 and 2007, but has not issued any new indices since then.

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upon value of that basket. For a fee, investors could take either the “long” position, betting on the rise of the index, or the “short” position, betting on the fall of the index, without having to physically purchase or hold any of the referenced securities or raise the capital needed to pay for the full face value of those referenced securities. The index also used standardized CDS contracts that remained in effect for a standard period of time, making it easier for investors to participate in the market, and buy and sell ABX-linked CDS contracts.

The ABX Index allowed investors to place unlimited bets on the performance of one or more of the subprime RMBS baskets. It also made it easier and cheaper for investors, including some investment banks, to short the subprime mortgage market in bulk. Investment banks not only helped establish the ABX Index, they encouraged their clients to enter into CDS contracts based upon the ABX Index, and used it themselves to bet on the mortgage market as a whole.
The ABX Index expanded the risks inherent in the subprime mortgage market by providing investors with a way to make unlimited investments in RMBS securities.

1254

Synthetic CDOs. By mid-2006, there was a large demand for RMBS and CDO securities

as well as a growing demand for CDS contracts to short the mortgage market. To meet this demand, investment banks and others began to make greater use of synthetic CDOs, which could be assembled more quickly, since they did not require the CDO arranger to find and purchase actual RMBS securities or other assets. The increasing use of synthetic CDOs injected even greater risk into the mortgage market by enabling investors to make unlimited wagers on various groups of mortgage related assets and, if those assets performed poorly, expanding the number of investors who would realize losses.

Synthetic CDOs did not depend upon actual RMBS securities or other assets to bring in

cash to pay investors. Instead, the CDO simply developed a list of existing RMBS or CDO securities or other assets that would be used as its “reference obligations.” The parties to the CDO were not required to possess an ownership interest in any of those reference obligations; the CDO simply tracked their performance over time. The performance of the underlying reference obligations, in the aggregate, determined the performance of the synthetic CDO.

The synthetic CDO made or lost money for its investors by establishing a contractual

agreement that they would make payments to each other, based upon the aggregate performance of the underlying referenced assets, using CDS contracts. The “short” party essentially agreed to make periodic payments, similar to insurance premiums, to the other party in exchange for an agreement that the “long” party would pay the full face value of the synthetic CDO if the underlying assets lost value or experienced a defined credit event such as a ratings downgrade. In essence, then, the synthetic CDO set up a wager in which the short party bet that its underlying assets would perform poorly, while the long party bet that they would perform well.

Subcommittee Interview of Joshua Birnbaum (4/22/2010); Subcommittee Interview of Rajiv Kamilla

1254 (10/12/2010).

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Synthetic CDOs provided still another vehicle for investors looking to short the mortgage

market in bulk. The synthetic CDO typically referenced a variety of RMBS securities. One or more investors could then take the “short” position and wager that the referenced securities as a whole would fall in value or otherwise perform poorly. Synthetic CDOs became a way for investors to short multiple specific RMBS securities that they expected to incur delinquencies, defaults, and losses.

Synthetic CDOs magnified the risk in the mortgage market because arrangers had no limit on the number of synthetic CDOs they could create. In addition, multiple synthetic CDOs could reference the same RMBS and CDO securities in various combinations, and sell financial instruments dependent upon the same sets of high risk, poor quality loans over and over again to various investors. Since every synthetic CDO had to have a “short” party betting on the failure of the referenced assets, at least some poor quality RMBS and CDO securities could be included in each transaction to attract those investors. When some of the high risk, poor quality loans later incurred delinquencies or defaults, they caused losses, not in a single RMBS, but in multiple cash, synthetic, and hybrid CDOs whose securities had been sold to a wide circle of investors.

1255

Conflicts of Interest. Investment banks that designed, obtained credit ratings for,

1256

underwrote, sold, managed, and serviced CDO securities, made money from the fees they charged for these and other services. Investment banks reportedly netted from $5 to $10 million in fees per CDO. Some also constructed CDOs to transfer the financial risk of poorly performing RMBS and CDO securities from their own holdings to the investors they were soliciting to buy the CDO securities. not only from the CDO sales, but also eliminated possible losses from the assets removed from their warehouse accounts. In some instances, unbeknownst to the customers and investors, the investment banks that sold them CDO securities bet against those instruments by taking short positions through single name CDS contracts. Some even took the short side of the CDO they

By selling the CDO securities to investors, the investment banks profited

1257

See “Banks’ Self-Dealing Super-Charged Financial Crisis,” ProPublica (8/26/2010),

See, e.g., “Senate’s Goldman Probe Shows Toxic Magnification,” Wall Street Journal (5/2/2010) (showing how

1255 a single $38 million subprime RMBS, created in June 2006, was included in 30 CDOs and, by 2008, had caused $280 million in losses to investors). 1256 http://www.propublica.org/article/banks-self-dealing-super-charged-financial-crisis (“A typical CDO could net the bank that created it between $5 million and $10 million – about half of which usually ended up as employee bonuses. Indeed, Wall Street awarded record bonuses in 2006, a hefty chunk of which came from the CDO business.”). Fee information obtained by the Subcommittee is consistent with this range of CDO fees. For example, Deutsche Bank received nearly $5 million in fees for Gemstone 7, and the head of its CDO group said that Deutsche Bank received typically between $5 and 10 million in fees, while Goldman Sachs charged a range of $5 to $30 million in fees for Camber 7, Fort Denison, and the Hudson Mezzanine 1 and 2 CDOs. 12/20/2006 Gemstone 7 Securitization Credit Report, DB_PSI_00237655-71 and 3/15/2007 Gemstone CDO VII Ltd. Closing Memorandum, DB_PSI_00133536- 41; Subcommittee interview of Michael Lamont (9/29/2010); and Goldman Sachs response to Subcommittee QFRs at PSI-QFR-GS0249. 1257 tried selling subprime loans but could not; it was easier and more efficient to securitize them and then sell the securitized product to transfer loans in bulk; it was also easier to sell CDOs than individual underlying positions).

See, e.g., discussion of the Hudson CDO, below; Subcommittee interview of Daniel Sparks (4/15/10) (Goldman

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constructed, and profited when the referenced assets lost value, and the investors to whom they had sold the long side of the CDO were required to make substantial payments to the CDO.

The following two case studies examine how two investment banks active in the U.S.

mortgage market constructed, marketed, and sold RMBS and CDO securities; how their activities magnified risk in the mortgage market; and how conflicts of interest negatively impacted investors and contributed to the financial crisis. The Deutsche Bank case history provides an insider’s view of what one senior CDO trader described as Wall Street’s “CDO machine.” It reveals the trader’s negative view of the mortgage market in general, the poor quality RMBS assets placed in a CDO that Deutsche Bank marketed to clients, and the fees that made it difficult for investment banks like Deutsche Bank to stop selling CDOs. The Goldman Sachs case history shows how one investment bank was able to profit from the collapse of the mortgage market, and ignored substantial conflicts of interest to profit at the expense of its clients in the sale of RMBS and CDO securities.

B. Running the CDO Machine:
Case Study of Deutsche Bank

This case history examines the role of Deutsche Bank USA in the design, marketing, and

sale of collateralized debt obligations (CDOs) that incorporated or referenced residential mortgage backed securities (RMBS).

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From 2004 to 2008, U.S. financial institutions issued over $1.4 trillion worth of CDO

securities. At first, this complex structured finance product proved highly profitable for investment banks which established CDO departments and trading desks to create and market the securities. By early 2007, however, due to declining housing prices, accelerating mortgage delinquencies, and RMBS losses, investor interest in CDOs began to drop off sharply. In July 2007, the major credit rating agencies began lowering credit ratings for many CDO securities, at times eliminating the investment grade ratings that had supported CDO sales. Despite waning investor interest, U.S. investment banks continued to issue new mortgage related CDOs throughout 2007, in an apparent effort to sustain their fees and CDO departments. Some investment banks supported the CDO market by purchasing existing CDO securities for inclusion in new, even more complex CDOs, seeking customers in Europe and Asia, or retaining risky CDO securities on their own books.

Deutsche Bank was a major player in the CDO market, both in creating new CDO issues

and trading these securities in the secondary market. Deutsche Bank’s top global CDO trader, Greg Lippmann, began to express concerns that the CDO market was unsustainable. By the middle of 2006, Mr. Lippmann repeatedly warned and advised his Deutsche Bank colleagues and some of his clients seeking to buy short positions about the poor quality of the assets underlying many CDOs. He described some of those assets as “crap” and “pigs,” and predicted the assets and the CDO securities would lose value.

At one point, Mr. Lippmann was asked to buy a specific CDO security and responded

that it “rarely trades,” but he “would take it and try to dupe someone” into buying it. He also at times referred to the industry’s ongoing CDO marketing efforts as a “CDO machine” or “ponzi scheme.” Deutsche Bank’s senior management disagreed with his negative views, and used the bank’s own funds to make large proprietary investments in mortgage related securities that, in 2007, had a notional or face value of $128 billion and a market value of more than $25 billion.

Despite disagreeing with his negative views on the mortgage market, Deutsche Bank

allowed Mr. Lippmann, in 2005, to develop a large proprietary short position for the bank in the RMBS market. Since carrying that short position required the bank to pay millions of dollars in premiums, senior management also required Mr. Lippmann to defray or eliminate those costs by convincing others to take short positions in the mortgage market, thereby generating fees for the bank from arranging those shorts. In 2006, Mr. Lippmann generated an estimated $200 million in fees by encouraging his clients, such as hedge funds, to buy short positions. Simultaneously, Mr. Lippmann increased the size of the bank’s short position by taking the short side of credit default swaps (CDS) referencing individual RMBS securities, an investment strategy often

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To understand how Deutsche Bank continued to issue and market CDO securities even as

referred to as investing in “single name CDS” contracts. Over a two-year period from 2005 to 2007, Mr. Lippmann built a massive short position in single name CDS contracts totaling $5 billion. From 2007 to 2008, at the direction of the bank’s senior management, he cashed in that position, generating a profit for his trading desk of approximately $1.5 billion, which he claims made more money on a single position than any other trade had ever made for Deutsche Bank in its history. Despite that gain, due to its substantial long investments, Deutsche Bank incurred an overall loss of about $4.5 billion from its mortgage related proprietary investments.1258

the market for mortgage related securities began collapsing, the Subcommittee examined a specific CDO in detail, called Gemstone CDO VII Ltd. (Gemstone 7). In October 2006, Deutsche Bank began assisting in the gathering of assets for Gemstone 7, which issued its securities in March 2007. It was the last in a series of CDOs sponsored by HBK Capital Management (HBK), a large hedge fund which acted as the collateral manager for the CDO.
Deutsche Bank made $4.7 million in fees from the deal, while HBK was slated to receive $3.3 million. It was not the last CDO issued by Deutsche Bank. Even after Gemstone 7 was issued in March of 2007, Deutsche Bank issued 9 additional CDOs.

RMBS securities initially valued at $1.1 billion when issued. Deutsche Bank’s head global trader, Mr. Lippmann, recognized that these RMBS securities were high risk and likely to lose value, but did not object to their inclusion in Gemstone 7. Deutsche Bank, the sole placement agent, marketed the initial offering of Gemstone 7 in the first quarter of 2007. Its top tranches received AAA ratings from Standard & Poor’s and Moody’s, despite signs that the CDO market was failing and the CDO itself contained many poor quality assets.

Gemstone 7 was a hybrid CDO containing or referencing a variety of high risk, subprime

Nearly a third of Gemstone’s assets consisted of high risk subprime loans originated by Fremont, Long Beach, and New Century, three lenders known at the time within the financial industry for issuing poor quality loans and RMBS securities. Although HBK directed the selection of assets for Gemstone 7, Mr. Lippmann’s CDO Trading Desk was involved in the process and did not object to including certain RMBS securities in Gemstone 7, even though Mr. Lippmann was simultaneously referring to them as “crap” or “pigs.” Mr. Lippmann was also at the same time advising some of his clients to short some of those same RMBS securities. In addition, Deutsche Bank sold five RMBS securities directly from its inventory to Gemstone 7, several of which were also contemporaneously disparaged by Mr. Lippmann.

The Deutsche Bank sales force aggressively sought purchasers for the CDO securities, while certain executives expressed concerns about the financial risk of retaining Gemstone 7 assets as the market was deteriorating in early 2007. In its struggle to sell Gemstone 7, Deutsche Bank motivated its sales force with special financial incentives, and sought out buyers in Europe and Asia because the U.S. market had dried up. Deutsche Bank also talked of providing HBK’s marks, instead of its own, to clients asking about the value of Gemstone 7’s assets, since HBK’s

1258 Subcommittee interview of Greg Lippmann (10/18/2010); Net Revenues from ABS Products Backed by U.S. Residential Mortgages, DB_PSI_C00000003.

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marks showed the CDO’s assets performing better. Deutsche Bank was ultimately unable to sell $400 million, or 36%, of the Gemstone 7 securities, and agreed with HBK to split the unsold securities, each taking $200 million onto its own books. Deutsche Bank did not disclose to the eight investors whom it had solicited and convinced to buy Gemstone 7, that its global head trader of CDOs had an extremely negative view of a third of the assets in the CDO or that the bank’s internal valuations showed that the assets had lost over $19 million in value since purchased.1259

Gemstone 7 also demonstrated how CDOs magnified risk by including or referencing

within itself 115 different RMBS securities containing thousands of high risk, poor quality subprime loans. Many of those RMBS securities carried BB ratings, which are non-investment grade credit ratings and were among the highest risk securities in the CDO. Gemstone 7 also included CDO securities that, in themselves, concentrated the risk of their underlying assets.
Over 75% of Gemstone’s assets consisted of RMBS securities with ratings of BBB or lower, including approximately 33% with non-investment grade ratings, yet Gemstone’s top three tranches were given AAA ratings by the credit rating agencies. The next three tranches were given investment grade ratings as well. Those investment grade ratings enabled investors like pension funds, insurance companies, university endowments, and municipalities, some of which were required by law, regulation, or their investment plans to put their funds in safe investments, to consider buying Gemstone securities. Eight investors actually purchased them. Within eight months, the Gemstone securities began incurring rating downgrades. By July 2008, all seven tranches in the CDO had been downgraded to junk status, and the long investors were almost completely wiped out. Today, the Gemstone 7 securities are nearly worthless.

Deutsche Bank was, in Mr. Lippmann’s words, part of a “CDO machine” run by

investment banks that produced hundreds of billions of high risk CDO securities. Because the fees to design and market CDOs ranged from $5 to $10 million per CDO, investment bankers had a strong financial incentive to continue issuing them, even in the face of waning investor interest and poor quality assets, since reduced CDO activity would have led to less income for structured finance units, smaller bonuses for executives, and even the disappearance of CDO departments, which is eventually what occurred. The Deutsche Bank case history provides a cautionary tale for both market participants and regulators about how complex structured finance products gain advocates within an organization committed to pushing the products through the pipeline to maintain revenues and jobs, regardless of the financial risks or possible impact on the marketplace.

1259 See Sections 11 and 12 of Securities Act of 1933. See also Rule 10b-5 of the Securities Exchange Act of 1934. For a more detailed discussion of the legal obligations of underwriters, placement agents, and broker-dealers, see Section C(6) on conflicts of interest analysis, below.

(1) Subcommittee Investigation and Findings of Fact

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As part of its investigation into the CDO market and the Deutsche Bank case study, the

Subcommittee collected and reviewed hundreds of thousands of Deutsche Bank documents including reports, analyses, memoranda, correspondence, transcripts, spreadsheets, and email.
The Subcommittee also collected and reviewed documents from HBK Capital Management, several financial institutions that purchased Deutsche Bank CDO securities, and the Securities and Exchange Commission (SEC). In addition, the Subcommittee conducted 14 interviews, including interviews with current and former Deutsche Bank and HBK executives, managers, sales representatives, and traders; spoke with personnel from the financial institutions that invested in Gemstone 7; and consulted with a number of experts from the SEC, academia, and industry.

Based upon the Subcommittee’s review, the Report makes the following findings of fact.

CDO Machine. From late 2006 through 2007, despite increasing mortgage

delinquencies, RMBS losses, and investor flight from the U.S. mortgage market, U.S. investment banks continued to issue new CDOs, including Deutsche Bank which issued 15 new CDOs securitizing nearly $11.5 billion of primarily mortgage related assets from December 2006 to December 2007.

Fee Incentives. Because the fees charged to design and market CDOs were in the

range of $5 to $10 million per CDO, investment banks had strong incentives to continue issuing CDOs despite increasing risks and waning investor interest, since reduced CDO activity meant less revenues for structured finance units and even the disappearance of CDO departments and trading desks, which is eventually what occurred.

Deutsche Bank’s $5 Billion Short. Although Deutsche Bank as a whole and through

an affiliated hedge fund, Winchester Capital, made proprietary investments in long mortgage related assets, the bank also permitted its head CDO trader to make a $5 billion short investment that bet against the mortgage market and produced bank profits totaling approximately $1.5 billion.

Proprietary Loss. By 2007, Deutsche Bank, through its mortgage department and an

affiliated hedge fund, had substantial proprietary holdings in the mortgage market, including more than $25 billion in long investments and a $5 billion short position, which together resulted in 2007 losses to the bank of about $4.5 billion.

Gemstone 7. In the face of a deteriorating market, Deutsche Bank aggressively sold a $1.1 billion CDO, Gemstone 7, which included RMBS securities that the bank’s top CDO trader had disparaged as “crap” and “pigs,” and which produced $1.1 billion of high risk, poor quality securities that are now virtually worthless.

Total Annual CDO Issuance

2000-2009 Total CDO Issuance

($ in billions)

Year 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

67.99
78.45
83.07
86.63
157.82
251.27
520.64
481.60
61.89
4.34

(2) Deutsche Bank Background

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CDOs In General. According to the Securities Industry and Financial Markets

Association, $1.4 trillion worth of CDOs were issued in the United States from 2004 through the end of 2007.1260 The following chart depicts the dramatic rise and fall of the U.S. CDO market over the last ten years, with total CDO issuance reaching its peak in 2006 at $520 billion, and then falling to a low of $4 billion in 2009.1261

In 2006 and 2007, investment banks created around half a trillion dollars in CDO securities each year, even as U.S. housing prices began to stagnate and decline, subprime mortgages began to default at record rates, and RMBS securities began to incur dramatic losses.
By the middle of 2007, due to the increasing risks, U.S. institutional investors like pension funds, hedge funds, and others began to purchase fewer CDO securities, and investment banks turned their attention increasingly to European and Asian investors as well as the issuers of new CDOs who became the primary buyers of CDO securities.1262 In 2007, U.S. investment banks kept issuing and selling CDOs despite slowed sales, which meant that investment banks had to retain an increasing portion of the unsold assets on their own balance sheets.1263

1260 10/15/2010 “Global CDO Issuance,” Securities Industry and Financial Markets Association, http://www.sifma.org/research/statistics.aspx.
1261 Chart prepared by the Subcommittee using data from 10/15/2010 “Global CDO Issuance,” Securities Industry and Financial Markets Association, http://www.sifma.org/research/statistics.aspx. By 2004, most, but not all, CDOs relied primarily on mortgage related assets such as RMBS securities. Subcommittee interview of Gary Witt, former Managing Director of Moody’s RMBS Group (10/29/2009).
1262 See 7/12/2007 email from Michael Lamont to Boaz Weinstein at Deutsche Bank, DBSI_01201843; “Banks’ Self-Dealing Super Charged Financial Crisis,” ProPublica (8/26/2010), http://www.propublica.org/article/banks- self-dealing-super-charged-financial-crisis; and “Mortgage-Bond Pioneer Dislikes What He Sees,” Wall Street Journal (2/24/2007).
1263 “Banks’ Self-Dealing Super Charged Financial Crisis,” ProPublica (8/26/2010).

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The credit rating agencies marked a “sea change” in the CDO market in 2007, in which investment banks issued CDOs at near record levels in the first half of the year, but then sharply reined in their efforts after the mass rating downgrades of RMBS and CDO securities began in July 2007:

“[The CDO] market in the U.S. was very active in terms of issuance throughout the first half of 2007. … The year 2007 saw a sea change for the CDO market. Moody’s rated more than 100 SF [structured finance] CDO transactions in each of the first two quarters, but the number fell sharply to 40 in the third quarter and to just eight in the fourth quarter as the sheer speed and magnitude of the subprime mortgage fallout significantly weakened investors’ confidence.”1264

In the years leading up to the financial crisis, the typical size of a CDO deal was between

1265 and generated large fees for investment banks in the range of $5 to $10 To handle these transactions, a number of large investment banks

$1 and $1.5 billion, million per CDO.1266 established CDO departments and trading desks charged with designing, underwriting, selling, or trading CDO securities. The CDO origination desks typically worked with the investment banks’ structured finance sales force to sell the resulting CDO securities. This structure meant that stopping the issuance of CDO securities would require the investment banks to lose out on the fees, prestige, and market share tied to CDO sales. In addition, whole CDO departments, with their dedicated bankers, traders, and supervisors, would have to disappear, which is eventually what happened after the CDO market crashed.

CDOs at Deutsche Bank. From 2004 to 2008, Deutsche Bank issued 47 asset backed

1267 According to analysts, in both 2006 and CDOs for a total securitization of $32.2 billion. 2007, Deutsche Bank ranked fourth globally in issuing asset backed CDOs, behind Merrill Lynch, JPMorgan Chase, and Citigroup.1268

1264 Moody’s 2008 Global CDO Review (3/3/2008).
1265 “Wall Street’s money machine breaks down,” CNNMoney.com (11/12/2007), http://money.cnn.com/magazines/fortune/fortune_archive/2007/11/26/101232838/index.htm. 1266 See “Banks’ Self-Dealing Super-Charged Financial Crisis,” ProPublica (8/26/2010), http://www.propublica.org/article/banks-self-dealing-super-charged-financial-crisis (“A typical CDO could net the bank that created it between $5 million and $10 million – about half of which usually ended up as employee bonuses. Indeed, Wall Street awarded record bonuses in 2006, a hefty chunk of which came from the CDO business.”). Fee information obtained by the Subcommittee is consistent with this range of CDO fees. For example, Deutsche Bank received nearly $5 million in fees for Gemstone 7, and the head of its CDO Group said that Deutsche Bank received typically between $5 and 10 million in fees per CDO, while Goldman Sachs charged a range of $5 to $30 million in fees for its Camber 7, Fort Denison, and Hudson Mezzanine 1 and 2 CDOs. 12/20/2006 Gemstone 7 Securitization Credit Report, DB_PSI_00237655-71; undated Gemstone 7 Securitization Credit Report, MTSS000011-13; 3/15/2007 Gemstone CDO VII Ltd. Closing Memorandum, DB_PSI_00133536-41; Subcommittee interview of Michael Lamont (Deutsche Bank) (9/29/2010); 3/21/2011 letter from Deutsche Bank’s counsel to the Subcommittee, PSI-Deutsche_Bank-0001-04; Goldman Sachs response to Subcommittee QFRs at PSI-QFR-GS0249. 1267 Chart, ABS CDOs Issued by DBSI (between 2004 and 2008), PSI-Deutsche_Bank-02-0005-23.
1268 See “Global ABS CDO Issuance” chart, Reuters (4/20/2010), http://graphics.thomsonreuters.com/10/04/GLB_GCDOV0410.gif; “Banks in Talks to End Bond Probe,” Wall Street Journal (12/2/2010),

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At Deutsche Bank, five different parts of the Securitized Product Group played key roles

The CDO Group had two co-heads, Michael Lamont and Michael Herzig, and

in its CDO business. They were the CDO Group (North America); the CDO sales force, formally called Securitized Products; the CDO Syndication Desk which helped promote and track CDO sales; the mortgage department; and the CDO Trading Desk, formally called ABS (Asset Backed Security) Trading, CDO Trading, and ABS Correlation Trading.

approximately 20 employees. The heads of the group reported to Richard D’Albert, Global Head of Deutsche Bank’s Securitized Product Group. The CDO Group designed and structured the bank’s CDOs, analyzed the assets that went into the CDOs, monitored the purchasing and warehousing of those assets, obtained CDO credit ratings, prepared CDO legal documentation, acted as the CDO underwriter or placement agent on behalf of Deutsche Bank, and oversaw the issuance of the CDO securities.1269

The CDO sales force sold the resulting CDO securities for Deutsche Bank. It received assistance from the CDO Syndication, sometimes called the “syndicate,” which helped promote the deals with investors and tracked CDO sales. The CDO sales force was headed by Sean Whelan and Michael Jones. They reported to Munir D’auhajre, overall head of sales, who reported, in turn, to Fred Brettschneider, the head of the Institutional Client Group of Deutsche Bank Americas. The CDO sales force had approximately 20 employees. In the United States, the CDO Syndication had about seven employees, and was headed by Anthony Pawlowski, who reported to Mr. Lamont and Mr. Herzig, who headed the CDO Group.

The Deutsche Bank mortgage department was responsible for purchasing residential

mortgages from a variety of sources, warehousing those mortgages, and securitizing the mortgages into RMBS securities for which Deutsche Bank acted as the underwriter or placement agent. Some of those RMBS securities were later included or referenced in CDOs issued by the bank.

The CDO Trading Desk was headed by Greg Lippmann, who served as global head of

Deutsche Bank’s CDO, ABS, and ABS Correlation Trading Desks.1270 Those desks were responsible for trading a variety of RMBS, CDO, and other asset backed securities on the secondary market. Mr. Lippmann had a staff of approximately 30 employees, 20 in the United States and 10 in London. Like the head of the CDO Group, Mr. Lippmann reported to Mr. D’Albert, the head of the bank’s Securitized Product Group. Mr. Lippmann was also the head of risk management for all new issue CDOs and described himself as “involved in underwriting, structuring, marketing and hedging our warehouse risk for new issue cdos.”1271

http://online.wsj.com/article/SB10001424052748704594804575649170454587534.html?KEYWORDS=Banks+in+ . See also 10/2006, “CDO Primary Update Progress Report,” prepared by Deutsche Talks+to+End+Bond+Probe Bank, DBSI_PSI_EMAIL03970167-72, at 68 (ranking Deutsche Bank as third in CDO issuances as of October 2006).
1269 Subcommittee interview of Michael Lamont (9/29/2010). 1270 Organizational Chart for Deutsche Bank Global CDO Group, DB_PSI_C00000001. 1271 7/14/2006 email from Greg Lippmann to Melissa Goldsmith at Deutsche Bank, DBSI_PSI_EMAIL01400135-

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The CDO Trading Desk conducted trades for both clients and other Deutsche Bank

entities. It was further divided into three trading desks, designated the CDO, ABS, and ABS Correlation Desks. Each traded certain structured finance products, tracked relevant market news and developed expertise in its assigned products, and served as a source of asset and market information for other branches of Deutsche Bank. The CDO Desk focused on buying and selling CDO securities; the ABS Desk concentrated on trading RMBS and other asset backed securities as well as short trading strategies involving credit default swap (CDS) contracts in single name RMBS; and the ABS Correlation Desk acted primarily in a market making capacity for Deutsche Bank clients, trading both long and short RMBS and CDO securities and CDS contracts with the objective of taking offsetting positions that minimized the bank’s risk.1272

Deutsche Bank in 2000, after a stint at Credit Suisse trading bonds. One publication noted that Mr. Lippmann “made his name with big bets on a housing bust,” continuing: “Mr. Lippmann emerged as a Cassandra of the financial crisis, spotting cracks in the mortgage market as early as

His warnings helped Deutsche brace for the crisis. He also helped investors – and himself
– land huge profits as big bets that the housing market would collapse materialized.”1273

Mr. Lippmann was well known in the CDO marketplace as a trader. He had joined

(3) Deutsche Bank’s $5 Billion Short

In 2006 and 2007, Deutsche Bank’s top CDO trader, Greg Lippmann, repeatedly warned his Deutsche Bank colleagues and some clients outside of the bank about the poor quality of the assets underlying many RMBS and CDO securities. Although senior management within the bank did not agree with his views, they allowed Mr. Lippmann, in 2005, to establish a large short position on behalf of the bank, essentially betting that mortgage related securities would fall in value. From 2005 to 2007, Mr. Lippmann built that position into a $5 billion short.

(a) Lippmann’s Negative Views of Mortgage Related Assets

Emails produced to the Subcommittee provide repeated examples of Mr. Lippmann’s

negative views of mortgage related assets, particularly those involving subprime mortgages. At times, he expressed his views to colleagues within the bank; at other times he expressed them in connection with advising a client to bet against an RMBS security by taking a short position. At times, Mr. Lippmann recommended that his clients short poor quality RMBS assets, even while his trading desk was participating in a selection process that included those same assets in Gemstone 7. The following emails by Mr. Lippmann, written during 2006 and 2007, provide examples of his negative views.

1272 Subcommittee interview of Greg Lippmann (10/18/2010). 1273 “Lippmann, Deutsche Trader, Steps Down,” New York Times (4/21/2010), http://dealbook.nytimes.com/2010/04/21/lippmann-deutsche-trader-steps-down/. See also Michael Lewis, The Big Short (2010), at 64.

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• Emails regarding LBMLT 2004-3 M8, a subprime RMBS security issued by Long

Beach: “[T]his bond blows.”1274

(2/24/2006)

• Email providing Deutsche Bank trader his opinion regarding RMBS shelves:

[“[Y]ikes didn’t see that[.] … [H]alf of these are crap and rest are ok[.] …[C]rap-heat pchlt sail tmts.”1275

(4/5/2006)

• Email advising an investment banker at JPMorgan Chase regarding subprime RMBS

securities issued by Aegis Asset Backed Securities Trust (“aabst”), Bay View Financial Acquisition Trust (“bayv”), Home Equity Mortgage Loan Asset Based Trust (“inabs”), Park Place Securities Inc. (“ppsi”), and Structured Asset Investment Loan (“sail”): “This is a good pool for you because it has a fair number of weak names but not so many that investors should balk (I wouldn’t add more of these) and also has only a few names that are very good.”1276

(6/23/2006)

• Email advising an investment banker at Oppenheimer Funds: “[Y]ou can certainly build a portfolio by picking only bad names and you have largely done that as Rasc ahl is considered bad as is Fremont (bsabs fr, fhlt, jpmac fre, sabr fr, nheli fm deals) ace, arsi and lbmlt.”1277 Mr. Lippmann listed ACE Securities Corp. as a “bad name” even though it was created by and associated with Deutsche Bank itself.1278 (8/4/2006)

1274 2/24/2006 emails between Greg Lippmann and Rocky Kurita at Deutsche Bank, DBSI_PSI_EMAIL00966290.
Mr. Lippmann’s negative comments did not begin in 2006; as early as May 2005, he wrote that the “real money flows are buying protection.” 5/11/2005 email from Greg Lippmann to Rocky Kurita at Deutsche Bank, DBSI_PSI_EMAIL00048683. 1275 4/5/2006 email from Greg Lippmann to Deutsche Bank employee, DBSI_PSI_EMAIL01073270. The acronyms in the email refer to the following lenders: Home Equity Asset Trust (“heat”), People’s Choice Home Loan Securities Trust (“pchlt”), Structured Asset Investment Loan (“sail”), and Terwin Mortgage Trust (“tmts”). 1276 6/23/2006 email from Greg Lippmann to Derek Kaufman at JPMorgan, DBSI_PSI_EMAIL01344930-33.
1277 8/4/2006 email from Greg Lippmann to Michelle Borre at Oppenheimer Funds, DBSI_PSI_EMAIL01528941-

The acronyms in the email refer to the following lenders: Residential Asset Securities Corp. (“Rasc”), American Home Loans (“ahl”), Fremont (“fr,” “fre,” “fm,” and “fhlt”), Bear Stearns Asset Backed Securities (bsabs), JPMorgan Acquisition Trust (“jpmac”), Securitized Asset Backed Receivables Trust (“sabr”), Nomura Home Equity Loan, Inc. (“nheli”), ACE Securities Corp. (“ace”), Argent Securities Inc. (“arsi”), and Long Beach Mortgage Trust (“lbmlt”). 1278 Subcommittee interview of Greg Lippmann (10/18/2010); Subcommittee interview with Deutsche Bank’s counsel (3/7/2011); 3/21/2011 letter from Deutsche Bank’s counsel to the Subcommittee (ACE is one of “Deutsche Bank’s own shelf offerings.”), PSI-Deutsche_Bank-32-0001-04. See also 3/2/2011 letter from Deutsche Bank’s counsel to the Subcommittee (“Deutsche Bank has no ownership interest in ACE Securities Corp. (‘ACE’). All shares of ACE are held by Altamont Holdings Corp, a Delaware corporation. Deutsche Bank Securities, Inc. (‘DBSI’), however, is an administrative agent for ACE and in that role has authority to act on behalf of ACE in connection with offerings of asset-backed securities, including RMBS offerings. … Deutsche Bank hired the AMACAR Group, LLC (‘AMACAR’) to assist in the creation of ACE to act as a registrant and depositor in connection with RMBS offerings sponsored and/or underwritten by Deutsche Bank.”), PSI-DeutscheBank-31-0004-

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• Email to co-head of the Deutsche Bank CDO Group and to Global Head of Deutsche

Bank’s Securitized Product Group: “I was going to reject this [long purchase of a synthetic CDO] because it seems to be a pig cdo position dump 60^ but then I noticed winchester [Deutsche Bank affiliated hedge fund] is the portfolio selector……any idea???”1279

(8/4/2006)

• Email responding to a hedge fund trader at Spinnaker Capital asking about a

subprime RMBS security issued by Credit Based Asset Servicing and Securitization, LLC (“cbass”): “That said I can probably short this name to some CDO fool.”1280 (8/30/2006)

• Email responding to a hedge fund trader at Spinnaker Capital asking about MABS

2006-FRE1, a subprime RMBS security that contained Fremont loans and was issued by Mortgage Asset Securitization Transactions Asset-Backed Securities Trust: “This kind of stuff rarely trades in the synthetic market and will be tough for us to cover i.e. short to a CDO fool. That said if u gave us an order at 260 we would take it and try to dupe someone.”1281

(9/1/2006)

• Email describing MABS 2006-FRE1, a subprime RMBS security that contained

Fremont loans and was issued by Mortgage Asset Securitization Transactions Asset- Backed Securities Trust, as a “crap bond.”1282

(9/01/2006)

• Email describing MSHEL 2006-1 B3, an RMBS security issued by Morgan Stanley as “crap we shorted”; referring to GSAMP 2006-HE3 M9, an RMBS security issued by Goldman Sachs, as “this bond sucks but we are short 20MM”; and noting with regard to ACE, which was created by and associated with Deutsche Bank, that “ace is generally horrible.”1283

(9/21/2006)

• Email responding to a hedge fund trader at Mast Capital: “Long Beach is one of the

weakest names in the market.”1284

(10/20/2006)

• Email to a client selecting bonds to short: “u have picked some crap right away so u

have figured it out.”1285

(12/04/2006)

1279 8/23/2006 email from Greg Lippmann to Michael Lamont and Richard D’Albert, DBSI_PSI_EMAIL01605465. 1280 8/30/2006 email from Greg Lippmann to Bradley Wickens at Spinnaker Capital, DBSI_PSI_EMAIL01634802. 1281 9/1/2006 email from Greg Lippmann to Bradley Wickens at Spinnaker Capital, DBSI_PSI_EMAIL02228884. 1282 9/1/2006 email from Greg Lippmann to Bradley Wickens at Spinnaker Capital, DBSI_PSI_EMAIL01645016. 1283 9/21/2006 email from Greg Lippmann to Deutsche Bank employee, DBSI_PSI_EMAIL01689001-02. In an October 2006 email, a Deutsche Bank employee wrote to Mr. Lippmann and others that a number of RMBS such as LBMLT, HEAT, INABS, AMSI/ARSI, RAMP/RASC, and CWL “would be impossible to sell to the public” due to their poor quality. 10/2/2006 email from Axel Kunde at Deutsche Bank to Sean Whelan with copy to Mr. Lippmann, DBSI_PSI_EMAIL02255361. 1284 10/20/2006 email from Greg Lippmann to Craig Carlozzi at Mast Capital, DBSI_PSI_EMAIL01774820-21.

• Email regarding GSAMP 06-NC2 M8, an RMBS security that contained New

Century loans and was issued by Goldman Sachs: “[T]his is an absolute pig.”1286 (12/8/2006)

• Email describing ABSHE 2006-HE1 M7, a subprime RMBS security issued by Asset

Backed Securities Corporation Home Equity Loan Trust, as a “crap deal”; and describing ACE 2006 HE2 M7, a subprime RMBS securitization issued by ACE Securities Corp., as: “[D]eal is a pig!”1287

(3/1/2007)

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When asked about these emails, Mr. Lippmann told the Subcommittee that he generally thought all assets in CDOs were weak, and that his descriptions were often a form of posturing while negotiating prices with his clients. In a number of cases, however, Mr. Lippmann was assisting his clients in devising short strategies or communicating with Deutsche Bank colleagues, rather than negotiating with clients over prices. As will be seen later in this Report, some of the RMBS securities he criticized were, at virtually the same time, being included by his trading desk in Gemstone 7, which was later sold by Deutsche Bank’s CDO Group.

In addition to disparaging individual RMBS securities, Mr. Lippmann expressed repeated negative views about the CDO market as a whole. At times during 2006 and 2007, he referred to CDO underwriting activity by investment banks as the workings of a “CDO machine” or “ponzi scheme.”1288 In June 2006, for example, a year before CDO credit ratings began to be downgraded en masse, Mr. Lippmann sent an email to a hedge fund trader warning about the state of the CDO market: “[S]tuff is flat b/c [because] the cdo machine has not slowed but I am fielding 2-4 new guys a day that are kicking the tires so we probably don’t go tighter.” 1289 A few months later, in August 2006, Mr. Lippmann wrote about the coming market crash: “I don’t care what some trained seal bull market research person says this stuff has a real chance of massively blowing up.”1290

When asked about his comments, Mr. Lippmann told the Subcommittee that the CDO

Mr. Lippmann also told the Subcommittee that while he knew that the

market was not really a ponzi scheme, because people did receive an investment return, and asserted that he had used the term because he was “grasping at things” to prove he was right in his short position.1291 major credit rating agencies had given AAA ratings to an unusually large number of RMBS and CDO securities and most people believed in the ratings, he did not. He also told the

1285 12/4/2006 email from Greg Lippmann to Mark Lee at Contrarian Capital, DBSI_PSI_EMAIL01866336. The acronyms in the email refer to the following lenders: Bear Stearns Asset Backed Securities (“bsabs”), Option One Mortgage Loan Trust (“omlt”), and Ameriquest Mortgage Securities, Inc. (“amsi”). 1286 12/8/2006 email from Greg Lippmann to Peter Faulkner at PSAM LLC, DBSI_PSI_EMAIL01882188. 1287 3/1/2007 email from Greg Lippmann to Joris Hoedemaekers at Oasis Capital UK, DBSI_PSI_EMAIL02033845. 1288 In the 1920s, Charles Ponzi defrauded thousands of investors in a speculation scheme that “involves the payment of purported returns to existing investors from funds contributed by new investors.” “Ponzi Schemes – Frequently Asked Questions,” SEC, http://www.sec.gov/answers/ponzi.htm. 1289 6/8/2006 email from Greg Lippmann to Bradley Wickens at Spinnaker Capital, DBSI_PSI_EMAIL01282551.
1290 8/29/2006 email from Greg Lippmann to Bradley Wickens at Spinnaker Capital, DBSI_PSI_EMAIL01628496. 1291 Subcommittee interview of Greg Lippmann (10/18/2010).

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Subcommittee that he “told his views to anyone who would listen” but most CDO investors
disagreed with him.1292

In March 2007, Mr. Lippmann again expressed his view that mortgage related assets

were “blowing up”:

“I remain firm in my belief that these are blowing up whether people like it or not and that hpa [housing price appreciation] is far less relevant than these bulls think. Can’t blame them because if this blows up lots of people lose their jobs so they must deny in hope that that will help prevent the collapse. At this price I’m nearly just as short as I’ve ever been.”1293

(b) Building and Cashing in the $5 Billion Short

Mr. Lippmann did not just express negative views of RMBS and CDO securities to his colleagues and clients, he also acquired a significant short position on those assets on behalf of Deutsche Bank. Despite the views of virtually all other senior executives at the bank that RMBS and CDO securities would gain in value over time, Mr. Lippmann convinced the bank to allow him to initiate and build a substantial proprietary short position that would pay off only if mortgage related securities lost value.

Initiating the Short Position. In 2005, Deutsche Bank was heavily invested in the U.S. mortgage market and, by 2007, had accumulated a long position in mortgage related assets that, according to Deutsche Bank, had a notional or face value of $128 billion and a market value of more than $25 billion.1294 These positions had been accumulated and were held primarily by the Deutsche Bank mortgage department, the ABS Trading Desk, and a Deutsche Bank affiliated hedge fund, Winchester Capital, which was based in London.1295

Mr. Lippmann told the Subcommittee that, despite the bank’s positive view of the

mortgage market, in the fall of 2005, he requested permission to establish a proprietary trading

1292 Subcommittee interview of Greg Lippmann (10/18/2010).
1293 3/4/2007 email from Greg Lippmann to Harvey Allon at Braddock Financial, DBSI_PSI_EMAIL02041351-53.
On June 23, 2007, Mr. Lippmann wrote to a Deutsche Bank colleague, “Yup this is the beginning of phase 2 (the bulls still can’t see it), sales by the longs and how do you think the foreign banks will feel when they see that the true mark for what they have is … this could be the end of the cdo biz.” 6/23/2007 email from Greg Lippmann to Michael George, DBSI_PSI_EMAIL02584591.
1294 According to Deutsche Bank, as of March 31, 2007, it held a total long position in mortgage related securities whose notional or face value totaled $127.8 billion, including $4.3 billion at “ABS Correlation London”; $5 billion at “CDO Primary Issue/New York”; $102 billion at “RMBS/New York”; $7.6 billion at “SPG-Asset Finance/New York”; and $8.9 billion at “Winchester Capital/London.” 3/2/2011 letter from Deutsche Bank’s counsel to the Subcommittee, PSI-DeutscheBank-31-0004-06. The market value of those positions was substantially lower. For example, according to Deutsche Bank, the $102 billion long investment held by its RMBS/New York office had a market value of about $24 billion. 3/21/2011 letter from Deutsche Bank’s counsel to the Subcommittee, PSI- Deutsche_Bank-32-0001-04.
1295 Id.

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position that would short RMBS securities.1296 He explained that he made this request after reviewing data he received from a Deutsche Bank quantitative analyst, Eugene Xu. He said that this data showed that, in regions of the United States where housing prices had increased by 13%, the default rates for subprime mortgages had increased to 7%.1297 At the same time, he said, in other regions where housing prices had increased only 4%, the subprime mortgage default rates had quadrupled to 28%.1298 Mr. Lippmann explained that he had concluded that even a moderate slow down in rising housing prices would result in significant subprime mortgage defaults, that there was considerable correlation among these subprime mortgages, and that the defaults would affect BBB rated RMBS securities. Mr. Lippmann stressed that his negative view of RMBS securities was based primarily on his view that moderating home prices would cause subprime mortgage defaults and was not dependent upon the quality of the subprime loans.1299

In the fall of 2005, Mr. Lippmann said that he approached his supervisor Richard

D’Albert, Global Head of the Structured Products Group, for permission to enter into CDS agreements to short RMBS securities totaling $1 billion.1300 that a cost benefit analysis favored a short RMBS position, because the bank would pay a relatively small amount of CDS premiums per year in exchange for a potentially huge payout.
Mr. Lippmann said that he estimated at the time that, when the costs were compared to the potential payout if the BBB securities defaulted, the proposed short position offered a potential payout ratio of 8 to 1.

He said that he explained at the time

Mr. Lippmann also developed a presentation supporting his position entitled, “Shorting

Home Equity Mezzanine Tranches.” It made the following points:

• “Over 50% of outstanding subprime mortgages are located in MSAs [metropolitan

statistical areas] with double digit 5 year average of annual home price growth rates.

• There is a strong negative correlation between home price appreciation and loss

• Default of subprime mortgages are also strongly negatively correlated with home

severity.

price growth rates.

1296 Subcommittee interview of Greg Lippmann (10/18/2010). When asked if the position was a proprietary investment by the bank, Mr. Lippmann told the Subcommittee that it was. Id. Deutsche Bank acknowledges in a 20-F filing with the U.S. Securities and Exchange Commission that it conducts proprietary trading, in addition to trading activity that facilitates customer business. Deutsche Bank stated that it trades for its own account (i.e., uses its capital) to exploit market opportunities. See Deutsche Bank Aktiengesellschaft’s Form 20-F filed with the Securities and Exchange Commission on March 26, 2008, at 24. 1297 Subcommittee interview of Greg Lippmann (10/18/2010).
1298 Id.
1299 Id.
1300 Id.

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• Nearly $440 billion subprime mortgages will experience payment shocks in the next 3

• Products that may be riskier than traditional home equity/subprime mortgages have

years.

become popular.” 1301

Mr. Lippmann told the Subcommittee that Mr. D’Albert approved his taking the short position in or around November 2005, but said the trade was so big and controversial that Mr. Lippmann also had to get the approval of Rajeev Misra, Global Head of Credit Trading, Securitization and Commodities, who was based in London.1302 around November 2005, Mr. Misra reluctantly gave his approval for the short position, even though Mr. Misra believed mortgage related securities would continue to increase in value over time.

Mr. Lippmann said that, in or

Building the Short Position. Mr. Lippmann told the Subcommittee that he used some

Mr. Lippmann told the Subcommittee that he spent much of 2006 pitching his clients to

existing short positions that had been undertaken as hedges to begin building his position.1303 He said that, throughout 2006, he gradually accumulated a larger short position, which eventually reached $2 billion. According to Mr. Lippmann, Deutsche Bank senior management reluctantly went along.1304 He told the Subcommittee that, at one point in 2006, Boaz Weinstein, who reported to Mr. Misra, told him that the carrying costs of his position, which required the bank to pay insurance-like premiums to support the $2 billion short position, had become so large that he had to find a way to pay for them. According to Mr. Lippmann, the bank’s senior management asked him to persuade them that he was right by demonstrating that others were willing to “short” the market as well. Mr. Lippmann told the Subcommittee he was then motivated to convince his clients that they ought to short the mortgage market, arrange the shorts for them, and make enough in fees from those transactions to pay for the costs of his multi-billion-dollar short.1305

short the mortgage market. He said that he often made presentations to prospective clients sharing with them his “strategy on how to cash in on a slowing housing market.”1306 He said that, in early 2006, he expended approximately 200 hours trying to convince AIG to short single name RMBS, but was unsuccessful. He told the Subcommittee that he also believed that his presentations helped convince AIG to stop buying RMBS and CDO securities and stop selling CDS protection for those deals. In an August 2006 email, Mr. Lippmann wrote: “In 05 for a time, we sold EVERY single one to AIG. They stepped out of the market in March of 06 after speaking with me and our research people (and I don’t doubt other dealers).”1307 Mr. Lippmann

1301 9/2005 “Shorting Home Equity Mezzanine Tranches, A Strategy to Cash in on a Slowing Housing Market,” DBSI_PSI_EMAIL00502892-29. 1302 Subcommittee interview of Greg Lippmann (10/18/2010).
1303 Id.
1304 Id.
1305 Id. 1306 Id. 1307 8/26/2006 email from Greg Lippmann to Richard Axilrod at Moore Capital, DBSI_PSI_EMAIL01618236.

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told the Subcommittee that Mr. Lamont, who co-led Deutsche Bank’s CDO Group, was not pleased that Mr. Lippmann had convinced AIG, a very large purchaser of long interest in RMBS and CDO securities, to stop buying them.

The documents indicate that Mr. Lippmann and his trading team were aware at the time

that the CDO Trading Desk was expected to promote rather than discourage client interest in purchasing Deutsche Bank’s CDO securities. One of Mr. Lippmann’s top traders, Rocky Kurita, put it this way in mid-2005: “[W]e have to make money. Customer happiness is a secondary goal but we cannot lose sight of the trading desk[’]s other role of supporting new issue and the customer franchise.”1308 In a 2007 email to a client, Mr. Lippmann wrote: “[P]lease please do not forward these emails outside of your firm. … I do not want to be blamed by the new issue people for destroying their business.”1309

securities, he did convince some of his other clients, usually hedge funds, to undertake such shorts, primarily by purchasing single name CDS contracts referencing specific RMBS securities. Those trades generated substantial sums for the ABS Correlation Trading Desk which acted as a market maker in the CDS market for those clients. Mr. Lippmann told the Subcommittee that the shorts executed by his clients ultimately generated about $200 million in revenues for his desk in 2006.1310

Although Mr. Lippmann was unsuccessful in convincing AIG to short RMBS and CDO

Defending the Short. According to Mr. Lippmann, in December 2006, he met in

London with a senior bank official, Anshu Jain, Head of Global Markets at Deutsche Bank, and suggested that Deutsche Bank’s long positions in mortgage related securities created too much exposure for the bank and should be reduced.1311 Mr. Lippmann recommended that the bank hedge its risk using his short strategy. His suggestion was not acted upon, but as the market grew more volatile in late 2006 and early 2007, Mr. Lippmann’s short position began to gain in value and caught the attention of senior management at the bank.

Mr. Lippmann told the Subcommittee that, in January 2007, he met with Mr. Jain, Mr.

Misra, and Mr. D’Albert at a hotel in Lisbon, where all three again challenged him to defend his short position by noting that it had required him to pay out $20 million in CDS premiums during 2006.1312 Mr. Lippmann told the Subcommittee that he countered by pointing out, while he had paid out $20 million, his desk made $200 million from trading in RMBS and CDO shorts for his clients. He said that the three concluded he could keep his short position.1313 According to Mr. Lippmann, in February 2007, Mr. Jain met with him again to discuss whether or not to keep his short position, because it had gained in value and Deutsche Bank could cash in the position and

1308 5/12/2005 email from Rocky Kurita to Greg Lippmann, DBSI_PSI_EMAIL00054826. 1309 2/1/2007 email from Greg Lippmann to Wyck Brown at Braddock Financial, DBSI_PSI_EMAIL01969867.
1310 Subcommittee interview of Greg Lippmann (10/18/2010).
1311 Id.
1312 Id.
1313 Id.

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take the profits at that time. Mr. Lippmann said that the result of the meeting was that, once again, his position was left in place.

While defending his position within the bank, Mr. Lippmann continued to speak with his

outside clients about his negative views of the market, continued to make presentations to potential clients about shorting the market,1314 building his desk’s proprietary short position.

and continued to execute shorts for them, while

According to Mr. Lippmann, in late February or early March 2007, as the ABX Index showed subprime RMBS securities losing value and subprime mortgages continued incurring delinquencies at record rates, an ad hoc meeting of Deutsche Bank’s executive committee took place in London to discuss the bank’s risk exposure in mortgage related securities. According to Mr. Lippmann, he happened to be in London at the time and was invited to attend. He estimated that ten to twelve persons were at the meeting in person, and another two to four persons participated by telephone. He said that, at the meeting, Deutsche Bank executives discussed whether the recent market volatility reflected short term or longer term trends and whether the bank should make any changes in its holdings.1315 At that time, Mr. Lippmann held the only large short position on behalf of the bank, then about $4 to 5 billion in size.1316 In contrast, the Deutsche Bank mortgage group held $102 billion in long RMBS and CDO securities, and Winchester Capital, Deutsche Bank’s hedge fund affiliate, held a net long position of $8.9 billion.1317 Mr. Lippmann told the Subcommittee that he was the only person at the meeting who argued for the bank to increase its short position.1318

At the time of the London meeting, Mr. Lippmann’s position was showing a significant profit. Mr. Misra brought up the alternative of cashing in his position while RMBS prices were down, because he thought prices were in a short term dip and the profits might disappear later on. Mr. Lippmann contended that the bank should not only keep his short position, but increase it, but more senior voices disagreed with him. He told the Subcommittee that the decision at the end of the meeting was for all parties to keep their positions unchanged, including Mr. Lippmann.1319

Cashing In the Short. In July 2007, the major credit rating agencies began issuing

downgrades of RMBS and CDO securities, in particular those that incorporated or referenced subprime mortgages. The value of those securities began to plummet. By the end of the summer of 2007, Deutsche Bank initiated efforts to sell off the long positions held by Winchester Capital and other Deutsche Bank entities, reflecting a shift in the bank’s strategy, but its sales force had

1314 See, e.g., 2/2007 presentation, “Shorting Home Equity Mezzanine Tranches,” prepared by Mr. Lippmann, DBSI_PSI_EMAIL01988773-845. 1315 Subcommittee interview of Greg Lippmann (10/18/2010).
1316 2/23/2007 email from Greg Lippmann to Anshu Jain, DBSI_PSI_EMAIL02383117-18. 1317 3/2/2011 letter from Deutsche Bank’s counsel to the Subcommittee, PSI-DeutscheBank-31-0004-06. 1318 Subcommittee interview of Greg Lippmann (10/18/2010).
1319 Id.

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difficulty due to the lack of customers willing to buy long.1320 During 2007 and 2008, at the direction of senior management, Mr. Lippmann gradually cashed in his short position, obtaining a total return of about $1.5 billion, which Mr. Lippmann told the Subcommittee he believes was the largest profit obtained from a single position in Deutsche Bank history.1321

Despite the gain from Mr. Lippmann’s short position, Deutsche Bank told the

Subcommittee that, overall in 2007, it had a long position in mortgage related holdings, with a face value of about $128 billion and a market value of more than $25 billion. Deutsche Bank told the Subcommittee that, despite the size of these holdings and their declining value, it lost only about $4.5 billion on those mortgage related holdings for the year.1322 Deutsche Bank also filed a 2007 annual report with the SEC claiming a 2007 profit of €7.2 billion.1323 When asked why its large long position in mortgage holdings did not lose more value, Deutsche Bank told the Subcommittee that it had placed large hedges, using U.S. Treasury bonds, which reduced its losses.1324

(4) The “CDO Machine”

From 2006 to 2007, Mr. Lippmann repeatedly cautioned his colleagues and clients that

the mortgage market was headed for a downfall, convinced a number of his clients to short RMBS and CDO securities, and built his $5 billion short position on behalf of Deutsche Bank.
Meanwhile, the “CDO machine,” as he described it, continued issuing new CDO securities through the end of 2007. The reasons for this continuing CDO activity, despite a deteriorating mortgage market and waning investor interest, are key to understanding how these complex, high risk, structured finance products ended up in multiple financial portfolios throughout the U.S. financial system.

Mr. Lippmann was frequently asked why, given his negative views, the CDO market was continuing to operate. He pointed to investment bank fees, prestige, and pressure to preserve the CDO jobs involved. In August 2006, for example, Mr. Lippmann wrote:

1320 Subcommittee interview of Jordan Milman (10/22/2010). Mr. Milman, one of Mr. Lippmann’s top traders, stated that the market first weakened in February 2007, stabilized until June or July 2007, and then it was a “one way train” down from then through 2008. Id. 1321 Subcommittee interview of Greg Lippmann (10/18/2010). See Net Revenues from ABS Products Backed by U.S. Residential Mortgages, DB_PSI_C00000003. 1322 According to a chart prepared by Deutsche Bank for the Subcommittee, in 2007 and 2008, its RMBS holdings lost about $3.4 billion; the CDO Group lost about $1.0 billion; Winchester Capital lost about $1.1 billion; and two other trading desks lost nearly $650 million. These losses were offset by the $1.5 billion gain from the bank’s short position, for total mortgage related losses of about $4.5 billion. Net Revenues from ABS Products Backed by U.S. Residential Mortgages, DB_PSI_C00000003.
1323 Deutsche Bank stated in its annual report filed with the SEC that it ended 2007 in the black, due to gains in other areas of the bank, including its Corporate and Investment Bank which reported a pre-tax profit of €5.1 billion and its Private Clients and Asset Management division which reported a pre-tax profit of €2.1 billion. See Deutsche Bank’s 2007 annual report filed with the SEC, in particular the Executive Summary of Deutsche Bank’s Annual Report and the letter from the Chairman of the Board. 1324 Subcommittee interview with Deutsche Bank’s counsel (3/7/2011). See also 3/21/2011 letter and accompanying chart from Deutsche Bank’s counsel to the Subcommittee, PSI-Deutsche_Bank-32-0001-04.

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“Why have we done this? It is not without reluctance and we are looking for ways to get out of this risk, but for now the view has been, we like the fees and the league table credit (and dammit we have a budget to make).”1325

In January 2007, after a trader asked Mr. Lippmann why the CDO market hadn’t imploded, Mr. Lippmann responded: “league table, fees, never has one blown up yet.”1326 The reference to “league table credit” indicates that investment banks considered it prestigious to be listed as the leading producer of a complex structured finance product like CDOs, and used their standing in the tables that tracked total origination numbers as a way of burnishing their reputations, attracting top talent, and generating new business. An October 2006 “Progress Report” on its CDO business, for example, which was prepared internally by the bank, included a slide entitled, “CDO Primary Revenue Forecast and League Tables,” in which a chart ranked Deutsche Bank third in CDO issuance, behind Merrill Lynch and Citigroup.1327 The slide indicated that Deutsche Bank had completed 38 CDOs to date, had a 7% share of the CDO market, and “expected to close 50 deals by year end,” with the “pipeline for Q1 and Q2 2007 building.” The final page of the presentation, providing a chart listing the top 20 Deutsche Bank CDO salespersons by region, together with their individual sales credits, identifies some of the bank personnel invested in the continuation of the CDO business.

On the issue of fees, the head of Deutsche Bank’s CDO Group Michael Lamont told the

Subcommittee that he estimated the bank received 40-200 basis points for each CDO created, depending upon the complexity of the CDO.1328 He indicated those fees translated into about $5 to $10 million per CDO.1329 When asked what he meant by saying “we have a budget to make,” Mr. Lippmann explained that new CDO deals had to be completed continuously to produce the revenues needed to support the budgets of the CDO desks and departments involved with their creation.1330

1325 8/26/2006 email from Greg Lippmann to Richard Axilrod at Moore Capital, DBSI_PSI_EMAIL01618236-42.
On August 1, 2006, Mr. Lippmann wrote to Mr. Milman, “who has all this crap and let me know which ones to look at looks like a lot of crappy deals.” 8/1/2006 email from Greg Lippmann to Jordan Milman, DBSI_PSI_EMAIL01510643. Mr. Lippmann’s negative views were shared by his traders. In an email originally sent by one of the traders on his desk, Rocky Kurita, the CDO business is set to a song, “CDO Oh Baby,” by Vanilla Ice with the following lyrics: “Yo vip let’s kick it! CDO oh baby, CDO oh baby. All right, stop, collaborate and listen. Spreads are wide with a technical invasion. Home Eq Subs were trading so tightly. Until Hedge Funds Bot Protection daily and nightly. Will they stop? Yo I don’t know. Turn up the Arb and let’s go. To the extreme Macro Funds do damage like a vandal. Now, BBs are trading with a new handle. Print, even if the housing bubble looms. There are never ends to real estate booms. If there is a problem, yo, we’ll solve it. Check out the spreads while my structurer revolves it. CDO oh baby, CDO oh baby.” 11/8/2005 email from Jordan Milman to Greg Lippmann, DBSI_PSI_EMAIL00686597-601 (forwarding an 11/8/2005 email from Rocky Kurita at Deutsche Bank).
1326 1/5/2007 email from Greg Lippmann to Chris Madison at Mast Capital, DBSI_PSI_EMAIL02333467-68.
1327 10/2006, “CDO Primary Update Progress Report,” DBSI_PSI_EMAIL03970167-72, at 68.
1328 Subcommittee interview of Michael Lamont (9/29/2010).
1329 Id.
1330 Subcommittee interview of Greg Lippmann (10/18/2010).

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A similar view as to why the CDO business continued to operate despite increasing

market risk was expressed by a former executive at the hedge fund Paulson & Co. in a January 2007 email exchange with another investor. The Paulson executive wrote:

“It is true that the market is not pricing the subprime RMBS wipeout scenario. In my opinion this situation is due to the fact that rating agencies, CDO managers and underwriters have all the incentives to keep the game going, while ‘real money’ investors have neither the analytic tools nor the institutional framework to take action before the losses that one could anticipate based [on] the ‘news’ available everywhere are actually realized.”1331

At the end of September 2006, the head of Deutsche Bank’s sales force, Sean Whelan, wrote to Mr. Lippmann expressing concern that some CDO tranches were getting increasingly 1332 Mr. difficult to sell: “[T]he equity and the AAA were the parts we found difficult to place.” Lippmann told the Subcommittee that once firms could not sell an entire CDO to investors, it was a warning that the market was waning, and the investment banks should have stopped structuring new ones.1333 source of CDO demand was found – when new CDOs started buying old CDO securities to include in their assets. One media report explained how this worked:

Instead of getting out of the CDO business, however, he said, a new

“As the housing boom began to slow in mid-2006, investors became skittish about the riskier parts of those investments. So the banks created – and ultimately provided most of the money for – new CDOs. Those new CDOs bought the hard-to-sell pieces of the original CDOs. The result was Each new CDO had its own risky pieces. Banks created yet other CDOs to buy those.”1334

a daisy chain that solved one problem but created another:

Research conducted by Thetica Systems, at the request of ProPublica, found that in the

last years before the financial crisis, CDOs had become the dominant purchaser of high risk CDO securities, largely replacing real money investors like pension funds, insurance companies, and hedge funds. The CDO market analysis found that, by 2007, 67% of the high risk mezzanine CDO securities had been purchased by other CDOs, up from 36% in 2004.

1335

1331 1/14/2007 email from Paolo Pellegrini at Paulson to Ananth Krishnamurthy at 3a Investors, PAULSON ABACUS 0234459. 1332 9/27/2006 email from Sean Whelan to Greg Lippmann, DBSI_PSI_EMAIL02255361-63.
1333 Subcommittee interview of Greg Lippmann (10/18/2010). Mr. Lippmann told the Subcommittee that he thought Mr. Lamont’s CDO Group at Deutsche Bank had too many CDOs in the pipeline in the spring of 2007, when it could not sell all of its CDO securities. He reported that he told Mr. Lamont that defaults would increase.
1334 “Banks’ Self-Dealing Super Charged Financial Crisis,” ProPublica, (8/26/2010), http://www.propublica.org/article/banks-self-dealing-super-charged-financial-crisis. 1335 Id. ProPublica even found that, from 2006 to 2007, nearly half of all the CDOs sponsored by Merrill Lynch bought significant portions of other Merrill CDOs.

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Mr. Lippmann told the Subcommittee that he considered it a “shady” practice when, in 2006, difficult-to-sell BBB CDO tranches began to be placed in new CDOs.1336 In a June 2007 email to Mr. Lippmann, Richard Kim, a Deutsche Bank Managing Director, described placing unsold CDO tranches into a new CDO to be sold to investors as a “CDO2 balance sheet dump.”1337

In addition to placing unsold CDO securities in newly issued CDOs, investment banks

turned increasingly to non-U.S. investors to keep the CDO machine going. In August 2006, Mr. Lippmann noted that European and Asian banks were being targeted to buy CDOs:

“Hear what you are saying and in a normal market your logic would be inarguable, but the demand for this crap is virtually entirely technically driven, all cdos. And each person at the cdo table thinks someone else is the fool- cdo equity, ostensibly only two buyers one mutual fund in Australia, and one hedge fund in Chicago, who is actually putting on a bearish correlation trade: bbb sold mostly ponzi-like to other cdos with limited distribution in Europe. AA and Junior AAA sold mostly to high grade cdos and to a certain extent European and Asian banks and lastly the senior AAA, this may ultimately break the cdo market.”1338

In a December 2006 email, Mr. Lippmann wrote to a client: “[W]ho owns the cdos…insurance company and german and asian banks…and high grade cdos (can you say ponzi scheme)[?]”1339 In early 2007, he wrote:

“[T]he other side is all cdos..so it is the cdo investors who r on the other side who buys cdos: aaa-reinsurance, ws [Wall Street] conduits, European and Asian banks, aa-high grade cdos, European and Asian banks and insurers..some US insurers, bbb other mezz [mezzanine] abs [asset-backed security] cdos (i.e. ponzi scheme), European banks and insurers, equity some US hedge funds, Asian insurance companies, Australian and Japanese retail investors through mutual funds.” 1340

In February 2007, when an investor wrote to Mr. Lippmann inquiring about the status of

the “CDO machine,” Mr. Lippmann responded: “[G]etting slower but not dead yet[.] … 2-5 ramping a day instead of 10-15[.] … [H]earing of many investors in [A]sia especially shutting down … but the window is not completely shut yet.”1341 Deutsche Bank emails demonstrate that, in 2007, like other investment banks, it was actively trying to sell CDOs in Asia.1342

1336 Subcommittee interview of Greg Lippmann (10/18/2010).
1337 6/14/2007 email from Richard Kim at Deutsche Bank to Greg Lippmann, DBSI_PSI_EMAIL02202920. 1338 8/26/2006 email from Greg Lippmann to Richard Axilrod at Moore Capital, DBSI_PSI_EMAIL01618236. 1339 12/4/2006 email from Greg Lippmann to Deutsche Bank employee, DBSI_PSI_EMAIL01867147-49. 1340 2/27/2007 email from Greg Lippmann to Fabrizio Wittenburg at Deutsche Bank, DBSI_PSI_EMAIL02027053-

1341 2/20/2007 email from Greg Lippmann to David Homan at Moore Capital, DBSI_PSI_EMAIL02006853-54. 1342 See, e.g., “I would like these guys to push Asia sales on this…, but also as Ilinca said, the question arises why weren’t they working on this thus far?” 2/21/2007 email from Abhayad Kamat at Deutsche Bank to Michael Lamont and others at Deutsche Bank, DBSI_PSI_EMAIL04056326-36.

Mr. Lippmann had an unrelentingly negative view of the RMBS and CDO securities he traded. He believed the securities would ultimately lose value, but he also believed investment banks would do all they could to sustain the CDO market for as long as possible due to the CDO fees, prestige, market share, and jobs at stake.

(5) Gemstone

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To understand how one investment bank, Deutsche Bank, continued to develop and

aggressively solicit its clients to purchase CDO securities even as mortgage related securities lost value and the CDO market began collapsing, the Subcommittee examined in detail Gemstone 7, a $1.1 billion CDO. Gemstone 7 was assembled and marketed by Deutsche Bank, as sole placement agent, from October 2006 to March 2007.1343 Gemstone 7 was the last in a series of CDOs sponsored by HBK Capital Management (HBK), a large hedge fund.1344

Deutsche Bank issued the Gemstone 7 securities in March 2007. Six out of Gemstone’s

seven tranches received investment grade ratings, including AAA ratings for the top three tranches. Two months later, in July 2007, the major credit rating agencies issued mass rating downgrades of RMBS and CDO securities, including 19 of the 115 RMBS securities included or referenced in Gemstone 7. In November 2007, the credit rating agencies began to downgrade the Gemstone 7 securities. Today, all seven tranches have been downgraded to junk status, and the Gemstone 7 securities are nearly worthless.

(a) Background on Gemstone

Gemstone 7 was a $1.1 billion hybrid CDO whose assets consisted predominantly of high

risk subprime RMBS securities. Nearly 90% of its assets were mid and subprime RMBS securities with 33% carrying non-investment grade ratings.1345 Of the remaining assets, 4.5% were CDO securities; 3.3% were commercial mortgage backed securities; and 3.5% were securities backed by pools of student loans.1346 When the deal closed in March 2007, Gemstone 7 had about $476 million in cash RMBS assets as well as $625 million in synthetic assets.1347

Gemstone 7 was constructed as a “partially static” CDO, meaning that while some of its assets were set and could not change, others could be replaced by the collateral manager, HBK.

1343 In the Gemstone 7 offering circular, Deutsche Bank is described as the placement agent: “The Notes purchased by the Initial Purchaser, if any, will be privately placed with eligible investors by the Initial Purchaser” where the Initial Purchaser was Deutsche Bank. Gemstone 7 Offering Circular, GEM7-00000427-816 at GEM7-00000640. In contrast, other documents produced by Deutsche Bank indicate that the bank was acting as an underwriter in the Gemstone 7 transaction. See, e.g., 12/20/2006 Gemstone 7 Securitization Credit Report, DB_PSI_00237655-71 and undated Gemstone 7 Securitization Credit Report, MTSS000011-13. For ease of reference but without making a judgment on the matter, this Report uses the term “placement agent” when describing Deutsche Bank’s role in Gemstone 7.
1344 Subcommittee interview of HBK Managing Director Jamiel Akhtar (9/15/2010). 1345 The intended portfolio composition of Gemstone 7 was disclosed to investors in a Debt Investor Presentation.
See 2/2007 Gemstone 7 Debt Investor Presentation, GEM7-00001687-1747 at 1695.
1346 Id. at 1691. 1347 9/14/2010 Gemstone 7 Asset Chart, PSI-Deutsche Bank-17-Gemstone7-0001-03.

HBK is a Dallas based hedge fund that was founded in October 1991, and by 2007,

managed approximately $12 billion in capital.1348 According to HBK, its Structured Products Group, one of its 21 business units, was “one of the leading purchasers and long-term investors in credit sensitive mortgages … including RMBS and ABS, a component in HBK’s overall strategy since 2002.”1349 Deutsche Bank told the Subcommittee that HBK had a reputation as a competent manager of mortgage related assets.1350 HBK had acted as the collateral manager for seven previous CDO deals (six named Gemstone), choosing to alternate the mandate for the deals between Lehman Brothers and Deutsche Bank.

In October 2006, HBK retained Deutsche Bank to act as the placement agent for

Gemstone 7. Under the agreement, HBK was to receive 30 basis points, or 0.3%, per year of the notional amount of Gemstone 7 (approximately $3.3 million) in return for serving as the collateral manager. Deutsche Bank was slated to receive $6.79 million in “underwriting fees,” but because the deal did not sell completely, Deutsche Bank ultimately received a lesser amount of $4.7 million.1351

On October 25, 2006, HBK and Deutsche Bank signed an agreement outlining the terms

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of Gemstone 7. HBK told the Subcommittee:

“The collateral purchased under the warehouse arrangement was selected by HBK and subject to Deutsche Bank’s right of approval. The warehouse documents originally contemplated a total collateral pool of $750 million, which was increased to $1.1 billion in late December 2006.”1352

On October 24, 2006, Deutsche Bank opened a warehouse account to store the assets that would serve as the collateral for the CDO when it closed.1353 Deutsche Bank and HBK shared the risk

1348 1/2007 Gemstone 7 Debt Investor Presentation, at 17, DBSI_PSI_EMAIL01980000-60. 1349 Id.
1350 Subcommittee interview of Sean Whelan, co-head of Deutsche Bank sales force (9/22/2010). 1351 See 12/20/2006 Gemstone 7 Securitization Credit Report, DB_PSI_00237655-71; undated Gemstone 7 Securitization Credit Report, MTSS000011-13; 3/15/2007 Gemstone CDO VII Ltd. Closing Memorandum, DB_PSI_00133536-41. According to the Gemstone Offering Circular, HBK was to receive “0.30% per annum on the Quarterly Amount payable in arrears on each distribution date.” 3/15/2007 Offering Circular for Gemstone CDO VII, Ltd., GEM7-00000427-816, “The Management Agreement,” at 168. As opposed to an upfront fee, which Deutsche Bank received, the fee to HBK was paid quarterly. Thus, 0.30% of $1.1 billion translates to a fee of approximately $3.3 million for HBK. See 7/11/2007 email from Chehao Lu at Deutsche Bank to Marco Lukesch at HBK, GEM7-00003568. See also email noting HBK’s quarterly collateral management fee of $826,067.88 as of September 11, 2007. 9/11/2007 email from Eric Martel at HBK to Jamiel Akhtar at HBK, GEM7-00006900.
1352 8/20/2010 letter from HBK’s counsel to the Subcommittee, at 2. 1353 See chart, “Assets Purchased by Gemstone VII CDO during Warehouse Period,” GEM7-00001831-33 (showing assets purchased during the warehouse period). According to Credit magazine, “The financial press will often make its first mention of a ‘new’ CDO on or around the time of its closing – with the closing date generally the day on which the CDO issues tranches of debt and equity to investors. Prior to that day, however, there will have been a so- called pre-closing or ‘warehousing’ period, typically lasting between three and six months. During that period the asset manager will have acquired (or ‘warehoused’) assets to act as collateral for the securities to be issued by the CDO … on the closing day.” See “CDO Guide: recovery rates,” Credit magazine (May 2004), http://db.riskwaters.com/public/showPage.html?page=133193.

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for any change in value of the warehoused assets if the deal failed to close. Pursuant to the risk sharing agreement, if the deal failed to close, HBK would incur the risk for the first $80 million in losses, and Deutsche Bank would bear the remaining risk.1354

Deutsche Bank CDO Group. Several departments and desks at Deutsche Bank were involved in designing, marketing, and selling the Gemstone 7 securities. The CDO Group, co- headed by Michael Lamont and Michael Herzig, was responsible for designing its structure, monitoring the purchasing and warehousing of its assets, obtaining its credit ratings, preparing the legal documentation, establishing its administrative structure, obtaining underwriting approval of the deal, designing the marketing materials, and overseeing the issuance of the CDO securities.1355 Abhayad Kamat within the CDO Group was assigned lead responsibility for structuring Gemstone 7.1356 the CDO approval process once HBK selected assets. The CDO sales force, headed by Sean Whelan and Michael Jones, was responsible for selling the Gemstone 7 CDO securities.

The CDO Trading Desk, headed by Greg Lippmann, participated in

To issue the CDO securities, Deutsche Bank established an offshore corporation in the Cayman Islands called Gemstone CDO VII, Ltd.1357 To administer the corporation, Deutsche Bank appointed its Cayman Island affiliate, Deutsche Bank Cayman, which is a licensed trust company.1358 As administrator, Deutsche Bank Cayman provided Gemstone 7 with the administrative services needed to operate the CDO securitization, including but not limited to, providing office facilities and secretarial staff, maintaining the books and records required by Cayman law, naming at least two Cayman directors, and acting as the Share Registrar for Gemstone shares.1359

HBK’s Long Investment in Gemstone. HBK routinely purchased the equity

HBK told investors in its sales presentation that “HBK has retained 100% of the equity

tranche,1360 also known as the residual interest, in all of its Gemstone deals, including Gemstone 7.1361

1354 12/20/2006 Gemstone 7 Securitization Credit Report, DB_PSI_00237655-71. 1355 Subcommittee interview of Michael Lamont (9/29/2010).
1356 Subcommittee interview of Abhayad Kamat (10/8/2010). 1357 Gemstone CDO VII Ltd. Certificate of Incorporation and Memorandum and Articles of Association of Gemstone CDO VII Ltd., DB_PSI_00236844.
1358 Deutsche Bank International Limited is a wholly owned subsidiary of Deutsche Bank AG. It currently has several offices around the world, including one in the Cayman Islands, Deutsche Bank (Cayman) Limited (“DB Cayman”), that was opened in 1983. “Deutsche Bank International Ltd.,” Bloomberg Businessweek, http://investing.businessweek.com/research/stocks/private/snapshot.asp?privcapId=884191; “Deutsche Bank in the Cayman Islands,” Deutsche Bank, http://www.dboffshore.com/page.php?title=cayman_islands. DB Cayman is a licensed trust company incorporated in the Cayman Islands. Preference Share Paying Agency Agreement, GEM7- 00001089-1030, at 1092. 1359 Amended and Restated Administrative Agreement, GEM7-00001223-31; Preference Share Paying Agency Agreement, GEM7-00001089-1130 at 1095-96.
1360 An equity tranche is the tranche in an RMBS or CDO structure that is designed to be the first to incur any losses from the securitization. Since it is expected to incur at least some level of losses, the equity tranche is usually not given a credit rating and is often retained by the originator of the securitization. See American Banker definition, http://www.americanbanker.com/glossary/e.html. 1361 According to HBK, “HBK’s investment process integrates expertise in capital markets, structural analysis, collateral and loan level analysis, due diligence, and in house surveillance. HBK is seen as not as a trader but as a

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from CDO transactions resulting in strong alignment of interests between HBK and investors.”1362 According to Kevin Jenks, HBK’s collateral manager, HBK had a “buy and hold” approach to all of its Gemstone CDOs.1363 HBK also told the Subcommittee that it participated in Gemstone 7 with “the objective of obtaining long exposure to the CDO’s collateral, on a leveraged basis, through ownership of the Residual interest.”1364

HBK deals were known for containing above average concentrations of BB or lower

rated assets, but HBK prided itself on its ability to run in-depth analysis and accurate stress tests on assets it selected for its CDOs.1365 HBK expected to receive a 15% return on its investment in the equity tranche.1366 In its investor presentation, HBK stated: “The firm strives to provide superior risk-adjusted rates of return with relatively low volatility and relatively low correlation to most major market indices.”1367 HBK’s presentation also claimed that, as of January 2007, it had only three downgrades in its asset backed security portfolio, and that its upgrade to downgrade ratio was 23 to 3.1368 Investor M&T Bank, who later purchased Gemstone 7 securities, told the Subcommittee that it had relied on HBK’s assertions when choosing what it thought was an investment with “minimal risk.”1369

HBK informed the Subcommittee that it had never shorted any of the assets in its seven Gemstone CDOs, that its CDO trade book was evenly matched with long and short CDO assets during the 2006-2007 period,1370 and that it lost over $700 million in its Structured Credit business unit during 2007.1371

(b) Gemstone Asset Selection

As the collateral manager, HBK selected the assets for Gemstone 7, subject to approval

by Deutsche Bank’s structuring and trading groups before each asset could be placed in the Deutsche Bank warehouse account for the CDO.1372 According to HBK and Deutsche Bank

vigilant investor that maximizes value through intensive analysis and surveillance.” 1/2007 Gemstone 7 Debt Investor Presentation, DBSI_PSI_EMAIL01980000-60 at 23. 1362 Id.
1363Subcommittee interview of Kevin Jenks (10/13/2010). Also see 1/2007 Gemstone 7 Debt Investor Presentation, DBSI_PSI_EMAIL01980000-60 at 25.
1364 8/20/2010 letter from HBK’s counsel to the Subcommittee.
1365 Subcommittee interview of Abhayad Kamat (10/8/2010). Mr. Kamat was the individual at Deutsche Bank who was primarily responsible for structuring Gemstone 7.
1366 Subcommittee interview of Jamiel Akhtar (9/15/2010). 1367 1/2007 Gemstone 7 Debt Investor Presentation, DBSI_PSI_EMAIL01980000-60 at 17.
1368 Id. at 25. 1369 Subcommittee interview of M&T (9/20/2010).
1370 According to HBK, “HBK never had a short position in any securities issued by the Gemstone 7 CDO.” HBK also told the Subcommittee staff that it had approximately $350 million of long exposure in Gemstone 7 and another $800 million of “additional long exposure to the same assets underlying collateral outside the CDO.” 8/20/2010 letter from HBK’s counsel to the Subcommittee. HBK told the Subcommittee that it did at times take short positions in certain mortgage backed securities unrelated to the Gemstone transactions. 1371 8/20/2010 letter from HBK’s counsel to the Subcommittee, and exhibit to letter, HBK’s exposure to Gemstone VII Notes, GEM7-00000001-10.
1372 Subcommittee interview of Abhayad Kamat (10/8/2010).

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personnel, the approval process worked in the following manner. First, HBK identified the RMBS, CDO, and other securities it wanted to include or reference in the CDO. HBK then sent an email to Mr. Lippmann or his traders at Deutsche Bank requesting that the identified assets be placed in the warehouse account for Gemstone 7. Deutsche Bank traders, sometimes in consultation with Mr. Lamont’s structuring group, would then either approve or voice concerns regarding the proposed assets. If they had concerns, the traders would work with HBK personnel to resolve them. For example, on January 9, 2007, HBK’s Jason Lowry sent an email to Mr.
Lippmann and his trader, Jordan Milman, with a list of RMBS securities proposed for inclusion in Gemstone 7, and asked: “This is the last BB list for approval. Could you take a look?” On the same day, Mr. Milman wrote back: “approved contingent upon first pay defaults getting bought back on the 2 heat bonds.”1373

Although the Gemstone 7 offering circular did not describe Deutsche Bank’s role in the

asset selection process, the private engagement agreement between HBK and Deutsche Bank did.1374 According to the terms of the engagement agreement, Deutsche Bank agreed to provide, among other items, the following service: “advising the Issuer [Gemstone 7] and the Company [HBK] on the selection and acquisition of the Underlying Assets” and “the scope of due diligence for the Underlying Assets.”1375 Under both the engagement agreement and a separate risk sharing agreement, Deutsche Bank also had the right to reject assets selected by HBK for the Gemstone warehouse account.1376 When asked about Deutsche Bank’s obligations under these agreements, Mr. Lippmann told the Subcommittee that he viewed Deutsche Bank as having an obligation to the entity, Gemstone 7, to price the assets accurately as they were purchased, which included comparing the price of each security or CDS contract on the date it went into the warehouse account to its market price and ensuring that the CDO did not overpay for the assets it purchased.1377 Mr. Lippmann’s trader, Mr. Milman, and Mr. Kamat, of Mr. Lamont’s CDO Group, agreed with that assessment.1378 not require Deutsche Bank to analyze the quality of the assets being purchased or how those assets were expected to perform.

All three also stated that the engagement agreement did

On the other hand, documents reviewed by the Subcommittee indicate, in at least a few instances, that Deutsche Bank personnel voiced concerns about an RMBS security being placed in the deal due to performance concerns in addition to price. For example, Mr. Kamat, who also assisted Mr. Lippmann’s trading desks, wrote to Mr. Jenks about the quality of an asset being

1373 See, e.g., 1/9/2007 email from Jason Lowry to Greg Lippmann, GEM7-00002154; and 12/11/2006 email from Greg Lippmann to Kevin Jenks, GEM7-00002805. The term “heat” refers to an RMBS security issued by Home Equity Asset Trust.
1374 The Gemstone 7 offering circular states that with regard to the purchase of underlying assets: “The Issuer [Gemstone 7] will acquire Underlying Assets from a warehouse facility (the ‘Warehouse Facility’) provided by an affiliate of DBSI [Deutsche Bank Securities, Inc.], which provides for the purchase of Asset-Backed Securities at the direction of the Collateral Manager [HBK] on behalf of the Issuer prior to the Closing Date.” Gemstone 7 Offering Circular, GEM7-00000427-816 at 494.
1375 10/25/2006 signed letter agreement between HBK and Deutsche Bank, GEM7-00000071-89 at 72. 1376 Id.; 10/24/2006 Risk Sharing Agreement, GEM7-00000090-99 at 91.
1377 Subcommittee interview of Greg Lippmann (10/18/2010). 1378 Subcommittee interview of Jordan Milman (10/22/2010) and Abhayad Kamat (10/8/2010).

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considered for Gemstone 7. Mr. Kamat wrote: “MLMI 2005-HE1 B3 [is] on credit watch – do you want to move this out of the portfolio – investors might question/resist[.]” Mr. Jenks responded: “[N]o let’s leave it in[.]”1379

On another occasion, Mr. Jenks from HBK exchanged several emails with Mr. Lippmann

about several RMBS securities that Mr. Jenks wanted to include in the Gemstone 7 warehouse account. Mr. Jenks sent the list to Mr. Lippmann and wrote: “please approve.” Mr. Lippmann responded: “ok approved but would like to lower these 2 pts each given recent press on fhlt and significant widening in the baa3 cds. Is that cool?” The term “fhlt” referred to RMBS securities issued by Fremont; by saying he wanted to “lower these 2 pts,” Mr. Lippman indicated he wanted to assign them a lower value for warehouse purposes. Mr. Jenks replied: “Greg, Fremont overall is really not trading badly just the ones on downgrade watch,” to which Mr. Lippmann responded: “we have seen the fhlt 05-d bbb-trade wide …. please work with me on this. … I am trying to work with you.” Mr. Jenks replied:

“Greg, I have been trying to work with you. Doing trades just with you and not on bid lists. But we play in the higher quality part of the market, I really expected you to approve the list as is. We still have several hundred million of bonds to do in cds form to do [sic].”1380

HBK told the Subcommittee that it selected good quality bonds using a very complex

This exchange shows that Mr. Lippmann was cognizant of the quality of the assets being included in the CDO, and pushed for lower prices when he thought the assets were of poor quality.

model to analyze them.1381 It told investors that it “analyze[d] every bond in the market, providing for a vast range of data …. [F]rom this data, trends can be observed early regarding the bonds themselves as well as the general economy and the implications on future issuance.”1382 the asset selection process:

HBK provided this description for the Subcommittee regarding the tools it used in

“HBK used a statistically driven mortgage behavior model to help make trading decisions and select assets for inclusion in the Gemstone VII CDO. Three separate database tools were utilized in this process. First, HBK licensed a commercial database called LP Database, which contained detailed information and performance history for millions of non-agency mortgages. The LP Database was a robust dataset comprising close to 80% of the market, back to the 1996 vintage. Utilizing the data acquired from the LP

1379 1/5/2007 email from Abhayad Kamat to Kevin Jenks, GEM7-00001977.
1380 12/8/2006 and 12/11/2006 emails between Mr. Lippmann and Mr. Jenks, DBSI_PSI_EMAIL01886779-80.
1381 See 1/2007 Gemstone 7 Debt Investor Presentation, DBSI_PSI_EMAIL01980000-60 (“HBK’s investment model utilizes proprietary default, prepay and severity loan level models to make investments in the residential market. … Transaction performance is tracked monthly via trustee surveillance reports and ongoing loan level information to monitor and analyze parameters such as collateral yields, delinquency and default trends, recoveries, prepayments, and available credit enhancement.”).
1382 Id. at 42.

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Database, HBK then developed a proprietary system called the Loss Model that forecasted the likelihood of default, prepayment, delinquency, or timely payment for an individual mortgage monthly over a ten-year time horizon. The Loss Model made these forecasts based on a series of 50 loan characteristics, including whether the mortgage was a first or second lien mortgage, the type of mortgage (e.g., fixed or ARM), its geographic location, FICO score, loan-to-value ratio, and level of documentation, and projections of home price appreciation and unemployment rates.

Finally, HBK merged the information from the Loss Model into a Bond Evaluation Engine, which was based on software licensed from Intex Solutions. The Bond Evaluation Engine provided information that assisted HBK traders in pricing mortgage bonds and evaluating how the bonds might perform under certain stresses. … This portion of the analysis focused on the structure and enhancements of the RMBS and how those structures would contribute to bond performance.”1383

Mr. Jenks of HBK told the Subcommittee that HBK “never had a bond that we thought was bad that was put in a CDO.”1384 Mr. Jenks also told the Subcommittee that he had frequent conversations with Mr. Lippmann, was aware of his “negative housing view,” but disagreed with the magnitude of Mr. Lippmann’s negative views.1385 Mr. Lippmann told the Subcommittee that although he occasionally suggested bonds to Mr. Jenks for Gemstone 7, and Mr. Jenks at times purchased them, Mr. Jenks had strong views on the assets that should be included in the CDO and was not required to listen to him. HBK and Deutsche Bank emails confirm that Mr. Lippmann or his traders offered at times to sell certain bonds to HBK, which occasionally purchased them.1386 Deutsche Bank sold five bonds from its inventory, with a value of more than $27 million, to HBK for inclusion in Gemstone 7.1387 According to Mr. Lamont, his CDO Group was “agnostic” towards the quality of the assets that HBK purchased for Gemstone 7, and told the Subcommittee that investors had relied on HBK, the collateral manager, to analyze their quality.1388 Mr. Lamont said that the role of the CDO Group was, not to select the CDO’s assets, but to structure the deal and then use models to conduct stress tests on it.1389

1383 10/12/2010 letter from HBK’s counsel to the Subcommittee.
1384 Subcommittee interview of Kevin Jenks (10/13/2010).
1385 Id.
1386 See, e.g., 12/8/2006 email from Greg Lippmann to Kevin Jenks, DBSI_PSI_EMAIL01883072 (discussing trade they agreed to). See also 2/23/2007 email from Jordan Milman to Greg Lippmann, DBSI_PSI_EMAIL02022054 (“I’d rather just have Ilinca show hbk, he loves bonds like this.”).
1387 Assets Purchased by Gemstone VII CDO during Warehouse Period, GEM7-00001831-33. 1388 Subcommittee interview of Michael Lamont (9/29/2010). Mr. Kamat also agreed that Deutsche Bank was agnostic with regard to the quality of the assets. Subcommittee interview of Abhayad Kamat (10/8/2010).
1389 Subcommittee interview of Michael Lamont (9/29/2010).

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Gemstone 7’s assets were assembled in late 2006 and early 2007, when the mortgage

market was deteriorating and subprime mortgages were experiencing record delinquency rates.
The CDO posed a host of risks due to both the state of the market and the poor quality of many of its underlying assets.

Credit Report. In December 2006, Mr. Lamont’s CDO Group prepared a Credit Report

for Deutsche Bank’s credit risk management group to obtain internal approval for the securitization of Gemstone 7.1390 Deutsche Bank regarding Gemstone 7, including the possibility that the bank would be unable to sell $400 million of the Gemstone securities, which carried “significant” risk:

The Credit Report noted the following business risks for

• “The portfolio is concentrated on RMBS obligations, with 67.6%, 20.2% and 1.9% of

the RMBS exposure represented by 2005, 2006, and 2007 vintages, respectively, which results in significant vintage risk.”

• “RMBS accounts for ~90.0% of the initial collateral portfolio.”

• “All unsold tranches have been taken back by HBK except for the Class A-1B

($400mm). Currently, we are working with [redacted] to see if they will be interested in taking the tranche. The plan for distribution if [redacted] decides not to take the tranche, will be a senior sequential repack. The Class A-1B will be broken into two tranches. DB will take the senior part (Class A-1B(i) $200mm) and HBK will take the bottom part (Class A-1B(i) $200mm). Once the repack is setup, then DB will try to syndicate the Class A-1B(i).” 1391

The business risks described in the internal Deutsche Bank credit report relating to

“significant vintage risk” for the 2005, 2006, and 2007 vintage RMBS securities1392 disclosed in the Gemstone 7 offering materials given to investors. Although the March 15, 2007 Offering Circular contained a “Risk Factor” section describing multiple risks associated with an investment in Gemstone 7, including those associated with residential asset backed securities, the Offering Circular was silent with respect to the above risks identified in the Credit Report, which were highlighted for Deutsche Bank management.

were not

1390 Id. See undated Gemstone 7 Securitization Credit Report, MTSS000011-13 and 12/20/2006 Gemstone 7 Securitization Credit Report, DB_PSI_00237655-71. The 12/20/2006 Credit Report appears to be an earlier version of the document.
1391 Gemstone 7 Securitization Credit Report, MTSS000011-13.
1392 Id.

The Offering Circular did, however, describe in detail a number of significant risks

associated with RMBS securities. For example, it stated:

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• “The risk of losses on residential mortgage loans is particularly relevant now. While

there is always a risk of defaults or delinquencies in payment, recently losses on residential mortgage loans have been increasing and may continue to increase in the future. The losses have been most significant in respect of subprime mortgage loans but all are affected.

• A number of factors are contributing to the increase in losses. Residential property

values that increased for many years are now declining. … Declining property values also exacerbate the losses due to a failure to apply adequate standards to potential borrowers. Failures to properly screen borrowers may include failures to do adequate due diligence on a borrower (including employment and income history) or the relevant property (including valuation) or failures to follow predatory lending and the other borrower-protection statutes. Increases in interest rates may also contribute to higher rates of loss. …

• The increase in delinquencies and defaults has contributed to a declining market for

mortgage loans. The declining market has, in turn, seriously impacted mortgage originators and servicers. … The financial difficulties of servicers in particular are likely to result in losses in respect of securities backed by residential mortgage loans. … At any one time, the portfolio of Residential ABS Securities may be backed by residential loans with disproportionately large aggregate principal amounts secured by properties in only a few states or regions.”1393

Long Beach-Fremont-New Century Bonds. A substantial portion of the cash and

These disclosures demonstrate that both HBK and Deutsche Bank were well aware of the deteriorating mortgage market and increased risks associated with RMBS and CDO securities, even as they were marketing the Gemstone 7 securities and claiming HBK had applied careful analysis in the asset selection process to ensure good quality CDO securities.

synthetic assets included in Gemstone 7, 30% in all, involved subprime residential mortgages issued by three subprime lenders, Long Beach, Fremont, and New Century, all known for issuing poor quality loans and securities.1394 Loans by these lenders were among the first to collapse.
According to Moody’s, these three originators, plus WMC Corporation, accounted for 31% of

1393 3/15/2007 Offering Circular for Gemstone CDO VII, Ltd., GEM7-00000427-816 at 483-84. While an earlier offering circular for Gemstone 7, dated February 14, 2007, identifies some risks associated with the CDO, the March offering circular contains additional language, quoted above, on the risks associated with the deteriorating mortgage market. 2/14/2007 Offering Circular for Gemstone CDO VII, Ltd., PSI-M&T_Bank-02-0001-370. 1394 For more information on these three lenders, see sections D(3)(d) and E(2)(c)-(d) of Chapter IV. Mr. Jenks of HBK told the Subcommittee that he saw data showing that Long Beach and Fremont were poor performers, but he thought the performance varied depending upon the tranche, and he believed he could pick the better tranches. He thought he could buy low, structure the deal well, and make money. Subcommittee interview of Kevin Jenks (10/13/2010).

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During the period when securities were being assembled for the Gemstone 7 warehouse

the subprime RMBS securities issued in 2006, but 63% of the rating downgrades issued in the second week of July 2007, when the mass rating downgrades began.1395

in late 2006 and early 2007, Mr. Lippmann frequently disparaged many of the same assets he and his traders allowed to be included in Gemstone 7. About $27 million of these assets came from Deutsche Bank’s own inventory. In emails to colleagues and his clients, Mr. Lippmann used words like “crap” and “pig” to describe the assets. Mr. Lippmann brought some of the assets of Gemstone 7 to the attention of some of his clients that shorted these assets.1396

On October 20, 2006, for example, one of Mr. Lippmann’s clients sent him an email

seeking advice about certain subprime bonds issued by Long Beach Mortgage Loan and Trust (LBMLT) and other originators. Mr. Lippmann responded:

“LBMLT-06-5 M9-375. Long Beach is one of the weakest names in the market. We shorted this bond to a CDO in the mid-300s on October 13[.] Deal was done before S&P changed their criteria on July 1. Lots of 40 year mortgages …. Less than half the loans have full documentation and 10% are investor properties. This is a real pig.

LBMLT -06-2 M9 350. See above on Long Beach. This one is already performing poorly with substantial delinquencies .… Further the FICO is less than the 06-05 and there are fewer full doc loans. This seems a better short than the 06-5. Only reason I can think for my guys showing you a tighter level is that we are short this one and that the June 06 deals have a taint that earlier months don[’]t due to the theory that late June deals were crammed with bad stuff in order to beat the S & P revisions.”1397

Despite these negative views of Long Beach, Mr. Lippmann’s group raised no concerns

when $25 million in LBMLT 2006-5 M9 securities was purchased by HBK for Gemstone 7’s warehouse account, $20 million of which was purchased on October 24, 2006, four days after Mr. Lippmann’s email. Altogether, a total of $79.5 million in Long Beach bonds went into Gemstone 7.1398

Mr. Lippmann had similar negative views of RMBS securities containing subprime loans originated by Fremont, yet his group did not object to including Fremont securities in Gemstone

For instance, on December 6, 2006, Mr. Lippmann’s traders did not object to including $20 million of an RMBS known as SABR 2005-FR4 B3, which contained Fremont loans, in Gemstone 7.1399

One week earlier, on November 29, 2006, when asked by a bank colleague

1395 7/12/2007 Moody’s Structured Finance Teleconference and Web Cast: RMBS and CDO Rating Actions, at Moody’s SI 2010-0046902, Hearing Exhibit 4/23-106. 1396 Subcommittee interview of counsel for Deutsche Bank (2/1/2011).
1397 10/20/2006 email from Greg Lippmann to Craig Carlozzi at Mast Capital, DBSI_PSI_EMAIL01774820-21.
1398 9/14/2010 Gemstone 7 Asset Chart, PSI-DeutscheBank-17-Gemstone7-0001-03.
1399 Id.

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Mr. Lippmann made similar negative remarks about RMBS securities containing

about the same RMBS security, Mr. Lippmann labeled it a “pig.”1400 Two days later, on December 1, 2006, Mr. Lippmann declared in an email to a client that the security was “blowing up.”1401

In addition, on November 29, 2006, Mr. Lippmann called still another RMBS security with Fremont loans, FHLT 2005-A M9, a “pig.”1402 Yet a month earlier, on October 30, 2006, approximately $1 million of FHLT 2005-A M9 had been purchased for Gemstone 7, with no objection from Mr. Lippmann’s trading desk.1403

subprime loans originated by New Century. On November 28, 2006, Mr. Lippmann wrote: “MABS 2005-NC2 M9 … huge payment shock coming.”1404 Yet six weeks later, on January 17, 2007, $10 million of this exact asset, MABS 2005-NC2 M9, was purchased by Gemstone 7, without objection from Mr. Lippmann’s traders.1405 On December 8, 2006, Mr. Lippmann wrote about another New Century security underwritten by Goldman Sachs: “GSAMP 06-nc2 m8 this is an absolute pig.”1406 Although Gemstone 7 did not purchase the M8 securities, it did purchase a total of $30 million in GSAMP 2006-NC2 M9 securities – from a lower tranche in the same securitization with less subordination. It purchased those securities over a month-long period, with $10 million of the securities on November 13, 2006; another $10 million on December 8, 2006; and still another $10 million on December 21, 2006.1407 In addition, on December 18, 2006, Gemstone 7 purchased $8.8 million worth of a similar security, GSAMP 2006-NC2 B2.1408

Mr. Lippmann was equally critical of New Century loans securitized by ACE, an entity

On March 2, 2007, a client sent an email to Mr. Lippmann stating: “[T]hey are

created by and associated with Deutsche Bank. On September 21, 2006, for example, when asked by a Deutsche Bank salesperson for his opinion of ACE 2006-NC1 M9, an RMBS issued by ACE with New Century subprime loans, Mr. Lippmann responded that ACE was “generally horrible.”1409

1400 With regard to the asset, Mr. Lippmann wrote: “pig probably a 400-525 market.” 11/29/2006 email from Greg Lippmann to Francis Blair at Deutsche Bank, DBSI_PSI_EMAIL01853153.
1401 See 12/1/2006 email from Greg Lippmann to Tyler Duncan at Wayzata Investment Partners, DBSI_PSI_EMAIL01864446 (Mr. Lippmann wrote: “sabr 05-fr4 b3 another Fremont blowing up we traded in august at 260”). Later in January 2007, Greg Lippmann wrote: “SABR Fr [Fremont] blows.” 1/25/2007 email from Greg Lippmann to Mark Lee at Contrarian Capital, DBSI_PSI_EMAIL01961580.
1402 11/29/2006 email from Greg Lippmann to Jashin Patel at Deutsche Bank, “Where is this pig marked?,” DBSI_PSI_EMAIL01854608.
1403 See 9/14/2010 Gemstone 7 Asset Chart, PSI-DeutscheBank-17-Gemstone7-0001-03.
1404 11/28/2006 email from Greg Lippmann to Rocky Kurita, DBSI_PSI_EMAIL01846000. 1405 See 9/14/2010 Gemstone 7 Asset Chart, PSI-DeutscheBank-17-Gemstone7-0001-03. 1406 12/8/2006 email from Greg Lippmann to Peter Faulkner at PSAM, LLC, DBSI_PSI_EMAIL01882188.
1407 See 9/14/2010 Gemstone 7 Asset Chart, PSI-DeutscheBank-17-Gemstone7-0001-03. 1408 Id. 1409 9/21/2006 email from Greg Lippmann to Melissa Goldsmith at Deutsche Bank, DBSI_PSI_EMAIL01689001-

Mr. Lippmann confirmed to the Subcommittee that he believed ACE was “horrible.” Subcommittee interview of Greg Lippmann (10/18/2010). On May 19, 2006, Mr. Lippmann wrote to a Deutsche Bank colleague, “We traded that ACE piece of crap with Ike at 380.” 5/19/2006 email from Greg Lippmann to Rocky Kurita at Deutsche Bank, DBSI_PSI_EMAIL0120552. On May 29, 2007, Mr. Lippmann wrote with regard to ACE 2006-ASP3 M7,

claiming that DB [Deutsche Bank] was one of the last ones to tighten standards on buying loans to securitize. [Y]ou were right - ACE is crap.” Mr. Lippmann responded: “INDEED … IT IS.”1410 Yet on December 19, 2006, Mr. Lippmann’s traders did not object to the purchase of $10 million of ACE 2006-NC1 M9 for Gemstone 7.1411

Mr. Lippmann also had negative opinions about other securities purchased for Gemstone

On March 1, 2007, for example, Mr. Lippmann wrote that ABSHE 2006-HE1 M7 was “crap.”1412 But $5 million of this same security had been purchased three months earlier by Gemstone 7, on November 16, 2006, without objection from Mr. Lippmann’s trading desk.1413
In still another instance, on March 19, 2007, Mr. Milman described FFML 2006-FF13 as “a piece of crap.”1414 Yet over the prior five months, the Lippmann trading desk had approved the purchase of a total of $38.5 million of this exact bond, FFML 2006-FF13, for inclusion in Gemstone 7: $11.7 million of the class B1 securities on October 30, 2006; $16.2 million of the class B2 securities on November 17, 2006 and January 9, 2007; and $10.6 million of the class M9 securities on March 15, 2007.1415

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Securities from Deutsche Bank’s Inventory. Gemstone 7 purchased five securities

totaling $27 million directly from Deutsche Bank’s inventory.1416 Mr. Lippmann, and his trader Jordan Milman, shared negative views of one of the bonds, ACE 2006-HE1 M10, a security in which over 75% of the loans had been originated by Fremont.1417 In an instant message conversation in December 2006, Mr. Lippmann asked Mr. Milman his thoughts on ACE 2006- HE1 M10. Mr. Lippmann asked: “DOESNT THIS DEAL BLOW,” to which Mr. Milman replied: “yes it blows I am seeing 20-40% writedowns.”1418 Not only did HBK include $10 million of this asset in the Gemstone 7 warehouse account, HBK purchased it from Deutsche Bank that same month through one of Mr. Lippmann’s traders.1419 Thus, Deutsche Bank allowed Gemstone 7 to acquire a $10 million asset that its traders believed would perform poorly, and effectively removed the financial risk of this asset from its own inventory, shifting it to its customers.

“this stinks though I didn’t mention it.” 5/29/2007 email from Greg Lippmann to Danielle Pluthero at Deutsche Bank, DBSI_PSI_EMAIL02532365.
1410 3/2/2007 email from Greg Lippmann to Clark Baker at Harbinger Capital, DBSI_PSI_EMAIL02038599. 1411 9/14/2010 Gemstone 7 Asset Chart, PSI-DeutscheBank-17-Gemstone7-0001-03. 1412 3/1/2007 email from Greg Lippmann to Joris Hoedemaekers at Oasis Capital, DBSI_PSI_EMAIL02033845. 1413 9/14/2010 Gemstone 7 Asset Chart, PSI-DeutscheBank-17-Gemstone7-0001-03.
1414 3/19/2007 email from Jordan Milman to Greg Lippmann, DBSI_PSI_EMAIL02412084.
1415 9/14/2010 Gemstone 7 Asset Chart, PSI-Deutsche Bank-17-Gemstone7-0001-03.
1416 These five securities were: (1) ACE 2006-HE1 M10, (2) Securitized Asset Backed Receivables (SABR) 2005- OP1 B4, (3) Ameriquest Mortgage Securities Inc. (AMSI) 2005-R11 M10, (4) Deutsche Bank Alt-A Securities, Inc. (DBALT) 2006-AR6 M10, and (5) First Franklin Mtg Loan Asset Backed Certificate (FFML) 2005-1 B4. See Assets Purchased by Gemstone VII CDO during Warehouse Period, GEM7-00001831-33. See also 9/14/2010 Gemstone 7 Asset Chart, PSI-Deutsche Bank-17-Gemstone7-0001-03.
1417 9/14/2010 Gemstone 7 Asset Chart, PSI-Deutsche Bank-17-Gemstone7-0001-03.
1418 12/1/2006 instant message conversation between Greg Lippmann and Jordan Milman, DBSI_PSI_EMAIL01863636. 1419 12/19/2006 email from Jason Lowry at HBK to Greg Lippmann and others at Deutsche Bank, DBSI_PSI_EMAIL01910568; 12/19/2006 email from Greg Lippmann to Jordan Milman and others at Deutsche Bank, DBSI_PSI_EMAIL01910580.

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Mr. Lippmann expressed a negative outlook for other assets as well, including SABR

2005-OP1, that was taken from Deutsche Bank’s inventory and sold to Gemstone 7. On August 26, 2006, Mr. Lippmann wrote to a client about more securities “blowing up,” including SABR 2005-OP1:

“I am encouraged that in spite of the virility of the cdo bid, there are numerous examples of bonds blowing up … the tripling of serious delinq [delinquencies] in sabr 05-opl to over 6.5% since feb even though the avg [average] mortgage age is now only 21 months i.e. hasn’t reset yet .… What I’m saying is there is plenty of fundamental evidence that bonds are blowing up even as the new issue and index market are remaining buoyant.”1420

A third example involved securities issued by Ameriquest Mortgage Securities Inc.

On December 12, 2006, with no objection from Mr. Lippmann’s desk, Gemstone 7 purchased $5.5 million of SABR 2005-OP1 B4 from Deutsche Bank, the same asset that he had described months earlier as incurring “serious delinquencies.”1421

(AMSI), which Gemstone purchased from Deutsche Bank’s inventory. On April 6, 2006, Mr. Lippmann called AMSI 2005-R7 M8 a “crap name.”1422 In a June 16, 2006 email, Mr. Lippmann called AMSI generally a “weakish name.”1423 On December 12, 2006, Gemstone 7 purchased $5 million of another RMBS, AMSI 2005-R11 M10, with no objection from the Lippmann trading desk.1424

In still another instance, Deutsche Bank praised its sales force for placing a security it

was having difficulty selling as the underwriter, Deutsche Alt-A Securities Inc. (DBALT) 2006- AR6, in Gemstone 7. On November 17, 2006, the Deutsche Bank Option Arms Desk sent the following email, “The Arms Desk would like to express its sincere appreciation to the sales force for an outstanding job in helping us place the bonds off DBALT 06-AR6. Thanks a lot!!”1425

Less than two weeks later, on November 29, 2006, a member of the Deutsche Bank sales force wrote: “Some success in CMO [collateralized mortgage obligation] land today: Sold 9 mm [million] DBALT 06-AR6 M10 (Ba2/BBB-) to HBK. This class was never sold in the new issue

1420 8/26/2006 email from Greg Lippmann to Richard Axilrod, DBSI_PSI_EMAIL01618236.
1421 Assets Purchased by Gemstone VII CDO during Warehouse Period, GEM7-00001831-33.
1422 4/6/2006 email from Greg Lippmann to himself, DBSI_PSI_EMAIL01075218.
1423 6/16/2006 email from Greg Lippmann to Rocky Kurita, DBSI_PSI_EMAIL01314036.
1424 Assets Purchased by Gemstone VII CDO during Warehouse Period. GEM7-00001831-33.
1425 11/17/2006 email from Deutsche Arms to Deutsche Bank employees, DBSI_PSI_EMAIL01831021; 11/14/2006 email from Deutsche Arms to Deutsche Bank employees, DBSI_PSI_EMAIL01822045. DBALT was “one of Deutsche Bank’s own shelf offerings.” 3/21/2011 letter from Deutsche Bank’s counsel to the Subcommittee, PSI- Deutsche_Bank-32-0001-04.

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marketing.” 1426 HBK records indicate that, the next day, it agreed to purchase $8.8 million of DBALT 2006-AR6 M10.1427

Many investors would likely have found the negative views of Mr. Lippmann, Deutsche Bank’s top CDO trader, important to their decision as to whether or not to buy Gemstone 7, but his views, as described above, were not disclosed to them. At the time, the traders on his desk as well as other Deutsche Bank CDO personnel knew that many clients valued and relied on Mr. Lippmann’s opinion when making investment decisions, yet did not disclose his views of the specific assets included in Gemstone 7.1428 M&T Bank told the Subcommittee that had it known about Mr. Lippmann’s views, it might have “thought twice” before purchasing Gemstone 7 securities.1429

(d) Gemstone Sales Effort

Deutsche Bank began aggressively marketing Gemstone 7 to investors beginning in January 2007.1430 The bank communicated with potential investors about Gemstone 7 in a variety of ways, including through emails, telephone calls, face to face meetings, and at conferences. Deutsche Bank personnel also went on what they called “road shows” to cities around the world, to meet investors and pitch the CDO to them.1431 Deutsche Bank CDO sales force, and Ilinca Bogza, a vice president in the Deutsche Bank syndicate group, worked to market Gemstone 7 to investors, including by scheduling road shows and personal meetings with potential investors.

Sean Whelan, co-head of the

Investors were typically shown a “Debt Investor Presentation” that had been prepared by

HBK and Deutsche Bank.1432 That presentation provided an overview of the transaction, a description of HBK’s organization, and its investment strategy. The presentation highlighted investment considerations, including HBK’s expertise in the capital markets, how its structured products exhibit relatively stable performance, and their low default history. The presentation also contained a description of HBK’s analytical systems and surveillance capabilities, and included an appendix describing the risk factors for the deal. HBK told the Subcommittee that its employees attended investor meetings, and were at times called upon to answer questions, but did not always participate in the Gemstone 7 sales efforts which were led by Deutsche Bank.1433

1426 11/29/2006 email from Larry Pike to Eleanny Pichardo and others, DB_PSI_01731794. 1427 11/30/2006 email from Jason Lowry at HBK to Abhayad Kamat and others, GEM7-00005480. See also Assets Purchased by Gemstone VII CDO during Warehouse Period, GEM7-00001831-33.
1428 See 7/6/2006 email from Axel Kunde to Greg Lippmann, DBSI_PSI_EMAIL01374694 (“If you tell the sales guy the bond is really bad his investor will use that as an argument against us and demand we buy back his note, because he trusted DB [Deutsche Bank] to pick a good portfolio etc, etc.”). 1429 Subcommittee Interview of M&T (9/20/2010).
1430 See, e.g., 1/25/2007 Deutsche Bank internal email chain, DB_PSI_00346491-99, at 99. 1431 Subcommittee interview of Sean Whelan (9/22/2010).
1432 See, e.g., 1/2007 Gemstone 7 Debt Investor Presentation, DBSI_PSI_EMAIL01980000-60 and 2/8/2007 Gemstone 7 Debt Investor Presentation, GEM7-00001687-1747. 1433 Subcommittee interview of Kevin Jenks (10/13/2010).

One Gemstone investor, M&T Bank, told the Subcommittee that, after observing a

presentation made by Mr. Jenks and receiving Deutsche Bank’s assurances in connection with its solicitation efforts, it believed that Gemstone 7 securities posed minimal investment risk.1434
According to the transcript of a telephone call on February 5, 2007, Sean Whelan of Deutsche Bank’s sales force pitched the Gemstone 7 deal to M&T Bank and stated in part: “If you indicate early, like Gemstone deals go very well, and this deal will all go very well and it will get oversubscribed.”1435 The following day, February 6, 2007, Mr. Whelan again pitched the deal to M&T and stated that Gemstone 7 “was like a lay up.”1436 When asked about these comments, Mr. Whelan told the Subcommittee that what he meant was that working with a quality hedge fund like HBK was a “lay up,” not that the Gemstone 7 deal itself was a “lay up.”1437 With regards to his comment about oversubscription, he said he was referring to the tranches that M&T Bank was considering purchasing, which ultimately were fully subscribed.1438

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In early 2007, as the closing date for Gemstone 7 neared, the Deutsche Bank sales force

was having difficulty getting commitments from investors to buy Gemstone securities. Many investors who were solicited declined to invest because of concerns about the high concentration in subprime RMBS with BBB or BB ratings.1439 In the beginning of 2007, there was a general lack of buyer interest in mortgage related securities in the United States, other than from new CDOs purchasing CDO securities from prior deals. It was not the first time, however, that a Gemstone deal involving Deutsche Bank and HBK could not be fully sold. HBK had conditioned Deutsche Bank’s participation in Gemstone 7 on its purchasing unsold securities from Gemstone 4 and 5, BB rated securities that HBK still had on its books for $13.1 million. In an email sent to a colleague, an HBK Managing Director Jamiel Akhtar wrote:

“As a condition for receiving the underwriting mandate, Kevin [Jenks] and I insisted that DB [Deutsche Bank] buy from us the $13.1mm of BB rated CDO liabilities HBK retained on its own books from Gemstone IV and V. This was a fairly sharp-elbowed tactic on our part, as the BB bonds are the worst part of the capital structure, but I felt like we should be sharp-elbowed with DB right now.”1440

The head of Deutsche Bank’s CDO Group, Michael Lamont, sent an email to the CDO Group banker assigned lead responsibility for structuring Gemstone 7, acknowledging the risk the bank took on by purchasing the earlier unsold securities, but also noting the “nice” fee being paid to the bank: “[T]hat is part of the risk we took when we were awarded the mandate and we are still making a nice all in fee.”1441 When Deutsche Bank told HBK that it intended to resell the Gemstone 4 and 5 securities, the HBK official indicated it was “ok with that as long as it is

1434 Subcommittee interview of M&T (9/20/2010).
1435 2/5/2007 telephone transcript between Sean Whelan and Alex Craig of M&T, MTSS000920-25, at 22. 1436 2/6/2007 telephone transcript between Sean Whelan, Alex Craig, and David Borchard of M&T, MTSS000929- 31, at 31.
1437 Subcommittee interview of Sean Whelan (9/22/2010).
1438 Id. 1439 See spreadsheet containing potential investor feedback regarding Gemstone 7, DBSI_PSI00117568.
1440 10/5/2006 email from Jamiel Akhtar at HBK to Jon Mosle at HBK, GEM7-00006353. 1441 2/8/2007 email from Michael Lamont to Abhayad Kamat, DBSI_PSI_EMAIL04045219-24.

not blasted out to everyone so as not to affect his current deal [Gemstone 7] in the market.”1442

Deutsche Bank and HBK did not disclose in the Gemstone 7 offering materials both the bank’s purchase of the Gemstone 4 and 5 securities as a precondition to the deal and the bank’s plan to sell the Gemstone 4 and 5 securities contemporaneously with the Gemstone 7 securities.

Struggle to Sell Gemstone. Evidence obtained by the Subcommittee shows that both HBK and Deutsche Bank were concerned about their exposure should Gemstone 7 not be fully subscribed and worked hard to sell the deal in the face of U.S. investor disinterest.1443
According to the terms of the Gemstone deal, if the securities were not fully sold, the risk of the first $80 million in losses would fall on HBK, while all remaining losses would fall on Deutsche Bank.1444 On February 27, 2007, Mr. Kamat of Deutsche Bank wrote to Mr. Jenks of HBK about selling the Gemstone 4 and 5 securities and brought up the CDO Group’s need to reduce risk: “[W]e are trying to reduce our exposure right now given internal very senior mgmt review of our business.” Mr. Jenks responded: “We are also trying to reduce exposure.”1445

In January 2007, Michael Lamont, head of Deutsche Bank’s CDO Group, and Mr. Jenks,

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the HBK collateral manager, discussed the urgency of selling Gemstone 7 in the face of a deteriorating market. On January 9, 2007, Mr. Jenks wrote to Mr. Lamont: “[W]ith this market this way and probably going to get worse we would like to really move on the cdo. Please allocate the resources to expedite this.” Four minutes later Mr. Lamont responded: “[W]e are focused on this as well. We don’t have a deal in the market and you will be first.”1446

Several developments in early 2007 signaled problems in the mortgage industry. On

January 29, 2007, subprime lender Fremont Investment & Loan announced that it had “severed ties” with 8,000 brokers whose loans had high delinquency rates.1447 The following week on February 7, 2007, New Century, another major subprime lender, disclosed in a conference call with investors that “the level of early-payment defaults and loan repurchases [had] led to tighter underwriting guidelines,” that its nonprime loan production would be declining, and that it would be restating its earnings.1448 An additional warning to the market that occurred as Gemstone was being marketed to investors was the plunge in the ABX Index that tracked the value of subprime RMBS securities. In February 2007, the ABX Index fell from a high of $0.90 early in the month

1442 Id. at 24.
1443 Subcommittee interview of Kevin Jenks (10/13/2010). Mr. Jenks recalled that there were more non U.S. investors in CDOs in 2007, but he believed that was because there was not much of a CDO market in Europe.
Subcommittee interview of Kevin Jenks (10/13/2010). Mr. Whelan told the Subcommittee that in 2006 and 2007, CDO subscription was “spotty.” Subcommittee interview of Sean Whelan (9/22/2010). 1444 12/20/2006 Gemstone 7 Securitization Credit Report, DB_PSI_00237655-71. 1445 2/27/2007 email between Abhayad Kamat and Kevin Jenks, DB_PSI_00421609 (discussing potential exposure due to purchase of earlier Gemstone 4 and 5 tranches in Gemstone 7).
1446 1/9/2007 email chain between Michael Lamont and Kevin Jenks, GEM7-00002156.
1447 2/1/2007 S&P internal email, “Defaults cause Fremont to end ties to 8,000 brokers,” Hearing Exhibit 4/23-93d. 1448 “New Century plunges on loan production,” MarketWatch (2/8/2007), http://www.marketwatch.com/story/new- centurys-shares-punished-over-loan-production-warning. On the day before the New Century conference call, Deutsche Bank received a request from HBK to approve a New Century asset purchase for the Gemstone 7 deal and approved this request on February 9. See 2/9/2007 email from Jordan Milman to Ashley Bonilla at HBK, DB_PSI_00845552.

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to $0.69 by the end of the month, indicating a drop of more than 23% in the value of subprime RMBS securities.1449 These and other events affected both the RMBS and CDO markets, since so many CDOs included or referenced subprime RMBS securities.

Emails reviewed by the Subcommittee show that CDO personnel at Deutsche Bank were well aware of the worsening CDO market and were rushing to sell Gemstone 7 before the market collapsed. On February 7, 2007, Mr. Lippmann, reacting to the New Century developments, raised concerns with Mr. Lamont about the ability of Deutsche Bank to continue to sell CDO securities: “I was calling about warehouse marks and distribution risk b/c [because] hearing rumors about other dealers having big trouble placing this stuff.”1450 The next day, February 8, 2007, Mr. Lamont told Abhayad Kamat, the CDO Group employee structuring Gemstone 7:
“[R]egardless we need to sell it [Gemstone 7] now while we still can.”1451 The same day, Mr. Lamont wrote to Mr. Jenks at HBK: “Keep your fingers crossed but I think we will price this just before the market falls off a cliff.”1452 The next day, February 9, 2007, Ilinca Bogza, of the Deutsche Bank syndicate group, wrote to Mr. Lamont: “Jenks just called me. … He is frightened that accounts will pull their orders given the widening in abx today. … He mentioned he was going to give you a call. He is very nervous.”1453

On February 13, 2007, the head of Deutsche Bank’s syndicate group, Anthony

Pawlowski, wrote to Mr. Lamont: “I am not sure how to push guys upstairs without having them crack. Everyone wants to price this deal asap (Sean Whelan [co-head of Deutsche Bank’s CDO sales force] is pushing for Friday to lock up his guys on the AAA and AA)[.] Let me know.”1454 A week later, on February 20, 2007, Mr. Lamont wrote to Deutsche Bank syndicate to ask:

“[O]n our managed mezz[anine] abs [asset backed security] CDOs last year what was the split by risk tranche across deals between real money and cdo warehouses. The street may be pulling back so this would be good info to have as we think about how we are going to place risk.”1455

1449 On Feb. 23, 2007, MarketWatch announced: “The ABX.HE index that tracks CDS on the riskiest subprime loans, rated BBB-, that were sold in the second half of 2006 fell to $0.69 on Friday, according to Markit.com, which administers the indexes. That’s down from $0.72 on Thursday and $0.79 at the beginning of the week. In early February, this index was above 90.” “Subprime mortgage derivatives index plunges; Bankruptcies, losses in subprime home loan industry spark drop,” MarketWatch (2/23/2007), subprime-mortgage-derivatives-plunges-on-sector-woes. 1450 2/7/2007 email from Greg Lippmann to Michael Lamont, DBSI_PSI_EMAIL02366193-96, at 94. When Mr. Lamont heard about the New Century developments he wrote: “yikes. I think we will stay short a while.” 2/7/2007 email from Michael Lamont to Greg Lippmann, DBSI_PSI_EMAIL02366194. 1451 2/8/2007 email from Michael Lamont to Abhayad Kamat, DBSI_PSI_EMAIL04045219-24.
1452 2/8/2007 email from Michael Lamont to Kevin Jenks, DBSI_PSI_EMAIL04045360.
1453 2/9/2007 email from Ilinca Bogza to Michael Lamont, DBSI_PSI_EMAIL04047421-23. 1454 2/13/2007 email from Anthony Pawlowski at Deutsche Bank to Michael Lamont, DBSI_PSI_EMAIL04049521. 1455 2/20/2007 email from Michael Lamont to Ilinca Bogza, DBSI_PSI_EMAIL04054492. On February 20, 2007, a client of Mr. Lippmann’s who was looking to short more RMBS commented in an email to him about the negative news concerning Novastar Financial Inc., which announced losses that day. His client described the situation in the market “like the plague.” 2/20/2007 email from Steven Eisman at Frontpoint Partners to Greg Lippmann, DBSI_PSI_EMAIL02008182.

http://www.marketwatch.com/story/index-of-

In one odd instance, Ms. Bogza, from the CDO syndicate, sent an email to the Deutsche Bank sales force suggesting that Gemstone 7 was experiencing greater investor interest than it really was. The February 20, 2007 email by Ms. Bogza stated that the bank had received an “indication of [investor] interest” in 75% of the BBB securities in Gemstone 7.1456 After receiving this email, Mr. Lippmann wrote to Ms. Bogza: “[W]ow that much interest in the bbb?
Is that real?? We would take as much as you can oversell.”1457 Ms. Bogza responded: “no. that is def[initely] not real .. it is at 50%.; cant oversell any tranche to be honest,” to which Mr. Lippmann responded: “very sneaky.”1458

In late February, as the market continued to deteriorate, Deutsche Bank attempted to

motivate its employees to sell Gemstone 7 by providing special incentives to its sales force for selling the deal. On February 21, 2007, Mr. Kamat wrote to Ms. Bogza: “[W]e need help on selling the As and BBBs in the Gemstone CDO 7 transaction – we have nearly 50% unsold on both tranches in the transaction.”1459 In another email the same day, he wrote: “[S]hould we offer more PCs for Gemstone 7 CDO given the market?”1460 “PCs” refers to Production Credits, which were used to boost a salesperson’s compensation including through an end-of-year bonus.
Later the same night, Mr. Kamat sent an email to the co-head of the CDO Group seeking to increase the Production Credits that could be awarded for selling Gemstone 7: “[D]ouble digit PCs? I guess my original offer of 300 on single-As and 600 on triple-Bs is too low … what can we offer?”1461

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Showing Investors Higher Marks. As the value of mortgage related assets grew more

volatile, some potential investors in Gemstone 7 inquired about the mark to market (MTM) value of the CDO’s underlying assets. MTM is a valuation method by which the current value of an asset is recorded on a firm’s books at the price it would sell in the marketplace on the day it is marked. Investors at times inquire about MTM values to determine if the underlying assets of a CDO have dropped in value since their inclusion in the warehouse account. Traders who closely follow buy and sell activity for a particular class of assets are generally best able to provide the most accurate current valuation. At Deutsche Bank, the CDO Trading Desk marked the value of assets monthly as a service to its clients and at times provided this service to HBK for the assets underlying Gemstone 7.1462 HBK also prepared its own internal marks valuing Gemstone’s assets. According to both Deutsche Bank and HBK, assigning a mark is a very complicated process that involves credit analysis of the securities at issue. Both explained it was not unusual for different entities to mark an asset differently.1463

1456 2/20/2007 email from Ilinca Bogza to sales force, DBSI_PSI_EMAIL02007608. 1457 2/20/2007 email from Greg Lippmann to Ilinca Bogza, DBSI_PSI_EMAIL02007608.
1458 2/20/2007 email between Greg Lippmann and Ilinca Bogza, DBSI_PSI_EMAIL02007794.
1459 2/21/2007 email from Abhayad Kamat to Ilinca Bogza, DBSI_PSI_EMAIL04055827.
1460 Id.
1461 2/21/2007 email from Abhayad Kamat at Deutsche Bank to Michael Lamont and others at Deutsche Bank,
DBSI_PSI_EMAIL04056326-36.
1462 3/27/2007 email from Richard Leclezio at Deutsche Bank to Jordan Milman noting that HBK has requested marks from Deutsche Bank, DB_PSI_00423053-61.
1463 Subcommittee interview of Jordan Milman (10/22/2010). Subcommittee interview of Kevin Jenks (10/13/2010).

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During the marketing phase of Gemstone 7, documents indicate several potential

investors asked Deutsche Bank to provide MTM values for the underlying assets in the CDO. In response, those potential investors were given HBK’s marks, rather than the generally lower

valuations assigned to the assets by Deutsche Bank’s CDO Trading Desk. On January 23, 2007, Mr. Kamat sent an email to HBK explaining that some potential investors had requested marks for the Gemstone 7 assets:

“Some investors are asking for current marks on the Gemstone 7 CDO portfolio. The attached file has the purchase price and the current marks that we got from our desk.
There are many bonds where the price difference between purchase price and current mark is more than 4% .… I have asked Jordan [Milman, a Deutsche Bank trader] to review the marks but it would be great if you could have someone at HBK review also to check if the current marks seem correct. It seems as if the entire portfolio price has dropped since purchase by 1.74% which does not show well to investors.”1464

Before he heard back from HBK, Mr. Kamat sent a very similar request to Mr. Milman to

review the marks to verify them. He wrote:

“There are many [Gemstone 7] bonds where the price difference between purchase price and the current mark is more than 4% .… Before we send these over to CDO investors, pls could you review to check if the current marks are correct. It seems as if the entire portfolio price has dropped since purchase by 1.74% which does not show well to investors.”1465

On January 23, 2007, Mr. Kamat learned that HBK’s marks showed a loss of 0.9% or

The next day, a Deutsche Bank trader verified the marks: “I checked the names that Abhayad [Kamat] highlighted [and] most are marked within the recent color[.] [T]here are 4 which should be tightened.”1466

$9.4 million in the Gemstone 7 portfolio, while Deutsche Bank’s marks showed a greater loss of 1.7% or $19 million.1467 On January 24, 2007, Mr. Kamat directed Deutsche Bank’s syndicate group to share HBK’s marks with investors instead of Deutsche Bank’s. He wrote: “[F]or investors who have asked for current marks on the Gemstone CDO 7 portfolio, tell them: HBK says that the overall current portfolio is down USD 9 million.”1468

1464 1/23/2007 email from Abhayad Kamat to HBK, GEM7-00003101. This document has HBK showing a loss of $9.4 million in the value of the Gemstone assets, whereas Deutsche Bank showed a loss of $19 million. In interviews with the Subcommittee, both Mr. Milman and Mr. Lippmann said that a 1.74% drop would not have concerned them because of the relative small dollars involved compared to the $1.1 billion deal.
1465 1/23/2007 email from Abhayad Kamat to Jordan Milman, DB_PSI_00465462.
1466 1/24/2007 email from Jashin Patel to Jordan Milman, DB_PSI_00843917.
1467 1/23/2007 email from Abhayad Kamat to HBK, GEM7-00003101.
1468 1/24/2007 email from Abhayad Kamat to Chehao Lu and others at Deutsche Bank, DB_PSI_00741750-52.

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A couple weeks later, a question arose about using Deutsche Bank marks for Gemstone 7.

On February 7, 2007, Ms. Bogza from the syndicate group wrote to Mr. Kamat: “Why can we not show a priced [marked] portfolio?? We need to show this [to investors].” Mr. Kamat responded: “[T]he marks we got from Jordan are too low … and it will take quite some time if we try to take on an exercise where we try to get kevin and jordan to agree on the correct marks.”1469 Mr. Kamat wrote to another colleague later that day: “[U]se this for the current prices to be sent to investors, but please note to investors that this is from HBK.”1470 HBK also appeared to want to show higher marks to investors. When Mr. Kamat emailed Mr. Jenks seeking marks for the Gemstone 7 portfolio on February 7, Mr. Jenks sent an internal email to an HBK assistant trader. Mr. Jenks wrote: “Need line item marks for cdo portfolio[.] use dec or jan depending on which is better[.]1471

When asked about these documents, Mr. Kamat stated that he advised using HBK’s

marks instead of Deutsche Bank’s marks, because HBK’s marks were better due to the collateral manager’s familiarity with the assets.1472 the biggest traders in RMBS and CDOs on Wall Street, making it unlikely that the desk could not adequately price the assets that it traded. Deutsche Bank also chose not to share both sets of marks with investors; it shared only the HBK marks showing higher asset values.

However, Deutsche Bank’s trading desk was one of

When HBK was asked about this matter, Mr. Jenks told the Subcommittee that he did not

authorize Deutsche Bank to give out HBK’s marks to investors and would be “surprised” if Deutsche Bank had given out HBK’s marks.1473 Mr. Jenks only recalled one time when an investor asked Deutsche Bank for Gemstone 7 marks. When the Subcommittee asked several of the investors who ultimately purchased Gemstone securities if they had asked for marks showing the current value of the underlying assets, M&T Bank told the Subcommittee that it did not know to ask for marks.1474 Standard Chartered, Wachovia, and Commerzbank told the Subcommittee that they did not ask for the marks and it would have been unusual for them to do so. Eight days before the Gemstone CDO closed and its securities issued, HBK estimated that its portfolio marks were down approximately $30 million.1475

$400 Million of Unsold Securities. The mortgage market continued to worsen in March

as Deutsche Bank continued to market the Gemstone securities. On March 8, 2007, one week before the Gemstone 7 deal closed, New Century – the subprime lender whose RMBS securities made up part of Gemstone – filed an 8-K with the SEC which said: “The Company has only been able to fund a portion of its loans this week. In addition, its capacity to fund new originations is substantially limited due to its lenders’ restrictions or refusals to allow the

1469 2/7/2007 emails between Abhayad Kamat and Ilinca Bogza, DB_PSI_00434692-96. 1470 2/7/2007 email from Abhayad Kamat to Chehao Lu, DB_PSI_00711486. 1471 2/7/2007 email from Kevin Jenks to Jason Lowry, GEM7-00003084. 1472 Subcommittee interview of Abhayad Kamat (10/8/2010). 1473 Subcommittee interview of Kevin Jenks (10/13/2010).
1474 Subcommittee interview of M&T (9/20/2010). 1475 3/7/2007 email from Kevin Jenks to Abhayad Kamat, GEM7-00001958.

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Company to access their financing arrangements.”1476 New Century’s financial troubles were prominently reported in the financial press on March 11, 2007.1477 On March 15, 2007, the day Gemstone 7 closed, Bear Stearns said that “residential mortgage-related revenue decreased from the prior year period, reflecting weakness in the U.S. residential mortgage-backed securities market. … New Century Financial Corp., which had been a major provider of loans to people with risky credit, said it has lost support from its financial backers and is being delisted from the NYSE.”1478

Ultimately $400 million of Gemstone 7 was unsold. Although not contractually obligated to do so, Deutsche Bank agreed to split the unsold $400 million of Gemstone 7 securities between itself and HBK.1479 Meetings concerning taking back the $400 million were held at the highest levels of both Deutsche Bank and HBK.1480 As Mr. Lippmann put it: “[W]e don’t have much choice … either we repo for them or we take it down.”1481

New Century comprised 15% of Gemstone 7.

1476 3/8/2007 New Century Financial Corporation 8-K filing with the SEC. Even senior Deutsche Bank management was aware of the problems involving New Century and Fremont during this time period. On March 2, 2007, Mr. Lippmann sent an email to Mr. Misra, copying Mr. D’Albert, with a subject line: “Fremont Shut Down Sub-Prime business” that contained a number of negative news headlines concerning New Century including, “New Century says U.S. attorney conducting criminal probe … New Century says NYSE reviewing transactions in its securities … New Century says SEC requested meeting on restatement.” The next day Mr. Misra replied to Mr. Lippmann, “Well, no regrets. Let’s hold tight on our shorts now. It will be a bumpy market to market ride but we will prevail.” 3/2/2007 and 3/3/2007 email chain between Mr. Lippmann and Mr. Misra, DBSI_PSI_EMAIL02392659-61.
1477 See, e.g., “Crisis Looms In Market for Mortgages,” The New York Times (3/11/2007), http://www.nytimes.com/ 2007/03/11/business/11mortgage.html. (“On March 1, a Wall Street analyst at Bear Stearns wrote an upbeat report on a company that specializes in making mortgages to cash-poor homebuyers. The company, New Century Financial, had already disclosed that a growing number of borrowers were defaulting, and its stock, at around $15, had lost half its value in three weeks. What happened next seems all too familiar to investors who bought technology stocks in 2000 at the breathless urging of Wall Street analysts. Last week, New Century said it would stop making loans and needed emergency financing to survive. The stock collapsed to $3.21.”) 1478 “Bear Stearns 1Q profit rises 8 percent on strong results in bonds, credit,” Associated Press Financial Wire (3/15/2007). Also see “New Century Understated Debt; Faces SEC Probe, Stock Delisting,” Associated Press (3/13/2007),
http://www.cnbc.com/id/17590171/New_Century_Understated_Debt_Faces_SEC_Probe_Stock_Delisting; “New Century Subpoenaed, Faces Delisting,” Washington Post (3/13/2007), http://www.washingtonpost.com/wp-dyn/content/article/2007/03/13/AR2007031300603.html. 1479 On 3/14/2007, Fred Brettschneider, head of Deutsche Bank institutional sales, wrote: “We believe that we have reached an acceptable compromise with HBK. We will be restructuring the unsold mezz AAA and we will underwrite the senior portion leaving them [HBK] with the junior piece.” 3/14/2007 email from Fred Brettschneider to Anshu Jain and others, DBSI_PSI_EMAIL02064810-12. On 3/27/2007, Larry Pike of Deutsche Bank wrote with regard to Gemstone 7, “400mm of the unsold bonds were a middle (mezz) AAA class that were expected to be purchased by an investor who backed out at a late stage due to a deteriorating market. HBK was upset about this and wanted DB to take these bonds down, threatening to curtail business globally with HBK if we didn’t.”
3/27/2007 email from Larry Pike to Sean Whelan and others, DB_PSI_00859611.
1480 Subcommittee interview of Michael Lamont (9/29/2010). 1481 Apparently, Mr. Lippmann was explaining that either Deutsche Bank could “repo” or loan money to HBK in order for HBK to purchase the unsold Gemstone 7 securities or Deutsche Bank would have to “take it down” – either purchase the securities itself or liquidate the CDO. 2/20/2007 email from Greg Lippmann to Rich Rizzo at Deutsche Bank, DBSI_PSI_EMAIL02377303.

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Deutsche Bank and HBK were unable to sell 36% of the securities and instead kept those

securities on their books. Mr. Jenks of HBK told the Subcommittee that he always wanted to know if unsold portions of a CDO he was interested in investing in would be bought back by the underwriter, but he did not know if everyone asked about this.1482 M&T Bank told the Subcommittee that it would have been useful information, though it would have been more concerned if the tranches it was purchasing were not fully subscribed.1483

(e) Gemstone Losses

Gemstone 7 closed on March 15, 2007, and received credit ratings from S&P and Moody’s on the same day.1484 The top three tranches, representing 73% of the value of the CDO, received AAA ratings. The next three tranches received investment grade ratings of AA, A, and BBB.1485 The CDO received these ratings even though one third of its underlying assets carried non-investment grade ratings.

Eight months later, in November 2007, five of its seven tranches were downgraded,

including one of its AAA rated tranches. By July 2008, all seven tranches had been downgraded to junk status, and the Gemstone securities were nearly worthless. This chart, using S&P data, displays the downgrades.1486

Gemstone VII Ratings by Tranche

Tranche Class A-1a Class A-1b Class A-2 Class B Class C Class D Class E Preference Shares Source: S&P

Not rated

1st Downgrade: Date

Initial Rating: Date 2nd Downgrade: Date AAA: March 15, 2007 A+: Feb. 5, 2008 BB+: July 11, 2008 AAA: March 15, 2007 B-: Feb. 5, 2008 CC: July 11, 2008 AAA: March 15, 2007 AA-: Nov. 21, 2007 CCC-: Feb. 5, 2008 BBB: Nov. 21, 2007 AA: March 15, 2007 CC: Feb. 5, 2008 A: March 15, 2007 B-: Nov. 21, 2007 CC: Feb. 5, 2008 BBB: March 15, 2007 CCC+: Nov. 21, 2007 CC: Feb. 5, 2008 BB+: March 15, 2007 CCC: Nov. 21, 2007 CC: Feb. 5, 2008

3rd Downgrade: Date CC: August 19, 2009 n/a CC: July 11, 2008 n/a n/a n/a n/a

1482 Subcommittee interview of Kevin Jenks (10/13/2010).
1483 Subcommittee interview of M&T (9/20/2010). In addition, Standard Chartered reported that it didn’t know that a portion of the CDO was unsold, and that it would have been information worth knowing but that it wouldn’t have ultimately impacted its decision to invest in Gemstone 7. Subcommittee interview of counsel for Standard Chartered (10/14/2010).
1484 3/15/2007 letter from S&P to Gemstone CDO VII Ltd, GEM7-00001658-61; 3/15/2007 letter from Moody’s to Gemstone CDO VII Ltd., GEM7-00001657.
1485 Gemstone 7 ratings from S&P’s RatingsDirect on the Global Credit Portal, https://www.globalcreditportal.com/ratingsdirect/Login.do, with subscription.
1486 Chart prepared by the Subcommittee using data from S&P’s RatingsDirect on the Global Credit Portal, https://www.globalcreditportal.com/ratingsdirect/Login.do, with subscription.

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Investors contacted by the Subcommittee reported that they had lost all or most of their

investments. In June 2008, M&T Bank wrote down the value of its Gemstone 7 securities to about 2% of their original value – from $82 million to $1.87 million.1487 Wachovia Bank told the Subcommittee that its $40 million investment in Gemstone paid out approximately $3 million from 2007-2010, but is currently worth nothing.1488 Standard Chartered Bank told the Subcommittee that, in 2008, it liquidated its Gemstone investment and received approximately 25-30% of its initial $224 million investment.1489 Commerzbank told the Subcommittee that its initial $16 million investment in Gemstone is currently worth nothing.1490

(6) Other Deutsche Bank CDOs

Gemstone 7 was only one of many CDOs that Deutsche Bank assembled and underwrote

as the mortgage market deteriorated in 2007. From December 2006 through December 2007, Deutsche Bank issued 15 new CDOs with assets totaling $11.5 billion.1491 The Subcommittee did not examine these CDOs, but a brief discussion of a few shows that the bank’s issuance of high risk mortgage related assets was not confined to Gemstone 7.

Magnetar CDOs. Magnetar is a Chicago based hedge fund that, according to press

reports, worked with several financial institutions to create CDOs with riskier assets and then bet on those CDOs to fail.1492 Deutsche Bank underwrote one of those CDOs and served as trustee for two other Magnetar CDOs.

According to press reports, Magnetar’s investment strategy was to purchase the riskiest

portion of a CDO – the equity – and, at the same time, to purchase short positions on other tranches of the same CDO.1493 Thus, Magnetar would receive a large return on the equity if the security did well, but would also receive a substantial payment from its short positions if the securities lost value. This strategy was dubbed by some as the “Magnetar Trade.” It apparently generated large profits for Magnetar. By the end of 2007, when the market was in turmoil, Magnetar’s Constellation Fund was up 76% and its Capital Fund was up 26%.1494

Mr. Lippmann disapproved of the Magnetar CDOs.1495

In August 2006, when an

investor asked Mr. Lippmann about Magnetar, he responded that it was a “Chicago based hedge

1487 M&T Bank Corporation v. Gemstone CDO VII, (N.Y. Sup.), Complaint (June 16, 2008), DB_PSI_00000027- 79, at ¶ 52. For a list of customers and their allocations of Gemstone 7, see Gemstone VII Summary, DB_PSI_00711305.
1488 11/19/2010, 11/23/2010 emails from counsel of Wachovia to Subcommittee staff.
1489 Subcommittee interview of counsel of Standard Chartered (11/23/2010).
1490 12/7/2010 email from counsel of Commerzbank to Subcommittee staff.
1491 ABS CDOs Issued by DBSI (between 2004 and 2008), PSI-Deutsche_Bank-02-0005-23. 1492 See, e.g., “The Magnetar Trade: How One Hedge Fund Helped Keep the Bubble Going,” ProPublica (4/9/2010), http://www.propublica.org/article/the-magnetar-trade-how-one-hedge-fund-helped-keep-the-housing-bubble-going.
1493 Id. 1494 “Magnetar’s Exit: A Deal So Bad Even a Credit-Rating Agency Balked,” ProPublica (4/9/2010), http://www.propublica.org/article/magnetars-exit-a-deal-so-bad-even-a-credit-rating-agency-balked.
1495 Subcommittee interview of Greg Lippmann (10/18/2010).

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fund that is buying tons of cdo equity and shorting the single names .… [T]hey are buying equity and shorting the single names … a bit devious.”1496

In May 2006, Magnetar created its first CDO, Orion 2006-1 Ltd., a $1.3 billion hybrid

CDO with cash and synthetic assets.1497 The CDO closed on May 26, 2006, and was underwritten by Calyon and managed by NIBC Credit Management, Inc.1498 Deutsche Bank’s Special Situations Group purchased equity in Orion, and helped create the CDO.1499 A Deutsche Bank employee, Michael Henriques, who worked on Orion as managing director of the Special Situations Group, left Deutsche Bank and ultimately went to work for Magnetar.1500

Although Orion received investment grade ratings from Fitch and Moody’s in June 2006,1501 a little over a year later, on August 21, 2007, Fitch issued the first of several rating downgrades.1502 In November 2007, Moody’s downgraded the Class A notes six notches and the Class B notes seven notches.1503 By May 2008, every class of Orion’s securities had been downgraded to junk status.1504

START CDOs. Deutsche Bank also underwrote six START CDOs with a combined

value of $5.25 billion from June 2005 to December 2006.1505 worked with Elliot Advisors, a hedge fund that bought the equity tranche in the CDO and

In one of the deals, Deutsche Bank

1496 8/23/2006 email from Jeremy Coon at Passport Management to Greg Lippmann, DBSI_PSI_EMAIL01603121.
In another email, when asked how Magnetar distorted the market, Mr. Lippmann responded, “easy but lengthy answer get him on the phone and call me.” 8/31/2006 email from Warren Dowd at Deutsche Bank to Greg Lippmann, DBSI_PSI_EMAIL01641089.
1497 See Loreley Financing v. Credit Agricole Corporate and Investment Bank, (N.Y. Sup.), (10/29/2010). Orion 2006-1 is one of two Magnetar CDOs that are the subjects of this lawsuit filed by Loreley Financing, a European- based investment fund, and Crédit Agricole, a French bank. See also “Magnetar Deals at Center of New Lawsuit,” ProPublica (10/25/2010), http://www.propublica.org/article/magnetar-deals-at-center-of-new-lawsuit. 1498 See Loreley Financing v. Credit Agricole Corporate and Investment Bank, (N.Y, Sup.), (10/29/2010) (alleging Calyon permitted Magnetar to select poor assets for the two Magnetar CDOs and fraudulently induced investors to purchase the securities).
1499 “Magnetar Gets Started,” ProPublica (4/9/2010), http://www.propublica.org/article/magnetar-gets-started; Loreley Financing v. Credit Agricole Corporate and Investment Bank, (N.Y. Sup.), (10/29/2010). 1500 Loreley Financing v. Credit Agricole Corporate and Investment Bank, (N.Y. Sup.), (10/29/2010).
1501 “Fitch Rates Orion 2006-1, Ltd./LLC.,” BusinessWire (5/26/2006), http://www.thefreelibrary.com/Fitch+Rates+Orion+2006-1,+Ltd.%2FLLC.-a0146274727; 6/9/2006 “$292.5 Million of Debt Securities Rated, $936 Million of Senior Credit Swap Risk Rated,” Moody’s, http://v3.moodys.com/viewresearchdoc.aspx?docid=PR_109282. 1502 Fitch downgraded the CDO’s Class A notes from AAA to AA, the Class B notes from AA to A-, the Class C notes from A to BB, and the Class D notes from BBB to B+. “Fitch Downgrades $289MM of Orion 2006-1, Ltd.,” BusinessWire (8/21/2007), http://www.highbeam.com/doc/1G1-167859601.html. 1503 11/1/2007 “Moody’s takes neg action on Orion 2006-1,” Moody’s, http://v3.moodys.com/viewresearchdoc.aspx?docid=PR_143474.
1504 10/28/2010 “Moody’s lowers ratings of 95 Notes issued by 56 structured finance CDO transactions,” Moody’s, http://v3.moodys.com/viewresearchdoc.aspx?docid=PR_208444.
1505 They included Static Residential 2005-A for $1 billion; Static Residential 2005-B for $1 billion; Static Residential 2005-C for $500 million; Static Residential 2006-A for $1 billion; Static Residential 2006-B for $1 billion; and Static Residential 2006-C for $750 million. Chart, ABS CDOs Issued by DBSI (between 2004 and 2008), PSI-Deutsche_Bank-02-0005-23.

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simultaneously bought CDS protection against the entire structure, essentially shorting the deal and betting that the value of its assets would fall.1506 On four of the deals, Deutsche Bank worked with Paulson Advisors, a hedge fund that bought the equity tranche and apparently shorted the rest of the CDO, while Deutsche Bank sold the rest of the securities.1507 Deutsche Bank email explained one of the 2005 START CDOs as follows:

An internal

“The $1 billion START 2005-B trade was backed by a static pool of CDS on mezzanine RMBS for Paulson Advisors ($4 bln risk arb hedge fund). Paulson retained the bottom 6% of the trade and we sold the rest of the capital structure. Paulson, who came to us with the strong desire to short the U.S. housing market, wrote CDS on underlying ABS (over 100 names) to DB [Deutsche Bank] and DB intermediated them into the deal.”1508

Mr. Lamont told the Subcommittee that Mr. Paulson shorted the START deals, and he

believed investors were aware of that fact. Mr. Lamont told the Subcommittee that Mr.
Lippmann’s ABS desk shorted the START CDOs only in its role as an intermediary for other clients, which was confirmed by Mr. Lippmann. In an email discussing START with a Deutsche Bank colleague, Mr. Lippmann advised him to buy protection for the bank against START. He wrote: “Start is crap you should short because I bet we’ll have to … buyback cash ones next year.”1509

Mr. Lippmann told the Subcommittee that Deutsche Bank ended up losing a great deal of

money on the START deals. One Deutsche Bank employee wrote to Mr. Lippmann regarding one of the deals in June 2007: “This along with our remaining held inventory if we can’t sell away we repack into a CDO 2 balance sheet dump later this summer. Worst case we hold it but it is probably the lesser of two evils (the greater evil being our held START position).”1510

(7) Analysis

Deutsche Bank was the fourth largest issuer of CDOs in the United States. It continued to issue CDOs after mortgages began losing money at record rates, investor interest waned, and its most senior CDO trader concluded that the mortgage market in general and the specific RMBS securities being included in the bank’s own CDOs were going to lose value. Mr. Lippmann derided specific RMBS securities and advised his clients to short them, at the same time his desk was allowing the very same securities to be included or referenced in Gemstone 7, a CDO that the bank was assembling for sale to its clients. In fact, the bank was selling some assets that Mr. Lippmann believed contained “crap.” While the Gemstone CDO was constructed and marketed by the bank’s CDO Desk, which is separate from the trading desk controlled by Mr. Lippmann, both desks knew of Mr. Lippmann’s negative views. The bank managed to sell

1506 Subcommittee interview of Michael Lamont (9/29/2010). 1507 Subcommittee interview of Greg Lippmann (10/18/2010).
1508 10/10/2005 email from Michael Raynes at Deutsche Bank to Greg Lippmann, DBSI_PSI_EMAIL00574452.
1509 12/14/2006 email from Greg Lippmann to Taranjit Sabharwal at Deutsche Bank, DBSI_PSI_EMAIL01895617. 1510 6/14/2007 email from Richard Kim at Deutsche Bank to Greg Lippmann, DBSI_PSI_EMAIL02202920.

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This case history raises several concerns. The first is that Deutsche Bank allowed the

$700 million in Gemstone 7 securities which then failed within months, leaving the bank’s clients with worthless investments.

inclusion of Gemstone 7 assets which its most senior CDO trader was asked to review and saw as likely to lose value. Second, the bank sold poor quality assets from its own inventory to the CDO. Third, the bank aggressively marketed the CDO securities to clients despite the negative views of its most senior CDO trader, falling values, and the deteriorating market. Fourth, the bank failed to inform potential investors of Mr. Lippmann’s negative views of the underlying assets and its inability to sell over a third of Gemstone’s securities. Each of these issues focuses on the poor quality of the financial product that Deutsche Bank helped assemble and sell. Still another concern raised by this case history is the fact that the bank made large proprietary investments in the mortgage market that resulted in multi-billion-dollar losses – losses that, in this instance, did not require taxpayer relief but, due to their size, could have caused material damage to both U.S. investors and the U.S. economy.

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C. Failing to Manage Conflicts of Interest: Case Study of Goldman Sachs

The Goldman Sachs case study shows how one investment bank profited from the

collapse of the mortgage market and engaged in troubling and sometimes abusive practices that raise multiple conflict of interest concerns. The first part of this case study shows how Goldman used structured finance products, including CDO, CDS, and ABX instruments, to take a proprietary net short position against the subprime mortgage market. Reaching its peak at $13.9 billion, Goldman’s net short investments realized record gains for the Structured Products Group in 2007 of over $3.7 billion which, when combined with other mortgage losses, resulted in overall net revenues for Goldman’s Mortgage Department of $1.1 billion. The second half of the case study shows how Goldman engaged in securitization practices that magnified risk in the market by selling high risk, poor quality mortgage products to investors around the world. The Hudson, Anderson, Timberwolf, and Abacus CDOs show how Goldman used these financial instruments to transfer risk associated with its high risk assets, assist a favored client make a $1 billion gain, and profit at the direct expense of the clients that invested in the Goldman CDOs. In addition, the case study shows how conflicts of interest related to proprietary investments led Goldman to conceal its adverse financial interests from potential investors, sell investors poor quality investments, and place its financial interests before those of its clients.

(1) Subcommittee Investigation and Findings of Fact

During the course of its investigation into the Goldman Sachs case study, the

Subcommittee issued 13 document subpoenas as well as multiple document request letters to financial institutions, government agencies, hedge funds, due diligence firms, insurance companies, individuals, and others. The Subcommittee obtained tens of millions of pages of documents, including internal reports, memoranda, correspondence, spreadsheets, and email. The Subcommittee conducted over 55 interviews and one deposition, including interviews with a variety of senior executives and Mortgage Department personnel at Goldman Sachs. The Subcommittee also spoke with agency officials, law enforcement, and industry and academic experts in financial products and securities law. On April 27, 2010, the Subcommittee held a hearing which took testimony from Goldman senior executives and current and former employees of its Mortgage Department, and released 173 hearing exhibits. After that hearing, the Subcommittee gathered additional information in post-hearing interviews and through post- hearing questions for the record.1512

1511

“Wall Street and the Financial Crisis: The Role of Investment Banks,” before the U.S. Senate Permanent

1511 Subcommittee on Investigations, S.Hrg. 111-674 (4/27/2010) (hereinafter “April 27, 2010 Subcommittee Hearing”). 1512 See, e.g., Responses to Questions for the Record from Goldman Sachs, including Lloyd C. Blankfein; David A. Viniar; Craig W. Broderick; Daniel L. Sparks; Michael J. Swenson; Joshua S. Birnbaum; and Fabrice P. Tourre, PSI_QFR_GS0001-548 [Redacted]. Unredacted version maintained in the files of the Subcommittee [Sealed Exhibit]. Hereinafter referred to as “Responses to Subcommittee QFR.”

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In connection with the hearing, the Subcommittee released a joint memorandum from Chairman Levin and Ranking Member Coburn summarizing the investigation to date into the role of the investment banks in the financial crisis. The memorandum contained the following findings of fact, which this Report reaffirms, regarding the Goldman Sachs case study.

Securitizing High Risk Mortgages. From 2004 to 2007, in exchange for lucrative fees, Goldman Sachs helped lenders like Long Beach, Fremont, and New Century, securitize high risk, poor quality loans, obtain favorable credit ratings for the resulting residential mortgage backed securities (RMBS), and sell the RMBS securities to investors, pushing billions of dollars of risky mortgages into the financial system.
Magnifying Risk. Goldman Sachs magnified the impact of toxic mortgages on

financial markets by re-securitizing RMBS securities in collateralized debt obligations (CDOs), referencing them in synthetic CDOs, selling the CDO securities to investors, and using credit default swaps and index trading to profit from the failure of the same RMBS and CDO securities it sold.

Shorting the Mortgage Market. As high risk mortgage delinquencies increased, and

RMBS and CDO securities began to lose value, Goldman Sachs took a net short position on the mortgage market, remaining net short throughout 2007, and cashed in very large short positions, generating billions of dollars in gain.

Conflict Between Client Interests and Proprietary Trading. In 2007, Goldman

Sachs went beyond its role as market maker for clients seeking to buy or sell mortgage related securities, traded billions of dollars in mortgage related assets for the benefit of the firm without disclosing its proprietary positions to clients, and instructed its sales force to sell mortgage related assets, including high risk RMBS and CDO securities that Goldman Sachs wanted to get off its books, and utilizing key roles in CDO transactions to promote its own interests at the expense of investors, creating a conflict between the firm’s proprietary interests and the interests of its clients.

Abacus Transaction. Goldman Sachs structured, underwrote, and sold a synthetic CDO called Abacus 2007-AC1, did not disclose to the Moody’s analyst overseeing the rating of the CDO that a hedge fund client taking a short position in the CDO had helped to select the referenced assets, and also did not disclose that fact to other investors.
Using Naked Credit Default Swaps. Goldman Sachs used credit default swaps (CDS) on assets it did not own to bet against the mortgage market through single name and index CDS transactions, generating substantial revenues in the process.

(2) Goldman Sachs Background

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Goldman Sachs was established in 1869 as an investment bank.

1513

partnership, in 1999, it became a publicly traded corporation. In 2008, it converted to a bank holding company. Its headquarters are located in New York City, and the firm manages about $870 billion in assets. Goldman employs about 14,000 employees in the United States and 32,500 worldwide. In 2007, it reported net revenues of $11.6 billion, of which $3.7 billion was generated by the Structured Products Group in the Mortgage Department, primarily as a result of its subprime investment activities.1515

1514

Originally a private

Unlike other Wall Street banks, Goldman has no retail banking operations. It does not

accept deposits from, nor lend to, retail customers, nor does its broker-dealer provide advice to or execute trades on behalf of retail customers. Goldman provides services only to so-called “sophisticated” institutional investors, generally large corporations, financial services firms, pension funds, hedge funds, and a few very wealthy individuals.

1516

For most of its history, Goldman operated exclusively as an investment bank, providing

investment advice to corporate clients, arranging and executing mergers and acquisitions, and arranging financing for customers through stock and bond offerings. After the 1999 repeal of the Glass-Steagall Act, which had restricted the activities that could be engaged in by investment banks, Goldman expanded its operations.

1517

Over the last ten years, traditional investment banking activities have become a small

percentage of Goldman’s business. Goldman has instead become primarily a Wall Street trading house, providing broker-dealer services to institutional customers, acting as a prime broker to hedge funds, conducting proprietary trading activities for its own benefit. In the years leading up to the financial crisis, Goldman became an active investor and participant in the deals and transactions that it was handling for clients as well as selling to investors.1519

structuring and financing deals for customers from its own capital, and

1518

During 2006 and 2007, Goldman’s headquarters were at 85 Broad Street in Manhattan. In 2010, the firm moved

1513 The background information about Goldman in this section was taken from several sources. See “Profile, Goldman Sachs,” Reuters.com; “Profile, The Goldman Sachs Group, Inc.,” Hoovers.com; 4/19/2010, “A Brief History of Goldman Sachs – Timeline,” Wall Street Journal; 1/2010, “The Bank Job,” Vanity Fair (written with cooperation of Goldman Sachs). 1514 its headquarters to 200 West Street in Manhattan. See “Morgan Stanley May Lease Old Goldman Sachs Building,” Bloomberg (10/18/2010). 1515 11/30/2007 “SPG Trading Mortgages Weekly Metrics 30-November-2007,” GS MBS-E-015646485. 1516 1517 1518 including securities lending, leveraged trade execution, and cash management. See definition of “prime brokerage” at Investopedia.com. 1519

See supra note 1513.
Id. “Prime brokers” are generally large broker-dealers that provide a special set of services to special clients,

See Goldman Sachs Form 10-K for the fiscal year ending Nov. 30, 2007, filed with the SEC on 1/28/2008, at 64;

See supra note 1513.

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Goldman Sachs Mortgage Department. In 2006 and 2007, the time period reviewed by

the Subcommittee, the most senior Goldman executives were the Chairman of the Board and Chief Executive Officer Lloyd Blankfein; Chief Operating Officer and Co-President Gary Cohn; Co-President Jon Winkelried; and Chief Financial Officer David Viniar. Goldman’s Chief Risk Officer, Craig Broderick, was head of the Market Risk Management & Analysis area of the firm, which monitored and measured risk for the firm as a whole and for each business unit. Goldman’s Treasurer, Sarah Smith, was in charge of the Controllers area of the firm, which was responsible for financial accounting, profit and loss statements, customer credit, collateral/margin matters, and position valuation verification.

1520

1521

In 2006 and 2007, Goldman Sachs’ operating activities were divided into three segments:

Investment Banking, Trading and Principal Investments, and Asset Management and Securities Services. The Trading and Principal Investments Segment was divided into three businesses: Fixed Income, Currency and Commodities (FICC); Equities; and Principal Investments. FICC had five principal businesses: commodities; credit products; currencies; interest rate products; and mortgage related securities and loan products and other asset backed instruments.1523

1522

In its mortgage business, Goldman Sachs acted as a market maker, underwriter,

placement agent, and proprietary trader in residential and commercial mortgage related securities, loan products, and other asset backed and derivative products. The Mortgage Department was responsible for buying and selling virtually all of the firm’s mortgage related assets. It originated and invested in residential and commercial mortgage backed securities; developed, traded, and marketed structured products and derivatives backed by mortgages; and traded mortgage market products on exchanges.

1524

1525

In 2006 and 2007, the head of the Mortgage Department was Daniel Sparks. Goldman Co-Presidents Gary Cohn and Jon Winkelried, as well as CFO David Viniar, had been involved in Mr. Sparks’ earlier career at Goldman, and he maintained frequent, direct contact with them regarding the Mortgage Department. In 2006, Mr. Sparks formally reported first to Jonathan Sobel, who had run the Mortgage Department prior to Mr. Sparks. Richard Ruzika, who was then co-head of Commodities. reporting directly to Thomas Montag, who was co-head of Global Securities for the Americas, which included both the FICC Division and the Equities Division. In mid-2007, Mr. Sparks

In late 2006, Mr. Sparks began

He next reported to

1527

1526

1528

1529

Subcommittee interviews of David Viniar (4/13/2010), Craig Broderick (4/9/2010), and Daniel Sparks

1520 (4/15/2010). 1521 1522 1523 1524 1525 1526 1527 1528 1529

2/6/2007 Goldman Sachs Form 10-K filing with the SEC. Id. Id. Id. Id. Subcommittee interview of Daniel Sparks (4/15/10). Id. Id. Id.

began reporting to Donald Mullen, who was head of U.S. Credit Sales & Trading, and Mr. Mullen in turn reported to Mr. Montag.1530

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The Mortgage Department was divided into seven different desks: (1) the Residential

Whole Loan Trading Desk; (2) the Structured Product Group (SPG) Trading Desk; (3) the CDO Origination Desk, which also handled collateralized loan obligations (CLOs); (4) the Structured Product Syndicate and Asset Backed Security (ABS) Finance Desk; (5) the Collateralized Mortgage Obligations (CMO) and Derivatives Desk; (6) the Advisory Group Desk; and (7) the Commercial Real Estate Loan Trading Desk.

1531

The Residential Whole Loan Trading Desk was headed by Kevin Gasvoda.

It bought packages of residential whole loans; issued RMBS securities in the subprime, Alt A and prime categories; originated residential and commercial mortgages; and gave lines of credit to certain selected mortgage lenders in exchange for direct access to pools of mortgages they originated, in so-called “conduit” arrangements.

1532

1533

1534

The SPG Trading Desk was headed by Michael Swenson.

It was further subdivided into three different desks: the ABS Desk, the Correlation Trading Desk, and the Commercial Mortgage Backed Securities (CMBS) Desk. The ABS Desk was also headed by Michael Swenson and traded mainly synthetic asset backed securities, particularly RMBS and CDO securities and single name CDS contracts related to RMBS and CDOs. The ABS Desk also had an important sub-desk called the ABX Trading Desk, which was headed by Joshua Birnbaum, and traded synthetic mortgage backed securities based on the ABX Index. The Correlation Trading Desk was headed by Jonathan Egol. It structured, marketed, and traded complex synthetic structured finance products, including a series of 23 CDOs known as Abacus. The 1535 CMBS Desk was headed by David Lehman and traded commercial mortgage backed securities. With the exception of the Correlation Desk, the SPG Trading Desk was primarily devoted to “secondary trading,” meaning the buying and selling of pre-existing asset backed securities. The SPG Trading Desk was also sometimes referred to as the “Mortgage Secondary Trading Desk.”

Id. “North America Mortgages,” chart prepared by Goldman Sachs, GS MBS-E-007818849 (showing organization

1530 1531 of Mortgage Department). 1532 1533 MBS-E-004060914.
1534 1535

mortgage related assets.

Id. See, e.g., 6/27/2006 email from Brian O’Brien to John Cassidy, “Conduit Sellers and u’writing guides,” GS

Subcommittee interview of Michael Swenson (4/16/2010). 4/22/2010 Goldman Sachs Form 8-K filing with the SEC. Of the 23 Abacus CDOs, 16 contained primarily

381

The CDO Origination Desk was headed by Peter Ostrem.

1536

This desk structured and

originated most of Goldman’s CDOs and CLOs, excluding Abacus. The CDO Desk was primarily an underwriting desk that arranged for the issuance of new securities which had not yet been sold in the marketplace. Because of its underwriting focus, the CDO Desk’s activities required a higher level of disclosure to customers regarding newly issued securities than was ordinarily required of a secondary trading desk, which buys and sells only pre-existing securities. activities for its clients and proprietary trading for the firm.

Goldman maintained an inventory of RMBS and CDO securities to carry out

1537

The Structured Product (SP) Syndicate and ABS Finance Desk was headed by Bunty

Bohra and Curtis Probst. This desk was often referred to simply as the “Syndicate.” It coordinated Goldman’s sales efforts and the issuance of different securities across different desks.

1538

In the middle of 2007, the Mortgage Department was restructured. One key change was

that the CDO Origination Desk was moved into the secondary trading area under the SPG Trading Desk. Mr. Lehman was designated as head of the CDO Origination Desk, with assistance from Mr. Swenson. selling new Goldman-originated CDO securities as well as engaging in secondary trading of pre- existing CDOs and RMBS securities, related credit default swaps (CDS), ABX trading, correlation trading, property derivatives, CMBS, and other asset backed securities.

As a result, the SPG Trading Desk had responsibility for

1540

1539

In 2006 and 2007, the Residential Whole Loan Trading Desk underwrote 93 RMBS

1541

The CDO Origination Desk acted as a placement agent and underwrote

worth $72 billion. approximately 27 mortgage based CDOs worth $28 billion. Of the 27 CDOs, 84% were hybrid CDOs, 15% were synthetic, and only about 1% were cash CDOs with physical assets. 1543 The mortgage-based CDOs included 8 CDOs on the Abacus platform, with $5 billion in issued securities; a $2 billion synthetic CDO known as Hudson Mezzanine 2006-1; a $300 million synthetic CDO known as Anderson Mezzanine 2007-1; and $1 billion hybrid CDO known as Timberwolf I.

1542

1544

1536 “North America Mortgages,” chart prepared by Goldman, GS MBS-E-007818849 (showing organization of Mortgage Department). In 2006, Mr. Ostrem co-headed the CDO Origination Desk with David Rosenblum, who was primarily involved in the CLO aspects of the desk’s activities. Mr. Rosenblum was in the process of leaving the Mortgage Department for a position in the Credit business in late 2006, though he continued to have some responsibilities with respect to the CDO Origination Desk. 1537 See discussion of the disclosure obligations of broker-dealers, underwriters, and placement agents, above. The Correlation Trading Desk, which also arranged for the issuance of new CDOs had the same obligations as the CDO desk when issuing a new CDO.
1538 Mortgage Department). 1539 1540 1541 1542 1543 1544

“Mortgages Organizational Structure,” chart prepared by Goldman Sachs, GS MBS-E-010872812. Id. Undated chart prepared by Goldman for the Subcommittee, GS-PSI-00172. Undated chart prepared by Goldman for the Subcommittee, GS MBS 0000021129 and GS MBS 0000004276. Id. Id.

“North America Mortgages,” chart prepared by Goldman, GS MBS-E-007818849 (showing organization of

(3) Overview of Goldman Sachs Case Study

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This Report looks at two activities undertaken by Goldman in 2006 and 2007. The first is Goldman’s intensive effort, beginning in December 2006 and continuing through 2007, to profit from the subprime mortgage market collapse, particularly by shorting subprime mortgage assets. The second is how, in 2006 and 2007, Goldman used mortgage related CDOs to unload the risk associated with its faltering high risk mortgage assets onto clients, help a favored client make a $1 billion gain, and profit from the failure of the very CDO securities it sold to its clients.

These activities raise questions related to Goldman’s compliance with its obligations to

provide suitable investment recommendations to its clients and disclose its material adverse interests to potential investors. They also raise questions about whether some of Goldman’s incomplete disclosures were deceptive, and whether some of its activities generated conflicts of interest in which Goldman placed its financial interests before those of its clients. They also raise questions about the high risk nature of some structured finance products and their role in U.S. financial markets.

(a) Overview of How Goldman Shorted the Subprime Mortgage Market

Beginning in December 2006 and continuing through 2007, Goldman twice built and

profited from large net short positions in mortgage related securities, generating billions of dollars in gross revenues for the Mortgage Department. Its first net short peaked at about $10 billion in February 2007, and the Mortgage Department as a whole generated first quarter revenues of about $368 million, after deducting losses and writedowns on subprime loan and The second net short, referred to by Goldman Chief Financial Officer warehouse inventory. David Viniar as “the big short,” peaked in June at $13.9 billion. As a result of this net short, the SPG Trading Desk generated third quarter revenues of about $2.8 billion, which were offset by losses on other mortgage desks, but still left the Mortgage Department with more than $741 million in profits. generated net revenues of $3.7 billion. Mortgage Department repeatedly breached its risk limits, and Goldman’s senior management responded by repeatedly giving the Mortgage Department new and higher temporary risk limits to accommodate its trading.

Altogether in 2007, Goldman’s net short positions from derivatives These positions were so large and risky that the

1548

1549

At one point in 2007, Goldman’s Value-at-Risk measure

1545

1546

1547

7/25/2007 email from Mr. Viniar to Mr. Cohn, “Private & Confidential: FICC Financial Package 07/25/07,” GS

1545 See net short chart prepared by the Subcommittee, below; 9/17/2007 Presentation to GS Board of Directors, Residential Mortgage Business at 5, GS MBS-E-001793845, Hearing Exhibit 4/27-41; 3/10/2007 email to Daniel Sparks, “Mortgage Presentation to the board,” GS MBS-E-013323395, Hearing Exhibit 4/27-17. 1546 MBS-E-009861799, Hearing Exhibit 4/27-26. 1547 1548 1549

10/2007 Global Mortgages, Business Unit Townhall at 4-5, GS MBS-E-013703463, Hearing Exhibit 4/27-47. 4Q07 Fact Sheet prepared for David Viniar, GS MBS-E-009724276, Hearing Exhibit 4/27-159. See discussion of risk limits, VAR measurements, and risk reports, below.

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indicated that the Mortgage Department was contributing 54% of the firm’s total market risk, even though it ordinarily contributed only about 2% of its total net revenues.

1550

To build its net short positions, Goldman’s Mortgage Department personnel used

structured finance products to engage in multiple, complex transactions. Its efforts included selling high risk loans, RMBS, CDO, ABX, and other mortgage related assets from its inventory and warehouse accounts; shorting RMBS and CDO securities, either by shorting the assets themselves or by taking the short side of CDS contracts that referenced them, in order to profit from their fall in value; and shorting multiple other mortgage backed assets simultaneously, including different tranches of the ABX Index, tranches of CDOs, and CDS contracts on such assets. To lock in its profits after the short assets fell in value, Goldman often entered into offsetting CDS contracts to “cover its shorts,” as explained below. Senior Goldman executives directed and monitored these activities.

The evidence reviewed by the Subcommittee shows that some of the transactions leading to Goldman’s short positions were undertaken to advance Goldman’s own proprietary financial interests and not as a function of its market making role to assist clients in buying or selling assets. In the end, Goldman profited from the failure of many of the RMBS and CDO securities it had underwritten and sold. As Goldman CEO Lloyd Blankfein explained in an internal email to his colleagues in November 2007: “Of course we didn’t dodge the mortgage mess. We lost money, then made more than we lost because of shorts.”1551

Covering Shorts to Lock In Profits. To understand how Goldman profited from its

short positions, it is important to understand references in its internal documents to “covering” or “monetizing” its shorts. When Goldman built its short positions, it generally used CDS contracts to short a variety of mortgage related securities, including individual RMBS and CDO securities and baskets of 20 RMBS securities identified in the ABX indices. Goldman’s shorts then gained or lost value over time, depending upon how the underlying referenced assets performed during the same period.

Most CDS contracts expire after a specified number of years. As explained earlier,

during the covered period, the short party makes periodic premium payments to the opposing long party in the CDO. The short party is essentially betting that a “credit event” will take place during the covered period that will result in the long party having to provide it with a large

Id. “Value-at-Risk” or VAR is a key risk measurement system used by Goldman. At a 95% confidence level,

1550 VAR represents the dollar amount a business unit could expect to lose once every 20 trading days or about once per month. Subcommittee interview of Craig Broderick (4/9/2010). See also Philippe Jorion, “Value at Risk: The New Benchmark for Managing Financial Risk,” at 20 (3d ed. 2007). 1551

11/18/2007 email from Lloyd Blankfein, “RE: NYT,” GS MBS-E-009696333, Hearing Exhibit 4/27-52.

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payment that outweighs the cost of the short party’s premium payments. party does not have to wait for a credit event in order to realize a gain on its CDS contract.

However, the short

1552

One possible alternative is for the short party simply to sell its short position to another party for a profit. If, however, the short party does not want to sell or has no ready buyer, the short party can still lock in a gain by entering into a second, offsetting CDS contract in which it takes the long position on an offsetting asset, an action often referred to as “covering the short.”

In practice, there were several different, technical methods for a party to cover its short positions. The simplest example is if the short party bought a $100,000 CDS contract whose reference asset is a single RMBS security. Suppose after one month the RMBS security performs so poorly that the market value of the short position increases to $150,000. If the short party wanted to lock in the $50,000 gain, it could do so simply by entering into a new offsetting CDS contract, referencing the same RMBS security, in which it takes the long position with a new party who takes the short position at the new higher market value of $150,000. The result would be that the original short party would own a short position and a long position that offset each other, and would lock in the $50,000 difference in value as profit.

During 2007, Goldman executives repeatedly directed the Mortgage Department to

“cover its shorts” and lock in the gains from the increased value of its short positions. When it covered its short positions by entering into offsetting contracts, the Mortgage Department simultaneously “monetized” its short positions – recorded the locked in profit. That is because, when it covered a short by entering into an offsetting contract, the Mortgage Department’s general practice was to record a profit on its books equal to the gain on the original short position. Because the original purchase price of the CDS was known and fixed, and the new higher price obtained in the offsetting transaction was known and fixed, the Mortgage Department was able to capture the difference between the two prices as profit.

Going Past Home: The First Net Short. Because Goldman’s activities were so varied

and complex during the period reviewed, this overview provides a brief summary of the key events detailed in the following sections. The review begins in mid to late 2006, when Goldman realized that the market for subprime mortgage backed securities was beginning to decline, and the large long positions it held in ABX assets, loans, RMBS and CDO securities, and other mortgage related assets began to pose a disproportionate risk to both the Mortgage Department In October 2006, the Mortgage Department designed a synthetic CDO called and the firm.

1553

Under standard CDS contracts designed by the International Swaps and Derivatives Association (ISDA), a credit

1552 event is defined as a (1) bankruptcy; (2) failure to pay; (3) restructuring; (4) repudiation of or moratorium on payment in the event of an authorized government intervention; or (5) an acceleration of an obligation. Another common credit event is incurring a credit rating loss.
1553 010917469 (acquisition of a large net long position described as “slipp[ing] up a bit”). In an email to Goldman Co- President Gary Cohn, Richard Ruzika criticized the accumulation of the large net long position: “You know and I know this position was allowed to get too big – for the liquidity in the market, our infrastructure, and the ability of our traders. That statement would be the same even if we had gotten the market direction correct – although the

See, e.g., 10/17/2006-10/18/2006 email from Tom Montag to Daniel Sparks, “3 things,” GS MBS-E-

385

Hudson Mezzanine 2006-1, which included over $1.2 billion of long positions on CDS contracts to offset risk associated with ABX assets in Goldman’s own inventory and another $800 million in single name CDS contracts referencing subprime RMBS securities that Goldman wanted to short; the Mortgage Department then sold the Hudson securities to its clients. CDO transferred $1.2 billion of subprime risk from Goldman’s inventory to its clients and gave Goldman an opportunity to short another $800 million in RMBS securities it thought would perform poorly, the Mortgage Department still held billions of dollars of long positions in subprime mortgage related assets, primarily in ABX index assets.

While this

1555

1554

On December 14, 2006, as Goldman’s mortgage related assets continued to lose value,

Goldman’s Chief Financial Officer, David Viniar, held a meeting with key Mortgage Department personnel and issued instructions for the Department to “get closer to home.” By “closer to home,” Mr. Viniar meant for the Mortgage Department to assume a more neutral risk position, one that was neither substantially long nor short, but actions taken by the Mortgage Department in response to his instructions quickly shot past “home,” resulting in Goldman’s first large net short position in February 2007.1557

1556

The actions taken by the Mortgage Department included selling outright from its

inventory large numbers of subprime RMBS, CDO, and ABX assets, even at a loss, while simultaneously buying CDS contracts to hedge the long assets remaining in its inventory. The Mortgage Department also halted new RMBS securitizations, began emptying its RMBS warehouse accounts, and generally stopped purchasing new assets for its CDO warehouse accounts. It also purchased the short side of CDS contracts referencing the ABX index for a basket of AAA rated subprime residential loans, as a kind of “disaster insurance” in the event that even AAA rated mortgages started defaulting.

Within about a month of the “closer to home” meeting, in January 2007, the Mortgage Department had largely eliminated or offset Goldman’s long positions on subprime mortgage related assets. The Mortgage Department then started to build a multi-billion-dollar short position to enable the firm to profit from the subprime RMBS and CDO securities starting to lose value. By the end of the first quarter of 2007, the Mortgage Department had swung from a $6 billion net long position in December 2006, to a $10 billion net short position in late February

vultures wouldn’t be circling. You also know that we probably would have gotten the position correct had I been involved a year ago – I probably would have gotten short to protect our warehouse and general hedge against the business given our outlook in the space.” 2/5/2007 email from Richard Ruzika to Gary Cohn, “Are you living Morgatages? [sic],” GS MBS-E-016165784. 1554 1555 ABX holdings”). 1556 009726498, Hearing Exhibit 4/27-3. 1557

For more information about the Hudson CDO, see below. See, e.g., 12/7/2006 email from Tom Montag, GS MBS-E-009756572 (“I don’t think we should panic regarding

12/14/2006 email from Daniel Sparks, “Subprime risk meeting with Viniar/McMahon Summary,” GS MBS-E-

Subcommittee interview of David Viniar (4/13/2010).

386

2007, a $16 billion reversal. of $3 billion in subprime mortgage backed securities as “huge and outsized.” 1559 net short position in February 2007 was $10 billion – more than triple that size.

A senior Goldman executive later described a net short position But Goldman’s

1558

In late February, Goldman’s Operating Committee, a subcommittee of its Firmwide Risk Committee, became concerned about the size of the $10 billion net short position. The Firmwide Risk Committee was co-chaired by Mr. Viniar, and Messrs. Cohn and Blankfein regularly attended its meetings. The concern arose, in part, because the $10 billion net short position had dramatically increased the Mortgage Department’s Value-at-Risk or “VAR,” the primary measure Goldman used to compute its risk. The Committee ordered the Department to lock in its profits by “covering its shorts,” as explained above. The Mortgage Department complied by covering most, but not all, of the $10 billion net short and brought down its VAR. It then maintained a relatively lower risk profile from March through May 2007.

1560

Attempted Short Squeeze. In May 2007, the Mortgage Department’s Asset Backed

1561

Security (ABS) Trading Desk attempted a “short squeeze” of the CDS market that was intended to compel other market participants to sell their short positions at artificially low prices. Goldman’s ABS Desk was still in the process of covering the Mortgage Department’s shorts by offering CDS contracts in which Goldman took the long side. The ABS Desk devised a plan in which it would offer those CDS contracts to short parties at lower and lower prices, in an effort to drive down the overall market price of the shorts. As prices fell, Goldman’s expectation was that other short parties would begin to sell their short positions, in order to avoid having to sell at still lower prices. The ABS Desk planned to buy up those short positions at the artificially low prices it had caused, thereby rebuilding its own net short position at a lower cost. The ABS Desk initiated its plan, and during the same period Goldman customers protested the lower values assigned by Goldman to their short positions as out of line with the market. Despite the lower prices, the parties who already held short positions generally kept them and did not try to sell them. In June, after learning that two Bear Stearns hedge funds specializing in subprime mortgage assets might collapse, the ABS Desk abandoned its short squeeze effort and recommenced buying short positions at the prevailing market prices.

1562

The Big Short. In mid-June 2007, the two Bear Stearns hedge funds did collapse,

triggering another steep decline in the value of subprime mortgage assets. In response, Goldman immediately went short again, to profit from the falling prices. Within two weeks, Goldman had massed a large number of CDS contracts shorting a variety of subprime mortgage assets. On

3/10/2007 email to Daniel Sparks, “Mortgage Presentation to the board,” GS MBS-E-013323395, Hearing

8/23/2007 email from Tom Montag, “Current Outstanding Notional SN ames,” GS MBS-E-010621231. 11/13/2007 Goldman email, GS MBS-E-010023525 (attachment, 11/14/2007 “Tri-Lateral Combined

1558 Exhibit 4/27-17. 12/13/2006 Goldman email, “Subprime Mortgage Risk,” Hearing Exhibit 4/27-2. 1559 1560 Comments,” GS MBS-E-010135693-715 at 695).
1561 Salem, GS-PSI-03157-80 at 72 (hereinafter “Salem 2007 Self-Review”). 1562

9/7/2007 Fixed Income, Currency and Commodities Annual Individual Review Book, Self-Review of Deeb

Id.

387

June 22, 2007, Goldman’s net short position reached its peak of approximately $13.9 billion, as calculated by the Subcommittee. That total included the $9 billion in AAA ABX assets that Goldman had earlier acquired as “disaster protection,” in case the subprime market as a whole lost value. The resulting net short, referred to by Mr. Viniar as the “big short,” was nearly 40% larger than its first net short which had peaked at $10 billion in February 2007.

1563

To lock in its profits on the $13.9 billion short, the Mortgage Department began working to cover its shorts, buying long assets and entering into offsetting CDS contracts in which it took the long position. On July 10, 2007, the credit rating agencies issued the first of many mass rating downgrades that affected hundreds and then thousands of RMBS and CDO securities, whose values began to fall even more rapidly. The Mortgage Department was able to purchase long assets at a low cost, managed to cover most of its short positions, and locked in its profits. At the same time, the Mortgage Department maintained a net short position in higher risk subprime RMBS securities carrying credit ratings of BBB or BBB-, betting that those securities would lose still more value and produce still more profits for the firm. In August, however, Goldman senior management again became concerned about the size of the Department’s net short position and its VAR levels, which had reached record levels. On August 21, 2007, Goldman’s Chief Operating Officer Gary Cohn ordered the Mortgage Department to “get down now.”

1564

Big Short Profits. In response, the Mortgage Department began another round of

By the end of 2007, the SPG Trading Desk in the

covering its shorts and locking in its profits, including the shorts referencing BBB and BBB- rated RMBS securities. In the third quarter of 2007, the SPG Trading Desk reported record revenues from its short positions totaling $2.8 billion. Mortgage Department recorded year-end net revenues totaling $3.7 billion, which were used to offset losses on other desks, leaving the Mortgage Department as a whole with record net revenues of over $1.1 billion for the year. wrote that 2007 was “the [year] I am most proud of to date,” because of the “extraordinary profits” from the short positions he had advocated. headed the ABX Desk within SPG, also reviewed the year in terms of the profitable short positions it built. He wrote: “The prevailing opinion within the department was that we should just ‘get close to home’ and pare down our long,” but he decided his ABS Desk should “not only

The head of the SPG Desk, Michael Swenson, later

His colleague, Joshua Birnbaum who

1567

1565

1566

For more information about the mass rating downgrades, see Chapter V, above. See also 7/10/2007 Goldman

See chart entitled, “Goldman Sachs Mortgage Department Total Net Short Position, February-December 2007 in

1563 $ Billions,” prepared by the Permanent Subcommittee on Investigations, Hearing Exhibit 4/27-162 (April 2010 version), updated January 2011 (updated version), derived from Goldman Sachs Mortgage Strategies, Mortgage Dept Top Sheets provided by Goldman Sachs (hereinafter “PSI Net Short Chart”), See Section C(4)(g).
1564 email, “GS Cashflow/Abacus CDOs Mentioned in S&P Report on CDO Exposure to Subprime RMBS,” GS MBS-E- 001837256. 1565 1566 derivative products, without deduction of related losses, were apparently $5.9 billion. 4Q07 Fact Sheet prepared for David Viniar (FY07 P&L [profit and loss]: . . . derivatives +5.9B), GS MBS-E-009724276, Hearing Exhibit 4/27- 159. 1567

10/2007 Global Mortgages, Business Unit Townhall at 4-5, GS MBS-E-013703463, Hearing Exhibit 4/27-47. Quarterly Breakdown of Mortgage P/L, GS MBS-E-009713204 at 205. Goldman’s gross revenues from all

Swenson self evaluation, Hearing Exhibit 4/27-55b.

388

1568

He wrote: “[W]e implemented the plan by hitting on almost

… get flat, but get VERY short.” every single name CDO protection buying opportunity in a 2-month period. Much of the plan began working by February as the market dropped 25 points and our very profitable year was under way.” When the subprime mortgage market fell further in July after the credit rating mass downgrades, he wrote: “We had a blow-out [profit and loss] month, making over $1Bln that month.”1569

The $3.7 billion in net revenues from the SPG’s short positions helped to offset other

mortgage related losses, and, at year’s end, at a time when mortgage departments at other large financial institutions were reporting record losses, Goldman’s Mortgage Department reported overall net revenues of $1.1 billion.

1570

(b) Overview of Goldman’s CDO Activities

This Report also examines four CDOs that Goldman originated, underwrote, and marketed

in the years leading up to the financial crisis: Hudson Mezzanine 2006-1, Anderson Mezzanine 2007-1, Timberwolf I, and Abacus 2007-AC1. Hudson was conceived in 2006, and issued its securities in December 2006, as Goldman began its concerted effort to sell its mortgage holdings. Anderson, Timberwolf, and Abacus issued their securities in 2007, as RMBS and CDO securities were losing value, and Goldman was shorting the subprime mortgage market.

During 2007, as Goldman built and profited from its net short positions in the first and third quarters of the year, it continued to design, underwrite, and sell CDO securities. Due to waning investor interest, in February 2007, Goldman conducted a review of the CDOs in its pipeline. The Mortgage Department decided to cancel four pending CDOs, downsize another two, and bring all of its remaining CDOs to market as quickly as possible. Also in February 2007, the Mortgage Department limited its CDO Origination Desk to carrying out only the CDO transactions already underway.

“Gameplan” for CDO Valuation Project. In the first quarter of 2007, Goldman’s Mortgage Department worked to sell the warehouse assets from the discontinued CDOs, the securities issued by past Goldman-originated CDOs, and the new securities from CDOs being originated by Goldman in 2006 and 2007. In May 2007, as CDO sales slowed dramatically, Goldman became concerned about the lack of sales prices to establish the value of its CDO holdings. Goldman needed accurate values, not just to establish its CDO sales prices, but also to value the CDO securities for collateral purposes and in compliance with Goldman’s policy of using up-to-date market values for all of its holdings. On May 11, 2007, Goldman senior executives, including Mr. Cohn and Mr. Viniar, Mortgage Department personnel, controllers, and

1571

1568 1569 1570 1571

Birnbaum self evaluation, Hearing Exhibit 4/27-55c. Id. Quarterly Breakdown of Mortgage P/L, GS MBS-E-009713204 at 205. 5/11/2007 email from Daniel Sparks, “You okay?,” GS MBS-E-019659221.

389

others held a meeting and developed a “Gameplan” for a CDO valuation project. Gameplan called for the Mortgage Department, over the course of about a week, to use three different valuation methods to price all of its CDO warehouse assets, unsold securities from past CDOs, and new securities from the CDOs currently being marketed to clients.

The

1572

1573

While the CDO valuation project was underway, Goldman senior executive Thomas

Montag asked Daniel Sparks for an estimate of how much the firm would need to write down the value of its CDO assets. Mr. Sparks responded that “the base case from traders is down [$]382 [million].” He also wrote: “I think we should take the write-down, but market [the CDO securities] at much higher levels.” expressed concern about selling clients CDO securities at one price and then immediately devaluing them: “[D]on’t think we can trade this with our clients andf [sic] then mark them down dramatically the next day.” Broderick told his staff to anticipate deep markdowns and highlighted the need to identify clients that might suffer financial difficulty if Goldman devalued their CDO securities and demanded they post more cash collateral.

At the same time, Goldman’s Chief Credit Risk Officer Craig

Another Goldman senior executive, Harvey Schwartz,

1575

1574

On May 20, 2007, the Gameplan results were summarized in an internal presentation.

It projected that Goldman would have to take from $248 to $440 million in writedowns on unsold CDO securities and warehouse assets, making it clear to Goldman executives that its CDO assets were losing value rapidly. In several drafts of the presentation, the Mortgage Department had also written that Goldman’s CDOs were expected “to underperform,” but that statement was removed from the final presentation given to senior executives.

1578

1577

1576

Targeted Sales. The Gameplan also recommended a two-pronged approach to selling the firm’s remaining CDO assets. First, it recommended transfer of the CDO warehouse assets to the Mortgage Department’s SPG Trading Desk for further valuation and sale. Second, it recommended that the Mortgage Department use a “targeted” approach to sell off the existing and

Id.; 5/14/2007 email from David Lehman, “Gameplan – asset model analysis,” GS MBS-E-001865782 (last

Id.; 5/14/2007 email from Elisha Weisel, “Modelling Approaches for Cash ABS CDO/CDO^2,” GS MBS-E-

5/14/2007 email from Tom Montag to Daniel Sparks, GS MBS-E-019642797.
5/11/2007 email from Harvey Schwartz to Daniel Sparks, Tom Montag, and others, GS MBS-E-010780864. 5/20/2007 email, “Viniar Presentation - Updated,” GS MBS-E-010965211 (attached file, “Mortgages

1572 email in a longer email chain). 1573 001863618. 1574 1575 1576 Department, May 2007,” Goldman presentation, GS MBS-E-010965212); see also 5/19/2007 “Mortgages CDO Origination – Retained Positions & Warehouse Collateral, May 2007,” Goldman presentation, GS MBS-E- 010951926. 1577 presentation, GS MBS-E-010951926. 1578 Goldman presentation, GS MBS-E-010951926, with 5/20/2007 “Mortgages Department, May 2007,” Goldman presentation, GS MBS-E-010965212.

Compare 5/19/2007 “Mortgages CDO Origination – Retained Positions & Warehouse Collateral, May 2007,”

5/19/2007 “Mortgages CDO Origination – Retained Positions & Warehouse Collateral, May 2007,” Goldman

390

new securities from Goldman-originated CDOs, naming four hedge funds as the primary targets and providing a list of another 35 clients as secondary targets.

1579

At the same time, Mr. Sparks named David Lehman, a commercial mortgage backed securities trader, as the new head of the CDO Origination Desk. Shortly thereafter, Goldman dismantled the CDO Origination Desk and moved all remaining CDO securities to the SPG Trading Desk, where he was based. The SPG Trading Desk, which was a secondary trading desk and had little experience with underwriting, assumed responsibility for marketing the remaining unsold Goldman-originated CDO securities. The SPG Trading Desk’s lack of underwriting experience meant that it was less familiar with the obligations of underwriters and placement agents to disclose all material adverse interests to potential investors.

The SPG Trading Desk worked with Goldman’s sales force to market the CDO securities. Goldman employed “hard sell” tactics, repeatedly urging its sales force to sell the CDO securities and target clients with limited CDO familiarity. After trying the Gameplan’s “targeted” client approach during May, June, and July 2007, the Mortgage Department switched back to issuing sales directives or “axes” to its entire sales force, including sales offices abroad. Axes on CDOs generally went out at weekly or monthly intervals, identified specific CDO securities as top sales priorities, and offered additional financial incentives for selling them. Despite the CDOs’ declining value, the sales force succeeded in selling some of the CDO securities, primarily to clients in Europe, Asia, Australia, and the Middle East, but was unable to sell all of them.

1580

The four CDOs that the Subcommittee examined illustrate a variety of conflict of interest

issues related to how Goldman designed, marketed, and administered them.

Hudson Mezzanine 2006-1. Hudson Mezzanine 2006-1 (Hudson 1) was a $2 billion

synthetic CDO comprised of $1.2 billion in ABX assets from Goldman’s own inventory, and $800 million in single name CDS contracts on subprime RMBS and CDO securities that Goldman wanted to short. It was called a “mezzanine” CDO, because the referenced RMBS securities carried the riskier credit ratings of BBB or BBB-. Goldman used the CDO to transfer the risk associated with its ABX assets to investors that bought Hudson 1 securities. Goldman also took 100% of the short side of the CDO, which meant that it would profit if any of the Hudson securities lost value. In addition, Goldman exercised complete control over the CDO by playing virtually every key role in its establishment and administration, including the roles of underwriter, initial purchaser of the issued securities, senior swap counterparty, credit protection buyer, collateral put provider, and liquidation agent.

5/19/2007 “Mortgages CDO Origination – Retained Positions & Warehouse Collateral, May 2007,” Goldman

1579 presentation, GS MBS-E-010951926; 5/20/2007 email from Lee Alexander to Daniel Sparks, Donald Mullen, Lester Brafman, Michael Kaprelian, “Viniar Presentation - Updated,” GS MBS-E-010965211 (attached file “Mortgages V4.ppt,” “Mortgages Department, May 2007,” GS MBS-E-010965212). 1580

See discussions of Hudson, Anderson, Timberwolf, and Abacus sales efforts, below.

391

Goldman began marketing Hudson 1 securities in October 2006, soliciting clients to buy

Hudson securities. It did not fully disclose to potential investors material facts related to Goldman’s investment interests, the source of the CDO’s assets, and their pricing. The Hudson 1 marketing materials stated prominently, for example, that Goldman’s interests were “aligned” with investors, because Goldman was buying a portion of the Hudson 1 equity tranche. marketing materials, Goldman did not mention that it was also shorting all $2 billion of Hudson’s assets – an investment that far outweighed its $6 million equity share and which was directly adverse to the interests of prospective investors. In addition, the marketing materials stated that Hudson 1’s assets were “sourced from the Street” and that it was “not a balance sheet CDO.” 1582 However, $1.2 billion of the Hudson assets had been selected solely to transfer risk from ABX assets in Goldman’s own inventory.

In its

1581

Goldman also did not disclose in the materials that it had priced the assets without using

any actual third party sales. The absence of arm’s length pricing was significant, because the Hudson CDO was designed to short the ABX Index using single name RMBS securities, and there was a pricing mismatch between the two types of assets. Goldman not only determined the pricing for the RMBS securities purchased by Hudson 1, but retained the profit from the pricing differential. The marketing materials did not inform investors of Goldman’s role in the pricing, the pricing methodology used, or the gain it afforded to Goldman. In addition, the marketing materials stated Hudson 1 was “not a balance sheet” CDO, without disclosing that Hudson had been designed from its inception to remove substantial risk from Goldman’s balance sheet.

1583

The Hudson 1 Offering Circular contained language that may have also misled investors

about Goldman’s true investment interest in the CDO. The Offering Circular stated:

“[Goldman Sachs International] and/or any of its affiliates may invest and/or deal, for their own respective accounts for which they have investment discretion, in securities or in other interests in the Reference Entities, in obligations of the Reference Entities or in the obligors in respect of any Reference Obligations or Collateral Securities … , or in credit default swaps … , total return swaps or other instruments enabling credit and/or other risks to be traded that are linked to one or more Investments.”

1584

This provision seems to inform investors that Goldman “may invest” for its own account in the CDO’s securities, reference obligations, or CDS contracts, while withholding the fact that, by the time the Offering Circular had been drafted, Goldman had already determined to take 100% of the short position in the CDO, an investment which was directly adverse to the interests of Hudson securities investors.

10/2006 Goldman Sachs report, “Hudson Mezzanine Funding, 2006-1, LTD.,” at 4, GS MBS-E-009546963,

Id. For more information on this pricing mismatch, see the Hudson discussion, below. 12/3/2006 Hudson Mezzanine 2006-1, LTD. Offering Circular, GS MBS- E-021821196 at 251 (emphasis

1581 Hearing Exhibit 4/27-87. 1582 1583 1584 added).

392

Once Hudson issued its securities, Goldman placed a priority on selling them, and delayed

the issuance of a CDO on behalf of another client in order to facilitate Hudson sales. Goldman sales representatives reported that clients expressed skepticism regarding the quality of the Hudson assets, but Goldman continued to promote the sale of the CDO.

In 2008, as Hudson’s assets lost value and received rating downgrades from the credit

rating agencies, Goldman, in its role as liquidation agent, was tasked with selling those assets to limit losses to the long investors. The major Hudson investor, Morgan Stanley, pressed Goldman to do just that. Goldman, however, delayed selling the assets for months. As the assets dropped in value, Goldman’s short position increased in value. Morgan Stanley’s representative reported to a colleague that when Goldman rejected the firm’s request to sell the poorly performing Hudson assets, “I broke my phone.” “[O]ne day I hope I get the real reason why you are doing this to me.” nearly $960 million on its Hudson investment.

He also sent an email to the head of Goldman’s CDO Desk saying:

Morgan Stanley lost

1586

1585

Anderson Mezzanine 2007-1. Anderson Mezzanine 2007-1 (Anderson) was another synthetic CDO referencing BBB and BBB- rated subprime RMBS securities. It was issued in March 2007. Among other roles, Goldman served as the CDO’s placement agent, initial purchaser, collateral put provider, and liquidation agent. Goldman hired another firm, a New York hedge fund founded by former Goldman employees, GSC Partners, to act as the collateral manager. Goldman took a short position on approximately 40% of the $305 million in assets underlying Anderson.

Anderson referenced a number of poor quality assets. Those assets had been selected by

GSC Partners, with the approval of Goldman. Over 45% of the referenced subprime RMBS securities contained mortgages originated by New Century, a subprime lender known within the industry, including Goldman, for issuing poor quality loans and which was experiencing financial problems while Anderson was being structured and marketed. aware of New Century’s problems and were taking action to return substantial numbers of substandard loans purchased from New Century and demand repayment for them. Other assets in the Anderson CDO were also performing poorly, and at one point, Goldman personnel estimated

Inside Goldman, staff were

1588

1587

1585 2/6/2008 email from John Pearce to Michael Petrick, HUD-CDO-00005146. 1586 2/7/2008 email from John Pearce to David Lehman, HUD-CDO-00005147. 1587 In April 2007, the month after Anderson issued its securities, New Century announced it would have to restate its earnings. It declared bankruptcy soon after. For more information about New Century, see Chapter IV, section E(2)(c). 1588 putting back 26% of the pool….if possible.”). See also 2/2/2007 email from Matthew Nichols to Kevin Gasvoda, GS MBS-E-005556331 (“NC is running a 10% drop rate [due diligence drop] at ~6 points / drop and 4% EPD rate at close to 20 points.”). 2/8/2007 email from John Cassidy to Joseph Ozment, others, GS MBS-E-002045021 (“Given the current state of the company I am no longer comfortable with the practice of taking loans with trailing docs . . . that we need in order to conduct compliance testing. . .”).

See, e.g., 3/2007 Goldman internal email, GS MBS-E-002146861, Hearing Exhibit 4/27-77 (“I recommend

393

its warehouse assets had fallen in value by $22 million. Due to the asset quality problems, the Mortgage Department head, Daniel Sparks, initially decided to cancel Anderson, but later changed his mind and decided to market the CDO as quickly as possible, using the $305 million in assets already in its warehouse account, rather than wait to accumulate all of the $500 million in assets initially planned.

1589

When Anderson issued its securities in March 2007, Goldman placed a high priority on

selling them, even delaying another CDO – Abacus 2007-AC1 which was being organized at the request of the Paulson hedge fund – to allow its sales force to concentrate on promoting Anderson. Potential investors raised questions about the quality of its underlying assets, especially the New Century loans, and Goldman provided its sales representatives with talking points to dispel concerns about the New Century assets. When one client asked how Goldman had gotten “comfortable” with the New Century loans, Goldman did not disclose to the client its own negative views of New Century loans or that it had 40% of the short side of the CDO.

Goldman marketed Anderson securities to a number of its clients, including pension funds,

In the end, and recommended using Anderson securities as collateral security in other CDOs. 1590 Goldman sold only $102 million or about one third of the Anderson securities. Seven months 1591 after the securities were issued, they suffered their first credit rating downgrade. Currently, all of the Anderson securities have been reduced to junk status, and the Anderson investors have lost virtually their entire investments.

Timberwolf I CDO. Timberwolf I was a $1 billion hybrid CDO transaction that

referenced single-A rated securities from other CDOs. Those CDO securities referenced, in turn, RMBS securities carrying lower credit ratings, primarily BBB. Altogether, Timberwolf referenced 56 unique CDO securities that had over 4,500 unique underlying assets. Goldman served as the CDO’s placement agent, initial purchaser, collateral put provider, and liquidation agent. It also hired a hedge fund with former Goldman employees, Greywolf Capital Management, to act as the collateral manager. Greywolf selected the CDO’s assets, with Goldman’s approval. Goldman took a short position on approximately 36% of the $1 billion in assets underlying Timberwolf.

1592

Timberwolf’s securities began losing value almost as soon as they were purchased. In February 2007, Goldman’s Mortgage Department head told a senior executive that Timberwolf was one of two deals “to worry about.” He also wrote that the assets in the Timberwolf warehouse account had declined so much in value that they had already exhausted Greywolf’s responsibility to pay a portion of any warehouse losses, and any additional losses would be Goldman’s exclusive

3/16/2007 GSI Risk Committee Memo, “GSI Warehousing for Structured Product CDOs,” GS MBS-E-

1589 001806010. 1590 3/12/2007 email from Robert Black to Matthew Bieber and others, GS MBS-E-000898037. 1591 See Goldman response to Subcommittee QFR at PSI_QFR_GS0223 and PSI_QFR_GS0235. 1592 Among other assets, Goldman sold $15 million in certain Abacus securities to the Timberwolf CDO. Goldman held 100% of the short side of the relevant Abacus CDO. Its sale of the Abacus securities meant that Goldman held the short side of those assets, while Timberwolf investors took the long side.

394

Goldman rushed Timberwolf to market, and it closed on March 27, 2007,

1593

obligation. approximately six weeks ahead of schedule. issued, they too began to lose value.

1594

Almost as soon as the Timberwolf securities were

Despite doubts about its performance and asset quality, Goldman engaged in an aggressive campaign to sell the Timberwolf securities. As part of its tactics, Mr. Lehman instructed Goldman personnel not to provide written information to investors about how Goldman was valuing or pricing the Timberwolf securities, and its sales force offered no additional assistance to potential investors trying to evaluate the 4,500 underlying assets. Mr. Sparks and Mr. Lehman sent out numerous sales directives or “axes” to the Goldman sales force, stressing that Timberwolf was a priority for the firm. In April, Mr. Sparks suggested issuing “ginormous” sales credits to any salesperson who sold Timberwolf securities, only to find out that large sales credits had already been offered. continued to sell the securities at a much higher price than the company knew it was worth. At one point, a member of the SPG Trading Desk issued an email to clients and investors, advising them that the market was rebounding and the downturn was “already a distant memory.” Goldman also began targeting Timberwolf sales to “non-traditional” buyers and those with little CDO familiarity, such as increasing its marketing efforts in Europe and Asia.

In May, while Goldman was internally lowering the value of Timberwolf, it

1597

1595

1596

On June 18, 2007, Goldman sold $100 million worth of Timberwolf securities to an Australian hedge fund, Basis Capital. Just 16 days later, on July 4, Goldman informed Basis Capital that the securities had lost value, and it had to post additional cash collateral to secure its CDS contract. On July 12, Goldman told Basis Capital that the value had dropped again, and still more collateral needed to be posted. In less than a month, the value of Timberwolf had fallen by $37.5 million. Basis Capital posted the additional capital, but soon after declared bankruptcy.

On June 1, 2007, Goldman Sachs sold $36 million in Timberwolf securities to a Korean life

insurance company, Hungkuk Life, that had little familiarity with the product. The head of the Korean sales office said his office was willing to sell the company additional securities, if assured the office would receive a 7% sales credit. Goldman agreed, and said “get ‘er done.” The sales office sold another $56 million in Timberwolf securities to the life insurance company which paid $76 per share when Goldman’s internal value for the security was $65.

Within ten days of that sale, Thomas Montag, a senior Goldman executive, sent an email to

the Mortgage Department head, Daniel Sparks, stating: “boy that timeberwof [Timberwolf] was

2/26/2007 email between Tom Montag and Daniel Sparks, GS MBS-E-019164806. 3/2007 Goldman internal email chain, GS MBS-E-001800634. See, e.g., 6/2007-8/2007 Goldman internal emails, “Timberwolf Sales Efforts,” Hearing Exhibit 4/27-166;

1593 1594 1595 3/2007 Goldman internal email, “GS Syndicate Structured Product CDO Axes,” Hearing Exhibit 4/27-100.
1596 102 (Mr. Bohra responds, “[w]e have done that with Timberwolf already.”). 1597

4/19/2007 email chain between Daniel Sparks and Bunty Bohra, GS MBS-E-010539324, Hearing Exhibit 4/27-

5/14/2007 email from Edwin Chin, GS MBS-E-012553986.

one shitty deal.” its clients.

1598

Despite that comment, Goldman continued to market Timberwolf securities to

395

Goldman had also arranged for its subsidiary, Goldman Sachs International (GSI), to act as

both the primary CDS counterparty and the collateral put provider in Timberwolf. GSI received a fee for serving as the collateral put provider, GSI began to refuse to approve Timberwolf’s purchase of new collateral securities whose values might decline below par value and put Goldman at risk of having to make up the difference. Instead, GSI pressured Timberwolf to keep its collateral in cash, even though an internal Goldman analysis had confirmed that cash collateral produced lower returns for Timberwolf investors than collateral securities. When Greywolf objected to this practice, Goldman backed down and allowed the purchase of a narrow range of very safe, short term asset backed securities as collateral.

Although

1599

In the fall of 2007, a Goldman analyst provided executives with a price history for

Timberwolf A2 securities. It showed that, in five months, Timberwolf securities had lost 80% of their value, falling from $94 in March to $15 in September. Upon receiving the pricing history, the Timberwolf deal captain, Matthew Bieber, wrote that March 27 – the day Timberwolf issued its securities – was “a day that will live in infamy.”

Timberwolf was liquidated in 2008.

1600

Abacus 2007-AC1. Abacus 2007-AC1 was a $2 billion synthetic CDO that referenced

BBB rated mid and subprime RMBS securities issued in 2006 and early 2007. It was a static CDO, meaning once selected, its reference obligations did not change. It was the last in a series of 16 Abacus CDOs that referenced primarily mortgage backed assets and were designed by Goldman. Those Abacus CDOs were known as single tranche CDOs, structures pioneered by Goldman to provide customized CDOs for clients interested in assuming a specific type and amount of investment risk. They enabled the client to select the assets, the size of the investment, the amount of subordination or cushion before the securities would be exposed to loss, and could be issued with a single tranche. The Abacus CDOs also enabled investors to short a selected group of RMBS or CDO securities at the same time. Goldman used the Abacus CDOs not only to sell short positions to investors, but also as a way for Goldman itself to short mortgage assets in bulk.1602

1601

6/2007 Goldman internal email to Daniel Sparks, Hearing Exhibit 4/27-105. In synthetic CDOs, the cash proceeds from the sales of the CDO securities were used to purchase “collateral

1598 1599 debt securities.” Later, when cash was needed to make payments to a long or short party, those collateral securities were sold, and the cash was used to make the payments. In the event the collateral securities used to pay the short party (called “default swap collateral”) could not be sold for face (par) value, Goldman, the short party, absorbed the loss, effectively serving as the default swap collateral put provider. For more information, see discussion of Goldman’s actions taken while the collateral put provider of Timberwolf, below. 1600 1601 Goldman brand name for single-tranche CLN [credit linked note] issuances referencing portfolios comprised entirely of structured products.”); 4/2006 Goldman presentation “Overview of Structured Products,” GS MBS-E-016067482. 1602 by ACA,” GS MBS-E-002406025, Hearing Exhibit 4/27-118.

9/17/2007 email from Matthew Bieber to Christopher Creed, GS MBS-E-000766370, Hearing Exhibit 4/27-106. 6/2007 Goldman document, “CDO Platform Overview,” at 31, GS MBS-E-001918722 (“ABACUS is the

3/12/2007 Goldman internal memorandum to Mortgage Capital Committee, “ABACUS Transaction sponsored

396

Abacus 2007-AC1 was the first and only Abacus transaction in which Goldman allowed a

third party client to essentially “rent” its CDO structure and play a direct, principal role in the selection of the assets. Goldman did not itself intend to invest in the CDO. Instead, it functioned primarily as an agent, earning fees for its roles in structuring, underwriting, and administering the CDO. Those roles included Goldman’s acting as the placement agent, collateral securities selection agent, and collateral put provider. Unlike previous Abacus CDOs, Goldman employed a third party to serve as the portfolio selection agent, essentially using that agent to promote sales and mask the role of its client in the asset selection process.

1603

Goldman originated Abacus 2007-AC1 in response to a request by Paulson & Co. Inc. (Paulson), a hedge fund that was among Goldman’s largest customers for subprime mortgage related assets. Paulson had a very negative view of the mortgage market, which was publicly known, and wanted Goldman’s assistance in structuring a transaction that would allow it to take a short position on a portfolio of subprime mortgage assets that it believed were likely to perform poorly or fail. Goldman allowed Paulson to use the Abacus CDO for that purpose. In entering into that arrangement with Paulson and simultaneously acting as the placement agent responsible for marketing the Abacus securities to long investors, Goldman created a conflict of interest between itself and the investors it would be soliciting to buy the Abacus securities.

Paulson established a set of criteria to select the reference assets for the Abacus CDO to

1604

After establishing those parameters, Paulson worked with the

achieve its investment objective. actual portfolio section agent to select the assets. Documents show that Paulson proposed, substituted, rejected, and approved assets for the reference portfolio. Goldman was aware of Paulson’s investment objective, the role it played in the selection of the reference assets, and the fact that the selection process yielded a set of poor quality assets. Of the final set of 90 assets referenced in the Abacus CDO portfolio, 49 had been initially proposed by Paulson. Yet Goldman did not publicly disclose the central role played by Paulson in the asset selection process or the fact that the economic interest held by an entity actively involved in the asset selection process was adverse to the interest of investors who would be taking the long position.

ACA Management LLC, the company hired by Goldman to serve as the portfolio selection

agent, told the Subcommittee that, while it knew Paulson was involved, it was unaware of Paulson’s true economic interest in the CDO. The ACA Managing Director who worked on the Abacus transaction stated that ACA believed that Paulson was going to invest in the equity tranche of the CDO, thus aligning its interests with those of ACA and other investors.

ACA and its

1605

As collateral put provider, which it performed for a fee, Goldman did carry risk in the Abacus 2007-AC1

1603 transaction. In addition, shortly before the Abacus 2007-AC1 transaction closed, Goldman agreed to take the long side of a CDS contract on the performance of a small portion of the underlying assets when Paulson wanted to increase its short position at the last minute. Goldman tried to find an investor to assume its small long position, but was unable to do so.
1604 April 27, 2010 Subcommittee Hearing at 82. 1605 Subcommittee interview of Laura Schwartz (ACA) (4/23/2010). See also In the Matter of Abacus 2007-AC1 CDO, File No. HO-10911 (SEC), Statement of Laura Schwartz (January 21, 2010), ACA ABACUS 00004406 at

(hereinafter “Statement of Laura Schwartz”).

397

parent company both acquired long positions in the Abacus CDO as did a third investor. The Abacus securities lost value soon after purchase. The three long investors together lost more than $1 billion, while Paulson, the sole short investor, recorded a corresponding profit of about $1 billion. Today, the Abacus securities are worthless.

In addition to not disclosing the asset selection role and investment objective of the Paulson hedge fund, Goldman did not disclose to investors how its own economic interest was aligned with Paulson. In addition to accepting a sizable placement fee paid by Paulson for marketing the CDO securities, Goldman had entered into a side arrangement with the hedge fund in which it would receive additional fees from Paulson for arranging CDS contracts tied to the Abacus CDO that included low premium payments falling within a specified range. While those lower premium payments would benefit Paulson by lowering its costs, and benefit Goldman by providing it with additional fees, they would also reduce the amount of cash being paid into the CDO, disadvantaging the very investors to whom Goldman was marketing the Abacus securities. Goldman nevertheless entered into the arrangement, contrary to the interests of the long investors in Abacus, and failed to disclose the existence of the fee arrangement in the Abacus marketing materials.

1606

On April 16, 2010, the SEC filed a complaint against Goldman and one of the lead

salesmen for the Abacus CDO, Fabrice Tourre, alleging they had failed to disclose material adverse information to potential investors and committed securities fraud in violation of Section 17(a) of the Securities Act of 1933 and Section 10(b) and Rule 10b-5 of the Securities Exchange Act of

On July 14, 2010, Goldman reached a settlement with the SEC, admitting:

“[T]he marketing materials for the ABACUS 2007-AC1 transaction contained incomplete information. In particular, it was a mistake for the Goldman marketing materials to state that the reference portfolio was ‘selected by’ ACA Management LLC without disclosing the role of Paulson & Co. Inc. in the portfolio selection process and that Paulson’s economic interests were adverse to CDO investors.”

1607

Goldman agreed to pay a $550 million fine.

The Hudson, Anderson, Timberwolf, and Abacus CDOs provide concrete details about how

Goldman designed, marketed, and administered mortgage related CDOs in 2006 and 2007. The four CDOs also raise questions about whether Goldman complied with its obligations to offer suitable investments that it believed would succeed, and provide full disclosure to investors of material adverse interests. They also illustrate a variety of conflicts of interest in the CDO transactions that Goldman resolved by placing its financial interests and favored clients before those of its other clients.

1606

3/12/2007 Goldman memorandum to Mortgage Capital Committee, “ABACUS Transaction sponsored by

ACA,” GS MBS-E-002406025-28, Hearing Exhibit 4/27-118.

Securities and Exchange Commission v. Goldman, Sachs & Co. and Fabrice Tourre, Case No. 10-CV-3229,

1607 (S.D.N.Y.), Consent of Goldman Sachs, (July 14, 2010), at 2.

398

Each of the four CDOs examined by the Subcommittee presents conflict of interest

concerns and elements of deception related to how information about the CDO was presented to investors, including disclosures related to the relevant CDO’s asset selection process, the quality and value of the CDO’s assets and securities, and the nature and size of Goldman’s proprietary financial interests. The Subcommittee’s investigation raises questions regarding whether Goldman complied with its obligations to disclose material information to investors, including its material adverse interests, and to refrain from making investment recommendations that are unsuitable for any investor by recommending financial instruments designed to lose value and perform poorly. A key issue underlying much of this analysis is the structuring of and disclosures related to financial instruments that enable an investment bank to bet against the very financial products it is selling to clients.

(4) How Goldman Shorted the Subprime Mortgage Market

Having provided an overview of Goldman’s shorting activities and CDO activities in the

years leading up to the financial crisis, this next section of the Report provides detailed information about how Goldman shorted the subprime mortgage market.

(a) Starting $6 Billion Net Long

By mid-2006, Goldman’s Mortgage Department had a predominantly pessimistic view of

the U.S. subprime mortgage market. According to Michael Swenson, head of the Mortgage Department’s Structured Products Group: “[D]uring the early summer of 2006 it was clear that the market fundamentals in subprime and the highly levered nature of CDOs [were] going to have a very unhappy ending.”

1608

$6 Billion Long. In mid-2006, Goldman held billions of dollars in long subprime

mortgage related securities, in particular the long side of CDS contracts referencing the ABX Index. In September 2006, Mortgage Department head Daniel Sparks and his superior, Jonathan Sobel, initiated a series of meetings with Mr. Swenson, head of the Structured Products Group (SPG), and Mr. Birnbaum, the Mortgage Department’s top trader in ABX assets, to discuss the Department’s long holdings. In those meetings, they discussed whether the Asset Backed Security (ABS) Trading Desk within SPG should get out of its existing positions or “double- down.” After the first meeting, Mr. Birnbaum emailed Mr. Swenson:

1609

9/26/2007 Michael J. Swenson Self-Review, GS-PSI-02396-401 at 398, Hearing Exhibit 4/27-55b. See also

1608 12/14/2006 email from Daniel Sparks to Messrs. Montag and Ruzika, “Subprime risk meeting with Viniar/McMahon Summary,” GS MBS-E-009726498, Hearing Exhibit 4/27-3 (“there will be very good opportunities as the market[] goes into what is likely to be even greater distress”); 7/13/2006 email from Stuart Bernstein copied to Mr. Cohn, GS MBS-E-016209254 (“he believes the REIT market is dead. We agreed . . . that as the market got worse, his ‘distressed’ expertise would be more (not less) interesting to investors”). See also Section 5(a)(iii) below regarding Goldman executives’ negative views of the market for subprime mortgages and subprime mortgage backed securities. 1609

9/19/2006 email chain between Joshua Birnbaum and Daniel Sparks, “ABX,” GS MBS-E-012683946.

399

“Sobel and Sparks want to know if we should exit or double down. We double down if we have a structured place to go with the risk. … [W]e are going to sit down with the CDO guys and talk about a deal.”

1610

If the Department’s existing long positions could be transferred off SPG’s books by finding a “structured place to go with the risk,” the ABS Trading Desk would then be free to “double down” by taking on new positions and risk.

That same month, September 2006, the ABS and CDO Desks reached agreement on constructing a new CDO to provide the ABS Desk with a “structured exit” from some of its existing investments. The result was Hudson Mezzanine 2007-1, a CDO designed by Goldman to transfer to Hudson investors the risk associated with $1.2 billion in net long ABX assets then in Goldman’s inventory. The Hudson CDO was also designed to allow Goldman to short $800 million in RMBS securities to offset a portion of its long ABX assets.

1611

In December 2006, even after the $2 billion Hudson CDO was constructed, the Mortgage Department calculated that it still had a $6 billion net long position in subprime mortgage related assets.

Goldman’s ABX holdings continued to be a major source of its long assets.

1612

Goldman’s Long ABX Assets. In January 2006, Goldman, Deutsche Bank, and several

1613

Investors could enter into CDS contracts that used a particular ABX Index as the

other Wall Street firms launched the ABX Index which, for the first time, allowed investors to use standardized CDS contracts to invest in baskets of subprime RMBS securities. The ABX Index measured the aggregate performance of a selected basket of 20 RMBS securitizations, producing a single value that rose or fell over time in line with the performance of the underlying RMBS securities. “reference obligation,” without physically purchasing or holding any of the RMBS securities in the underlying basket. Because the ABX Index itself was synthetic, and did not depend upon the acquisition of large blocks of RMBS securities, it enabled an unlimited number of investors to make unlimited bets on the performance of a group of subprime RMBS securities, using standardized contracts that could be bought and sold. The ABX Index also made it economical for investors to short subprime RMBS securities in bulk.1614

3/10/2007 email to Daniel Sparks, “Mortgage presentation to the Board,” GS MBS-E-013323395, Hearing

Id. Goldman responses to Subcommittee QFRs at PSI_QFR_GS0239. For more information on Hudson, see

1610 1611 section C(5)(b)(ii)AA., below.
1612 Exhibit 4/27-17 (Mortgage Department was $6 billion net long at start of the quarter). 12/13/2006 Goldman email, “Subprime Mortgage Risk,” Hearing Exhibit 4/27-2. 1613 securities pulled from the 20 RMBS securitizations in the ABX basket. The sets varied according to their assigned credit ratings. One index tracked the 20 RMBS securities with AAA ratings, another tracked the 20 RMBS securities with AA ratings, and so on. 1614 (10/12/2010).

The ABX Index actually consisted of five separate indices. Each index tracked a different set of RMBS

Subcommittee interview of Joshua Birnbaum (10/1/2010); Subcommittee interview of Rajiv Kamilla

400

1617

1615

In internal documents, Goldman described itself as “the leader and principal driver in the In July 2006, Joshua Birnbaum, Rajiv Kamilla, David Lehman,

creation of” the ABX Index. and Michael Swenson from the Mortgage Department nominated Goldman’s role in the creation of both the ABX and CMBX – a similar index based on Commercial Mortgage Backed Securities – for an internal Goldman award, called the “Mike Mortara Award for Innovation.” That award “recognize[d] the creative, forward-looking, and entrepreneurial contributions of an individual or team” within the equities or fixed income divisions. that the new indices “enable[d] market participants to trade risk without ownership of the underlying SP [structured product] security – thereby permitting market participants to efficiently go short the risk of these securities.” They also wrote that “Goldman Dominates Client Trading Volume” with “an estimated 40% market share,” and also “dominates the inter-dealer market.”

1619 In 2007, Rajiv Kamilla, the ABS trader who spearheaded Goldman’s efforts to launch the ABX Index, wrote that he “[c]ontinued to enhance our trading dominance in … ABX indices.”1620

The Mortgage Department personnel wrote

1616

1618

While Mr. Kamilla led Goldman’s efforts to develop the ABX Index, the firm’s day-to-day

ABX trading was conducted primarily by Joshua Birnbaum on the Mortgage Department’s Structured Products Group (SPG) Trading Desk.

Mr. Birnbaum had a negative view of the

1621

Id. at 8.
6/20/2006 email from “Equities and FICC Communications” to “All Equities and FICC,” Mike Mortara Award for

Mortara Award Submission at 2. Id. at 3-4. See also 8/30/2006 Fixed Income, Currency and Commodities Individual Review Book for Rajiv K.

1615 6/20/2006 email from David Lehman, “Mortara Nomination – ABX/CMBX Indices,” GS MBS-E-014038810 (attached file, “2006 Mike Mortara Award for Innovation Nomination Template for ABX & CMBX Indices,” GS MBS-E-014038811 at 6 (hereinafter “Mortara Award Submission”)).
1616 1617 Innovation,” GS MBS-E-010879020 [original email].
1618 1619 Kamilla, at 20, GS-PSI-04064 (hereinafter “Kamilla 2006 Review”); 9/6/2007 Fixed Income, Currency and Commodities Individual Review Book for Rajiv K. Kamilla, at 19, GS-PSI-04100 (hereinafter “Kamilla 2007 Review”).
1620 1621 2006: “Josh for EMD [Extended Managing Director] – he is an extraordinary commercial talent and a key franchise driver. … He will make us a lot of money.” 10/17/2006-10/18/2006 emails from Daniel Sparks, “3 things,” GS MBS-E-010917469. Other Goldman senior executives also relied on his trading skills. See, e.g., 2/21/2007 email from David Lehman, “ACA/Paulson Post,” GS MBS-E-003813259 (before approving the Abacus CDO, Mr. Lehman asked Mr. Tourre to “[w]alk josh through the $, if that makes sense, let’s go”); 6/29/2007 email from David Lehman, “ABS Update,” GS MBS-E-011187909 (during exceptionally bad trading day, Mr. Lehman asked Mr. Swenson, “Is Josh in? Mr. Swenson replied “No he is in Spain – don’t worry I am fine.”).

Kamilla 2007 Review at 19. In 2007, Mr. Kamilla was named a Managing Partner at Goldman. Daniel Sparks, the Mortgage Department head, viewed Mr. Birnbaum as a talented trader, writing in October

subprime mortgage market, and favored the firm’s building a net short position. during 2006, Goldman’s overall ABX position was net long, not net short.

1622

However,

401

Goldman was net long because, as a market maker that helped launch the ABX Index in

2006, it facilitated ABX trades for a number of clients, and many of those clients – primarily hedge funds – went almost exclusively short, requiring Goldman to take the opposing long side of the CDS contracts referencing the ABX indices. These transactions enabled Goldman to amass a 30-40% market share in ABX trading during its first year of existence. But by mid-2006, they had also contributed to the Mortgage Department’s net long position in subprime mortgage related assets. When the mortgage market began showing signs of strain in the second half of 2006, the risks associated with the firm’s net long ABX position became more of a concern.

Senior

1623

1624

1622 Subcommittee interview of Joshua Birnbaum (4/22/2010). Throughout 2006, Mr. Birnbaum was also working to develop a new product for Goldman, a suite of home price derivatives that would track the Case/Schiller Home Price Indices. Like the ABX Index, a derivative product tracking the Case/Schiller Indices would enable investors to bet on the rise or fall in home prices in various U.S. markets, and provide another vehicle to short the mortgage market. See 12/18/2006 New Product Memorandum, “Launch of US Property Derivatives Trading,” GS MBS-E-

In May 2006, Mr. Swenson forwarded an email to Mr. Birnbaum about another financial firm seeking to develop the same type of home price derivatives as Mr. Birnbaum. A note with the email said: “FYI–The cat is crawling out of the bag,” meaning that other firms were thinking about launching similar products. See 5/16/2006 email from Michael Swenson to Joshua Birnbaum, “Housing Futures and Options,” GS MBS-E-016087363. Goldman offered the new U.S. property derivatives briefly in 2007, but they did not develop significant trading volumes. Subcommittee interview of Joshua Birnbaum (10/1/2010). 1623 The ABX Index began trading in January 2006. Goldman’s position in the ABX Index was flat when the Index debuted, but became long and grew considerably longer in the fall of 2006. See, e.g., 10/17/2006-10/18/2006 email exchange between Daniel Sparks and Tom Montag, “3 things,” GS MBS-E-010917469; 3/1/2007 email from Daniel Sparks, “Dinner,” GS MBS-E-002356757, Hearing Exhibit 4/27-143 (“Most of the synthetic flows were hedge funds getting short and CDO vehicles getting long.”). Goldman executives also told the Subcommittee that the firm often took the long side of ABX transactions in which hedge funds were going short. Subcommittee interview of Daniel Sparks (4/15/2010); Subcommittee interview of David Viniar (4/13/2010). See also, e.g., 8/10/2006 email from Goldman salesperson, “Paulson bookings,” GS MBS-E-012395893 (“GS sold 550mm protection on ABX.HE.A 06- 2 to Paulson”); 12/7/2006 email chain between Daniel Sparks and Tom Montag, “More thorough response,” GS MBS-E-010931324 (Goldman had previously handled approximately $9 billion in transactions for Paulson); Subcommittee interview of Michael Swenson (4/16/2010) (“Paulson [hedge fund] was the biggest counterparty on day 1 [of the ABX Index] and throughout 2006”). 1624 Mr. Birnbaum’s acquisition of a large net long position in the ABX was viewed negatively by Goldman senior executives. When Mr. Sparks recommended Mr. Birnbaum for a promotion to managing director in October 2006, Mr. Montag responded: “Josh slipped a bit with the abx position etc. Is that appropriate.” Mr. Sparks replied: “Josh … has had a rough couple of months. But he has handled it very well and is a key person for our franchise. I don’t think those 2 months should confuse his value to the firm.” 10/17/2006 email exchange between Daniel Sparks and Tom Montag, “3 things,” GS MBS-E-010917469. Mr. Birnbaum was named a managing director later that month, but Mr. Montag again raised the issue of his net long ABX position when Mr. Sparks sought to allow Mr. Birnbaum to continue buying equity put options on companies with subprime exposure. Mr. Montag wrote: “Unfortunately trader josh has not demonstrated a track record of controlling his position. … Instead of these lousy hedges he should just be selling his position.” 3/21/2007 email chain between Tom Montag and Daniel Sparks, GS MBS-E-010629379, Hearing Exhibit 4/27-21. See also 2/5/2007 email from Richard Ruzika to Gary Cohn, “Are you living Morgatages [sic],” GS MBS-E-016165784 (Mr. Ruzika: “You know and I know this position was allowed to get too big – for the liquidity in the market, our infrastructure, and the ability of our traders. That statement would be the same even if we had gotten the market direction correct –although the vultures would not be circling.”).

402

Goldman executives expressed the view that the subprime mortgage related market was likely to get much worse, and the firm should prepare for it.1625

In December 2006, Goldman used the Hudson CDO to transfer the risk associated with

$1.2 billion of its ABX long holdings to Hudson investors. But even after this transfer, Goldman still had billions of dollars in long ABX holdings on its books.

Goldman’s Long Mortgage Holdings. In addition to its long ABX holdings, the

Mortgage Department’s $6 billion net long position in December 2006 was due to a large inventory of RMBS, CDO, and other mortgage related assets in Goldman’s investment and sale inventories and in its CDO warehouses. In 2006, the Mortgage Department conducted numerous RMBS and CDO securitizations that required it to acquire and repackage whole loans, RMBS and CDO securities, and other mortgage related assets. When assembling CDOs, Goldman often worked with third party partners. These strategic partners bought a portion of the equity and bore some of the risk of loss in the CDO. The partners were generally smaller financial firms, such as hedge funds or asset managers with expertise in CDOs or a particular asset class. For a fee, the partners also sometimes served as a CDO’s collateral manager, helping to select the assets.

1626

Peter Ostrem, who was head of the CDO Origination Desk from 2006 until May 2007, was

aware of substantial problems in the subprime mortgage market, but believed that the market distress was temporary and the market would stabilize. Mr. Ostrem wanted to continue to increase the CDO Desk’s business by producing as many marketable CDOs as possible. Darryl Herrick, who worked for Mr. Ostrem on the CDO Origination Desk expressed the view that hedge funds were shorting only the worst CDOs: “[CDO] shelves people are shorting are enhanced garbage.”

1628

1627

1629

The CDO Origination Desk was a primary contributor to the Mortgage Department’s net

long position, as Goldman often had to hold or “warehouse” subprime assets until they were

1625 See, e.g., 12/15/2006 email from David Viniar to Tom Montag, “Subprime Risk Meeting with Viniar/McMahon Summary,” GS MBS-E-009726498, Hearing Exhibit 4/27-3 (“there will be very good opportunities as the markets goes into what is likely to be even greater distress”); 2/8/2007 email from Daniel Sparks, “Post,” GS MBS-E- 002201668, Hearing Exhibit 4/27-7 (“Subprime environment going from bad to worse (think whack a mole).”); 1/9/2007 Goldman Presentation, “Mortgage Department Update,” GS MBS-E-002320968 (“Risks, Challenges and Structural Issues: –Very tough going in Resi Credit world – p&l [profit and loss] will be challenging; –Housing price and loan volume declines; –Investing in business in very difficult environment”); cf. 11/1/2006 Goldman Structured Products Strategist memorandum, “Q3 Mortgage Investor Survey,” GS MBS-E-006576068-76 (“Clients expect a downturn in housing in 2007, investors worried about high LTV [loan-to-value], low/no doc loans, pay option ARMs, origination volumes to be down 10% in 2007”). 1626

Subcommittee interview of Peter Ostrem (10/5/2010); Subcommittee interview of Darryl Herrick (10/13/2010). Subcommittee interview of Peter Ostrem (10/5/2010). See also, e.g., 8/10/2006 email from Peter Ostrem to

1627 Daniel Sparks, “Leh CDO Fund,” GS MBS-E-010898470 (urging Goldman to “do our own fund. SP CDO desk. Big time.”). 1628 1629

Subcommittee interview of Peter Ostrem (10/5/2010). 6/8/2006 email from Darryl Herrick to Peter Ostrem, “GS ABS RMBS CDS Lineup,” GS MBS-E-

403

1630

Each CDO was designed to include or reference hundreds of millions or

packaged into a CDO. billions of dollars in assets, which the CDO Origination Desk and its partners had to locate and acquire, a process called “ramping” that averaged six to nine months per CDO. its partners acquired these assets from other large Wall Street broker-dealers, often called “the Street,” or took them from their own inventory of assets.

Goldman and

1631

When assembling a CDO, Goldman generally opened an internal “warehouse account” for

1632

the CDO in which it stored the acquired assets until a target amount was achieved, and the CDO was brought to market. While the assets were in the warehouse account, they were included in Goldman’s warehouse balance sheet and contributed to its long or short positions. When the bulk of the target assets were acquired for a particular CDO, perhaps 75% to 95% of the total, in some cases Goldman priced the CDO securities and began selling them to clients who were told what the remaining assets would likely be. When a CDO transaction “closed” and its securities were issued, Goldman transferred the relevant assets from its warehouse account to the corporation or trust established for the CDO. The CDO entity then housed the long assets that had been on Goldman’s warehouse books, and Goldman was left with a corresponding short position which it could keep or sell to the CDO’s short parties.

For example, as of March 16, 2007, Goldman calculated that its CDO warehouses

In 2006 and early 2007, since it was often acquiring assets for several CDOs at once, the CDO Desk generally had a substantial net long position in subprime assets in its CDO warehouse accounts. contained $4.7 billion in mortgage related assets. After deducting potential liabilities assumed by Goldman’s partners and making other adjustments, Goldman calculated that it had $2.3 billion in net long warehouse risk. In early 2007, Goldman executives began to express concern about the risks posed by the subprime mortgage related assets in the CDO warehouse accounts.

1635

1633

1637

1634

1636

See, e.g. 3/7/2007 and 3/13/2007 internal emails, “Timberwolf I, Ltd. Preliminary Offering Circular,” GS MBS-

Subcommittee interview of Daniel Sparks (4/15/2010); Subcommittee interview of Peter Ostrem (10/5/2010). See 5/19/2007 Goldman presentation, “Mortgages CDO Origination – Retained Positions & Warehouse

Subcommittee interview of Daniel Sparks (4/15/2010); Subcommittee interview of David Lehman (4/12/2010). See, e.g., 3/16/2007 Goldman memorandum from Mitch Resnick and Peter Ostrem to GSI Risk Committee,

1630 1631 Collateral, May 2007,” GS MBS-E-010951926 (“average ramp period 6-9 months”). 1632 E-001800634 (Collateral manager Greywolf wrote: “We will not be fully ramped and I want to use the remaining bucket strategically. Is it OK if we have 5% ramp post-close?” Goldman responded: “We represented to BSAM [Bear Stearns Asset Management] that deal would be fully ramped upon closing. As long as they’re ok (or get veto rights), I don’t have any issue.”). 1633 1634 “GSI Warehousing for Structured Product CDOs,” GS MBS-E-001806010; 2/8/2007 email from Daniel Sparks to Messrs. Cohn, Montag, Viniar et al., “Post,” GS MBS-E-002201668, Hearing Exhibit 4/27-7 (“Loan business is long by nature and goal is to mitigate.”); Subcommittee interview of Peter Ostrem (10/15/2010). 1635 Warehousing for Structured Product CDOs,” GS MBS-E-001806010. 1636 1637 first thing in the morning,” GS MBS-E-001800707; 2/28/2007 email from David Rosenblum, “Hedges Status Report,” GS MBS-E-002640538 (new ABX hedges added and other hedges allocated to ensure that CDO warehouse risk was fully hedged); 2/22/2007 email from Peter Ostrem to David Rosenblum, “League Tables,” GS MBS-E- 001800683 (“FYI Liquidating 3 warehouses tomorrow.”); 2/22/2007 email from Daniel Sparks to Tom Montag, GS

Id. 2/28/2007 email from David Rosenblum to Peter Ostrem, “Pete– pls send me cob 2/28 MTM for SP CDO WH’s

3/16/2007 Goldman memorandum from Mitch Resnick and Peter Ostrem to GSI Risk Committee, “GSI

404

On December 7, 2006, Daniel Sparks, the Mortgage Department head, exchanged emails

with Goldman senior executive Thomas Montag about why Goldman was not doing more to reduce the firm’s risk associated with its net long positions. On the same day, Mr. Montag complained to CFO David Viniar about the Mortgage Department’s lack of aggressiveness in trying to reduce its net long ABX position:

1638

“[O]n ABX having numerous conversations–I don’t think we should panic out but we certainly didn’t do a good job of keeping pressure on … makes me mad because they should have kept doing it ugh.”1639

The next week, Mr. Viniar called a meeting with the Mortgage Department to discuss its holdings.

(b) Going Past Home: Goldman’s First Net Short

CFO David Viniar told the Subcommittee that, in early December 2006, he received reports

showing that the Mortgage Department had lost money on ten successive days.

1640

Viniar Meeting. On December 14, 2006, Mr. Viniar convened a meeting in the conference room next to his office on the 30th floor, in which he and other senior Goldman executives met for several hours with Mortgage Department managers, as well as representatives from Market Risk Management & Analysis and from the Controllers group. Goldman executives conducted an in-depth review of the Mortgage Department’s holdings. Mr. Viniar concluded the Mortgage Department’s position in subprime mortgage related assets was too long, and its risk exposure was too great.

At the meeting, Mr. Viniar and other

1642

1641

Mr. Viniar and others told the Subcommittee that Mr. Viniar’s basic message to the

Mortgage Department at the December meeting was not necessarily to go short, but instead to “get closer to home.” In trading parlance, “home” means a net neutral trading position – a position

1643

12/7/2006 email chain between Daniel Sparks and Tom Montag, “More thorough response,” GS MBS-E-

MBS-E-010989710 (“There are a few deals that look tough now, including a A-rated CDO of CDOs with Greywolf [Timberwolf]”). 1638

Mr. Montag also raised the possibility of hiring a trader from the Paulson hedge fund to help Goldman short the mortgage market. In addition, the email exchange indicates that Goldman had previously done $7 billion in transactions with the Paulson hedge fund, but had not done much with the hedge fund recently. Mr. Sparks wrote: “They had asked us to do another tranched protection trade for them, and seem fine with it being pushed to January.” Id. The tranched protection trade for Paulson that Mr. Sparks mentioned later became the Abacus 2007-AC1 CDO discussed in this Report. 1639 1640 1641 009726498, Hearing Exhibit 4/27-3. 1642 4/27-3. 1643 (4/12/2010).

12/7/2006 email chain between Tom Montag and David Viniar, GS MBS-E-009756572. Subcommittee interview of David Viniar (4/13/2010). 12/14/2006 email from Daniel Sparks, “Subprime risk meeting with Viniar/McMahon Summary,” GS MBS-E-

Id. See also 12/15/2006 email from David Viniar to Tom Montag, GS MBS-E-009726498, Hearing Exhibit

Subcommittee interview of David Viniar (4/13/2010), Daniel Sparks (4/15/2010), and David Lehman

405

that is neither significantly short nor long. Mr. Viniar told the Subcommittee that, by telling the Mortgage Department to “get closer to home,” he meant that it should assume a more neutral risk position. One way to “get closer to home” was for the Department to sell its long assets. Another way to achieve a more neutral risk position was for the Department to take new short positions to offset its existing long positions.1646

1644

1645

Internal documents indicate that the directions given to the Mortgage Department in the

December meeting were more detailed than the general instruction to “get closer to home.” In an email sent on the same day by Mr. Sparks to Goldman executives Messrs. Montag and Ruzika entitled, “Subprime risk meeting with Viniar/McMahon Summary,” Mr. Sparks wrote:

“Followups:

Reduce exposure, sell more ABX index outright, basis trade of index vs. CDS too large.
Distribute as much as possible on bonds created from new loan securitizations and clean previous positions.
Sell some more resid[ual]s
Mark [the value of assets in] the CDO warehouse more regularly …
Stay focused on the credit of the originators we buy loans from and lend to
Stay focused and aggressive on MLN [Mortgage Lending Network] (warehouse customer and originator we have EPDs [early payment defaults] to that is likely to fail)
Be ready for the good opportunities that are coming (keep powder dry and look around the market hard).”

1647

The next day, December 15, 2006, Mr. Montag forwarded Mr. Sparks’ email to Mr. Viniar

Mr. Viniar replied: “Yes.” Mr. Viniar noted:

asking: “is this a fair summary?”

1648

“On ABX, the position is reasonably sensible but is just too big. Might have to spend a little to size it appropriately. On everything else my basic message was let’s be aggressive distributing things because there will be very good opportunities as the markets [go] into

1644

Subcommittee interview of David Viniar (4/13/2010). 1645 Id. 1646 Id. In terms of risk reduction, taking on offsetting short positions to reduce long positions does not necessarily offer the same degree of certainty of risk protection as simply selling off the long assets. In many cases, the offsets may not perfectly match, leaving some degree of risk exposure known as “basis risk.” See, e.g., 2/12/2007 email from Mr. Sobel to Mr. Cohn, “Post today,” GS MBS-E-009763506 (“Risk that concerns me is basis between ABX and single names.”); 2/11/2007 email from Tom Montag, GS MBS-E-009688192 (discussing ABX offsets: “There is no est[imated] loss in the basis risk. Big wildcard. They [the traders] think they have correlation right and moves either way should be ok but obviously index assumptions have been wrong starting last may or june when positions were being put on and the gains seduced us to do more.”). 1647 12/14/2006 email from Daniel Sparks, “Subprime risk meeting with Viniar/McMahon Summary,” GS MBS-E- 009726498, Hearing Exhibit 4/27-3. “Residuals” refers to the equity positions that Goldman had retained from the RMBS and CDO securitizations it originated. 1648

12/14/2006 email from Tom Montag to David Viniar, GS MBS-E-009726498, Hearing Exhibit 4/27-3.

406

what is likely to be even greater distress and we want to be in a position to take advantage of them.”1649

In response to the Viniar meeting, the Mortgage Department took immediate action. It

began selling its long ABX positions outright when possible and entering into large single name CDS shorts to offset its remaining long assets. Goldman personnel developed a chart depicting the long positions the Mortgage Department had taken on BBB and BBB- rated ABX assets. This chart also showed how quickly the Mortgage Department moved after the Viniar meeting to offset those long positions by amassing single name RMBS and CDS short positions.

1650

[SEE CHART NEXT PAGE: Notionals (ABX convention), prepared by Goldman Sachs, reformatted by the Permanent Subcommittee on Investigations to be readable in black and white print, GS MBS-E- 010214410.]

1649 12/15/2006 email from David Viniar to Tom Montag, GS MBS-E-009726498, Hearing Exhibit 4/27-3. 1650 See 1/5/2007 “Notionals (ABX convention)” chart, taken from “Index and Single Name Position History 2006 as of 05Jan07.xls,” attachment to 1/8/2007 email from Joshua Birnbaum to Daniel Sparks, “ABX Subprime Risk by vintages,” GS MBS-E-010214409. The SPG Desk also periodically updated that chart. See, e.g., chart attachments to 2/6/2007 email from Kevin Kao to Joshua Birnbaum, “Index and Single Name Position History 2006 as of 05Feb07.xls,” GS MBS-E-012744553; chart attachments to 2/23/2007 email from Tom Barrett to Kevin Kao, Michael Swenson and Justin Gmelich, “Index and Single Name Position History 2006 As of 22Feb07.xls,” GS MBS-E-012411673; chart attachments to 3/2/2007 email from Kevin Kao to Joshua Birnbaum, “Index and Single Name Position History 2006 As of 01Mar07.xls,” GS MBS-E-012776557.

Notionals (ABX convention)

10,000,000,000

8,000,000,000

6,000,000,000

4,000,000,000

2,000,000,000

0 19-Jan 18-Feb 20-Mar 19-Apr 19-May 18-Jun 18-Jul 17-Aug 16-Sep 16-Oct 15-Nov 15-Dec 14-Jan 13-Feb

-2,000,000,000

-4,000,000,000

Prepared by the U.S. Senate Permanent Subcommittee on Investigations, February 2011. Derived from Goldman Sachs document, GS MBS-E-010214410.

BBB Index Only BBB Index + CDS BBB- Index Only BBB- Index + CDS All BBBs Index Only All BBBs Index + CDS

BBB bucket includes BBB+ CDS Notionals: refers to current notionals Positive notionals: long risk

408

Within about a month, in January 2007, the Mortgage Department had largely eliminated or offset its long subprime mortgage assets, but it didn’t stop there. In January and February, the Mortgage Department began building a multi-billion-dollar short position as part of a plan by the SPG Trading Desk to profit from the subprime RMBS and CDO securities starting to lose value. The plan was discussed with Mr. Sparks and Mr. Ruzika before it was set in motion. By the end of February 2007, the Department had swung from a $6 billion net long position to a $10 billion net short position, a $16 billion reversal in the span of two months.

Selling Assets Outright. On December 14, 2006, the same day as the Viniar meeting,

Kevin Gasvoda, head of the Residential Whole Loan Trading group, instructed his staff to begin selling the RMBS securities in Goldman’s inventory, focusing on RMBS securities issued from Goldman-originated securitizations. He urged them to “move stuff out” even at a loss:

“[P]ls refocus on retained new issue bond positions and move them out. … [W]e don’t want to be hamstrung based on old inventory. Refocus efforts and move stuff out even if you have to take a small loss.”1651

In February 2007, to further encourage sales, Mr. Gasvoda issued a sales directive or “axe” to the Goldman sales force to sell the remaining RMBS securities from Goldman-originated RMBS securitizations. On February 9, 2007, the sales force reported a substantial number of sales, and Mr. Gasvoda replied: “Great job syndicate and sales, appreciate the focus.”

1652

In February 2007, Goldman CEO Lloyd Blankfein personally reviewed the Mortgage Department’s efforts to reduce its subprime RMBS whole loan, securities, and residual equity positions, asking Mr. Montag: “[W]hat is the short summary of our risk and the further writedowns that are likely[?]”

After a short report from Mr. Montag, Mr. Blankfein replied:

1653

“[Y]ou refer to losses stemming from residual positions in old deals. Could/should we have cleaned up these books before and are we doing enough right now to sell off cats and dogs in other books throughout the division?”1654

12/14/2007 email from Mr. Gasvoda, “Retained bonds,” GS MBS-E-010935323, Hearing Exhibit 4/27-72.
2/9/2007 email exchange between Kevin Gasvoda and sales syndicate, “GS Syndicate RMBS Axes

2/11/2007 email exchange between Lloyd Blankfein and Tom Montag, “Mortgage Risk – Credit residential,” GS

1651 1652 (INTERNAL),” GS MBS-E-010370495, Hearing Exhibit 4/27-73. 1653 MBS-E-009686838, Hearing Exhibit 4/27-130. 1654

Id.

409

At the end of February, Goldman’s controllers prepared a summary of the changes in

Goldman’s RMBS and whole loan inventory since December 2006, and reported:

“Residential Credit Loans: The overall loans inventory decreased from $11bn to $7bn. … subprime loans decreased from $6.3bn to $1.5bn, Second Liens decreased from $1.5bn to $0.7bn and S&D [scratch and dent] Loans remained unchanged at $0.8bn.”1655

This analysis indicates that, in less than three months, Goldman had reduced its subprime loan inventory by over two-thirds, and its second lien inventory by half.

The Mortgage Department reduced its inventory, not only by selling assets outright, but

also by reducing its purchase of whole loans and securitization efforts. In March 2007, Goldman informed its Board of Directors and the SEC that it had stopped purchasing subprime loans and RMBS securities through, in its words, the use of “conservative bids.” presentations did not explain the phrase “conservative bids,” an email to Goldman’s Chief Credit Officer, Craig Broderick, discussing a March 2007 presentation to Goldman’s Audit Committee about the subprime mortgage business, was much more explicit: “Just fyi not for the memo, my understanding is that the desk is no longer buying subprime. (We are low balling on bids).”

1657 Still another method to reduce its loan inventory was an ongoing effort by the Mortgage Department to return defaulted or fraudulent loans to the lenders from which it had purchased them.

While those

1656

On April 23, 2007, Mr. Gasvoda reported to Messrs. Montag and Sparks a dramatic

reduction in Goldman’s inventory of subprime loans and RMBS securities:

“[W]e have $180mm in loans (unsecuritized) and $255mm of residuals off old deals. The $180mm of loans is the smallest we’ve been since we started the business in 2002. We had been running at an average loan position balance in subprime of around $4B . … The $255mm we have retained is from deals dating back to 2002 and while we’ve developed some buying partners, it is not a deep market. These have been intentional principal retained positions.”1658

3/26/2007 Goldman presentation to Board of Directors, “Subprime Mortgage Business,” GS MBS-E-

2/23/2007 “Significant Cash Inventory Change (Q1’07 vs. Q4’06),” prepared by Goldman, GS MBS-E-

1655 010037310, Hearing Exhibit 4/27-12. “Scratch and dent” loans are loans that are not performing. 1656 005565527, Hearing Exhibit 4/27-22 ; 3/14/2007 Goldman Presentation to SEC, “Subprime Mortgage Business 14- Mar-2007,” at 7, GS MBS-E-010022328. 1657 21_Draft_Mortgage_Page.ppt,” GS MBS-E-009986805, Hearing Exhibit 4/27-63. In the context of assets offered by a customer to the Correlation Desk, it appears that Mr. Egol also may have returned an unappealing bid: “Many of these assets are garbage. I told her should would not like the level [the price bid by Goldman] ….” 2/26/2007 email from Jon Egol, “Portfolio for Proposed Transaction 070226 (2).xls,” GS MBS-E-002631719.
1658

3/2/2007 email from Patrick Welch to Craig Broderick, “Audit Committee Package_Feb

4/22/2007 email from Kevin Gasvoda, “Resi credit QTD/YTD P&L and positions,” GS MBS-E-010474983.

410

The subprime loan balance of $180 million was just over one-tenth of the $1.5 billion total Goldman had held at the end of February 2007, reflecting a reduction in its subprime inventory over a two-month span by nearly 90%. Overall, the $180 million loan balance was down from an average subprime loan position balance of $4 billion, which was a 95% reduction in overall subprime loan inventory levels.

Building the First Short Position. At the same time the Residential Whole Loan Trading Desk was selling loans and RMBS securities, the Structured Product Group (SPG) Trading Desk was working to sell its inventory of long CDS contracts linked to the ABX indices. At first, in December and January, because so many market participants were going short, the SPG’s ABX Trading Desk found its long ABX positions difficult to sell. The ABS Desk then decided to offset the long ABX assets in part by purchasing the short side of single name CDS contracts on certain RMBS and CDO securities. Within about six weeks, by February 2007, the ABS Desk had acquired a huge net short position in single name CDS contracts referencing RMBS and CDO securities that totaled more than $5 billion. By then, the ABX market had stabilized somewhat, and the ABS Desk was able to sell outright more of its long ABX positions. Rather than slow down once its $6 billion long position was offset, however, the ABS Desk used CDS contracts to short RMBS and CDO securities “at every opportunity,” in the words of one trader, going increasingly net short.

1660

1659

1661

1662

The Mortgage Department also worked to sell assets from its CDO warehouse accounts, an issue discussed in

Subcommittee interview of Michael Swenson (4/16/2010). Id. By adopting the strategy of offsetting the long positions with similar, but not necessarily identical short

1659 part below and in part in connection with the Report’s section on Goldman’s CDO activity. 1660 1661 positions, the SPG Desk was incurring a very large amount of basis risk – the risk of a mismatch between the offsetting assets. Mr. Sparks and other senior Goldman executives wanted to reduce that basis risk by paring the positions down on both sides – selling the long assets and covering the short assets. The SPG Desk was not, however, making the progress Mr. Sparks wanted to see in reducing the basis risk. On January 23, 2007, Mr. Sparks wrote to Messrs. Swenson, Birnbaum, and Lehman:

“It does not look like you made any progress on the things we discussed – I want a plan and daily reports on progress. Not to be difficult, but if you 3 are too busy I can add someone who can focus on the issue. My other concern is I want to stay nimble, and not get too wedded to one way positions – getting massively short could be more painful than what we have experienced.”

1/23/2007 email from Daniel Sparks, GS MBS-E-010267341. A week later, Mr. Swenson requested a meeting with Mr. Sparks and Mr. Ruzika to discuss the difficulties the traders were encountering in reducing the basis risk. He wrote: “I want to go over the facts of what we are up against.” 1/30/2007 email from Michael Swenson to David Lehman, GS MBS-E-011375519. Mr. Swenson and Mr. Birnbaum met with Mr. Ruzika and Mr. Sparks around February 1, 2007. The group apparently discussed the SPG Desk’s net short position and the difficulties of reducing the basis risk. On February 5, 2007, Mr. Ruzika wrote to Mr. Cohn about how the short position was “allowed to get too big” and stated: “I don’t want to be short – I want to neutralize the risk and shed our basis risk.” 2/5/2007 email from Richard Ruzika to Gary Cohn, “Are you living Morgatages [sic]?,” GS MBS-E- 016165784. About a week later, when the large net short positions began producing large profits, Mr. Ruzika apparently changed his mind and became supportive of the large net short, though he still wanted to reduce basis risk “whenever possible.” 2/13/2007 email from Richard Ruzika to Gary Cohn, “Catch up,” GS MBS-E-019794071. 1662

Salem 2007 Self-Review, GS-PSI-03157 at 71-72.

411

On February 12, 2007, Mr. Sparks reported to senior management on the Mortgage Department’s progress and the substantial profits that its new net short position was already showing:

“(1) +20mm [million] P&L [profit and loss] today. Secondary trading desk is net short risk in the form of single names and structured index vs index longs (some index shorts also). Large move down again today ….

(2) Possible significant upside in book. The desk has been moving [marking down] single names about 1/3 of what they feel the correct correlation [to ABX Index] is (around 70%) …. As the market has moved so much one way, there is the potential for the book to currently have significant upside embedded in it.1663

(3) Loan & resid[ual] books flat [i.e., already hedged].”

1664

The reference to 70% in the email involves correlation assumptions. Correlation trading depends upon

1663 assumptions about the relative values between one asset (such as a CDS contract referencing the ABX Index) and another (such as a CDS contract referencing a single RMBS security). A correlation value of 100% means that the values of both assets move together in the same amounts. With 100% correlation, a 10% decline in the value of one asset implies a 10% decline in the value of the other. The correlation ratios between different assets are a matter of the trading desk’s informed judgment. As one Goldman mortgage trader noted: “We should discuss base correlations live . . . there is no market standard for calculating them.” 3/26/2007 email from SPG Trading to Goldman London, “ABX – TABX : Request from [customer],” GS MBS-E-021893369. Once a correlation ratio was set, however, the general practice at Goldman was to change correlation ratios only upon a showing of observable market trade prices supporting the change. Traders, thus, engaged in frequent discussions of “observability.” A change in correlation ratios could result in an immediate markdown or markup of particular positions, which could effect Goldman’s profit and loss calculations, collateral calls, and the value of individual customer positions.

In his February 12 email, Mr. Sparks wrote that the SPG Desk had been marking down the value of single

name long CDS contracts by only one-third of the amount that would apply if the desk’s true calculation of the correlation between single name and ABX CDS contracts was correct – that the two products were more closely correlated than the market recognized. Mr. Swenson told the Subcommittee that, in late 2006 and early 2007, single name long CDS contracts were trading at higher prices than similar ABX CDS contracts, and the observable market prices of single name CDS contracts were not falling as quickly as market professionals thought they should. Subcommittee interview of Michael Swenson (4/16/2010). Nonetheless, in a steeply declining market, Goldman’s Mortgage Department assumed that the single name long CDS contracts would eventually fall to the same low values as the long ABX contracts. If that happened, since the SPG Desk was net short single name CDS contracts, the anticipated drop in value would result in an equivalent amount of profit for the desk’s short position – hence, Mr. Sparks’ reference to the “upside embedded in” the book.

On February 14, 2007, the Mortgage Department actually captured that upside by changing its correlation assumptions to recognize a higher correlation between single name CDS and ABX CDS contracts. Using the new assumptions, Goldman then marked down the value of its customers’ single name CDS contracts to levels closer to the ABX Index assets. As the short party to those same CDS contracts, Goldman also realized a profit of $100 million in a single day. See 2/14/2007 email from Arbind Jha to Michael Swenson, “Mortgages Estimate REVISED,” GS MBS-E-012474685.
1664

2/12/2007 email from Daniel Sparks, “Post today,” GS MBS-E-009763506.

On February 14, 2007, Mr. Sparks again reported to senior management on the

Department’s progress, describing how it was neutralizing its net long position:

412

“[O]ur risk reduction program consisted of: (1) selling index outright (2) buying single name protection and (3) buying protection on super-senior portions of the BBB/BBB- index. … That is good for us position-wise, bad for accounts who wrote that protection … but could hurt our CDO pipeline position as CDOs will be harder to do.”

1665

“Overall,” Mr. Sparks wrote, “as a business we are selling our longs and covering our shorts.”1666

With respect to market conditions, Mr. Sparks reported:

“Subprime environment – bad and getting worse. Everyday is a major fight for some aspect of the business (think whack-a-mole). Trading position has basically squared … plan to play from short side. Loan business is long by nature and goal is to mitigate. Credit issues are worsening on deals and pain is broad (including investors in certain GS-issued deals). Distressed opportunities will be real, but we aren’t close to that time yet.”1667

In order to “play from the short side,” the Mortgage Department continued building a net Mr. Birnbaum, Goldman’s ABX trader, later He wrote that he

short position, employing aggressive strategies. wrote: “I concluded that we should not only get flat, but get VERY short.” then “socialized,” or discussed, his proposal with others in the Mortgage Department, and “we all agreed the plan made sense.”

The ABS Desk began implementing the plan by taking a very

1668

1670

1669

2/8/2007 email from Daniel Sparks, “Post,” GS MBS-E-002201668, Hearing Exhibit 4/27-7. Id.; see also 3/10/2007 email from Mr. Dinias to Daniel Sparks, “Mortgage Presentation to the board,” GS

2/14/2007 email from Daniel Sparks, “Post,” GS MBS-E-009635410, Hearing Exhibit 4/27-8. 3/21/2007 email from Daniel Sparks to Tom Montag, GS MBS-E-010629379, Hearing Exhibit 4/27-21. See

1665 1666 also 2/19/2007 email from Mr. Sparks to Mr. Montag, “2 things,” GS MBS-E-010378492 (“Please send a short note to Josh Birnbaum, Mike Swenson and David Lehman telling them great week – short singles and short CDOs.”); 2/28/2007 email from Michael Sherwood to Messrs. Sparks, Swenson, Birnbaum and Lehman, “ABX/Single name notional/risk history,” GS MBS-E-010389296 (Mr. Sherwood, a London managing director and member of the Firmwide Risk Committee, wrote: “Many congrats on last few weeks trading … keep it up!”). 1667 1668 MBS-E-013323395, Hearing Exhibit 4/27-17; 3/11/2007 email from Daniel Sparks, “Risk Changes Over Quarter,” GS MBS-E-010400546, Hearing Exhibit 4/27-18; cf. 3/27/2007 Presentation to GS Board of Directors, “Subprime Mortgage Business,” GS MBS-E-005565527, Hearing Exhibit 4/27-22. 1669 Mr. Birnbaum provided a detailed explanation of his reasons for recommending that the SPG Desk go “VERY short”: “(1) Given how much ABX we had purchased through the broker market in 2006, the world would think GS was very long for the foreseeable future. We could use that fear to our advantage if we could flip our risk, (2) After unsuccessfully trying to sell our long to some of [a Goldman salesperson’s] accounts, I realized traditional distressed buyers were no more likely to buy ABX at 85, 75, 65, etc. than at 95. The cash flow was just too binary, so there would be little support if negative momentum began, (3) The fundamentals for mortgage credit were undeniably deteriorating, (4) CDO managers were in denial … [their positive market] sentiments would allow us to amass large amounts of cheap single name protection if we desired, and (5) If the market truly tanked, the already large CDO warehouses would have to liquidate, further exacerbating the move and ultimately allowing us to cover.” Id. 1670

9/26/2007 2007 EMD Reviews, Joshua Birnbaum Self-Review, Hearing Exhibit 4/27-55c. In his self-review,

Id.

413

large short position in single name CDS contracts referencing RMBS and CDO securities to offset the Department’s remaining ABX long position:

“After socializing the plan with [Daniel] Sparks and ultimately [Richard] Ruzika, we implemented the plan by hitting on almost [every] single name CDO protection buying opportunity in a 2-month period. Much of the plan began working by February when the market dropped 25 points and our profitable year was underway.”1671

By clearing the plan with Mr. Sparks and Mr. Ruzika first, SPG Trading Desk informed

senior management of its intent to use the firm’s capital to build the net short position. Mr. Birnbaum also wrote:

“When we were socializing our plan to get short in the beginning of the year, I put together a tool . . . quantifying our position risk and the p&l [profit and loss] under various market level scenarios. I believe this was key for senior management to gain confidence that we were taking controlled and quantifiable risk that was well understood.”

1672

The Mortgage Department’s lead trader in single name CDS contracts referencing RMBS securities, Deeb Salem, also described the plan in his 2007 performance self-evaluation:

“Mike [Swenson], Josh [Birnbaum] and I were able to learn from our bad long position at the end of 2006 and layout the game plan to put on an enormous directional short. The results of that are obvious.”1673

In an interview, Mr. Salem told the Subcommittee that the “obvious” results he was referring to were the desk’s resulting profits.

1674

The ABS Desk within the Structured Product Group (SPG) used CDS contracts to short RMBS and CDO securities as well as the ABX Index. The Correlation Desk within SPG used a different technique, obtaining approval to use a Goldman-designed CDO platform, Abacus, “to short structured product CDOs in bulk. The ABACUS transactions are currently one of the unique formats available to . . . [short] in large size on this type of structured product risk.”1675

From January to late February, the Mortgage Department continued to pile on short

By the end of the first quarter in 2007, it had built a

positions in the subprime mortgage market.

1676

Id. Id. Salem 2007 Self-Review at GS-PSI-03157 at 71-72. Subcommittee interview of Deeb Salem (10/6/2010). 3/12/2007 Mortgage Capital Committee memo, “ABACUS Transaction to be Lightly-Managed by Lion

1671 1672 1673 1674 1675 Capital,” at 2, GS MBS-E-002665382, Hearing Exhibit 4/27-150. 1676 013323395, Hearing Exhibit 4/27-17; 3/11/2007 email from Daniel Sparks, “Risk Changes Over Quarter,” GS MBS- E-010400546, Hearing Exhibit 4/27-18; 3/27/2007 presentation to GS Board of Directors, “Subprime Mortgage

See 3/10/2007 email from Mr. Dinias to Daniel Sparks, “Mortgage Presentation to the board,” GS MBS-E-

414

$10 billion net short position. In a later performance self-evaluation, Mr. Salem described the aggregate $10 billion net short position as “HUGE” and “enormous.” executive, Thomas Montag, later referred to a net short position of $3 billion in subprime mortgage backed securities as “huge and outsized.” more than three times that size.

Goldman’s net short position in February 2007 was

A Goldman senior

1678

1677

Profiting from the First Net Short. In February 2007, Goldman’s senior management decided that the $10 billion net short position had become too risky, and ordered the Mortgage Department to cover a portion of the short. Covering some of the short not only reduced the risk, but also locked in some of the profit associated with the position.

In late February 2007, the Mortgage Department’s net short position, coupled with added

volatility in the subprime mortgage market, caused a sharp increase in the Department’s risk profile, as measured by Value at Risk or “VAR.” Goldman had assigned a VAR limit of $35 million to the Mortgage Department. $13 million, well below its limit. 1680 million – an increase of over 550%.

1679 By late February 2007, however, its VAR had reached $85 1681

In November 2006, the Department’s reported VAR was

Goldman senior management closely monitored the Department’s increasing VAR. On

February 23, 2007, Goldman risk controllers told senior executives that the Mortgage Department’s increasing VAR was “primarily driven by a combination of increased volatility in ABX market and the [SPG] desk increasing their net short risk in RMBS subprime sector.” February 14, 2007, Justin Gmelich, a managing director asked to help Mr. Sparks with the Mortgage Department on a short term basis, sent an email to Mr. Montag expressing unease with the Department’s increasing risk profile:

1682

“Abx risk should be working to get closer to home. My opinion, singles v. short index is too big (no news here). Abx correlation trade is good. I think we should be covering a bit of our short. There is a lot to do.”1683

Salem 2007 Self-Evaluation [emphasis in original]. 8/23/2007 email from Tom Montag, “Current Outstanding Notional SN ames,” GS MBS-E-010621231. 2/8/2007 email from Bill McMahon, “VaR limit for Mtg SPG,” GS MBS-E-009980807. 2/23/2007 Goldman internal document, “Mortgage VaR Change (Q1’07 vs. Q4’06),” GS MBS-E-010037310,

Business,” at 8, GS MBS-E-005565527, Hearing Exhibit 4/27-22 [footnote omitted]. 1677 1678 1679 1680 Hearing Exhibit 4/27-12; 3/8/2007 email from Jha Arbind, “Risk changes over the quarter,” GS MBS-E-010400546, Hearing Exhibit 4/27-18. 1681 1682 Hearing Exhibit 4/27-12. 1683

Id. 2/23/2007 Goldman internal document, “Mortgage VaR Change (Q1’07 vs. Q4’06),” GS MBS-E-010037310,

2/14/2007 email from Mr. Gmelich to Tom Montag, GS MBS-E-016165580.

415

Mr. Montag forwarded Mr. Gmelich’s email to Goldman’s Co-Presidents, Gary Cohn and Jon Winkelried, as well as to Mr. Ruzika, commenting: “clearly need to opportunistically take position down.”1684

On February 21, 2007, senior management told Mr. Sparks to reduce the size of the Mr. Sparks

Mortgage Department’s $10 billion net short position by covering $3 billion. communicated the decision to personnel on the SPG Desk:

1685

“We need to buy back $1 billion single names and $2 billion of the stuff below [CDO securities] – today. I know that sounds huge, but you can do it – spend bid/offer, pay through the market, whatever to get it done.

It is a great time to do it – bad news on HPA [housing price appreciation], originators pulling out, recent upticks in unemployment, originator pain. . . .

This is a time to just do it, show respect for risk, and show the ability to listen and execute firm directives.

You called the trade right, now monetize a lot of it.

You guys are doing very well.”

1686

Although some SPG traders disagreed with the decision,

1687

immediate action in response to the order. By the end of the day, February 21, 2007, Mr. Sparks reported to senior management that the ABS Desk had covered $400 million in single name CDS contracts, but had not been able to reach the $3 billion goal:

the Mortgage Department took

“Market sold off significantly (BBB and BBB- indices over 100 bps wider) We covered over $400mm single names – still significant work to do. …

“We are net short, but mostly in single name CDS and some tranched index vs the some [sic] index longs. We are working to cover more, but liquidity makes it tough. Volatility is causing our VAR numbers to grow dramatically.”1688

Id. Subcommittee interview of Joshua Birnbaum (4/22/2010) (Mr. Birnbaum wanted to continue to hold the short

Id. 2/22/2007 email from Daniel Sparks to Messrs. Birnbaum, Swenson and Lehman, “Block size tranche protection

1684 1685 offers for Paulson or others,” GS MBS-E-010381411.
1686 1687 position, rather than cover it, since he thought it would earn additional profit); see also 2007 Birnbaum Self-Review, Hearing Exhibit 4/27-55c (Mr. Birnbaum wrote that he should have argued more forcefully against covering the shorts in February 2007). 1688

In response, Mr. Viniar wrote to Mr. Sparks: “Good start. Keep covering.” 2/21/2007 email from David Viniar to Daniel Sparks, “Mortgages today,” GS MBS-E-009757841. In another email, Mr. Montag wrote: “How hard are

2/21/2007 email chain from Daniel Sparks, “Mortgages today,” GS MBS-E-010381094, Hearing Exhibit 4/27-

416

Mr. Ruzika sent an email to Mr. Montag and Mr. Sparks commenting on the covering efforts:

“I think Dan’s guys are being practical. I know Bill [McMahon] was upset but covering the single name bbb and bbb- is prudent as it cuts vol and var the most. … Guys didn’t give up bid ask but they also didn’t stand on the bid.”1689

The Mortgage Department found that its single name CDS contracts were difficult to cover,

in part because many of the referenced RMBS and CDO securities had already been acquired by securitizers for inclusion in CDOs and so were not for sale. could not cover its single name short positions simply by buying the offsetting long asset – the RMBS and CDO securities were no longer available for purchase. Instead, the SPG Desk had to use offsetting CDS contracts, ones which referenced the same RMBS or CDO securities, but in which Goldman took the long side. The problem with those contracts, however, was that many market participants had already acquired short positions on RMBS and CDO securities and weren’t in the market to buy more. In addition, their purchases had driven up the price of short contracts. Between market saturation and high price levels, Goldman found few buyers when it wanted to cover its shorts. Messrs. Montag and Ruzika, who continued to press for quick progress.

That meant the SPG Trading Desk

1693

The Mortgage Department’s inability to cover its single name shorts concerned

1690

1691

1692

On February 25, 2007, Mr. Sparks reported to Messrs. Montag and Ruzika on the Mortgage

Department’s progress after a week of effort:

“Cover[ed] around [$]1.55 billion single name subprime BBB- CDS and about $700mm single name subprime BBB CDS. The desk also net sold over $400mm BBB- ABX index. Desk is net short, but less than before. Shorts are in senior tranches of indexes sold and in single names. Plan is to continue to trade from short side, cover more single names and sell BBB- index outright.”1694

On February 27, 2007, Mr. Ruzika sent an email to Messrs. Montag, Gmelich, and Sparks indicating that the Mortgage Department needed to reduce its net short position by covering even more than $3 billion in shorts: “There are two issues – first is the size of the short – I want to see

we pushing covering some of singlename. Let’s not be bidoffer foolish. The downside isn’t worth the upside imo.” 2/21/2007 email from Tom Montag to Daniel Sparks, GS MBS-E-017237596. Mr. Sparks replied: “Pushing hard, but need to be realistic with respect to expectation on liquidity. Very hard to force it. Trade has been right, and should continue to run (though there will be bumps). Entire team knows we have to reduce and is focused on it.” Id. Mr. Montag responded: “If you sold it in a bad market u ough[t] to be able to buy it.” Id. 1689 2/22/2007 email from Richard Ruzika to Tom Montag and Daniel Sparks, GS MBS-E-010381967. 1690 Subcommittee interview of Michael Swenson (4/16/2010). 1691 Id. 1692 Id. 1693 A similar situation existed at the time in the market for commercial mortgage backed securities (CMBS). In a February email to Mr. Lehman, a CMBS trader remarked: “It’s amazing that everyone was lifting [accepting bids on] cmbs 1 and 2 [CMBX indices], but NOBODY will bid single names.” 2/23/2007 email from [CMBS trader] to David Lehman, “CT CDO w/ [Bank],” GS MBS-E-011270138-39 [emphasis in original]. 1694

2/25/2007 email from Daniel Sparks to Tom Montag, “Questions you had asked,” GS MBS-E-010987763.

417

1695

us getting the short down to 4.5 bil[lion] net. … Second – the basis in the book needs to be reduced as well.” Less than an hour later, Mr. Ruzika sent Mr. Sparks another email at the conclusion of a meeting of Goldman’s Operating Committee (OpCom), comprised of Goldman’s senior executives. In an email entitled, “OpCom Directive,” Mr. Ruzika wrote:

“Dan. Directly from the opcom we have to pick up the pace of buying back single names even if it costs us some money. I know your guys are trying but we can pay away some if it helps to get size done.”1696

In response, Mr. Sparks immediately sent an email to Messrs. Swenson, Lehman, and Birnbaum regarding the “Opcom directive.” He wrote: “Buyback single names in size today.” He also sent the SPG and CDO Desk managers a set of “Goals”:

1697

“Reduce risk. That means: (1)

get m[o]re super-seniors done on CDOs or take other steps to reduce CDO pipeline risk; cover more single name shorts BBB- and BBB reduce the basis trade between BBB- index and BBB- single names reduce the index/index trades in A and AAA.”1698

(2) (3) (4)

Mr. Sparks’ list of goals showed that he was closely tracking the SPG Desk’s activities and directed them to reduce rather than eliminate its basis and index trades.

At the end of February, the Mortgage Department’s efforts got a substantial boost when a

new hedge fund client, Harbinger, purchased the short side of $4 billion in single name CDS contracts referencing RMBS securities. Department was able to cover its shorts by the same amount.

By taking the long side in those contracts, the Mortgage

1699

2/27/2007 email from Richard Ruzika to Tom Montag, Justin Gmelich, and Daniel Sparks, GS MBS-E-

1695 002204942. 1696 Id. 1697 2/27/2007 email from Daniel Sparks, “Opcom Directive,” GS MBS-E-017250218. 1698 2/27/2007 email from Daniel Sparks, “Goals,” GS MBS-E-010387086, Hearing Exhibit 4/27-11. 1699 See, e.g., 2/22/2007 Goldman internal emails, GS MBS-E-018938493, GS MBS-E-018940734; 2/27/2007 email from Michael Swenson to Bill McMahon, GS MBS-E-012502371 (“Bought 1.5bb of sn baa3 risk from harbinger.”); 3/1/2007 email from Daniel Sparks, “SN Protection Offers for Harbinger (50 names),” GS MBS-E-019460848 (“Trade was executed at +725 ”); 3/3/2007 email to Michael Swenson and Daniel Sparks, “Harbinger Update,” GS MBS-E-010707216. As a result, Harbinger became Goldman’s largest hedge fund counterparty credit risk: “Harbinger is our #1 hedge fund exposure globally. We had to explain this to the SEC this month.” 4/20/2007 Goldman internal email, “Harbinger didn’t add the last piece we had spoke of, but are now thinking of adding ~50mm,” GS MBS-E-012523933. Harbinger was also instrumental in Goldman’s second round of short covering efforts in August 2007. See, e.g., 7/30/2007 email to Michael Swenson, “Harbinger Single-A Offerings.xls,” GS MBS-E-012374026; 8/23/2007 email from Michael Swenson, “Harbinger Post,” GS MBS-E-009739009.

418

On February 28, 2007, Mr. Sparks reported at a Firmwide Risk Committee meeting on the The committee minutes reflect that Mr.

1700

Mortgage Department’s progress in reducing its VAR. Sparks’ report stated the following:

“–VaR up due to vols. Business working to reduce exposures; a lot of shorts already covered. –ABX widened 500bp on the week. Business covered $4BN in single names. –Noted a lot of negative news in the subprime market with rumors on everyone. –CDS on CDOs started to widen significantly over the week. … –Business continuing to clear out loans.”1701

Five days later, on March 5, 2007, Mr. Montag requested another update: “Do we think the

business is net short, long or flat right now?” Mr. Sparks responded: “We think the overall business is net short.” Mr. Gmelich added: “I think we have a very modest short across all the businesses at current market levels. I concur with Dan.”1702

The Mortgage Department’s efforts to cover its $10 billion net short position reduced its

VAR; it also allowed the Department to lock in and record large profits from its net shorts. In March 2007, in connection with Goldman’s quarterly earnings call with analysts, “Mortgage Talking Points” prepared for Mr. Viniar stated that the Department’s revenues were primarily the result of its short positions:

“The Mortgage business’ revenues were primarily driven by synthetic short positions concentrated in BBB/BBB- sub prime exposure and single A CDO exposure which benefitted from spread widening.”1703

At the end of the first quarter of 2007, the Mortgage Department reported total net revenues of $368 million.1704

The Mortgage Department continued its efforts to cover the rest of its short position. On March 14, 2007, Mr. Sparks reported to Messrs. Cohn and Montag that a Goldman salesperson

2/28/2006 Goldman internal memorandum, “Firmwide Risk Committee: February 28th FWR Minutes, ”GS

Id. See also 2007 Swenson Self-Review (“we prudently covered $5bb of single-name shorts at the all time lows

1700 MBS-E-009687468, Hearing Exhibit 4/27-13 [sic - correct year is 2007]. 1701 at the time back in February”), Hearing Exhibit 4/27-55b. 1702 3/5/2007 email from Tom Montag, GS MBS-E-010393092. Goldman COO Gary Cohn expressed concern that a positive move in the markets would cause the Mortgage Department to incur large losses due to its net short: “A big plus would hurt the Mortgage business but Justin [Gmelich] thinks he has a big trade lined up for the morning to get us out of a bunch of our short risk.” 3/5/2007 email from Gary Cohn, GS MBS-E-009656525, Hearing Exhibit 4/27-

The big trade referred to by Mr. Cohn was one of the Harbinger trades that enabled Goldman to cover $4 billion of its single name CDS short positions. 1703 Exhibit 4/27-16. 1704 Hearing Exhibit 4/27-41.

3/9/2007 email to David Viniar, “Mortgage Talking Points for Earnings Call,” GS MBS-E-009762678, Hearing

9/17/2007 Presentation to GS Board of Directors, Residential Mortgage Business at 5, GS MBS-E-001793840,

419

“did a fantastic job for the desk by bringing in $1.2BB [billion] in A-rated single names today.” Mr. Montag in turn reported to Goldman CEO Lloyd Blankfein: “Covered another 1.2 billion in shorts in mortgages–almost flat–now need to reduce risk.”1706

1705

That same day, March 14, 2007, in response to his request, the Mortgage Department sent It disclosed that, despite Mr. Ruzika a detailed breakdown of its subprime mortgage holdings. offsetting short and long positions in a number of areas, the SPG Desk still held three sizeable net short positions involving about $2.6 billion in ABX assets, $2.2 billion in single name CDS contracts, and $2 billion in mezzanine CDOs.1708

1707

Goldman personnel prepared the following chart tracking the SPG Trading Desk’s efforts

to cover its BBB and BBB- net short position from February through mid-May 2007.

1709

[SEE CHART NEXT PAGE: Notionals (ABX convention), prepared by Goldman Sachs, reformatted by the Permanent Subcommittee on Investigations to be readable in black and white print, GS MBS-E- 012890600.]

AAA Disaster Insurance. Despite all the attention paid to the Mortgage Department’s

subprime mortgage holdings beginning in December 2006, one large short position seemed to have escaped the directives of senior management in the first quarter of 2007 to cover the Department’s shorts. It consisted of a massive $9 billion net short position made up of CDS contracts referencing an ABX index that tracked a basket of 20 AAA rated subprime RMBS securities.

1710 Goldman representatives could not recall when that short position was acquired, who acquired it, or whether proprietary funds were used, relatively constant level of $9 billion from some time in 2006 until July 2007. Mr. Sparks told the Subcommittee that the net short position served as a form of low cost “disaster insurance” that would pay off only in a “worst case” scenario – when even the top tier AAA rated RMBS securities, among the safest of all subprime mortgage investments, lost value.

but the CDS contracts appear to have been held at a

1711

1713

1712

3/14/2007 email from David Lehman, “ABS Trading - Subprime risk,” GS MBS-E-010397102. Id. See “Notionals (ABX convention),” chart attached to 5/23/2007 email from Kevin Kao to Joshua Birnbaum,

1705 3/17/2007 email from Daniel Sparks and Tom Montag, “Cactus Delivers,” GS MBS-E-009632839. 1706 Id. Mr. Montag’s comment suggests that he may have wanted the Mortgage Department to reduce the size of both its longs and shorts to reduce its overall risk, or to reduce its basis risk, the risk that arises when two different types of assets are used to offset one another, and the assets are imperfectly matched.
1707 1708 1709 “RMBS Subprime risk history as of 18May07,” GS MBS-E-012890599. 1710 (noting Mortgage Department’s $9 billion short position on the AAA ABX index). 1711 (4/22/2010), and Michael Swenson (4/16/2010). 1712 $ Billions,” prepared by the Subcommittee, April 2010, updated January 2011, derived from Goldman Mortgage Strategies and Mortgage Department Top Sheets.
1713

Subcommittee interview of Daniel Sparks (4/15/2010), David Lehman (4/12/2010), Joshua Birnbaum

See, e.g., 3/8/2007 email from Mr. Sparks, “Mortgage Risk,” GS MBS-E-002206279, Hearing Exhibit 4/27-75

See chart entitled “Goldman Sachs Mortgage Department Total Net Short Position, February-December 2007 in

Subcommittee interview of Daniel Sparks (10/3/2010).

10,000,000,000

8,000,000,000

6,000,000,000

4,000,000,000

2,000,000,000

Notionals (ABX convention)

105

100

0 19-Jan18-Feb20-Mar19-Apr19-May18-Jun18-Jul17-Aug16-Sep16-Oct15-Nov15-Dec14-Jan13-Feb15-Mar14-Apr14-May13-Jun 75

-2,000,000,000

-4,000,000,000

-6,000,000,000 Prepared by the U.S. Senate Permanent Subcommittee on Investigations, February 2011. Derived from Goldman Sachs document, GS MBS-E-012890600.

e c i r P x e d n

BBB Index Only

BBB Index + CDS

BBB- Index Only

BBB- Index + CDS

All BBBs Index Only

All BBBs Index + CDS

06-2 BBB- Index Equiv

06-2 BBB- Idx Eq (MRMA)

06-2 BBB- Index Equiv (w/Cash) 06-2 BBB- Index Price

BBB bucket includes BBB+ CDS Notionals: refers to current notionals Positive notionals: long risk CDS: 2005 / 2006 vintages only

421

1714

The most comprehensive description of the AAA ABX short position located by the Subcommittee was a chart prepared by a Mortgage Department analyst in August 2007. The analyst sent the chart to Mr. Birnbaum at his request, to show the Mortgage Department’s overall position in synthetic products, including CDS contracts referencing ABX, RMBS, and CDO assets. The chart includes the AAA ABX short position as a long, nearly flat line showing an approximately $9 billion net short until early July 2007, when the value turned sharply upward. The analyst wrote in an August email, after much of the AAA ABX net short position had been covered: “M[ortgage] department is short ABX AAA [$]8.7b[illion], splitting among ABS/Alt A/prime/conduit in the beginning of fiscal year 2007, and is now long [$]410m[illion].” While this chart and the covering email do not reveal the origin of the AAA short, they indicate that, by early 2007, it was split between the ABS Trading Desk in the Structured Product Group and three desks in Mr. Gasvoda’s Residential Whole Loan Trading area – the Alt A Trading Desk under Genevieve Nestor, the Prime Trading Desk under Clay DeJacinto, and the Conduit for conducting subprime loan pool securitizations under Matt Nichols.

1715

Goldman emails provide additional information about the AAA ABX short. One series of emails, from March 2007, indicates that about $8 billion of the $9 billion AAA short was then held by the three desks in Mr. Gasvoda’s Residential Whole Loan Trading area, and that he favored maintaining the short, because it provided billions of dollars in coverage and cost only $5 million per quarter in premiums to maintain. On March 4, 2007, Mr. Gasvoda emailed Mr. Sparks with “Quick Thoughts on ABX AAA risk”:

“I talked to [Matt] Nichols and Clay [DeJacinto] about the AAA ABX short. Think it offers a good amount downside protection w/ relatively light pain if we’re wrong. Below is a $8B ABX AAA short #s. It costs us $5mm/quarter to carry. On the downside, if the market rallies to par … we drop $50mm. Taking it to 0 spread we lose $80mm.

“On the upside front, we get good jump risk. If AAA’s widen to current AA levels … we gain $70mm and if spreads move up to super senior risk pricing in CDOs … we’re up $190mm.

1714 8/17/2007 Goldman internal chart, “RMBS Subprime Notional History (Mtg Dept.),” GS MBS-E-012928391, Hearing Exhibit 4/27-56a. The analyst’s cover email stated: “The attached spreadsheet covers the single name and ABX positions of the entire mortgage department for the fiscal year 2007. I spot checked the numbers with risk reports they tie out well.” See also 8/17/2007 email from Joshua Birnbaum, GS MBS-012928388, Hearing Exhibit 4/27-56b.
1715 When shown the chart during his interview, Mr. Sparks told the Subcommittee he was unfamiliar with it and pointed what he believed to be an anomaly related to its depiction of the Mortgage Department’s short position involving BBB rated RMBS securities. He also indicated that he could not confirm its depiction of the AAA ABX short position. Since multiple Goldman email messages confirm the existence of the AAA ABX short position during most of Goldman’s fiscal year 2007, however, the chart’s depiction of that position as a nearly flat line at about $9 billion short until July 2007 appears consistent with the other evidence.

422

“Net, think this is a good position to have on given downside protection and relatively light upside pain. If we get an opportunity to buy some back next week, think we should but I’m thinking buy back $1-2B, not $8B.”1716

Mr. Sparks replied to Mr. Gasvoda: “Good trading response and thought process. We need to consider daily.”1717

The next day, March 5, 2007, the Residential Whole Loan Trading Desk under Mr.

1718

Gasvoda and the CDO Origination Desk under Peter Ostrem exchanged information about the “ABX hedges” that each business was carrying to reduce the risk associated with its respective long assets. The Residential Whole Loan Trading Desk reported: “[b]elow are all our ABX hedges across our Resi Credit + Prime books,” which included approximately $7 billion in AAA ABX holdings. The CDO Origination Desk, in turn, reported holding another $2.25 billion in AAA ABX “hedges.” Mr. Egol had remarked: “Love that huge AAA abx short.”

A few days earlier, with respect to the CDO Origination Desk’s holdings,

1721

1719

1720

Although the $7 billion figure reported by Mr. Gasvoda’s group on March 5 was $1 billion

1722

less than the $8 billion reported the day before, Origination Desk was larger than the $1 billion that the August 2007 email later ascribed to the Structured Product Group, all of the evidence indicates that Goldman had a massive AAA ABX short position in 2007. A few days later, on March 8, 2007, in an email to senior management entitled, “Mortgage Risk,” Mr. Sparks described the AAA ABX short as a hedge against long positions in the Department’s loan books and CDO warehouse accounts:

and the $2.25 billion reported by the CDO

“[O]verall the department has significant shorts against loan books and the CDO warehouse. The bulk of these shorts ($9BB) are on the AAA index, so the downside is limited as the index trades at 99.”

1723

3/4/2007 email from Kevin Gasvoda to Daniel Sparks, “Quick thoughts on ABX AAA risk,” GS MBS-E-

1716 010398072. 1717 Id. Despite Mr. Gasvoda’s suggestion that he might try to cover a portion of the $8 billion net short, the AAA ABX short position in Mr. Gasvoda’s area appears to have remained unchanged until around July 2007. 8/17/2007 Goldman internal chart, “RMBS Subprime Notional History (Mtg Dept.),” GS MBS-E-012928391, Hearing Exhibit 4/27-56a. 1718 Goldman’s hedging practice was that each desk was responsible for its own hedges. Accordingly, different desks would not necessarily share information about their respective hedges, even if both were hedging with the same product, such as an ABX short. 1719 1720 1721 1722 the additional $1 billion in hedges, the figure may be a typographical error, or the group may have chosen not to disclose some of its hedges. The Goldman personnel interviewed by the Subcommittee were unable to explain the discrepancy. 1723

3/5/2007 email from Cyrus Pouraghabagher, “ABX hedges for Resi businesses,” GS MBS-E-012085546. Id. 2/28/2007 email from Jonathan Egol to Fabrice Tourre, “Hedges Status Report,” GS MBS-E-002628642. The report from Mr. Gasvoda’s group may have inadvertently omitted a particular loan book that was holding

3/8/2007 email from Daniel Sparks, “Mortgage Risk,” GS MBS-E-002206279, Hearing Exhibit 4/27-75.

In this email to senior executives, Mr. Sparks put the size of the AAA ABX short at $9 billion, which seems to have been the amount most commonly cited for the short.

1724

423

When asked about the Gasvoda email which described the AAA ABX short as an

1727

1725

Mr. Sparks told the Subcommittee that the email was referring to

Since AAA rated RMBS securities were typically the safest of the RMBS

inexpensive “jump risk,” acquiring “jump insurance” against a sudden, huge loss arising from the total default of an asset. In this context, the short was acquired as insurance against the unlikely event that a significant portion of the AAA rated RMBS securities identified in the ABX Index defaulted simultaneously. securities offered for sale, it was widely believed in 2006 and 2007, that they would remain untouched even if defaulting mortgages harmed riskier RMBS securities. By shorting AAA rated RMBS securities, Goldman was insuring against a “tail risk” – the risk of an event that appeared to have a very small probability of ever actually occurring, but which was likely to cause catastrophic losses if it did occur. Mr. Sparks also explained that, since the subprime mortgage industry considered losses in AAA rated RMBS securities to be exceedingly unlikely, the price of acquiring and holding such a short position was relatively inexpensive.

1728

1726

From the time the $9 billion AAA ABX short was acquired in 2006 until July 2007, it was not included in Goldman senior management’s directives to cover shorts, and it does not appear to have been part of the Mortgage Department’s efforts to get “closer to home,” build a net short position in early 2007, or cover that net short in February and March. short may have been left out of management’s directives on the first net short, because it was serving as a hedge for long subprime mortgage assets held by several Mortgage Department desks. to unwind or remove the $9 billion AAA ABX hedge. entirely intact as a net short. The value, cost, and risk associated with the AAA ABX short had been monitored, but not acted upon, until the short suddenly began approaching profitability and

As those long assets were sold or written down, however, no apparent steps were taken

By June 2007, it remained almost

The $9 billion AAA ABX

1729

1731

1730

Subcommittee interview of Daniel Sparks (4/15/2010). Id.
Id. See 8/17/2007 Goldman internal chart, “RMBS Subprime Notional History (Mtg Dept.),” GS MBS-E-

1724 Id. See also 8/23/2007 email from Tom Montag to Lloyd Blankfein, GS MBS-E-009585951, Hearing Exhibit 4/27-37 (Mortgage Department “bought back 9 billion of AAA abx index over last two weeks.” ); 8/23/2007 email from Tom Montag to Gary Cohn and David Viniar, “Harbinger Post,” GS MBS-E-009739009. 1725 3/4/2007 email Kevin Gasvoda to Daniel Sparks, “Quick thoughts on ABX AAA risk,” GS MBS-E-010398072 (“ we get good jump risk . . . Net, think this is a good position to have on given downside protection and relatively light upside pain.”). 1726 1727 1728 1729 012928391, Hearing Exhibit 4/27-56a. 1730 areas in March 2007. Many of those assets were sold during the spring and summer of 2007. If a hedged asset is sold, the hedge is ordinarily unwound commensurately. See, e.g., 5/30/2007 email from David Lehman, “ABX hedges – Buy order,” GS MBS-E-011106690 (directing the unwinding of certain short ABX hedges held against the CDO Origination Desk when the CDO positions were transferred to another desk). 1731 012928391, Hearing Exhibit 4/27-56a.

The AAA ABX short appears to have served as a hedge for long assets in the Whole Loan and CDO Origination

See 8/17/2007 Goldman internal chart, “RMBS Subprime Notional History (Mtg Dept.),” GS MBS-E-

424

began contributing to high VAR levels for the Mortgage Department. It then drew the attention of Goldman senior management which included the AAA ABX short in its directive to cover the firm’s second big net short. Covering the AAA ABX net short contributed to the multi-billion- dollar profits realized by Goldman in the third and fourth quarters of 2007.

Report To Board. On March 26, 2007, Mr. Sparks and Goldman senior executives gave a 1732

presentation to Goldman’s Board of Directors regarding the firm’s subprime mortgage business. The presentation recapped for the Board the various steps the Mortgage Department had taken since December 2006, in response to the deterioration of the subprime mortgage market. presentation noted, among other measures, the following steps:

1733

The

“– GS reduces CDO activity – Residual assets marked down to reflect market deterioration – GS reverses long market position through purchases of single name CDS and reductions of ABX – GS effectively halts new purchases of sub-prime loan pools through conservative bids – Warehouse lending business reduced – EPD [early payment default] claims continue to increase as market environment continues to soften.”1734

By the time this presentation was given to the Board of Directors, Goldman’s Mortgage Department had swung from a $6 billion net long position in December 2006, to a $10 billion net short position in February 2007, and then acted to cover much of that net short. Despite having to sell billions of dollars in RMBS and CDO securities and whole loans at low prices, and enter into billions of dollars of offsetting long CDS contracts, Goldman’s mortgage business managed to book net revenues for the first quarter totaling $368 million.1735

In a section entitled, “Lessons Learned,” the presentation stated: “Capital markets and

financial innovation spread and increase risk,” an acknowledgment by Goldman that “financial innovation,” which in this context included ABX, CDO, and CDS instruments, had magnified the risk in the U.S. mortgage market.

1736

3/26/2007 Goldman presentation to Board of Directors, “Subprime Mortgage Business,” GS MBS-E-

1732 005565527, Hearing Exhibit 4/27-22. While the final version of the presentation indicated Goldman had an overall net long position in subprime assets by about $900 million, a near-final draft of the presentation indicated that Goldman had an overall net short position of $2.8 billion. 3/16/2007 draft presentation to Board of Directors by Daniel Sparks, “Subprime Mortgage Business,” GS MBS-E-002207710. The primary difference between the two figures appears to be the inclusion in the final version of Goldman’s net long holdings of Alt A mortgages, even though Alt A assets are not usually considered to be subprime mortgages. Subcommittee interview of David Viniar (4/13/2010). 1733 Id. at 4. 1734 Id. at 8 [footnotes defining CDO and CDS omitted]. 1735 9/17/2007 Presentation to Goldman Sachs Board of Directors, Residential Mortgage Business, at 5, GS MBS-E- 001793840, Hearing Exhibit 4/27-41. 1736 005565527, Hearing Exhibit 4/27-22.

3/26/2007 Goldman Sachs presentation to Board of Directors, “Subprime Mortgage Business,” GS MBS-E-

425

In May 2007, Goldman’s Structured Product Group (SPG) continued to work to cover the

Mortgage Department’s short position by offering to take the long side of CDS contracts referencing RMBS and CDO securities, but found few buyers. Many market participants had already shorted subprime mortgage assets, driving the price relatively high, and few wanted to buy additional short positions at the prevailing price. In order to turn the situation to its benefit, SPG’s traders attempted to carry out a “short squeeze” of the subprime CDS market in May 2007.

1737

1738

The ABS Desk’s traders were already offering single name CDS contracts in which Goldman would take the long position, in order to cover the Mortgage Department’s short position. To effectuate a short squeeze, they appear to have decided to offer the short positions on those contracts at lower and lower prices, in order to drive down the market price of subprime CDS shorts to artificially low levels. Once prices fell below what the existing CDS holders had paid for their short positions, the CDS holders would have to record a loss on their holdings and might have to post additional cash collateral with their opposing long parties. Goldman hoped the CDS holders would react by selling their short positions at the lower market price. When the sell off was large enough and the price low enough, Goldman planned to move in and buy more shorts for itself at the artificially low price.

This short-squeeze strategy was later laid out in a 2007 performance self-evaluation by one of the traders on Goldman’s ABS Desk who participated in the activity, Deeb Salem. In the self- evaluation he provided to senior management, Mr. Salem wrote:

“In May, while we were remain[ing] as negative as ever on the fundamentals in sub-prime, the market was trading VERY SHORT, and susceptible to a squeeze. We began to encourage this squeeze, with plans of getting very short again, after the short squeezed [sic] cause[d] capitulation of these shorts. This strategy seemed do-able and brilliant, but once the negative fundamental news kept coming in at a tremendous rate, we stopped waiting for the shorts to capitulate, and instead just reinitiated shorts ourselves immediately.”1739

When interviewed by the Subcommittee, Mr. Salem denied that the ABS Desk ever intended to squeeze the market, and claimed that he had wrongly worded his self-evaluation. He said that reading his self-evaluation as a description of an intended short squeeze put too much emphasis on “words.”

1740

1741

See, e.g., Salem 2007 Self-Review. See, e.g. 4/5/2007 email from Deeb Salem, “let’s sell ~200mm in Baa2 protection . . .,” GS MBS-E-004516519

1737 1738 (Mr. Swenson’s reply: “Make that 500mm”). 1739 1740 1741

Deeb Salem 2007 Self-Review [emphasis in original]. Subcommittee interview of Deeb Salem (10/6/2010). Id.

426

Mr. Salem’s description of an attempted short squeeze by Goldman’s Structured Product

Group is supported by other evidence. In May 2007, Michael Swenson, the head of both SPG and ABS Desks and Mr. Salem’s supervisor, wrote emails that appear to confirm the attempted short squeeze. In the first email, dated May 25, 2007, Mr. Swenson wrote:

“We should be offering sn [single name] protection down on the offer side to the street on tier one stuff to cause maximum pain.”1742

Four days later, on May 29, 2007, Mr. Swenson followed up with another email:

“We should start killing the sn [single name] shorts in the street – let’s pick some high quality stuff that guys are hoping is wider today and offer protection tight – this will have people totally demoralized.”1743

When asked about these emails, Mr. Swenson also denied that Goldman had attempted to squeeze the CDS short market. He claimed that the cost of single name CDS shorts had gone too high, and the purpose behind Goldman’s actions was to restore balance to the market. Mr. Swenson could not explain, however, why in an effort to restore balance to the market, he used the phrases “cause maximum pain,” and “this will have people totally demoralized.”

Goldman documents show there was a plan and an attempt to conduct a short squeeze, despite the harm that might be caused to Goldman’s clients. Contemporaneous emails further show that clients were complaining about a sudden markdown by Goldman in the value of their short positions, especially compared to prevailing market prices and the worsening of the subprime market itself.1745

1744

On May 18, 2007, a Friday, the ABS Desk marked down the value of many of its clients’ CDS short positions. On Monday, May 21, Mr. Salem sent an email to Mr. Swenson and Edwin Chin entitled, “A few things . . . pain-related.”1746

“Guys r gonna complain about their marks [hedge fund] already emailed me. I would talk about the recent flow of OWICS [offers] and the levels … they have been trading as the

Subcommittee interview of Michael Swenson (10/8/2010). Goldman’s CDS collateral agreements were usually bilateral, meaning collateral could flow either way, to the

5/25/2007 email from Michael Swenson to Edwin Chin and Deeb Salem, GS MBS-E-012443115. 5/29/2007 email from Michael Swenson to Deeb Salem, “they want to think about doing this again,” GS MBS-

1742 1743 E-012561798. 1744 1745 short or long party, depending upon price movements in the underlying assets. Subcommittee interview of Michael Swenson (10/18/2010). Clients wrote emails to Goldman questioning how they could owe collateral on CDS contracts they had only recently purchased from Goldman. 1746 E-021887795 [ellipses in original].

5/21/2007 email from Deeb Salem to Michael Swenson and Edwin Chin, “A few things pain-related,” GS MBS-

427

reason we moved marks on Friday. … [Another customer] lost 6 pct based on fridays moves.”1747

That same day, a Goldman sales representative sent Mr. Chin a complaint from a hedge

fund customer named Stanfield Capital regarding the lower values assigned to its CDS short positions. The sales representative wrote:

“Stanfield feels we are marking them tighter than other dealers with whom they have similar protection. …

In addition, 14 of the 25 names below were marked over 100 bps [basis points] tighter week-on-week. That is a massive move and is creating major stress at the clients, as we can’t see a similar move in the broader market. …

Finally, be aware that Stanfield may look for you to offer protection very close to your mark. … I’m hoping your attention to the marks below will defuse a situation in which they think we’re messing with them via our marks on their protection.”1748

Mr. Chin forwarded the email to Mr. Swenson and Mr. Salem. Mr. Swenson replied: “We are ok with that they do not have much more gun powder.” Mr. Swenson’s response suggested that Goldman did not have to be concerned about Stanfield’s threat to buy CDS shorts at the same low price Goldman had applied to his CDS holdings, since Stanfield did not have the financial resources – the “gun powder” – to make a large purchase.

1749

On May 24, 2007, the Stanfield trader wrote to Goldman that he had thought the purchase of the CDS contract signaled the beginning of a partnership between Stanfield and Goldman, but he had lost credibility with his company because of the CDS contracts and expressed concern that he may have been “naive to trust the pitch” from Goldman:

“When we put on the Single A protection trade the underlying names were suppose[d] to have a large similarity to the index. … The indexes are up only a couple of points since we did the trade. Looking at the mid’s on our Single A trades we have tightened roughly 33%. … I’m just trying to figure out how we can reverse some of the losses we have incurred.

Also, from where our BBB trade was marked last Friday … [t]his trade is tighter by 35% as well. …

I had always thought that these trades were meant to be the start of a partnership building of future business between Stanfield and Goldman Sachs. I know we are big boys and we did the trade there is no doubt of that. What I am attempting to do is either cut our losses and

1747 1748 1749

Id. 5/21/2007 email to Edwin Chin, “Edwin–Important–Stanfield levels,” GS MBS-E-012570169. Id.

428

get out or determine what I can say to keep this trade on …. I’ve lost a lot of credi[b]ility on the desk with this trade. Maybe I was naive to trust the pitch on the trade. It has cost me a lot.”1750

A week later, on May 31, 2007, Stark Investments indicated interest in buying a short on

certain RMBS securities backed by home equity loans. The Goldman sales representative trying to close the sale emailed SPG personnel that the client was hesitating due to Goldman’s valuations which were “drastically different” from other dealers:

“Stark has an interest in looking at this trade; but there is an obstacle we need to address: They feel Goldman is very inconsistent in the single name HEL [Home Equity Loan] CDS marks that we provide them. We are drastically different in marking positions versus other dealers. It is an annoyance that would potentially limit their interest in putting on incremental CDS trades. I can name specific examples if you would like. Please advise.”1751

Mr. Salem replied: “you couldn’t be more wrong,” while Mr. Swenson replied:

“Frankly, we believe we are best in class and have numerous data from controllers, collateral posting and markit (the company, not market) that reflect upon this. This process is thoroughly reviewed by all levels of senior management at GS. …

“Unlike other dealers we stand by our marks and are willing to transact in the context of our marks. …

We also don’t mark our book wide if we are long protection and tight if we are short. [W]e mark to market.”1752

When the salesman replied: “I am trying to work with you guys,” Mr. Swenson chided him: “You need to manage their opinions on marks – that has been fully vetted over here.”1753

On June 7, 2007, Mortgage Department personnel learned that two Bear Stearns hedge

funds specializing in subprime mortgage assets were in financial distress. Desk immediately decided to buy more shorts at the prevailing market price to take advantage of the possible collapse of the Bear Stearns hedge funds, which would send subprime mortgage prices

In response, the ABS

1754

Id.; see also, e.g., “Valuation & Pricing Related to Transactions with AIG,” prepared by Goldman in response to

5/24/2007 email from Stanfield, “Our thoughts on single-name RMBS CDS,” GS MBS-E-012891722. 5/31/2007 email from sales to Edwin Chin and Deeb Salem, “Stark CDO CDS potential trade 5/31,” GS MBS-

1750 1751 E-012443662. 1752 inquiry by the Financial Crisis Inquiry Commission, GS MBS 0000039096. 1753 5/31/2007 Goldman email chain, “Stark CDO CDS potential trade 5/31,” GS MBS-E-012443675. Mr. Swenson made no mention of his email from two days earlier in which he recommended lowering CDS values to “have people totally demoralized.” 5/29/2007 email from Michael Swenson to Deeb Salem, GS MBS-E-012561798. 1754

6/7/2007 Goldman internal email chain, “BSAM Post,” GS MBS-E-011184213.

429

still lower. To do so meant the ABS Desk had to sacrifice its “short squeeze” play. On June 7, 2007, Mr. Salem emailed Messrs. Swenson and Chin:

“We need to go to magnetar [a hedge fund] and see if we can buy a bunch of the cdo protection. … Can tell them we have a protection buyer, who is looking to get into this trade now that spreads have tightened back in.”1755

Raising no concerns about the proposed deception, Mr. Swenson replied “Great idea.” Salem continued:

1756

Mr.

“Should we also send an email to select sales people in the mtg [mortgage] sales force saying that we r looking to buy a block of single name protection vs a cdo OUT OF COMP [in a private, off-market transaction]? It’s a no lose situation . . . either we get some sn [single name] protection that we want or we gave these guys a chance and nobody can say we aren’t working with them.”1757

Mr. Swenson responded: “We need to be careful.” Mr. Chin wrote that he knew of another CDO collateral manager that might also be willing to sell some shorts: “I mentioned there was a hedge fund on the side and he was very axed to do something.”1758

Having decided to start buying shorts outright, the ABS Desk also stopped offering to sell CDS short positions to Goldman customers, effectively abandoning the attempted short squeeze. On June 8, 2007, Mr. Swenson told his traders: “[w]ant to slow down on protection offers.”

1759 On June 10, 2007, in response to a customer inquiry about a CDS short, Mr. Salem wrote: “Not sure if we have any to offer any more.” offer any.” looking to buy protection on cdos.”

On June 13, 2007, a Goldman salesman emailed SPG personnel: “[Customer] is

Mr. Salem replied: “too late!”

1760

Mr. Swenson was less equivocal: “Really don’t want to

1761

1762

Once it began buying CDS shorts, the SPG Desk immediately changed its CDS short

valuations and began increasing their value. Clients with long positions began to complain that the marks were too high, and internal Goldman business units also raised questions. For example, on June 11, 2007, a Goldman valuation specialist sent an email to Mr. Swenson, with copies to Compliance and the Controller’s Office noting that “Client challenging marks,” followed by

6/7/2007 email from Deeb Salem to Michael Swenson and Edwin Chin, GS MBS-E-012444252. Id. Id. Id. 6/8/2007 email from Michael Swenson to Benjamin Case, Edwin Chin, and Deeb Salem, “CDO CDS protection

6/10/2007 email from Michael Swenson to Deeb Salem, Edwin Chin, and salesman, “CDSs on CDOs,” GS

1755 1756 1757 1758 1759 offers,” GS MBS-E-012551726. 1760 MBS-E-012551460. 1761 1762

Id. 6/13/2007 email from sales, “CDO protection,” GS MBS-E-012445931.

430

1763

“Trading has agreed to change … marks.” representative from the Controller’s Office sent an email to Mr. Salem, asking: “Given recent gyrations in the ABX and CDS markets, when can I come by to discuss how you are marking the book tonight?” The following week, on June 19, 2007, the Controller’s office sent an email to Mr. Swenson raising questions about values assigned to certain CDS contracts: “These levels look quite wide. Do you have any specific market color that points this direction?”1765

The next day, June 12, 2007, a Goldman

1764

The May 2007 attempted short squeeze described in Mr. Salem’s performance self-

evaluation did not succeed in compelling existing CDS holders to sell their short positions. In Subcommittee interviews, Mr. Salem and Mr. Swenson denied that an attempted short squeeze even took place. Any attempt that did take place was apparently abandoned in June 2007, when Goldman stopped offering to sell CDS short positions. Trading with the intent to manipulate market prices, even if unsuccessful, is a violation of the federal securities laws. Given the novelty of credit default swaps and their use in the mortgage field, however, the Subcommittee is unaware of any enforcement action or case applying an anti-manipulate prohibition to the CDS market. Because Goldman is a registered broker-dealer subject to the supervision of the Financial Industry Regulatory Authority (FINRA), the conduct of its ABS traders raises questions about their compliance with FINRA’s Rule 2010, which provides: “A member, in the conduct of his or her business, must observe high standards of commercial honor and just and equitable principles of trade.”

1766

(d) Building the Big Short

In the months of June and July 2007, Goldman’s Mortgage Department went short again.

This time, it built an even larger net short position than earlier in the year, reaching a peak of $13.9 billion in late June,

which Mr. Viniar later referred to as “the big short.”

This net short

1768

1767

See Markowski v. SEC, 274 F.3d 525, 527-28 (D.C. Cir. 2001) (Congress determined that “‘manipulation’ may

6/11/2007 Goldman email chain, “Please advise – Client challenging marks,” GS MBS-E-018947548. 6/12/2007 email from controllers, “CDS,” GS MBS-E-012445404. 6/19/2007 email from controllers, “A3 subprime bonds in transition account,” GS MBS-E-012458169. Mr.

1763 1764 1765 Swenson replied: “Tier 4 bonds talk to Deeb [Salem].”
1766 be illegal solely because of the actor’s purpose”); In re IPO Litigation, 241 F. Supp. 2d 281, 391 (S.D.N.Y. 2003) (no additional requirements aside from manipulative intent); H.R. Rep. No. 1383, 73rd Cong., 2d Sess. 20 (1934) (under Securities Exchange Act, “if a person is merely trying to acquire a large block of stock for investment, or desires to dispose of his holdings, his knowledge that in doing so he will affect the market price does not make his actions unlawful. His transactions become unlawful only when they are made for the purpose of raising or depressing the market price.”); but see GLF Advantage Fund, Ltd. v. Colkitt, 272 F.3d 189, 205 (3d Cir. 2001) (requiring, in addition to manipulative intent, “that the alleged manipulator injected inaccurate information into the market or created a false impression of market activity”). Single name CDS contracts referencing RMBS and CDO securities appear to qualify as “security-based swap agreements” subject to anti-manipulation and anti-fraud prohibitions under the federal securities laws. 1767 MBS-E-012928391, Hearing Exhibit 4/27-56a. 1768 MBS-E-009861799, Hearing Exhibit 4/27-26.

PSI Net Short Position Chart; 8/17/2007 Goldman chart, “RMBS Subprime Notional History (Mtg Dept.),” GS

7/25/2007 email from Mr. Viniar to Mr. Cohn, “Private & Confidential: FICC Financial Package 07/25/07,” GS

431

position included the $9 billion AAA ABX short which had suddenly begun gaining value as the subprime market worsened. In June, two Bear Stearns hedge funds specializing in subprime mortgage assets collapsed. In July 2007, the credit rating agencies began downgrading ratings for hundreds and then thousands of RMBS and CDO securities. Soon after, the subprime mortgage backed securities market froze and then collapsed. Each of these events increased the value of Goldman’s net short position.

Bear Stearns Hedge Fund Collapse. The collapse of the Bear Stearns hedge funds in

mid-June triggered Goldman’s effort to rebuild its net short position. On June 7, 2007, the Mortgage Department learned that the Bear Stearns hedge funds were seeking quietly to sell some of their subprime portfolio to meet client redemption requests, which Goldman interpreted as a signal of serious financial distress. employee remarked:

After reviewing the hedge funds’ assets, one Goldman

1769

“In total these two portfolios add up to roughly $17bil in total exposure after leverage. It goes without saying that if this portfolio were to be released into the market the implications would be pretty severe.”1770

1769 See 6/7/2007 Goldman email chain, “BSAM Post,” GS MBS-E-011184213. 1770 Id. Some have suggested that the financial problems experienced by the Bear Stearns hedge funds were caused in part by severe markdowns taken by Goldman on assets held in the funds’ portfolios, and that Goldman caused the funds to collapse. In its final report, the Financial Crisis Inquiry Commission (FCIC) briefly addressed these allegations. See The Financial Crisis Inquiry Report 2010 at 237-40, 244 (hereinafter “Final Report”). Goldman denied the allegations with respect to its April and May 2007 marks in filings with the FCIC. See 11/1/2010 letter from Goldman counsel Janet Broecke to FCIC, “FCIC Requests for Documents and Information” and Appendices A- G, available at www2.goldmansachs.com. The FCIC’s Final Report was critical of Goldman’s marks in general as being significantly lower than those of other banks and noted in particular its collateral dispute with AIG. See Final Report at 243-44, 265-71. With respect to the Bear Stearns hedge funds, however, the Final Report merely noted that Bear Stearns had disputed marks from Goldman and three other banks and cited the testimony of the funds’ portfolio manager, Ralph Cioffi, that “a number of factors contributed to the April revision [in the hedge funds’ values, which ultimately led to the funds’ collapse], and Goldman’s marks were one factor.” Final Report at 240.

In addition to the markdowns in April and May, Goldman also marked down certain CDO securities held by the Bear Stearns funds in June 2007, but it appears those June markdowns did not play a significant role in the hedge funds’ collapse. That month, Goldman marked down their positions in four Goldman CDOs by two points each. See, e.g., 6/8/2007 email from Jonathan Egol to Daniel Sparks, “BSAM mark recap,” GS MBS-E-001920339 (Mr. Egol emailed Mr. Sparks a recap of the Bear Stearns markdowns and stated: “We lowered the marks on 4 bonds down 2 pts each.”).

Mr. Swenson had urged larger markdowns, but his advice was not followed. On June 7, 2007, Mr. Egol had

first marked down the funds’ holdings in a single Abacus CDO by 2 points, from 89 to 87. Mr. Egol emailed Mr. Sparks a spreadsheet with a cover note: “GS exposure to BSAM [Bear Stearns Asset Management] as of today. ABACUS mark corrected to 87 to handle.” 6/7/2007 email from Mr. Egol to Mr. Sparks GS MBS-E-003375593. Since Abacus was only one of four Goldman CDOs in which the Bear Stearns funds held positions, Mr. Swenson emailed Mr. Lehman recommending further markdowns:

Mr. Swenson: I am on the same page [as] egol we n[e]ed to mark him [Ralph Cioffi, Portfolio Manager of the Bear Stearns funds]

432

On June 8, 2007, Mr. Sparks received an urgent early morning email from Goldman’s

Japan office regarding “unprecedented overnight [rates] market volatility,” suggesting that he call in the ABX traders early. RMBS/ABS spreads.” 1772 in the ABX market, Mr. Birnbaum replied: “Patience, patience. The CDO unwind has only begun.”

“Given the recent correlation of risk assume this is not a good sign for 1771 Later that day, when another trader complained about “getting crushed”

1773

Around June 12, 2007, public news accounts indicated that the two Bear Stearns funds 1774

were unable to meet collateral calls on their subprime mortgage backed securities holdings. funds also devalued their Net Asset Valuations (NAVs) to significantly lower levels, which effectively triggered the funds’ total collapse.

1775

The

Mr. Lehman: Told Egol I’m comfortable w/ the prices, especially when u include the 5 pt [percent] HC [haircut.] Don’t think mar[k]ing him down 1 or 2 pts makes sense or sends the right message …. I wud run it by Dan [Sparks] and get his take …. [M]y opinion is that the Firm is appropriately protected w/ current HC [haircut] and mark. Mr. Swenson: We need to mark him he is the biggest elephant by far and it has an impact on the m$arket[.] Mr. Lehman: How much do u [sic] want to mark him by? Mr. Swenson: A lot[.] Mr. Lehman: I disagree on this one … Let’s talk tomorrow[.] Mr. Swenson: He is done[.]

6/7/2007 email exchange between Mr. Swenson and Mr. Lehman, “BSAM Post,” GS MBS-E-011184213.

The next day, Friday, June 8, 2007, Mr. Egol reported he had marked down all four CDO positions by two

points. 6/8/2007 email from Jon Egol to Daniel Sparks, “BSAM mark recap,” GS MBS-E-001920339. Upon reviewing the marks the following Monday, Mr. Sparks wrote: “The marks look stale.” 6/11/2007 email from Daniel Sparks, “BSAM Exposure Summary,” GS MBS-E-010798675. A Mortgage Department employee replied: “Marks for everything but the correlation positions are taken from work egol did last thurs. Correlation marks are as of friday’s cob [close of business].” Id.

On June 12, Bear Stearns announced that it would be changing the hedge funds’ Net Asset Valuations

(NAVs). 6/12/2007 email to Craig Broderick, “BSAM Bullet Points,” GS MBS-E-009967117 (“BSAM is currently in the process of restating their performance figures for April, from down 5% to down 10%. This was due to many dealers changing the way they are marking their Repo positions”). The Mortgage Department later marked down two Timberwolf tranches owned by the Bear Stearns hedge funds by another 2 points and 5 points, respectively, to 95 and 89, before it bought them back from Bear Stearns at 96 and 90 on June 19, 2007, in a negotiated unwind of the Bear funds’ positions with Goldman. See 6/22/2007 emails from Mr. Lehman, “BSAM Repo Summary,” GS MBS-E-001916435. See also 6/18/2007 email from Mr. Lehman, “Today’s Bear Stearns Prices,” GS MBS-E- 001919600; 6/27/2007 email from Mr. Sparks to Mr. Viniar, “CDO^2s,” GS MBS-E-009747489. 1771 6/8/2007 email to Daniel Sparks, “Heads Up – rates market volatile,” GS MBS-E-010796702. 1772 Id. 1773 6/8/2007 email from Joshua Birnbaum, “* ABX Markets 07-1, 06-2, 06-1: 11:00 a.m.,” GS MBS-E-012900708. 1774 6/12/2007 email to Craig Broderick, “BSAM Bullet Points,” GS MBS-E-009967117. 1775 Id. A month later, on July 17, 2007, Mr. Sparks reported to Mr. Mullen and Mr. Montag that the Bear Stearns funds were “returning 9 cents and 0 cents on the dollar in the less-levered and more-levered funds.” 7/17/2007 email from Daniel Sparks, “Mortgages Estimate,” GS MBS-E-010857498.

433

The failure of the Bear Stearns hedge funds triggered another decline in the value of

subprime mortgage related assets. The ABX Index, which was already falling, began a steep, sharp decline. The collapse had further negative effects when the hedge funds’ massive subprime holdings were suddenly dumped on the market for sale, further depressing prices of subprime RMBS and CDO assets.

The creditors of the Bear Stearns hedge funds met with Bear Stearns management in an

1776

attempt to organize a “workout” solution to stabilize the funds. underway, Goldman and Bear Stearns agreed to an unwind in which Goldman bought back $300 million of two AAA CDO tranches of Goldman’s Timberwolf CDO, which the hedge funds had purchased two months earlier in April 2007. Goldman paid Bear Stearns 96 and 90 cents on the Goldman also bought a few other RMBS dollar, respectively, for the two Timberwolf tranches. The attempt to organize a workout solution for the and CDO assets, which it immediately sold. funds was ultimately unsuccessful. Large blocks of subprime assets from the Bear Stearns hedge funds’ inventory began flooding the market, further depressing subprime asset values.1779

While those efforts were

1778

1777

Goldman’s Structured Product Group (SPG) took the collapse of the Bear Stearns hedge funds as the signal to begin rebuilding its net short position. As Joshua Birnbaum, the head ABX trader on the SPG Desk, later wrote:

“[T]he Bear Stearns Asset Management (BSAM) situation changed everything. I felt that this mark-to-market event for CDO risk would begin a further unraveling in mortgage

6/12/2007 email to Craig Broderick, “BSAM Bullet Points,” GS MBS-E-009967117. See 6/22/2007 emails from David Lehman, “BSAM Repo Summary,” GS MBS-E-001916435. See also

1776 1777 6/18/2007 email from David Lehman, “Today’s Bear Stearns Prices,” GS MBS-E-001919600; 6/27/2007 email from Daniel Sparks to David Viniar, “CDO^2s,” GS MBS-E-009747489. The prices Goldman paid to Bear Stearns on the A1B and A1C tranches of Timberwolf were approximately one cent (or 100 basis points) above its own internal marks on the Timberwolf tranches in the week of June 18, which were then at 95 and 89 points, respectively. Id. In May 2007, Goldman had completed a re-evaluation of its CDO assets, which suggested on a preliminary basis that the AAA Timberwolf securities should be marked down dramatically in value. Accordingly, Goldman may have been generous toward Bear Stearns in buying back the Timberwolf positions at 96 and 90. On the other hand, repurchasing the Timberwolf securities near its own low internal marks might have reduced the price Goldman could obtain in reselling the tranches, which it identified in a June 22 sales directive to its sales force and recommended selling at 98.5 and 95, respectively. When asked about the buyback of the Timberwolf tranches, Mr. Viniar told the Subcommittee that Goldman had financed the purchase of both tranches and may have been legally entitled to seize them, but there are circumstances in which Goldman voluntarily settles a dispute on agreed terms, rather than going through the legal process entailed in seizing and selling collateral. Subcommittee interview of David Viniar.
(4/13/2010). 1778 “Can I get a complete rundown on everything we bought from BSAM and what’s left?” Mr. Sparks: “Yes – main thing left is 300mm timberwolfs Other large positions were tmts - gone, octan - gone, abacus - we will collapse against short There were some small rmbs positions.”). 1779 Managment] story will dictate the tone in the market in the short term, as a continued liquidation of their holdings will put further downward price pressure on … ABX trading.” 6/18/2007 email to Edwin Chin, “ABX Open,” GS MBS-E-021890868.

6/22/2007 email from Tom Montag to Daniel Sparks, “Few Trade Posts,” GS MBS-E-010849103 (Mr. Montag:

At the time, a trader from another bank stated in a market update: “[T]he BSAM [Bear Stearns Asset

434

credit. Again, when the prevailing opinion in the department was to remain close to home, I pushed everyone on the [SPG] desk to sell risk aggressively and quickly. We sold billions of index and single name risk.”1780

In a later internal presentation for Goldman senior executives which Mr. Birnbaum drafted

for another purpose, Trading Desks went net short outright and that the shorts were not a hedge for long positions:

Mr. Birnbaum wrote that, after the Bear Stearns funds collapsed, SPG’s

1781

“By June, all retained CDO and RMBS positions were identified already hedged. … SPG trading reinitiated shorts post BSAM [Bear Stearns Asset Management] unwind on an outright basis with no accompanying CDO or RMBS retained position longs. In other words, the shorts were not a hedge.”1782

On June 29, 2007, the ABX Index and the value of single name CDS contracts referencing

RMBS and CDO securities plummeted in value and continued dropping until mid-July. Mr. Swenson, head of the SPG Trading Desk, exchanged emails with Mr. Lehman and other Goldman executives about that day’s trading: “There is absolutely no support at the lower levels from the street. CDOs are wider by 50 bps or more.” Mr. Lehman responded: “[W]e r in the middle of a mkt meltdown.”1783

On July 10, 2007, the two primary ratings agencies, Standard & Poor’s and Moody’s, began

the first of many mass ratings downgrades for subprime RMBS and CDO securities. downgrades sent another negative shockwave through the subprime mortgage market as investors scrambled to assess the impact of the downgrades on their RMBS and CDO holdings. On July 12, 2007, when still more RMBS and CDO ratings downgrades were announced, Mr. Birnbaum

The

1785

1784

This presentation was drafted to support a proposal that the SPG traders be compensated in a manner similar to

1780 9/26/2007 2007 MD Reviews, Joshua Birnbaum Self-Review, GS-PSI-01956, Hearing Exhibit 4/27-55c. The SPG Desk’s ABX shorting efforts caught the attention of another Goldman trader who was apparently unaware of Mr. Birnbaum’s strategy. The trader emailed: “yo-who the F- is getting short the ABX at these levels.” 6/21/2007 email to Deeb Salem, GS MBS-E-021905440. 1781 hedge fund managers. 10/3/2007 “SPG Trading – 2007,” presentation by Joshua Birnbaum, GS MBS-E-015654036. Mr. Birnbaum had drafted the presentation on behalf of the SPG Trading Desk as a whole. Mr. Swenson and Mr. Lehman reviewed and commented upon the presentation, and Mr. Birnbaum revised it to make the changes they suggested. See, e.g., 10/2/2007 email from David Lehman to Joshua Birnbaum, “SPG Trading - 2007.ppt,” GS MBS-E-015653681 (providing comments and suggesting text for presentation). Mr. Birnbaum replied and copied Mr. Swenson on the email chain as well: “I added your bullet and one more.” Id. See also 10/4/2007 email from Joshua Birnbaum to Michael Swenson and David Lehman, “How’s this?,” GS MBS-E-015712249 (forwarding another revised bullet point for presentation). Mr. Birnbaum told the Subcommittee, however, that the SPG Trading Desk ultimately did not use the presentation. See Birnbaum responses to Subcommittee QFRs at PSI_QFR_GS0509. 1782 original]. See also Birnbaum responses to Subcommittee QFRs at PSI_QFR_GS0509.
1783 1784 to Subprime RMBS,” GS MBS-E-001837256. 1785

6/29/2007 emails between Michael Swenson and David Lehman, “ABS Update,” GS MBS-E-011154528. 7/10/2007 Goldman internal email, “GS Cashflow/Abacus CDOs Mentioned in S&P Report on CDO Exposure

10/3/2007 “SPG Trading – 2007,” presentation by Joshua Birnbaum, GS MBS-E-015654036 [emphasis in

See id.

435

wrote to his colleagues: “Seen massive flows recently. Many accounts ‘throwing in the towel’. Anybody who tried to call the bottom left in bodybags.”1786

On July 27, 2007, a Goldman senior sales executive summarized the state of the market:

“Whether you remember ‘94, ‘98, or ‘03, the general themes/patterns are consistent. An initial dislocation to the market (in this instance a credit deterioration in sub prime mortgages) acts as a tipping point and leads to spread widening in other sectors. This in turn quickly becomes a liquidity crunch/crisis. It appears this is where the structured product market is now – searching for liquidity. This has produced numerous capitulation/liquidation situations and forced customers to trade. . . . The impact of this week leaves the account base in three camps: The Paralyzed . . . The Wounded (some fatally) . . . The Opportunistic.”1787

Although the July subprime market meltdown was a disaster for many investors, the value of Goldman’s net short positions climbed rapidly. Senior management at all levels were aware of the Mortgage Department’s net short and the profits it was generating. On July 20, 2007, CEO Lloyd Blankfein and COO Gary Cohn received a profit and loss report showing that the Mortgage Department was up $72.7 million for the day, across almost every mortgage trading desk. Mr. Cohn wrote to Mr. Blankfein: “There is a net short.” Department posted a profit of $83 million for the day, while the firm’s overall net revenue for the day was only $74 million. “Mergers, overnight asia and especially short mortgages saved the day.” On July 29, 2007, Mr. Sparks reported to Messrs. Montag and Mullen:

Mr. Viniar forwarded the report to Mr. Blankfein with a note saying:

On July 24, 2007, the Mortgage

1788

1789

“Department-wide P&L [Profit & Loss] for the week was $375mm (this is after adjusting for the $100mm [error] discussed today). Correlation P&L on the week was $234mm, with CMBS, CDOs, and RMBS/ABX shorts all contributing.”1790

Mr. Birnbaum later recapped the SPG Trading Desk’s profits during this period: “[W]hen the [ABX] index dropped 25 pts in July, we had a blow-out p&l month, making over $1Bln that month.”

1791

7/12/2007 email from Joshua Birnbaum, “ABX Markets 07-1, 06-2, 06-1: 12:00 p.m.,” GS MBS-E-012944742,

7/27/2007 email to Tom Montag, Daniel Sparks, and Donald Mullen, “Structured Products Weekly Update –

7/20/2007 email from Gary Cohn to Lloyd Blankfein, “Private & Confidential: FICC Financial Package

1786 Hearing Exhibit 4/27-146. 1787 7/27/07,” GS MBS-E-010876357. 1788 07/20/07,” GS MBS-E-009648405, Hearing Exhibit 4/27-24. 1789 MBS-E-009690033, Hearing Exhibit 4/27-25. 1790 010876594, Hearing Exhibit 4/27-27. 1791

7/24/2007 email from David Viniar to Lloyd Blankfein, “Daily Estimate 07-24-07 – Net Revenues $74M,” GS

7/29/2007 email from Daniel Sparks to Tom Montag, “Correlation information you asked for,” GS MBS-E-

9/26/2007 2007 EMD Reviews, Joshua Birnbaum Self-Review, GS-PSI-01975, Hearing Exhibit 4/27-55c.

436

Covering the Big Short to Lock in Profits. Starting in July and throughout August 2007,

Goldman undertook an intensive effort to cover its $13.9 billion net short and lock in its profits. To do so, the Mortgage Department bought long assets, offered CDS contracts in which it took the long side, and even sold some short positions.

The Mortgage Department was particularly focused on purchasing long AAA assets to

cover Goldman’s $9 billion AAA ABX short, to lock in the unexpected profits on that position. In August 2007, Mr. Lehman, co-head of the SPG Desk, wrote: “[A]s swenny/deeb/josh have done an awesome job sourcing risk, the CDO transition book AAA ABX short decreased from 1.55bb to 250m over the past two weeks – we love covering that trade.” Montag reported to Messrs. Cohn and Viniar: “We … bought back almost 9 billion of aaa abx over last two weeks.”1793

On August 23, 2007, Mr.

1792

From mid-July through the end of August, the Mortgage Department also covered a range

of other shorts.

1794

On August 5, 2007, Mr. Swenson reported a “phenomenal week”:

“In summary, a phenomenal week for covering our Index shorts on the week. The ABS Desk bought $3.3bb of ABX Index across various vintages and ratings over the past week. $1.5 billion was retained by the ABS desk to cover shorts in ABX ($900mm in ABX 06-1 As being the most significant) and $1.0 billion was sold to internal desks across the mortgage department ($925mm in triple-As).”1795

Mr. Swenson also reported that the Mortgage Department was still $8.3 billion net short across all subprime asset classes, including $4 billion of AAA ABX assets.

1796

On August 8, the market rallied for a short period, and the Mortgage Department’s net short

position suffered a $100 million loss. Mr. Swenson explained: “Market rallied especially at the top end of the capital structure – AAA (up 2 pts), AA (up 3 pts), and A (up 2 pt.).” He reported that the Department still held a $3.1 billion net short in AAA rated subprime mortgage assets. 1797 Mr. Montag replied: “now on to the 3 billion short.” Montag reported to his colleagues: “mortgages bought back 1 billion of 3 billion short in AAA indices at ½ to 1 point better than yesterday.”1799

The next day, August 9, 2007, Mr.

1798

The one short position the Mortgage Department did not attempt to cover was its $3 billion net short in BBB and

8/11/2007 email from David Lehman, “Japan exposure to CDOs,” GS MBS-E-001929202. 8/23/2007 email from Tom Montag to Gary Cohn and David Viniar, “Harbinger Post,” GS MBS-E-009739009.

1792 1793 See also 8/21/2007 email from Michael Swenson, “Mortgage Commentary for Firmwide Risk Committee,” GS MBS-E-010619375 (“Current SPG Trading Desk Position Summary: – RMBS AAA – long $2.2bb”). 1794 BBB- rated RMBS securities, as discussed below. 1795 1796 1797 1798 1799

8/5/2007 email from Michael Swenson, “great week,” GS MBS-E-012376888, Hearing Exhibit 4/27-28. Id. Id. 8/8/2007 email from Tom Montag to Michael Swenson and David Lehman, GS MBS-E-011088957. 8/9/2007 email from Tom Montag, GS MBS-E-009640293.

437

On August 11, 2007, reports of firms having to sell CDO securities in Asia prompted Mr.

1800

Mullen to ask: “Did we cover to[o] soon? Looks like more selling at the higher end of cap stack” gone the other way by 1.44bb since June 1 ) and that is where the market still has bad longs – st th[in]k AAA rmbs is a very different trade.”

Mr. Lehman replied: “Don’t th[in]k so – we haven’t covered any CDO risk (we have

1801

On August 20, 2007, Mr. Sparks reported on the Mortgage Department’s progress in

covering its net short, telling Mr. Montag: “[L]oan books had been heavily net short (still are some – especially … in alt a) and I have been forcing them to cover over the past 2 weeks.” Mr. Montag responded: “[H]eavily isn’t the half of it – we have bought back 4 - 5 billion and still short.”1802

Buying More AAA RMBS Securities. In August 2007, the Mortgage Department

proposed buying $10 billion in AAA rated RMBS securities, but did not receive permission to initiate the investment.

By August 2007, AAA rated RMBS and CDO securities were available from many

1803

financial firms at a very low price. On August 14, 2007, in summarizing the prior week’s trading Mr. Swenson wrote: “Top of the capital structure is where all the action is. AAAs are extremely Mr. Sparks agreed: “[T]he AAA ABX index is a cheap …. [W]ant to scale into a large long.” great opportunity and we continue to like it.” On August 19, 2007, Mr. Lehman reported that the Mortgage Department had purchased $1.6 billion of the long side of CDS contracts referencing the ABX Index for AAA RMBS securities, and that its value had increased 1.5 percent over the prior week. Given Goldman’s dominant market share and recent large purchases, however, Mr. Montag was skeptical: “How much of the aaa outperforming was us buying?” Mr. Birnbaum responded: “On the AAA outperformance question, I think AAAs would have performed similarly without our adding.” He also wrote that the “likelihood of loss on ‘real’ RMBS AAAs (i.e., not AAA CDOs),” was “remote.”

1805

1804

1806

1807

8/11/2007 emails between Donald Mullen and David Lehman, “Japan exposure to CDOs,” GS MBS-E-

8/20/2007 email exchange between Daniel Sparks and Tim Montag, “Hsbc loans,” GS MBS-E-010681855. 8/14/2007 email from Michael Swenson, “ABS Summary for Week Ended August 10 ,” GS MBS-E-

1800 001929202. 1801 Id. See also 8/11/2007 email from Daniel Sparks to Tom Montag and Donald Mullen, “GSC ms prop/Paulson swap,” GS MBS-E-010673306 (“We need to keep buying AAA ABX, and now we can start looking to cover some CDO CDS”). 1802 1803 010678428. 1804 1805 1806 1807 Rosenblum circulated an email to Mortgage Department managers and research analysts with a series of questions about how AAA subprime RMBS securities would be affected by other market developments. 6/29/2007 email from David Rosenblum, GS MBS-E-010060183. The head of Goldman’s Structured Product Strategies area, Alan Brazil, responded: “Well, as is becoming clearer to the market is [sic] that the subprime issue is really a triple-a issue, either directly as a aaa subprime or indirectly in a aaa cdo. As a rough guide, over 90% of a subprime deal are in aaas. … And once you start downgrading bbb/bbb- you will ultimately be start [sic] downgrading aaas. And, in my view, that

Id. 8/19/2007 email from Tom Montag, “Mtg Department Weekly Update,” GS MBS-E-010681647. Id. Id. Not everyone at Goldman agreed that the risk of loss on AAA was “remote.” On July 29, 2007, Mr.

438

According to Mr. Birnbaum, a key reason for buying the AAA rated assets was that Mr. Birnbaum and others in the Mortgage Department wanted to maintain a large short position in ABX assets referencing BBB and BBB- rated RMBS securities, because they believed the ABX Index for those securities would fall even further. Mr. Birnbaum told the Subcommittee that covering the BBB/BBB- net short position in August would have amounted to leaving money on He explained that the Mortgage Department thought that buying a proportionate the table. amount of AAA ABX long positions could be used to offset the risks of continuing to hold the BBB/BBB- short until the ABX Index bottomed out.1810

1808

1809

On August 14, 2007, Mr. Sparks updated Goldman senior executives on the success of the Mortgage Department’s efforts to cover its shorts and added that the Department was interested in increasing its purchase of AAA rated RMBS securities: “we will likely come to you soon and say we’d like to get long billions[.]” responded: “We’re continuing to cover some shorts and we may cover some BBB with AAA, but I got the message clearly that we shouldn’t get long without Gary [Cohn]/Tom [Montag]/Don [Mullen] all saying OK.”1813

Senior executives reacted with skepticism.

Mr. Sparks

1811

1812

On August 20, 2007, Mr. Sparks pitched the idea again to Mr. Montag and other senior

executives in an email entitled, “Big Opportunity”:

“We are seeing large liquidations – we bought $350mm AAA subprime RMBS from … SIV unwinds today. … We think it is now time to start using balance sheet and it is a unique opportunity with real upside – specifically for AAA RMBS. We’ve sold over $100mm of what we bought today – most up 1-2 points.

That’s a great trade – buy and flip up 1-2 points, however, we’re not always going to be able to do that – and there’s the opportunity for us to make 5-10 points if we have a longer term hold.”1814

is a significant escalation of the subprime meltdown. … At its heart, the main shoe to fall will be when the rating agencies downgrade to the aaa level. I don’t see as they have much of a choice. Mez[zanine] aaa cdo trade in the 20 and 30s cannot be overlooked even by the agencies.” Id. 1808 Subcommittee interview of Joshua Birnbaum (4/22/2010). 1809 Id. 1810 Id. 1811 8/14/2007 email from Daniel Sparks, “Fw: Post,” GS MBS-E-010678053, Hearing Exhibit 4/27-30. 1812 See 8/14/2007 email from Gary Cohn to Daniel Sparks, “Fw: Post,” GS MBS-E-010678053, Hearing Exhibit 4/27-30 (“Talk to me before you go long.”); 8/14/2007 email from Tom Montag, “Post,” GS MBS-E-009741145 (“We will not be going long billions. Lots of risk to clean up first imo”). 1813 1814 Mullen, “Big Opportunity,” GS MBS-E-009739836. See also 8/20/2007 email exchange between Daniel Sparks and Tom Montag, “Hsbc loans,” GS MBS-E-010681855 (Mr. Sparks pitched the plan again to Mr. Montag separately: “As a overall business, we’re not short AAA’s anymore. We are putting on the long index (mostly AAA)/short single name mezz trade on …. We are planning to continue to play offense. . . . Discussions on the up the quality trade (top cap stack and top quality collateral) were had in various times with don [Mullen], gary [Cohn] and bill

8/15/2007 email from Daniel Sparks, “Post,” GS MBS-E-009740784, Hearing Exhibit 4/27-32. 8/20/2007 email from Daniel Sparks to Gary Cohn, David Viniar, Jon Winkelried, Tom Montag, and Donald

439

On August 21, 2007, Mr. Birnbaum presented the Mortgage Department’s plan to buy up to

$10 billion in AAA rated RMBS securities. intrinsic financial value of the proposed assets and to use those assets to preserve, rather than cover, the Department’s existing $3.5 billion BBB/BBB- net short:

The plan had dual objectives, to profit from the

1815

“– The mortgage department thinks there is currently an extraordinary opportunity for those with dry powder to add AAA subprime risk in either cash or synthetic form.

– We would like to be opportunistic buyers of up to $10Bln subprime AAAs in either cash or synthetic (ABX) form and run that long against our $3.5Bln in mezzanine subprime shorts.

– Mortgage dept VAR would be reduced by $75mm and Firmwide VAR would be reduced by $25mm.

– At current dollar prices, the implied losses at the AAA level are 2.5x higher than the implied losses at the BBB level where we have our shorts (the ratio is even cheaper for cash due to technicals). If AAAs were priced consistent with BBB implied loss levels, they would be trading 5-10pts higher in synthetics and 10-15 points higher in cash. …

– On the demand side, we plan to share this trade quietly with selected risk partners. We began doing so yesterday when we sold 1/3 of the AAAs purchased off the [seller] list to [customer] and 100% of the AAAs from [seller] to [customer] and [customer].”

1816

Mr. Montag responded that he wanted to discuss the concept further. “What are we holding against the 3.5b mezz shorts right now? Why don’t we just cover the shorts?” the idea but you[r] call.” the debate.

Co-President Gary Cohn emailed Messrs. Mullen, Winkelried, and Montag: “I do like

Before any further discussion took place, however, events overtook

Mr. McMahon wrote:

1817

1818

1819

[McMahon]. We aren’t going crazy with it, just being opportunistic. Before we get large, we are going to lay out a strategy for the four of you.”). 1815 8/21/2007 email from Joshua Birnbaum, “Potential large subprime trade and impact on firmwide VAR,” GS MBS-E-016359332, Hearing Exhibit 4/27-34; 8/21/2007 email from Joshua Birnbaum, “For 2 p.m. meeting,” GS MBS-E-010608145 (graphs in support of plan to go long up to $10 billion in AAA ABX index). 1816 Id. 1817 See 8/21/2007 email from Mr. Montag to Mr. Birnbaum, GS MBS-E-010682736 (“FYI. I think it would be much better for all concerned that we all discuss this and any strategy and have agreem[e]nt before we go to the presidents and cfo …. Secondly, I think we should be reducing our basis trades to reduce var as is …. Let’s sit down”). 1818 E-012606879. 1819 MBS-E-016359332, Hearing Exhibit 4/27-34

8/21/2007 email from Joshua Birnbaum, “Potential large subprime trade and impact on firmwide VAR,” GS

8/21/2007 email from Bill McMahon, “Potential large subprime trade and impact on Firmwide VAR,” GS MBS-

(e) “Get Down Now”

440

Despite direction from senior management to cover its $13.9 billion net short position, the Mortgage Department continued to maintain several large net shorts, including at least $3 billion in single name CDS contracts referencing BBB and BBB- rated RMBS securities that it expected to gain in profits. In August 2007, Co-President Gary Cohn finally issued an order to “get down now.”1820

Excessive VAR. By late August, a combination of the large net short and volatility in the

subprime mortgage market had driven the Mortgage Department’s VAR to an all-time high. When the AAA ABX short position was far out-of-the-money, it entailed little market risk, as it was not actively traded and had little likelihood of ever paying off. Once the AAA ABX short became profitable, however, the $9 billion position was so large that it had a major impact on the firm’s risk measurements. Even a small percentage change in $9 billion can cause substantial changes in a profit and loss statement. As Mr. Sparks explained: “The combination of our large AAA ABX index shorts and the relatively new volatility in the AAA part of the index will result in much larger daily swings in P&L [profit and loss] both ways.”

1821

As predicted, due to the $9 billion short, the Mortgage Department’s daily profit and loss

reports began to show much larger swings. it showed a loss of $100 million on August showed a profit of $71 million on July 21, 2007, 8. Mr. Birnbaum wrote to a colleague: “I’m sure the AAA ABX is being blamed as the reason the dept was down 100 yest[erday].”

Upon hearing of that loss, Mr. Montag asked “so who lost the hundy?”

While some in the Mortgage Department disagreed with the use of VAR as a

For example, while the Mortgage Department

1825

1822

1823

1824

1826

See id. (noting $50 million down trading day, followed by a day in which the AAA index accounted for half of

8/15/2007 email from Gary Cohn, “Trading VaR $165mm,” GS MBS-E-009778573.
7/21/2007 email from Daniel Sparks to Donald Mullen, Tom Montag, and others, “Mortgages Estimate,” GS

1820 1821 MBS-E-009640287. 1822 the day’s profit). 1823 1824 1825 Swenson explained that the approximately $100 million loss was split between the Residential Whole Loan Trading Desk, the SPG Trading Desk, and the CDO Origination Desk. Id. 1826

Id. 8/9/2007 email from Joshua Birnbaum to Deeb Salem, GS MBS-E-012927140. 8/8/2007 email from Tom Montag to Michael Swenson and David Lehman, GS MBS-E-011311633. Mr.

8/9/2007 email from Joshua Birnbaum to Deeb Salem, GS MBS-E-012927140.

441

measure of risk, short posed real risk to Goldman.

1827

the gyrations in daily profit and loss figures demonstrated that the $9 billion net

VAR depends primarily on the aggregate size of net asset positions and the volatility of the relevant market. Goldman was holding several large net short positions, the subprime market had become extremely volatile, and the Department’s efforts to cover its shorts further complicated matters. Although Goldman’s covering of its $9 billion net short AAA position would ordinarily be expected to reduce risk, the massive size of the position, combined with unprecedented levels of volatility in the market, the speed of Goldman’s covering, and the size of the trades involved, resulted in steep increases in the Department’s VAR.

The Mortgage Department’s VAR had increased from around $13 million in mid-2006,

well under the Department’s permanent limit of $35 million, to $85 million in February 2007, to a high of around $113 million in August 2007. Department’s $35 million permanent VAR limit by more than 350%. Moreover, the Mortgage Department, which had never contributed more than about 2% of firmwide net revenue prior to 2007, was generating some 54% of all the risk incurred by the firm in August 2007. The Mortgage Department’s risk level, however profitable, was of increasing concern from a firmwide perspective.1829

The $113 million figure exceeded the

1828

In an effort to maximize the profit potential from its net short positions, SPG personnel in

the Mortgage Department argued against indiscriminately covering all of the Department’s shorts. unpredictable.

But the Mortgage Department’s VAR level proved to be both intractable and highly It also contributed to record high levels of firmwide VAR, a figure carefully

1831

1830

8/9/2007 email from Joshua Birnbaum to Deeb Salem, “MarketRisk: Mortgage Risk Report (cob 08/08/2007),”

1827 GS MBS-E-012927200 (“These VAR numbers are ludicrous, btw. Completely overestimated for SPG trading, underestimated for other mortgage desks.”). See also 8/21/2007 email from Joshua Birnbaum to Bill McMahon, “Potential large subprime trade and impact on Firmwide VAR,” GS MBS-E-012606879 (“We have the 13.5Bln IO which makes us less short by $1-1.5 Bln ….”) (IO is an asset arising from differences in the duration and timing of CDS premium payment streams); 8/21/2007 email from Michael Dinias, “Trading VaR Analysis,” GS MBS-E- 009993267 (“the mortgage desk has questioned the size of the implied short exposure (i.e. desk believes they are less short than implied by the VaR model). We are reviewing the current VaR methodology with the mortgage traders/strategists and assessing the impact of various potential enhancements.”); Subcommittee interview of Joshua Birnbaum (10/1/2010). 1828 For more information on the Mortgage Department’s VAR levels, see below. 1829 On August 7, 2007, a senior risk executive wrote to Messrs. Cohn, Viniar, and McMahon: “We are doing a detailed analysis of mortgage and credit trading var contributors to see where we might get the most efficient var reduction.” 8/7/2007 email from Bruce Petersen, “VaR,” GS MBS-E-009775575. 1830 See, e.g., 8/21/2007 email from Joshua Birnbaum, “Potential large subprime trade and impact on firmwide VAR,” GS MBS-E-016359332, Hearing Exhibit 4/27-34 (favoring preservation of the $3.5 billion BBB/BBB- short). 1831 acutely sensitive to estimates of correlation implicit in the data used in the VAR computation: “[T]here will be days where ‘nothing happened’ – positions didn’t change, markets were quiet, but small changes in correlation will mean the difference between 140 and 160. It will really be difficult to explain to you and to the desks why we were under [VAR limits] yesterday but over today.” 8/15/2007 email from Robert Berry, “MarketRisk: End of Day Summary –

Risk controller Robert Berry explained to Messrs. Viniar, McMahon, and Broderick that VAR was becoming

442

monitored by the firm’s most senior management. The Mortgage Department and its risk controllers tried unsuccessfully to reduce the Department’s VAR, and were discussing new alternatives, same day that Goldman’s firmwide VAR hit a then-record high of $165 million, Mr. Cohn emailed the Mortgage Department’s senior managers, risk analysts and controllers: “There is no room for debate – we must get down now.”

when Goldman’s Co-President Gary Cohn intervened. On August 15, 2007, the

1833

1832

The Mortgage Department took immediate action. To reduce its VAR, the Department had

to sell at least some of its BBB/BBB- net short position. reported that Harbinger had bought a large block of single name CDS contracts shorting BBB/BBB- rated RMBS securities which allowed Goldman to take the long side: “We just printed $400mm of Singles with Harbinger. 130mm of BBB and 270mm BBB-.” Mr. Montag passed the message on to Messrs. Cohn and Viniar: “Finally actuall[y] covering singles.” Mr. Cohn responded: “Great.”

On August 23, 2007, Mr. Swenson

1834

1835

But even after that $400 million sale, Mr. Sparks reported to Mr. Montag: “[W]e are short Mr. Montag responded that the $3 billion net short position was

… about $3BB single names.” “huge and outsized” and $800 million had to be sold: “[I]f I make you sell a whopping 800 [million] out of 3 billion which is less than 30% how can anyone complain–the position is huge

1836

See, e.g., 8/15/2007 email from Michael Dinias, “Hedge Analysis cob 8/13/07,” GS MBS-E-010678553

cob 8/10/07,” GS MBS-E-009779885. Mr. McMahon responded: “var can swing between 140 and 160 without any changes in the complexion of our trading books – essentially it is just noise.” 8/15/2007 email from Bill McMahon to Gary Cohn and David Viniar, “Trading VaR $165mm,” GS MBS-E-009778573. 1832 (analyzing 6 potential VAR-reducing trading scenarios featuring different proposed transactions); 8/21/2007 email from Michael Dinias, “Trading VaR Analysis,” GS MBS-E-009993267 (analyzing the VAR-reducing impact of going long in various classes of assets); 8/22/2007 email from Daniel Sparks to Tom Montag and Donald Mullen, “VAR reduction possibilities,” GS MBS-E-010619824 (proposed transactions in single name CDS protection to reduce VAR). 1833 8/15/2007 email from Gary Cohn, “Trading VaR $165mm,” GS MBS-E-009778573. Mr. Viniar agreed. Two days earlier, after seeing a daily risk report showing Firmwide VAR at $159 million, Mr. Viniar emailed senior risk executives: “No comment necessary. Get it down.” 8/13/2007 email from David Viniar to Bill McMahon, Craig Broderick, and Robert Berry, “MarketRisk: End of Day Summary – cob 8/10/2007,” GS MBS-E-009779885. Even after Mr. Cohn’s order to “get down now,” Firmwide VAR continued to increase. On August 16, Firmwide VAR rose from $165 million to $171 million. 8/16/2007 email from Michael Dinias, “Trading VAR $171mm,” GS MBS- E-099775568. On August 17, it rose to $174 million. 8/17/2007 email to David Viniar, Gary Cohn, Jon Winkelried, Tom Montag, Bill McMahon, Craig Broderick et al., “Weekly Market Risk Summary as of 8/17/07,” GS MBS-E- 009756424. 1834 On August 22, 2007, Mr. Montag emailed Mr. Blankfein: “[W]e are covering a number of shorts in mortgages today and tomorrow–probably $1.5 billion worth–will reduce mortgages [VAR] hopefully to below 80.” 8/22/2007 email from Tom Montag to Lloyd Blankfein, “Trading VaR $144mm,” GS MBS-E-009605812, Hearing Exhibit 4/27-36. The next morning Mr. Montag emailed Mr. Blankfein that the Department “covered about 700 million in shorts in mtgs last night–500 million in single names . . . . lots more to go–but they fortunately had bought back 9 billion of AAA abx index over last two weeks.” 8/23/2007 email from Tom Montag to Lloyd Blankfein, GS MBS- E-009585951, Hearing Exhibit 4/27-37. 1835 1836

8/23/2007 email from Michael Swenson, “Harbinger Post,” GS MBS-E-009739009. 8/23/2007 email from Daniel Sparks, “Current Outstanding Notional SN ames,” GS MBS-E-010621231.

443

1837

At the end of the trading day on August 23, Mr. Montag asked Mr. Sparks:

and outsized.” “How much did we cover–shooting for $1 billion.” Mr. Sparks responded: “Not much more today – trying.”1838

Although the Mortgage Department did not cover its shorts as quickly as Mr. Montag

wanted, within days of Mr. Cohn’s August 15 order to “get down,” Goldman’s firmwide trading VAR had dropped by $40 million and the Mortgage Department’s VAR had dropped below $100 million. “The message got through.” Mr. Blankfein responded: “Good job.” Mr. Cohn wrote: “Down 40 in 2 days.”1840

On August 23, 2007, Mr. Cohn forwarded a VAR report to CEO Lloyd Blankfein:

1839

Although the Mortgage Department’s VAR measure fell substantially, it remained well

above its permanent risk limit of $35 million throughout the rest of 2007. Goldman senior executives rejected the Mortgage Department’s plan to buy $10 billion in AAA rated RMBS securities, the Department ultimately purchased over $2.2 billion in AAA rated RMBS securities positions through the end of 2007.

and continued to hold and strategically sell off its BBB and other short

In addition, although

1841

1843

1842

1844

12/2007 Quarterly Market Risk Review, GS MBS-E-009586222, Hearing Exhibit 4/27-54f (third quarter

Id. Goldman senior executives continued to monitor the Mortgage Department’s actions. For example, on

8/23/2007 email exchange between Gary Cohn and Lloyd Blankfein, “Trading VaR $133mm,” GS MBS-E-

Id. 8/23/2007 email exchange between Tom Montag and Daniel Sparks, “Current Outstanding Notional SN ames,”

1837 1838 GS MBS-E-010621324. 1839 009643469. 1840 August 31, 2007, Mr. Montag emailed Mr. Lehman: “abx hurting us today? Mkt over reacting?” 8/31/2007 email from Tom Montag, “Structured Products Weekly Update – 08/30/07 (Internal Use only),” GS MBS-E-009589083. Mr. Birnbaum responded: “Based on the markets we are making, we would be ok in this move. We are +50mm in AAAs alone right now.” Mr. Montag forwarded the emails to Mr. Blankfein who wrote: “Thanks. Appreciate the posts, I’m watching the financial news.” 1841 mortgages average VAR was $68 million; fourth quarter mortgages average VAR was $75 million). 1842 Subcommittee interview of Joshua Birnbaum (4/22/2010). 1843 8/21/2007 email from Michael Swenson, “Mortgage Commentary for Firmwide Risk Committee,” GS MBS-E- 010619375 (“Current SPG Trading Desk Position Summary: – RMBS AAA – long $2.2bb”); Michael J. Swenson, responses to Subcommittee QFRs at PSI_QFR_GS0474.
1844 position in the residential sector.” 12/7/2007 email to David Viniar, “Weekly Market Risk Summary as of 12/06/07,” GS MBS-E-009708911, Hearing Exhibit 4/27-53. See also 9/5/2007 email from Michael Swenson to Tom Montag, “ABS Update,” GS MBS-E-012386239, Hearing Exhibit 4/27-39; 9/23/2007 email to David Viniar, “Mortgage P&L for the Week Ended 9/21,” GS MBS-E-009732431, Hearing Exhibit 4/27-43 (Finance division reported that, in week of September 21, the Mortgage Department reported $63 million from “short synthetic positions including SPG Trading (+$40M), CDO (+22M) and Residential Credit (+12M).”).

Subcommittee interview of David Viniar (4/13/2010); Subcommittee interview of Daniel Sparks (4/15/2010);

In the week of December 6, 2007, the Mortgage Department’s risk managers noted “an increase in net short

(f) Profiting from the Big Short: Making “Serious Money”

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Goldman’s short positions continued to produce profits for the firm, as mortgage related

assets continued to lose value. In September 2007, one of the key traders in the Mortgage Department, Deeb Salem, summarized four key short-side trading strategies that enabled the Mortgage Department to profit from the collapse of the subprime mortgage market:

1845

(a)

(b)

(c)

(d)

a “dispersion trade,” in which Goldman took advantage of “mispriced” single name CDS contracts that referenced very poorly performing RMBS securities, but were not priced much lower than better performing RMBS securities, resulting in profits of $750 million “so far”;

a massive purchase of single name CDS contracts referencing a variety of RMBS securities, taking advantage of Goldman’s estimated 33% “dominant” market share in single name CDS to make a “HUGE directional bet” against the subprime mortgage market, resulting in profits of $1.7 billion;1846

the purchase “at a discount” of single name CDS contracts referencing Alt A and A rated RMBS securities, which “others don’t want/know where to price,” resulting in profits of $400 million “so far”; and

the purchase of single name CDS contracts on A, AA and AAA rated CDO securities “in size,” amassing an “enormous” market share whose profits had “exceeded all of our high expectations” at $900 million “so far.”1847

1845 1846 1847

Salem 2007 Self-Review. Id. [emphasis in original]. Id. Mr. Salem described the trading strategies as follows:

“a. The Dispersion Trade More than a year ago, Edwin [Chin] and I realized that the dispersion amongst single-name subprime CDS was grossly mispriced. Bad names (tier 4), that the market almost universally disliked traded only 50 bps wider than securities that we all agreed were superior. … So for the past year, we bought protection on tier 4 names at every chance possible . . . When we wanted to flatten out the book, we just wrote protection on the tier 1 names. Amazingly we did this for most of the year without a usable model to value different single names. … We were very aggressive with pricing and only shared risk with smart guys if they gave us insight on names to go short or go long in return. Even when the dispersion widened out … by the end of February, Edwin and I refused to monetize the trade …. With 3-4bb of notional in this dispersion trade, we have recognized $750mm of P&L so far on this trade.

“b. Our single name market share: Having traded over $200bb of notional in SN [single name] CDS, GS is the dominant market-maker in single name CDS. We approximate our market share to be greater than 33%. … This market share and willingness to trade size proved invaluable in November, December and January when we decided to make the HUGE directional bet of being long SN CDS protection [or “short risk,” i.e., taking the short side of a CDS transaction]. … If we did not have such presence in the SN CDS market, it is unlikely that we would have achieved the size short that we desired and eventually put on. We’re up $1.7bb in RMBS SN CDS!

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In October 2007, after the credit rating agencies downgraded hundreds of CDO

1848

securities, Mr. Swenson wrote to Mr. Mullen that the downgrades would eventually cause defaults in many CDO securities that Goldman had shorted, meaning that Goldman’s “CDS protection premiums paid out will go to zero,” payments on those CDOs from the long parties. Mr. Mullen responded: “Looks like we’re going to make some serious money.” Mr. Swenson replied: “Yes, we are well-positioned.”

and Goldman would receive substantial CDS

1849

1850

Indeed, the Mortgage Department made $110 million the very next day.

1851

Mr. Swenson

explained: “65mm was from yesterday’s downgrades which lead to the selloff.” Mr. Mullen replied: “Great day!” approximately $3.7 billion in net revenues from its SPG Trading Desk.1853

By the end of 2007, the Mortgage Department had brought in

1852

(g) Goldman’s Records Confirm Large Short Position

In addition to contemporaneous emails, presentations, and reports, Goldman’s large net short position is reflected in its own financial records, including its Mortgage Department Top Sheets.

Goldman’s Mortgage Department kept records of its overall net short positions across

1854

“c. Willingness to put on trades that others don’t want/know where to price The 2 most successful trades in this regard have been our $70mm long Alt-A protection and our $1-2bb long sub- prime Single-A protection [i.e., being “short risk” or taking short side in a CDS transaction]. When CDOs wanted to sell Alt-A and single-A protection … the rest of the street was tentative. … We viewed this as a tremendous opportunity to buy cheap out-of-the-money options at a significant discount to fair-value. Our exit strategy was always that if sub-prime fundamentals got bad enough, and they did, that the contagion would have to spread up the capital structure because cum loss vol/uncertainty has to go up thus. . . .$400mm so far for the desk ….

See, e.g., 10/11/2007 email from Michael Swenson to Donald Mullen, “Early post on P and L,” GS MBS-E-

“d. CDO CDS trade: This trade has made $900mm so far, which exceeded all of our high expectations for the trade. I had the confidence and desire for the desk to buy A, AA, and AAA CDO CDS protection in size during the fall of 2006 for several reasons: … [T]he rating agencies’ correlation assumptions were out of whack with the growing concern about the housing market and the remarkable similarity between the bonds in a CDO, the difficulty that GS was having in placing such mezzanine liabilities and the complexity of such securities scared hedge funds from buying the protection themselves. Edwin and I used the same aggressive strategies in purchasing protection that we used to dominate the SN CDS market. Our market share was enormous … and we did every … trade possible.” Id. 1848 016031234, Hearing Exhibit 4/27-69. For more information about this downgrade, see Chapter V. 1849 1850 1851 Hearing Exhibit 4/27-68. 1852 1853 Goldman chart, “Mortgages Weekly Metrics 16-November-2007,” GS MBS-E-015863620 (“P&L YTD Annl 3,742,461”). 1854 $ Billions,” chart prepared by the Subcommittee, Hearing Exhibit 4/27-162 (compiled from Top Sheets); examples of Top Sheets include GS MBS-E-010369585 and GS MBS-E-010850895, Hearing Exhibit 4/27-162.

Id. Id. 10/12/2007 email exchange between Michael Swenson and Donald Mullen, “P and L,” GS MBS-E-018936577,

Id. See 10/3/2007 Goldman presentation, “SPG Trading – 2007,” GS MBS-E-015654036. See also 11/16/2007

See, e.g., 4/2010 “Goldman Sachs Mortgage Department Total Net Short Position, February - December 2007 in

446

various subprime asset classes on a daily basis throughout most of 2007. that the Mortgage Department had large net short positions in the subprime mortgage market throughout most of 2007. Goldman’s documents reveal that it had a $10 billion net short position at the end of February 2007, and a $13.9 billion net short position in mid-June 2007.1856

Those records indicate

1855

(i) Top Sheets

Daniel Sparks told the Subcommittee that, in 2006 and earlier, he was frustrated because he

felt Goldman had inadequate systems to track and aggregate the daily positions of the various desks in the Mortgage Department. At the end of each trading day, he had to review up to a dozen separate reports from the desks to develop a composite mental picture of the Mortgage Department’s overall positions. To remedy this shortcoming, in February 2007, Mr. Sparks and the Department’s strategic analysts, sometimes called “strats,” developed a single-page report called the Mortgage Department Top Sheet.

1858

1857

The Mortgage Department Top Sheet became the primary report through which the

Mortgage Department tracked its daily positions in various classes of mortgage related assets. It provided a comprehensive listing of the Mortgage Department’s long and short positions in different asset classes across all desks at the end of each trading day. The Top Sheet drew data from up to a dozen separate reports generated by Goldman’s electronic systems. Mr. Sparks told the Subcommittee that the Top Sheet evolved over time to become a good tool that provided a comprehensive record of the Department’s positions. Subcommittee that Goldman did not maintain any other type of comprehensive daily report regarding the Mortgage Department’s net positions in various asset classes.

The Goldman Controller’s office told the

1860

1859

Subcommittee interview of Daniel Sparks (4/15/2010). Id.; 2/26/2007 email to Daniel Sparks, Michael Swenson, and others, “New cross desk Top Sheet risk report,”

Subcommittee interview of Daniel Sparks (4/15/2010). Subcommittee discussions with Goldman Controller staff on Responses to Questions for the Record and related

Id. See 2/26/2007 Mortgage Department Top Sheet, GS MBS-E-010388545, and 6/25/2007 Mortgage Department

1855 1856 Top Sheet, GS MBS-E-010850895, Hearing Exhibit 4/27-162. 1857 1858 GS MBS-E-010386051. 1859 1860 documents. Despite the fact that the Mortgage Department Top Sheet was the primary comprehensive position report available to Mortgage Department managers, some more senior Goldman executives appeared to be unaware of its existence. Chief Risk Officer Craig Broderick, for example, testified that he was unaware of a Mortgage Department Top Sheet and he thought the “top sheet” concept might not be suitable for the Mortgage Department. Subcommittee interview of Craig Broderick (4/9/2010). His risk office produced its own daily risk reports that translated the Mortgage Department’s electronic trading data directly into risk measures, such as “VAR.” Id.; see also, e.g., 8/9/2007 email from risk manager, “MarketRisk: Mortgage Risk Report (cob 08/08/2007),” GS MBS-E- 010674894 (attached Goldman report, “Mortgage Risk Report – 8/9/07,” GS MBS-E-010674895). The Controller’s office also produced its own reports based on the Mortgage Department’s electronic trading data, such as the daily profit and loss report for the Mortgage Department. Subcommittee discussions with Goldman Controller staff on responses to Subcommittee QFRs and related documents. See also 7/20/2007 email from controllers, “Mortgages Estimate,” GS MBS-E-009640287.

447

The Top Sheet was literally the top sheet, or cover page, to a comprehensive report

distributed daily to Mr. Sparks and other Mortgage Department managers. Top Sheet listed the aggregate total amounts held by the Mortgage Department in various asset classes, including AAA, AA, BBB, and BBB- rated assets. During most of 2007, the Top Sheet also provided an overall net short or long figure that summed across the top line totals for each of the respective asset classes, providing an overall figure by which the Mortgage Department was net long or net short across all asset classes each day. By plotting this overall net figure for each daily Top Sheet, the Subcommittee developed a graph of the Mortgage Department’s net position during 2007, as indicated on the chart on the following page.1863

The top line of the

1861

1862

[SEE CHART NEXT PAGE: Goldman Sachs Mortgage Department Total Net Short Position, prepared by the Permanent Subcommittee on Investigations.]

2/26/2007 email to Daniel Sparks, Michael Swenson, and others, “New cross desk Top Sheet risk report,” GS

1861 MBS-E-010386051. The Mortgage Department shared its Top Sheet and several sub-reports for September 25, 2007, with Mr. Viniar around October 1, 2007, in a presentation that summarized the changes in the Mortgage Department’s long/short positions across all desks and all assets since the initiation of the Gameplan in May 2007. 10/1/2007 Goldman internal document, “September Risk Pack Viniar,” GS MBS-E-013693128 (attached to 10/1/2007 email, “Viniar Risk Pack - Sept,” GS MBS-E-013693127).
1862 The balance of the page provided detail regarding the amount of each asset class held by each of the Mortgage Department’s desks or business units. Behind the top sheet, the report provided detailed data regarding the various desks and provided different data analyses, such as changes in position from week to week. The last page of each report listed all of the electronic data sources and separate reports from which the Top Sheet was compiled. See, e.g., 2/5/2007 Mortgage Department Top Sheet, GS MBS-E-010369585, Hearing Exhibit 4/27-162. 1863 $ Billions,” prepared by the Permanent Subcommittee on Investigations, Hearing Exhibit 4/27-162 (April 2010 version), updated January 2011 (updated version), derived from Goldman Sachs Mortgage Strategies, Mortgage Dept Top Sheets provided by Goldman Sachs (hereinafter “PSI Net Short Chart”).

See chart entitled, “Goldman Sachs Mortgage Department Total Net Short Position, February-December 2007 in

Goldman Sachs Mortgage Department Tot al Net Short Position, February - December 2007 in S Billions

(Market Value, Including All Synthetic and Cash Positions in Mortgage Related Products)

5.0

0.0

2/ /07

3/5/07

4/5/07

5/5/07

6/5/07

7/5/07

8/5/07

9/5/07

10/5/0

11/5/07

12/5/07

-5.0

-10.0

-15.0

Prepared by the U.S. Senate Permanent Subcommittee on Investigations, April 2010. Updated January, 2011. Derived from Goldman Sachs Mortgage Strategies, Mortgage Dept Top Sheet s provided by Goldman Sachs.

449

The Subcommittee’s net short chart is generally consistent with a Goldman chart that Mr. Birnbaum asked one of the Mortgage Department’s analysts to prepare for him in August 2007, which can be seen on the following page.

[SEE CHART NEXT PAGE: RMBS Subprime Notional History, prepared by Goldman Sachs.]1864

The “zero” line in the middle of the chart represents a neutral trading position that is neither net long nor net short. To use Mr. Viniar’s description, the zero line represents “home.” The area below the zero line represents net short positions; the area above the line represents net long positions. The chart shows that the Goldman Mortgage Department was net short throughout 2007, with a total net short position that reached $13.9 billion in July.

8/17/2007 Goldman internal chart, “RMBS Subprime Notional History (Mtg Dept - ‘Mtg NYC SPG

1864 Portfolio’),” GS MBS-E-012928391, Hearing Exhibit 4/27-56a. The title of the Goldman chart, “NYC SPG Trading” is confusing, as Mr. Birnbaum asked the analyst, Kevin Kao, for a chart of all synthetic positions across the entire Mortgage Department (including areas other than SPG Trading). In an email to Mr. Birnbaum, Mr. Kao confirmed that despite the title, the chart actually included all synthetic positions across the entire Mortgage Department, and not just the SPG Trading Desk positions. 8/17/2007 email from Mr. Kao to Mr. Birnbaum, GS MBS-E-012929469. Mr. Kao explained that his chart did not include cash positions, meaning long positions in mortgage loans or RMBS from any remaining warehouse inventory. Id. That omission was not significant, however, since Goldman had rapidly sold off the vast bulk of its cash inventory starting in November 2006. 4/2010 “Goldman Sachs Long Cash Subprime Mortgage Exposure, Investments in Subprime Mortgage Loans, and Investments in Subprime Mortgage Backed Securities November 24, 2006 vs. August 31, 2007 - in $ Billions,” chart prepared by the Subcommittee, Hearing Exhibit 4/27-163. In any event, the Subcommittee’s net short chart includes the Department’s cash positions and demonstrates that any long cash positions were insufficient to offset the shorts, as the Mortgage Department was massively net short throughout most of 2007. See PSI Net Short Chart.

In his Supplemental Responses to Questions for the Record from the Subcommittee, Mr. Birnbaum

conceded that the Subcommittee’s net short chart includes cash positions and therefore fixed the problem of being limited to synthetics as was the case with Goldman’s own net short chart. See 8/17/2007 Goldman internal chart, “RMBS Subprime Notional History (Mtg Dept - Mtg NYC SPG Portfolio),” GS MBS-E-012928391, Hearing Exhibit 4/27-56a; Birnbaum responses to Subcommittee QFRs at PSI_QFR_GS0509. Mr. Birnbaum maintained his objection that the Subcommittee’s net short chart improperly summed the notional amounts of different asset classes. Id. However, as noted in the text, the Mortgage Department’s Top Sheet actually converted the notional amounts of each asset class into their market values, making it fair to sum across all asset classes.

Some Goldman representatives told the Subcommittee that they objected to both the

451

For example, in a 2010 interview with the Subcommittee, Mr. Birnbaum

Subcommittee’s net short chart, and Goldman’s own similar chart, on the grounds that the charts are too simplistic and fail to account for the relative “weight” or value of short positions in differing asset classes. said that because of their differing “weights” or values relative to one another, the notional amounts in each asset class could not simply be summed up together. For example, he said the notional amount of AAA assets cannot be added to the notional amount of BBB assets, because the market assigns each of those positions different weights or values relative to each other. said that these relative weights or values are often expressed as specific “hedge ratios” which Goldman traders can call up on their computer screens in real time to tell them, for example, the amount of AAA assets they should buy long to hedge a given net short position in BBB assets.

1867 Each class also poses a different level of risk than the others. For example, short positions in AAA assets were relatively inexpensive, as the risk of loss in that tier was considered relatively low, while short positions in BBB assets would have higher prices, because the risk of loss was considered high. Mr. Birnbaum said the only chart of Goldman’s net short position that he would accept as fairly representative would be one that was “Beta-adjusted” to account for differences in the relative weights, but he admitted that he was unaware of any such charts or reports created by Goldman during 2007. Without considering these relative weights (which continually change based on market price movements in various asset tiers), Mr. Birnbaum said it would be impossible to say that Goldman was ever “net short” at all or in what amount.1869

1866

1865

1868

Goldman’s own documents provide a different picture, however. The Top Sheet was the primary comprehensive record used by the Mortgage Department to track all net positions across the Mortgage Department. Goldman did not keep any other records that identified the Mortgage Department’s net positions in various asset classes, and did not keep any records that used the “Beta-adjustment” method advocated by Mr. Birnbaum. By early March 2007, the Top Sheet generally expressed the market values of positions in different asset classes, rather than the

1870

Subcommittee interview of Joshua Birnbaum (10/1/2010); Subcommittee interview of Michael Swenson

See Birnbaum responses to Subcommittee QFRs at PSI_QFR_GS0509. Subcommittee interview of Joshua

1865 Birnbaum (10/1/2010).
1866 (10/8/2010). 1867 Subcommittee interview of Joshua Birnbaum (10/1/2010). 1868 Id. 1869 Id. Mr. Swenson made similar statements in his second Subcommittee interview. “Were we ever net short? It’s hard to say what ‘net short’ means really.” Subcommittee interview of Michael Swenson (10/8/2010). Mr. Swenson had no such difficulty, however, in his first Subcommittee interview. When asked the greatest amount by which he remembered his desk being net short, Mr. Swenson replied: “$9 billion.” Subcommittee interview of Michael Swenson (4/16/2010). 1870 As noted above, the risk management and controller areas at Goldman kept their own daily reports based on the Mortgage Department’s electronic trading data, but they did not track Goldman’s aggregate positions in each asset class on either a notional or market value basis. Rather, the risk area converted the Mortgage Department data into risk measures, while the controllers’ area converted the data into profit and loss reports. Though based on the Mortgage Department’s reported daily trading, these reports did not directly reflect specific net positions in subprime mortgage assets.

452

1871

notional amount of the positions. By using the market values of positions in each asset class on a given day, the Mortgage Department did, in fact, create a reasonable method for summing across all asset classes in a single common denominator – the amount of cash the assets would bring in the market that day. Since the Subcommittee’s net short chart relies on the Department’s daily Top Sheet figures as expressed in market values rather than notional amounts, it does not suffer from the incompatibility defect pointed out by Mr. Birnbaum.

Mr. Birnbaum’s position that the notional amounts of each asset class cannot be summed up together is also inconsistent with what Goldman’s Mortgage Department did on a day-to-day basis in 2007. Mr. Sparks, the Mortgage Department head who helped design the Top Sheet, used it to measure the Department’s daily position. Mortgage Department personnel and other Goldman executives also discussed the Department’s being “net short”– either overall or in specific asset classes – on a daily basis.

1872

Indeed, the phrase “net short” appears more than 3,400 times in the documents produced to

1873

the Subcommittee by Goldman. Since Mr. Birnbaum claimed that one could never really say whether Goldman was truly “net short,” the Subcommittee asked him why the phrase “net short” appeared so many times in Goldman’s documents. Mr. Birnbaum said that the use of the phrase “net short” was a “shorthand” that was used internally in the Mortgage Department. In fact, neither Mr. Birnbaum, Goldman, nor the Subcommittee could identify any specific document or instance from 2007 in which the weighting exercise advocated by Mr. Birnbaum in his September 2010 interview was ever used or suggested.

1874

Aside from the Top Sheet that summed up totals across different asset classes to obtain an

aggregate total, there are also many documents in which Goldman personnel described the total amounts by which Goldman was net short in respective asset classes. For example, Mr. Swenson, and later Mr. Lehman, compiled an email summary each week that described each Mortgage Department desk’s net position in different asset classes. A typical format was as follows:

“Current [SPG Trading] Desk Position Summary:

•

RMBS Single-As - net short 900mm 100% in single-name CDS

See e.g., 3/5/2007 email from Daniel Sparks to Tom Montag and others, GS MBS-E-010646842 (“We think the

1871 In general, positions were expressed in market values for all liquid assets and in “hedge equivalents” of illiquid assets, meaning the market value of a position that could be used to hedge that asset. See e.g., 3/5/2007 Mortgage Department Top Sheet, GS MBS-E-010630691 (Legend: “Market Value (MM$)(Hedge Equiv MV for CDS)”); 9/11/2007 email, GS MBS-E-010690522, attaching 9/10/2007 Mortgage Department Top Sheet, GS MBS-E- 010690523 (“Market value of bonds/loans, bond equiv mkt val for synthetics.”). 1872 overall business is net short”); 3/8/2007 email from Daniel Sparks to Jon Winkelried and others, “Mortgage Risk,” GS MBS-E-002211242 (“We are still net short”); 7/21/2007 email from Daniel Sparks to Donald Mullen and others, “Mortgages Estimate,” GS MBS-E-009640287 (“There is also a large net short that we are chipping away to cover”). 1873 1/10/2011 Concordance search of all documents produced to the Subcommittee by Goldman for the phrase “net short.” 1874

Subcommittee interview of Joshua Birnbaum (10/1/2010).

453

•

• •

RMBS BBB/BBB- - net short 3,000mm (80% in single-name CDS - 50% 2005 vintage Correlation Desk - net short $400mm of ABX 06-1 BBB and BBB- Mortgage Department short approx $4bb AAA ABX”1875

Mr. Swenson’s email summaries were forwarded to Mr. Montag and other senior executives to keep them apprised of the Department’s positions. aggregate overall net short position for the Mortgage Department, they did establish net short positions in each of the various specific asset classes described, and they were apparently acceptable to and relied upon by various Goldman executives. Throughout most of 2007, these weekly reports clearly show very large net short positions in mortgage related assets.1877

While these documents did not provide an

1876

Email correspondence among Goldman’s senior executives also routinely referred to the

Mortgage Department’s net short positions in “billions.” Subcommittee that a loss (or gain) in the amount of even $25 million was considered “large” and would immediately be brought to his attention. from the Mortgage Department’s net short positions in the third quarter of 2007 would have been considered significant and monitored by senior management, as indeed they were.

By that standard, net revenues of $2 billion

CFO David Viniar told the

1878

1879

In testimony before the Subcommittee and other public statements, Goldman attempted to

minimize the size of its net short position by suggesting to the Subcommittee that the short positions held by the Mortgage Department were hedges for other, unidentified long assets. 1880 Blankfein even made that argument to his colleagues in September 2007: “The short position wasn’t a bet. It was a hedge.” But Mr. Birnbaum contradicted that position just a few days later. On October 4, 2007, Mr. Birnbaum prepared on behalf of the SPG Trading Desk a

1881

Mr.

8/5/2007 email from David Lehman to Tom Montag, “Mtg Department Weekly Update,” GS MBS-E-

1875 010671564. 1876 Id. 1877 Id. 1878 See, e.g., 8/23/2007 email from Tom Montag to Daniel Sparks, “Current Outstanding Notional in SN ames,” GS MBS-E-010621231 (Mr. Montag said, “so if I make you sell a whopping 800 out of 3 billion which is less than 30% how can anyone complain- -the position is huge and outsized.”); 3/14/2007 email from Tom Montag to Lloyd Blankfein, “Cactus Delivers,” GS MBS-E-009632839 (“Covered another 1.2 billion in shorts in mortgages”); 8/23/2007 email from Tom Montag to Gary Cohn and David Viniar, “Harbinger post,” GS MBS-E-009739009 (“We had bought back almost 9 billion of aaa abx over last two weeks though”); 2/27/2007 email from Richard Ruzika to Tom Montag, GS MBS-E-002204942 (“I want to see us getting the short down to 4.5 bil[lion] net”). 1879 Subcommittee interview of David Viniar (4/13/2010). 1880 See, e.g., Testimony of David Viniar, April 27, 2010, Subcommittee Hearing at 98, 99-100; 4/7/2010 Blankfein & Cohn Letter to Shareholders (quoted in 4/2010 Goldman report, “Risk Management and the Residential Mortgage Market,” at 12, Hearing Exhibit 4/27-161). 1881

Mr. Blankfein went on to explain what he meant by “hedge”: “Ie, the avoidance of a bet. Which is why for a part it subtracted from var, not added to var.” Mr. Blankfein did not explain the “part” in which the big short subtracted from VAR. In February and August 2007, most of Goldman’s senior management expressed concern that the large net short positions added to VAR, rather than subtracted from it, and indeed, pushed the firmwide VAR to record levels.

9/26/2007 email from Lloyd Blankfein, “Fortune: How Goldman Sachs Defies Gravity,” GS MBS-E-

454

presentation entitled, “SPG Trading – 2007,” in which he advocated that SPG Trading Desk personnel should be compensated like hedge fund managers and not as ordinary participants in Goldman’s traditional bonus pool system. anticipate and refute counter-arguments that might be made by Goldman senior executives, explicitly addressed and rejected the contention that the profitable net short positions managed by the SPG Trading Desk were hedges for long assets held by other desks. Mr. Birnbaum, one of the chief architects of Goldman’s big short, stated:

The presentation, which Mr. Birnbaum prepared to

1882

“By June [2007], all retained CDO and RMBS positions were identified as already hedged. … SPG trading re-initiated shorts post BSAM [Bear Stearns Asset Management] unwind on an outright basis with no accompanying CDO or RMBS retained position longs. In other words, the shorts were not a hedge.”

(Emphasis in original).

1883

In response to Questions for the Record from the Subcommittee, Mr. Birnbaum once again stated that SPG Trading initiated the “shorts on an outright basis with no accompanying CDO or RMBS retained position longs following the Bear Stearns Asset Management unwind in 2007, and that these positions were not a hedge.”1884

Mr. Birnbaum’s statement that “all retained CDO and RMBS positions were identified as

already hedged” by June 2007 is also supported by other documents provided by Goldman’s Mortgage Department. On February 28, 2007, for example, David Rosenblum, Co-Head of the CDO/CLO Origination Desk, initiated a project to ensure that all of the CDO Origination Desk’s warehouse accounts were “fully hedged.” As a result, the CDO Origination Desk initiated new hedges and specifically allocated others to cover all the desk’s warehouse risk. Learning of these actions, Mr. Rosenblum responded: “Great. Getting pretty nailed down.” February 12, 2007 email, Mr. Sparks reported to senior management: “Loan and residual books flat,” and indicated that the Department’s long positions were fully hedged with the short ABX

In addition, in a

1886

1885

10/3/2007 Goldman presentation, “SPG Trading – 2007,” GS MBS-E-015654036. Mr. Swenson and Mr.

1882 Lehman reviewed and commented upon the “SPG Trading – 2007 ” presentation. Mr. Birnbaum revised the presentation to make the changes Mr. Swenson and Mr. Lehman suggested. See, e.g., 10/2/2007 email from David Lehman to Joshua Birnbaum, “SPG Trading - 2007.ppt,” GS MBS-E-015653681 (providing comments and suggesting text for presentation). Mr. Birnbaum replied and copied Mr. Swenson on the email chain as well: “I added your bullet and one more.” Id. See also 10/4/2007 email from Joshua Birnbaum to Michael Swenson and David Lehman, “How’s this?,” GS MBS-E-015712249 (forwarding revised bullet point for presentation). This collaboration indicates the presentation was made on behalf of the SPG Trading Desk as a whole. Mr. Birnbaum, however, told the Subcommittee that the SPG Trading Desk ultimately did not use the presentation in connection with its proposal for 2007 compensation. See Birnbaum responses to Subcommittee QFRs at PSI_QFR_GS0509. 1883 1884 1885 first thing in the morning,” GS MBS-E-001800707; 2/28/2007 email from David Rosenblum,“Hedges Status Report,” GS MBS-E-002640538 (new ABX hedges added and other hedges allocated to ensure that CDO warehouse risk was fully hedged). 1886

10/3/2007 Goldman presentation, “SPG Trading – 2007,” GS MBS-E-015654036 [emphasis in original]. See Birnbaum responses to Subcommittee QFRs at PSI_QFR_GS0509. 2/28/2007 email from David Rosenblum to Peter Ostrem, “Pete– pls send me cob 2/28 MTM for SP CDO WH’s

Id.

455

1887

In a third example, after conclusion of the CDO valuation project, all of the

positions. remaining CDO assets were transferred from the CDO Origination Desk to the SPG Trading Desk in May 2007. Even after the transfer of those long assets, the SPG Trading Desk remained short, suggesting again that the CDO assets may have already been hedged. documents all support Mr. Birnbaum’s statement that all retained CDO and RMBS positions were identified as already hedged when the SPG desk started rebuilding its net short position in June 2007.

These Goldman

1888

(ii) Risk Reports

The Mortgage Department’s large net short positions were also demonstrated by the periodic risk reports that recorded Goldman’s key risk measure, “Value at Risk” or “VAR,” throughout 2007. At a 95% confidence level, VAR represents the dollar amount a business unit, here the Mortgage Department, could expect to make or lose once every 20 trading days – or about once a month.

1889

The Mortgage Department’s VAR skyrocketed during 2007, climbing far beyond the

Mortgage Department’s permanent VAR limit of $35 million and hitting a record high of $113 million in mid-August 2007. In 2007, with notable exceptions discussed below, whenever the Mortgage Department’s trading exceeded its risk limits, Goldman’s risk managers simply assigned the department a new, higher “temporary” risk limit to accommodate the Department’s trading.1891

1890

At the same time, the higher VAR did signal the presence of a large net short position and functioned to limit the size of that position. Twice during 2007, in late February and again in late August, Goldman’s senior executives ordered the Mortgage Department to reduce its large short positions in order to bring the firm’s overall VAR measure down. The senior executives were aware of the Mortgage Department’s large net short positions, in part, because those positions had contributed to increases in Goldman’s firmwide or trading VAR.

1892

See Mortgage Department Quarterly Average VAR. (Third Quarter 2006 - $13 million; Fourth Quarter 2006 -

2/12/2007 email from Daniel Sparks, “Post today,” GS MBS-E-002202310. Id.; PSI Net Short Chart.
Subcommittee interview of Craig Broderick (4/9/2010). See also Philippe Jorion, “Value at Risk: The New

1887 1888 1889 Benchmark for Managing Financial Risk,” at 20, (3d ed. 2007). 1890 $14 million; Second Quarter 2007 - $63 million; Third Quarter 2007 - $68 million; Fourth Quarter 2007 - $75 million). See 9/2007 Quarterly Market Risk Review, “Market Risk Management and Analysis,” GS MBS-E- 009590673, Hearing Exhibit 4/27-54e; see also 12/2007 Quarterly Market Risk Review, “Market Risk Management and Analysis,” GS MBS-E-009586222, Hearing Exhibit 4/27-54f. 1891 GS MBS-E-012927202. 1892 from Gary Cohn, “Trading VaR $165mm,” GS MBS-E-016344758; Subcommittee interview of Joshua Birnbaum (10/1/2010).

8/9/2007 email from Joshua Birnbaum to Deeb Salem, “MarketRisk: Mortgage Risk Report (cob 08/08/2007),”

2/27/2007 email from Richard Ruzika to Tom Montag and others, GS MBS-E-002204942; 8/15/2007 email

456

The firm tolerated the exceptionally high levels of VAR generated by the Mortgage

1893

Department, despite the risks reflected in those high VAR levels. market rallied, the Mortgage Department incurred huge losses from its net short position that were immediately reported up the chain to senior management. For example, upon hearing of a $100 Mr. Viniar told million loss in a single day, Mr. Montag asked: “Okay, who lost the hundy?” 1894 the Subcommittee that he was notified of even a $25 million loss in a single day. Allowing the 1895 Mortgage Department to maintain high VAR levels meant that Goldman’s large net short positions left the firm exposed to large losses, which in some instances did occur, though not as often as its VAR predicted they might.1896

On the few days when the

Risk Management at Goldman. Every business unit and trading desk at Goldman had a counterpart in the firm’s risk management area. Risk managers were assigned to “shadow” the relevant business unit and trading desk operations to ensure that their respective trading activities did not exceed pre-determined risk limits. and for each division. The division then allocated its VAR limit among each department or

Separate VAR limits were set for the firm as a whole

1897

1898

Subcommittee interview of Craig Broderick (4/9/2010). 8/8/2007 email from Tom Montag to David Lehman and Michael Swenson, GS MBS-E-011311633. Subcommittee interview of David Viniar (4/13/2010). Mr. Birnbaum frequently argued that VAR, or at least Goldman’s then-current model of VAR, was an

1893 1894 1895 1896 inappropriate risk measure for the Mortgage Department’s shorting activities. 8/9/2007 email from Joshua Birnbaum to Deeb Salem, “MarketRisk: Mortgage Risk Report (cob 08/08/2007),” GS MBS-E-012927200 (“These VAR numbers are ludicrous, btw. Completely overestimated for SPG trading, underestimated for other mortgage desks.”). He contended that for various reasons, the Mortgage Department was not actually as short as the VAR measure reflected. See, e.g., 9/26/2007 2007 MD Reviews, Joshua Birnbaum Self-Review, GS-PSI-01956, Hearing Exhibit 4/27-55c. In arguing for a special compensation model for the SPG Trading Desk, Mr. Birnbaum pointed out that the desk never lost as much money as the firm’s VAR measure predicted it would. 10/3/2007 Goldman presentation, “SPG Trading – 2007,” GS MBS-E-015654036. Accordingly, Mr. Birnbaum may have been correct that the firm’s VAR measure did not accurately measure risk to the firm. Id. On the other hand, since VAR rests on probability theory which is based on a “normal” distribution of profits and losses (the typical “bell curve”), the Mortgage Department may have benefitted from the extraordinary and continual one-way movement downward in the subprime mortgage markets.

One risk management expert testified before Congress: “It is well known that VaR cannot measure crisis risk. During periods of crisis the relationship between securities changes in strange and seemingly unpredictable ways. VaR, which depends critically on a set structure for volatility and correlation, cannot provide useful information in this situation. It contains no mechanism for predicting the type of crisis that might occur, and does not consider the dynamics of market crises. This is not to say that VaR has no value or is hopelessly flawed. Most of the time it will provide a reasonable measure of risk – indeed the vast majority of the time this will be the case. If one were forced to pick a single number for the risk of a portfolio in the near future, VaR would be a good choice for the job.” Prepared statement of Richard Bookstaber, “The Risks of Financial Modeling: VaR and the Economic Meltdown,” before the U.S. House of Representatives Committee on Science and Technology, Subcommittee on Investigations and Oversight, Serial No. 111-48 (9/10/2009), at 4. 1897 Subcommittee interview of Craig Broderick (4/9/2010). 1898 The Mortgage Department had other risk limits aside from VAR, including Credit Spread Widening or “CSW,” which seeks to measure what would happen if credit spreads suddenly widened by large amounts (called “shocks”); “dv01,” which measures the dollar amount by which a security’s value would change based on a 1 basis point change in the relevant index or interest rate; and balance sheet limits, meaning the amount of Goldman’s balance sheet the relevant business unit would be permitted to consume. Subcommittee interview of Craig Broderick (4/9/2010).

business area within a division. Some trading desks within a department also had assigned risk limits.

457

At the end of a typical trading day, Goldman’s Risk Department prepared risk reports

containing some or all of the risk measures used for the Mortgage Department. The Risk Department prepared daily, weekly, and quarterly risk reports, as well as reports for the Board of Directors and various management committees. (FWRC) was co-chaired by David Viniar and its weekly meetings were often attended by Co- President Gary Cohn and CEO Lloyd Blankfein. Goldman senior executives noted that the Mortgage Department was discussed at every meeting of the FWRC throughout 2007. Decisions regarding, e.g., short positions in mortgages taken by business units but with full knowledge of the 30th floor.”

Goldman also noted that risk “[l]imits are set by the FWRC.

In preparation for a meeting with regulators,

Goldman’s Firmwide Risk Committee

1899

1900

1901

1902

Goldman executives told the Subcommittee that, in general, risk limits were firm and

1903

At the end of each day, department and divisional personnel, their

compliance was mandatory. respective risk managers, and other executives were provided with risk reports from which they could readily see whether a trading desk had breached its limits. In the event of a violation, the desk would be directed to curtail its activities or to take whatever steps were necessary to bring its trading within the applicable limits. Once a desk was notified of its breach of a limit, it was generally required to act immediately to comply with the existing limits.

1904

At times, the Mortgage Department proposed various modifications or alternatives to its But from

existing risk measures. Some of these proposals were adopted and some were not.

1905

11/13/2007 Goldman email, GS MBS-E-010023525 (attachment, 11/14/2007 “Tri-Lateral Combined

9/2006-12/2007 Goldman Sachs Quarterly Market Risk Review, “Market Risk Management & Analysis,”

Id. Id. The reference to the 30th floor was to the floor on which Goldman’s senior executives then had their offices

1899 Hearing Exhibits 4/27-54a-f and GS MBS-E-010674895. 1900 Comments,” GS MBS-E-010135693-715). In November 2007, Goldman’s Chief Risk Officer, Craig Broderick, Controller Sarah Smith, and senior members of their staffs met with the Tri-Lateral Review Group, which included representatives of the Federal Reserve Bank, the SEC, and the United Kingdom’s Financial Services Authority, to discuss risk management during the financial crisis. The “Trilateral Combined Comments” are the talking points prepared by Goldman senior executives for that meeting, in order to respond to specific written questions Goldman and other firms had received from the Trilateral Review Group. 1901 1902 in Goldman’s New York headquarters. Goldman also noted that “sr mgmt participated actively in all of the significant exposure management including when / how to reduce positions.”11/13/2007 Goldman email, GS MBS-E-010023525 (attachment, 11/14/2007 “Tri-Lateral Combined Comments,” GS MBS-E-010135693-715 at 695). 1903 (4/9/2010). 1904 1905 2/24/2007 email from Robert Berry to David Viniar, Craig Broderick and Bill McMahon, “Mortgage VaR,” GS MBS-E-009778897 (recommending model parameters for VAR calculations); 4/18/2007 email from Jeremy Primer to Joshua Birnbaum, “Resolution from MRMA meeting?,” GS MBS-E-012868698 (discussing further adjustment to

Subcommittee interview of Joshua Birnbaum (10/1/2010). See, e.g., 2/8/2007 email from Michael Dinias to Robert Berry, and Craig Broderick, GS MBS-E-009980807;

Subcommittee interview of Joshua Birnbaum (10/1/2010); Subcommittee interview of Craig Broderick

the perspective of the firm’s most senior executives, VAR appeared to have been the predominant risk measure by which the Department’s activities were judged.

1906

458

VAR Levels Show Net Short. The primary factors that influence VAR are: (1) the While VAR is

relative size and correlation of positions, and (2) the volatility of trading. computed by applying a complex algorithm to trading data, the VAR measure directly reflects position size and correlation, and volatility – or a combination of both factors. Changes in VAR levels over time can also provide information about the general magnitude and direction of trading positions.

1907

1908

In the fourth quarter of 2006, the Mortgage Department’s permanent VAR limit was $20 Early the next year, on February 5, 2007, the On February 8, 2007, a

million, of which it consumed only $13 million. Mortgage Department exceeded its limit with a VAR of $20.5 million. senior risk manager recommended that the Mortgage Department’s permanent VAR limit be increased to $30 million to accommodate anticipated increased price volatility in the mortgage markets that year. permanent VAR limit to $35 million, which remained the Mortgage Department’s “permanent” limit throughout 2007.

A senior manager concurred and increased the Mortgage Department’s

1909

1910

1911

1912

Almost immediately, however, the Mortgage Department breached its new limit, and its VAR continued to climb. Over the course of a single quarter, the Mortgage Department’s VAR jumped from $13 million at the end of 2006, to $85 million in the first quarter of 2007 – a 550%

See id. Based on these factors, VAR is generally lower if a desk has many small and non correlated (well

See, e.g., 8/21/2007 email from Tom Montag to Gary Cohn, GS MBS-E-016344758; 8/21/2007 email from

VaR calculation); 4/23/2007 email from Robert Berry to Daniel Sparks and SPG Trading Desk, “Mortgage VaR,” GS MBS-E-009708690 (adjustments to VAR calculations). 1906 Michael Dinias, “Trading VaR Analysis,” GS MBS-E-009742070; Subcommittee interview of David Viniar (4/13/2010) and Joshua Birnbaum (10/1/2010); 2/24/2007 email from Robert Berry to David Viniar and others, “FW: Mortgage VaR,” GS MBS-E-009778897. 1907 See generally “The Risks of Financial Modeling: VaR and the Economic Meltdown,” before the U.S. House of Representatives Committee on Science and Technology, Subcommittee on Investigations and Oversight, H.R. Hrg. 111-48 (9/10/2009), at 4 (Written Testimony of Richard Bookstaber); Philippe Jorion, “Value at Risk: The New Benchmark for Managing Financial Risk (3d ed. 2007) at 64. 1908 diversified) positions that are trading at steady and predictable price levels. By contrast, VAR is higher if a desk is holding a small number of very large and highly correlated positions that are trading at volatile and unpredictable price levels. The position size/correlation and volatility factors may also operate independently. Thus, even if the desk has a large number of relatively small and non correlated positions, VAR tends to rise as the volatility of trading rises. Similarly, even if there is little volatility in trading, VAR tends to rise as the desk’s position sizes become larger and increasingly correlated. The two factors also reinforce one another – large position sizes combined with high volatility tend to increase VAR dramatically. 1909 Hearing Exhibit 4/27-54; see also 2/6/2007 email from MarketRisk,“MarketRisk: Mortgage Risk Report (cob 02/06/07),” GS MBS-E-009980807 (Mortgage SPG VaR Limit 20). 1910 1911 1912

2/8/2007 email from Michael Dinias, “VaR limit for Mtg SPG,” GS MBS-E-009980807. Id.
Id.

Market Risk Management & Analysis, Quarterly Market Risk Review, December 2006, GS MBS-E-009583144,

459

increase. Goldman’s Chief Risk Officer, Craig Broderick, told the Subcommittee that he would be concerned about any breach of a VAR limit, and would certainly investigate the doubling of a business unit’s VAR, but he admittedly took no action when the Mortgage Department’s VAR more than quintupled over the course of a single quarter. Mr. Broderick attributed the steep rise in VAR almost exclusively to unprecedented market volatility, although other Goldman officials stated that the VAR levels were being driven by Goldman’s large net short positions.1914

1913

For the most part, Goldman’s risk managers ignored the Mortgage Department’s VAR violations and did not demand immediate compliance with the last applicable limit, as would ordinarily be the case. Goldman’s risk managers continually assigned the Mortgage Department new “temporary” VAR limits large enough to accommodate whatever risk levels resulted from the Department’s trading. Mr. Birnbaum later described this pattern as the risk area’s “policy to just keep increasing ou[r] limit.”

With notable exceptions in late February and late August 2007,

1915

1916

The first quarter of 2007 is illustrative of the pattern. During that quarter, the Mortgage

Department’s trading activities exceeded three new VAR limits in as many weeks. The Mortgage Department received its new permanent VAR limit of $35 million on February 8, 2007. Four days later, on February 12, the Department’s VAR hit $49 million.

1917 On February 14, the

1918

Subcommittee interview of Craig Broderick (4/9/2010). 2/27/2007 email from Richard Ruzika to Tom Montag, others, GS MBS-E-002204942; Subcommittee interview

1913 1914 of Joshua Birnbaum (4/22/2010); Subcommittee interview of Daniel Sparks (4/15/2010); 8/9/2007 email from Joshua Birnbaum to Deeb Salem, “MarketRisk: Mortgage Risk Report (cob 08/08/2007),” GS MBS-E-012927202; 8/16/2007 email from Michael Dinias, “mortgage var contribution,” GS MBS-E-011247689 (“Mortgage Trading has 53.8% marginal contribution to Firmwide VaR and removing the entire mortgage business reduces Firmwide VaR by $53mm (from $165mm to $112mm). … As expected SPG Trading desk dominates this risk with 56% contribution and adds $49mm to Firmwide VaR. This is primarily driven by ABS Synthetics and Correlation book which have the bulk of the mortgage shorts.”); 8/21/2007 email from Michael Dinias, “Trading VaR Analysis,” GS MBS-E- 009742070 (Mortgage VAR “primarily driven by mortgage shorts on the ABS Synthetics and Correlation desks.”); 8/22/2007 email from Tom Montag to Lloyd Blankfein, “Trading VaR $144mm,” GS MBS-E-009605812, Hearing Exhibit 4/27-36 (“we are covering a number of shorts in mortgages today and tomorrow–probably 1.5 billion worth–will reduce mortgages [VAR] hopefully to below [$]80 [million]”). 1915 1916 GS MBS-E-012927198. It is unclear the extent to which Goldman’s regulators were aware of the Mortgage Department’s VAR levels. In November 2007, Goldman met with the Tri-Lateral Review Group, which included the Federal Reserve Bank, the SEC, and the United Kingdom’s Financial Services Authority, regarding its risk management during the financial crisis. Talking points prepared by Goldman personnel for that meeting stated that with respect to VAR: “Exposures were managed responsibly by the business units within agreed limits. Highs were set in Mortgages …. Benign P&L allowed for a disciplined but measured response.”11/13/2007 Goldman email, GS MBS-E-010023525 (attachment, 11/14/2007 “Tri-Lateral Combined Comments,” GS MBS-E-010135693-715 at 707). This description did not disclose that the Mortgage Department, for nearly the entire year, had routinely exceeded its $35 million VAR limit by significant amounts for months on end. 1917 1918 2/14/2007 Goldman internal email, “Increase in Mortgage VaR,” GS MBS-E-010374687 (“MTG SPG Desk VaR increase from $21 mm to $48mm from cob Feb 6 to cob Feb 13, driven primarily by SPG Trading desk”).

Subcommittee interview of Joshua Birnbaum (10/1/2010). 8/9/2007 email from Joshua Birnbaum to Deeb Salem, “MarketRisk: Mortgage Risk Report (cob 08/08/2007),”

2/8/2007 email from Michael Dinias, “FW: VaR limit for Mtg SPG,” GS MBS-E-009980807. 2/13/2007 email, “MarketRisk: End of Day Summary - cob 02/12/2007,” GS MBS-E-009716432; see also

460

1920

1919

1923

By February 20, however, the Department’s VAR was $63 million, well in excess of its

So the Department was assigned a new temporary limit of $60 Instead of dropping below the

Department was assigned a new “temporary” limit of $50 million that would expire on February 20. temporary limit of $50 million. million – a level it was already exceeding – until February 27. new temporary limit of $60 million, the Mortgage Department’s VAR continued to rise until it hit a quarter-high level of $85 million on February 23 and February 26. In response, on February 27, the Department was given yet another temporary limit of $90 million through the end of the month. which ordered the Department to reduce the size of its net short position to $4.5 billion. Department responded immediately and, by February 28, had reduced its VAR to $81 million.

But the precipitous rise in VAR apparently alarmed Goldman’s Operating Committee,

The 1925

1922

1924

1921

The pattern created by the Mortgage Department’s increasing VAR levels, and the lagged reaction of Goldman’s risk managers in setting new “temporary” limits over the course of 2007 is shown in the chart on the next page.

[SEE CHART NEXT PAGE: Goldman Sachs Mortgage Department Value at Risk (VaR), prepared by Permanent Subcommittee on Investigations.]

The continual increases in the Mortgage Department’s VAR also had an impact on VAR

for all of Goldman’s trading activities, called “Trading VAR” or “Firmwide VAR.” Goldman carefully tracked the amount of its trading VAR that was attributable to the activities of each of its trading desks or units. During the first quarter of 2007, its records show that the firm’s Trading VAR rose from $119 million in the prior quarter to $154 million. Goldman has stated that its Mortgage Department’s activities have historically resulted in only about 2% of the firm’s net revenues. about 3% of the Firmwide Trading VAR of $119 million, which is roughly consistent with or proportionate to the 2% contribution to firmwide net revenues that Goldman has reported.1928

At the end of 2006, the Mortgage Department’s VAR of $14 million contributed only

1926

1927

2/20/2007 email, “MarketRisk: End of Day Summary - cob 02/16/2007,” GS MBS-E-009724779. 2/22/2007

2/14/2007 email, “MarketRisk: End of Day Summary - cob 02/13/2007,” GS MBS-E-009763394 (“Mortgages

Id. (“Mortgages VAR has a temporary $60mm limit until cob 2/27/2007.”). 2/26/2007 email, “MarketRisk: End of Day Summary - cob 2/23/2007,” GS MBS-E-009720057; 2/27/2007

1919 VAR is over its $35mm limit. Temporary $50mm limit was granted until cob 02/20/2007.”). 1920 email, “MarketRisk: End of Day Summary - cob 02/21/2007,” GS MBS-E-009762741 (Mortgages VAR on 2/20 was 63 million). 1921 1922 email, “MarketRisk: End of Day Summary - cob 2/26/2007,” GS MBS-E-009764685. 1923 2/27/2007 email, “MarketRisk: End of Day Summary - cob 2/26/2007,” GS MBS-E-009764685 (“Mortgages VAR has a temporary $90mm limit until cob 03/06/07.”). 2/28/2007 email, “MarketRisk” End of Day Summary - cob 2/27/2007,” GS MBS-E-009762239. 1924 1925 1926 009685934, Hearing Exhibit 4/27-54c. 1927 1928 009583144, Hearing Exhibit 4/27-54b.

2/27/2007 email from Richard Ruzika to Tom Montag, others, GS MBS-E-002204942. 3/1/2007 email, “MarketRisk: End of Day Summary - cob 02/28/2007,” GS MBS-E-009757430.
3/2007 Goldman “Quarterly Market Risk Review, Market Risk Management & Analysis,” GS MBS-E-

4/2010 Goldman report, “Risk Management and the Residential Mortgage Market,” Hearing Exhibit 4/27-161. 12/2006 Goldman “Quarterly Market Risk Review, Market Risk Management & Analysis,” GS MBS-E-

Goldman Sachs Mortgage Department Value at Risk (VaR)

December 2006 - December 2007 (in $ Millions)

Mortgage Department VaR

Mortgage Department Permanent VaR Limit

Mortgage Department Temporary VaR Limit

120

100

Derived from Goldman Sachs Firmwide Risk Committee Appendices and Market Risk End of Day Summaries provided by Goldman Sachs.
Prepared by the U.S. Senate Permanent Subcommittee on Investigations, April 2010.

462

At the end of the first quarter in 2007, however, the Mortgage Department’s VAR of $85

million was contributing a total of 23% to the Firmwide VAR. Mortgage Department’s percentage contribution to Firmwide VAR continued to rise until it hit an all-time high of 54% on August 14, 2007, when the Mortgage Department’s VAR reached $110 million on a Firmwide VAR of $165 million.

During the rest of 2007, the

1929

1930

The 54% contribution rate to Firmwide VAR means that the Mortgage Department’s

trading alone accounted for a 54% of total firmwide risk, while all of Goldman’s other trading activities combined – including all equities, commodities, foreign exchange, and interest rate instruments – accounted for the rest. Given the serious financial ramifications of such a large and highly concentrated position, the decision to allow the Mortgage Department to incur such a high level of firmwide risk would have required approval at the highest levels of firm management. Indeed, it was Goldman’s Operating Committee and its Co-President, Mr. Cohn, who decided in February and August 2007, respectively, that the Mortgage Department’s VAR had risen too high and had to be brought down.1931

Because of the net short’s impact on the Mortgage Department and Firmwide VAR levels, Goldman’s senior executives not only knew about the “big short,” but made frequent inquiries and exercised frequent control over the Mortgage Department’s activities. On August 16, 2007, for example, Jon Winkelried, who served as Co-President with Mr. Cohn, asked Mr. Sparks: “Do you still feel we are being conservative with our marks …. Good time to make sure we’re conservative.” Mr. Sparks replied:

1932

“I try, but it is much harder than you think with all the things we are dealing with – completely dislocated markets with little price transparency, systems/tools that are not where they should be, focused controllers (who I think are doing a very good job in a tough market) and many cooks in the kitchen who like to micro-manage. … But I hear your message.”

Mr. Winkelried replied: “I think you should drop the micro manage theme in this environment.”

1933

3/2007 Goldman Quarterly Risk Review, “Market Risk Management and Analysis,” GS MBS-E-009685958,

8/14/2007 Market Risk Report, Mortgage Portfolio Summary, GS MBS-E-012380294, Hearing Exhibit 4/27-35

2/27/2007 email from Richard Ruzika to Tom Montag and Daniel Sparks, GS MBS-E-002204942; 8/15/2007

1929 Hearing Exhibit 4/27-54. 1930 (Mortgage Structured Products, VAR 110.1 on 8/14/07, Percentage Contribution to Firmwide VaR 53.8%). 1931 email from Gary Cohn, “Trading VaR $165mm,” GS MBS-E-016344758.
1932 8/16/2007 email from Jon Winkelried to Daniel Sparks, “Mort P&L Explanation,” GS MBS-E-010680327-330; 7/25/2007 email from David Viniar to Gary Cohn, “Private & Confidential: FICC Financial Package 07/25/07,” GS MBS-E-009861799, Hearing Exhibit 4/27-26; 2/27/2007 email from Richard Ruzika to Tom Montag, others, GS MBS-E-002204942; 8/15/2007 email from Gary Cohn, “Trading VaR $165mm,” GS MBS-E-016344758. 1933

8/16/2007 email from Jon Winkelried to Daniel Sparks, “Mort P&L Explanation,” GS MBS-E-010680327-330.

463

Mr. Mullen also expressed concern that the Mortgage Department’s practice of skirting the

normal decisionmaking channels and communicating directly with the Co-Presidents Gary Cohn and Jon Winkelried, among other very senior officers, could create problems. When Mr. Birnbaum drafted the Mortgage Department’s proposal to buy $10 billion in AAA RMBS securities, he sent it directly to Mr. Cohn and Mr. Winkelried, as well as to his more immediate superiors, Messrs. Mullen, Montag, and Sparks, among others. Mr. Mullen wrote to Messrs. Cohn and Winkelried, the Co-Presidents of Goldman: “It would help to manage these guys if u would not answer these guys and keep bouncing them back to Tom and I.” Mr. Cohn replied: “Got that and am not answering,” but then added: “I do like the idea but you[r] call.”

1934

For his part, Mr. Montag was also aware that he and Mr. Mullen were taking a more active role in the management of the Mortgage Department than they normally would. Mr. Montag, for example, was Global Co-Head of Securities for the Americas, which encompassed both the FICC Division and the Equities Division, and was responsible for numerous departments. Nonetheless, he was involved in management decisions regarding the Mortgage Department on a near-daily basis in 2007. In August of that year, Mr. Lehman reported to Mr. Sparks that Mr. Montag had asked:

“how the desk thought about him and mullen being very involved. I told him we understood the scrutiny on the business given the overall pressure on our market, large P+L [profit and loss] and risk swings, etc.”

1935

Given the scrutiny by senior executives, the fact that the Mortgage Department’s VAR was

permitted to reach over $113 million in mid-August 2007 – more than three times its permanent limit – suggests that senior management knew and approved of the magnitude of the risk the Department incurred. It also suggests that the net short positions the Mortgage Department took were proprietary. they were seeking only the small spread arbitrage available from market-making activities for customers.

Goldman’s senior executives would have no reason to take such large risks if

1936

On February 26, 2007, the Mortgage Department’s VAR reached a quarterly high of $85.4 1937

million. On February 22, Mr. Sparks had told Messrs. Swenson, Lehman, and Birnbaum that they would have to cover $2 billion in subprime mortgage related net short positions that same

8/21/2007 email from Joshua Birnbaum, “Potential large subprime trade and impact on firmwide VAR,” GS

1934 MBS-E-016359332, Hearing Exhibit 4/27-34 1935 6/28/2007 email from David Lehman to Daniel Sparks, GS MBS-E-010623720. 1936 See 8/16/2007 email from Jon Winkelried to Daniel Sparks, “Mort P&L Explanation,” GS MBS-E-010680327- 330; 7/25/2007 email from David Viniar to Gary Cohn, “Private & Confidential: FICC Financial Package 07/25/07,” GS MBS-E-009861799, Hearing Exhibit 4/27-26. 2/27/2007 email from Richard Ruzika to Tom Montag, others, GS MBS-E-002204942; 8/15/2007 email from Gary Cohn, “Trading VaR $165mm,” GS MBS-E-016344758. 1937

2/26/2007 Market Risk Report, Mortgage Risk Portfolio Summary, GS MBS-E-010388177.

1938

464

On February 27, 2007, Mr. Ruzika wrote Mr. Sparks and others: “I want to see us getting

day. the short down to 4.5 bil[lion] net.” Directive” to Mr. Sparks: “Dan. Directly from the opcom we need to step up the pace of buying back single names even if it costs us some money.” Mr. Birnbaum told the Subcommittee that the SPG Trading Desk’s actions in February were taken to reduce the level of VAR.

Later that day, Mr. Ruzika forwarded the “OpCom

1939

1940

1941

On August 9, 2007, Mr. Birnbaum received a note from the Department’s risk managers

indicating that the Department’s temporary VAR limit might not be extended, which would reverse the prior policy of continually extending temporary limits:

“–Temporary MTG [Mortgage Department] SPG VaR limit of $110mm expired on 8/7/2007[.] –MTG SPG is over its permanent VaR limit of $35mm.”1942

Mr. Birnbaum told the Subcommittee that he read the note as an indication that the temporary trading limit would not be renewed, and he was being directed to reduce his net short positions to bring VAR under the permanent limit of $35 million. Birnbaum sent an email to the ABS Desk trader, Mr. Salem:

On the same day, August 9, Mr.

1943

“Are you getting any more heat to cut/cover risk? These VAR numbers are ludicrous, btw.

Completely overestimated for SPG trading, underestimated for other mortgage desks.”

1944

Mr. Salem replied that he had “waved in ~120mm in bbb and bbb- protection in the last 2 days,” which covered shorts, so he felt no heat about covering.

Mr. Birnbaum said:

1945

“I just asked b/c I saw the note about mortgages dropping back down to a permanent limit of 35mm (which we are way over). This would mark a change of their recent policy to just keep increasing ou[r] limit. Makes me a little nervous that we may be told to do something stupid.”1946

2/27/2007 email from Richard Ruzika to Tom Montag, Justin Gmelich, and Daniel Sparks, GS MBS-E-

2/22/2007 email from Daniel Sparks, “FW: Block size tranche protection offers for [redacted] or others,” GS

1938 MBS-E-010381411.
1939 002204942. 1940 Id. 1941 Subcommittee interview of Joshua Birnbaum (10/1/2010); see also 2/22/2007 email from Mr. Ruzika to Mr. Montag and Mr. Sparks, GS MBS-E-010381967 (Mr. Ruzika: “covering the single name bbb and bbb- is prudent because it cuts vol and var the most”). 1942 GS MBS-E-012927200. 1943 1944 GS MBS-E-012927200. 1945 1946

Id.; Subcommittee interview of Joshua Birnbaum (10/1/2010). 8/9/2007 email from Joshua Birnbaum to Deeb Salem, “MarketRisk: Mortgage Risk Report (cob 08/08/2007),”

8/9/2007 email from Deeb Salem to Joshua Birnbaum, “MarketRisk: Mortgage Risk Report (cob 08/08/2007),”

Id. Id.

Mr. Birnbaum continued: “I do think it is a real concern. How quickly can you work with strats to get them to revise our VAR to a more realistic number?”1947

465

Mr. Birnbaum explained to the Subcommittee that by the phrase, “be told to do something stupid,” he meant being ordered by senior Goldman leadership to cover all of the desk’s lucrative BBB and BBB- short positions immediately. Mr. Birnbaum and others were reluctant to cover all of SPG Trading’s BBB/BBB- shorts, because they believed the ABX Index for BBB and BBB- rated RMBS securities would fall further in coming months, so covering the entire short immediately would amount to leaving significant money on the table. traders, analysts, and risk managers designed and executed specific transactions over the month of August to lower VAR, but they were unsuccessful.

The Department’s

1950

1948

1949

1951

On August 15, 2007, Goldman’s Co-President Gary Cohn issued 1953

For a week between August 14 and August 21, 2007, the Mortgage Department’s VAR hovered around $100 million. The Department’s record-high VAR contributed to a record Firmwide VAR of $167 million on August 17, 20, and 21, all of which exceeded the Firmwide VAR limit of $150 million. 1952 his order: “[G]et down now.” a portion of its BBB/BBB- net short position, and its VAR quickly dropped to $68 million by August 31. The Mortgage Department was allowed to keep a substantial net short in certain assets, and was granted renewed “temporary” VAR limits at levels between $80 and $110 million through the end of Goldman’s fiscal year 2007. throughout 2007 further demonstrate Goldman’s net short position. By 2010, the Mortgage Department’s permanent VAR limit had increased from $35 million to only $40 million.

1955

In response, the Mortgage Department began selling and covering

The Risk Reports recording these VAR levels

1954

See, e.g., 8/14/2007 Goldman Market Risk Report, GS MBS-E-010679220; 8/21/2007 email from

1947 Id. 1948 Subcommittee interview of Joshua Birnbaum (10/1/2007). 1949 Id. 1950 8/15/2007 email from Daniel Sparks, “Trading VaR $165mm,” GS MBS-E-016344758; See, e.g., 8/15/2007 email from Michael Dinias, “Hedge Analysis cob 8/13/07,” GS MBS-E-010678553 (analyzing 6 potential VAR- reducing trading scenarios featuring different proposed transactions); 8/21/2007 email from Mr. Dinias, “Trading VaR Analysis,” GS MBS-E-009993267 (analyzing the VAR-reducing impact of going long in various classes of assets); 8/22/2007 email from Daniel Sparks to Tom Montag and Donald Mullen, “VAR reduction possibilities,” GS MBS-E-010619824 (proposed transactions in single name CDS protection to reduce VAR). 1951 MarketRisk,“MarketRisk: End of Day Summary - cob 8/20/07,” GS MBS-E-009740158. 1952 8/21/2007 email from MarketRisk, “MarketRisk: End of Day Summary - cob 8/20/07,” GS MBS-E-009740158. 1953 8/15/2007 email from Gary Cohn, “Trading VaR $165mm,” GS MBS-E-016344758. 1954 See, e.g, 8/28/2007 email from MarketRisk, “MarketRisk: End of Day Summary - cob 8/28/07,” GS MBS-E- 009716460 (Mortgages temporary VAR limit was $110 million); 9/14/2007 email from MarketRisk, “MarketRisk: End of Day Summary - cob 9/13/07,” GS MBS-E-009714807 (Mortgages temporary VAR limit was $90 million); 9/27/2007 email from MarketRisk, “MarketRisk: End of Day Summary - cob 9/27/07,” GS MBS-E-009708872 (Mortgages temporary VAR limit was $90 million); 10/3/2007 email from MarketRisk, “MarketRisk: End of Day Summary - cob 10/2/07,” GS MBS-E-009717721 (Mortgages temporary VAR limit was $85 million); 10/19/2007 email from MarketRisk, “MarketRisk: End of Day Summary - cob 10/18/07,” GS MBS-E-009724040 (Mortgages temporary VAR limit was $85 million); 12/13/2007 email from MarketRisk, “MarketRisk: End of Day Summary - cob 12/12/07,” GS MBS-E-009707379 (Mortgages temporary VAR limit was $80 million). 1955

Subcommittee interview of Craig Broderick (4/9/2010).

466

The dates on which Goldman senior executives ordered the Mortgage Department to reduce

its VAR – on February 21 and August 21 – were within two weeks before the end of Goldman’s fiscal quarters. In each case, the result was an immediate drop in VAR through the end of the quarter. In February 2007, the Department’s VAR dropped from $92 million to $81 million by the end of the quarter. In August 2007, the Department’s VAR dropped even more sharply, from a record high of over $110 million to $79.7 million by the end of the quarter. Firmwide VAR figures that resulted from the Mortgage Department’s VAR reductions were publicly reported in Goldman’s quarterly financial reports.1957

The lower

1956

(h) Profiting From the Big Short

In the third quarter of 2007, Goldman posted financial results showing that it had shorted the subprime mortgage market and profited from its net short position. After posting those third quarter financial results, Goldman continued to trumpet its success, both inside and outside the firm.

Third Quarter Financials. On September 20, 2007, Goldman announced record net

revenues of $12.3 billion for its third quarter. financial analysts on Goldman’s third quarter results, Goldman’s CFO, David Viniar, highlighted the performance of the Mortgage Department:

On September 19, 2007, in a conference call with

1958

“Let me also address Mortgages specifically. The mortgage sector continues to be challenged and there was a broad decline in the value of mortgage inventory during the third quarter. As a result, we took significant markdowns on our long inventory positions during the quarter, as we had in the previous two quarters. However, our risk bias in that market was to be short and that net short position was profitable.”1959

Goldman also issued a press release about its third quarter earnings that mentioned mortgages:

“Net revenues in mortgages were also significantly higher, despite continued deterioration in the market environment. Significant losses on non-prime loans and securities were more than offset by gains on short mortgage positions.”1960

Market Risk Report, GS MBS-E-009926240.

See 10/9/2007 Goldman Sachs Group Inc. Form 10-Q at 66. See also, e.g., “How Goldman Sachs Defies

9/28/2007 Goldman See 4/3/2007 Goldman Sachs Group Inc. Form 10-Q at 79 (first quarter 2007 Average Daily VAR reported as

1956 1957 $127 million); 10/9/2007 Goldman Sachs Group, Inc. Form 10-Q at 86 (third quarter 2007 Average Daily VAR reported as $139 million). 1958 Gravity,” Fortune (9/20/2007). 1959 E-009779213, Hearing Exhibit 4/27-45. 1960 Hearing Exhibit 4/27-44.

9/17/2009 email to Daniel Sparks, “Mortgage commentary on Q3 earnings call,” GS MBS-E-009853301,

9/19/2007 Goldman internal document, “Third Quarter 2007 Earnings Call Script for David Viniar,” GS MBS-

467

Internal Statements. In September 2007, Goldman summarized its third quarter results for its Board of Directors, highlighting the Mortgage Department’s record profits: “[W]e were overall net short the mortgage market and thus had very strong results.”

1961

In early October, the Mortgage Department held an internal Global Townhall to discuss its third quarter profits in detail. In a draft of the presentation he prepared for the Townhall, Mortgage Department head Daniel Sparks reported that global mortgages generated aggregate net revenues of $741 million, a 152% increase over the same quarter in the prior year, while benefitting from a “proprietary short.” wrote:

Under the heading of “Performance Drivers (Net Revenues),” Mr. Sparks

1962

“SPG Trading: +2.04bn [up] $1.92bn vs. Q3 2006 – The desk benefited from a proprietary short in CDO and RMBS single names – Additionally, we captured P&L [profit & loss] on spread widening [price declines] in various indices”1963

To put the SPG Trading Desk’s performance in perspective, it had generated $80 million in the third quarter of 2006, a big year for mortgage related products, but in the third quarter of 2007, an exceptionally poor year for mortgage related products, Goldman’s SPG Trading Desk generated $2.04 billion in net revenues – nearly 25 times more. SPG Trading’s $2.04 billion in net revenues was offset by other mortgage related losses, including losses from the CDO Origination, Residential Credit, and Residential Prime Desks, but left an aggregate net profit of $741 million for the Mortgage Department as a whole – more than twice the comparable quarter net profit of $294 million in the prior year. The $2.04 billion in net revenues from the SPG Desk accounted for over 16% of Goldman’s overall net revenues of $12.3 billion in the third quarter of 2007. The $741 million in net revenues for the Mortgage Department as a whole contributed about 6% of the firm’s total net revenues of $12.3 billion for the third quarter, which was three times the department’s historical average contribution of about 2% to net revenue.1965

1964

In his draft presentation, Mr. Sparks wrote that the “desk benefited from a proprietary short

in CDO and RMBS single names.” acquired with the firm’s own capital, solely for the benefit of the firm and not related to customer orders or the firm’s role as a market maker. In a later version of the presentation, Mr. Sparks

In industry parlance, a “proprietary” position is one

1966

9/17/2007-9/18/2007 Goldman Sachs Board of Directors Meeting, “Financial Summary, Quarter Ended August

10/5/2007 Goldman presentation, “Global Mortgages Business Unit Townhall Q3 2007,” GS MBS-E-

1961 31, 2007,” GS MBS-E-009776900, Hearing Exhibit 4/27-42. 1962 013703463, Hearing Exhibit 4/27-47. 1963 1964 1965 Sachs, Hearing Exhibit 4/27-161. 1966 013703463, Hearing Exhibit 4/27-47.

Id. Id. 4/2010 “Goldman Sachs: Risk Management and the Residential Mortgage Market,” report prepared by Goldman

10/5/2007 Goldman presentation, “Global Mortgages Business Unit Townhall Q3 2007,” GS MBS-E-

468

1967

revised the line to read that the desk benefitted from “strong results from trading long correlation and net short bias.” proprietary short,” Mr. Sparks told the Subcommittee that the language was inaccurate.

When asked why he had originally written that “the desk benefitted from a

1968

Later in October 2007, Goldman’s Chief Risk Officer, Craig Broderick, discussed the

Mortgage Department’s performance before an internal Goldman audience:

“So what happened to us? A quick word on our own market and credit risk performance in this regard. In market risk – you saw in our 2nd and 3rd qtr results that we made money despite our inherently long positions. – because starting early in ‘07 our mortgage trading desk started putting on big short positions, mostly using the ABX index, which is a family of indices designed to replicate cash bonds. And did so in enough quantity that we were net short, and made money (substantial money in the 3rd quarter) as the subprime market weakened. (This remains our position today).”1969

Goldman’s net short positions were also featured in the internal self-evaluations that

Mortgage Department personnel were required to prepare and which they expected to be read by their supervisors. In these self-evaluations, which were completed in September 2007, two months before Goldman’s fiscal year end on November 30, 2007, several Mortgage Department traders who were active in its shorting activities described the profits produced by the Department’s net shorts. Mr. Birnbaum, the senior ABX trader, wrote:

“As a co-head of ABS and SPG trading, my performance in 2007 has been my best ever by any objective measure: 1. P&L. YTD: ABS synthetics: $2.5Bln, ABS: $2.0Bln, SPG Trading: $3.0Bln, all #1 on the street by a wide margin, #2 in the world trading subprime risk (behind Paulson Partners).”

1970

His self-evaluation showed that the SPG Trading Desk alone generated profits of $3 billion.

1971

10/29/2007 “Contagion and Crowded Trades,” Goldman Sachs Tax Department Presentation, GS MBS-E-

“Global Mortgages Business Unit Townhall Q3 2007,” Final version, GS MBS-E-013668603. Subcommittee interview of Daniel Sparks (10/4/2010). In his subsequent responses to the Subcommittee’s

1967 1968 Questions for the Record, Mr. Sparks said: “The presentation should have used the words ‘net short position,’ not ‘proprietary position.’” Daniel L. Sparks responses to Subcommittee QFRs, PSI_QFR_GS0452 at 470 (Question 6). Mr. Sparks’ response did not resolve the question of whether the position was proprietary or undertaken on behalf of customers, as a “net short position” could be either. 1969 010018511, Hearing Exhibit 4/27-48 [emphasis in original]. 1970 Joshua Birnbaum Self-Review, Hearing Exhibit 4/27-55c. The figures cited for ABS synthetics and ABS (both cash and synthetics) are apparently both included within the total of $3 billion profit cited for the SPG Trading Desk as a whole. 1971 to the Correlation desk[’]s $800+mm in YTD p&l by dissuading that desk from externalizing their shorting opportunities to the likes of Paulson Partners, even when significant risk-free p&l was available at the time.” Id.

Id. Mr. Birnbaum also wrote: “During this period, I would also add that the ABS team contributed significantly

469

Mr. Swenson, the head of the SPG and ABS trading desks, wrote:

“It should not be a surprise to anyone that the 2007 year is the one that I am most proud of to date. … I … [built] a number one franchise that was able to achieve extraordinary profits (nearly $3bb to date). … The contributions to the $3bb of SPG Trading profits and $2bb of ABS trading p & l are spread out across various trades and strategies.”1972

Mr. Salem, one of the ABS traders, wrote:

“Obviously the most important aspect of my 2007 and my contribution to the firm has been the desk’s P&L. Mike, Josh, and I were able to learn from our bad long position at the end of 2006 and layout the game plan to put on an enormous directional short. The results of that are obvious.”

1973

Mr. Salem went on to outline estimated profits from four specific trading strategies pursued by the ABS Desk that generated profits totaling $3.75 billion.

1974

In these three internal documents, key Mortgage Department personnel involved in

constructing the Department’s net short positions describe the profits generated by those net shorts as “#1 on the street by a wide margin,” “extraordinary,” and “an enormous directional short” that produced $3.7 billion in profits for the firm.

Statements to Regulators. Goldman also described its short positions and the profits they produced to its regulators. In October 2007, Goldman sent a letter to the Securities and Exchange Commission answering questions about its trading activities and reporting that it had been “net short” during “most of 2007”:

“[W]e are active traders of mortgage securities and loans and . . . we may choose to take a directional view of the market …. For example, during most of 2007, we maintained a net short sub-prime position and therefore stood to benefit from declining prices in the mortgage market.”1975

Michael Swenson Self-Review, Hearing Exhibit 4/27-55b. The $2 billion profit figure attributed to ABS trading

1972 is apparently included within the $3 billion figure cited as the year-to-date profit for the SPG Trading Desk. 1973 1974 1975 added].

Salem 2007 Self-Review.
See description of Mr. Salem’s single name trading strategies, above. 10/4/2007 letter from Goldman Sachs to the SEC, GS MB S-E-009758287, Hearing Exhibit 4/27-46 [emphasis

470

In November 2007, in another letter to the SEC, Goldman explained further:

“During most of 2007, we maintained a net short subprime position with the use of derivatives, including ABX index contracts and single name CDS which hedged [our] long cash exposure.”1976

Also in November 2007, in talking points prepared for a meeting with the Tri-Lateral

Review Group, which included the Federal Reserve Bank, the SEC, and the United Kingdom’s Financial Services Authority, Goldman wrote: “[W]e were able to maintain a short throughout the year.”

Goldman also wrote:

1977

“The press and others have discussed an anticipated Q4 [2007 fourth quarter] write-down for GS. Our remaining long subprime exposure totals $695 million, inclusive of whole loans and CDO positions. However, we’re net short – as we have been throughout 2007. Accordingly, we have nothing to write down.”1978

Public Statements. Goldman also discussed its net short and related profits in public

settings. In November 2007, the Bloomberg news service reported that Goldman’s CEO, Lloyd Blankfein, told a public audience at a securities industry conference that Goldman was, and would continue to be, net short the subprime markets:

“[Mr. Blankfein] said the firm is still betting that mortgage-backed assets and collateralized debt obligations will drop. … ‘Given that point of view, we continue to be net short in these markets.’”

1979

In reaction to another November 2007 news report on how Goldman “dodged the mortgage mess,” mortgage mess. We lost money, then made more than we lost because of shorts.”1981

Mr. Blankfein sent an email to his colleagues stating: “Of course we didn’t dodge the

1980

Goldman also prepared for public use a corporate statement entitled, “How Did GS Avoid

The statement was prepared for Mr. Viniar’s use in

the Mortgage Crisis? Our Response.”

1982

11/7/2007 letter from Goldman Sachs to the SEC, GS MBS-E-015713460, Hearing Exhibit 4/27-50. 11/13/2007 Goldman email, GS MBS-E-010023525 (attachment, 11/14/2007 “Tri-Lateral Combined

Id. “Goldman Doesn’t Plan Significant Mortgage Writedown,” Bloomberg (11/13/2007); see also 11/13/2007 email

1976 1977 Comments,” GS MBS-E-010135693-715 at 694).
1978 1979 to Lloyd Blankfein, GS MBS-E-009601759 (forwarding Bloomberg article regarding Mr. Blankfein’s remarks at conference sponsored by Merrill Lynch & Co. in New York City on Nov. 13, 2007).
1980 “Goldman Sachs Rakes in Profit in Credit Crisis,” New York Times (11/19/2007). 1981 11/18/2007 email from Lloyd Blankfein, “RE: NYT,” GS MBS-E-009696333, Hearing Exhibit 4/27-52. Goldman’s Co-President, Gary Cohn, replied to Mr. Blankfein’s message, adding, “We were just smaller in the toxic products” Id. 1982 Exhibit 4/27-51.

11/7/2007 Goldman document, “How Did GS Avoid the Mortgage Crisis?,” GS MBS-E-009713204, Hearing

471

responding to questions about the Mortgage Department’s performance in a fourth quarter conference call with analysts. Goldman’s public statement outlined the steps it took to reduce its subprime mortgage inventory and related subprime risks in late 2006 and early 2007, characterizing these “proactive” steps as part of its ordinary risk management efforts. Goldman went on to state: “[O]ne should not be led to believe that we went through this period unscathed and somehow significantly profited from a ‘bet’ on the downturn in mortgage markets.” After noting that significant writedowns in the value of its long mortgage inventory had resulted in a “weak” second quarter for mortgages, Goldman wrote:

1983

“[D]uring the third quarter we were able to make money on mortgages as a result of our net short position. As a consequence, we believe that we are well-positioned to opportunistically participate in the inevitable restructuring of the mortgage market.”1984

Despite denying earlier in its statement that it significantly profited from a “bet” against a downturn in mortgage markets, Goldman wrote that, in the third quarter of 2007, it had profited from a “net short position” on mortgages. A “net short position” is, in essence, a bet on a downturn in the relevant market, and Goldman’s bet was “able to make money.”

2007 Year-End Results. The SPG Trading Desk’s net revenues for the full fiscal year 2007

In fiscal year 2007, Goldman’s total net revenues were were approximately $3.7 billion. approximately $46 billion, and its net earnings (after tax) were approximately $11.6 billion.

1985

1986

At the Subcommittee hearing, Goldman’s Chief Financial Officer, David Viniar, stated that

the Mortgage Department’s net revenue for 2007 was “less than $500 million, approximately 1 percent of Goldman Sachs’s overall net revenues.” the mortgage market “was not a large short,” omitting that, in 2007, the Mortgage Department’s SPG Trading Desk generated a record $3.7 billion in net revenues for the Department as a whole from its net shorts. the Mortgage Department and Goldman through the harsh financial environment of the subprime mortgage market meltdown and the global credit crisis in 2007. While much of those revenues were offset by other losses, they were a bulwark of profitability in what would otherwise have been a disastrous year for Goldman’s mortgage business.

and was largely offset by its long positions,

He insisted that its 2007 net short position in

1989

Those profits sustained

1987

1988

Id. Id. See 11/30/2007 “SPG Trading Mortgages Weekly Metrics 30-November-2007,” GS MBS-E-015646485. See Goldman Sachs Form 10-K for the fiscal year ending Nov. 30, 2007, filed on 1/28/2008, at 64; see also

1983 1984 1985 1986 Goldman presentation, “Overview of Goldman Sachs,” at 5, available at
http://www2.goldmansachs.com/our-firm/investors/creditor-information/creditor-presentation-3-1-11.pdf. 1987 1988 1989

April 27, 2010 Subcommittee Hearing at 96. See also 235, 252, 345. Id. at 98. 11/30/2007 “SPG Trading Mortgages Weekly Metrics 30-November-2007,” GS MBS-E-015646485.

In contrast, other major Wall Street banks reported losses in the third quarter of 2007,

472

1990

primarily due to multi-billion-dollar writedowns in the value of their subprime mortgage related assets. Goldman had not only profited from its net shorts, but had also sold off the bulk of its subprime mortgage assets earlier and at higher prices than many other banks. After observing the losses and writedowns suffered by other Wall Street banks, Mr. Viniar wrote: “Tells you what might be happening to people without the big short.”

1991

At one point, Mr. Birnbaum also contrasted Goldman’s performance with its competitors:

“Results out of DB, Citi, UBS, Bear, Lehman etc. all bear evidence that we were far ahead of our competition in marking down positions and moving CDO risk before the market cratered and came to a standstill post-BSAM [Bear Stearns Asset Management].”1992

All of these explanations point to actions taken by Goldman to transfer the risks of its own subprime mortgage inventory to others, including many of its own customers, before they became fully aware of the risks entailed in the products Goldman was marketing to them.

Goldman Denials. In late 2007, Goldman spoke openly of shorting the subprime mortgage market and that its net short position was profitable. Afterward, as mortgage losses erupted into a full blown financial crisis in the United States and abroad, Goldman began to downplay and even deny the size of its short position, its proprietary nature, and the profits it generated for the firm.1993

Goldman had not been the only market participant to profit from a large net short position in

mortgage related products. Other investors also aggressively shorted the mortgage market and profited from their short positions. A particularly large short position taken by one hedge fund – Goldman’s customer, the Paulson Credit Opportunity Fund of Paulson & Co. Inc. – netted billions of dollars in what was later characterized as “the greatest trade ever.” Mr. Birnbaum, however, had described Goldman’s own massive net short position as the “greatest trade ever” as early as July

1994

In the third quarter of 2007, for example, Lehman Brothers had $700 million in loan and mortgage writedowns.

1990 9/23/2007 email to Lloyd Blankfein and others, “Weekly Competitor, EM and Regulatory News – Week Ending 9/21/07,” GS MBS-E-009653853. Morgan Stanley had $940 million in loan writedowns. Id. Bear Stearns had $250 million in loan writedowns and $450 million in mortgage writedowns. Id. Citibank had approximately $1.6 billion in mortgage writedowns and a $636 million loss in credit trading. 10/21/2007 email to Lloyd Blankfein and others, “Weekly Competitor, EM and Regulatory News – Week Ending 10/19/07,” GS MBS-E-009631348. JPMorgan Chase had $1.3 billion in loan writedowns and $339 million in mortgage writedowns. Id. 1991 GS MBS-E-009861799, Hearing Exhibit 4/27-26. 1992 1993 related products associated with prime and Alt A residential loans. The Subcommittee did not investigate Goldman’s use of short positions in 2008, nor its involvement with prime and Alt A loan products. 1994 Gregory Zuckerman, The Greatest Trade Ever (2009); Michael Lewis, The Big Short (2010).

10/3/2007 Goldman presentation, “SPG Trading – 2007,” GS MBS-E-015654036. Goldman also highlighted losses it suffered in 2008, related to its mortgage business, particularly mortgage

7/25/2007 email from David Viniar to Gary Cohn, “Private & Confidential: FICC Financial Package 07/25/07,”

473

1996

1995

Earlier in the year, Mr. Birnbaum had also described Goldman as the market leader in

2007. shorting the housing market, but by July 2007, Mr. Birnbaum conceded that Paulson was “definitely the man in this space, up 2-3 bil on this trade. We were giving him a run for his money for a while but now are a definitive #2.” compensation for their 2007 efforts, Mr. Birnbaum again made a comparison to Paulson: “RMBS- related revenues: #1 on the street by a wide margin. #2 in the world behind Paulson Partners.”

When preparing his case for SPG traders to be paid additional

1997

In the aftermath of the financial crisis, however, Goldman no longer claimed credit for its market-leading performance during the subprime meltdown. After many of its customers suffered major losses, and several had declared bankruptcy during the financial crisis, Goldman began to downplay the size of its short position and the impact on its profits. attempted to dispel the perception that it sold its own customers CDOs it knew were destined to fail, and then profited by betting against them, as discussed in the next section.2000

In particular, Goldman

1999

1998

In April 2010, Goldman posted a statement on its website entitled, “Goldman Sachs: Risk In the statement’s Executive Summary,

Management and the Residential Mortgage Market.” 2001 Goldman made the following assertions, among others:

–“Goldman Sachs did not take a large directional ‘bet’ against the U.S. housing market, and the firm was not consistently or significantly net ‘short the market’ in residential mortgage- related products in 2007 and 2008, as the performance of our residential mortgage-related products business demonstrates.

– Goldman Sachs did not engage in some type of massive ‘bet’ against our clients. The risk management of the firm’s exposures and the activities of our clients dictated the firm’s overall action, not any view of what might or might not happen to any security or market.”2002

7/12/2007 email from Joshua Birnbaum, “ABX Markets 07-1, 06-2, 06-1: 12:00 p.m.,” GS MBS-E-012944742,

10/3/2007 Goldman presentation, “SPG Trading – 2007,” GS MBS-E-015654036; Birnbaum Self-Review,

7/20/2007 email from Joshua Birnbaum, “ABX Markets 07-02, 07-01, 06-2, 06-1: 3:00 p.m.,” GS MBS-E-

See 9/17/2007 Goldman presentation to Board of Directors, “Residential Mortgage Business, Global Impact of

1995 012962076 (Mr. Birnbaum: “greatest trade ever . . . I have a huge short . . .”). 1996 Hearing Exhibit 4/27-146. 1997 Hearing Exhibit 4/27-55c. 1998 the Mortgage Crisis,” at 2, GS MBS-E-001793840, Hearing Exhibit 4/27-41 (noting bankruptcies of Goldman clients IKB and Basis Capital). See also 8/10/2007 Goldman internal memorandum, “Summary of German Bank US Sub Prime Exposure,” GS MBS-E-009994305; 11/27/2007 email from Mr. Lehman to Mr. Sparks, “ACA” (discussing “what would happen upon an ACA bankruptcy (which is the most likely scenario in our opinion).”), GS MBS-E-013746511. 1999 2000 2001 2002

See, e.g., April 27, 2010 Subcommittee Hearing, testimony of Lloyd Blankfein at 132 and David Viniar at 98.
4/7/2010 Blankfein & Cohn, Letter to Shareholders (quoted in Hearing Exhibit 4/27-161 at 12). 4/2010 Goldman report, “Risk Management and the Residential Mortgage Market,” Hearing Exhibit 4/27-161. Id.

On April 7, 2010, Goldman CEO Lloyd Blankfein and Co-President Gary Cohn made

similar assertions in a letter to shareholders contained in Goldman’s Annual Report:

474

– “The firm did not generate enormous net revenues or profits by betting against residential mortgage-related products, as some have speculated; rather our relatively early risk reduction resulted in our losing less money that we otherwise would have when the residential housing market began to deteriorate rapidly ….

–Although Goldman Sachs held various positions in residential mortgage-related products in 2007, our short positions were not a ‘bet against our clients.’ Rather, they served to offset our long positions.”2003

At the Subcommittee hearing, Mr. Blankfein repeated the same claims. He testified:

“Much has been said about the supposedly massive short Goldman Sachs had on the U.S. housing market. The fact is, we were not consistently or significantly net short the market in residential mortgage-related products in 2007 and 2008. Our performance in our residential market-related business confirms this. During the 2 years of the financial crisis, while profitable overall, Goldman Sachs lost approximately $1.2 billion from our activities in the residential housing market. We didn’t have a massive short against the housing market and we certainly did not bet against our clients. Rather, we believe that we managed our risk as our shareholders and our regulators would expect.”2004

Mr. Viniar, Goldman’s Chief Financial Officer, testified:

“[A]cross 2007, we were primarily, although not consistently short, and it was not a large short. … The short positions themselves made a lot of money in 2007, but they offset long positions that lost a lot of money in 2007.”2005

Goldman’s denials of its net short positions in the subprime mortgage market, and the large profits produced by those net short positions, are directly contradicted by its own financial records and internal communications, as well as its own public statements in 2007, and are not credible.

(5)

How Goldman Created and Failed to Manage Conflicts of Interest in its Securitization Activities

In the years leading up to the financial crisis, Goldman was an active trader in the mortgage market, buying and selling a variety of mortgage related assets, including RMBS, CDO, ABX, and

4/7/2010 Blankfein & Cohn, Letter to Shareholders (quoted in 4/2010 Goldman report, “Risk Management and

2003 the Residential Mortgage Market,” at 12, Hearing Exhibit 4/27-161). 2004 2005

April 27, 2010 Subcommittee Hearing at 132. Id. at 98.

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CDS instruments, as described in the prior section. In addition, Goldman was one of the leaders in mortgage related securitizations, helping to originate both CDO and RMBS securities. Goldman’s 2006 and 2007 securitization activities are the focus of this section.

In 2006 and 2007, Goldman originated 27 CDOs and 93 RMBS securitizations with a total

2006

Goldman designed the structure of each securitization, including the

value of about $100 billion. number of tranches, how the payments would be allocated, and the projected rate of return or “coupon rate” that would be paid to investors. In some, Goldman selected the assets to be securitized; in others, it hired a portfolio selection agent or collateral manager to help select the assets and manage the portfolio. For each securitization, Goldman typically housed all of the assets to be securitized in a “warehouse” account until the transaction was ready to go to market. The assets in the warehouse accounts were then included in Goldman’s balance sheet. Goldman also typically worked with one or more credit rating agencies to obtain favorable credit ratings for the proposed securities.

In addition, Goldman typically established a domestic and an offshore corporation to act as the nominal owners of the securitization’s incoming cash, assets, and collateral securities; to serve as the actual issuers of the securities; and to perform certain administrative services. Goldman also established arrangements for the servicing of any underlying mortgages. In some CDOs, Goldman or its affiliate provided additional services as well, acting in such roles as the collateral securities selection agent, the collateral put provider, or the liquidation agent charged with selling impaired assets. Goldman also used its global sales force to market its securities to investors around the world, typically selling Goldman-issued CDO securities through a private placement and RMBS securities through a public offering.

In late 2006, when subprime residential mortgages began to incur higher than expected rates of delinquency, fraud, and default, and its inventory of mortgage related assets began to lose value, Goldman took a number of actions. It sold the mortgage related assets in its inventory; returned poor quality loans to the lenders from which they were purchased and demanded repayment; limited new RMBS securitizations; sold or securitized the assets in its RMBS warehouse accounts; limited new CDO securitizations to transactions already in the pipeline; and sold assets from discontinued CDOs.

Throughout this process, Goldman made a concerted effort to sell securities from the CDO and RMBS securitizations it had originated, even when those securities included or referenced poor quality assets and began losing value. Many of the CDO and RMBS securities that Goldman sold to its clients incurred substantial losses. The widespread losses caused by CDO and RMBS securities originated by investment banks are a key cause of the financial crisis that affected the global financial system in 2007 and 2008.

The 27 CDOs securitized about $28 billion in assets. See undated chart prepared for Subcommittee by Goldman

2006 Sachs, GS MBS 0000004276. The 93 RMBS securitized about $72 billion in home loans. See undated chart prepared for Subcommittee by Goldman Sachs, GS-PSI-00172.

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This section of the Report examines how Goldman originated, marketed, and sold its mortgage related securities, in particular CDO securities, during late 2006 and in 2007, as the mortgage market deteriorated and as Goldman was profiting from its own net short positions. The section begins with general information about Goldman’s securitization activities, followed by detailed case studies of four Goldman-originated CDOs: Hudson 1, Anderson, Timberwolf I, and Abacus 2007-AC1.

The evidence discloses troubling and sometimes abusive practices which show, first, that Goldman knowingly sold high risk, poor quality mortgage products to clients around the world, saturating financial markets with complex, financially engineered instruments that magnified risk and losses when their underlying assets began to fail. Second, it shows multiple conflicts of interest surrounding Goldman’s securitization activities, including its use of CDOs to transfer billions of dollars of risk to investors, assist a favored client make a $1 billion gain at the expense of other clients, and produce its own proprietary gains at the expense of the clients to whom Goldman sold its CDO securities.

Under Goldman’s sales policies and procedures, an affirmative action by Goldman

2007

Under federal securities law, when acting as an underwriter, placement agent, or

personnel to sell a specific investment to a specific customer constituted a recommendation of that investment. broker-dealer recommending an investment to a customer, Goldman had an obligation to sell investments that were suitable for any investor and were not designed to fail. When acting in those roles and affirmatively soliciting clients to buy securities, Goldman also had an obligation to disclose material information that a reasonable investor would want to know, including material conflicts of interest or adverse interests in connection with its sale of a security.

2008

In 2006 and 2007, when selling subprime CDO securities to customers, Goldman did not

always disclose that the securities contained or referenced assets Goldman believed would perform poorly, and that the securities themselves were rapidly losing value. Goldman also did not disclose that the firm had built a large net short position betting that CDO and RMBS securities similar to the ones it was selling would lose value. In the case of the Hudson, Anderson, and Timberwolf CDOs, Goldman failed to disclose to potential investors that it was shorting the very securities Goldman was selling to them. In the case of the Abacus CDO, Goldman failed to disclose to potential investors that it had allowed an interested party to help select the CDO assets and act as the sole short party, with the expectation that the selected assets would lose value and that party would make money at the expense of the long investors to whom Goldman had sold the securities. Goldman created these and other conflicts of interest with its clients in connection with its CDO activities.

2007 2008

See Goldman Sachs response to Subcommittee QFR at PSI_QFR_GS0252, at 0262. For a detailed discussion of these obligations under federal securities laws, see Section (6)(a), below.

(a) Background

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To understand Goldman’s securitization activities, this section provides general background about its CDO and RMBS business and how Goldman changed its securitization activities when the mortgage market began to deteriorate in late 2006.

(i) Goldman’s Securitization Business

The Goldman Mortgage Department originated CDOs through two different desks within

the Department. Approximately half of Goldman’s CDOs were originated by its CDO Origination Desk, which assembled the assets, structured the CDOs, and worked with the Goldman sales force to market the resulting securities to a broad range of investors. The CDO Origination Desk was headed by Peter Ostrem from 2006 until May 2007, after which all remaining Goldman-originated CDOs were transferred to the Structured Product Group (SPG) Trading Desk and were overseen by David Lehman.

Goldman’s other CDOs, which were part of a series issued under the name of Abacus, were originated by the Correlation Trading Desk, which was a sub-desk of the SPG Trading Desk. The Correlation Trading Desk specialized in arranging customized trades for investors and used the Abacus series of CDOs as one of its investment alternatives. The Correlation Trading Desk was headed by Jonathan Egol. The CDO Origination and Correlation Trading Desks were located on the same floor as the other SPG Trading Desks.

RMBS securitizations were handled by the Residential Whole Loan Trading Desk, headed

by Kevin Gasvoda. Sub-desks within the Residential Whole Loan Trading area oversaw the purchase of residential loan pools, constructed the RMBS securitizations, and worked with the Goldman sales force to sell the resulting securities to investors.

After a desk originated a CDO or RMBS securitization and sold the Goldman-originated securities for the first time, all secondary trading of the securities was handled by the Structured Products Group’s Asset-Backed Security (ABS) Desk. In mid-2007, Goldman shut down its CDO Origination Desk and directed the ABS Desk to sell all remaining Goldman-originated CDO securities, in addition to conducting the secondary trading it normally handled.

Daniel Sparks, as head of the Mortgage Department, oversaw all of Goldman’s CDO and

RMBS origination activities. Mr. Sparks reported at times to Jonathan Sobel, the prior department head, and Richard Ruzika, then head of Commodities Trading. He also worked with Justin Gmelich, a managing director asked to help him run the Department on a short term basis. Mr. Sparks also had frequent contact with more senior Goldman executives, including Thomas Montag, then global co-head of Securities Trading, and Donald Mullen, then head of Credit Trading. On occasion, he also received directives from Chief Financial Officer David Viniar and Co-Presidents Gary Cohn and Jon Winkelried.

(ii) Goldman’s Negative Market View

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As established earlier in the Report, all of Goldman’s securitization activities from 2006 to 2007 took place against the backdrop of a subprime mortgage market that, in Goldman’s view, was in distress and worsening.

On December 7, 2006, for example, Mr. Sparks sent this gloomy assessment to senior

executive Thomas Montag:

“Generally, originators are struggling with EPDs [early payment defaults] which require them to buy back loans and take losses – thinly capitalized firms can’t take much of it. Lower margins and volumes are also causing pain. Ownit [a mortgage originator] … closed Monday. Premiums for these originators – all of whom are for sale – are rapidly falling. … Likely fall-out – more originators close and spreads in related sectors widen.”

2009

A week later, on December 13, 2006, Mr. Sparks repeated his negative view of the subprime

mortgage market before senior Goldman executives on the Firmwide Risk Committee. The committee minutes described his report as follows:

“Dan Sparks: Noted the stress in the subprime market; Concern around ‘06 originators, as two more failed last week; Concern around early payment defaults, $5BN in loans to subprime borrowers, warehouse lines to 6 subprime lenders, and $16MM in ‘06 residual positions and alt-a and subprime residual positions from ‘04-‘05; Street aggressively putting back early payment defaults to originators thereby affecting the originator’s business. Rumors around more failures are in the market.”2010

On December 14, 2006, CFO David Viniar held a meeting with senior Mortgage

Department executives, reviewed their mortgage related holdings, and directed them to offset the risk posed by declining values. The Mortgage Department then initiated its first multi-billion- dollar net short positions in 2007, essentially betting that subprime mortgage related assets would fall in value.

2011

In early 2007, Mr. Sparks made increasingly dire predictions about the decline in the

subprime mortgage market and issued emphatic instructions to his staff about the need to get rid of subprime loans and other assets. On February 8, 2007, for example, Mr. Sparks wrote:

2009 2010 2011

See 12/7/2006 email from Daniel Sparks to Tom Montag, “Subprime Volatility,” GS MBS-E-010931233. 12/13/2006 Firmwide Risk Committee December 13 Minutes, GS MBS-E-009582963-64. For more information about this December 14 meeting, see discussion in Section C(4)(b), above.

479

“Subprime environment – bad and getting worse. Everyday is a major fight for some aspect of the business (think whack-a-mole). . . . [P]ain is broad (including investors in certain GS- issued deals).”2012

On February 14, 2007, Mr. Sparks wrote some notes to himself:

“Bad week in subprime

collateral performance on loans was poor – we took a write-down on second lien deals and on the scratch and dent book last week …

Synthetics market got hammered – around 150 [basis points] wider …

Originators are really in a bad spot. Thinly capitalized, highly levered, dealing with significant loan putbacks, some with retained credit risk positions, now having trouble selling loans above par when it cost them 2 points to produce.

What is the next area of contagion.”2013

That same day, February 14, 2007, Mr. Sparks exchanged emails with Goldman’s Co-

President Jon Winkelried about the deterioration in the subprime market:

Mr. Winkelried: “Another downdraft?”

Mr. Sparks: “Very large – it’s getting messy. … Bad news everywhere. Novastar bad earnings and 1/3 of market cap gone immediately. Wells [Fargo] laying off 300 subprime staff and home price appreciation data showed for first time lower prices on homes over year broad based.”2014

On February 26, 2007, when Mr. Montag asked him about two CDO transactions being

assembled by the CDO Origination Desk, Timberwolf and Point Pleasant, Mr. Sparks expressed his concern about both:

Mr. Montag: cdo squared–how big and how dangerous

Mr. Sparks: Roughly 2bb, and they are the deals to worry about.2015

2/8/2007 email from Daniel Sparks, “Post,” Hearing Exhibit 4/27-7. 2/14/2007 email from Daniel Sparks to himself, “Risk,” GS MBS-E-002203268. 2/21/2007 email exchange between Daniel Sparks and Jon Winkelried, “Mortgages today,” GS MBS-E-

2012 2013 2014 010381094, Hearing Exhibit 4/27-10. 2015

2/26/2007 emails between Tom Montag and Daniel Sparks, “Questions you had asked,” GS MBS-E-019164799.

480

On March 3, 2007, Mr. Sparks made notes after a telephone call: “Things we need to do ….

Get out of everything.” Risk Committee on accelerating problems in the subprime mortgage market:

On March 7, 2007, Mr. Sparks again reported to Goldman’s Firmwide

2016

“– ‘Game Over’ – accelerating meltdown for subprime lenders such as Fremont and New Century. – The Street is highly vulnerable . … Current strategies are to ‘put back’ inventory and liquidate positions. – The Mortgage business is currently closing down every subprime exposure possible.”2017

On March 8, 2007, Mr. Sparks emailed several senior executives, including Mr. Viniar and Mr. Cohn about “Mortgage Risk”: “[W]e are trying to close everything down, but stay on the short side.”2018

Other Mortgage Department personnel gave similarly bleak assessments of the subprime

mortgage market. As early as January 2007, Jonathan Egol, head of the Correlation Trading Desk, wrote to a colleague expressing his clients’ views: “The mkt is dead.” In February 2007, when discussing plans to issue an Abacus CDO with a Correlation Desk Trader, Fabrice Tourre, Mr. Egol repeated that assessment as his own:

2019

Mr. Egol: [T]he paulson trade may already be dead (although given it is baa2 it may still have a decent shot).

Mr. Tourre: Don’t think the Paulson trade is dead. Supersenior pretty much done with ACA, AAAs could be placed in 2 shots, this is sufficient. Remember we make $$$ per tranche placed. …

Mr. Egol: You know I love it all I’m saying is the cdo biz is dead we don’t have a lot of time left.

2020

3/8/2007 email from Daniel Sparks, “Mortgage risk,” Hearing Exhibit 4/27-75. 1/29/2007 email from Jon Egol to Fabrice Tourre, GS MBS-E-002620292. Mr. Tourre responded: “‘The

2016 3/3/2007 email from Daniel Sparks, “Call,” Hearing Exhibit 4/27-14. 2017 3/12/2007 Goldman Firmwide Risk Committee, “March 7th FWR Minutes,” GS MBS-E-00221171, Hearing Exhibit 4/27-19; see also 3/7/2007 email from Daniel Sparks to himself, “Risk Comm,” GS MBS-E-002212223. 2018 2019 market is dead’??? Ouahhh, what do you mean by that? Do you have any insight I don’t?” Mr. Egol replied: “LDL [let’s discuss live] tomorrow.” Id. Mr. Egol later wrote: “This is not my personal opinion – just a synopsis of the views of the customers we have seen today.” 1/29/2007 email from Jon Egol to Daniel Sparks, GS MBS-E-

2020 2/11/2007 email from Jon Egol, “Index Tranche Pricing Study - 08Feb07.xls,” GS MBS-E-002640951. See also 2/20/2007 email from Fabrice Tourre to Jon Egol, GS MBS-E-009332408 (Mr. Tourre: “By the way, quote from an ABS correlation trader (non-GS): “the mezz ABS CDO business is dead.” Mr. Egol responded: “who.” Mr. Tourre replied: “LDL.” “LDL,” which means “let’s discuss live,” is an abbreviation that appears throughout the Goldman documents produced to the Subcommittee.); 3/27/2007 email from a Goldman analyst, GS MBS-E- 009685430 (“The housing slowdown has the risk now not be[ing] offsetting [sic] by stronger capital spending. Both

481

On March 8, 2007, in an email to senior management, Mr. Sparks listed a number of “large

2021

At the top of the list was “CDO and Residential loan securitization

risks I worry about.” stoppage – either via buyer strike or dramatic rating agency change.” Mr. Sparks was referring to the possibility that Goldman would be unable to securitize and sell its remaining subprime mortgage related inventory by repackaging it into RMBS and CDOs for sale to customers. His concern was either that buyers would refuse to purchase such products (“buyer strike”), or that the ratings agencies might realize the poor quality and high risks associated with these products and downgrade them so they could not be sold with AAA ratings (“dramatic rating agency change”). In essence, Mr. Sparks was worried about Goldman’s being left with a large inventory of unsold and unsaleable subprime mortgage related assets when the market finally collapsed.2022

At the same time Goldman personnel were expressing these negative views of the

securitization business, the Mortgage Department was building its large net short positions in the first and third quarters of the year.

(iii) Goldman’s Securitization Sell Off

In response to the December 14, 2006 meeting at which CFO David Viniar ordered the

Mortgage Department to offset the risk associated with its mortgage related holdings, the Department initiated an intensive effort to sell off the subprime RMBS and CDO securities and other assets in its inventory and warehouse accounts.

2023

AA. RMBS Sell Off

As described earlier, on the same day as the Viniar meeting, December 14, 2006, Kevin

Gasvoda, head of the Mortgage Department’s Residential Whole Loan Trading Desk, instructed his staff to undertake an immediate, concerted effort to sell the whole loans and RMBS securities in Goldman’s inventory and warehouse accounts, focusing on RMBS securities from Goldman- originated securitizations.

By February 9, 2007, the Goldman sales force reported a substantial

2024

growth and the market are DEAD if that’s the case.”) [emphasis in original]. 2021 3/8/2007 email from Daniel Sparks, “Mortgage risk,” Hearing Exhibit 4/27-75. 2022 See also emails expressing concerns about the CDO market in particular. 6/27/2007 email from Jonathan Sobel, “Citi feedback on debt mkts,” GS MBS-E-010807091 (reporting a conversation with the head of the mortgage desk at Citibank: “He is very nervous. … Some Citi people think the CDO market is dead - a potential result of [subprime] contagion.”); 8/30/2007 email from Daniel Sparks, “RAIT,” GS MBS-E-010626401 (“the business model pursued by these guys (taking junior parts of the . . . capital structure and obtaining further leverage via the CDO market) is dead for the foreseeable future.”). 2023 See also Section C(4)(b) of this chapter, above. 2024 12/14/2007 email from Kevin Gasvoda, “Retained bonds,” GS MBS-E-010935323, Hearing Exhibit 4/27-72. See also 2/8/2007 email from Kevin Gasvoda to Tom Montag, “Mortgage risk – credit residential,” at 2, GS MBS-E- 010372233, Hearing Exhibit 4/27-74 (seven weeks later, Mr. Gasvoda reported transferring the remaining Goldman- originated RMBS securities to the mortgage trading desk to sell: “moving retained bonds out of primary desk hands and into 2ndry desk.”).

482

2025

number of sales, inventory of whole loans had “decreased from $11bn to $7bn” with “subprime loans decreased from $6.3bn to $1.5bn,” a reduction of more than two-thirds.

and by the end of February, Goldman’s controllers reported that Goldman’s

2026

In addition, during the first quarter of 2007, the Mortgage Department drastically slowed its Those actions

RMBS origination business and its purchase of whole loans and RMBS securities. meant that Goldman was not only reducing its inventory, but also reducing its intake of what had previously been a constant inflow of billions of dollars in whole loans and RMBS securities purchased as part of its securitization business.

2027

In addition to selling whole loans and RMBS securities, the Mortgage Department wrote down the value of its remaining subprime mortgage portfolio. On February 8, 2007, for example, Mr. Gasvoda recommended that certain whole loan pools and RMBS securities be marked down by $22 million. performing loans. coming. Let’s go through the residual risk and make sure we get to the correct number for the quarter.” often retained from the RMBS securitizations they originated; those tranches were also written

Residual risk referred to the non rated equity tranches that underwriters like Goldman

On February 9, 2007, Mr. Sparks reported a $30 million writedown on non

Mr. Ruzika responded: “Ok, you’ve been communicating the write down was

2029

2030

2028

2/9/2007 email exchange between Kevin Gasvoda and sales syndicate, “GS Syndicate RMBS Axes

See, e.g., 3/8/2007 email from Daniel Sparks, “Mortgage risk,” GS MBS-E-002206279, Hearing Exhibit 4/27-

2/23/2007 “Significant Cash Inventory Change (Q1’07 vs. Q4’06),” datasheet prepared by Goldman, GS MBS-

2025 (INTERNAL),” GS MBS-E-010370495, Hearing Exhibit 4/27-73. 2026 E-010037311, Hearing Exhibit 4/27-12. 2027 75 (“[f]or residential loans, we have not bought much lately”); 3/26/2007 Goldman presentation to Board of Directors, “Subprime Mortgage Business,” GS MBS-E-005565527, Hearing Exhibit 4/27-22 (reporting that Mortgage Department is using “conservative bids” on loans); 3/14/2007 Goldman Presentation to SEC, “Subprime Mortgage Business 14-Mar-2007,” at 7, GS MBS-E-010022328; 3/2/2007 email to Craig Broderick, “Audit Committee Package_Feb 21_Draft_Mortgage_Page.ppt,” GS MBS-E-009986805, Hearing Exhibit 4/27-63 (we are “lowballing” bids on loans). 2028 2/8/2007 email from Kevin Gasvoda to Daniel Sparks, “Post,” GS MBS-E-002201668, Hearing Exhibit 4/27-7 (“monthly performance analysis completed this morning on what can be securitized vs will be foreclosed tells us we should mark down around $22mm”). See also 2/2/2007 email from Daniel Sparks, “Second lien deal performance and write-down,” GS MBS-E-002201050, Hearing Exhibit 4/27-92 (“Gasvoda alerted me last night that we will take a write-down to some retained positions next week as the loan performance data from a few second lien sub-prime deals just came in (comes in monthly) and it is horrible.”); 2/8/2007 email from Kevin Gasvoda to Tom Montag, “Mortgage risk – credit residential,” at 2, GS MBS-E-010372233, Hearing Exhibit 4/27-74. Mr. Gasvoda summarized the other write-downs as follows:

“– 2nd lien residual – took $20-25mm write-downs over last 3 months (could lose $5-15 mm more) – 2nd lien retained bonds–took $18mm write-down this week (could lose $5-15 more) – Subperforming loan book – taking $28mm write-down this week (could lose $20-40mm more) What do all these areas have in common? – most HPA [housing price appreciation] sensitive sectors. They’ve crumbled under HPA slowdown as these are the most levered borrowers. What have we done to mitigate? – we stopped buying subprime 2nd liens in the summer of ‘06 and have focused on alt-a and prime.” 2/9/2007 email from Daniel Sparks, “Scratch & dent loan write down $30mm,” GS MBS-E-009760380. Id.

2029 2030

483

down in value. Those writedowns not only implemented Goldman’s policy of using current market values for its assets, but also effectively reduced the size of Goldman’s “long” position in subprime mortgage related assets. As Mr. Ruzika wrote to Mr. Cohn: “working with Dan to uncover exactly what else needs to be written down so that we can pnl [profit and loss] it this quarter and be clean going into next quarter.”

2031

Loan Repurchase Campaign. In addition to its sales and writedowns, the Mortgage

Department intensified its efforts to identify and return defaulted or otherwise deficient loans to the originating lender from which they had been purchased in exchange for a refund of the purchase price. Altogether in 2006 and 2007, Goldman made about $475 million in repurchase claims for securitized loans, and recovered about $82 million. claims for unsecuritized loans, and recovered about $17 million.

It also made about $40 million in repurchase

2033

2032

In the years leading up to the financial crisis, most subprime loan purchase agreements

provided that if a loan experienced an early payment default (EPD), meaning the borrower failed to make a payment within three months of the loan’s purchase, or if the loan breached certain representations or warranties, such as representations related to the loan’s characteristics or documentation, the loan could be returned or “put back” to the seller which was then obligated to repurchase it. In late 2006, as subprime loans began to experience accelerated rates of EPDs and fraud, Wall Street firms began to intensify their efforts to return those loans for refunds. Some subprime lenders began to experience financial distress due to unprecedented waves of repurchase requests that drained their cashflows.2035

2034

Although Goldman, either directly or through a third party due diligence firm, routinely

conducted due diligence reviews of the mortgage loan pools it bought from lenders or third party brokers for use in its securitizations, those reviews generally examined only a sample of the loans

2/13/2007 email from Richard Ruzika to Gary Cohn, “Catch Up,” GS MBS-E-019794071. Mr. Cohn forwarded

See Goldman Sachs response to Subcommittee QFR at PSI_QFR_GS0039. Id. Using loan data, the U.S. mortgage industry had developed anticipated default rates, including EPDs, for

2031 Mr. Ruzika’s report to Messrs. Blankfein and Winkelried. Id. See also 6/8/2007 email from Kevin Gasvoda, “Project Omega - Mortgages MTM of Resids,” GS MBS-E-013411815 (working on potential deal to sell marked- down mortgage residuals). 2032 2033 2034 different mortgage classes, such as subprime, Alt A, and prime loans. These default rates, however, were based in large part on past loan underwriting practices and loan types that bore little resemblance to the loans issued in the years leading up to the financial crisis, as explained in Chapter V of this Report. In 2006, subprime loans began to experience higher than anticipated EPD rates, and lenders were hit by unanticipated repurchase demands they could not afford to pay. The first EPD-related mortgage lender failures occurred in late 2006, and bankruptcies continued throughout 2007. 2035 MBS-E-005565527 at 532, Hearing Exhibit 4/27-22 (timeline showing Ownit, a subprime lender, filed for bankruptcy on December 28, 2006, and list of subprime related businesses bankrupted, suspended, closed, sold, or put up for sale).

See, e.g., 3/26/2007 “Subprime Mortgage Business,” Goldman presentation to Board of Directors, at 3-5, GS

484

2036

Instead, Goldman

and did not attempt to identify and weed out all deficient mortgages. purchased loan pools with the expectation that they would incur a certain rate of defaults. In late 2006, however, like other Wall Street firms, Goldman began to see much higher than anticipated delinquency and default rates in the loan pools in its inventory and warehouse accounts, and in the subprime RMBS and CDO securitizations it originated. Defaulted loans generally could not be sold or securitized, and had to be terminated through foreclosure proceedings or sold in so-called “scratch and dent” pools that generally produced less money than the loans cost to buy. In addition, defaulted loans meant that the borrowers who took out those loans stopped making loan payments to the securitized loan pool, reducing the cashflow into the related securities. RMBS and CDO securities whose underlying assets incurred high rates of loan delinquencies and defaults experienced reduced cashflows, lost value, and sometimes failed altogether, resulting in substantial losses for investors.

2037

In early 2007, Goldman’s Mortgage Department initiated an intensive review of the loans in its inventory, warehouse accounts, and RMBS and CDO securitizations, to identify deficient loans and return them for refunds. On February 2, 2007, Mr. Sparks reported to senior Goldman executives Messrs. Viniar, Montag, and Ruzika that obtaining refunds from the loan originators would be “a battle”:

“The team is working on putting loans in the deals back to the originators (New Century, WAMU, and Fremont – all real counterparties), as there seem to be issues potentially including some fraud at origination, but resolution will take months and be contentious. … The put backs will be a battle.”

2038

Goldman or a third party due diligence firm it hired typically examined a sample of the loans. Based on the

2036 number of problem loans found in the sample, Goldman or the due diligence firm extrapolated the total percentage of problem loans likely to be contained in the pool. This information was then factored into the price Goldman paid for the pool. Any specific loans identified in the sampling process as deficient were generally returned to the lender for repurchase, but it was rare for an investment bank to review 100% of a pool to identify all of the deficient loans and return them. Subcommittee interview of Clayton Holdings (11/9/2010). 2037 See, e.g., 1/8/2007 email from Daniel Sparks, “Color on the Sub Prime Market,” GS MBS-E-002195434 (after receiving a report on potential EPD problems, Mr. Sparks wrote: “I just can’t see how any originator in the industry is worth a premium. I’m also a bit scared of accredited and new century, and I’m not sure about taking on a bunch of new exposures.”); 2/8/2007 email from FICC analyst to Mr. Sparks, Mr. Gasvoda, and others, “2006 Subprime 2nds Deals Continue to Underperform,” GS MBS-E-003775340, Hearing Exhibit 4/27-167d (“2006 vintage Subprime closed-end seconds (CES) issuance has continued to deteriorate. … [N]on-GS Subprime CES deals are categorically experiencing similar negative behavior across shelves, originators, and servicers. … Outlook: 2006 vintage … could eventually reach 4-5+ times that of 2004/early 2005 vintages (more than double that of RA expected losses).”). 2038 Exhibit 4/27-92. See also 2/2/2007 email from Michelle Gill, “Warehouse policy,” GS MBS-E-005556331 (discussing proposal to charge higher warehouse fees to mortgage originators with higher EPD and “drop-out” rates, including Fremont and New Century).

2/2/2007 email from Daniel Sparks to Messrs. Montag, Ruzika, and Viniar, GS MBS-E-002201050, Hearing

485

To manage its loan repurchase campaign, Goldman expanded an operations center in St.

Petersburg, Florida, 2039 securitized loan pools. mortgages purchased from specific lenders, including New Century, Fremont, Long Beach, and later Countrywide.

and made extensive use of third party due diligence firms hired to review its 2040

Goldman instructed the firms to “re-underwrite” every loan in pools of

2041

By March 2007, the average EPD rate for subprime loans in Goldman’s inventory had On March 7, 2007, Mr.

climbed from 1% of aggregate volume to 5%, a dramatic increase. Sparks described Goldman’s exposure as follows:

2042

“As for the big 3 originators – Accredited, New Century and Fremont, our real exposure is in the form of put-back claims. Basically, if we get nothing back we would lose around $60mm vs loans on our books (we have a reserve of $30mm) and the loans in the [CDO and RMBS] trusts could lose around $60mm (we probably suffer about 1/3 of this in ongoing exposures). … Rumor today is that the FBI is in Accredited.”2043

Five days later, on March 12, 2007, Mr. Sparks wrote: “The street is aggressively putting things back, like a run on the bank before there is no money left to fulfill the obligations.”

2044

One of the lenders that was an initial focus of Goldman’s loan repurchase effort was New Century, a subprime lender whose loans Goldman had used in many Goldman-originated RMBS securitizations. After completing a review of one New Century loan pool, an analyst recommended “putting back 26% of the pool … if possible.”

A putback rate of 26% meant that about one in

2045

2/27/2007 email from Christopher Gething, “Our Expansion,” GS MBS-E-010387242 (expansion of St.

See 3/9/2007 email from Kevin Gasvoda, “priorities,” GS MBS-E-002211055 (listing priority mortgage

See, e.g. 3/2007 Goldman email chain, “RE: NC Visit,” GS MBS-E-002048050 (mentioning four different third

2039 Petersburg office to accommodate staff for loan repurchase effort). 2040 party “vendors” conducting loan reviews for the loan repurchase effort and stating: “We’re off to other vendors at this point.”). 2041 originators as Accredited, Fremont, New Century, and Novastar); 3/14/2007 Goldman email, “NC Visit,” GS MBS- E-002048050 (identifying New Century, Fremont and Long Beach); 6/29/2007 email from Ed Chavez, “Countrywide Investigation Review Update,” GS MBS-E-002134411. 2042 009986805, Hearing Exhibit 4/27-63. 2043 2044 email, “March 2007 Counterparty Surveillance,” GS MBS-E-002135667 (forwarding report to loan repurchase team, “Please find attached the March counterparty surveillance report (and boy, is it a doozy).”); 3/26/2007 “Subprime Mortgage Business,” Goldman presentation to Board of Directors, at 5, GS MBS-E-005565527, Hearing Exhibit 4/27-22 (list of subprime related businesses bankrupted, suspended, closed, sold, or put up for sale).
2045 The review of the New Century loan pool found:

3/7/2007 email from Daniel Sparks, “Originator exposures,” GS MBS-E-002206279, Hearing Exhibit 4/27-75. 3/12/2007 email from Daniel Sparks, “Subprime Opportunities,” GS MBS-E-004641002. See also 4/15/2007

3/13/2007 email from Manisha Nanik, “New Century EPDs,” GS MBS-E-002146861, Hearing Exhibit 4/27-77.

3/2/2007 email to Craig Broderick, “Audit Committee Package_Feb 21_Draft_Page.ppt,” GS MBS-E-

“– approx 7% of the pool has material occupancy misrepresentation where borrowers took out anywhere from 4 to 14 loans at a time and defaulted on all. … – approx 20% of the pool has material compliance issues. These are mainly missing HUDs. … – approx 10% of the pool is flagged as potential REO [Real Estate Owned by lender] or potential unsecured

486

four of the loans in the New Century pool had EPDs, were fraudulent, or otherwise breached New Century’s contractual warranties. It also implied that about 25% of the expected mortgage payments might not be made to the relevant RMBS securitization. Unless the problem loans could be successfully “put back” to New Century in exchange for a refund, a fail rate of that magnitude would likely impair the performance of all of the securities dependent upon that pool of mortgages.

Goldman made a total of about $67 million in repurchase requests to New Century, which was among the five mortgage originators to whom Goldman directed the most repurchase requests in 2006 and 2007. to insufficient cash, and the loan repurchase team sought advice from Mr. Gasvoda:

In March 2007, however, New Century stopped paying Goldman’s claims due

2046

“As you know, we have an extensive re-underwrite review underway on 06 NC2 [New Century second lien loans] and also other NC loans in the 2nds deals that are in the pipeline for scrubs. Should we change course at all here given the fact NC can’t pay?”2047

Mr. Gasvoda responded:

“Yes …. I think priority s/b [should be] on Fremont and Long Beach on 2 lien deals. Fremont first since they still have cash but may not for long. … [O]n NC2 we need not halt that entirely but should pull back resources there. We should also move 06FM2 [Fremont second lien loans] up the priority list.”

Goldman made a total of about $46 million in repurchase requests to Fremont, another subprime lender for whom Goldman had underwritten multiple securities and which was also among the five mortgage originators to whom Goldman made the most repurchase requests in 2006 and 2007. When Goldman personnel reviewed a loan pool purchased from Fremont, the results were even worse than for the New Century loans. Goldman concluded that “on average, about 50% of about 200 files look to be repurchase obligations.”

Later, Goldman came to a similar

2048

2049

(if 2nd liens). … – approx 5% of the pool was possibly originated fraudulently based on the dd [due diligence] results. Main findings: possible ID theft, broker misrepresentations, straw buyer, and falsification of information in origination docs. … “approx 62% of the pool has not made any payments (4% were reversed pymts/nsf [non-sufficient funds]) … “approx 38% of the loans are out of [loan to value] tolerance.”

See Goldman Sachs response to Subcommittee QFR at PSI_QFR_GS0040. 3/14/2007 Goldman email, “NC Visit,” GS-MBS-E-002048050. See also 3/21/2007 email from Daniel Sparks

2046 2047 to Tom Montag, GS MBS-E-002207114 (noting progress in cutting down funding commitments to mortgage originators to $300 million, including closeout of all funding to New Century in exchange for loans).
2048 See Goldman Sachs response to Subcommittee QFR at PSI_QFR_GS0040. 2049 3/14/2007 Goldman email, “NC Visit,” GS-MBS-E-002048050. See also 8/10/2007 email from Michelle Gill, “Fremont - Incremental Information,” GS MBS-E-009860358 (Goldman’s repurchase claims against Fremont would have amounted to a 9% ownership stake in Fremont after a proposed buyout by investor group; Goldman was not the largest purchaser of Fremont loans but its repurchase claims were 3-4 times larger than the claims of the nearest counterparty).

conclusion after reviewing certain loans purchased from Countrywide, again finding that about 50% of the loans reviewed were candidates for return to the lender.

2050

487

Goldman made a total of about $34 million in repurchase requests to Long Beach, a

2051

subprime lender for whom Goldman had underwritten billions of dollars in RMBS securities and which was also among the five mortgage originators to whom Goldman made the most repurchase requests in 2006 and 2007. Mutual for repayment of millions of dollars in refunds. At one point, a Goldman executive involved in the repurchase effort sent an email to the head of Washington Mutual Home Loans Division, David Schneider. After noting that Long Beach second lien loans were “performing dramatically worse” than other 2006 RMBS securities, the Goldman executive wrote: “As you can imagine, this creates extreme pressure, both economic and reputational, on both organizations.”2052

Goldman pressed both Long Beach and its parent Washington

Goldman’s loan repurchase campaign recovered substantial funds from some lenders,2053 Non performing loans that were not repurchased by the lender

but little or none from others. generally remained in Goldman’s inventory or the relevant securitized loan pool. Many other securitizers engaged in similar loan repurchase efforts which continued in 2011.2055

2054

Poor Quality RMBS Securities. As a result of its loan repurchase and writedown efforts,

the Mortgage Department was keenly aware of the poor quality of many of the loan pools in its warehouse accounts. Nevertheless, during this time period, Goldman continued securitizing many of those loans and selling the resulting RMBS securities to clients.

In March 2007, for example, Goldman securitized over $1 billion in subprime loans that it

had purchased from Fremont, originating an RMBS securitization called GSAMP Trust 2007- FM2. Goldman underwrote the security in the same month that it was attempting to return

2056

2/15/2007 email from Loren Morris of Goldman Sachs to David Schneider of WaMu and others, GS MBS-E-

6/29/2007 email from Ed Chavez, “Countrywide Investigation Review Update,” GS MBS-E-002134411. See Goldman Sachs response to Subcommittee QFR at PSI_QFR_GS0040. The five mortgage originators to

2050 2051 which Goldman directed the most repurchase requests were First Franklin, New Century, Fremont, Greenpoint, and Long Beach. Id. 2052 002142424, Hearing Exhibit 4/13-69b. 2053 See, e.g., Goldman response to Subcommittee QFR at PSI_QFR_GS0040; 3/8/2007 email from Daniel Sparks to Jon Winkelried and others, “Mortgage risk,” GS_MBS-E-002206279, Hearing Exhibit 4/27-75 (“Accredited … plan to send us $21mm”); 6/25/2007 email from Deana Knox, “Option One,” GS MBS-E-019645932 (“Option One has agreed to settle the entire claim, paying $2.5M (repurchase and monitor) and $3M will be rescinded.”). 2054 New Century, for example, declared bankruptcy in April 2007. In re New Century TRS Holdings, Inc., Case No. 07-10416 (KJC) (US Bankruptcy Court, District of Delaware). See also 6/7/2007 email from Loren Morris, “WFALT 05-2 Repurchase demand,” GS MBS-E-002131857. 2055 bankofamerica.com (announcing agreements to pay $3 billion to Freddie Mac and Fannie Mae to resolve residential mortgage repurchase claims related to loans originated by Countrywide). 2056 2007,” GS MBS-E-002201064; 2/5/2007 Mortgage Capital Committee Memorandum regarding GSAMP Trust 2007-FM2, GS MBS-E-002201055-58.

See 2/2/2007 Goldman memorandum to the Mortgage Capital Committee, “Agenda for Monday, February 5,

See, e.g., 1/3/2011 Bank of America press release, “Bank of America Announces Fourth-Quarter Actions,”

488

millions of dollars in deficient loans to the lender, subprime loans. Goldman marketed and sold the RMBS securities to clients. Within seven months, by October 2007, the rating downgrades began; by August 2009, every tranche of the GSAMP securities had been downgraded to junk status.

and regulators ordered Fremont to stop issuing

2057

2059

2058

On March 26, 2007, the Mortgage Department sought permission from Goldman’s

Mortgage Capital Committee to securitize and underwrite a new RMBS called GSAMP Trust 2007- HE2, which contained nearly $1 billion in subprime mortgage loans in a Goldman warehouse account, over 70% of which had been purchased from New Century. securitization even though it knew at the time that New Century’s subprime loans were performing poorly, many of the New Century loans in Goldman’s inventory were problematic, and New Century was in financial difficulty. the same month New Century declared bankruptcy. securities to its clients. The securities first began to be downgraded in October 2007, and all of the securities have since been downgraded to junk status.2063

The securitization was approved for issuance in April 2007,

Goldman marketed and sold the RMBS

Goldman approved this

2062

2060

2061

Had Goldman not securitized the $2 billion in Fremont and New Century loans, the

Mortgage Department would likely have had to liquidate the warehouse accounts containing them and either sell the loan pools or keep the high risk loans on its own books.

On April 11, 2007, a Goldman salesman forwarded to Mr. Egol a scathing letter from a

customer, a Wachovia affiliate, which had purchased $10 million in RMBS securities backed by Fremont loans and underwritten by Goldman. The client wrote that it was “shocked” by the poor performance of the securities “right out of the gate,” and concerned about Goldman’s failure to have disclosed information about the poor quality of the underlying loans in the deal termsheet:

www.globalcreditportal.com.

See discussion of Goldman’s loan repurchase effort, above. In addition, in the prior month, a Goldman

In re Fremont Investment & Loan, Docket No. FDIC-07-035b, Order to Cease and Desist (March 7, 2007). See Standard & Poor’s 3/23/2007 Goldman memorandum to members of the Mortgage Capital Committee, “Agenda for Monday,

2057 employee in the mortgage credit trading department sent senior Mortgage Department officials a lengthy email on the deteriorating subprime mortgage market and observed: “Subprime originators, large and small, ha[ve] exhibited a notable increase in delinquencies and defaults, however, deals backed by Fremont and Long Beach collateral have generally underperformed the most.” 2/8/2007 email from Fabrice Tourre, “FW: 2006 Subprime 2nds Deals Continue to Underperform INTERNAL ONLY,” at GS MBS-E-003775340, Hearing Exhibit 4/27-167d. 2058 2059 2060 March 26, 2007,” Hearing Exhibit 4/27-79 (“GSAMP 2007-HE2 – Goldman to securitize $960 million of subprime mortgage loans purchased by Goldman Sachs from New Century (71.9%)” and other mortgage originators. “The securitization is scheduled to be completed by April 12, 2007.”). 2061 See discussion of Goldman’s loan repurchase effort, above. Earlier in March, a Goldman review of a different New Century loan pool had found that 26% of the loans were deficient and ought to be returned to New Century for a refund. 3/13/2007 email from Manisha Nanik, “New Century EPDs,” GS MBS-E-002146861, Hearing Exhibit 4/27-77. In addition, New Century had already informed Goldman that it had insufficient cash to pay any loan repurchase requests. 3/14/2007 Goldman email, “NC Visit,” GS-MBS-E-002048050. 2062 2063

In re New Century TRS Holdings, Inc., Case No. 07-10416 (KJC) (US Bankruptcy Court, District of Delaware). See Standard & Poor’s

www.globalcreditportal.com.

489

“ As you know, we own $10mm of the GSAMP 06-S3 M2 bond. … We are shocked by how poorly this bond has performed right ‘out of the gate’ and had asked [Goldman] to send us the attached ProSupp [Prospectus Supplement]. After having read the ProSupp and compared it to the termsheet we have several concerns:

According to the Prosupp, approximately $2.2mm … of loans were delinquent when they were transferred to the trust. However, there is no mention of delinquent loans anywhere in the termsheet that was sent to investors when the deal was priced.
According to the Prosupp, approximately $3.3mm … are re-performing loans. However, there is no mention of reperforming loans anywhere in the termsheet.
Approx. 53.14% of the loans in the deal allow for a Prepayment Premium and that all Prepayment Premiums collected from borrowers are paid to the Class P certificateholders. None of this was disclosed in the termsheet and my concerns are two-fold: (1) The presence of Prepayment Premiums effects prepayment speeds which affects … [the deal’s performance]; (2) Prepayment Premiums are not staying inside the deal for the benefit of all investors but are being earmarked for the Class P holder (which is not mentioned in the termsheet). Note that … $1.2mm in Prepayment Premiums has already been paid out to the Class P holder.
… [T]he servicer must charge off any loan that becomes 180 days delinquent, giving rise to a Realized Loss inside the deal. Currently losses are at 9.71% of the original deal balance, or approximately $48mm despite the fact that the deal is only 11 months old (note that this figure already exceeds Moody’s expec[ta]tion for cumulative losses for the deal over the ENTIRE LIFE of the deal). I will also note that there are an additional $57.5mm of loans in the delinquency pipeline. This seems to indicate significant fraud at either the borrower or lender level ….
… [A]ny subsequent recoveries on the charged-off loans do not inure to the benefit of all investors in the deal but ONLY to the Class X1 certificateholder. This is not mentioned anywhere in the termsheet. Who owns the Class X1 notes? Is that Goldman or an affiliate? How much has been recovered so far? This is a material fact to me especially considering that loss severities are coming in at around 105% on the charged-off loans.”2064

Reduced RMBS Business. By the end of 2007, Goldman had substantially reduced its RMBS securitization business. In November 2007, in response to a request, Goldman provided specific data to the SEC about the decrease in its inventory of subprime mortgage loans and RMBS securities. Goldman informed the SEC that the value of its subprime loan inventory had dropped from $7.8 billion on November 24, 2006, to $462 million on August 31, 2007. Over the same time period, the value of its inventory of subprime RMBS securities had dropped from $7.2 billion to

4/11/2007 email to Jon Egol, “GSAMP 2006-S3 – Computational Materials for Wachovia (external),” GS MBS-

2064 E-003322028 [emphasis in original].

490

$2.4 billion, a two-thirds reduction. The graph below, which was prepared by the Subcommittee using the data provided by Goldman to the SEC, illustrates the rapid decline in Goldman’s subprime holdings.2066

2065

[SEE CHART NEXT PAGE: Goldman Sachs Long Cash Subprime Mortgage Exposure, prepared by the Permanent Subcommittee on Investigations, Hearing Exhibit 163.]

11/7/2007 letter from Sarah Smith, Controller and Chief Accounting Officer to SEC, at 5, GS MBS-E-

2065 015713460, Hearing Exhibit 4/27-50. Goldman issued its final RMBS securitization for the year in August 2007. 2066 4/2010 “Goldman Sachs Long Cash Subprime Mortgage Exposure, Investments in Subprime Mortgage Loans, and Investments in Subprime Mortgage Backed Securities November 24, 2006 vs. August 31, 2007 in $ Billions,” chart prepared by the Subcommittee, Hearing Exhibit 4/27-163.

Goldman Sachs Long Cash Subprime Mortgage Exposure,

Investments in Subprime Mortgage Loans, and

Investments in Subprime Mortgage Backed Securities November 24, 2006 vs. August 31, 2007 - in $ Billions

7.8

7.2

Investments in Subprime Mortgage Loans

Investments in Subprime Mortgage Backed Securities

Long Cash Subprime Mortgage Exposure (Total of Loans and Exposure (Total of Loans and Securities)

2.862

2.4

0.462

Prepared by the U.S. Senate Permanent Subcommittee on Investigations, April 2010. Data from Nov. 7, 2007, letter from Goldman Sachs to the Securities and Exchange Commission, GS MBS‐E‐015713460, at 5 (Exhibit 50).

BB. CDO Sell Off

492

Goldman reduced its inventory of subprime loan pools and RMBS securities through

outright sales, writedowns, and its loan repurchase campaign. It was equally aggressive in reducing its subprime CDO warehouse inventory.

In January 2007, after the CDO Origination Desk worked to sell securities from a CDO

called Camber 7, Mr. Sparks wrote to Mr. Montag: “Need you to send message to peter ostrem and darryl herrick telling them what a great job they did. They structured like mad and traveled the world, and worked their tails off to make some lemonade out of some big old lemons.”2067

In February 2007, the Mortgage Department conducted a review of the CDOs in its

2068

origination pipeline. acquired some but not all of the assets needed for the CDOs to go to market. 2007, Mr. Sparks reported to Mr. Montag and Mr. Ruzika:

As part of that review, Mr. Sparks cancelled four pending CDOs that had On February 25,

2069

“The CDO business liquidated 3 warehouses for deals of $530mm (about half risk was subprime related). Business also began liquidation of $820mm [redacted] warehouse – all synthetics done, cash bonds will be sold in the next few days.”2070

The Mortgage Department rushed several remaining CDOs to market, including Anderson, In May

Timberwolf, and Point Pleasant, which issued their securities in March and April 2007. and June 2007, the Mortgage Department began closing all of its remaining CDO warehouse accounts and transferring the assets to the SPG Trading Desk for sale. Lehman reported that the ABS Desk had just sold another $50 million in RMBS securities from the CDO warehouse accounts for a profit of $1 million, and that: “[o]nly 40mm RMBS A3/A- remain in the WH [warehouse] accounts, ½ of which is Long Beach paper - continue to work.”

On June 22, 2007, Mr.

2071

2073

2072

See 2/23/2007 email from Daniel Sparks, “Mortgages today,” GS MBS-E-009759477 (“We liquidated 3 CDO

1/31/2007 email from Daniel Sparks to Tom Montag, “MTModel,” Hearing Exhibit 4/27-91. See, e.g., 2/25/2007 emails between Daniel Sparks and Tom Montag, “Questions you had asked,” GS MBS-E-

2067 2068

2069 warehouses today and started the liquidation of another.”); 2/26/2007 emails between Daniel Sparks and Tom Montag, “Questions you had asked,” GS MBS-E-019164799; 2/22/2007 email from Peter Ostrem to David Rosenblum, “League Tables,” GS MBS-E-001800683 (“FYI Liquidating 3 warehouses tomorrow. And Dan [Sparks] wants to liquidate Greywolf.”). 2070 2071 Exhibit 4/27-75 (Mortgage Department is “rushing to get deals rated”). See also discussions of Anderson and Timberwolf CDOs, below. 2072 warehouses”); 5/30/2007 email from David Lehman, “ABX hedges – Buy order,” GS MBS-E-011106690 (directing trading desk to unwind hedges for CDO warehouse accounts). Some of the assets were accounted for in a separate “CDO Transition book,” but the sale of the assets became the responsibility of the SPG trading desk. 2073

2/25/2007 emails between Daniel Sparks and Tom Montag, “Questions you had asked,” GS MBS-E-019164799. See, e.g., 3/8/2007 email from Daniel Sparks to Mr. Winkelried and others, GS MBS-E-002206279, Hearing

See 6/1/2007 email from David Lehman, “CDO Update,” GS MBS-E-001866889 (referring to “liquidated

6/22/2007 email from David Lehman, “Few trade posts,” GS MBS-E-010848985.

Throughout 2007, Goldman sought to sell all of its remaining subprime assets from the CDO warehouse accounts as well as the new securities issued by Goldman-originated CDOs.2074

493

Aggressive Sales Efforts. On March 9, 2007, Mr. Sparks emailed a call for “help” to

Goldman’s top sales managers around the world to “sell our new issues – CDOs and RMBS – and to sell our other cash trading positions.” In response, Mr. Sparks and key sales managers had a dialogue about “reaching the next wave of players here and abroad.”

2075

2076

The Goldman sales manager for Europe and the Middle East suggested that Mr. Sparks

focus the CDO sales efforts abroad, because the clients there were not involved in the U.S. housing market and therefore were “not feeling pain”:

“The key to success in the correlation melt-down 2 years ago was getting new clients/capital into the opportunity quickly. Saved/made us a lot of money. Lots of banks and real money clients in Europe and middle east and lots of macro hedge funds are not involved and not feeling pain. In Europe we need a summary of key opportunities/axes and I will get the team to focus on. 2-3 most important things plus sales talking points rather than laundry list.”2077

Mr. Ostrem, head of the CDO Origination Desk, agreed with expanding Goldman’s CDO sales efforts in Europe and the Middle East: “I agree with [sales manager’s] comments on new clients. Middle east, french banks, macro hedge funds could and are making these deals ‘work’ currently.” Goldman sales force placing a priority on selling securities from the Anderson, Timberwolf, and Hudson CDOs:

The following week, Mr. Lehman issued three new sales directives or “axes” to the

2079

2078

“As per [European/Middle East sales manager’s] suggestion last Friday, below are the three main focus areas for SP CDOs/SPG Trading, including Anderson Mezzanine, Timberwolf CDO^2 and secondary CDO positions (Hudson Mezzanine and high grade BBBs).”

Goldman’s New York sales office forwarded the axe sheet to the European/Middle East sales office saying: “London – this is for you.”

2080

Between the fall of 2006 and mid-2007, Goldman originated 14 CDOs, which included or referenced many

3/9/2007 email exchange between Daniel Sparks and sales managers, “help,” GS MBS-E-010643213, Hearing

2074 assets that were from or similar to Goldman’s own inventory. The Subcommittee examined seven of those CDOs, and found that 57% of the CDO assets had come from Goldman, including over $3 billion in synthetic assets in which Goldman was the short party, and therefore stood to profit from a decline in the value of the underlying assets. Goldman had unsold securities from a number of these CDOs on its books. 2075 Exhibit 4/27-76. 2076 2077 2078 2079

2080

Id. Id. Id. 3/12/2007 email from David Lehman, “Internal Three focus axes for SP CDOs/SPG Trading,” GS MBS-E-

Id.

In an additional effort to expand Goldman’s sales effort, the Mortgage Department’s sales

syndicate provided a list of “non-traditional buyers” to the CDO and SPG Trading Desks:

494

“We have pushed credit sales to identify accounts in the credit space that would follow yield into the ABS [asset-backed security] CDO market, and tried to uncover some non-traditional buyers. … Below is a list of higher delta accounts uncovered so far; and we continue to push for leads. We are working with sales on these accounts to push our axes.”

2081

Goldman personnel worked diligently to pitch CDO securities to various clients, internal documents show. On March 30, 2007, for example, Fabrice Tourre reported to senior Mortgage Department executives about his efforts and plans to sell the CDO securities:

“This transaction [Abacus 2007-AC1] has been showed to selected accounts for the past few weeks. Those selected accounts had previously declined participating in Anderson mezz, Point Pleasant and Timberwolfe. … Plan would still be to ask sales people to focus on Anderson mezz, Point Pleasant and Timberwolfe, but if accounts pass on these trades, steer them towards available tranches in ABACUS 07-AC1 since we make $$$ proportionately with the notional amount of these tranches sold. Wanted to make sure everyone is comfortable with this plan.”2082

In April 2007, the Mortgage Department issued a new directive to its sales force with a list

of new and old CDO securities in its inventory that it wanted sold, including Timberwolf and Anderson as well as CDOs known as Point Pleasant and Altius. sales, Mr. Sparks suggested issuing a separate axe for each CDO and offering additional sales credits: “Why don’t we go one at at a time with some ginormous credits - for example, let’s double the current offering of credit for timberwolf.” A sales manager responded: “We have done that with timberwolf already. Don’t want to roll out any more focus axes until we get some traction there but at the same time, don’t want to stop showing inventory.”

Dissatisfied with the pace of

2083

2084

“Gameplan” for CDO Valuation Project. By May 2007, CDO sales had slowed

significantly. Goldman executives became concerned about the lack of sales prices to establish the

3/21/2007 email from syndicate, “Non-traditional Buyer Base for CDO AXES,” GS MBS-E-003296460,

3/30/2007 email from Fabrice Tourre to Daniel Sparks, David Lehman, and others, GS MBS-E-002678071,

4/11/2007 email from syndicate, “GS Syndicate Structured Product CDO Axes (INTERNAL),” GS MBS-E-

2081 Hearing Exhibit 4/27-78. 2082 Hearing Exhibit 4/27-80. 2083 010533482, Hearing Exhibit 4/27-101. Mr. Sparks forwarded the directive to global senior sales executives with a note: “Your focus on this ax would be very helpful – we are trying to clean up deals and this is our priority.” 2084 4/19/2007 email from Daniel Sparks to Bunty Bohra, GS MBS-E-010539324, Hearing Exhibit 4/27-102. Mr. Sparks authorized large sales credits on at least one other occasion as well – for sales to cover the Department’s $9 million AAA ABX net short position in September 2007. See 9/27/2007 email from Tom Montag to Daniel Sparks, GS MBS-E-010703744 (Mr. Montag asked: “Did we really pay sixty million in gcs [gross credits] on the aaa short covering? Why so high?” Mr. Sparks responded: “It was a very big ax, but sales credits have become such a contentious point that trading team doesn’t debate it anymore. The politics around sales credits had become unbelievable and were a hinderance [sic] to business.” Mr. Montag replied: “so you overpay?”).

495

2085

value of its CDO holdings. Goldman needed accurate values, not just to establish its CDO sales prices, but also to value the CDO securities for collateral purposes and to comply with Goldman’s policy of using up-to-date market values for all of its holdings. Mr. Sparks expressed concern that the value of the remaining CDO assets were rapidly declining, warning one senior executive: “We are going to have a very large mark down – multiple hundreds. Not good.”

2086

On May 11, 2007, Goldman senior executives, including Mr. Cohn and Mr. Viniar, held a

lengthy meeting with Mortgage Department personnel, their risk controllers, and others to develop a “Gameplan” for a CDO valuation project. over the course of about a week, to use three different valuation methods to price all of its remaining CDO warehouse assets and unsold securities from the Goldman-originated CDOs then being marketed to clients.

The Gameplan called for the Mortgage Department,

2087

2088

A few days later, on May 14, 2007, while the CDO valuation project was underway, Mr.

Montag asked Mr. Sparks for an estimate of how much the firm would need to write down the value of its CDO assets. Mr. Sparks responded that the “base case from traders is down [$]382 [million].” He also wrote:

“I think we should take the write-down, but market [the CDO securities] at much higher levels. I’m a little concerned we are overly negative and ahead of the market, and that we could end up leaving some money on the table.”

2089

The valuation project’s results were summarized in a presentation dated Sunday, May 20,

2007, prepared for a 9:00 p.m. conference call that night with Mr. Viniar, in which Mr. Mullen, Mr. Sparks, Mr. Lehman, and others also participated.

Using the three valuation methods, the

2090

2085 See, e.g., 5/11/2007 email from Tom Montag to Daniel Sparks, GS MBS-E-019648100. 2086 5/11/2007 email from Daniel Sparks to Richard Ruzika, “You okay?,” GS MBS-E-019659221. 2087 Id. (“We had a meeting today with viniar, don [Mullen], mcmahon, my team, controllers, gary [Cohn] on the phone to walk through situation. The market has seized up so much that levels are very hard to determine for the complex products – which also are difficult to model for value due to market changes.”); 5/14/2007 email from David Lehman, “Gameplan – asset model analysis,” GS MBS-E-001865782 (last email in a longer email chain). 2088 5/14/2007 email from David Lehman, “Gameplan – asset model analysis,” GS MBS-E-001865782 (last email in a longer email chain) (“Following up from this afternoon’s meeting. We are going to better evaluate the CDO^2 risk using three distinct frameworks: 1) Blended scenario analysis using HPA [housing price appreciation;] … 2) Risk neutral/correlation framework, consistent with our current synthetic ABS CDOs[;] 3) Simplistic loss assumptions on the underlyings / Market Value Coverage”); 5/14/2007 email from Elisha Weisel, “Modelling Approaches for Cash ABS CDO/CDO^2,” GS MBS-E-001863618. See also 3/6/2007 email from Elisha Weisel to Daniel Sparks, “Property Derivs,” GS MBS-E-010649734 (discussing lack of model or models to consistently value subprime assets). 2089 2090 “Viniar Presentation - Updated,” GS MBS-E-010965211 (attached file “Mortgages V4.ppt,” “Mortgages Department, May 2007,” GS MBS-E-010965212). This document is identified in the relevant correspondence as “v.4,” and appears to be the final version of a draft presentation prepared earlier that day, “Mortgages Department, May 2007,” GS MBS-E-001863651, which bears a time and date stamp of May 20, 2007, 2:58 p.m. See also 5/20/2007 Goldman document, “Mortgage Presentation to David Viniar – Dial In Information,” GS MBS-E-

5/14/2007 email from Tom Montag to Daniel Sparks, GS MBS-E-019642797. 5/20/2007 email from Lee Alexander to Daniel Sparks, Donald Mullen, Lester Brafman, and Michael Kaprelian,

496

2091

presentation estimated that the loss in value and the total writedowns required for the firm’s CDO assets were between $237 and $448 million. The executive summary of the presentation also expressed concern about Goldman-originated CDO securities, especially its two CDO transactions, Timberwolf and Point Pleasant, since “[t]he complex structure of these positions makes them difficult to value and distribute.” securities, plus the equity and super senior tranches that had been retained by Goldman, was $4.3 billion. The executive summary also estimated the market value of the remaining assets from the CDO warehouse accounts at $1.5 billion, and expressed particular concern about selling $742 million in CDO securities from non Goldman originated CDOs due to “limited liquidity and price transparency in this space.” The executive summary stated that since “securitization is no longer a viable exit, the warehouse collateral will be marked to market on an individual basis.”

The presentation estimated that the market value of those CDO

2092

2093

The presentation also presented “Next Steps.” It recommended that Goldman “unwind the

warehouses” and use “[i]ndependent teams to continue to value” the CDO securities, equity tranches, and super senior tranches from the Goldman-originated securitizations. It also recommended that sales of the Goldman-originated CDO securities be targeted, first, at four hedge fund customers, Basis Capital, Fortress, Polygon, and Winchester Capital. The presentation also attached a list of 35 other target customers with notes regarding the status of efforts to sell them CDO securities in the past.2095

2094

The final document, “Mortgages V4.ppt” was emailed to Mr. Sparks and Mr. Mullen, and also messengered to Mr. Mullen’s home, at 8:31 p.m. on May 20, immediately before the scheduled call. 5/20/2007 email to Daniel Sparks and Donald Mullen, “Viniar Presentation – Updated,” GS MBS-E-010971156.

Goldman also produced a similar document prepared the day before, which may have been an earlier draft

Id. 5/20/2007 email from Lee Alexander to Daniel Sparks, Donald Mullen, Lester Brafman, Michael Kaprelian,

of the final presentation. 5/19/2007 Goldman presentation, “Mortgages CDO Origination – Retained Positions & Warehouse Collateral, May 2007,” GS MBS-E-010951926. This document is identified in the relevant correspondence as “Mortgages CDO Origination,” and the file name is “Mortgages V3.ppt.” This presentation was forwarded to Mr. Sparks for comment on May 19, 2007 at 12:32 a.m., and Mr. Sparks replied with comments at 5:57 p.m. Mr. Sparks forwarded the file “Mortgages V3.ppt” to himself at home on Sunday, May 20, 2007 at 8:07 a.m. 2091 The writedowns were required, in part, because the assets in the CDO warehouses had generally been marked at cost when purchased or at a value related to the final securitized structure, called “mark-to-securitization-exit.” Those valuation methods generally resulted in values well above what the assets would bring if sold individually in a declining mortgage market. 2092 2093 “Viniar Presentation - Updated,” GS MBS-E-010965211 (attached file “Mortgages V4.ppt,” “Mortgages Department, May 2007,” GS MBS-E-010965212). By May 2007, Goldman had ceased originating any new CDO securitizations. 2094 success in selling the CDO assets. Two of the customers, Basis Capital and Polygon, had already made recent purchases of Point Pleasant and Timberwolf securities, respectively, from Goldman. See Goldman Sachs response to Subcommittee QFR at PSI_QFR_GS0226.
2095 specific clients for CDO sales, but different Mortgage Department desks maintained their own “target lists” that focused on specific types of products, specific transactions, and specific types of cross-selling opportunities with other Goldman departments. See, e.g., 3/1/2007 email from Michael Swenson, “names,” GS MBS-E-012504595 (SPG Trading target list tiered according to likelihood of purchasing); 2/14/2007 email to Matthew Bieber, “Timberwolf I, Ltd. – Target Account List,” GS MBS-E-001996121 (list of U.S. accounts “we should be directly targeting” for Timberwolf sales); 3/2/2007 email from David Lehman, “ABX/Mtg Credit Accts,” GS MBS-E-

The client list drawn up pursuant to the Gameplan was a stark example of actions taken by Goldman to target

Id. The four identified customers appear to be ones which the sales force felt it had the greatest likelihood of

497

The CDO valuation project undertaken in May provided clear notice to Goldman senior

management at the highest levels that its CDO assets had fallen sharply in value, and that despite their lower value, the Mortgage Department planned to aggressively market them to customers. In an earlier draft of the presentation, the Mortgage Department had also stated that it expected Goldman’s CDO and CDO securities “to underperform”:

“The complexity of the CDO^2 product and the poor demand for CDOs in general has made this risk difficult to sell and the desk expects it to underperform.”2096

Mr. Sparks reviewed that draft language and made comments about other items on the same page, The same phrase appeared but did not change the phrase, “the desk expects it to underperform.”

2097

011057632 (mortgage credit business shared with SPG Trading Desk “a fairly lengthy list of accounts that are considered to be ‘key’”). In December 2006, the Correlation Trading Desk drew up a list of target customers for 2007: the “proposed top 20 correlation customer list.” 12/29/2006 email from Fabrice Tourre, “Last call–any other comments on the proposed top 20 correlation customer list,” GS MBS-E-002527843, Hearing Exhibit 4/27-61. Mr. Tourre issued a “last call” for comments on the list and suggested focusing on “buy-and-hold rating-base buyers” who might be more profitable for the desk than more sophisticated and demanding hedge fund customers:

“[T]his list might be a little skewed towards sophisticated hedge funds with which we should not expect to make too much money since (a) most of the time they will be on the same side of the trade as we will, and (b) they know exactly how things work and will not let us work for too much $$, vs. buy-and-hold rating- based buyers who we should be focused on a lot more to make incremental$ $ next year.”

The proposed top 20 list identified a number of European accounts, as well as customers who had purchased asset backed security products from Goldman in the past.

The reference to “buy and hold, ratings-based buyers” was to conservative financial institutions, often

insurance companies or pension funds, that tended to hold their investments indefinitely or until maturity, some of which were limited to holding investments with AAA or other investment grade credit ratings. Many of these buyers tended to rely on the AAA rating as a “seal of approval” signaling that the rated instrument offered predictable, safe returns. Many viewed the AAA rating as, in effect, all these buyers thought they needed to know about the CDO securities they were purchasing. See, e.g.,11/13/2007 Goldman email, GS MBS-E-010023525 (attachment, 11/14/2007 “Tri-Lateral Combined Comments,” GS MBS-E-010135693-715 at 713) (“Investors in subprime related securities, especially higher rated bonds, have historically relied significantly on bond ratings particularly when securities are purchased by structured investing vehicles.”). But as one press article explained: “CDO ratings may mislead investors because they can obscure the risk of default, especially compared with similar ratings for bonds, says Darrell Duffie, a professor of finance at Stanford Graduate School of Business in California, who’s paid by Moody’s to advise the company on credit risk. ‘You can’t compare these CDO ratings with corporate bond ratings,’ Duffie says. ‘These ratings mean something else – entirely.’” See 5/31/2007 email to David Lehman and others, “CDO Boom Masks Subprime Losses,” GS MBS-E-001865723 at 733. The article pointed out that the lowest grade of corporate bonds rated by Moody’s had a default rate of 2.2%, while the default rate for CDOs with the same rating was 24%. Id. 2096 May 2007,” GS MBS-E-010951926. 2097 5/19/2007 email from Daniel Sparks, “Mortgages CDO Origination Presentation,” GS MBS-E-010973174 (Mr. Sparks: “p. 5 again ‘marked to securitization exit’ [re marked to model language] … some A and BBB were sold on the deals [re demand only for the supersenior tranche language]”).

5/19/2007 Goldman presentation, “Mortgages CDO Origination – Retained Positions & Warehouse Collateral,

in several earlier versions of the presentation as well, but was removed from the final version sent to Mr. Viniar.

2098

498

CDO Desk Shutdown. In May 2007, Goldman decided to stop issuing new CDOs, and the

head of its CDO Origination Desk, Peter Ostrem, left the firm. replacement David Lehman, who was a senior member of the Structured Product Group (SPG) and head of its CMBS Trading Desk, but had little experience in either underwriting or CDOs. On 2100 May 19, 2007, Mr. Lehman received an email from a former Goldman managing director who wrote: “Congratulations, but seems like you have a lot ofwork [sic] ahead of you.” asked Mr. Egol: “What do u th[in]k he means by ‘lot of work to do?’”

Mr. Sparks named as his

Mr. Egol responded:

Mr. Lehman

2099

2101

2102

“I know what he means. If you talk to people knowledgeable about cdos, you will find that external perception of GS franchise in this space is much lower than Sparks and Sobel believed. Over the last 2 years, GS [Goldman Sachs] is perceived to be a bottom quartile abs [asset-backed security] cdo underwriter and to have done several poor deals. There is a reason [the CDO desk] didn’t sell much paper. The fact that [the CDO desk] was basically giving money away in these no-fee principal deals and could still only get TCW, GSC (both street wh—e managers) and some start up managers to work with GS is a stain that will take time to remove. The HG [high-grade] deals in particular are very poor. I thought the alladin deals had some potential but fortius 2 is going to be a real mess.

“These are not just my views – they are from customers whose views resonate in the market. Sales people have just been too timid internally or not engaged enough with their accounts to provide accurate feedback. It pains me to say it but citi, ubs, db [Deutsche Bank], lehman and ms [Morgan Stanley] have much stronger franchises – among large dealers only ML [Merrill Lynch] is more reviled than [Goldman’s] business. …

“I should add altius 3 is a doozy as well. I’ll spare you the detailed list.”2103

That May 19, 2007 email provided Mr. Lehman with additional notice of the poor quality of the CDO securities he was charged with selling.

See 5/19/2007 email from Dan Sparks to Lee Alexander, others, GS MBS-E-010973174 (attached file

2098 “Mortgages V3.ppt,” GS MBS-E-010973175); and 5/20/2007 9:52 a.m. draft “Mortgages V4.ppt,” GS MBS-E- 010952331; compared to final version, 5/20/2007 email from Lee Alexander to Daniel Sparks, Donald Mullen, Lester Brafman, and Michael Kaprelian, “Viniar Presentation - Updated,” GS MBS-E-010965211 (attached file “Mortgages V4.ppt,” “Mortgages Department, May 2007,” GS MBS-E-010965212). 2099 2100 responsibility of the business away from Ostrem to david lehman (with Swenson helping).”). 2101 MBS-E-018921924. 2102 2103

5/17/2007 email from Daniel Sparks to Tom Montag, “Ostrem is resigning,” GS MBS-E-019654926. 5/11/2007 email from Daniel Sparks, “You okay?,” GS MBS-E-019659221 (“I’m going to make a change in the

5/19/2007 email to David Lehman, “congratulations, but seems like you have a lot of work ahead of you,” GS

Id. 5/19/2007 email from Jon Egol to Daniel Sparks, GS MBS-E-018921924.

499

The CDO valuation project presentation given the next day, May 20, 2007, recommended that all assets from the CDO warehouse accounts be transferred to the SPG Trading Desk for sale. A CDO “transition book” was created to account for profits and losses from some of the assets, and the transfer took place the following week. In addition, by June 1, 2007, Goldman eliminated the CDO Origination Desk as a separate entity, and moved all of the remaining Goldman-originated CDO securities to the SPG Trading Desk, where Mr. Lehman was based. As a result, the SPG Trading Desk, which was a secondary trading desk and had little experience with the greater disclosure obligations involved with selling newly minted securities, became solely responsible for selling all Goldman-originated CDO securities.

2105

2104

Renewed Sales Efforts. After the transfer of the CDO assets, the SPG Trading Desk began

to work with the Goldman sales force to identify potential customers and sell the CDO products. On May 24, 2007, a Goldman salesperson contacted Messrs. Sparks and Lehman regarding two potential customers interested in Timberwolf and Point Pleasant securities. With respect to one customer, the salesman wrote that it was “[n]ot experts in this space at all but [I] made them a lot of money in correlation dislocation and will do as I suggest.” With respect to the second customer, the Goldman salesperson wrote that the customer had “just raised another $1bln for their ABS [asset backed security] fund and they are very short the ABX so are natural buyers of our axe.”

2107

2106

A couple of weeks before the CDO valuation project, Goldman’s Australia sales

2108

representative, George Maltezos, announced he had found a potential Australian buyer for a Goldman CDO being constructed by the Correlation Desk: “I think I found white elephant, flying pig and unicorn all at once.” On the same day the project identified Basis Capital as a primary target for CDO sales, May 20, 2007, Mr. Maltezos sent Mr. Lehman an email saying he would contact the Basis principals as soon as they returned from a business trip the following day.2109

On May 24, 2007, the CDO sales dry spell ended, when Paramax Capital Group, a U.S. On May 30, Mr.

investment adviser, purchased $40 million in AA Timberwolf securities. Lehman announced the sale of $20 million in AAA Timberwolf securities to Tokyo Star Bank in Japan.

2110

2111

Subcommittee interview of David Lehman (9/27/2010). 5/24/2007 email from Yusuf Aliredha to Mr. Sparks, Mr. Lehman, and others, “Priority Axes,” GS MBS-E-

2104 5/20/2007 email from David Lehman, “ABX hedges – Buy order,” GS MBS-E-011106690 (“begin unwinding certain ABX hedges vs. the CDO WH [warehouse] and transition book”); 6/1/2007 email from Mr. Lehman, “CDO Update,” GS MBS-E-001866889 (“liquidated warehouses and the trading books”). 2105 2106

2107 2108
2109 2110 2111 Tokyo Star Bank was not on the list of “targeted” customers, but had been solicited previously by the Japan sales team pursuant to an earlier sales directive listing Timberwolf as a priority.

5/20/2007 email from George Maltezos to David Lehman, “T/wolf and Basis,” GS MBS-E-001863555. See Goldman Sachs response to Subcommittee QFR at PSI_QFR_GS0226. 5/30/2007 email from David Lehman, “Timberwolf – Order from Tokyo Star Bank,” GS MBS-E-001934058.

Id. 4/27/2007 email from George Maltezos, Goldman Australia sales, to Jon Egol, “utopia,” GS MBS-E-

500

CDO Sales in Asia. On June 11, 2007, Mr. Lehman received a note from the Mortgage Department’s sales syndicate desk asking whether the directive listing high priority CDO sales could be sent to the Japan sales office, which oversaw sales throughout Asia:

“Know there was sensitivity w/ sending this out, but asia sales management is asking again. Do you want to consider sending more broadly for asia sales or do you want to stick with the more targeted approach?”2112

The Japan sales group wrote that the head of the Japan office “is saying that we need it to go more broadly to all Sales at least in Japan. Given her request twice now and her help in getting focus, think we should at least push this in Japan.” Mr. Lehman responded: “Fine – let’s send to all Japan sales then.”2114

2113

The Japan sales office responded to the new directive with several quick sales. On June 13,

2007, the Japan sales office sent out this celebratory note:

“We have moved over $250mm of SP CDO axes to account in Japan, Australia and Korea over the past 2+ weeks. These are HUGE orders for the firm as they have helped reduce balance sheet risk and further exhibits the importance of the Asia franchise to the global Structured Products Group business. Note that in line with these trades we have paid out over $14mm of gross credits – this is clearly the top focus for us now in SP [Structured Product] CDO space. … Call the SPG Asia desk in Tokyo for updated axes and offer levels. We hope to trade another $20mm of CDO^2 risk with a Japanese account in the coming week+. Thanks.”2115

Mr. Lehman replied: “Thx for sending this out.”

2116

A few days later, Mr. Lehman reported to senior management that the Japan sales office had

been successful in selling another $20 million in CDO securities. Mr. Lehman wrote:

“Great job by [Japan sales] (again) on our CDO^2 axes. Tonight we will trade $20mm Point Pleasant A1s @90.7 to Tokyo Star Bank …. We hope to trade another $20mm of these bonds next week w/ this account.”

2117

6/11/2007 email from syndicate, “GS Syndicate Structured Product CDO Axes (INTERNAL USE ONLY),” GS

6/18/2007 email from David Lehman, “$20mm Point Pleasant trade w/ TK Star Bank,” GS MBS-E-011136832.

Id. Id. See also “New Investors Board the Asian CDO Train,” Creditflux (6/1/2007) (noting that while non bank

2112 MBS-E-001914921-24. 2113 2114 investors had previously been barred from buying CDO assets in most Asian countries, regulators increasingly allowed life insurance companies and other financial firms to buy them within prescribed limits). 2115 USE ONLY),” GS MBS-E-010803888 [emphasis in original]. 2116 USE ONLY),” GS MBS-E-011212260.
2117

6/13/2007 email from Goldman Sachs Japan sales, “GS SP CDO Axes – Asia Trade Update (INTERNAL

501

Mr. Lehman sent an email to the head of the Japan sales office letting him know that Goldman’s senior management was aware of the sales effort: “Montag ve[r]y involved in this fyi.” The Japan sales manager responded: “Yes – he made that clear when he spent almost 20 minutes on the desk with me in TKO [Tokyo] last week going through every potential lead.” Japan sales manager sent out a new email urging the trading team to bring in another $20 million from Tokyo Star Bank and promising them additional sales incentives:

That same day, the

2118

“To reward your strong effort and in hopes of the follow on 20mm order from the client on this deal, we plan on paying you a total bonus GC payment of $40 / bond (double our $20/bond for AAA’s on our axes that are not lower mezz AAA). We look forward to additional trades from Tokyo Star Bank on our CDO axes.”2119

During June and July, additional sales took place in Japan, Korea, Taiwan, and Australia.

2120

Goldman also made sales to customers in Europe and the Middle East.

2121

Despite the sales in June and July, Goldman continued to have a significant inventory of

2122

unsold CDO securities. On August 15, 2007, Mr. Mullen even made a casual reference to “our cdo business which remains unsaleable.” If Goldman’s CDOs remained unsaleable, however, it was not for lack of trying. In August and September 2007, Goldman switched from its targeted customer approach to issuing broad directives to its entire sales force in the United States and abroad urging them to concentrate on its CDO securities. On August 17, 2007, for example, the SPG Trading Desk issued a new directive to certain salespersons asking them to place a priority on selling interests in two Timberwolf super senior tranches. These tranches were first in line to receive payments within the CDO and so had the lowest risk. Super senior CDO positions were often sold through CDS contracts, sometimes called super senior swaps, in which the customer took the long side and the CDO originator took the short side, and that’s what Goldman wanted the sales force to market. But the following week, on August 23, 2007, Goldman sent a new directive to the sales force urging them to find customers willing to take the short side of the super senior tranches, so the Mortgage Department could take the long side and cover some of its shorts. When asked his opinion of the directive, the head of Japan sales office expressed skepticism about sales to Asian customers:

2123

2124

“The only question in my mind is that we have not seen many accounts pushing hard to find ways to get short (typically they are long only). That being said, the reality of the current

See Goldman Sachs response to Subcommittee QFR at PSI_QFR_GS0226; 7/24/2007 email from [Taiwan],

Id. 6/18/2007 email from Goldman Sachs Japan sales, “Point Pleasant 07-A1 // Tokyo Star Bank (internal use

2118 2119 only),” GS MBS-E-001920459 [emphasis in original]. 2120 “7/23 CDO/RMBS requests from Taiwan,” GS MBS-E-011198375, Hearing Exhibit 4/27-67. 2121 2122 2123 2124 ONLY), GS MBS-E-011310717.

Id. 8/15/2007 email from Donald Mullen, “Post,” GS MBS-E-009740784, Hearing Exhibit 4/27-32. 8/17/2007 email from Michael Swenson, “Twolf super seniors,” GS MBS-E-001927791. 8/23/2007 email from Jon Egol, “** SP CDO/Correlation Desk Super Senior Axes ** (INTERNAL USE

502

market may have finally sunk in and investors may be able to convince their boards [n]ow to put on this sort of trade.”2125

On September 5, 2007, notwithstanding “the reality of the current market,” the SPG Trading The directive placed a priority

Desk issued a “Refresh of Axe Priorities” to its entire sales force. on selling Goldman’s residual CDO equity tranches as well as a variety of other assets to help Goldman cover and lock in the profits from its big short. Mr. Sparks emailed senior sales executives:

2126

“Please let me know how these are going. I am personally going to work to do a better job making sure you understand the things we are trying to achieve as a business. In addition to this, the super-senior ABX trade [Jonathan] egol sent around and general securities financing trades are priorities for us.”2127

Mr. Sparks forwarded this email to Mr. Cohn, who responded “Great to see.” On September 6, Mr. Sparks emailed the syndicate desk about the “Refresh of Axe Priorities”: “Want to get you to send out daily 1-3 priority axes for department – let’s discuss.”2129

2128

Goldman has at times suggested that many of its CDO sales were not the result of

affirmative client solicitations and recommendations made by the firm, but were in response to client requests–generally known as “reverse inquiries.” In a letter to the Financial Crisis Inquiry Commission, for example, Goldman’s General Counsel, Gregory Palm, made the following statement about Goldman’s role as an underwriter of synthetic CDOs:

“Goldman Sachs’ CDOs containing primarily residential mortgage-related synthetic assets were initially created in response to the request of a sophisticated institutional investor that approached the firm specifically seeking that particular exposure. Reverse inquiries from clients were a common feature of this market. … These transactions often are initiated by our clients, and when proposed by us are often in response to previously expressed

Id. Around the same time, a Goldman managing director who ran Corporate / PWM [Private Wealth

2125 Management] Sales in Japan and sold investments to wealthy individuals, inquired: “Do you have any cdo secondary inventory.” 8/21/2007 email from PWM Managing Director, GS MBS-E-010619382. He was advised by the SPG Trading Desk that Goldman was “prohibited from offering cdo paper to all pw [private wealth] clients, even [qualified institutional] pw clients. … To change this, we would have to petition the committee that oversees such things [the Structured Investment Product Committee].” Id. Mr. Lehman added: “Spoke with Sparks about this.
Given the complexity of the product, we would like to handle this on a client by client basis.” Id. After receiving information that potential clients had previously purchased ABS CDOs from other firms, Mr. Lehman asked Goldman compliance: “What do we need to do on our end to get this approved.” 8/28/2007 email from David Lehman, “Japan PWM Client Interest in ABS CDO (internal use only),” GS MBS-E-011090928. One of Mr. Lehman’s team members in the Mortgage Department replied: “Ldl [let’s discuss live]. Have info on this.” Id. Mr. Lehman replied “xoxo.” Id. 2126 2127 2128 2129

9/5/2007 email from Michael Swenson, “Refresh of Axe Priorities,” GS MBS-E-010684858. Id. Id. 9/6/2007 email from Daniel Sparks to syndicate desk, “Refresh of Axes Priorities,” GS MBS-E-010685200.

503

investment interests of the client. We are responding to our clients’ desires either to establish, or to increase or decrease, their exposure to a position based on their own investment views.”2130

Mr. Palm’s characterization of Goldman as playing only a passive, responsive role is at odds with the firm’s documented and concerted efforts to market its CDO securities in the face of investor disinterest and falling values. Throughout 2007, Goldman issued directives to its sales force to sell specific CDO securities on a “first priority” basis. It expanded its selling efforts to “nontraditional buyers” as well as to banks, hedge funds, and other clients in Asia, Europe, and the Middle East. It offered its sales force substantial incentives, such as “ginormous” sales credits, to push the sales to clients. Under its CDO Gameplan, Goldman “targeted” four primary and 35 secondary clients for CDO sales, and celebrated selling CDO securities to several of them. The weight of this evidence demonstrates that Goldman was soliciting sales rather than responding solely to client inquiries.

2131

CC. CDO Marks

One issue that gained intensity as the mortgage market continued its decline was Goldman’s

practice of selling CDO securities to customers at one price only to mark down the value substantially within days or weeks of the sale, where Goldman had an ongoing client relationship.

Goldman used a mark-to-market process to manage its risk, which required valuing its

holdings on a daily basis to reflect their current market value. related assets were marked on a monthly rather than daily basis, including many of its CDO securities. Nonetheless, Goldman appears to have been more active in re-marking the value of its mortgage related assets than other Wall Street firms and to have used lower marks than many of its competitors. Goldman also had a process for automatically marking down its internal value of any asset held longer than a specified period of time, in order to encourage its trading desks to sell their aged assets.

In practice, many of its mortgage

2132

2135

2133

2134

Subcommittee interview of David Viniar (4/13/2010) and Craig Broderick (4/9/2010). See, e.g., 2/2007 Goldman email chain, “FYIs,” GS MBS-E-002339552 (regarding residential credit scratch &

3/1/2010 letter from Goldman Sachs to the Financial Crisis Inquiry Commission, GS-PSI-01310 at 16. 4/19/2007 email from Daniel Sparks, “UPDATE GS Syndicate Structured Product CDO Axes,” GS MBS-E-

2130 2131 010539324, Hearing Exhibit 4/27-102. 2132 2133 dent loan book: “Has the biz agreed with controllers about how frequently each book is to be marked? Daily? Weekly? Monthly?”; Mr. Sparks’ response: “For this book I think monthly is the right way as the data comes monthly on performance. Dramatic mkt moves could change things.”). CDOs were often marked monthly, as hedge fund clients generally needed month-end valuations of CDOs in their portfolios to enable them to report hedge fund Net Asset Values (NAVs) to clients. See, e.g., 6/28/2007 email from Bear Stearns, “Missing Marks (15).xls,” GS MBS-E-001965860 (portfolio manager requesting month-end marks: “I need the 4 bonds marked for 5/31/07 we still need to report an NAV.”); 6/19/2007 email from Lester Brafman to Jon Egol, GS MBS-E-003373736 (regarding Abacus CDO securities, Mr. Egol wrote: “We mark them monthly”). 2134 See, e.g., 2/12/2007 email from Daniel Sparks, “Post today,” GS MBS-E-009763506 (New Century “claim[s] we are the only ones being harsh. C-Bass claims we are the only one margin calling. Our marks are appropriate for moves in the market. More margin calls going out today.”). 2135 Subcommittee interview of David Lehman (4/12/2010).

504

2136

During 2007, Goldman’s markdowns of the value of its CDO securities became a source of

Some clients were negatively affected in a variety of ways when

dispute with its customers. lower values were assigned to Goldman’s CDO securities. Some had purchased their CDO securities through “repo” financing arrangements with Goldman; under those arrangements, a decline in the value of the CDO securities being financed required the client to post more cash margin with Goldman. In a few other instances, clients had invested in CDO securities through a CDS contract with Goldman. If the CDO securities declined in value, the CDS contracts required those clients to post more cash collateral with Goldman. In other cases, clients did not have to post additional cash collateral, they simply incurred losses from the lower values.

2137

Lower marks also had significance for Goldman internally, since a CDO security with a

marked down value might reduce the firm’s profits and reduce its long position. Alternatively, if Goldman held the short side of an investment, a lower mark might increase the firm’s profits, increase the value of its short position, and bring in more cash from the long parties. When the firm held a proprietary position in opposition to the position held by a client, the fact that Goldman was marking the value of its own position created a conflict of interest, since Goldman would benefit as the client lost money.

Mr. Broderick explained in his interview with the Subcommittee that because of the volatility in the subprime

2136 market, Goldman had an unusually large number of disputes with customers over marks or collateral valuation during 2007. Subcommittee interview of Craig Broderick (4/9/2010). See also 8/2/2007 email from Stacy Bash- Polley, “Marks Summary,” GS MBS-E-013349723 (transmitting complaints from eight clients that Goldman’s marks were far lower than those of other dealers); 2/12/2007 email from Daniel Sparks, “Post today,” GS MBS-E- 009763506 (New Century “claim[s] we are the only ones being harsh. C-Bass claims we are the only one margin calling.”); 8/10/2007 Goldman memorandum, “Summary of German Bank US Sub Prime Exposure,” GS MBS-E-009994305. This memorandum was generated by Goldman’s European Investment Banking Division, FICC Sales and Credit. It highlighted losses incurred by many German banks due to markdowns in the value of U.S. subprime assets, necessitating several European Central Bank bailouts. The memorandum stated: “We understand from clients that valuation marks provided by Goldman Sachs on ABS are substantially lower than the competition’s valuations. As a result, clients are irritated by the valuation difference.”

Goldman’s dispute with AIG FP is another example. The two companies disagreed over both the marks and

the amount of collateral and margin that AIG had to post with Goldman in connection with various mortgage products. At one point in the dispute, Co-President Jon Winkelried wrote to his colleagues: “[O]ne thing we’re not going to do is compromise on what we think the right marks are and our margin process.” 8/2/2007 email from Jon Winkelried, “Aig collateral call,” GS MBS-E-010055302. Goldman’s dispute with AIG continued for over a year until the Federal Reserve, through the Maiden Lane III transaction, ultimately ensured that Goldman and its customers received 100 cents on the dollar on the bulk of their disputed claims against AIG. Subcommittee interview of David Viniar (4/13/2010). Goldman later told regulators that it had more collateral disputes than anticipated during the financial crisis. 11/13/2007 Goldman email, GS MBS-E-010023525 (attachment, 11/14/2007 “Tri-Lateral Combined Comments,” GS MBS-E-010135693-715 at 695). According to Goldman documents, as late as October 30, 2007, its Mortgage Department generated approximately 66% of all derivative collateral disputes by Goldman customers. 10/30/2007 Goldman presentation, “Derivative Collateral Dispute Summary,” GS MBS-E- 009882064. 2137 MBS-E-009994305 (highlighting losses incurred by many German banks due to markdowns in the value of U.S. subprime assets, necessitating several European Central Bank bailouts).

See, e.g., 8/10/2007 Goldman memorandum, “Summary of German Bank US Sub Prime Exposure,” GS

505

Gameplan Markdowns. When, on May 11, 2007, Goldman executives and the Mortgage

Department decided to embark upon a CDO valuation project, Goldman’s Chief Risk Officer, Craig Broderick, sent an email to his team to discuss the consequences of lower CDO values for Goldman’s clients. He wrote:

“Sparks and the Mtg [Mortgage] group are in the process of considering making significant downward adjustment to the marks on their mortgage portfolios esp[ecially] CDOs and CDO squared. This will potentially have a big P&L [profit and loss] impact on us, but also on our clients due to the marks and associated margin calls on repos, derivatives and other products. We need to survey our clients and take a shot at determining the most vulnerable clients, knock on implications, etc.”2138

Mr. Broderick called for a client survey to identify which clients were “most vulnerable” to financial difficulty if Goldman’s CDO securities were marked down in value, and they either incurred losses or were required to post more cash margin or collateral. He also wrote: “This is getting lots of 30th floor attention right now.”2139

Some Goldman managing directors also raised the issue of selling CDO securities to clients

at a price that would be marked down almost immediately. In a May 11 email to colleagues, for example, Goldman senior executive, Harvey Schwartz, wrote: “[D]on’t think we can trade this with our clients andf [sic] then mark them down dramatically the next day.” exchange of emails with Mr. Schwartz, Mr. Montag, and Mr. Sparks, Don Mullen acknowledged Mr. Schwartz’s concern “about the representations we may be making to clients as well as how we will price assets once we sell them to clients.” The Goldman executives also agreed, however, not to “slow or delay” efforts to sell the CDO securities, if the sales force received “strong bids.”

Later that day, in an

2141

2140

2142

The May 2007 CDO valuation project resulted in lower values for many of Goldman’s CDO

assets. While those internal markdowns were taken at month’s end, around May 25, 2007, Goldman continued to price the CDO securities it was selling at much higher levels, creating the potential for a rapid markdown after an asset was sold.2143

“Monster CDO Re-Mark.” Six weeks later, in mid-June, the Mortgage Department

learned that two Bear Stearns hedge funds with a $17 billion portfolio of subprime assets were in

5/11/2007 email from Craig Broderick, “CDOs - Mortgages,” Hearing Exhibit 4/27-84. Id. The reference to the “30th floor” was the floor on which Goldman’s most senior executives had office space

2138 2139 in its New York headquarters. 2140 5/11/2007 email from Harvey Schwartz to Daniel Sparks, Tom Montag, and others, GS MBS-E-010780864. As explained earlier, some clients were affected by Goldman’s marks even after completing purchase of CDO securities, due to repo financing margin requirements, CDS collateral requirements, or other arrangements. 2141 010780849, Hearing Exhibit 4/27-103.
2142 2143

5/11/2007 chain of email exchanges among Messrs. Mullen, Schwartz, Montag, and Sparks, GS-MBS-E-

Id. See, e.g., discussion of Timberwolf CDO, below.

506

financial distress. The Mortgage Department immediately initiated an effort to build a new, large short position to take advantage of the expected drop in the value of subprime mortgage assets. 2144 Within two weeks, Goldman had amassed a large number of CDS contracts shorting a variety of subprime mortgage assets. By June 22, 2007, Goldman’s short position reached its peak size of approximately $13.9 billion.

2145

The Bear Stearns hedge funds failed in mid-June, subprime assets plummeted in value, and Goldman established its big short by the end of the month. After its new net short was in place, the Mortgage Department implemented a series of large markdowns in the value of its RMBS and CDO assets. The markdowns had the dual effect of increasing the value of Goldman’s net short position, while reducing the value of many of its customers’ holdings. Due to their financing arrangements or CDS contracts, the lower values meant that some of the affected clients also had to post more margin or cash collateral with the firm. Goldman issued broad and deep markdowns of its clients’ positions at month’s end in June, July and August 2007, as well as on intermittent dates in response to mass ratings downgrades of specific RMBS securities in July and August or to individual customer credit issues.

One of the markdowns took effect on July 25, 2007,

2146

2147

In an email to Mr. Mullen, Mr. Sparks wrote: “We made massive mark 2148

monster remark.” In a adjustments this week, pushed them through because of basis and counterparty exposure.” separate email to Mr. Montag, Mr. Sparks made clear that by “basis,” he meant Basis Capital, an Australian hedge fund that had financed the purchase of Timberwolf and other CDO securities using Goldman funds and defaulted on its margin and collateral obligations. Goldman then repurchased those securities at a low price and adjusted its marks for other clients.

2149

which Mr. Sparks called “the CDO

The CDO markdown drew an immediate negative reaction from Goldman’s customers. On

July 31, 2007, an internal report was sent to a dozen Goldman senior executives and Mortgage Department personnel regarding pending “mortgage derivative collateral disputes,” meaning customers who were disputing the lower valuations and resulting cash margin and collateral calls.

The email identified the “10 largest disputes,” naming AIG Financial Products, Morgan

2150

7/29/2007 email from Daniel Sparks to Tom Montag, “Problem,” GS MBS-E-010876595 (“[w]e probably

See 7/25/2007 email from Arbind Jha to Kevin Kao, “Cash bonds,” GS MBS-E-011128623 (“huge changes in

See Section (3)(a), above. 4/2010 “Goldman Sachs Mortgage Department Total Net Short Position, February - December 2007 in $

2144 2145 Billions (including All Synthetic and Cash Positions in Mortgage Related Products),” Hearing Exhibit 4/27-162. 2146 marks today”). 2147 should have taken more time to put through the CDO monster remark”).
2148 7/29/2007 email from Daniel Sparks to Mr. Mullen, “Problem,” GS MBS-E-010876565. 2149 7/29/2007 email from Daniel Sparks to Tom Montag, “Problem,” GS MBS-E-010876595 (“we rushed it because of Basis and a desire to protect ourselves against counter-parties”). See also 7/13/2007 email from John McHugh to Michael Swenson and David Lehman, “Talking Points Needed for Gary Cohn,” GS MBS-E-010853931 (“BSAM [Bear Stearns Asset Management] & other hedge fund managers (most recently Basis Capital) announced they were halting fund redemptions and/or liquidating holdings, with some likely to fail.”). 2150 Disputes – 7/31 Update (COB 7/27 marks),” GS MBS-E-009691545.

See 7/31/2007 email chain between Tom Montag and Lloyd Blankfein, “Mortgage Derivative Collateral

507

Stanley, and Deutsche Bank, among others. It stated: “The overall derivative collateral dispute amount is now $7.0 billion.” had been $3 billion, which suggests that the July 25 markdowns had caused the amount in dispute to more than double in a week. Mr. Montag immediately forwarded the report to Mr. Blankfein: “7 billion of collateral disputes!!!”

The email also noted that the total in dispute from the prior week

2152

2151

Mr. Blankfein responded: “Make sure they prioritize weaker credits where our risk is

2153

In other words, Mr. Blankfein directed Goldman personnel to focus on disputes

threatening.” with clients that had the weakest credit, and might have fewer resources to pay the amounts owed to Goldman as a result of the downward marks. The same markdowns causing losses for those clients were simultaneously increasing the profitability of Goldman’s net short.

Two weeks later, the Mortgage Department implemented another large markdown, this time

related to Goldman’s Abacus CDOs. This markdown took place on August 16, 2007, after the Correlation Trading Desk adjusted its correlation assumptions in a way that resulted in steep markdowns for Abacus CDO customers and a corresponding $94 million increase in the value of the Correlation Trading Desk’s net short positions on the same CDOs. Department as a whole reported a $121 million profit that same day. Mr. Sparks reported to senior management: “94mm … is from correlation adjustment in ABX (from 50 to 70%) as market Also on August 16, 2007, Mr. Egol observability better recently, rest is from outright shorts.” listed the Correlation Trading Desk’s Top Ten Winners and Losers due to Goldman’s markdowns and calculated that “[t]he aggregate P&L in the book is $405mm (ie net markdown to customers), much of this is scattered across a bunch of cashflow CDOs.”

The Mortgage

2155

2154

2156

DD. Customer Losses

Goldman’s internal marks demonstrate that, at the time it sold its CDO securities,

Goldman’s senior management knew its sales force was selling CDO securities at inflated prices and that the CDO securities were also rapidly losing value. In addition, soon after selling the CDO securities, Goldman marked down their value, causing some customers to incur substantial losses

Id. Id. By late August, Goldman had instituted a system that required senior management pre-approval for large

2151 2152 markdowns. On August 28, 2007, Mr. Lehman sent Mr. Sparks a list of “Mark changes which are greater than 5% / greater than 10%” for his approval. 8/28/2007 email from David Lehman to Daniel Sparks, GS MBS-E-010623779. Mr. Lehman asked whether he should ask Mr. Mullen for approval of the changes greater than 10%, and Mr. Sparks told him to do so. Id.
2153 2154 the entire net short side in many of its Abacus CDOs, the customers’ losses translated directly into gains for Goldman. 2155 other mortgage desks.
2156 name mark changes,” GS MBS-E-011092473, Hearing Exhibit 4/27-33.

Id. 8/16/2007 email from Daniel Sparks, “Mort P&L explanation,” GS MBS-E-010680327. Since Goldman took

8/16/2007 email from Jon Egol to Michael Swenson, “Projected Corr Customers winners/losers from single-

Id. The Correlation Trading Desk reported $145 million in total profits, which were then offset by losses on

508

within days or weeks of a purchase and undergo substantial margin and collateral calls that caused additional financial distress.

2157

One Goldman salesperson expressed remorse over the impact on their customers of CDO

sales followed by large markdowns within days or weeks of the client’s purchase:

“Real bad feeling across European sales about some of the trades we did with clients. The damage this has done to our franchise is significant. Aggregate loss for our clients on just … 5 trades alone is 1bln+.”

2158

At the same time, the salesperson thought the sales force deserved a bigger share of the profits generated for the firm:

“In addition team feels that recognition (sales credits and otherwise) they received for getting this business done was not consistent with the money it ended up making/saving the firm.”2159

A Goldman salesperson in Taiwan sought help in explaining Goldman’s markdowns to a

bank whose CDO investment had been marked down from about 97 to about 45 cents on the dollar in a matter of weeks:

“[B]ank just bought the altius deal from gs [Goldman Sachs] 5 weeks ago and the mtm [mark-to-market] dropped over 50%. We understand the liquidity is thin, but I really need some info to support this price. … This is very important as this transaction has a lot to do with our reputation in taiwan market. I understand all deals are down and spread is trading wider now. Unless the principal is at risk now, the mtm is not supposed to drop so quickly during such short period of time.”2160

On August 2, 2007, Stacy Bash-Polley, a Goldman senior sales executive, sent an email to Messrs. Montag, Mullen, Schwartz, and Sparks outlining eight specific instances in which clients had complained that Goldman’s marks were significantly lower that those of other dealers. Her summary of client concerns included the following:

2161

10/12/2007 email to Daniel Sparks, “US ABS SS Intermediation Trades,” GS MBS-E-013706095, Hearing

2157 See, e.g., 5/11/2007 email from Craig Broderick, “CDOs - Mortgages,” GS MBS-E-009976918, Hearing Exhibit 4/27-84; see also 8/10/2007 Goldman internal memorandum, “Summary of German Bank US Sub Prime Exposure,” GS MBS-E-009994305. 2158 Exhibit 4/27-70. 2159 2160 Exhibit 4/27-67. 2161 GS MBS-E-013349723.

Id. 7/24/2007 email from [Taiwan], “7/23 CDO/RMBS requests from Taiwan,” GS MBS-E-011198375, Hearing

8/2/2007 email from Stacy Bash-Polley to Messrs. Montag, Mullen, Schwartz, and Sparks, “Marks Summary,”

509

“–They have not agreed with our process and recently asked other dealers to analyze – say that we are off significantly from where other dealers are modeling this ….

–We took their mark on Fort Denison from 93.16 to 40.00[.] They admit the AAA CDO mkt is off substantially but feel that this particular bond [has objective characteristics that should make it] … perform better than the junior AAA market as a whole. Meanwhile, we took Hudson Mezz … AAA from 80.4 to 65. They would like our thoughts as to why Fort Den[ison] was marked down so much more. …

–The Alt-A marks were particularly punitive. … Our offerings are still 10-20 points higher than the marks. Look at GSAMP 2007-7. On financing, [customer] said our HC [haircuts] … were by far the most onerous of all dealers. …

–They bought AAA cdos …. They have communicated to sales that GS is by far an outlier and they will never be able to buy another cdo from us based on their lack of confidence in understanding how we are coming up with marks. …

–Issues with their CDO marks. Said we were many many points behind where other dealers were marking similar positions.”2162

Even before this email, Goldman’s sales force had been vocal in its criticism of Goldman’s low marks which were making their sales job more difficult. On June 21, 2007, Mr. Sparks stated in an email: “sales is making significant noise about gs notable conservatism in marking and haircuts.” managing director responded: “Would have tho[ugh]t that bsam event [failure of Bear Stearns Asset Management hedge funds] would provide reasonable explanation as to why our marking and haircuts r ok.” Mr. Sparks replied: “Kind of stunning – but we are hearing it.”

Mortgage Department personnel dismissed such criticisms out of hand. One

2163

Goldman generally declined to offer any written explanations of its marks to clients, and

rarely offered any financial accommodation or compromise regarding the marks or related collateral calls. On one occasion, when a sales representative asked about providing information about the

2164

Id. 6/21/2007 email from Mr. Sparks to Lester Brafman, “Repo,” GS MBS-E-010847490. The Subcommittee did identify at least one instance of a mark change. Goldman’s China sales representative

2162 2163 2164 contacted the ABS Desk to request an increase in a mark on an RMBS security:

“[C]an we try our best to show ‘better’ indicative prices for [client]? … [C]lient is under pressure of being questioned that they bought something looks really bad. … [W]e showed a price of LBMLT 06 A A1 as of 95-00 . . . this is something hard for client to believe …. [W]e need them to think of GS as the best firm, and we need them to be our best client when next biz boom comes. … We would highly appreciate if a slightly aggressive price can be showed from trading desk.”

5/21/2007 email from China sales representative to Edwin Chin and others, “Mark to market prices,” GS MBS-E-

Mr. Chin moved the mark in question from 95 to 98, and wrote:

510

firm’s CDO marks to a customer, Mr. Lehman wrote: “We cannot put this on paper - It concerns me they want something specifically in writing.” When told that other dealers had provided the customer with marks and a written description of their CDO pricing methodologies, Mr. Lehman responded: “Our marking policy is a market price (bid and/or offer) – We do not have a written methodology for pricing and we should tell them that.” In another instance, when a client asked for marks for the two prior months related to a CDO it was considering buying, Mr. Lehman wrote: “Verbal only …. Want to give them our tho[ugh]ts on market levels, not ‘marks.’” performance self-evaluation, the head of the SPG Trading Desk, Michael Swenson, wrote:

In his 2007

2165

2166

2167

“I spent numerous hours on conference calls with clients discussing valuation methodologies for GS issued transactions in the subprime and second lien space …. I said ‘no’ to clients who demanded that GS should ‘support the GSAMP’ program [Goldman RMBS securities] as clients tried to gain leverage over us. Those were unpopular decisions but they saved the firm hundreds of millions of dollars.”2168

2169

In November 2007, Goldman analysts issued a research report to clients about the crisis in Goldman predicted that the mortgage market crisis was likely to continue

the mortgage market. and would have serious implications for a significant number of financial institutions: “Write- downs and losses will continue to mount …. [M]anagements will need to repair some seriously Goldman estimated that industry-wide losses reflecting markdowns in damaged balance sheets.” subprime mortgage CDOs would approach $150 billion, of which about $40 billion would be taken in the third and fourth quarters of 2007.

2171

2170

Customers who purchased CDO assets from Goldman in 2007 generally suffered substantial losses from those investments, and several went bankrupt, including IKB, a German bank, and Basis Capital, the Australian hedge fund.

Goldman was not only aware of its clients’ predicaments,

2172

“After much discussion internally, we will improve our bid to 98-00 given the market color we have observed in the past two days. The markdown was mostly a reaction to rating agency downgrade and partly reflected the illiquidity of the position, but upon further analysis we have gotten more comfortable with the risk position and agree it should be marked at a higher price.”

Id. 2165

9/26/2007 Goldman Sachs 2007 Performance Review for Michael Swenson, “Reviewee’s Feedback,” GS-PSI-

11/20/2007 email from Thomson IFR - ABS, “ABS: Market Tense as Goldman Predicts RMBS CDO Problems

8/6/2007 email from David Lehman to Japan sales, “RE: Tokyo Star,” GS MBS-E-001927891. Id. 6/6/2007 email from David Lehman to Japan sales, “Point Pleasant Marks – request from Tokyo Star Bank,” GS

2166 2167 MBS-E-001912408-10 at 9. 2168 02399, Hearing Exhibit 4/27-55b. 2169 to Drag On,” GS MBS-E-013782989. 2170 2171 2172 the Mortgage Crisis,” at 2, GS MBS-E-001793840, Hearing Exhibit 4/27-41 (noting bankruptcies of Goldman clients IKB and Basis Capital). See also 8/10/2007 Goldman internal memorandum, “Summary of German Bank US Sub Prime Exposure,” GS MBS-E-009994305; 11/27/2007 email from David Lehman to Daniel Sparks, “ACA,”

Id. Id. See 9/17/2007 Goldman presentation to Board of Directors, “Residential Mortgage Business, Global Impact of

511

but in some cases, Goldman purchased CDS protection or equity puts on its clients’ stock, essentially betting that the stock price would fall or the company would lose value. For example, after ACA Financial Guaranty Corp., the parent company of ACA Management which acted as the collateral manager of Abacus 2007-AC1, purchased Abacus securities, Goldman purchased the short side of a CDS contract that referenced ACA Financial Guaranty. ACA Financial Guaranty encountered extreme financial distress in late 2007.2173

At the Subcommittee hearing, Goldman executives were asked about the four Goldman-

2174

originated CDOs highlighted in this Report, Hudson 1, Anderson, Timberwolf, and Abacus 2007- AC1. Senator John Tester noted Mr. Birnbaum’s testimony that, in 2007, Goldman could “see some things happening,” Senator Tester asked Mr. Sparks, in light of those developments, “how [he] got comfortable with sales,” and how he “in good faith” sold the CDO securities to Goldman’s customers – how he could “sell them out and collect the fees and make the dough?” had the following exchange:

and that Goldman itself was betting against the mortgage market.

2175

2176

Senator Tester and Mr. Sparks then

Senator Tester: Every one of these [CDOs] were – it looks like a wreck waiting to happen because they were all downgraded to junk in very short order.

Mr. Sparks: Well, Senator, at the time we did those deals, we expected those deals to perform.

Senator Tester: Perform in what way?

Mr. Sparks: To not be downgraded–

Senator Tester: Perform to go to junk, so that the shorts made out?

Mr. Sparks: To not be downgraded to junk in that short a time frame. In fact, to not be downgraded to junk. …

Senator Tester: Do you feel confident that the information about each one of these [CDOs] … was given to the investors, all of the information that was out there, and the credit rating agencies too?

See 6/21/2007 email from Fabrice Tourre, “Post on ACA,” GS MBS-E-002562148. See also ACA Financial

GS MBS-E-013746511 (discussing “what would happen upon an ACA bankruptcy (which is the most likely scenario in our opinion).”). 2173 Guaranty Corp. v. Goldman, Sachs & Co., Complaint (filed 1/6/2011, Sup. Ct. N.Y) at ¶ 7 (ACA now “operates as a run-off insurance company.”), available at http://www.aca.com/press/pdfs/2011/20110106-GoldmanComplaint.pdf. 2174 2175 2176

April 27, 2010 Subcommittee Hearing at 66. Id. Id.

512

Mr. Sparks: Well, I generally feel that the disclosure for the new issues that Goldman Sachs brought was good.2177

While Mr. Sparks testified that, in 2007, the Mortgage Department expected its CDOs “to perform,” a contemporaneous draft presentation that he helped prepare in May 2007 stated that the “desk expects [the CDOs] to underperform.” Many other emails provide his negative views of the CDO market at the time, including emails in which Mr. Sparks described the subprime market as “bad and getting worse,” everything,” 2182 “bad news everywhere,” and “the business is totally dead.” As Senator Tester noted, many of Mr. Sparks’s dire predictions were made before three of the four CDOs discussed at the hearing were even offered to customers.2184

and directed Goldman’s mortgage traders to “get out of

He wrote, among other things: “Game over,”

and “stay on the short side.”

2183

2180

2179

2178

2181

Mr. Sparks also testified that the Mortgage Department did not expect the Goldman-issued CDOs to be downgraded, but all were within a year of issuance. In April 2007, for example, six of the 20 RMBS deals that comprised the ABX Index were downgraded, and the Hudson CDO that referenced them followed soon after. Many of the RMBS securities referenced in the other three CDOs were downgraded within three months of the issuance of the last CDO in April 2007, making the downgrade of the CDOs themselves all but inevitable. S&P announced their first mass downgrades of RMBS securities on July 10, 2007, the S&P downgrade affected 35% of the assets in Timberwolf. the Subcommittee’s hearing were downgraded to junk status. On October 26, 2007, a Goldman employee sent an email about Abacus 2007-AC1, even noting this dubious distinction:

Ultimately, all of the CDOs discussed at

For example, when Moody’s and

2187

2186

2185

Id. Mr. Sparks went on to say: “I mentioned we made some bad business decisions. These deals performed

See 5/19/2007 draft Goldman presentation, “Mortgages CDO Origination – Retained Positions & Warehouse

2/8/2007 email from Mr. Sparks, “Post,” Hearing Exhibit 4/27-7. 3/3/2007 email from Mr. Sparks, “Call,” Hearing Exhibit 4/27-14. 3/8/2007 email from Mr. Sparks, “Mortgage risk,” Hearing Exhibit 4/27-75. 3/12/2007 Goldman memorandum to Firmwide Risk Committee, “March 7th FWR Minutes,” GS MBS-E-

2177 horribly. That is bad. … [T]hat said, just because one person in my business unit or a few people might have had one view, I can tell you there were a lot of people in my business unit that had a very different view, and there were a lot of investors that had a very different view.” Id.
2178 Collateral, May 2007,” GS MBS-E-010951926. 2179 2180 2181 2182 00221171, Hearing Exhibit 4/27-19. 2183 Exhibit 4/27-10. 2184 issued in March and April 2007. 2185 put on watch or downgraded). 2186 Exposure to Subprime RMBS,” GS MBS-E-001837256; 7/10/2007 email from Goldman Sachs analyst to Goldman Sachs Japan salesman, “GS Cashflow/ABACUS CDOs Mentioned in S&P Report on CDO Exposure to Subprime RMBS,” GS MBS-E-001990255 (updating percentage exposure from 25% to 35%). 2187

April 27, 2010 Subcommittee Hearing at 66. The Anderson, Timberwolf, and Abacus 2007-AC1 CDOs were

2/21/2007 email from Daniel Sparks to Jon Winkelried, “Mortgages today,” GS MBS-E-010381094, Hearing

4/27/2007 email from Deeb Salem to Michael Swenson, GS MBS-E-012432706 (6 of 20 deals in ABX Index

7/10/2007 email to George Maltezos, “GS Cashflow/ABACUS CDOs Mentioned in S&P Report on CDO

Id.

513

“This deal was number 1 in the universe of CDO’s that were downgraded by Moody’s and S&P. 99.89% of the underlying assets were downgraded.”

2188

(b) Goldman’s Conflicts of Interest

In late 2006 and 2007, Goldman’s securitization business was marked, not just by its hard sell tactics, but also by multiple conflicts of interest in which Goldman’s financial interests were opposed to those of its clients. The following examples illustrate the problem.

(i) Conflicts of Interest Involving RMBS Securities

In 2006 and 2007, Goldman originated 27 CDO and 93 RMBS securitizations. Beginning in

December 2006, Goldman originated and aggressively marketed some of these securities at the same time that subprime and other high risk loans were defaulting at alarming rates, the subprime and CDO markets were deteriorating, and Goldman was shorting subprime mortgage assets. At times, Goldman originated and sold RMBS securities that it knew had poor quality loans that were likely to incur abnormally high rates of default. At times, Goldman went further and sold RMBS securities to customers at the same time it was shorting the securities and essentially betting that they would lose value. Two examples illustrate how Goldman constructed and sold poor quality RMBS securities and profited from the decline of the very securities it had sold to its clients.

Long Beach RMBS. The first example involves Washington Mutual Bank (WaMu) and its

subprime lender, Long Beach Mortgage Corporation. WaMu, Long Beach, and Goldman had collaborated on at least $14 billion in loan sales and securitizations. In February 2006, Long Beach had a $2 billion warehouse account with Goldman, which was the largest of Goldman’s warehouse accounts at that time.

2189

2190

Long Beach was known within the industry for originating some of the worst performing

subprime mortgages in the country. As explained in Chapter III, in 2005, a surge of early payment defaults in its subprime loans required Long Beach to repurchase over $837 million of nonperforming loans from investors, as well as book a $107 million loss. affected its loans in 2006 and 2007. WaMu reviews and audits of Long Beach, as well as examinations by the Office of Thrift Supervision, repeatedly identified serious deficiencies in its lending practices, including lax underwriting standards, unacceptable loan error and exception rates, weak risk management, appraisal problems, inadequate oversight of third party brokers selling loans to the firm, and loan fraud. While these reviews were not available to the public, the performance of Long Beach paper was. Long Beach securitizations had among the worst credit losses in the

Similar EPD problems

2191

10/26/2007 email from Goldman salesman to Michael Swenson, “ABACUS 2007-AC1 – Marketing Points

2188 (INTERNAL ONLY) [T-Mail],” GS MBS-E-016034495. 2189 2190 2191

See “List of WaMu-Goldman Loans Sales and Securitizations,” Hearing Exhibit 4/13-47b. 2/13/2006 Goldman chart, “Current Warehouse Facilities and Funded Balances,” GS MBS-E-001157934. See Chapters III and IV, above.

514

industry from 1999-2003; in 2005 and 2006, Long Beach securities were among the worst performing in the market.

2192

Nevertheless, in May 2006, Goldman acted as co-lead underwriter with WaMu to securitize

about $532 million in subprime second lien mortgages originated by Long Beach. Long Beach Mortgage Loan Trust 2006-A (LBMLT 2006-A) issued approximately $495 million in RMBS securities backed by those Long Beach mortgages. The top three tranches, representing about 66% of the principal loan balance, received AAA ratings from S&P, even though the pool contained subprime second lien mortgages – loans which could recover funds in the event of a default only after the primary loan was repaid — and even though the loans were issued by one of the nation’s worst performing mortgage lenders. Yet Goldman was able to use two-thirds of that extremely risky debt to issue AAA rated securities which Goldman then sold to its customers.

In less than a year, the Long Beach loans began incurring delinquencies. In February 2007, a

Goldman analyst reported internally that all of Goldman’s 2006 subprime second lien RMBS securities were deteriorating in performance, but “deals backed by Fremont and Long Beach collateral have generally underperformed the most.” The analyst predicted “lifetime losses in the teens, and over 20% in some deals.” By May 2007, the cumulative net loss on the LBMLT 2006-A mortgage pool had climbed to over 12%, eliminating most of the financial cushion protecting the investment grade securities from loss. That month, S&P downgraded six out of the seven credit ratings for the mezzanine tranches of the securitization. The Long Beach securities plummeted in value.

2193

Goldman held some of the unsold Long Beach mezzanine securities on its books, meaning

LBMLT 2006-A securities that carried credit ratings of BBB or BBB-. Goldman had also purchased the short side of a CDS contract that would pay off if those same securities lost value. On May 17, 2007, Deeb Salem, a trader on the Mortgage Department’s ABS Desk, learned of additional losses in the Long Beach securitization and wrote to his supervisor Michael Swenson with the news:

“[B]ad news … [The loss] wipes out the m6s [mezzanine tranches] and makes a wipeout of the m5 imminent. … [C]osts us about 2.5 [million dollars]. … [G]ood news … [W]e own 10 [million dollars] protection at the m6 … [W]e make $5 [million].”

2194

In other words, Goldman lost $2.5 million from the unsold Long Beach securities still on its books, but gained $5 million from the CDS contract shorting those same securities. Overall, Goldman profited from the decline of the same type of securities it had earlier sold to its customers.

See, e.g., 4/14/2005 OTS email, “Fitch,” OTSWME05-012 0000806, Hearing Exhibit 4/13-8a. 2/8/2007 email from Goldman analyst to Mr. Sparks, Mr. Gasvoda, and others, “2006 Subprime 2nds Deals

2192 2193 Continue to Underperform INTERNAL ONLY,” GS MBS-E-003775340, Hearing Exhibit 4/27-167d. 2194 Exhibit 4/27-65.

5/17/2007 email from Deeb Salem to Michael Swenson, “FW: LBML 06A,” GS MBS-E-012550973, Hearing

By May 2008, even the AAA securities in LBMLT 2006-A had been downgraded to default

status. By March 2010, the securities recorded a cumulative net loss of over 66%.2195

515

Fremont RMBS. The second example involves Fremont Loan & Investment, another

subprime lender notorious for issuing poor quality loans. 8-K filing with the SEC that the FDIC filed a cease and desist order to which the company consented. Among other matters, it order Fremont to stop “[m]arketing and extending adjustable–rate mortgage products to subprime borrowers in an unsafe and unsound manner that greatly increases the risk that borrowers will default on the loans or otherwise causes losses.”

2197

In March 2007, Fremont reported in an

2196

Even before the actions taken by regulators in March 2007, Goldman was aware of the poor quality of at least some of Fremont’s loans. In a November 2006 exchange of emails, for example, two Goldman sales representatives were discussing trying to sell Fremont RMBS securities to a client. One salesperson forwarded to the other the client’s explanation of why it did not want to buy the securities and its low opinion of Fremont’s loan pools: “Fremont refused to make any forward looking statements so we really got nothing from them on the crap pools that are out there now.” 2198 In March 2007, Goldman initiated a detailed review of its Fremont loan inventory to identify deficient loans that it could return to the lender for a refund. Mr. Gasvoda placed a priority on reviewing Fremont loans “since they still have cash but may not for long.” conducted on March 14, 2007, found that “on average, about 50% of about 200 files look to be repurchase obligations,” meaning that fully half of the reviewed loans should be returned to the lender. was one of the top five mortgage originators from whom Goldman made repurchase requests in 2006 and 2007.

Goldman eventually made about $46 million in repurchase requests to Fremont, which

One loan pool review

2199

2200

2201

Despite these and other indications of Fremont’s poor quality loans, Goldman continued to

underwrite and market securities backed by Fremont loans. In an internal February 2007 memorandum to its Mortgage Capital Committee, Goldman wrote that it had a “significant relationship with Fremont,” based upon past securitizations, whole loan purchases, and warehouse fees. requests to Fremont, Goldman securitized over $1 billion in Fremont subprime loans in one of its

In March 2007, at the same time it was sending millions of dollars in loan repurchase

2202

wamusecurities.com.

See For more information about Fremont, see Chapter IV, Section D(2)(d). 3/7/2007 Fremont General Corporation 8-K filing with the SEC. 11/16/2006 Goldman internal email, “ACA and Freemont [sic] deal,” Hearing Exhibit 4/27-173. 3/14/2007 Goldman email, “NC Visit,” GS-MBS-E-002048050.
Id.; see also 8/10/2007 email from Michelle Gill, “Fremont - Incremental Information,” GS MBS-E-009860358

2195 2196 2197 2198 2199 2200 (Goldman’s repurchase claims against Fremont would have amounted to a 9% ownership stake in Fremont after a proposed buyout by investor group; Goldman was not the largest purchaser of Fremont loans but its repurchase claims were 3-4 times larger than the claims of the nearest counterparty). 2201 See Goldman Sachs response to Subcommittee QFR at PSI_QFR_GS0040. 2202 2/20/2007 Goldman memorandum to Mortgage Capital Committee, “Request for renewal of the existing $1 billion … 1-year revolving warehouse facility,” GS MBS-E-001157942. Goldman wrote that Fremont produced “revenues totaling $13.38 million in 2006 of which $620,000 came in the form of warehouse usage and commitment fees.”

516

2203

warehouse accounts, originating GSAMP Trust 2007-FM2. S&P rated the securities, even though analysts at both rating firms expressed concern about the quality of Fremont loans. At S&P, for example, in a January 2007 email to his supervisor, a credit ratings analyst wrote: “I have a Goldman deal with subprime Fremont collateral. Since Fremont collateral has been performing not so good, is there anything special I should be aware of?” One supervisor told him: “No, we don’t treat their collateral any differently,” while another wrote that, as long as the analyst had current FICO scores for the borrowers, he was “good to go.” agencies gave AAA ratings to the top five tranches of the securitization.

At Goldman’s request, Moody’s and

Both

2205

2206

2204

Goldman marketed and sold the Fremont securities to its customers, while at the same time

purchasing $15 million in CDS contracts referencing some of the Fremont securities it underwrote. 2009, every tranche in the GSAMP securitization had been downgraded to junk status.

Seven months later, by October 2007, the ratings downgrades had begun; by August

2208

2207

In both examples involving Long Beach and Fremont RMBS securities, Goldman obtained CDS protection and essentially bet against the very securities it was selling to clients. In each case, Goldman profited from the fall in value of the same securities it sold to its clients and which caused those clients to suffer substantial losses.

(ii) Conflicts of Interest Involving Sales of CDO Securities

As with some of its RMBS securities, Goldman at times originated CDO securities using assets that it believed were of poor quality and would lose value, and sold the securities at higher prices than it believed they were worth. In addition, Goldman took steps that created multiple conflicts of interest with the clients to whom it sold the CDO securities, and placed its financial interests ahead of those of its clients. Four examples involving the Hudson 1, Anderson, Timberwolf, and Abacus 2007-AC1 CDOs illustrate the problems. Those problems include troubling and sometimes abusive practices related to how Goldman designed the CDOs and selected

2209

See 2/2/2007 Goldman memorandum to the Mortgage Capital Committee, “Agenda for Monday, February 5,

1/24/2007 S&P internal email, “Quick Question: Fremont,” Hearing Exhibit 4/23-93b. See also 2/1/2007 S&P

1/24/2007 S&P internal email, “RE: Quick Question: Fremont,” Hearing Exhibit 4/23-93c. 4/17/2010 S&P downgrade of GSAMP Trust 2007-FM2 containing Fremont mortgages, Hearing Exhibit 4/23-

2203 2007,” GS MBS-E-002201064; 2/5/2007 Mortgage Capital Committee Memorandum regarding GSAMP Trust 2007-FM2, GS MBS-E-002201055 - 58. 2204 internal email, “Defaults cause Fremont to end ties to 8,000 brokers,” Hearing Exhibit 4/23-93d (S&P analysts circulated an article about how Fremont had stopped using 8,000 brokers due to loans with some of the highest delinquency rates in the country). 2205 2206 93f. 2207 013648130. 2208 2209 assets with falling value to the CDO and the investors who purchased the CDO securities. The Subcommittee examined seven CDOs issued by Goldman, and of those, 57% of the CDOs’ assets were sourced from Goldman, including over $3 billion in synthetic assets in which Goldman was the short party, and therefore stood to profit from a decline in the value of the underlying assets.

See Standard & Poor’s In some cases, Goldman used assets from its own inventory or warehouse accounts, so that it could transfer

See 3/21/2007 Goldman spreadsheet, “RMBS CDS Trade History 19Jan06 - 19Mar07 v3,” GS MBS-E-

www.globalcreditportal.com.

517

their assets; marketed and sold the CDO securities; designated the value of the CDO securities pre- and post-sale; and executed its duties as liquidation agent and collateral put provider.

AA. Hudson Mezzanine Funding 2006-1

Hudson Mezzanine Funding 2006-1 (Hudson 1) was a $2 billion synthetic CDO that

2211

2210

This CDO

and assets linked to the ABX Index.

referenced mezzanine subprime RMBS assets was the second in a series of three “Hudson” branded CDOs, which according to Goldman marketing materials were intended “to create a consistent, programmatic approach to invest in attractive relative value opportunities in the RMBS and structured product market.” One key feature of the three Hudson CDOs was that Goldman itself, without any third party participation, selected the CDO’s assets, which were supposed to remain with the CDO until they reached maturity or were deemed “credit risk assets,” at which point Goldman, acting as the liquidation agent for the CDO, was responsible for selling them. In each of the Hudson CDOs, Goldman played multiple roles in its formation and administration, including selecting assets and serving as the underwriter, initial purchaser of the CDO securities, collateral put provider, counterparty, and credit protection buyer. In Hudson 1, Goldman took 100% of the short side of the CDO, and when the Hudson 1 securities declined in value, Goldman made a $1.35 billion profit at the expense of the clients to whom it had sold the Hudson 1 securities.

senior swap

2212

2213

2215

2214

Mezzanine subprime RMBS assets are RMBS securities that carry a credit rating of BBB or BBB- or CDS

10/2006 Goldman document, “Hudson Mezzanine Funding 2006-1, Ltd.,” Hearing Exhibit 4/27-87. The first

The ABX Index tracks the performance of a designated basket of 20 subprime RMBS securitizations. It consists

2210 contracts that reference those types of RMBS securities. Mezzanine RMBS assets are riskier than AAA, AA, and A rated RMBS securities, but less risky than those that carry, for example, BB, B, or CCC ratings. 2211 of five separate indices, each of which tracks a different subset of the RMBS basket, divided according to credit ratings. The indices that track the mezzanine RMBS securities, for example, track the 20 RMBS securities that carry BBB and BBB- credit ratings. In ABX assets, investors enter into CDS contracts in which one party takes the long side, essentially betting that the ABX indices tracking the mezzanine RMBS securities will increase in value, while the other party takes the short side, essentially betting that the indices will fall in value. Prior to establishing the Hudson CDO, Goldman had taken the long side in a number of CDS contracts linked to the ABX indices tracking mezzanine RMBS securities. 2212 Hudson CDO, Hudson High Grade, was issued in September 2006. The second, discussed here, was Hudson Mezzanine 2006-1, issued in October 2006. The third was Hudson Mezzanine 2006-2, issued in February 2007. 2213 below. 2214 debt securities.” Later, when cash was needed to make payments to a long or short party, those collateral securities were sold, and the cash was used to make the payments. In the event the collateral securities could not be sold for face (par) value, the collateral put provider paid the difference to the CDO. For more information about the role of collateral put providers, see Section C(5)(b)(iii)BB, below. 2215 Sachs acted as underwriter,” GS MBS 0000004337 at 4338. Acting as the “senior swap counterparty” meant that Goldman served as an intermediary between the Hudson CDO and the super senior investor. Acting as “credit protection buyer” meant that Goldman initially took the short side of the CDO and, in the case of Hudson 1, kept 100% of the short side during the life of the CDO.

Id. For more information about Goldman’s role as the liquidation agent in Hudson, see Section C(5)(b)(iii)AA,

See 2/18/2008 Goldman document, “CDO Transactions (July 1, 2006 - December 31, 2007) in which Goldman

In synthetic CDOs, the cash proceeds from the sales of the CDO securities were used to purchase “collateral

518

Transferring Risk. Hudson 1 was conceived and designed by Goldman to transfer the risk

associated with a large collection of ABX assets in its inventory, in which Goldman held the long side of CDS contracts referencing mezzanine subprime RMBS securities that were tracked by the ABX Index and that might go down in value. The objective of the CDO was to transfer the risk of unwanted financial assets off of Goldman’s books. In response to questions from the Subcommittee, Goldman explained that Hudson 1 was “initiated by the firm as the most efficient method to reduce long ABX exposures.” Contemporaneous notes from Goldman’s Firmwide Risk Committee meetings also stated that Hudson 1 was an “exit for our long ABX risk.” Goldman records show that the firm used Hudson 1 to short $1.2 billion worth of the ABX assets in the firm’s inventory as well as $800 million in single name CDS contracts referencing subprime RMBS securities carrying mostly BBB or BBB- credit ratings. Hudson 1 was one of several methods Goldman used to transfer its risk associated with its subprime mortgage holdings during the fall of 2006.2218

2216

2217

Conceiving Hudson 1. In the months leading up to the creation of Hudson 1, Goldman had

2219

accumulated billions of dollars in ABX assets referencing mezzanine subprime RMBS securities. By August 2006, Goldman management had decided that this ABX trade had “run its course,” and directed the Mortgage Department’s ABS Desk to sell off its ABX holdings. weeks of effort, however, the ABS Desk was unable to find many buyers, and its ABX mezzanine assets, which were dropping in value, were losing millions of dollars for the firm.

After several

2220

2221

On September 19, 2006, Jonathan Sobel and Daniel Sparks called an 8:00 a.m. meeting to

discuss the ABX problem with Joshua Birnbaum, head of ABX trading, and Michael Swenson, head of both the Structured Product Group (SPG) Trading Desk and ABS Trading Desk. Swenson was unable to attend, and in a later email from Mr. Birnbaum who recounted the meeting to him, Mr. Sobel and Mr. Sparks wanted to know whether the Mortgage Department should sell all

Mr.

2222

Subcommittee interview of Michael Swenson (4/16/2010). Mr. Swenson told the Subcommittee that Goldman

See Goldman response to Subcommittee QFR at PSI_QFR_GS0239. 9/20/2006 email from Arbind Jha to Josh Birnbaum, GS MBS-E-012685289. See also 9/20/2006 Firmwide

2216 2217 Risk Committee Minutes, GS MBS 0000004472. 2218 See 10/24/2006 email from Jonathan Sobel to Tom Montag, Dan Sparks, and others, GS MBS-E-010919930 (“CDO should price tomorrow and is in good shape. … We also are starting to see some short covering, which we will sell into to further reduce our risk toward your 50% goal.”). 2219 had been long “several billion” in ABX in September 2006. 2220 8/9/2006 Firmwide Risk Committee Minutes, GS MBS-E-009682590; Subcommittee interview of Joshua Birnbaum (10/1/2010). Mr. Birnbaum recalled a “directive” to reduce ABX exposure in the summer of 2006. 2221 009739145 (“Down about $10mm.”); 9/12/2006 email from Jonathan Sobel to Michael Swenson and Daniel Sparks, “ABX,” GS MBS-E-012681410 (“The last post you gave me was this morning when you thought things were ‘firm’. Now I find out that we’re down $6mm on the day. I understand things move, but you need to post me. Also, I want to reduce this position.”); 9/9/2006 Firmwide Risk Committee Minutes, GS MBS 0000004468 (“Business continuing to reduce volatile ABX position.”); 8/23/2006 Firmwide Risk Committee Minutes, GS MBS-E-009615593 (“Mortgages sold down another net 15% of their large ABX position.”). 2222

9/19/2006 email from Jonathan Sobel to Daniel Sparks, Michael Swenson, and Josh Birnbaum, GS MBS-E-

See, e.g., 9/21/2006 email from Jonathan Sobel to Tom Montag, “ABX wider again today,” GS MBS-E-

519

of its ABX mezzanine holdings or “double down” the ABX holdings, which could happen only if it found a “structured place to go with the risk.”2223

Later that day, Mr. Sparks approached Peter Ostrem, who headed the desk that originated CDOs for Goldman, and asked “if there was something [the CDO Desk] could do with ABX.”

2224 Mr. Ostrem spoke with Darryl Herrick, who worked for him on the CDO Desk and who eventually became the Hudson 1 deal captain, about crafting a CDO to reduce the firm’s ABX risk. The two brainstormed a structure that became the foundation of Hudson 1.

2225

That same evening, September 19, 2006, Mr. Swenson scheduled a meeting with several traders on the ABS Desk he oversaw, Joshua Birnbaum from the ABX Desk, and Mr. Ostrem and other personnel from the CDO Origination Desk to discuss “ABX and Single-Name Opportunities.” announcing “Hudson Mezz - new”:

After the meeting, around 8:00 p.m., Mr. Ostrem sent his CDO team an email

2226

“We have been asked to do a CDO of $2bln [billion] for the ABS desk. Approx. $1.2bln will be CDS off single-names referenced from the AB[X] index 06-1 and 06-2. This is a trade we need to execute for the desk over the next 4-6 weeks and involves selling half the equity (at least 30mm to sell) and the seniors and the mezz (at least half of the BBBs to get true sale). I would like everyone to work together on this one. We expect to charge ongoing 10bp [basis point] liquidation agent fees and 1-1.5pts upfront. … Obviously important to overall SP [Structured Product] floor and Sobel and Sparks are focused on this happening.”2227

Also that evening, Mr. Swenson emailed Mr. Sobel to inform him they were “proceeding with the CDO solution, the CDO team has 60 single-names that they will be able to begin to build a deal around.”

2228

The next day, Mr. Sobel reported to senior executives at Goldman’s Firmwide Risk

Committee that the CDO Desk was working on the first ever ABX CDO, which would function as an exit for the firm’s long ABX position. Later that same afternoon Mr. Sobel sent an email to Goldman senior executive Thomas Montag, discussing the Mortgage Department’s ABX losses and

2229

2226

2223 9/19/2006 email from Josh Birnbaum to Michael Swenson, GS MBS-E-012683946. Mr. Sobel also informed Mr. Swenson later that day: “We need to reach a conclusion on the viability of a structured exit.” 9/19/2006 email from Jonathan Sobel to Michael Swenson, GS MBS-E-012328199. 2224 2225

Subcommittee interview of Peter Ostrem (10/5/2010). Id.; Subcommittee interview of Darryl Herrick (10/13/2010). 9/19/2006 calendar invite from Michael Swenson, GS MBS-E-012328194. 9/19/2006 email from Peter Ostrem, GS MBS-E-01818608, Hearing Exhibit 4/27-86. Goldman later told the

2227 Subcommittee that Hudson actually offset $1.39 billion in ABX assets on its books. Goldman response to Subcommittee QFR, PSI_QFR_GS0239. 2228 of 60 single names by Mr. Herrick and Mr. Salem, below. 2229 Birnbaum, GS MBS-E-012685289.

9/20/2006 Firmwide Risk Committee Minutes, GS MBS 0000004472; 9/20/2006 email from Arbind Jha to Josh

9/20/2006 email from Michael Swenson to Jonathan Sobel, GS MBS-E-012328203. See discussion of selection

stating: “I think most hedge funds have been right on this (i.e. they’ve been short). … The synthetic CDO seems like a viable takeout here.”2230

520

A Goldman risk officer, Arbind Jha, began contacting Goldman mortgage traders and CDO

2231

personnel for regular Hudson updates. with the Hudson 1 concept, Mr. Jha emailed Mr. Birnbaum asking about the CDO: “Sobel this morning mentioned in the Firmwide Risk Committee meeting that we are looking at CDO exit for our long ABX risk. Wanted to get some color on this.” Darryl Herrick:

In fact, the day after the ABS and CDO teams came up

On another occasion, Mr. Jha asked

2232

“Do we really have scenario risk on $2bn [billion] not’l [notional]? $1.2bn of not’l is being sourced from ABX desk - this risk is already being captured in our risk number for SPG Trading desk. … The remaining $0.8bn will be composed of single name CDS. Since we do not have any pre-existing long (credit), we will be going short after we price this CDO and therefore will have a risk mitigating impact on our risk. Please correct me if I am getting this wrong.”

2233

Designing Hudson 1. At the time Hudson 1 was conceived, no other investment bank had

issued a CDO in which the majority of assets referenced ABX assets. credit rating agencies refused to rate any CDO with more than a 5% exposure to credit default swaps (CDS) using an ABX index as the reference obligation. the reference obligation allowed the parties to the CDS to make a pure bet on the composite performance of a basket of 20 RMBS securities. Credit rating agencies were concerned that the inclusion of ABX assets in CDOs would increase market-wide correlation and make CDO performance more volatile.

Prior to that, the major

CDS that used an ABX index as

2235

2234

In order to get around that limitation and create a CDO that the credit rating agencies would be willing to rate, Goldman took several steps. First, it decided Hudson 1 would reference the two ABX 06-1 indices and the two ABX 06-2 indices that referenced RMBS securities with BBB and BBB- ratings. Since each of those four indices tracked 20 subprime mezzanine RMBS securities, altogether they tracked 80 RMBS securities.

Next, Goldman created 80 single name CDS

2236

9/21/2006 email from Jonathan Sobel to Tom Montag, GS MBS-E-009739145. See, e.g., 10/16/2006 email from John Li to Darryl Herrick, “Call Arbind Jha,” GS MBS-E-018209595

2230 2231 (“Regarding Hudson Mezz Risk issue”). 2232 9/20/2006 email from Arbind Jha to Josh Birnbaum, GS MBS-E-012685289. When asked about this email and Hudson 1 in general, Mr. Birnbaum told the Subcommittee that he had no specific recollection of any involvement with the Hudson 1 CDO. Subcommittee interview of Joshua Birnbaum (10/1/2010). 2233 10/12/2006 email from Arbind Jha, “Re: Risk Issue,” Hearing Exhibit 4/27-88. 2234 9/20/2006 Firmwide Risk Committee Minutes, GS MBS 0000004472. 2235 See, e.g., 3/23/2007 “CDO Rating Factors: Inclusion of Tranched ABX Indices in ABS CDOs,” Moody’s, Document No. SF95049. 2236 securitizations. Each Index also had its own subset of five indices tracking individual securities issued by those 20 securitizations, divided by credit rating. For example, one of the RMBS securitizations tracked by the ABX 06-2 Index was called CWL 2006-8. One of the sub-indices within the ABX 06-2 Index tracked BBB rated securities that

The ABX 06-1 Index and the ABX 06-2 Index each tracked a completely different set of 20 RMBS

521

2237

Goldman’s ABS Desk took the short position in each of By taking

contracts, each of which used as its reference obligation one of the subprime mezzanine RMBS securities tracked by the ABX indices. those 80 contracts, while Goldman’s CDO Origination Desk took the long position. the short position in the 80 single name CDS contracts, the ABS Desk essentially offset its long position in the corresponding ABX contracts. Next, the CDO Origination Desk entered into a CDS contract with Hudson 1, taking the short side while the Hudson CDO assumed the long side of the 80 single name CDS contracts. The end result was that Hudson 1 took the long side and assumed the risk associated with the long position for $1.2 billion worth of CDS single name contracts referencing the RMBS securities comprising the ABX 06-1 and 06-2 BBB and BBB- indices. 2239 transferring the long CDS position to Hudson, Goldman effectively transferred the risk associated with its ABX long assets to any investors who bought the Hudson securities.

2238

2240

In 2006, at the time Hudson was being constructed, the

In order to attract investors and convince them to buy the Hudson securities, Goldman decided to make use of a pricing difference between CDS contracts referencing the ABX Index versus single name RMBS securities. price of CDS contracts that used an ABX index as the reference obligation was lower than the price of CDS contracts that used an individual RMBS security as its reference obligation. Because Goldman exercised complete control over the CDO and created CDS contracts referencing assets from its own inventory, Goldman also exercised complete control over the pricing of those contracts. When Goldman set up the 80 single name CDS contracts, and sold the long side of those contracts to Hudson 1, Goldman decided internally what it would charge the CDO to acquire the long side of those contracts. Goldman decided to price the contracts, not according to the cost of a single name CDS contract on the market, but instead according to the cost of a CDS contract for the long side of the relevant ABX index that day. By using this pricing method, Goldman enabled Hudson to purchase the single name CDS contracts at the lower ABX prices, which meant it could

2241

A “single name CDS” contract uses a single security as its reference obligation, such as a specific RMBS

For simplicity, all 20 assets in each of the ABX baskets were given the same weighted price in Hudson 1. See, e.g., 4/27/2007 email from Fabrice Tourre to Michael Swenson, Deeb Salem, and Edwin Chin, GS MBS-E-

were issued as part of the 20 securitizations, including the M8 tranche of CWL 2006-8 which carried a BBB rating. Another of the five indices tracked the securities carrying a BBB- rating, including the M9 tranche of CWL 2006-8 which carried that credit rating. The CWL 2006-8 M8 and CWL 2006-M9 securities were just two of the 40 BBB and BBB- rated securities issued by the 20 RMBS securitizations in the ABX 06-2 Index. The ABX 06-1 Index functioned the same way; its sub-indices tracked another 40 mezzanine RMBS securities from the 20 RMBS securitizations that composed that Index.
2237 security. 2238 2239

2240 clients wanted to sell the ABX in order to express a negative view on the U.S. residential housing market. As a result of these trades, we took on long positions. In order to hedge those positions, we began to increase our short position in single-names. By November 2006, volatility in the ABX increased, pushing prices down. Because our positions in single names did not match identically the basket of securities that comprised the ABX, the positions moved at different rates and even different directions, resulting in losses for the ABS desk.” Prepared statement of Michael Swenson, April 27, 2010 Subcommittee Hearing, at 208-09. 2241 9/21/2006 email from Darryl Herrick to Deeb Salem, Michael Swenson, Joshua Birnbaum, Peter Ostrem, and Edwin Chin, GS MBS-E-012685645.

Mr. Swenson described this situation in his testimony before the Subcommittee: “Throughout 2006, numerous

Goldman decided to price the single name assets at one point below the median ABX trading price. See

tell investors that, by purchasing Hudson securities, they would be purchasing the single name CDS contracts at the discount price at which Hudson acquired them.

2242

522

The pricing differential also benefitted Goldman’s ABS Desk in two ways. First, it created a

modest incentive for investors to buy Hudson securities and take the long position needed to offset Goldman’s ABX risk. Second, it left Goldman with a short position in the form of CDS single name contracts, which Goldman expected to become more valuable than a short position in CDS contracts that referenced ABX indices. The ABS Desk kept both its long ABX positions and its short single name CDS positions in the same dedicated account. Over time, the short position in single name CDS did gain in value and boosted the overall value of the portfolio of assets held by the ABS Desk by more than $1 million, producing additional profits for Goldman.

2243

In addition to the $1.2 billion in single name CDS contracts to offset Goldman’s ABX risk, Mr. Herrick from the CDO Origination Desk and Deeb Salem from the ABS Desk worked together to select $800 million in additional single name CDS contracts to include in the Hudson CDO.

2244 Mr. Herrick told the Subcommittee that he gave Mr. Salem a specific set of criteria for selecting these CDS contracts, including a list of RMBS names that he wanted to be included, a list of RMBS names that he did not want to be included, and an acceptable price range for each CDS contract. Since Goldman planned to take 100% of the short side of Hudson 1, these lists were presumably used to identify RMBS contracts that Goldman expected to offset Goldman’s long positions. Mr. Herrick told the Subcommittee that Mr. Salem responded with an initial list of 60 possible RMBS reference obligations, 52 of which were ultimately included in Hudson 1.2245

See 10/2/2006 email from Darryl Herrick to Michael Swenson, Joshua Birnbaum, Deeb Salem, Peter Ostrem,

The gain generated by the CDS single name contracts was retained on the books of the ABS Desk, and created a

2242 and Daniel Sparks, GS MBS-E-010913416 (“We plan to announce Hudson Mezzanine Funding tomorrow in the am for Europe, Asia and the US[.] I’m circulating around to everyone the CDO portfolio and spreads we will be showing investors and agencies, based on our agreed upon amounts and levels from last week.”). Mr. Swenson responded: “Darryl we should use the 265 and 245 spread for the ABX2 and ABX1 triple-B minus spreads and 145 and 130 for triple-B ABX2 and ABX1 triple-B spreads.” Id. 2243 favorable “basis” compared to the cost of the ABX long position held by the desk. See 4/27/2007 email from Fabrice Tourre to Michael Swenson, Deeb Salem, and Edwin Chin, GS MBS-E-012432742; Goldman response to Subcommittee QFR at PSI_QFR_GS0239. See also 9/19/2006 email from Michael Swenson to Thomas Cornacchia and Joshua Birnbaum, GS MBS-E-012684557 (“[ABX] Index to single-name basis is at the wides[t] (ie 40 bp at BBB- level). Index to cash is even more extreme at 70bp. Bids for cash deals remain strong and have barely widened.”); Performance Review for Michael Swenson, GS-PSI-02396, Hearing Exhibit 4/27-55b (describing the mortgage trading desk’s strategy of shorting single-name RMBS to offset long ABX positions: “[D]uring the early summer of 2006 it was clear that the market fundamentals in subprime and the highly levered nature of CDOs was going to have a very unhappy ending. The beauty of the CDO short was that it allowed for a very efficient method for capturing the value in the ABX to single-name basis from the short side.”). 2244 Goldman salesperson, GS MBS-E-017502983 (discussing Hudson 1: “Omar, I realize lack of manager may be tough hurdle for them [investors]. May be helpful to let Deeb and I get on a call with the investor and discuss our asset selection criteria and I can go through asset sale criteria.”). 2245 See 9/19/2006 email from Darryl Herrick to Deeb Salem, Peter Osterm, others, GS MBS-E-011402123, with attachment GS MBS-E-011403442 (Mr. Salem wrote to Mr. Herrick: “Attached are 60 RMBS Ref Obs … for the CDO we’re discussing. On the RMBS side, we chose 30 Baa2 and 30 Baa3 CUSIPs evenly split btw 2005 and 2006 vintage. We can add a few alt-a names as well. How many of those would you like?”). When interviewed by the

Subcommittee interview of Darryl Herrick (10/13/2010). See also 10/8/2006 email from Darryl Herrick to a

523

2246

Because Hudson 1 contained only CDS contracts, it was entirely “synthetic”; it

According to Goldman’s contemporaneous records and its responses to Subcommittee

questions, 100% of the CDS contracts included in Hudson 1 were supplied by Goldman’s Mortgage Department. contained no loan pools or RMBS securities that directed actual cash payments to the CDO. Instead, the only cash payments made to Hudson 1 consisted of the cash paid by investors making initial purchases of the Hudson securities and the premiums that Goldman paid into Hudson 1 as the sole short party.

2247

Marketing Hudson. After establishing its basic characteristics and selecting the CDS

assets to be included in Hudson 1, Goldman began to look for investors. A key development took place early on, when near the end of September 2006, Morgan Stanley’s proprietary trading desk committed to entering into a CDS agreement with Goldman referencing the “super senior” portion of Hudson 1, meaning the CDO’s lowest risk tranche that would be the first to receive payments to the CDO. Morgan Stanley agreed to take the long side of a CDS that represented $1.2 billion of the $2 billion CDO, while Goldman took the short side. Hudson 1, Morgan Stanley was permitted to review the $800 million in single name CDS contracts to be included in the CDO and, in fact, vetoed the proposed inclusion of certain CDS contracts referencing commercial mortgage backed securities.2250

As part of its agreement to invest in

2249

2248

After getting the commitment from Morgan Stanley, Goldman turned its focus to selling the

remaining Hudson securities. On September 27, 2007, Mr. Swenson, the SPG Trading Desk and ABS Desk head, sent an email to set up a meeting, which later became a conference call, on “Marketing Strategy for the ABX CDO Trade.” Peter Ostrem, Darryl Herrick, and others. Mr. Herrick circulated a draft copy of the Hudson 1 termsheet and transaction overview for review in advance of the call.

The invitees included Daniel Sparks, Jon Sobel,

2251

2252

Goldman’s CDO marketing strategy typically involved its sales personnel sending clients a

marketing booklet outlining different features of a particular CDO. Mr. Herrick drafted the marketing booklet for Hudson 1, and circulated it for review to Mr. Ostrem and other members of

The $1.2 billion investment made by Morgan Stanley did not correspond to the CDO’s $1.2 billion in CDS

See, e.g., Goldman response to Subcommittee QFR, PSI_QFR_GS0192. Goldman used the cash paid into Hudson 1 to purchase “collateral securities,” as discussed further below. See 10/30/2006 email from Peter Ostrem, GS MBS-E-0000057886, Hearing Exhibit 4/27-90 (“Super senior note

Subcommittee, Mr. Salem had no specific recollection of how assets were selected for Hudson 1 and little specific recollection about Hudson 1 as a whole. Subcommittee interview of Deeb Salem (10/6/10). 2246 2247 2248 ($1.2bln in size) was executed in the first week of the transaction and was a key driver of this deal[’]s success.”).
2249 contracts referencing RMBS securities in the two ABX indices. Rather, Morgan Stanley was investing in the top tier of the CDO as a whole, which included CDS contracts referencing both the ABX and other RMBS securities. 2250 in Section C(5)(b)(iii)AA, below. 2251 Subcommittee that he had no recollection of this conference call, and that it would have been unusual for him to be involved in the marketing efforts of a CDO. Subcommittee interview of Michael Swenson (10/8/2010). 2252 MBS-E-014042220.

9/28/2006 email from Darryl Herrick, GS MBS-E-014042217, with attachments GS MBS-E-014042218 and GS

Subcommittee interview of Darryl Herrick (10/13/2010). See further discussion of Morgan Stanley investment

9/27/2006 email from Michael Swenson to Crystal Young, GS MBS-E-012328848. Mr. Swenson told the

524

the CDO Origination Desk including Benjamin Case and Matthew Bieber. The executive summary of the marketing booklet described Goldman’s Hudson CDO program generally and Hudson 1 in particular:

2253

“Goldman Sachs developed the Hudson CDO program in 2006 to create a consistent, programmatic approach to invest in attractive relative value opportunities in the RMBS and structured product market[.]

-We successfully launched Hudson High Grade in September. This is a continuation of the program using mezzanine Baa2/Baa3 quality RMBS[.]

Hudson CDOs are non-managed and static in nature and provide term non-recourse funding where Goldman Sachs acts as Liquidation Agent on an ongoing basis. The Liquidation Agent will be responsible for efficiently selling credit risk assets …

Goldman Sachs has aligned incentives with the Hudson program by investing in a portion of equity and playing the ongoing role of Liquidation Agent.”

2254

The marketing booklet also described the Hudson 1 assets, and the selection process for

those assets:

“The portfolio composition of Hudson Mezzanine Funding 2006-1 will consist of 100% CDS on RMBS.

60% of the RMBS will be single name CDS on all 40 obligors in ABX 2006-1 and ABX 2006-2
40% of the RMBS will consist of single name CDS on 2005 and 2006 vintage RMBS …

Goldman Sachs’ portfolio selection process:

Assets sourced from the Street. Hudson Mezzanine Funding is not a Balance Sheet CDO
Goldman Sachs CDO desk pre-screens and evaluates assets for portfolio suitability
Goldman Sachs CDO desk reviews individual assets in conjunction with respective mortgage trading desks (Subprime, Midprime, Prime, etc.) and makes decision to add or decline[.]”2255

2253 9/30/2006 email from Darryl Herrick to Peter Ostrem, Benjamin Case, and Matthew Bieber, GS MBS-E- 014367160, with attachment GS MBS-E-014367161; 9/30/2006 Goldman internal email chain among Darryl Herrick, Peter Ostrem, Benjamin Case, and Matthew Bieber, GS MBS-E-017504075. 2254 2255

10/2006 Hudson Mezzanine Funding 2006-1, LTD., GS MBS-E-009546963, at 966, Hearing Exhibit 4/27-87.
Id. at 966, 978.

525

The marketing booklet statement that “Goldman Sachs had aligned incentives with the

Hudson program by investing in a portion of equity,” was misleading. Goldman did, in fact, purchase approximately $6 million in Hudson equity. investment was outweighed many times over by Goldman’s $2 billion short position, which made Goldman’s interest adverse to, rather than aligned with, the Hudson investors. Neither the marketing booklet nor other offering materials disclosed to investors the size or nature of Goldman’s short position in Hudson 1.

However, that $6 million equity

2256

The marketing booklet also stated that Hudson’s assets were “sourced from the Street,” and

that it was “not a Balance Sheet CDO,” even though all of the CDS contracts had been produced and priced internally by Goldman and $1.2 billion of the contracts offset Goldman ABX holdings. The plain meaning of the phrase, “sourced from the Street,” is that the Hudson 1 assets were purchased from several broker-dealers on Wall Street. who sold Hudson 1 securities to investors told the Subcommittee that he thought “sourced from the Street” referred to assets being acquired from a variety of different broker-dealers at the best prices, and was surprised to learn that all of the Hudson assets had been provided by Goldman’s ABS Desk. A Hudson 1 investor told the Subcommittee that it had also interpreted the phrase “sourced from the Street” to mean assets acquired from a variety of different broker-dealers.

Indeed, a former Goldman salesperson

2257

2258

2259

The Subcommittee asked several Goldman traders involved in Hudson 1 to explain their understanding of the phrase, and received inconsistent answers. Darryl Herrick, who drafted the Hudson marketing booklet, stated that “sourced from the Street” meant the assets were “sourced from a street dealer at street prices.” His supervisor, CDO Managing Director Peter Ostrem, stated that “sourced from the Street” referred to the fact the underlying RMBS securities were not originated or underwritten by Goldman. 40% of the assets in Hudson 1, described “the Street” as simply “short hand for all broker- dealers.” and Matthew Bieber, who worked for Mr. Ostrem and later Mr. Lehman, claimed that it was accurate to say the Hudson assets were “sourced from the Street,” even though all the assets were acquired from the Goldman ABS Desk, because Goldman was part of “the Street.”

David Lehman, who became the head of the CDO Origination Desk after Mr. Ostrem,

Deeb Salem, a Goldman mortgage trader who selected

2260

2262

2261

See Goldman response to Subcommittee QFR, at PSI_QFR_GS0223. Barron’s Dictionary of Finance and Investment Terms defines “the Street” as “referring to the financial

2256 2257 community in New York City and elsewhere. It is common to hear ‘The Street likes XYZ.’ This means there is a national consensus among securities analysts that XYZ’s prospects are favorable.”
2258 Subcommittee interview of Andrew Davilman (9/30/2010). 2259 Subcommittee interview of Morgan Stanley (6/24/2010). 2260 The Subcommittee asked Mr. Ostrem whether he considered the Hudson 1 assets to be the RMBS securities or the credit default swaps referencing those securities, and Mr. Ostrem responded that the assets in the CDO were the RMBS securities which had been originated by a variety of financial institutions on Wall Street. When asked why it would be important to indicate to investors that not all the underlying RMBS securities were underwritten by Goldman, given that this information would be clear to a professional reviewing the names of the reference assets in Hudson 1, Mr. Ostrem replied that he didn’t know. Subcommittee interview of Peter Ostrem (10/5/2010). 2261 2262 (10/21/2010).

Subcommittee interview of Deeb Salem (10/6/2010). Subcommittee interview of David Lehman (9/27/2010); Subcommittee interview of Matthew Bieber

526

By using the phrase, “sourced from the Street,” Goldman may have misled investors into

thinking that the referenced assets had been purchased from several broker-dealers and obtained at arms-length prices, rather than simply taken directly from Goldman’s inventory and priced by its own personnel. Moreover, this phrase also appears to hide the fact that Goldman had an adverse interest to investors and was seeking to transfer unwanted risk from its own inventory to the clients it was soliciting. By claiming it was “not a Balance Sheet CDO,” Goldman may have misled investors into believing that Goldman had little interest in the performance of the referenced assets in Hudson, rather than having selected the assets to offset risks on its own books.

In addition to the Hudson marketing booklet, in December 2006, Goldman issued an

Offering Circular which it distributed to potential investors. The Offering Circular contained the statement that no independent third party had reviewed the prices at which the CDS contracts were sold to Hudson 1. participated in any aspect of the CDS contracts – all of the CDS contracts had been produced, signed, and priced internally by two Goldman trading desks which exercised complete control over the Hudson CDO.

In addition to lacking third party verification, no external counterparty had

2263

2264

Internally, while Hudson 1 was being constructed, Goldman personnel acknowledged that

2265

At one point, Mr. Swenson sent an email to Mr.

they were using a novel pricing approach. Birnbaum, raising questions about how they could explain some of the pricing decisions. Mr. Swenson wrote that he was: “concerned that the levels we put on the abx cdo for single-a and triple-bs do not compare favorably with the single-a off of a abx 1 + abx 2 trade,” telling Mr. Birnbaum “[w]e need a goo[d] story as to why we think the risk is different.” The prices that Goldman established for the CDS contracts that Hudson “bought” affected the value of the CDO and the Hudson 1 securities Goldman sold to investors, but the Offering Circular failed to disclose the extent to which Goldman had single-handedly controlled the pricing of 100% of the CDO’s assets.

2266

Perhaps the most serious omission from the marketing booklet and other offering materials

was Goldman’s failure to disclose the fact that it would be the sole short party in the entire $2 billion CDO. The Goldman materials told investors that an affiliate, Goldman Sachs International (GSI), would be the “credit protection buyer” or initial short party for the Hudson 1 CDO.

It was

2267

12/3/2006 Hudson Mezzanine 2006-1, LTD. Offering Circular, GS MBS-E-021821196. Id. at 021821241. See, e.g., 9/19/2006 email from Michael Swenson to Thomas Cornacchia and Joshua Birnbaum, GS MBS-E-

2263 2264 2265 012684557 (“we are going to price an innovative full capital structure $1+bb CDO deal with 60% of the risk in ABX (no one has done this before).”); 9/21/2006 email from Darryl Herrick to Deeb Salem, Michael Swenson, Joshua Birnbaum, Peter Ostrem, and Edwin Chin, GS MBS-E-012685645. 2266 2267 disclosure related to the master credit default swap, where Goldman Sachs International served as the credit protection buyer facing the Hudson Mezzanine 2006-1, Ltd., the legal entity that issued the Hudson 1 securities. See 12/1/2006 ISDA Master Agreement, GS MBS-E-021822056. In this role, Goldman was serving as an intermediary, and was protecting the CDO from credit risk by placing the Goldman Sachs name on the transaction and assuring investors that a single credit-worthy entity would be making all required payments to the Hudson 1 trust. Having one

9/27/2006 email from Michael Swenson to Joshua Birnbaum, GS MBS-E-012689798. 12/3/2006 Hudson Mezzanine 2006-1, LTD. Offering Circular, GS MBS-E-021821196, at 021821229. This

527

2268

The disclosure provided by Goldman contained boiler

common practice for underwriters to act as the initial short party in a CDO, acting as an intermediary between the CDO vehicle and broker-dealers offering competitive bids in order to short the assets referenced in the CDO. plate language suggesting that would be the role played by GSI in the Hudson transaction. Goldman never disclosed that it had provided all of Hudson’s assets internally, GSI was not acting as an intermediary, and GSI would not be passing on any portion of the short interest in Hudson to any other party, but would be keeping 100% of the short position. The Hudson disclosures failed to state that, rather than serving as an intermediary, Goldman was making a proprietary investment in the CDO which placed it in a direct, adverse position to the investors to whom it was selling the Hudson securities.

The Offering Circular contained a section entitled, “Certain Conflicts of Interest,” which included a subsection entitled, “The Credit Protection Buyer and Senior Swap Counterparty,” in which Goldman could have disclosed its short position. Rather than disclose that short position, however, Goldman stated in part:

2269

This disclosure indicates that GSI or an affiliate “may invest and/or deal” in securities or other “interests” in the assets underlying the Hudson CDO, and “may invest and/or deal” in CDS contracts that are “linked to” the Hudson “investments.” The Offering Circular, however, misrepresented Goldman’s investment plans. At the time it was created in December 2006, Goldman had already determined to keep 100% of the short side of the Hudson CDO and act as the sole counterparty to the investors buying Hudson securities, thereby acquiring a $2 billion financial interest that was directly adverse to theirs.

Tracking Hudson. Once it constructed the Hudson CDO, Goldman personnel were

focused on completing and selling the Hudson 1 securities as quickly as possible. At least one other CDO was pushed back to facilitate the execution of Hudson 1.

2270

Goldman intermediated between other broker-dealers and the CDO vehicle in Anderson Mezzanine Funding

broker-dealer intermediate between the market and a CDO vehicle was desirable to credit rating agencies in order to minimize risk in the CDO, and Goldman clearly disclosed this role to investors.
2268 2007-1, Camber 7, Hudson Mezzanine 2006-1, Hudson Mezzanine 2006-2, and Timberwolf I, among several other CDOs. See Goldman response to Subcommittee QFR, at PSI_QFR_GS0192. 2269 12/3/2006 Hudson Mezzanine 2006-1, LTD. Offering Circular, GS MBS- E-021821196, at 021821251.
2270 10/16/2006 email exchange between Daniel Sparks and Peter Ostrem, GS MBS-E-010916991 (“Cambridge is upset that we are delaying their deal. They know that Hudson Mezz (GS prop deal) is pushing their deal back.”).

528

2271

Goldman senior executives closely followed Hudson’s development and sale. Hudson was

2272

Mortgage Department executives also sent progress reports to the senior

During discussions over the best price at which to market the CDO’s equity tranche, a

discussed, for example, at five different Firmwide Risk Committee meetings attended by senior Goldman executives. executives on Hudson 1. On October 25, 2006, for example, Mr. Sobel sent an email to COO Gary Cohn and CFO David Viniar alerting them to Hudson sales efforts and the pricing of its securities. senior executive emailed Peter Ostrem and others: “keep in mind the overall objective - this is not about one trade - having said that, I agree that [the proposed price] may be too low.” 26, 2006, Mr. Jha, a Goldman risk officer, circulated a Mortgage Department Risk Report to a number of Goldman executives, including CEO Lloyd Blankfein and COO Gary Cohn, noting in the forwarding email: “Risk reduction [in the Mortgage Department] is primarily due to pricing of $2bn Hudson Mez synthetic CDO.”2274

On October

2273

Selling Hudson. Once the Hudson CDO was ready for sale, the Goldman sales force had

difficulty selling Hudson securities to investors due to its reliance on BBB and BBB- rated subprime RMBS securities. Allied Irish Bank (AIB), for example, apparently referred to the Hudson securities as “junk.” One Goldman employee emailed the CDO team and asked:

2275

“[D]o we have anything talking about how great the BBB sector of RMBS is at this point in time … a common response I am hearing on both Hudson & HGS1 is a concern about the housing market and BBB in particular? We need to arm sales with a bit more.”

2276

Firmwide Risk Committee meetings were often chaired by David Viniar and frequently attended by Lloyd

10/25/2006 email from Jonathan Sobel to David Viniar and Gary Cohn, GS MBS-E-009757821. 10/12/2006 email from Thomas Cornacchia to Peter Ostrem and others, GS MBS-E-0000066413. 10/26/2006 email from Arbind Jha, “MarketRisk: Mortgage Risk Report (cob 10/25/2006),” GS MBS-E-

2271 Blankfein and Gary Cohn. See 9/20/2006 Firmwide Risk Committee Minutes, GS MBS 0000004472; 9/27/2006 Firmwide Risk Committee Minutes, GS MBS 0000004474; 10/4/2006 Firmwide Risk Committee Minutes, GS MBS 0000004476; 10/11/2006 Firmwide Risk Committee Minutes, GS MBS 0000004478; 11/1/2010 Firmwide Risk Committee Minutes, GS MBS 0000004484. See also 10/11/2006 email from Arbind Jha to Joshua Birnbaum, GS MBS-E-012695030 (“Sobel this morning in the firmwide risk committee mentioned that we have circled up the junior and some of the equity tranches”). 2272 2273 2274 0000056041, Hearing Exhibit 4/27-89. That same day, October 26, 2006, Mr. Swenson also described the risk transfer to Goldman executive Bill McMahon when updating him on the trading desk’s ABX position: “In addition to $2bb of risk that was placed into the CDO, we have sold to retail since 4pm yesterday $2bb of BBB- risk.” 10/26/2006 email from Michael Swenson to Bill McMahon, others, GS MBS-E-0000054856. 2275 (A Goldman employee asked a sales associate: “what specifically did AIB say was ‘junk’ about the hudson mezz deal?” The employee then forwarded the email to Mr. Herrick saying: “You may want to ask [the sales associate] about this when she’s there tomorrow and Friday. … She said ‘AIB are too smart to buy this kind of junk.’”). 2276

“HGS1” refers to Abacus HGS1, a CDO where Goldman, as in Hudson 1, held 100% of the short interest.

10/19/2006 email from Mitchell Resnick to Jonathan Egol, Darryl Herrick, and David Rosenblum, GS MBS-E-

10/11/2006 Goldman internal email, “FW: Hudson Mezz,” GS MBS-E-017502610, Hearing Exhibit 4/27-170c.

Another Goldman salesman emailed Mr. Herrick on the CDO Desk, telling him:

529

“The guy at Schroders looking at this deal has one main issue h[e] has to get over: He is worried about how he is going to convince his boss to invest in a pool of sub prime mortgages with probably their greatest exposures in California and Florida. He is nervous on US house prices. … Anything else we could offer? He is not a big believer in the Moody’s data and rating system. I WANT THIS GUY THERE AND IN SIZE! Please help if you can - just three bullet points would help.”2277

Mr. Herrick kept the SPG Trading Desk posted on the progress of sales. On October 11,

2006, Mr. Herrick informed the group: “This [sale] clears the team of majority the senior risk Equity and BBs we are hammering away on and hope to get traction tomorrow/Friday.” Swenson responded: “you are doing an awesome job, keep it up.” Mr. Swenson emailed the sales team manager: “I am extremely impressed by darryl [a]nd the rest of your team.”

Mr.

2279

2278

On October 25, 2006, Mr. Sobel sent a Hudson update to COO Gary Cohn and CFO David Viniar: “$1.6bn of the $2bn sold, with the majority of the unsold bonds being investment grade. Equity more than 85% sold.”2280

The Goldman sales force sold most of the Hudson securities prior to the CDO’s closing in

December 2006, and continued its sales efforts after the closing as well. Two months after the closing, in February 2007, Goldman had $296 million in unsold Hudson securities, not including the $6 million equity investment Goldman had announced in the Hudson marketing material that it would purchase and hold. Over the following months, Goldman sold an additional $38 million worth of securities to investors, and received bids on several other securities but decided the bid prices were too low and kept the securities on its books instead. The unsold Hudson securities were split between the CDO Origination Desk and ABS Trading Desk.

2281

2282

Overall, Goldman sold Hudson securities to 25 investors. Morgan Stanley made the largest investment, taking $1.2 billion of the super senior portion of the CDO. Other investors included the National Australia Bank, which purchased $80 million worth of the AAA rated securities; Security

10/20/2006 email from Paul Carrett to Darryl Herrick, GS MBS-E-018321286 [emphasis in original]. 10/11/2006 email from Darryl Herrick to Michael Swenson, David Lehman, and Josh Birnbaum, GS MBS-E-

2277 2278

Mr. Swenson told the Subcommittee he had no recollection of being involved in the marketing of Hudson 1. Mr. Swenson said he did not work on CDOs and would not typically be involved in the marketing of CDOs. Subcommittee interview of Michael Swenson (10/8/2010). 2279 2280 2281 2282 securities between the CDO Desk and the ABS Desk, Mr. Herrick said unsold securities were usually split with the sponsor of a CDO. His response suggests that Goldman viewed the ABS Desk as the sponsor of Hudson 1, since it was designed to offset the risk associated with the ABS Desk’s ABX assets. See also 2/28/2007 email from David Rosenblum to Peter Ostrem, GS MBS-E-001800707 (“are we still sharing 50pct of ups and downs on [Hudson].”).

10/12/2006 email from Michael Swenson to David Rosenblum and Peter Ostrem, GS MBS-E-0000030518. 10/25/2006 email from Jonathan Sobel to David Viniar and Gary Cohn, GS MBS-E-009757821. Subcommittee interview of Darryl Herrick (10/13/2010). Subcommittee interview of Darryl Herrick (10/13/2010). When asked if it was common to divide unsold

530

Benefit Mutual, which bought $10 million of the AA rated securities; and Bear Stearns, which bought $5 million of the equity tranche.

Profiting from Hudson. On October 30, 2006, after Hudson 1 was presented to investors

and pre-sold most of its securities, Peter Ostrem, the head of the CDO Origination Desk, sent a celebratory email to the ABS and CDO teams with Hudson highlights. He wrote: “Goldman was the sole buyer of protection on the entire $2.0 billion of assets,” meaning Goldman had kept 100% of the short position. By shorting Hudson, Goldman had transferred $1.2 billion worth of risky ABX assets Goldman wanted off its books, and shorted another $800 million in RMBS securities. Mr. Ostrem also listed these “highlights”:

•

• •

“P&L [Profit and Loss] booked of $8.5mm …. Plus, ongoing P&L to GS for acting as liquidation agent equal to $2.5mm per year for the next 4 years
Hudson Mezz went long $1.2bln of BBB/BBB- ABX from ABS trading desk at market wides 4 weeks ago Fastest execution of a SP [Structured Product] CDO done at Goldman (4 weeks from inception to pricing) Over half the Equity was sold by Andy Davilman … Super senior note ($1.2bln in size) was executed in the first week of the transaction and was a key driver of this deal[’]s success (covered by Nicole Martin).”2283

Over the next year, Goldman pocketed nearly $1.7 billion in gross revenues from Hudson 1,

2284

As the value of the RMBS securities

all of which was at the expense of the Hudson investors. referenced in the ABX indices declined, Goldman, as the sole short party in Hudson, collected $1.393 billion in gains directly from the investors to whom it had sold the Hudson securities. Goldman’s $1.393 billion gains were, in turn, offset internally at the firm by the ABX losses recorded on the books of its ABS Desk. Goldman made another $304 million in gains due to its short of the other $800 million in single name CDS contracts included in Hudson 1. million gain was also at the expense of the investors to whom Goldman had sold the Hudson securities.

That $304

2285

Goldman also profited in other ways. It received substantial fees from the roles it played in underwriting and administering Hudson 1, including $31 million in underwriting fees, $3.1 million for serving as the liquidation agent, and $1 million for serving as the collateral put provider. The ABS Desk warehouse account that contained both the long ABX assets and the 80 offsetting single

2286

Goldman told the Subcommittee that Hudson experienced a gross gain of $1.697 billion offset by a loss of $1.39

10/30/2006 email from Peter Ostrem, “Great Job on Hudson Mezz,” GS MBS-E-0000057866, Hearing Exhibit

2283 4/27-90. 2284 billion (rather than $1.2 billion) in ABX assets on its balance sheet. 8/4/2010 email from Goldman to the Subcommittee, PSI_QFR_GS0243. 2285 2286

See Goldman response to Subcommittee QFR at PSI_QFR_GS0239. Id.

531

name CDS contracts reported a gain of approximately $1.2 million due to the higher value of the single name CDS compared to the ABX CDS.

2287

Goldman also incurred some losses in connection with Hudson 1. Although Goldman sold some additional Hudson securities several months after the CDO closed, it incurred a $267 million loss from the Hudson 1 securities that it was unable to sell at the prices it wanted and instead retained in its inventory. Goldman lost another $111 million from serving as the collateral put provider for Hudson collateral securities which also lost value. Overall, however, Goldman recorded a profit from Hudson 1 of more than $1.35 billion.

2288

In contrast to Goldman, Hudson 1 investors suffered substantial losses. In March 2007, less than three months after the issuance of the Hudson securities, when asked to analyze how a holder of Hudson securities could hedge against a drop in their value, a Goldman trader wrote: “their likelihood of getting principal back is almost zero.” downgrades began. In September 2007, Moody’s downgraded several Hudson 1 securities and followed with additional downgrades in November 2007. S&P began downgrades of Hudson 1 in December 2007, and by February 2008, had downgraded even the AAA rated securities.2290

Six months later, the credit rating

2289

Morgan Stanley, the largest Hudson investor, lost $930 million.

As other investors incurred increasing losses, they sold their securities back to Goldman at rock bottom prices. In September 2007, for example, nine months after the Hudson securities were first issued, Goldman repurchased $10 million worth of Hudson securities from Greywolf Capital at a price of five cents on the dollar; in October 2007, another hedge fund sold $1 million in Hudson securities back to Goldman at a price of 2.5 cents on the dollar. In November 2008, Hudson 1 was completely liquidated by Goldman. Today, Hudson securities are worthless.

2292

2291

Analysis. Goldman constructed Hudson 1 as a way to transfer its ABX risk to the investors who bought Hudson securities. When marketing the Hudson securities, Goldman misled investors by claiming its investment interests were aligned with theirs, when it was the sole short party and was betting against the very securities it was recommending. Goldman also implied that Hudson’s assets had been purchased from outside sources, and failed to state that it had selected the majority of the assets from its own inventory and priced the assets without any third party participation. By holding 100% of the short position at the same time it solicited clients to buy the Hudson securities, Goldman created a conflict of interest with its clients, concealed the conflict from them, and profited at their expense.

2287 2288 2289 2290 2291 2292

Id. Id., at PSI_QFR_GS_0280. 3/4/2006 email from Fabrice Tourre to George Maltezos, others, GS MBS-E-006638833. See Goldman response to Subcommittee QFR, at PSI_QFR_GS0211. 11/21/2008 letter from Goldman to Morgan Stanley, HUD-CDO-00005125. See Goldman response to Subcommittee QFR, at PSI_QFR_GS0223 and PSI_QFR_GS0235.

BB. Anderson Mezzanine Funding 2007-1

532

In the summer of 2006, Goldman began work on Anderson Mezzanine Funding 2007-1

(Anderson), a synthetic CDO whose assets were single name CDS contracts referencing subprime RMBS securities with mezzanine credit ratings. partnered with GSC Partners (GSC), a New York hedge fund. Goldman personnel working on the CDO included Peter Ostrem, head of the CDO Origination Desk, and Matthew Bieber, a CDO Origination Desk employee assigned to be deal captain for the Anderson CDO.

To execute the Anderson CDO, Goldman

2293

The CDO was originally conceived as part of the Hudson series of non-managed, proprietary But Goldman decided to enlist GSC to take part

2294

CDOs in which Goldman acted as the principal. in structuring the $500 million CDO.

2295

Partnering on Anderson. GSC Partners was founded by Alfred C. Eckert, III, a former

2296

partner and former head of private equity, distressed debt investing, and corporate finance at Goldman. Goldman had a longstanding relationship with GSC. In addition to Mr. Eckert, at least five other former Goldman Managing Directors were employed by GSC, and at least eight other former and current Managing Directors had invested in one or more of GSC’s funds. spring of 2006, GSC circulated information through Goldman about raising money for its Elliot Bridge Fund, a “fixed income arb[itrage] fund focusing primarily on ABS using cash and synthetics, long/short strategies.” When discussing the fund with other Goldman employees, Curtis Willing, the Goldman sales representative responsible for covering GSC wrote: “They are a strategic partner with the Synthetic desk and have handed us multiple CDO/CLO mandates.” informed of the internal conversations almost a month later, Mr. Sparks informed Mr. Willing that it was a “[m]istake not to involve me from early on,” telling Mr. Willing, “I’ve run a bunch of traps for [GSC] in the past.”2300

After being

In the

2299

2298

2297

Some documents indicate the CDO was slated to be Hudson Mezzanine 2006-2. But in December 2006,

2293 “Mezzanine” CDS assets reference securities that carry a credit rating of BBB or BBB-. Mezzanine assets are riskier than AAA, AA, and A rated assets, but less risky than those that carry, for example, BB, B, or CCC ratings. 2294 Goldman delayed Anderson in favor of issuing an ABX based CDO named Hudson Mezzanine 2006-2. Several of the documents cited in this section use the terms “Hudson” or “Hudson Mezz” when in fact they refer to Anderson. None of the Goldman employees interviewed by the Subcommittee could recall the reason for changing the name of the CDO to Anderson. 2295 9/25/2006 Goldman memorandum to the Mortgage Capital Committee, GS MBS-E-013475756-62 (hereinafter “9/25/2006 MCC Memorandum”). The MCC Memorandum states that Goldman was approached by GSC, but may be using standard language reused in many MCC Memoranda. In an interview with the Subcommittee, Edward Steffelin, a Senior Trader at GSC, stated that Goldman approached GSC about partnering in the transaction, and the memorandum language was “probably backward.” Subcommittee interview of Edward Steffelin (12/10/2010).
2296 2297 the information used for its response had been voluntarily provided by Goldman employees. 2298 Bridge Fund eventually invested in Anderson. 2299 2300

9/25/2006 MCC Memorandum, GS MBS-E-013475756-62. See Goldman response to Subcommittee QFR at PSI_QFR_GS0434. Goldman noted in its QFR response that

4/17/2006 email from Curtis Willing to David Solomon and Dan Holland, GS MBS-E-013870906-7. 5/14/2006 and 5/10/2006 emails from Dan Sparks to Curtis Willing, GS MBS-E-013870906-7.

5/10/2006 email from Curtis Willing to David Solomon and Dan Holland, GS MBS-E-013870906-7. The Elliot

533

GSC agreed to partner with Goldman on the Anderson CDO and to share in the associated risk, including by splitting the equity tranche and sharing the risk with Goldman that the Anderson assets would lose value while being warehoused. GSC also participated in selecting the assets for the CDO. Anderson, 2303 marketing Anderson.

2302 and allowed GSC to participate in pricing issues,

Later on, Goldman consulted with GSC on whether to liquidate or underwrite

while GSC at times assisted in

2301

2304

2305

Goldman offered to let GSC take a short interest in the CDO by offering to “sell protection

on BBBs to GSC at market for 0.75% times notional,” and agreeing to “source assets via GSC,” meaning GSC could propose assets for the CDO that GSC wanted to get rid of or short. GSC responded by shorting a select group of RMBS securities to hedge its risk while those assets were in the Anderson warehouse account. For instance, at one point in October 2006, GSC sought to add $56 million in assets to the Anderson CDO, while also taking a short position on $9 million of those assets, which it described as “GSC Hedge Amount.”

2306

2308

2307

Designing Anderson. GSC and Goldman participated together in the selection of assets for

Anderson. Anderson was designed to be a synthetic CDO whose assets would consist solely of CDS contracts referencing RMBS securities whose average credit ratings would be BBB or BBB-. GSC proposed some of the referenced RMBS securities, but it is unclear how many were included in Anderson. GSC and Goldman employees interviewed by the Subcommittee had no specific

2309

9/25/2006 MCC Memorandum, GS MBS-E-013475756-62. 8/8/2006 email from Edward Steffelin to Peter Ostrem and others, “GS/GSC EB Prop deal,” GS MBS-E-

Subcommittee interview of Edward Steffelin (12/10/2010). See 3/5/2007 emails between Matthew Bieber and Joshua Bissu, GS MBS-E-014605918. See 3/6/2007 email from Joshua Bissu to Matthew Bieber and Peter Ostrem, GS MBS-E-014597705. 8/8/2006 email from Edward Steffelin to Peter Ostrem and others, “GS/GSC EB Prop deal,” GS MBS-E-

2301 2302

8/8/2006 email from Peter Ostrem to Edward Steffelin, Joshua Bissu and others, GS MBS-E- 000904603 (Mr. Ostrem writes: “Happy to source assets via GSC.”). See e.g., 9/26/2006 email from Mr. Bissu to Matthew Bieber, “Names for tomorrow,” GS MBS-E-014335388.
2303 2304 2305 2306
GSC frequently executed trades with Goldman’s Correlation Trading Desk, and was known to have a “long/short strategy” in which it shorted assets it considered expensive and went long assets it thought were undervalued. See 9/15/2006 email from Geoffrey Williams to Correlation Trading Desk, GS MBS-E-009471708. See e.g., 10/31/2006 email from Shelly Lin to Joshua Bissu, and Matthew Bieber, GS MBS-E-016473768. 2307 Salem, “Re: GSC-Hudson Mezz 2,” GS MBS-E-000905571. A former GSC employee interviewed by the Subcommittee also indicated that the short positions were taken on Anderson assets in an effort to hedge GSC’s warehouse risk. Subcommittee interview of Edward Steffelin (12/10/2010). 2308 10/31/2006 email from Shelly Lin to Deeb Salem, Edwin Chin, and Matthew Bieber, GS MBS-E-000905571 (“GSC wants to short into the deal the amounts listed below. They’d like to trade the ones they want to hedge with your desk as well. I think they also did this with your desk a few weeks ago.”). When Mr. Bieber was shown this document during his 10/21/2010 interview with the Subcommittee he stated he didn’t know if GSC had shorted assets and that he didn’t know what Ms. Lin meant by her statement. Subcommittee interview of Matthew Bieber (10/21/2010).
2309 (12/10/2010).

10/31/2006 email from Curtis Willing, GSC Trades, GSC-CDO-FCIC-0029698; 10/31/2006 email from Deeb

10/31/2006 email from Shelly Lin to Joshua Bissu and Matthew Bieber, GS MBS-E-016473768. See also

Subcommittee interview of Matthew Bieber (10/20/2010); Subcommittee interview of Edward Steffelin

recollection of the asset selection process, beyond each party selecting some RMBS securities and the other having veto rights.

2310

534

Anderson’s assets were purchased from 11 different broker-dealers from September 2006 to

March 2007. Goldman was the source of 28 of the 61 CDS contracts in Anderson, and Goldman retained the short side. The next largest short party was Lehman Brothers which sold six CDS contracts to Anderson and retained the short side. Goldman also served as the sole credit protection buyer to the Anderson CDO, acting as the intermediary between the CDO and the various broker- dealers selling it assets.

2311

By February 2007, the Anderson warehouse account contained $305 million out of the intended $500 million worth of single name CDS, many of which referenced mortgage pools originated by New Century, Fremont, and Countrywide, subprime lenders known within the industry for issuing poor quality loans and RMBS securities. Approximately 45% of the referenced RMBS securities contained New Century mortgages.

2312

Falling Mortgage Market. During the same time period in which the Anderson single name CDS contracts were being accumulated, Goldman was becoming increasingly concerned about the subprime mortgage market, was reacting to bad news from the subprime lenders it did business with, RMBS securities referenced in Anderson. securities was falling, and the Goldman CDO Origination Desk was forced to mark down the value of the long single name CDS contracts in its CDO warehouse accounts, including Anderson.

and was building a large short position against the same types of BBB rated By February 2007, the value of subprime RMBS

2314

2313

Goldman was also aware that its longtime customer, New Century, was in financial distress.

On February 7, 2007, New Century announced publicly it would be restating its 2006 earnings, causing a sharp drop in the company’s share price. On February 8, 2007, Goldman’s Chief Credit Officer Craig Broderick sent Mr. Sparks and others a press clipping about New Century and warned:

“[T]his is a materially adverse development. The issues involve inadequate [early payment default] provisions and marks on residuals …. [I]n a confidence sensitive industry it will be

Id. See Goldman response to Subcommittee QFR at PSI_QFR_GS0192. This number was compiled using a list of referenced securities supplied by Goldman at QFR_PSI_GS0192 and

2310 2311 2312 registration statements available at www.sec.gov. When looking at all mortgages underlying each reference security, New Century originated 48% by value of the underlying mortgages. However, each mortgage may have a different weight in the Anderson CDO based on the size of the reference security it is held in. Therefore, the economic effect of the New Century mortgages could be greater than or less than 48%. The next largest mortgage originator by value was Countrywide at 8%. 2313 Hearing Exhibit 4/27-169. 2314

See, e.g., 1/4/2007 Goldman presentation, “Sub-Prime Mortgage Lenders - Update,” GS MBS-E-009978840-59,

See discussion of Goldman’s net short position, Section C(4), above.

535

ugly even if all problems have been identified. … We have a call with the company in a few minutes (to be led by Dan Sparks).”

2315

On some occasions, Mr. Sparks addressed negative news about New Century in the same email he discussed liquidating assets in warehouse accounts for upcoming CDOs. On March 8, 2007, for example, Mr. Sparks noted in an email to senior executives: “New Century remains a problem” due to loans experiencing early payment defaults, and informed them that the Mortgage Department had “liquidated a few deals and could liquidate a couple more.”

2316

On February 23, 2007, Mr. Sparks sent an email to senior Goldman executives estimating that Goldman had lost $72 million on the holdings in its CDO warehouse accounts, due to falling prices. He directed Mortgage Department personnel to liquidate rather than securitize the assets in certain warehouse accounts. Two days later, on February 25, 2007, Mr. Sparks informed senior executives of the possibility of liquidating Anderson:

2317

“[T]he CDO business liquidated 3 warehouses for deals of $530mm (about half risk was subprime related). … One more CDO warehouse may be liquidated this week - approximately $300mm with GSC as manager.”

2318

Three days later, David Rosenblum, head of Goldman’s Collateralized Loan Obligations activities, emailed Mr. Ostrem, head of the CDO Origination Desk, stating: “Dan tells me that SP [Structured Product] CDO desk has reported -77 [million dollars] from retained debt (Hmezz 1+2, etc), and -129 [million dollars] from unrealized and realized CDO WH [warehouse] markdowns.”

2319

On February 24, 2007, a Saturday, several persons from the Mortgage Department worked to

analyze the costs of unwinding and liquidating the assets collected for the Anderson CDO. Deeb Salem, a trader on the ABS Desk, estimated that unwinding Anderson would result in a $60 million loss due to the falling value of its single name CDS. On the same day, Mr. Ostrem sent his colleagues this explanation of why the losses in the CDO warehouse accounts were growing so rapidly:

2320

“Each warehouse is marked by either (a) MTM [mark-to-market] on each asset or (b) mark to model [MTModel] which involves taking the portfolio through the expected CDO execution and calculating Goldman’s P&L [profit and loss] given current market yields on debt and equity. MTM is preferred if CDO execution is highly uncertain or portfolio is

2315 2/8/2007 email from Craig Broderick to Daniel Sparks, David Viniar, others, GS MBS-E-002201486. 2316 3/8/2007 email from Daniel Sparks to senior executives, GS MBS-E-002206279, Hearing Exhibit 4/27-75. 2317 2/23/2007 email from Daniel Sparks to senior executives, GS MBS-E-009759477. 2318 2/25/2007 email from Daniel Sparks to Tom Montag, GS MBS-E-019164799. See also 2/23/2007 email from Daniel Sparks to senior executives, GS MBS-E-009759477 (“We liquidated 3 CDO warehouses today and started the liquidation of another. We may liquidate one more next week.”). 2319 2320 018936137-38.

2/28/2007 email from David Rosenblum to Peter Ostrem, GS MBS-E-001800707. 2/24/2007 email from Deeb Salem to Michael Swenson, Edwin Chin, and Josh Birnbaum, GS MBS-E-

536

small. Both the MTM and the MTModel take into account risk sharing arrangements with 3rd parties.

As CDO execution has become more uncertain we have moved a couple warehouses closer to their MTM which has significantly increased our losses. Also, our MTModel results have shown losses as expected liability spreads have widened significantly and the overall strength of the CDO market has waned due to fundamental credit decline in 06/07 in RMBS subprime (90+% of assets) and increased co[r]relation between ABX/TABX levels and mezz debt levels in CDOs. We expect this co[r]relation to increase volatility in our warehouse marks for the [sic] a while (this series of events have happened quickly within the last month and the co[r]relation is getting closer to 1 as global markets get more familiar with fundamentals in subprime and trading levels in ABX/TABX).

Additional losses have also resulted from the liquidation of 3 warehouses. In each case, the realized loss from the sale of assets has been higher than our MTM or MTModel. This is attributable to both volatility in subprime markets and that our competitors are closing their CDO warehouse accounts from buying our subprime or CDO positions. The buyer base has suddenly shrunk significantly. As this continues, we expect this lack of liquidity to further weaken our MTMs and feed into our losses in our remaining warehouse marks.”

2321

At about 11 p.m. that Saturday night, February 24, 2007, Mr. Sparks seemed to reach a decision to liquidate Anderson. He sent an email to Mr. Ostrem, Mr. Bieber, and several others stating: “I want to liquidate Anderson Monday – we should begin the discussion with gsc asap.”

2322

After Mr. Sparks relayed this decision, Messrs. Ostrem and Bieber began to strategize ways Messrs. Ostrem and Bieber assembled a list of

to convince Mr. Sparks to reverse his decision. likely buyers of the Anderson securities to present to Mr. Sparks, and brainstormed about other CDOs that could potentially buy Anderson securities for their asset pools. Mr. Ostrem also proposed allowing a hedge fund to short assets into the deal as an incentive to buy the Anderson securities, but Mr. Bieber thought Mr. Sparks would want to “preserve that ability for Goldman.”2325

2324

2323

At some point, Mr. Sparks changed his mind and decided to go forward with underwriting

the Anderson CDO. None of the Goldman personnel interviewed by the Subcommittee could recall why the final decision was made to go forward with Anderson. In one email on March 2, 2007, Jonathan Egol, head of the Goldman Correlation Trading Desk, suggested adding $195 million more in assets to Anderson, with Goldman selecting the assets internally and shorting them. 2326

Mr.

2321 2322 2323 2324 2325 2326

2/24/2007 email from Peter Ostrem to colleagues, GS MBS-E-010383828-29. 2/24/2007 email from Daniel Sparks to Peter Ostrem, others, GS MBS-E-001996601, Hearing Exhibit 4/27-95. 2/25/2007 Goldman internal email chain, GS MBS-E-001996601, Hearing Exhibit 4/27-97. Id. Id. 3/2/2007 email from Jon Egol to Daniel Sparks and others, GS MBS-E-010637566, Hearing Exhibit 4/27-97.

537

Sparks rejected any expansion of Anderson, responding: “we are not ramping - execute deal as is.”

2327

The Anderson CDO closed on March 20, 2007. As finally constructed, 100% of its assets were CDS contracts referencing $307 million in mezzanine subprime RMBS securities, meaning RMBS securities carrying BBB or BBB- credit ratings. About 45% of the subprime mortgages in the referenced RMBS securities were issued by New Century. Another 8% were issued by Countrywide, and almost 7% were issued by Fremont. Goldman took about 40% of the short side of the Anderson CDO. Ten other investors held the rest of the short interest in the CDO.

Selling Anderson. During March, selling Anderson securities became a top priority for Goldman. Goldman even put another deal on hold, the Abacus 2007-AC1 deal with the Paulson hedge fund, to promote Anderson. As Mr. Egol advised Goldman personnel: “Given risk priorities, subprime news and market conditions, we need to discuss side-lining [Abacus 2007-AC1] in favor of prioritizing Anderson in the short term.”

2328

On March 13, 2007, Goldman issued internal talking points for its sales force on the

Anderson CDO. Among the points highlighted were:

“Portfolio selected by GSC. Goldman is underwriting the equity and expects to hold up to 50%. … Low fee structure[.] … No reinvestment risk.”

2329

The talking points described Goldman as holding up to 50% of the equity tranche in the CDO – worth about $21 million, without mentioning that Goldman would also be holding 40% – about $135 million – of the short side of Anderson, placing its investment interests in direct opposition to the investors to whom it was selling Anderson securities.

The large number of poor assets referenced in Anderson raised investor questions and was

an impediment to sales. explaining its decision not to purchase the Anderson securities:

One potential investor wrote to a Goldman sales representative

2330

“We’re going to pass on this deal for a number of reasons: Two bonds . . . have been downgraded or are on negative watch; Another 12 bonds in the portfolio are negatively impacted by the downgrades lower in the capital structure; 28% of the portfolio is failing

3/13/2007 email from Peter Ostrem to Scott Wisenbaker and Matthew Bieber, GS MBS-E-000898410, Hearing

3/2/2007 email from Daniel Sparks to Jon Egol and others, GS MBS-E-010637566, Hearing Exhibit 4/27-97. 3/2/2007 email from Jon Egol to colleagues, “Re: Abacus AC1,” GS MBS-E-002676413, Hearing Exhibit 4/27-

2327 2328

2329 Exhibit 4/27-172.
2330 the Anderson warehouse account had reached $22.9 million. 3/16/2007 Goldman Sachs International Risk Committee memorandum, “GSI Warehousing for Structured Product CDOs,” GS MBS-E-001806010-16.

In mid-March, Mr. Ostrem informed the GSI Risk Committee that Goldman’s estimated losses on the assets in

538

delinquency triggers; We show that a lot of these bonds will take principal hits; Not crazy about the deal structure given the quality of the portfolio.”

2331

Other investors expressed concerns that the CDO would be downgraded. Goldman did not disclose to these investors that it had almost canceled the CDO, due to its assets’ falling values.

2332

Of particular concern for investors was the concentration of New Century mortgages in

2333

On March 13, 2007, a potential investor, Rabobank, asked Goldman sales

Anderson. representatives: “how did you get comfortable with all the new centu ry [sic] collateral in particular the new century serviced deals – con sidering [sic] you are holding the equity and their servicing may not be around is that concerning for you at all?” talking points with which to respond to the investor:

Goldman and GSC prepared a list of

2334

“- Historically New Century has on average displayed much better performance in terms of delinq[uency] and default data

Prepayments have tended to be higher lowering the extension risk
Losses and REO [Real Estate Owned by a lender taking possession of a property] are historically lower than the rest of the market
Traditionally the structures have strong enhancement/subordination.”

2335

The talking points did not disclose that, in fact, Goldman, too, was uncomfortable with New

Century mortgages. On March 8, 2007, five days before receiving the investor’s inquiry, Mr. Sparks had reported to senior Goldman executives, including Co-President Gary Cohn and CFO David Viniar, that New Century mortgages “remain[ed] a problem for [early payment default].”

2336 On March 13, the same day as the investor inquiry, Goldman personnel completed a review of New Century mortgages with early payment defaults that were on Goldman’s books and found fraud, “material compliance issues,” and collateral problems. The review found that “62% of the pool has not made any pmts [payments]” and recommended “putting back 26% of the pool” to New Century

5/31/2007 email from Goldman client to Andrew Davilman, GS MBS-E-015550857-58. Andrew Davilman

2331 relayed the message to Matthew Bieber, who suggested the client might be interested in higher rated securities. Mr. Davilman responded: “I’ll check, but given the portfolio I suspect he’s looking for a cleaner start.” 2332 3/16/2007 email from Russell Brocato to Scott Wisenbaker, GS MBS-E-000902498, Hearing Exhibit 4/27-172. Mr. Bieber and Mr. Ostrem were also informed by a salesperson that the client was “out on Anderson – they feel like the deal will be dow[n]graded and have interest coverage issues.” Mr. Ostrem instructed the Goldman salesperson to “[f]ix the miscommunication so the probability [of sale] goes up.”
2333 4/27-172 (“Looking like both dcp and terwin out. New Century issues.”). 2334 Hearing Exhibit 4/27-172. 2335 2336

3/6/2007 email from Joshua Bissu to Matthew Bieber and Peter Ostrem, GS MBS-E-014597705. 3/8/2007 email from Daniel Sparks to senior executives, GS MBS-E-002206279, Hearing Exhibit 4/27-75.

3/14/2007 email from Matthew Bieber to Scott Wisenbaker and others, GS MBS-E-000908336, Hearing Exhibit

3/13/2007 email from Wendy Rosenfeld at Rabobank to Olivia Ha at Goldman, GS MBS-E-000898417,

for repurchase “if possible.” 40% of the Anderson CDO.

2337

Goldman also did not disclose to the investor that it was shorting

539

2338

2339

This clarification was necessary, because although GSC’s role

Some Goldman clients also had questions about GSC’s involvement in Anderson. An Australian sales representative wanted “more color on asset selection process, especially with respect to GSC involvement.” was mentioned in numerous internal Goldman documents, the official Anderson marketing materials did not mention GSC’s role in asset selection. In previous drafts of the marketing materials, for example, Goldman stated that “Goldman Sachs and GSC Group co-selected the assets”; “GSC pre-screens and evaluates assets for portfolio suitability”; the CDO was “co- sponsored by Goldman and GSC Eliot Bridge Fund”; and “Goldman Sachs and GSC ha[ve] aligned incentives with Anderson Funding by investing in a portion of equity.” But all of the references Mr. Bieber told the Subcommittee that he did to GSC were removed from the final documents. not recall specifically why the references to GSC were removed, but recalled GSC having an issue with disclosing its name in the offering documents. Edward Steffelin, a Senior Trader at GSC, also did not recall the specifics regarding why the references to GSC were removed, but told the Subcommittee that he felt GSC’s role in the Anderson CDO did not rise to the level of “co- selecting.” he felt that “co-selecting” implied a level of control over the portfolio that GSC didn’t have.2344

Mr. Steffelin said that although GSC had the ability to suggest assets and veto others,

2341

2340

2342

2343

3/13/2007 email from Manisha Nanik to Loren Morris, “New Century EPDs,” at GS MBS-E-002146861,

2/2007 Anderson Mezzanine Funding 2007-1, Ltd. Debt Marketing Book, GS MBS-E-000855351. Anderson

3/1/2007 email from Scott Wisenbaker to Peter Ostrem and Matthew Bieber, GS MBS-E-000893661, Hearing

2/2007 Anderson Mezzanine Funding 2007-1, Ltd. Debt Marketing Book, GS MBS-E-000855351.
2/2007 Anderson Mezzanine Funding 2007-1, Ltd. Equity Marketing Book, GS MBS-E-000892557-598 at 560,

2337 Hearing Exhibit 4/27-77. See also 2/2/2007 email from Matthew Nichols to Kevin Gasvoda and others, GS MBS-E- 005556331 (“NC is running a 10% drop rate [due diligence drop] at ~6 points / drop and 4% EPD rate at close to 20 points.”); 2/8/2007 email from John Cassidy to Joseph Ozment, others, GS MBS-E-002045021 (“Given the current state of the company I am no longer comfortable with the practice of taking loans with trailing docs . . . that we need in order to conduct compliance testing.”). 2338 Exhibit 4/27-172. 2339 2340 569. 2341 Mezzanine Funding 2007-1, Ltd. Debt Marketing Book, GSC-CDO-FCIC-0031712 at 726. Around the time Goldman was deciding whether to underwrite Anderson, Fred Horton, head of CDOs at GSC, left the firm. While discussing whether to issue or underwrite the CDO with Matthew Bieber, Mr. Ostrem commented: “Will need disclosure on Horton. This looks bad.” 2/25/2007 email from Peter Ostrem to Matthew Bieber, GS MBS-E- 001996601, Hearing Exhibit 4/27-95.
2342 2343 Anderson assets were “sourced from the Street.” Mr. Steffelin described this as a “weird phrase,” but felt it implied “it would be open, sourced from all over.” See discussion of the phrase, “sourced from the Street,” in the prior section on Hudson 1. 2344 aware of its involvement, perhaps from talking to Goldman personnel. See 3/28/2007 email from Matthew Bieber to Edward Steffelin, “ACA Meeting,” GS MBS-E-014419176 (“Questions on [Anderson] – but also want to do manager due diligence. They’ve heard the GSC team shows well – so want to meet you in person.”).

Subcommittee interview of Matthew Bieber (10/21/2010). Subcommittee interview of Edward Steffelin (12/10/2010). The marketing materials also stated that the

Id. Despite GSC’s not being listed as having helped select the Anderson assets, some investors appeared to be

540

Despite the poor reception by investors, Goldman continued “pushing the axe” with its sales

2345

Mr. Bieber identified and monitored potential investors and

force to sell Anderson securities. attempted to sell Anderson securities to pension funds and place Anderson securities in other Goldman CDOs as collateral securities. $20 million in Anderson securities, his supervisor, Mr. Ostrem, responded with the single word: “Profit!” pushing to closure these deals in a period of extreme difficulty.”2348

In a separate email a week later, Mr. Ostrem told Mr. Bieber he did “an excellent job

On March 20, 2007, when Mr. Bieber reported selling

2346

2347

After several months of effort, Goldman was able to sell only a third, or about $102 million

of the $307 million in Anderson securities. The nine investors included Beneficial Life, Moneygram, and GSC which purchased the entire $11 million class D portion of the CDO.

2349

2350

Losing Money from Anderson. Due to its inability to sell two-thirds of the Anderson

securities, Goldman lost money overall on the CDO. Goldman’s biggest gain came from holding 40% of the short position on certain Anderson assets, which produced a $131 million gain at the direct expense of the investors to whom Goldman had sold the Anderson securities. Goldman was also paid $200,000 for serving as the liquidation agent, premiums while it warehoused Anderson assets.

and collected $2 million in CDS

2352

2351

Despite those gains, Goldman incurred a $185 million loss from the Anderson securities it

was unable to sell and had to keep on its books. It incurred another $122 million loss due to the decreased value of the securities Goldman had purchased as collateral for the CDO.

Anderson’s nine investors suffered more substantial losses. Seven months after its issuance,

in November 2007, Anderson securities experienced their first ratings downgrades. At that point, 27% of the assets underlying Anderson were downgraded below a B- rating. to Goldman a portion of the Anderson securities it had purchased at a price of 3 cents on the dollar. Within a year, Anderson securities that were originally rated AAA had been downgraded to BB. In the end, the Anderson investors were wiped out and lost virtually their entire investments.

GSC then sold back

2353

2354

Analysis. Goldman constructed the Anderson CDO using CDS contracts referencing subprime RMBS securities, the majority of which were issued by subprime lenders like New

2345 2346 2347 4/27-172. 2348 2349

3/12/2007 email from Robert Black to Matthew Bieber, others, GS MBS-E-000898037. Id. 3/20/2007 email from Peter Ostrem to Matthew Bieber and others, GS MBS-E-000906269, Hearing Exhibit

3/27/2007 email from Peter Ostrem to Matthew Bieber, GS MBS-E-000907935, Hearing Exhibit 4/27-172. See Goldman response to Subcommittee QFR at PSI_QFR_GS0223 and PSI_QFR_GS0235. GSC paid a price of 108.21% for the securities. See Goldman response to Subcommittee QFR at

2350 PSI_QFR_GS0223 and PSI_QFR_GS0235. 2351 2352 2353 Spreadsheet showing credit ratings for Anderson). 2354

See Goldman response to Subcommittee QFR at PSI_QFR_GS0223 and PSI_QFR_GS0235. See Goldman response to Subcommittee QFR at PSI_QFR_GS0239. 1/3/2008 email from Shelly Lin to Mr. Sparks, GS MBS-E-021880171 (attached file, “Deal Summary,” Excel

See Goldman response to Subcommittee QFR at PSI_QFR_GS0223 and PSI_QFR_GS0235.

541

Century who were known for issuing poor quality loans. When potential investors asked how Goldman was able to “get comfortable” with the New Century mortgage pools referenced in Anderson, Goldman attempted to dispel concerns about the New Century loans, withheld information about its own discomfort with New Century, and withheld that it was taking 40% of the short side of the CDO, essentially betting against the very securities it was selling to its clients. Instead, Goldman instructed its sales force to tell potential investors that Goldman was buying up to 50% of the equity tranche. Goldman also did not disclose to potential investors that it had almost cancelled the CDO due to the falling value of its assets.

CC. Timberwolf I

Timberwolf I was a $1 billion hybrid CDO transaction that Goldman constructed,

underwrote, and sold. It contained or referenced A rated CDO securities which, in turn, referenced primarily BBB rated RMBS securities. The assets in Timberwolf were selected by Greywolf Capital Management, a registered investment adviser, with the approval of Goldman. Greywolf served as the collateral manager of the CDO. Goldman effectively served as the collateral put provider.

Timberwolf was initiated in the summer of 2006, and closed in March 2007.

2355

2356

Partnering with Greywolf. Greywolf Capital Management was founded by a team of

It had experience in constructing former employees of Goldman’s fixed income trading division. and investing in CDOs. In the summer of 2006, Peter Ostrem, head of Goldman’s CDO Origination Desk, approached Greg Mount, a former Goldman trader working for Greywolf, and asked if Greywolf would be interested in managing a CDO transaction. Goldman and Greywolf negotiated a risk sharing agreement, and worked through the profitability of the CDO under expected market conditions. Greg Mount, as well as Joseph Marconi, another former Goldman trader, obtained approval from Greywolf’s Chief Investment Officer to manage the CDO.

2357

2358

Greywolf agreed to purchase half of the Timberwolf equity tranche, sharing that risk with

2359

Goldman. In addition, Greywolf agreed to share with Goldman the risk of the assets being purchased for the CDO falling in value before the CDO issued its securities. Greywolf also accepted the responsibility of selecting the assets with the approval of Goldman, which would then keep them in a warehouse account for the Timberwolf CDO. Greywolf agreed to provide ongoing surveillance of the performance of the assets in the CDO and liquidate any assets deemed to be impaired.

Constructing Timberwolf. In September 2006, Greywolf began identifying, purchasing, and warehousing CDO securities or single name CDS referencing CDO securities for Timberwolf.

2/2007 Timberwolf I, Ltd. Marketing Book, GS MBS-E-000676809, Hearing Exhibit 4/27-99a. For more information about Goldman’s actions as the collateral put provider for Timberwolf, see Section

2355 2356 (iii)(BB), below. 2357 2358 2359 Subcommittee QFR at PSI_QFR_GS0223 and PSI_QFR_GS0235.

2/2007 Timberwolf I, Ltd. Marketing Book, GS MBS-E-000676809, Hearing Exhibit 4/27-99a. Subcommittee interview of Joseph Marconi (10/19/2010). Greywolf eventually purchased the entire equity tranche in Timberwolf. See Goldman response to

542

Before selecting an asset for inclusion in Timberwolf, Greywolf did a detailed credit

analysis of the relevant CDO security, including examining its underlying mortgage portfolio, the CDO’s cashflow structure, and the mortgage servicer. analysis, it submitted its choices to Goldman’s CDO Origination Desk for review by Mr. Ostrem and Matthew Bieber, who was assigned to be the Goldman deal captain for Timberwolf. Goldman had the right to approve each asset going into the Timberwolf warehouse account and thus onto Goldman’s warehouse balance sheet.

Once Greywolf finished its credit

2360

Once an asset was approved by both Greywolf and Goldman, it was acquired in one of two

ways. In most instances, Greywolf circulated a list of the CDO securities or reference CDO securities that it was interested in buying to the broker-dealer community to get bids. To buy a single name CDS, Goldman wrote the CDS contract, taking the long side on behalf of Greywolf, while the broker-dealer who provided the best bid took the short side. The CDS contract would then be held by Goldman in the Timberwolf warehouse account until the CDO was ready to close. request with a price for a single name CDS on a similar CDO security, which Greywolf analyzed and sometimes agreed to acquire.2362

In some instances, after circulating a list for bids, a broker-dealer responded to Greywolf’s

2361

Timberwolf’s single name CDS and CDO securities were acquired from 12 different broker- 2363

Goldman was the single largest source of assets, providing 36% of the assets by value,

dealers. including $15 million in single name CDS contracts naming Abacus securities. Goldman held 36% of the short interest in Timberwolf. Altogether, Timberwolf contained 56 different assets, of which 51 were single name CDS contracts referencing CDO securities and five were cash CDO securities. The 51 single name CDS contracts referenced both CDO and CDO 2 securities, and each CDO or CDO security contained or referenced its own RMBS, CMBS, or CDO securities or other assets. In total, Timberwolf had over 4,500 unique underlying securities and a grand total of almost 7,000 securities. This process was further complicated by the fact that the CDO assets in Timberwolf were privately issued and often had little or no publicly available information on the underlying assets they contained.

As a result,

2365

2364

2367

2366

Joseph Marconi told the Subcommittee that well over half the assets were obtained through auctions, while just a

Subcommittee interview of Joseph Marconi (10/19/2010). In some cases, Goldman was permitted to “top-up” the deal, taking the short side on an additional $5 million in

2360 2361 the same CDO security at the same price paid by the auction winner. Greywolf’s goal was for each reference asset to be $20 million in size, but often asked for bids on only $10-15 million worth of CDS protection in order to get a better spread. Goldman would then have the option of providing the remaining $5-10 million in CDS protection at the transaction price, resulting in a total position size of $20 million on the Timberwolf balance sheet. 2362 few were negotiated. Subcommittee interview of Joseph Marconi (10/19/2010). 2363 2364 retained a short interest in $15 million in Abacus securities. 2365 Subcommittee QFR at PSI_QFR_GS0223 and PSI_QFR_GS0235. 2366 QFR at PSI_QFR_GS0192. 2367

See Goldman response to Subcommittee QFR at PSI_QFR_GS0192. The Abacus securities were cash assets. However, due to the synthetic nature of the Abacus CDOs, Goldman

A total of 84 CDS contracts produced the 51 unique reference assets. See Goldman response to Subcommittee

Timberwolf had about one dozen short parties of which Goldman was the largest. See Goldman response to

8/23/2007 email from Jay Lee to Matthew Bieber, David Lehman, and others, GS MBS-E-001927784.

By the time Greywolf and Goldman were nearing completion of the acquisition of the

543

Timberwolf assets in the spring of 2007, Goldman was becoming increasingly concerned about the deteriorating subprime mortgage market and the falling value of the assets in its CDO warehouse accounts. In February 2007, Mr. Sparks, the Mortgage Department head, and Goldman senior executive Thomas Montag exchanged emails about the warehouse risk posed by Timberwolf and another pending CDO called Point Pleasant. Mr. Montag asked Mr. Sparks: “cdo squared–how big and how dangerous?” Mr. Sparks responded: “[R]oughly 2bb [billion], and they are the deals to worry about.” Mr. Sparks also told Mr. Montag that, due to falling subprime prices, the assets accumulated in the warehouse account for the $1 billion Timberwolf CDO had already incurred significant losses, those losses had eaten through all of Greywolf’s portion of the warehouse risk sharing agreement, and any additional drops in value would be Goldman’s exclusive obligation.

2369

2368

In March 2007, due to the falling values of subprime RMBS and CDO securities, Goldman

decided against completing several CDOs under construction, and liquidated the assets in their warehouse accounts. Goldman decided, in contrast, to accelerate completion of Timberwolf. 2370

Timberwolf I closed on March 27, 2007, approximately six weeks ahead of schedule.

2371 The final CDO had $1 billion in cash and synthetic assets, including $960 million in single name CDS referencing CDO securities, and $56 million in cash CDO securities.

Selling Timberwolf. Selling Timberwolf securities became a high priority for Goldman. Mr. Sparks worked with senior sales managers to review ideas, telling them: “I can’t over state the importance to the business of selling these positions and new issues.”

2372

During the spring and summer of 2007, the Goldman Syndicate

emailed the CDO sales force a list of “Senior CDO Axes” or sales directives on a weekly and sometimes daily basis, many As early as February, the Goldman of which placed a priority on selling Timberwolf securities. sales force developed “broader lists” of clients to target for Timberwolf sales. After exhausting

2374

2375

2373

2/26/2007 email exchange between Tom Montag and Daniel Sparks, GS MBS-E-019164799.
2/26/2007 email exchange between Tom Montag and Daniel Sparks, GS MBS-E-010989241.
3/7/2007 email from Gaelyn Sharp, GS MBS-E-001800634. 3/2007 email chain, “Timberwolf I, Ltd. Preliminary Offering Circular,” GS MBS-E-001800634. 3/9/2007 email from Daniel Sparks, “Re: Help,” GS MBS-E-010643213, Hearing Exhibit 4/27-76. According to Goldman personnel interviewed by the Subcommittee, the Syndicate coordinated sales efforts

2368 2369 2370 2371 2372 2373 between the CDO Origination Desk and the CDO sales force. 2374 Hearing Exhibit 4/27-101; 4/19/2007 Goldman internal email, Hearing Exhibit 4/27-102; 6/22/2007 Goldman internal email, Hearing Exhibit 4/27-166. These “axe sheets” contained directives for selling Goldman issued securities and other financial products, as well as congratulatory and motivational notes. Some Goldman traders had a negative view of the axe sheets. One trader wrote, for example, that he was “guessing sales people view the syndicate ‘axe’ email we have used in the past as a way to distribute junk that nobody was dumb enough to take first time around.” 10/24/2006 Goldman internal email, GS MBS-E-009557699, Hearing Exhibit 4/27-170d. 2375

See, e.g., 4/11/2007 Goldman internal email, “GS Syndicate Structured Product CDO Axes (INTERNAL),”

2/14/2007 email from Robert Black to Matthew Bieber and others, GS MBS-E-001996121.

544

those initial lists, Goldman sales personnel began to target “non-traditional” buyers clients outside of the United States. 2007, for example, the Syndicate included a note in one of the axe sheets:

as well as The sales force had some early successes. On March 28,

2376

2377

“Great job Cactus Raazi trading us out of our entire Timberwolf Single-A position – $16mm. Sales – Good job over the last two weeks moving over $66mm of risk off the axe sheet. Please stay focused on trading these axes.”

2378

As sales began to flag in April, Mr. Sparks sent emails reminding Goldman sales personnel On one occasion, on April 19, 2007, Mr. Sparks suggested to

that Timberwolf “is our priority.” a sales manager offering “ginormous credits” as an incentive to sell Goldman’s CDO securities: “for example, let’s double the current offering of credits for [T]imberwolf.” Mr. Sparks was informed in response: “[W]e have done that with timberwolf already.”

2380

2379

On March 9, 2007, Harvey Schwartz, a senior executive at Goldman Sachs, expressed

concern to Mr. Sparks and others about what Goldman sales personnel were telling clients: “Seems to me … one of our biggest issues is how we communicate our views of the market – consistently with what the desk wants to execute.” Mr. Sparks responded by outlining several concerns and the need for the sales team and traders to work together.

He wrote:

2381

2382

“3 things to keep in mind: (1) The market is so volatile and dislocated that priorities and relative value situations change dramatically and constantly. (2) Liquidity is so light that discretion with information is very important to allow execution and avoid getting run over.
(3) The team is working incredibly hard and is stretched.”

He concluded: “Priority 1 – sell our new issues and our cash positions.”

Pricing Timberwolf Securities. Despite the urgency communicated by Goldman

management, Timberwolf sales slowed. By May 11, 2007, only one Timberwolf sale had taken place in the previous several weeks. Timberwolf securities, and the value of their underlying assets, were falling.

Goldman personnel also knew that the value of the

2384

2383

3/21/2007 email from Robert Black, “Non-tradition Buyer Base for CDO AXES,” GS MBS-E-003296460,

2376 Hearing Exhibit 4/27-78. 2377 2378 2379 2380 2381 2382 2383 2384 Christopher Creed, “RE: Timberwolf,” GS MBS-E-000766370, Hearing Exhibit 4/27-106 (showing price for Timberwolf securities carrying an AAA credit rating had fallen from $94 on 3/31/2007 to $87 on 4/30/2007).

3/2007 Goldman internal email chain, GS MBS-E-010643213, Hearing Exhibit 4/27-76. 3/28/2007 Goldman email from the Syndicate, GS-MBS-E-000740958, Hearing Exhibit 4/27-100. See, e.g., 4/11/2007 email from Daniel Sparks, GS MBS-E-010533482, Hearing Exhibit 4/27-101. 4/19/2007 email from Daniel Sparks to Bunty Bohra, GS MBS-E-010539324, Hearing Exhibit 4/27-102. 3/8/2007 email from Harvey Schwartz, GS MBS-E-010643213, Hearing Exhibit 4/27-76. 3/9/2007 email from Daniel Sparks, GS MBS-E-010643213, Hearing Exhibit 4/27-76. See Goldman response to Subcommittee QFR at PSI_QFR_GS0223 and PSI_QFR_GS0235. In fact, the decline had begun within a month after Timberwolf closed in late March. 9/17/2007 email from

545

On May 11, 2007, Mr. Sparks notified Goldman senior executives that marking down the

value of the unsold CDO securities so that, internally, the firm understood their current market value had become a “real issue”:

“Cdo positions and market liquidity and transparency have seized. I posted senior guys that I felt there is a real issue. … We are going to have a very large markdown – multiple hundreds. Not good.”

2385

That same evening, Mr. Lehman sent out a “Gameplan” to colleagues in the Mortgage Department announcing that Goldman was going to undertake a detailed valuation of its CDO securities using three different valuation methods, and would also take “a more detailed look” at the values of the assets in the CDO warehouse accounts and in Goldman’s own inventory.

2386

Also on May 11, Chief Credit Officer Craig Broderick sent an email to his team to set up a survey of Goldman clients who might encounter financial difficulty if Goldman lowered the value of the CDO securities they had purchased. As explained earlier, some Goldman clients had purchased their CDO securities with financing supplied by Goldman that required them to post more cash margin if the financed securities lost value. Other clients had invested in the CDO securities by taking the long side of a CDS contract with Goldman and also had to post more cash collateral if the value of the CDO securities declined. All of these clients would also have to record a loss on their books due to the lowered valuations.

2387

With respect to the CDO securities that had yet to be sold, Goldman senior executive Harvey

Schwartz raised another issue related to lowering the values of the CDO securities Goldman was selling to clients: “[D]on’t think we can trade this with our clients andf [sic] then mark them down dramatically the next day. … Needs to be a discussion if that risk exists.” Sparks, Mr. Montag, and Mr. Schwartz, Goldman senior executive Donald Mullen acknowledged concerns “about the representations we may be making to clients as well as how we will price assets once we sell them to clients.” efforts to sell Timberwolf securities if they got “strong bids.”

The executives also agreed, however, not to “slow or delay”

In an email to Mr.

2390

2388

2389

The CDO valuation project generated many comments on how to price the firm’s unsold CDO securities, including Timberwolf. One Goldman employee, who was applying Goldman’s most common valuation method to Timberwolf, wrote that the price should be dramatically lower:

5/11/2007 email from Daniel Sparks to Richard Ruzika, GS MBS-E-019659221. Mr. Sparks also noted that he

5/11/2007 email from David Lehman, GS MBS-E-003361238. For more information on this CDO valuation

2385 had a meeting with David Viniar, Don Mullen, and Gary Cohn to discuss the issue. 2386 project, see Section C(5)(a)(iii)BB, above. 2387

2388 2389 2390

5/11/2007 email from Harvey Schwartz to Daniel Sparks, Tom Montag, and others, GS MBS-E-010780864. 5/11/2007 email from Donald Mullen to Daniel Sparks, GS MBS-E-010780849, Hearing Exhibit 4/27-103. Id. at GS MBS-E-010780848-49.

5/11/2007 email from Craig Broderick, “CDO’s - Mortgages,” GS MBS-E-009976918, Hearing Exhibit 4/27-

“Based on current single-A CDO marks, the A2 tranche of Timberwolf would have a price of 72 cents on the dollar.”

He also noted:

2391

546

“Based on a small sample of single-A CDOs for which we have a complete underlier marks, we believe that the risks of the RMBS underliers are frequently not fully reflected in the marks on the CDOs. If the trends in this small sample are extrapolated, the fair spread on the CDOs could even be double where they are marked now; if that were the case, the price of the A2 tranche of Timberwolf would actually be 35-41 cents on the dollar, depending on the correlation.”

2392

Several days later, in preparation for a meeting with senior executives on the valuation issue, the same Goldman employee calculated that, for the A2 tranche of Timberwolf, the “price based on CDO marks” was 66 cents on the dollar, while the “price based on RMBS marks” was 24 cents on the dollar.2393

Throughout the valuation process, senior management, including Co-President Gary Cohn, was kept posted on how the Mortgage Department planned to value the firm’s CDO assets. On Sunday, May 20, 2007, the Mortgage Department presented its findings in a 9:00 p.m. conference call with CFO David Viniar and others. concern about valuing a range of CDO assets, including unsold securities from Goldman-originated CDOs. The presentation stated: “[T]he desk is most concerned about the CDO^2 positions, comprised of the recent Timberwolf and Point Pleasant transactions. The lack of liquidity in this space and the complexity of the product make these extremely difficult to value.”

The presentation’s executive summary expressed

2395

2397

2396

2394

The presentation recommended unwinding and selling the assets in the CDO warehouse

accounts and using “independent teams” to continue to value the unsold CDO securities from Goldman originations. It also recommended switching to a targeted sales effort for the unsold

Id. At least two drafts of the presentation also stated about Timberwolf and Point Pleasant that “the complexity

5/20/2007 email from Lee Alexander to Daniel Sparks, Donald Mullen, Lester Brafman, and Michael Kaprelian,

5/13/2007 email from Paul Bouchard to David Lehman, Daniel Sparks, and others, GS MBS-E-003361238. Id. 5/20/2007 email from Paul Bouchard, “Materials for Meeting,” GS MBS-E-001863725. 5/14/2007 email from Elisha Weisel, “Modeling Approaches for Cash ABS CDO/CDO^2,” GS MBS-E-

2391 2392 2393 2394

2395 “Viniar Presentation - Updated,” GS MBS-E-010965211 (attached file “Mortgages V4.ppt,” “Mortgages Department, May 2007,” GS MBS-E-010965212). 2396 of the CDO^2 product and the poor demand for CDOs in general has made this risk difficult to sell and the desk expects it to underperform.” This assessment was removed from the final version provided to senior executives. See 5/19/2007 email from Dan Sparks to Lee Alexander, and others, GS MBS-E-010973174 (attached file “Mortgages V3.ppt,” GS MBS-E-010973175); 5/20/2007 9:52 a.m. draft presentation, “Mortgages V4.ppt,” GS MBS-E- 010952331; 5/20/2007 email from Lee Alexander to Daniel Sparks, Donald Mullen, Lester Brafman, and Michael Kaprelian, “Viniar Presentation - Updated,” GS MBS-E-010965211 (final version) (attached file, “Mortgages Department,” GS MBS-E-010965212). 2397 “Viniar Presentation - Updated,” GS MBS-E-010965211 (attached file “Mortgages V4.ppt,” “Mortgages Department, May 2007,” GS MBS-E-010965212 at 14).

5/20/2007 email from Lee Alexander to Daniel Sparks, Donald Mullen, Lester Brafman, and Michael Kaprelian,

547

2398

CDO securities, focused on four hedge fund clients: Basis Capital, Fortress, Polygon, and Winchester Capital. The Goldman sales force apparently felt those four hedge funds were the clients most likely to buy the CDO securities, and two of them, Basis Capital and Polygon, did subsequently purchase Timberwolf securities. 35 clients for targeted sales efforts and provided an assessment of the CDO sales efforts for each. Several of those clients later purchased Timberwolf securities.

An appendix to the presentation identified another

2400

2399

2401

Despite Goldman’s internal analysis that the value of the Timberwolf securities was in rapid decline, the firm did not lower the prices at which it marketed the securities to clients. In a May 14 email, Mr. Sparks explained his Timberwolf pricing strategy to Mr. Mullen and Mr. Montag:

“I think we should take the write-down, but market at much higher levels. I’m a little concerned we are overly negative and ahead of the market, and that we could end up leaving some money on the table – but I’m not saying we shouldn’t find and hit some bids.”

2402

As a result of the CDO valuation project, Goldman took substantial writedowns on the value

of its CDO inventory on May 25, 2007. 2403 Timberwolf A2 securities to a value of $80. them at inflated prices, selling Timberwolf A2 securities to clients at $87.00 on May 24, at $83.90 on May 30, and at $84.50 on June 11. Timberwolf B securities to an internal value of $65.00. Over a month later, Goldman sold $9

For example, Goldman marked down the AAA rated At the same time, Goldman continued to market 2404

On May 25, Goldman also marked the AA rated

2405

5/20/2007 email from Lee Alexander to Daniel Sparks, Donald Mullen, Lester Brafman, and Michael Kaprelian,

Id. at 24. Polygon had already purchased Timberwolf securities prior to the drafting of the presentation, and was

2398 2399 apparently targeted for additional Timberwolf or Point Pleasant sales. See Goldman response to Subcommittee QFR at PSI_QFR_GS0223 and PSI_QFR_GS0235. Goldman had an existing relationship with Basis Capital. Goldman had engaged Basis Capital several months earlier as a collateral manager of a CDO Goldman was underwriting called Fort Denison. Mr. Ostrem, head of the CDO Origination Desk, apparently had a low opinion of the firm, describing the firm in an email to Mr. Bieber as “paranoid” and “not very sharp.” He told Mr. Bieber that Goldman should “be nice and just sell them stuff going forward.” 1/15/2007 email from Peter Ostrem to Matthew Bieber, GS MBS-E-001125549. 2400 “Viniar Presentation - Updated,” GS MBS-E-010965211 (attached file “Mortgages V4.ppt,” “Mortgages Department, May 2007,” GS MBS-E-010965212 at 31). 2401 2402 2403 MBS-E-012443167). 2404 cents on the dollar. 2405 See Goldman response to Subcommittee QFR at PSI_QFR_GS0223 and PSI_QFR_GS0235; 6/1/2007 email from David Lehman to Daniel Sparks, GS MBS-E-001866889 (indicating Goldman sold Timberwolf securities to Tokyo Star Bank for $83.90, when Goldman’s own mark was 80). Goldman took similar action with respect to its other CDO , Point Pleasant, marking down the internal value of its A2 securities to $82.50 on May 25, 2007, while on May 24, 2007, selling $40 million of the A2 securities to a client at a price of $91.00, a difference in market value of $3.4 million. See 5/26/2007 email from Michael Swenson to others, GS MBS-E-012443166 (attached file, “ABS Sec_0525,” GS MBS-012443167).

See Goldman response to Subcommittee QFR at PSI_QFR_GS0223 and PSI_QFR_GS0235. 5/14/2007 email from Daniel Sparks to Tom Montag and Donald Mullen, GS MBS-E-019642797. 5/26/2007 email from Michael Swenson to others, GS MBS-E-012443166 (attached file, “ABS Sec_0525,” GS

These prices indicate a percentage of security’s face (par) value. A price of $80 would be 80% of par or 80

548

million of those AA rated securities to Bank Hapoalim at a price of $78.25, but by then Goldman’s internal valuation had fallen to $55, a difference of more than 30% of the market value.

2406

In addition to marketing its CDOs at inflated prices compared to its internal valuations, the Mortgage Department told some clients that the mortgage market was strengthening. On May 14, 2007, for example, Edwin Chin, a trader on the Mortgage Department’s ABS Desk, sent this upbeat commentary to both Goldman traders and clients:

“Incredible as it may seem, the subprime mortgage slump is already [a] distant memory for some. It’s been two months since the ABX market plunged amid worries about a housing meltdown, and already investors (and some dealers) are beginning to get ‘complacent’ again. Blame it on the CDO bids, but with subprime production projected down 40-60% from last year’s level, appetite for spread products triumphs any risk concern in the marketplace right now. ABX Index is trading higher as dealers short cover their single name positions after a month of range-bound trading. Flows continue to weigh toward better seller of protection – longs outpace shorts by 3 to 1 as CDO demand has been robust the last two weeks. While warehouse activities might be slow, many CDOs are still looking to finish up their ramp post-closing.”2407

Daniel Sparks responded to Edwin Chin’s commentary by asking senior ABS traders, David Lehman, Mike Swenson, and Joshua Birnbaum: “Is this a head fake or does this make you bullish on all spread product?” Mr. Lehman responded: “[G]iven the sizable short interest in ABS/subprime mkt it does not surprise me that short covering is pushing spds [spreads] tighter. Not sure I would enter new longs here.” Mr. Swenson responded: “I would characterize this as a great opportunity to be constructive on the market.”

2408

See 7/12/2007 “Goldman Warehouse SP CDO positions and hedges_7-12-07,” GS MBS-E-001866482; See also

2406 Goldman response to Subcommittee QFR at PSI_QFR_GS0223 and PSI_QFR_GS0235. In an interview with the Subcommittee, David Lehman explained that the bid/offer spread (the difference between the price at which a security is offered for sale [“offer price”] and the price at which a bank would buy the same security [“bid price”]) was the reason for the difference between Goldman’s internal valuation of the price of the AA rated securities and price at which it sold them to Bank Hapoalim. However, in many instances during this period, it appeared as if Goldman’s internal valuation price had no relationship to the bid and offer prices quoted to clients. For example, at the end of June 2007, Goldman provided Timberwolf investor Moneygram with an offer price of $86 for Timberwolf A2 securities and bid price of $83, indicating a bid/offer spread of 3 points. Meanwhile, Goldman had an internal valuation of $75 for the same securities, far different from $83 and $86 quoted to Moneygram. See Moneygram valuation, 7/5/2007 email from Goldman Sachs Operations, “MoneyGram Marks from GS as of 06/29/07,” GS MBS-E-022023387; Goldman internal evaluations see “Warehouse SP CDO positions and hedges_6-29-07,” GS MBS-E-010809241. See also 6/6/2007 email from Sheara Fredman, GS MBS-E-010795808 and attachment GS MBS-E-010795809. Goldman’s pricing in such situations seemed consistent with the strategy articulated earlier by Mr. Sparks, the head of the Mortgage Department, that Goldman should write down the value of the assets, “but market [the CDO securities] at much higher levels,” because he was concerned that Goldman was “overly negative and ahead of the market, and that [Goldman] could end up leaving some money on the table.” 5/14/2007 email from Tom Montag to Daniel Sparks, GS MBS-E-019642797. 2407

5/14/2007 email from Edwin Chin, GS MBS-E-012553986. Mr. Birnbaum responded directly to Mr. Swenson: “what a beautiful quote.” Id.

2408

549

A few weeks later, Mr. Lehman forwarded an email to Goldman executives informing them “the market feels that GS is being more aggressive than other dealers moving CDO^2 paper,” and marking down clients more than their competitors. one pause about our selling prices?” Mr. Swenson responded to Mr. Mullen: “[N]o pause[.] [E]veryone else is afraid to execute at these levels and they will be wishing for these prices by the end of the summer.” Mr. Sparks added: “There is real market meltdown potential (although far from certain).”2410

Don Mullen responded: “Does this give any

2409

Timberwolf Sales to Basis Capital. At the conclusion of the CDO valuation project, which

found that Timberwolf and Goldman’s other CDO securities had lost significant value, the Mortgage Department resumed its efforts to push Timberwolf sales.

On Sunday, May 20, 2007, the same day the Mortgage Department made its valuation

presentation to Mr. Viniar and recommended targeting Basis Capital for CDO sales, George Maltezos, the Goldman sales representative responsible for Basis Capital, emailed Mr. Lehman saying he would contact the Basis Capital principals immediately upon their return from a business trip the following day.

2411

Mr. Maltezos began pressing Basis Capital to buy the securities. On May 22, Mr. Maltezos

urged Basis Capital to consider buying the securities before the end of the quarter:

“I appreciate you are flat chat [busy] at the moment, but pls [please] keep in mind GS is an aggressive seller of risk for QTR [quarter] end purposes (last day of quarter is this Friday). We would certainly appreciate your support, and equally help create something where the return on invested capital for Basis is over 60%.”2412

At the same time Mr. Maltezos was claiming that a Timberwolf investment could provide over a 60% return on invested capital, Goldman’s internal marks were showing that Timberwolf was continuing to fall in value.

Basis Capital indicated that it was interested in the Timberwolf securities, but had several

issues it needed to work through. First, Basis Capital indicated that Goldman would have to help it

6/6/2007 email from David Lehman, GS MBS-E-001936955. 6/6/2007 email from Daniel Sparks, GS MBS-E-001922156. Mr. Lehman further responded: “thk abt this - if

2409 2410 we establish a defined + healthy supply/demand dynamic in this product we can always create more CDO^2 at a significant profit vs current levels,” meaning that since Goldman’s internal marks were so much lower than the bids it was providing clients, if a client chose to buy additional securities at Goldman’s bid price, Goldman could sell the securities by taking a short position on a CDS facing the client, and make money on the trade. 6/6/2007 email from David Lehman, GS MBS-E-001936955. 2411 MBS-E-001863555 (“FYI – basis are back from their 2 week business trip on Monday. My focus will go to timberwolf 100mm AAA and AA block trade with them …. Pls confirm you are willing to trade this at [then-current marks] and that you are not marking these bonds any wider at moment for month end May.”). 2412

5/20/2007 email from George Maltezos, Goldman Australia sales, to David Lehman, “T/wolf and Basis,” GS

5/22/2007 email from George Maltezos to John Murphy of Basis Capital Management, JUL 000685.

550

2414

2413

Second, Basis Capital was concerned about the value of its

find financing for the purchase price. existing CDO investment with Goldman. On April 19, 2007, Basis Capital had purchased BBB rated Point Pleasant securities at a price of $81.72. purchase. Two weeks later, Goldman had marked down the value of the securities to $76.72, and asked Basis Capital to post additional cash collateral totaling $700,000. When Basis Capital asked how the value of the security had fallen $5 in just two weeks, Goldman responded that the price had gone back up to $81.72, and no additional cash was required.

Goldman had provided the financing for this

2415

2416

In May and June 2007, Mr. Maltezos worked to convince Basis Capital to purchase $100 million in Timberwolf securities. At one point Basis Capital pressed for a lower sales price, but was told by Mr. Maltezos: “I don’t think the trading desk shares the sentiment with regard to such spread levels [lower prices].” During the negotiations over the Timberwolf sale, on June 12, 2007, Goldman again marked down the value of the Point Pleasant securities to $75, and again asked Basis to post more cash collateral. lower value, Mr. Maltezos wrote:

When Basis Capital asked Mr. Maltezos to justify the

2418

2417

“[T]here has been further softening in the market since the Point Pleasant trade was put on 8 weeks ago. We have infact [sic] traded some Point Pleasant BBBs at this level in the last 2 weeks.”

2419

See. e.g., 5/30/2007 email from George Maltezos to John Murphy and Stuart Fowler, JUL 002032. See Goldman response to Subcommittee QFR at PSI_QFR_GS0223 and PSI_QFR_GS0235. See 5/1/2007 email from Macdara Molloy to Phillipa Chen, GS MBS-E-002003102. Id. 5/30/2007 email from George Maltezos to John Murphy and Stuart Fowler at Basis Capital, JUL 002032.

2413 2414 2415 2416 2417 “From a pricing perspective, we have been trading Timberwolf AAA and AA bonds. 550 dm on AAAs and north of 700dm on AAs is considered too wide for Timberwolf. . . . To be constructive, however, I know the desk is entertaining block size trades at the moment from real money accounts in the US and Asia at wide levels (much wider than what they have traded before). To give you a sense, I think these represent 400-450dm and 650-700dm respectively (for size) at the widest level of such enquiries.” The notation “dm” refers to “discount margin.” Higher discount margins correspond to greater markdowns from par prices. See e.g. Timberwolf I, Price-DM Table 05-16- 2007.xls, GS MBS-E-001810225. Basis Capital eventually accepted the 450 and 650 prices suggested by Mr. Maltezos. See 6/13/2007 email from David Lehman to Tom Montag, GS MBS-E-001914580. 2418 2419 Lehman and Mr. Egol about Point Pleasant pricing, asking them “does the 75 mark reflect actual trading or overall softness in the market? I know you had indicated 70 was more like the number.” 6/12/2007 email from George Maltezos to David Lehman, Jonathan Egol, and Omar Chaudhary, GS MBS-E-002002522. The Subcommittee was unable to locate Goldman’s response to his question.

6/12/2007 email from Sahil Sachdev to George Maltezos, GS MBS-E-001912398. 6/12/2007 email from George Maltezos, PSI-Basis_Capital_Group-03-0001. Mr. Maltezos emailed Mr.

551

In fact, no such sales had taken place, and the lower value could not be justified by any sales transactions. which had concluded that its CDO securities had lost significant value.

The lower mark was instead related to Goldman’s CDO valuation project in May,

2421

2420

Stuart Fowler at Basis Capital brought up the valuation issue in the context of the

Timberwolf securities, and asked Mr. Maltezos: “I need to be very clear on this and are we going to see a similar problem on [T]imberwolf?” foul here,” and offered to set up some “1-on-1 time with the trading desk” to discuss pricing.

Mr. Maltezos responded: “Stuart – I assure you no

2423

2422

Mr. Sparks was closely monitoring Mr. Maltezos’ ongoing effort to sell the Timberwolf

securities to Basis Capital and, on June 13, 2007, sent this email to Mr. Maltezos:

“Let me know if you need help tonight - or feel free to wake up [Mr. Lehman and Mr. Egol] in [S]pain. I’d love to tell the senior guys on 30 at risk comm[ittee] Wednesday morning that you moved 100mm [$100 million].”

2424

In response, Mr. Maltezos coordinated a call between Basis Capital and Mr. Lehman to “clarify any and all questions you have on the marking policy of Goldman, the actual marking of Point Pleasant, and the overall trading that has been seen by the [Goldman] desk in the last 1-6 months.” In that telephone call with Basis Capital, Mr. Lehman apparently corrected Mr. Maltezos’ misstatement about recent Timberwolf sales, and Mr. Maltezos followed up with an email to Basis Capital:

2425

“[P]lease accept my sincerest apologies for the mis-information below. As David mentioned, the 75 mark on Pt Pleasant BBB was more reflective of an interpretation of softer AAA-AA rated CDO-sqd paper translating to BBB part of the curve.”

2426

Later that same day, June 13, 2007, Mr. Lehman reported that Goldman had reached

agreement on $100 million in Timberwolf sales to Basis Capital. The sale consisted of the hedge fund taking the long side of a CDS contract with Goldman, referencing $50 million in AAA rated

The most recent Point Pleasant sale had been $40 million worth of the AAA rated A2 securities, which sold on

Internally, Goldman had marked down the value of the Point Pleasant securities to $50.00. The much higher bid

2420 May 24, 2007, for a price of $91. The next most recent sale had been $20 million worth of the A2 securities on April 24, 2007, for a price of $91.30. See Goldman response to Subcommittee QFR at PSI_QFR_GS0223 and PSI_QFR_GS0235. 2421 provided to Basis appears consistent with Goldman’s strategy to “market at much higher levels.” Goldman consistently offered investors bid prices that were much higher than its internal marks during the months of May and June as it attempted to sell its CDO inventory. See 5/26/2007 email from Michael Swenson to others, GS MBS-E- 012443166 (attached file, “ABS Sec_0525,” GS MBS-012443167). 2422 2423 2424 The reference to the “senior guys on 30” is to Goldman’s senior executives who had offices on the 30 floor of the Goldman headquarters in New York. 2425 MBS-E-001918603. 2426

6/12/2007 email from Stuart Fowler to George Maltezos, GS MBS-E-001912398. Id. 6/13/2007 email from Daniel Sparks to George Maltezos, David Lehman, and Jon Egol, GS MBS-E-002006149.

6/13/2007 email from George Maltezos to Stuart Fowler and John Murphy at Basis Capital and others, GS

6/13/2007 email from George Maltezos, PSI-Basis_Capital_Group-02-0001.

552

Timberwolf securities and $50 million in AA rated Timberwolf securities. Mr. Lehman told Mr. Montag that the CDS premiums that Basis Capital had agreed to accept implied a cash price of $84 for the AAA securities and $76 for the AA securities. Mr. Montag asked what Goldman’s internal mark was for the Timberwolf AA securities, and Mr. Lehman responded: “$65.”

2427

2428

The Timberwolf sale to Basis Capital was finalized on June 18, 2007.

Goldman provided the financing. Just two weeks later, Goldman informed Basis Capital that the Timberwolf securities had lost value and required the hedge fund to post additional cash collateral. immediately questioned the new value and asked to see a “comparable market data point for the Timberwolf marks.” In response, Mr. Lehman complained internally: “I would like to know what the precedent there is here – does GS need (outside of the client issue) to provide the below info to justify our prices???” appeared to agree to post the additional collateral.

After Goldman provided additional information, Basis Capital

Basis Capital

2429

2430

2432

2431

Eight days later, on July 12, Goldman again marked down the value of the Timberwolf

2433

securities to prices of $65 and $60, after having sold them to Basis Capital one month earlier at $84 and $76. This repricing resulted in a $37.5 million movement in the value of the securities, and required Basis Capital to post substantially more cash collateral with the firm. On July 13, 2007, Basis Capital told Goldman that one of its funds was “in real trouble.” again marked down Basis Capital’s securities to prices of $55 for AAA and $45 for AA. prices matched Goldman’s internal valuations. liquidate its hedge fund. July 31, at prices of $30 and $25.

These By the end of July, Basis Capital was forced to

Goldman bought back the Timberwolf securities from Basis Capital on

On July 16, Goldman

2434

2435

2436

2437

2439

2438

Other Timberwolf Sales. Basis Capital was only one of several clients that Goldman

contacted in connection with Timberwolf. On May 24, 2007, a Goldman sales associate told Mr. Lehman and Mr. Sparks that he wanted more information to send to a European hedge fund that was “not experts in the space at all but [I] made them a lot of money in correlation dislocation and will

6/13/2007 email from David Lehman to Tom Montag, GS MBS-E-001914580. Id. Goldman response to Subcommittee QFR at PSI_QFR_GS0223 and PSI_QFR_GS0235. 7/4/2007 email exchange among David Lehman, George Maltezos, and others, GS MBS-E-001990127. Id. 7/4/2007 email from David Lehman, GS MBS-E-001990127. 7/12/2007 email from Jon Egol, GS MBS-E-001866391. On the same day, Goldman’s internal marks for the

2427 2428 2429 2430 2431 2432 2433 securities were even lower, at $60 for the AAA securities and $55 for the AA securities. As Basis Capital’s financial situation became worse, Goldman responded by marking Basis Capital’s securities to levels that were closer to Goldman’s own internal evaluations.
2434 2435 2436 Capital’s Point Pleasant securities to $10, from an initial purchase price of $81.72. 2437 2438 2439 Agreement,” JUL 003958.

7/12/2007 Goldman datasheet, “Warehouse SP CDO positions and hedges_7-12-07,” GS MBS-E-001866482. 7/24/2007 email from David Lehman to others, GS MBS-E-013449641. 7/31/2007 letter from Goldman Sachs International to Basis Capital, “Event of Default Under ISDA Master

7/13/2007 email from David Lehman, “Re: Basis,” GS MBS-E-001866391 at 93. Id. at 91. 7/16/2007 email from Jon Egol, “Re: Basis,” GS MBS-E-010169281. Goldman also marked down Basis

553

do as I suggest. Would like to show stuff today if possible.” that he was available to get on the telephone with the clients, and forwarded him the Timberwolf offering circular and marketing materials.

Mr. Lehman told the sales associate

2440

2441

On June 5, 2007, Goldman trader Benjamin Case emailed Mr. Lehman with a “[g]ameplan

for distribution” or sales of Goldman’s remaining CDO securities. “institutional buyers that can take larger bite size than traditional CDO buyers … for example Asian banks and insurance companies.” names in the two portfolios [Timberwolf and Point Pleasant] and we have been aggressively sourcing further protection in the CDS market on names in the two portfolios recently.”2444

Mr. Case also noted that Goldman was shorting “51 CDO

The plan was to target

2442

2443

In early June, Goldman targeted a Korean insurance company called Hungkuk Life for

Timberwolf sales. According to a Goldman employee in the Japan sales office, Jay Lee, “the largest hurdle from the client perspective is whether or not they can get the mandate to buy something backed by synthetically sourced CDO’s [sic], as they have never bought CDO^2 before.” Mr. Lee was also concerned that the value of the securities would drop soon after the office sold the Timberwolf securities to the insurance company. Mr. Lee stated:

2445

“[T]he largest hurdle from a sales’ perspective is MTM [mark to market]. It is an important client, and if the mark widens out more than 1pt immediately after selling the asset to them, sales cannot sell it. Understanding that it is a volatile asset, sales wants to know that where we sell it to the client will not be more than 1pt less than where the mark would be, provided no new market information.”

2446

It is unclear how his valuation concern was addressed. Later the same day, on June 1, Mr. Lee reported that Hungkuk Life had purchased $36 million in AAA rated Timberwolf securities. Mr. Sparks responded “good job – keep going.”

2447

Six days later, on June 7, 2007, the head of the Goldman Japan sales office, Omar

Chaudhary, contacted Mr. Sparks and Mr. Lehman about a possible additional sale of Timberwolf securities to Hungkuk Life. Mr. Chaudhary wrote that the head of Goldman’s Korean sales office was “pushing on our personal relationships” to make the sale and wanted to be assured he’d be paid more if he “got it done”:

5/24/2007 email from Yusuf Aliredha to Mr. Sparks, Mr. Lehman, and others, “Priority Axes,” GS MBS-E-

2440

2441 2442 2443 2444 2445 2446 2447

Id. 6/5/2007 email from Benjamin Case to David Lehman, GS MBS-E-001919861. Id. Id. 6/1/2007 email from Jay Lee to David Lehman, Matthew Bieber, and others, GS MBS-E-010958182. Id. Id.

554

“Jay and I spoke to the head of Korea Sales today. He said that he feels we can push for H[ungkuk] Life to increase their size from the 36mm of AAA’s and wanted to see if we would pay more GC’s [sales credits] if he got it done. Told him that if we sell ~45-50mm+ [$45-50 million more] that we would honor the 7.0% even if we trade at the 84.5 dollar px [expected price]. Trust you will support this as we are pushing on our personal relationships to get this done.”

2448

Mr. Lehman and Mr. Sparks told Mr. Chaudhary to “go for it” and “[g]et ‘er done.” The Korean office did get it done, and Goldman sold another $56 million in Timberwolf securities to Hungkuk Life at a price of $84.50. 2451 Sparks wrote to the sales office: “you boys are awesome and many people are noticing.” Mr. Montag, a senior Goldman executive monitoring the Timberwolf sales, told the mortgage team it had done an “incredible job – just incredible.”

The sales representative was awarded the 7% sales credit.

Mr. 2452

2449

2453

2450

On June 11, 2007, Mr. Lehman received an email from the Goldman Syndicate asking

whether the CDO axe sheet, which included directives to sell Timberwolf securities, could be sent to the Japan sales office for re-distribution to sales representatives across Asia. Mr. Lehman agreed: “let’s send to all Japan sales.” over $250 million in new sales of Goldman’s CDO securities, including Timberwolf.2455

Two days later, on June 13, 2007, the Japan sales office reported

2454

Mr. Montag continued to monitor the sales of Timberwolf as well as other CDO securities in

Goldman’s inventory and warehouse accounts. On June 22, 2007, Mr. Sparks reported to him on the completion of a number of sales of CDO and RMBS securities that Goldman had purchased from the two failed Bear Stearns hedge funds. Mr. Montag asked Mr. Sparks to provide him with a “complete rundown” on “what[’]s left.” Mr. Sparks responded that the “main thing left” was $300 million in Timberwolf securities. Mr. Montag responded: “boy that timeberwo[l]f was one shitty deal.”

2456

2457

Despite Mr. Montag’s assessment of Timberwolf, he continued to press for the sale of

Timberwolf securities to Goldman clients. On June 25, 2007, Mr. Sparks emailed Mr. Montag and others with another update on selling Goldman’s remaining CDO assets. Mr. Sparks informed the group that Goldman would probably have to lower the values of the CDO assets over the next

2458

6/7/2007 email from Omar Chaudhary to Daniel Sparks, David Lehman, and Bunty Bohra, GS MBS-E-

2448 001866450, Hearing Exhibit 4/27-104. 2449 2450 2451 2452 2453

6/7/2007 emails from Daniel Sparks and David Lehman, GS MBS-E-001866450, Hearing Exhibit 4/27-104. See Goldman response to Subcommittee QFR at PSI_QFR_GS0223 and PSI_QFR_GS0235. See Goldman response to Subcommittee QFR at PSI_QFR_GS0223. 6/10/2007 email from Daniel Sparks to Omar Chaudary and Bunty Bohra, GS MBS-E-010971809. 6/11/2007 email from Tom Montag, GS MBS-E-001866144. 6/11/2007 email exchange between Syndicate and David Lehman, GS MBS-E-001914921-24. 6/13/2007 email from Japan sales office, GS MBS-E-011212260. 6/22/2007 email exchange between Tom Montag and Daniel Sparks, “Few Trade posts,” Hearing Exhibit 4/27-

2454 2455 2456 105. 2457 2458

Id. 6/25/2007 email from Daniel Sparks to Tom Montag, and others, GS MBS-E-010952698.

555

few days, but that the net effect for Goldman would be positive, since its short position was larger than its long. In fact, the Mortgage Department made $42.5 million that day. 2459 remained focused on Timberwolf, responding: “[h]ow are twolf sales doing?”2460

Mr. Montag

On July 12, 2007, another Goldman sales representative, Leor Ceder, reported selling $9

million in Timberwolf securities to Bank Hapoalim at a price of $78.25. Mitchell Resnick asked Mr. Lehman “to pay him well on this.” credit. CDO as a top sales priority for months afterward.

Mr. Ceder was paid an 8% sales That was Goldman’s last Timberwolf sale, even though its Syndicate continued to list the

Goldman trader

2462

2461

2463

Goldman ultimately sold about $853 million of the $1 billion in Timberwolf securities to about 12 investors. The unsold securities, with a face value of about $150 million, remained on Goldman’s books.

Limited Disclosures. Despite their aggressive sales efforts, Goldman sales personnel

typically did not help potential investors analyze the Timberwolf securities and the 4,500 unique assets underlying the CDO. One Goldman employee told his colleagues: “In terms of telling customers. I prefer to give them the general idea of the trade. Then give them the excel spread sheet with our info on ref obs [reference obligations] and let them draw their own conclusions.” Another Goldman employee, discussing a potential buyer of Timberwolf, warned:

2464

“[H]e is going to want to look at the TWOLF trade on a fundamental basis with a lot of supporting runs to back up any additional mark downs we have – telling him we are busy when it comes to month end and we can’t run that analysis because we are resource- constrained will not be good enough.”

2465

7/6/2007 email from Mitchell Resnick to David Lehman, GS MBS-E-001866752. See Goldman response to Subcommittee QFR at PSI_QFR_GS0223 and PSI_QFR_GS0235. 5/7/2007 Goldman email chain between Elisha Wiesel and others, “RE: Timeberwolf Analysis,” GS

6/26/2007 email from Deeb Salem to Michael Swenson, GS MBS-E-012371112. Id. Goldman’s internal price was then $55, 23% less. See 7/12/2007 Goldman datasheet, “Warehouse SP CDO

2459 2460 2461 positions and hedges_7-12-07,” GS MBS-E-001866482; see Goldman response to Subcommittee QFR at PSI_QFR_GS0223 and PSI_QFR_GS0235. 2462 2463 2464 MBS-E-003334218. Elisha Wiesel worked with Goldman’s legal department on issues related to disseminating information to potential investors. On May 20, 2007, the same day the Mortgage Department presented the conclusions of its CDO valuation project to Mr. Viniar and others, Mr. Wiesel sent an email to Mr. Bieber underscoring concerns about its valuation process: “[G]iven how complex the data is for a CDO^2, there’s little chance we’ll ever get fully ‘comfortable’ beyond a shadow of a doubt that there’s nothing materially misleading in the data cuts we provide. Is best outcome in this situation to just get a big-boy letter drafted?” 5/20/2007 email from Elisha Wiesel, GS MBS-E-001980637.
2465

7/16/2007 email to David Lehman, “Carlyle,” GS MBS-E-011050254.

556

Still another Goldman employee stated with respect to Timberwolf and Point Pleasant: “The trickiest part about sharing this [pricing] analysis with custies [customers] is that it shows just how rudimentary our own understanding of these positions actually is.”

2466

Goldman also in many instances refused to provide investors with its pricing methodology or specific prices or values for the CDO securities it was selling. After its securities began to lose value, Basis Capital emailed George Maltezos, David Lehman, and others asking: “How many times do we have to request data points and scenarios by email. These were read out to us on the call and it was agreed that GS would send them through. I am getting weary of continually hearing about transparency and yet an obvious avoidance of ‘putting things to paper.’”2467

Similarly, when Hungkuk Life requested additional information about the underlying

Timberwolf assets, Goldman sent an asset report, but only after removing all of its pricing and valuing information related to those assets. In August 2007, Jay Lee from Goldman’s Japan sales office told a sales associate who was seeking information about Goldman’s marks for Tokyo Star Bank:

2468

“[U]nder no circumstances are we going to be able to provide materials specific to Timberwolf … or even use the word ‘mark’ in written materials. … Everything will be described in general terms, and if what we provide is too vague or general, the medium for further clarification must be oral, not written.”

2469

Mr. Lehman added: “[W]e should be clear that the information we are providing is not our pricing methodology but rather some tho[ugh]ts on the current market.”

2470

In an interview with the Subcommittee, Mr. Lehman defended Goldman’s aggressive

markdowns by noting that Goldman would buy or sell at the prices it quoted to a customer. He explained that if a client thought Goldman’s mark was too low, the client could buy more of the securities from Goldman at the low price, then resell them for a profit. Since Goldman’s internal valuations were much lower than the price quoted to clients, however, such sales would still produce a profit for the firm. Furthermore, as Goldman marked down the values in the summer of 2007, it began to decrease the volume of the securities it was willing to buy or sell at the prices it quoted to clients. Goldman was initially willing to buy or sell CDO securities in blocks of $10 million, but by July, it lowered the maximum size to $3 million for some securities and $1 million for others: “Given current market environment, we would like our bid for size for CDO valuations

2471

5/7/2007 email from Elisha Wiesel, GS MBS-E-004735378. 7/7/2007 email from Stuart Fowler, GS MBS-E-011183045. 7/31/2007 email from Matthew Bieber to David Lehman, “FW: Requesting Compliance Approval,” GS MBS-E-

2466 2467 2468 001920215. 2469 2470 2471 establish a defined + healthy supply/demand dynamic in this product we can always create more CDO^2 at a significant profit vs current levels.”

8/7/2007 email from Jay Lee to others, GS MBS-E-001927858. 8/7/2007 email from David Lehman to others, GS MBS-E-001927858. See 6/6/2007 email from David Lehman, GS MBS-E-001936955. Mr. Lehman stated: “thk abt this – if we

to be MAX $3mm for AAA to AA and $1mm for A and below. No valuations should go out with a bid for $10mm.”

2472

557

“A Day That Will Live In Infamy.” The Timberwolf securities issued by Goldman

steadily lost money from the day they were issued. Less than four months after they were issued, on July 16, 2007, Mr. Lehman instructed the Timberwolf deal captain, Mr. Bieber, to “create an ‘unwind’ spreadsheet … where we can input CDS spds [spreads]/prices and liability prices so we can determine if unwinding these deals makes sense.” The analysis appeared to show that it would cost Goldman $140 million to unwind Timberwolf, and the conclusion was to “Hold Off.” Instead of unwinding, Goldman continued its sales push.

2473

2474

In September 2007, Mr. Montag asked for data tracking the drop in prices for a Goldman In response, a Goldman CDO that experienced a dramatic fall in value, such as Timberwolf. employee provided prices for the A2 tranche of the Timberwolf securities using a combination of Goldman’s internal marks and the bids provided to investors, from the issuance of the CDO on March 27, 2007 through September. The data showed that, in six months, prices for Timberwolf’s AAA rated A2 security had fallen from $94 per security to $15, a drop of almost 80%:

2475

“3/31/07 4/30/07 5/31/07 6/29/07 7/31/07 8/31/07 Current

94-12 87-25 83-16 75-00 30-00 15-00 15-00.”2476

After receiving this pricing history, Mr. Bieber, the Timberwolf deal captain, described March 27, the Timberwolf issuance date, as “a day that will live in infamy.”

2477

The chart on the next page shows how, between mid-June 2007 and early August 2007, the

value of Timberwolf securities dropped precipitously, and that Goldman personnel were aware of its falling value while selling the securities to clients.

[SEE CHART NEXT PAGE: Timberwolf Marks, Axes, and Sales, prepared by the Permanent Subcommittee on Investigations.]

2472 2473 2474 E-010857644). 2475 2476 2477

7/11/2007 email from David Lehman, “CDO Marks,” GS MBS-E-013427046 [emphasis in original]. 7/16/2007 email from David Lehman to Matthew Bieber, GS MBS-E-001913775. See 7/17/2007 email from David Lehman to Daniel Sparks, GS MBS-E-010857643 (with attachment GS MBS-

9/17/2007 email from Tom Montag, GS MBS-E-000766371, Hearing Exhibit 4/27-106. 9/17/2007 email from Christopher Creed, GS MBS-E-000766370, Hearing Exhibit 4/27-106. Id.

3/1/2007 3/1/2007 140 140

3/31/2007 3/31/2007

4/30/2007 4/30/2007

5/30/2007 5/30/2007

6/29/2007 6/29/2007

7/29/2007 7/29/2007

8/28/2007 8/28/2007

9/27/2007 9/27/2007

10/27/2007 10/27/2007

11/26/2007 11/26/2007

12/26/2007 12/26/2007

Timberwolf Marks, Axes, and Sales Timberwolf Marks, Axes, and Sales

Sales of Sales of TWOLF‐ TWOLF‐ 3/13/07: 3/13/07: A1A‐ $99.45 A1A‐ $99.45 A1B‐ $100 A1B‐ $100 A1C‐ $99.71 A1C‐ $99.71 A1D‐ $100 A1D‐ $100 INC‐ $100 INC‐ $100

Sales Sales

120 120

100 100

e e c c i i r r P P

80 80

60 60

Axes (Sales Axes (Sales Directives) Directives)

Marks Marks

0 3/1/2007

3/31/2007

4/30/2007

5/30/2007

6/29/2007

7/29/2007

8/28/2007

9/27/2007

10/27/2007

11/26/2007

12/26/2007

Prepared by the U.S. Senate Permanent Subcommittee on Investigations, February 2011. Derived from Goldman Sachs document, GS MBS-E-000779366.

559

Goldman profited in part from Timberwolf’s decline in value due to its 36% short interest in the CDO. In addition, June was the month that Goldman built its $13.9 billion big short, which meant that the decline in most mortgage related assets translated into increasing profits for Goldman.2478

Timberwolf experienced its first credit rating downgrades in November 2007, just eight months after the CDO closed and issued its securities. The downgrades included the AAA rated securities. In March 2008, one year after Timberwolf was issued, its AAA securities were downgraded to junk status. In June 2008, a controlling class of debt investors voted to liquidate Timberwolf, and the deal was terminated in October 2008.2479

Goldman’s 36% short position in Timberwolf produced about $330 million in revenues at the direct expense of the clients to whom Goldman had sold the Timberwolf securities. Goldman also made $3 million in interest while the Timberwolf assets were in Goldman’s warehouse account. At the same time, because Goldman was unable to sell about a third of the Timberwolf securities and had to keep the unsold securities on its books, it ended up losing $562 million from them. Goldman also lost $226 million from the decline in the value of the collateral securities securing the CDO. When offset by the profits from its Timberwolf short, Goldman ended up with a total loss of about $455 million.

2480

Timberwolf’s investors lost virtually their entire investments. Basis Capital ended up

declaring bankruptcy and has filed suit against Goldman.2481

Analysis. Goldman constructed Timberwolf using CDO assets that began to fall in value almost as soon as the Timberwolf securities were issued, yet solicited clients to buy the securities. Timberwolf contained or referenced CDO assets with more than 4,500 unique mortgage related securities, but Goldman offered potential investors little help in understanding those securities, and targeted clients with limited or no experience in CDO investments. When marketing Timberwolf, Goldman withheld its internal marks showing the securities losing value and did not mention its short position. Senior Goldman executives knew the firm was selling poor quality assets at inflated prices. Within six months of issuance, AAA Timberwolf securities lost almost 80% of their value. Due to its short position, Goldman profited at the expense of the clients to whom it sold the Timberwolf securities, but it lost money overall because Goldman was forced to retain so many of the unsold Timberwolf securities on its books.

Performance Review for Joshua Birnbaum, GS-PSI-01972, Hearing Exhibit 4/27-55c. See also 6/26/2007 email

2478 from Deeb Salem to Michael Swenson, GS MBS-E-012371112. 2479 2480 2481

See Goldman response to Subcommittee QFR at PSI_QFR_GS0030. Id. at PSI_QFR_GS0239. Id. at PSI_QFR_GS0030.

DD. Abacus 2007-AC1

560

Abacus 2007-AC1 was a $2 billion synthetic CDO whose reference obligations were BBB It was a static CDO, It was the last in a series of 16

rated mid and subprime RMBS securities issued in 2006 and early 2007. meaning once selected, its reference obligations did not change. Abacus CDOs referencing RMBS securities designed by Goldman. Goldman served as the underwriter or placement agent, 2484 in other roles related to the CDO. third party to select its assets, referring to it as the portfolio selection agent.2488

the lead manager, Unlike previous Abacus CDOs, Abacus 2007-AC1 used a 2487

and the protection buyer,

and also acted

2485

2486

2482

2483

Designing Single Tranche CDOs. Abacus CDOs were known as single tranche CDOs, a Goldman used this structure to

structure pioneered by Goldman through its Abacus platform. design customized CDOs for clients interested in assuming a specific type and amount of investment risk. An Abacus CDO could be issued with a single tranche, designed in coordination with a client who could select the assets the client wished to reference, the size of the investment, and the amount of subordination or cushion before the single tranche of securities would be exposed

2489

4/2/2007 email from Fabrice Tourre, “ABACUS 07-AC1,” GS MBS-E-002011152 (Abacus 2007-AC1 assets

Goldman internal documents sometimes describe it as the underwriter for Abacus 2007-AC1, and sometimes as

2482 See 3/23/2007 Goldman document, “Abacus 2007-AC1,” at 11, GS MBS-E-002807082, Hearing Exhibit 4/27- 120; Securities and Exchange Commission v. Goldman Sachs, Case No. 10-CV-3229 (S.D.N.Y.), Complaint (April 16, 2010), at 1, 6 (hereinafter “SEC Complaint against Goldman Sachs”). 2483 are “fully-identified, with no reinvestment, removals, substitutions or discretionary trading”). 2484 the placement agent. Compare 2/18/2008 Goldman document, “CDO Transactions (July 1, 2006 - December 31, 2007) in which Goldman Sachs acted as underwriter,” GS MBS 0000004337, to 3/12/2007 Goldman memorandum to Mortgage Capital Committee, “ABACUS Transaction sponsored by ACA,” at 2, GS MBS-E-002406025, Hearing Exhibit 4/27-118 (“Goldman is solely working as agent but retains the option to underwrite the risk as principal.”). 2485 2/27/2007 email from Curtis Willing, “ABACUS 2007 AC1, Ltd. – New Issue Announcement (144a/RegS),” GS MBS-E-009209654. 2486 3/12/2007 Goldman memorandum to Mortgage Capital Committee, “ABACUS Transaction sponsored by ACA,” at 6, GS MBS-E-002406025, Hearing Exhibit 4/27-118 (“Goldman is acting as principal as a protection buyer . . . as well as taking other principal roles.”). 2487 collateral put provider, the collateral put calculation agent, the collateral disposal agent, the credit default swap calculation agent, and the initial purchaser. 2/18/2008 Goldman document, “CDO Transactions (July 1, 2006 - December 31, 2007) in which Goldman Sachs acted as underwriter,” GS MBS 0000004337; 3/12/2007 Goldman Sachs memorandum to Mortgage Capital Committee, “ABACUS Transaction sponsored by ACA,” GS MBS-E- 002406025, Hearing Exhibit 4/27-118. 2488 ACA,” GS MBS-E-002406025, Hearing Exhibit 4/27-118; April 27, 2010 Subcommittee Hearing at 421. 2489 Goldman considered its Abacus platform, which commenced in 2004, to be “market-leading.” 4/2/2007 email from Fabrice Tourre, “ABACUS 07-AC1,” GS MBS-E-002011152; 2/27/2007 Goldman email, “ABACUS-2007- AC1 – Marketing Points (INTERNAL ONLY) [T-Mail],” GS MBS-E-008042545, Hearing Exhibit 4/27-116. See also 6/2007 Goldman document, “CDO Platform Overview,” at 31, GS MBS-E-001918722 (“ABACUS is the Goldman brand name for single-tranche CLN [credit linked note] issuances referencing portfolios comprised entirely of structured products.”); 4/2006 Goldman presentation “Overview of Structured Products,” GS MBS-E-016067482.

Goldman’s additional roles included acting as the basis swap counterparty, the basis swap calculation agent, the

3/12/2007 Goldman memorandum to Mortgage Capital Committee, “ABACUS Transaction sponsored by

561

to loss. Abacus also enabled investors to short a selected group of RMBS or CDO securities at the same time. Goldman used the Abacus CDOs not only to sell short positions to investors, but also to carry out its own shorts. As summarized in one Goldman Mortgage Capital Committee Memorandum, the Abacus design allowed “Goldman to short spreads in our core structured products business in large size.” referencing RMBS securities, including Abacus 2007-AC1, which together had an aggregate value of $13 billion.

Between 2004 and 2007, Goldman issued 16 Abacus deals

2491

2492

2490

Responding to Paulson Inquiry. In mid to late 2006, Goldman was approached by the

hedge fund Paulson & Co. Inc. (Paulson), and asked to structure a transaction that would enable the hedge fund to short multiple RMBS securities. Goldman had previously worked with Paulson and was aware that Paulson held strong negative views of the residential mortgage market and was making investments based on that view. The Goldman Mortgage Capital Committee Memorandum seeking approval of Abacus 2007-AC1, for example, stated:

2493

“Paulson is a macro hedge fund that has taken directional views on the subprime RMBS market for the past few months. In 2006 the Desk worked an order for Paulson to buy protection on a supersenior tranche off a portfolio similar to the Reference Portfolio selected by ACA, and the AC1 Transaction is another means for Paulson to accomplish their trading objective: buying protection in tranched format on the subprime RMBS market.”2494

An email sent to Daniel Sparks, head of the Mortgage Department, by Fabrice Tourre, a Correlation Trading Desk employee who led the effort on the Abacus CDO for Paulson, was even more blunt:

“Subordination” is “[t]he measure of losses that must occur within a portfolio before a tranche is at risk to loss.”

2490 Tranche size “[r]eflects the notional (value-at-risk) of a structured credit investment” and “is also a measure of leverage.” 7/2006 Goldman presentation, “Structured Credit Investments,” at 54, GS MBS-E-002055378; 4/2006 Goldman presentation, “Overview of Structured Products,” GS MBS-E-016067482. Goldman contended that, in a single-tranche CDO, investors could customize the tranche risk/return profile by specifying the tranche subordination and tranche size, and that investors could create “credit enhanced” credit exposure through the use of subordination. 4/2006 Goldman presentation, “Overview of Structured Products,” at 52, GS MBS-E-016067482. “Combined with tranche size, varying levels of subordination enable investors to tailor both the structural leverage and the risk/return profile of their investment.” “Investors are “[n]ot limited by new issuance calendar and bond allocations,” are “[n]ot limited by cash bonds in dealer inventory,” can “customize[] by sector (e.g. RMBS, CMBS, ABS), rating, vintage, servicer, etc.,” and can “meet various investment objectives via structure.” 7/2006 Goldman presentation, “Structured Credit Investments,” at 54, GS MBS-E-002055378. 2491 ACA,” GS MBS-E-002406025, Hearing Exhibit 4/27-118. 2492 including Abacus). 2493 ACA,” GS MBS-E-002406025, Hearing Exhibit 4/27-118.
2494

Goldman trading datasheet, GS MBS 0000004276 (showing closing dates and trade details on various CDOs,

3/12/2007 Goldman memorandum to Mortgage Capital Committee, “ABACUS Transaction sponsored by

Id.

562

“Gerstie and I are finishing up engagement letters … for the large RMBS CDO Abacus trade that will help Paulson short senior tranches off a reference portfolio of Baa2 subprime RMBS risk selected by ACA.”

2495

These documents make it clear that Goldman knew Paulson’s investment strategy was to identify a reference portfolio of assets for the Abacus CDO that Paulson believed would perform poorly or fail, so that its short position would profit at the expense of the long investors. In addition, during his Subcommittee interview, Mr. Tourre made it clear that he was aware of the Paulson investment strategy.

2496

2497

In response to the inquiry from Paulson, Goldman proposed structuring an Abacus CDO.

2498 Fabrice Tourre was given lead responsibility for organizing and structuring the Abacus transaction. Goldman’s primary role was to act as an agent and administrator of the CDO, obtaining its profit from the fees it charged for the services rendered, rather than from any investment in the CDO itself. In effect, Goldman “rented” the Abacus platform to the Paulson hedge fund and served as Paulson’s agent in carrying out the hedge fund’s investment objectives. Mr. Tourre had been suggesting that Goldman employ such an approach and supported the arrangement.

2499

Finding a Portfolio Selection Agent. According to Mr. Tourre, Paulson suggested that

Goldman employ an outside portfolio selection agent for the CDO. Paulson’s Managing Director who led Paulson’s selection of the reference assets for the Abacus 2007-AC1 transaction, told the SEC that it was Goldman’s idea to have a portfolio selection agent. At the same time, Goldman internal communications made it clear that the objective was to select a portfolio selection agent that would comply with Paulson’s suggestions for the assets to be referenced in the CDO. In an email to colleagues discussing the matter, Mr. Tourre suggested finding a manager that:

However, Paolo Pellegrini,

2500

2501

Subcommittee interview of Fabrice Tourre (4/24/2010). Mr. Tourre also told the SEC that he believed

2495 2/7/2007 email from Fabrice Tourre, GS MBS-E-003277939, Hearing Exhibit 4/27-114. 2496 See also 12/18/2006 email from Fabrice Tourre, “Re: Paulson,” GS MBS-E-003246145 (a series of email communications regarding the Abacus 2007-AC1 CDO in which Mr. Tourre referred to the asset portfolio that Paulson was proposing for the CDO as “a weak quality portfolio.”). 2497 Paulson’s selection criteria, such as interest-only mortgages and high loan-to-value ratios, were based on Paulson’s view that securities meeting those criteria were “weaker from the credit quality standpoint than other obligations that did not have those characteristics.” SEC deposition of Fabrice Tourre (3/3/2009), GS MBS 0000022785, at 813-14. 2498 2499 4/27-142. 2500 GS MBS-E-011359460-61, Hearing Exhibit 4/27-115. 2501

Subcommittee interview of Fabrice Tourre (4/24/2010). See, e.g., 12/10/2006 email from Fabrice Tourre to David Lehman, GS MBS-E-003453843, Hearing Exhibit

Subcommittee interview of Fabrice Tourre (4/24/2010); 2/21/2007 email from Fabrice Tourre to David Lehman,

SEC deposition of Paolo Pellegrini (12/3/2008), PSI-Paulson-04 (Pellegrini Depo)-0001, at 82-85, 175.

563

“will be flexible w.r.t. [with respect to] portfolio selection (i.e. ideally we will send them a list of 200 Baa2-rated 2006-vintage RMBS bonds that fit certain criteria, and the portfolio selection agent will select 100 out of the 200 bonds).”

2502

In the early part of January 2007, Mr. Tourre sent an email to prospective selection agents

describing their anticipated role in the CDO. One of his points was the following:

“Reference Portfolio: static, fully identified upfront, and consisting of approx 100 equally- sized mezzanine subprime RMBS names issued between Q4 [the fourth quarter of] 2005 and today. Starting portfolio would be ideally what the Transaction Sponsor shared, but there is flexibility around the names.”

2503

Goldman’s internal communications also suggest that Goldman was, in fact, more interested

in identifying cooperative portfolio selection agents for its own transactions, rather than locating one for the Paulson CDO. In an email chain discussing a portfolio selection agent for Abacus 2007- AC1, a Goldman employee wrote to a colleague that Mr. Tourre “suggested Faxtor was a potential portfolio selection agent [for Paulson] since they are relatively inexpensive and easy to work with.”
The colleague responded: “We already have a portfolio in front of Faxtor; they probably will be willing to structure a short that I believe we would want to keep for ourselves … not sure if this is the best fit.”2504

Jonathan Egol, chief architect of the Abacus structure and head of the Correlation Trading Desk, suggested that Goldman approach GSC Partners, a New York hedge fund that Goldman had worked with on other CDOs, including Anderson. Mr. Tourre sent an email to colleagues asking:

“Do you think gsc is easier to work with than faxtor? They will never agree to the type of names paulson wants to use, I don’t think steffelin [a senior trader at GSC] will be willing to put gsc’s name at risk for small economics on a weak quality portfolio whose bonds are distributed globally.”

2505

A colleague replied:

“There are more managers out there than just GSC / Faxtor. The way I look at it, the easiest managers to work with should be used for our own axes. Managers that are a bit more

12/18/2006 email from Fabrice Tourre, “Paulson,” GS MBS-E-003246145; 12/20/2006 email from Fabrice

1/10/2007 Goldman internal email, GS MBS-E-002480520, Hearing Exhibit 4/27-108; 1/9/2007 email from

2502 Tourre, GS MBS-E-002534649. 2503 Fabrice Tourre, “For ACA,” GS MBS-E-002480516. 2504 12/18/2006 Goldman internal email, GS MBS-E-003246145-46. 2505 “Re: Paulson,” GS MBS-E-003246145.

Mr. Egol also suggested HBK as a possible portfolio selection agent. 12/18/2006 email from Fabrice Tourre,

564

difficult should be used for trades like Paulson given how axed Paulson seems to be (i.e. I’m betting they can give on certain terms and overall portfolio increase).”2506

On January 4, 2007, on behalf of Paulson, Goldman approached GSC Partners as well as two other companies to act as the portfolio selection agent for the Abacus CDO. Following a meeting among representatives of Goldman, Paulson, and GSC, Mr. Tourre sent an email to his colleagues summarizing the meeting and indicating that Paulson was also looking for a portfolio selection agent that would be willing to accept many of the reference assets it identified:

2507

“At the end of the meeting, the Paulson team told us that they were happy to have met GSC and assuming that (1) GSC could get comfortable with a sufficient number of obligations that Paulson is looking to buy protection on in ABACUS format, (2) GSC could get comfortable being in the market as early as end of January with a transaction under which Gsc is disclosed as Portfolio Selection Agent (without any credit risk removal rights), and (3) Paulson, Goldman, and GSC agree[] on GSC’s required compensation for a transaction like this, then Paulson will want to proceed with gsc as soon as possible and be in the market as soon as possible.”

2508

Subsequently, Mr. Tourre reported to his colleagues that GSC had declined the offer to act

as the Abacus portfolio selection agent due to its negative views of the assets Paulson wanted to include in the CDO:

“As you know, a couple of weeks ago we had approached GSC to ask them to act as portfolio selection agent for that Paulson-sponsored trade, and GSC declined given their negative views on most of the credits that Paulson had selected.”2509

Later, when Goldman began to market Abacus 2007-AC1 securities, Edward Steffelin, a senior trader at GSC, sent an email to Peter Ostrem, head of Goldman’s CDO Origination Desk saying: “I do not have to say how bad it is that you guys are pushing this thing.” the Subcommittee what he meant, Mr. Steffelin responded that he believed that particular Abacus CDO created “reputational risk” for GSC as the collateral manager and for the whole market.2511

When asked by

2510

Goldman and Paulson eventually settled on ACA Capital Management, LLC, a company

with experience in selecting assets for CDOs. Goldman employees expressed the hope that ACA’s

2506 Id. An email indicates that, in late December 2006, Mr. Tourre was contemplating several possible portfolio selection agents, including “Aladdin, DRCM, Greywolf, and . . . GSC.” He also suggested Investec and TCW as possible candidates. 12/18/2006 email from Fabrice Tourre, “Re: Paulson,” GS MBS-E-003246145. 2507 See, e.g., 1/4/2007 email from Fabrice Tourre to Daniel Sparks, “Paulson post,” GS MBS-E-002526707 (On January 4, 2007, Goldman “reached out [to] GSC, Greywolf and ACA today re: acting as portfolio selection agent for a Paulson-sponsored trade.”). 2508 1/6/2007 Goldman email, GS MBS-E-003445985, Hearing Exhibit 4/27-152.

2509 1/29/2007 email from Fabrice Tourre, GS MBS-E-003248998, Hearing Exhibit 4/27-112. 2510 2/27/2007 email from Ed Steffelin to Peter Ostrem, “FW: ABACUS 2007-AC1, Ltd. – New Issue Announcement (144a/RegS),” GS MBS-E-009209654. 2511

Subcommittee interview of Edward Steffelin (12/10/2010).

565

involvement would improve the sales of the Abacus securities. In an internal memorandum seeking approval of the CDO, for example, Goldman personnel wrote: “We expect to leverage ACA’s credibility and franchise to help distribute this Transaction.”

2512

Selecting Assets. During January, February, and March 2007, the Abacus reference assets were selected. The Paulson hedge fund initiated the asset selection process by providing Goldman with criteria for choosing RMBS securities for the CDO. According to Mr. Tourre, Goldman’s subsequent identification of candidate assets was essentially ministerial, as Paulson’s specified criteria had restricted the scope of the RMBS securities that could be proposed. For example, Paulson wanted RMBS securities that had adjustable rate mortgages, low borrower FICO scores, and mortgages in states with slowing home price appreciation, like Arizona, California, Florida, and Nevada. Paulson specifically required 2006-vintage or 2007-vintage subprime RMBS that were

2513

2514

2515

At the Subcommittee hearing, Mr. Tourre testified that Paulson produced the portfolio selection criteria.

3/12/2007 Goldman memorandum to Mortgage Capital Committee, “ABACUS Transaction sponsored by

2512 ACA,” GS MBS-E-002406025, Hearing Exhibit 4/27-118 (The memorandum also stated: “We expect the strong brand-name of ACA as well as our market-leading position in synthetic CDOs of structured products to result in a successful offering.” “Partnering with ACA on this innovative, franchise-building transaction will enhance our leadership in the market for structured product synthetic CDOs. We expect that the role of ACA as Portfolio Selection Agent will broaden the investor base for this and future ABACUS offerings.” “We intend to target suitable structured product investors who have previously participated in ACA-managed cashflow CDO transactions or who have previously participated in prior ABACUS transactions.”). See also SEC Complaint against Goldman at 8. When asked to confirm that Mr. Tourre “suggested that it would be easier to market or to find sort of a counterparty to [Paulson’s] short trade if there was a portfolio selection agent involved,” Mr. Pellegrini responded, “Right.” SEC deposition of Paolo Pellegrini (12/3/2008), PSI-Paulson-04 (Pellegrini Depo)-0001, at 113. Mr. Tourre told the Subcommittee that having an agent gives comfort to potential investors. Subcommittee interview of Fabrice Tourre (4/24/2010). 2513 Senator Levin then asked Mr. Tourre, “And did those criteria which Paulson gave to you, were they plugged into your model? Did they generate a list of possible reference securities for that portfolio?” Mr. Tourre responded: “Yes.” They “were used to actually trim down the universe of RMBS.” April 27, 2010 Subcommittee Hearing at 82. 2514 Subcommittee interview of Fabrice Tourre (4/24/2010). 2515 Paolo Pellegrini told the SEC that Paulson’s selection criteria for Abacus 2007-AC1 included RMBS with a maximum weighted average FICO score of 640 and a minimum percentage (80%) of adjustable rate mortgages. Paulson also sought a minimum portfolio size of $750 million. SEC deposition of Paolo Pellegrini (12/3/2008), PSI- Paulson-04 (Pellegrini Depo)-0001, at 140-142. Sihan Shu, an analyst working for Paulson on the Abacus 2007- AC1 reference asset selection, told the Subcommittee that Paulson’s selection criteria generally included large percentages of adjustable rate mortgages; high concentrations of mortgages in areas such as California and Florida, where Paulson believed the housing bubble was greater than in other areas; and limited due diligence. Subcommittee interview of Sihan Shu (2/24/2010). See also SEC deposition of Sihan Shu (12/4/2008), PSI-Paulson-04 (Shu Depo)-0001, at 26-28. Similarly, the SEC Complaint listed Paulson’s selection criteria as favoring “RMBS that included a high percentage of adjustable rate mortgages, relatively low borrower FICO scores, and a high concentration of mortgages in states like Arizona, California, Florida and Nevada that had recently experienced high rates of home price appreciation.” SEC Complaint against Goldman Sachs at 9. However, Goldman’s initial submission to the SEC listed Paulson’s criteria as only 2006-vintage subprime RMBS rated Baa2 by Moody’s. In the Matter of Abacus 2007-AC1 CDO, File No. HO-10911 (SEC), Submission on behalf of Goldman Sachs (September 10, 2009), at 11 (hereinafter “Goldman Sachs Submission”). Goldman’s supplemental submission disclosed that Goldman did use additional criteria listed in draft engagement letters between Goldman and Paulson “to guide Goldman Sachs’ preliminary search for potential reference securities” that complied with Paulson’s criteria, which confirms what Mr. Tourre told the Subcommittee in his testimony at the April 27, 2010 Subcommittee Hearing. In the Matter of ABACUS CDO, File No. HO-10911 (SEC), Supplemental Submission on behalf of

rated BBB by S&P or Baa2 by Moody’s. listing the securities that met Paulson’s criteria. securities, and Goldman forwarded the resulting list to ACA. Over the next two months, a series of negotiations and meetings took place to finalize selection of the reference assets and the structure of the CDO.

Goldman sent Paulson a database and spreadsheet

Paulson used that database to select 123

2516

2518

566

2517

2519

On March 22, 2007, ACA and Paulson agreed on the final $2 billion reference portfolio for The assets consisted of 90 Baa2 rated mid and subprime RMBS securities The RMBS securities were “equally-sized,” each with a $22.22

Abacus 2007-AC1. issued after January 1, 2006. million notional value. Each asset in the final reference portfolio was approved by both Paulson and ACA. Of the final 90 RMBS securities, 49 had been initially proposed by Paulson, and 41 had been initially proposed by ACA.2522

2520

2521

1/29/2007 email from Fabrice Tourre to Peter Ostrem and others, GS MBS-E-003248998, Hearing Exhibit 4/27-

3/12/2007 Goldman internal memorandum to Mortgage Capital Committee, “ABACUS Transaction sponsored

Goldman Sachs (September 25, 2009), at 3, 4 (hereinafter “Goldman Supp. Submission”). A January 3, 2007 draft engagement letter listed the following portfolio selection criteria: Baa2 ratings; RMBS issued after March 1, 2006; weighted average FICO scores between 600 and 675; and at least 80% adjustable rate mortgages underlying the RMBS. 1/3/2007 draft engagement letter, PAULSON-ABACUS 0252736, at 40. See also 1/6/2007 email from Fabrice Tourre to Ed Steffelin and others, GS MBS-E-002754054 (listing criteria for the Abacus portfolio as 2006 vintage bonds underwritten after March 1, 2006; Baa2 rated bonds; average FICO score between 600 and 675; RMBS transaction size greater than $500 million; and percentage of adjustable rate mortgages greater than 80%). 2516 112; Goldman Sachs Submission at 12 (citing Gerst Tr. 13-14). 2517 See 1/9/2007 email from Gail Kreitman to Laura Schwartz, GS MBS-E-007974381. 2518 Id. 2519 See 3/22/2007 email from Sihan Shu to Fabrice Tourre and David Gerst, GS MBS-E-003010587. 2520 3/12/2007 Goldman memorandum to Mortgage Capital Committee, “ABACUS Transaction sponsored by ACA,” GS MBS-E-002406025, Hearing Exhibit 4/27-118; 3/23/2007 Goldman presentation, “ABACUS 2007- AC1,” GS MBS-E-002807082, Hearing Exhibit 4/27-120; SEC Complaint against Goldman Sachs at 11; Goldman Sachs Submission at 13. 2521 by ACA,” GS MBS-E-002406025, Hearing Exhibit 4/27-118. 2522 See “Abacus 2007-AC1 Reference Portfolio,” chart prepared by Subcommittee. See also 1/5/2007 email from Sihan Shu to Ed Steffelin, Fabrice Tourre, and others, GS MBS-E-002483408; 1/6/2007 email from Fabrice Tourre to Ed Steffelin and others, GS MBS-E-002754054; 1/9/2007 email from Gail Kreitman to Laura Schwartz, GS MBS-E-007974381; 1/22/2007 email from Laura Schwartz to Fabrice Tourre and others, GS MBS-E-002522389; 1/22/2007 email from David Gerst to Paolo Pellegrini and Sihan Shu, GS MBS-E-002480574; 1/28/2007 email from Fabrice Tourre to Gail Kreitman and David Gerst, GS MBS-E-002444359; 1/31/2007 email from David Gerst to Laura Schwartz, GS MBS-E-002620419; 2/1/2007 email from Laura Schwartz to David Gerst, GS MBS-E- 003026086; 2/2/2007 email from Paolo Pellegrini to Laura Schwartz and Sihan Shu, GS MBS-E-002483499; 2/2/2007 email from Laura Schwartz to Paolo Pellegrini and Sihan Shu, GS MBS-E-002483496; 2/5/2007 email from Paolo Pellegrini to Laura Schwartz, GS MBS-E-003062009; 2/5/2007 email from Laura Schwartz to Paolo Pellegrini and others, GS MBS-E-002856966; 2/5/2007 email from David Gerst to Paolo Pellegrini and Sihan Shu, PAULSON-ABACUS 0253248; 2/26/2007 email from Fabrice Tourre to Keith Gorman, GS MBS-E-002444961; 3/22/2007 email from Sihan Shu to Fabrice Tourre and David Gerst, GS MBS-E-003010587; 3/23/2007 Goldman document, “ABACUS 2007-AC1,” GS MBS-E-002807082, Hearing Exhibit 4/27-120. Goldman asserted: “The record in this investigation is clear that the overwhelming majority of the securities were identified by ACA.” Goldman Supp. Submission at 13. However, the Goldman and Paulson documents reviewed by the Subcommittee show otherwise.

567

Goldman characterized Paulson’s participation in the asset selection process as one in which

The evidence indicates, however, that Paulson did more

the hedge fund merely “express[ed] [its] views” about the reference portfolio, happens in synthetic CDO transactions. than express its views; it played an active and determinative role in the asset selection process. Paulson established the criteria used to identify the initial list of RMBS securities, proposed a majority of the reference assets in the final portfolio, and approved 100% of the reference assets. Moreover, the “views” expressed by Paulson directly conflicted with the interests of the investors to whom Goldman was marketing the Abacus 2007-AC1 deal. Mr. Pellegrini was quite clear about Paulson’s intentions in a deposition with the SEC:

which often

2524

2523

Question: Your portfolio analysis was designed in large part to identify bonds that weren’t going to perform, right?

Answer: Right.

Question: Because you wanted to short those bonds?

Answer: Right.2525

Goldman documents reviewed by the Subcommittee contain conflicting information on

2526

exactly who was involved in the asset selection process. Goldman’s Mortgage Capital Committee Memorandum on the Abacus CDO, the key internal Goldman document describing the new CDO, stated: “The Reference portfolio has been selected and mutually agreed upon by ACA and Goldman.” selected by “ACA/Paulson.” selection agent for the CDO, and stated that the portfolio selection agent had selected the reference assets. selected by ACA Management, L.L.C.”

The Abacus Offering Memorandum stated: “The Initial Reference Portfolio will be

In an email to a colleague, however, Mr. Tourre wrote that the portfolio had been

The Abacus Marketing book identified ACA as the portfolio

2529

2527

2528

Another email exchange, between Mr. Tourre and his colleague Mr. Egol, demonstrates the

strong influence Paulson had in the selection process. IKB, a German bank that was a frequent investor in past Abacus CDOs and was considering purchasing securities issued by Abacus 2007- AC1, apparently asked to have certain RMBS securities removed from the portfolio and sent the following email to a Goldman sales representative:

Goldman Supp. Submission at 10, 13. Id. at 10. SEC deposition of Paolo Pellegrini (12/3/2008), PSI-Paulson-04 (Pellegrini Depo)-0001, at 175-76. 3/12/2007 Goldman memorandum to Mortgage Capital Committee, “ABACUS Transaction sponsored by

2523 2524 2525 2526 ACA,” at 3, GS MBS-E-002406025, Hearing Exhibit 4/27-118. 2527 2528 120. 2529

5/8/2007 email from Fabrice Tourre to Josh Birnbaum, GS MBS-E-003611826, Hearing Exhibit 4/27-123. 3/23/2007 Goldman document, “Abacus 2007-AC1,” at 11-12, GS MBS-E-002807082, Hearing Exhibit 4/27-

4/26/2007 Goldman Sachs Offering Circular, “Abacus 2007-AC1, Ltd.,” at 2, GS MBS-E-001918034.

568

“[D]id you hear something on my request to remove Fremont and New Century serviced bonds? I would like to try to [sic] the advisory com[m]it[t]ee this week and would need consent on it.”

2530

The IKB email was forwarded to Mr. Tourre, who sent it to Mr. Egol with the following message: “Paulson will likely not agree to this unless we tell them that nobody will buy these bonds if we don’t make that change.” Mr. Tourre expressed concern, not about what ACA, the portfolio selection agent, might or might not agree to, but only about what the Paulson hedge fund might agree to.

2531

Failing to Disclose Key Information. Evidence obtained by the Subcommittee indicates

that Paulson’s role in the Abacus asset selection process and its investment objectives for the CDO were not fully or accurately disclosed to key parties or investors at the time the CDO was being structured and sold.

Moody’s, one of the credit rating agencies asked to rate the Abacus securities, was not

informed of Paulson’s role or investment objectives. At a Subcommittee hearing on the role of the credit rating agencies in the financial crisis, Eric Kolchinsky, a former Moody’s managing director who oversaw its CDO ratings and was familiar with Abacus 2007-AC1, provided sworn testimony that he had not known of Paulson’s involvement with the CDO at the time it was rated, did not know of Paulson’s role in selecting the referenced assets, and believed his staff did not know either. He testified that allowing an entity that wants a CDO to “blow up” to pick its assets “changes the whole dynamic,” and was information that he would have wanted to know when rating the securities:

Senator Levin: And were you or your staff aware at the time that Moody’s was working on the ABACUS rating that Paulson was shorting the assets in ABACUS and playing a role in selecting referenced assets expected to perform poorly?

Mr. Kolchinsky: I did not know, and I suspect, I am fairly sure, that my staff did not know either.

Senator Levin: And are these facts that you or your staff would have wanted to know before rating ABACUS?

Mr. Kolchinsky: From my personal perspective, it is something that I would have wanted to know because it is more of a qualitative not a quantitative assessment if someone who intends the deal to blow up is picking the portfolio. But, yes, that is something that I would have personally wanted to know. It changes the incentives in the structure.

2530 2531

3/12/2007 email from Jorg Zimmerman (IKB) to Michael Nartey, GS MBS-E-002683134. 3/12/2007 email from Fabrice Tourre to Jonathan Egol, GS MBS-E-002648826.

569

Senator Levin: Are people usually putting deals together that want the deal to succeed? Isn’t that the usual assumption?

Mr. Kolchinsky: That is the basic assumption, yes.

Senator Levin: And if the person wanting the deal to blow up is picking the assets, that would run counter to what the usual assumption is?

Mr. Kolchinsky: It just changes the whole dynamic of the structure where the person who is putting it together, choosing it, wants it to blow up.

2532

Moody’s assigned AAA ratings to two tranches of the Abacus CDO.

2533

2534

According to ACA, it

ACA told the Subcommittee that, throughout the asset selection process, it was not informed and remained unaware of Paulson’s true investment objective, which was to identify and short a set of assets that it believed would not perform and would lose value. believed that Paulson was going to be a long investor in the CDO through its purchase of the equity share that would incur the first losses in the CDO. Contemporaneous ACA documents support that position. An internal ACA Commitments Committee Memorandum on Abacus 2007-AC1 dated February 12, 2007, for example, stated: “The hedge fund is taking the 0-9% equity tranche.”

2535 Ten days later, on February 23, 2007, the ACA Managing Director who worked on the Abacus transaction spoke with a Goldman representative, and took notes of the conversation which stated in part: “Paulson taking 0-10%.” In April 2007, the same ACA Managing Director sent an email to the CEO and President of ACA’s parent company, ACA Capital Holdings Inc., which was considering buying Abacus securities for itself. Her email stated: “We did price $192 million in total of Class A1 and A2 today to settle April 26th. Paulson took down a proportionate amount of equity (0-10% tranche).”2537

2536

In addition, on January 10, 2007, a few days after ACA was first approached by Goldman

about working on the Abacus CDO, Mr. Tourre sent ACA a “Transaction Summary” describing the proposed transaction. The Transaction Summary identified the Paulson hedge fund as the “Transaction Sponsor,” described the “Contemplated Capital Structure” of the CDO, and indicated that the lowest tranche, “[0]%-[9]%,” was “pre-committed first loss.” Director told the Subcommittee that the “[0]%-[9]%” tranche identified in the Transaction

The ACA Managing

2538

April 23, 2010 Subcommittee Hearing at 63-64. See 3/23/2007 Goldman document, “Abacus 2007-AC1,” at 14, GS MBS-E-002807082, Hearing Exhibit 4/27-

Subcommittee interview of Laura Schwartz (ACA) (4/23/2010). 2/12/2007 “CDO Asset ‘Management’ Proposal for Abacus 2007-AC1,” submitted to ACA Commitments

2532 2533

Moody’s rating of Aaa is equivalent to a AAA rating. Standard and Poor’s also rated the Abacus Class A-1 notes and the Class A-2 notes as AAA.
2534 2535 Committee, at 2, ACA-ABACUS-0000121560-66. 2536 ABACUS 00004171 at 173. 2537 2538

4/10/2007 email from ACA Managing Director Laura Schwartz, ACA-ABACUS-0000006327. 1/10/2007 email from Fabrice Tourre to Laura Schwartz, GS MBS-E-002480520, Hearing Exhibit 4/27-108.

2/23/2007 handwritten notes of Laura Schwartz, ACA Managing Director of CDO asset management, ACA

She explained that it was typical for a CDO sponsor

Summary matched the general description of an equity tranche, and the wording suggested that someone had already committed to buy it. to purchase the equity tranche, and she believed that Paulson, as the Abacus “sponsor,” had committed to buy that tranche. tranche of the CDO, of a “[+10%]” size, was “Not Offered” for sale. Director declared in a statement to the SEC that she had interpreted the phrase, “Not Offered,” to indicate the equity tranche had been “pre-placed” and “ha[d] already been committed to purchase by an investor and [would] not be marketed.” fund.

The Abacus Marketing book also specified that the “First Loss”

She thought that investor was the Paulson hedge

The ACA Managing

2541

2540

570

2539

2542

When asked about the Transaction Summary description of the lowest tranche in the Abacus

CDO, Mr. Tourre told the Subcommittee that the phrase “pre-committed first loss” normally indicated that the tranche had been sold. He stated that he actually meant to communicate that the tranche had not been sold, and that portion of the Transaction Summary was poorly worded.2543

In his prepared statement at the Subcommittee hearing, Mr. Tourre testified that he never

told ACA that the Paulson hedge fund would be a long investor in the Abacus CDO:

“I never told ACA, the portfolio selection agent, that Paulson and Company would be an equity investor in the AC-1 transaction or would take any long position in the deal. Although I don’t recall the exact words that I used, I recall informing ACA that Paulson’s fund was expected to buy credit protection on some of the senior tranches in this deal. This necessarily meant that Paulson was expected to take some short position in the transaction.”

2544

In addition, Mr. Tourre testified that he informed ACA that the Paulson hedge fund was

going to invest only on the short side of the transaction:

Senator Levin: You did not disclose to ACA that Paulson was on the short side of this deal. Is that correct?

Mr. Tourre: I did mention to ACA that the expectation was that Paulson was going to buy protection on senior layers of risk in the transaction.

Senator Levin: That they were going to be only on the short side.

Id. See also 1/10/2007 email from Fabrice Tourre to Laura Schwartz, “Transaction Summary,” GS MBS-E-

2539 Subcommittee interview of Laura Schwartz (4/23/2010). See also Statement of Laura Schwartz, ACA ABACUS 00004406 at 408.
2540 002480520, Hearing Exhibit 4/27-108; SEC Complaint against Goldman Sachs at 14, 15; Goldman Sachs Submission at 32 (citing 1/10/2007 email from Fabrice Tourre to Laura Schwartz, “Transaction Summary,” GS MBS-E-003504901). 2541 120; Statement of Laura Schwartz, ACA ABACUS 00004406 at 408. 2542 Statement of Laura Schwartz, ACA ABACUS 00004406 at 408. 2543 Subcommittee interview of Fabrice Tourre (4/24/2010). 2544 April 27, 2010 Subcommittee Hearing at 44.

3/23/2007 ACA/Goldman document, “Abacus 2007-AC1,” ACA-ABACUS-002807082, Hearing Exhibit 4/27-

Mr. Tourre: Yes.2545

571

ACA has since filed a civil lawsuit against Goldman asserting that Goldman did not inform ACA that “Paulson intended to take an enormous short position” in Abacus and is seeking to recover $30 million in compensatory damages and $90 million in punitive damages for fraudulent inducement, fraudulent concealment, and unjust enrichment.2546

Regardless of the communications between Goldman and ACA, it is clear that the Abacus

marketing material and offering documents provided by Goldman to investors contained no mention of Paulson’s short position in the CDO nor the significant role it played in the selection of the CDO’s reference assets. This was confirmed by Mr. Tourre at the Subcommittee hearing:

Senator Levin: And was it reflected in the Goldman Sachs security offering to investors that Paulson had been part of the selection process? Was that represented in that document?

Mr. Tourre: Paulson was not disclosed in the Abacus 07 AC-1 transaction, Mr. Chairman.

Senator Levin: It was not?

Mr. Tourre: No, it was not.

2547

Still another troubling omission was Goldman’s failure to advise potential Abacus investors that the firm’s own economic interests were aligned with those of the Paulson hedge fund. As part of the Abacus CDO arrangement, Paulson agreed to pay Goldman a higher fee if Goldman could The provide Paulson with CDS contracts containing premium payments below a certain level.

2548

Id. at 86. ACA Financial Guaranty Corp. v. Goldman Sachs & Co., Index No. 650027/2011 (N.Y. Sup.), Complaint

April 27, 2010 Subcommittee Hearing at 86. See 3/12/2007 Goldman memorandum to Mortgage Capital Committee, “ABACUS Transaction sponsored by

2545 2546 (January 6, 2011), at 1, 23 (hereinafter “ACA Complaint against Goldman Sachs). 2547 2548 ACA,” GS MBS-E-002406025, Hearing Exhibit 4/27-118 (“Goldman will receive an upfront premium from Paulson for distributing risk at or within specified strike spreads.” “If Goldman succeeds in placing a given Targeted Tranche inside the related Strike Spread, Goldman will receive from Paulson a fee on the notional amount of such Targeted Tranche distributed. Such fee will have a floor component (the ‘Minimum Fee Rate’) and an upside sharing component, under which Goldman will share with Paulson any execution delivered at levels tighter than the Strike Spreads.”). See also 1/18/2007 email from Fabrice Tourre to David Lehman and others, GS MBS-E-002483446 (detailing the additional fees Goldman could earn by executing trades within the strike spread of each tranche); 3/14/2007 email from Paolo Pellegrini to Sihan Shu with “ACA ABACUS Paulson Fee Illustration” spreadsheet attached (the spreadsheet provides details of the incentive-based fees paid to Goldman, including for Goldman’s pricing of spreads), PAULSON-ABACUS 0250401. Mr. Pellegrini told the SEC that Goldman and Paulson had discussions regarding Goldman’s compensation, resulting in “a formula that tied their compensation to sort of kind of the spread that they sort of presented to or that they would present to us.” SEC deposition of Paolo Pellegrini (12/3/2008), PSI-Paulson-04 (Pellegrini Depo)-0001, at 118-19. Mr. Tourre described the compensation agreement in an email to Mr. Sparks, writing that if Goldman could place super senior risk inside a certain spread, Paulson would pay Goldman an upfront fee and periodic fees reflecting the money Goldman saved Paulson. 9/8/2006 email from Fabrice Tourre to Dan Sparks, GS MBS-E-009516671. Mr. Tourre told the SEC that Paulson was

572

problem with the fee incentive offer was that, while lower premiums would result in lower costs to Paulson, it would also result in lower premium payments to the CDO, directly reducing the amount of cash available to the long investors. The Paulson-Goldman compensation arrangement, thus, created a direct conflict of interest between Goldman and the investors to whom it was selling the Abacus securities.

Selling Abacus Securities. Abacus 2007-AC1 closed, and its securities were issued on

April 26, 2007. They were issued later than the securities from the Hudson, Anderson, and Timberwolf CDOs and hit the market as subprime mortgages were hitting record delinquency and default rates. Goldman sold the Abacus 2007-AC1 securities to just three investors: IKB, the German bank; ACA, the portfolio selection agent; and ACA Financial Guaranty Corp., the owner of ACA and a wholly owned subsidiary of ACA Capital Holdings Inc. IKB bought $150 million of the AAA rated Abacus securities. ACA bought about $42 million in the AAA securities for placement in another CDO it was managing. ACA Financial Guaranty Corp. was by far the largest investor, taking the long side of a $909 million CDS contract referencing the super senior portion of the CDO. to Paulson.

Goldman took the short side of the CDS contract, which it then transferred

2550

2549

2551

2552

SEC Complaint against Goldman Sachs at 18. See Credit Default Swap Insurance Policy, ACA ABACUS

See Goldman trading datasheet, GS MBS 0000004276 (showing closing dates and details on various deals,

5/8/2007 email exchange between Joshua Birnbaum and Fabrice Tourre, “Post on Paulson and ABACUS 07-

“comfortable buying protection only to the extent that the spreads they were paying were less than a certain level.” SEC deposition of Fabrice Tourre (3/3/2009), GS MBS 0000022785, at 899-900. 2549

ACA complaint against Goldman Sachs at 15, 16.
2550 including Abacus). 2551 AC1,” GS MBS-E-003352815; 4/13/2007 email exchange between Fabrice Tourre and Charlie Remnant, “ABACUS 07-AC1,” GS MBS-E-002485172; 5/9/2007 email to Fabrice Tourre, “ABN Amro,” GS MBS-E-002461503. ABN AMRO Bank N.V. (ABN), a large European bank, intermediated the swap between Goldman and ACA Financial Guaranty Corp. 2552 The CDS contracts were executed between Goldman Sachs International and Paulson Credit Opportunities Master II Ltd., one of the Paulson hedge funds. 4/9/2007 email from Nicholas Friedman to Fabrice Tourre and others, “Re: ABACUS 07-AC1,” GS MBS-E-002449178.

Shortly before the Abacus 2007-AC1 transaction closed, Goldman agreed to take the long side of a CDS contract on the performance of a small portion of Abacus’ underlying assets when Paulson wanted to increase its short position at the last minute. Although Goldman ended up retaining this long investment, it did so only because it could not find an investor who would buy it. Mr. Tourre admitted this fact in the April 27, 2010 Subcommittee Hearing.

Senator Levin: Did Goldman intend to keep a long stake in that transaction when the deal was structured? I know it ended up with a piece. Was it intended that it end up with a piece of that deal? Mr. Tourre: We tried to hedge our risk by selling that piece as well, but were not successful in doing so. Senator Levin: So it was intended to sell that piece? Mr. Tourre: For prudent risk management reasons, we were trying –
Senator Levin: Oh, I am sure for all the right reasons. But it was intended that Goldman not have any long stake on that piece. Is that correct? Mr. Tourre: Yes.

See also 6/5/2007 email from David Gerst to Jonathan Egol, GS MBS-E-002469912, Hearing Exhibit 4/27-126.

573

Within months, the high risk subprime mortgages underlying the RMBS securities

referenced in the Abacus portfolio incurred steep rates of default, and the Abacus securities began to lose value. According to the SEC, by October 2007, six months after the securities were issued, 83% of the underlying assets had received a credit rating downgrade and 17% of the underlying assets had been placed on a negative credit watch. sent an email about Abacus 2007-AC1 with an assessment even more negative than that of the SEC:

On October 26, 2007, a Goldman employee

2553

“This deal was number 1 in the universe of CDO’s that were downgraded by Moody’s and S&P. 99.89% of the underlying assets were downgraded.”

2554

The three long investors in Abacus 2007-AC1 together lost more than $1 billion. As the

sole short investor, Paulson recorded a corresponding profit of about $1 billion.2555

2556

On April 16, 2010, the SEC filed a complaint against Goldman and Mr. Tourre, alleging The SEC specifically alleged violations of Section

their actions constituted securities fraud. 17(a) of the Securities Act of 1933, as well as Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934. investors materially adverse information, that the party shorting the reference assets was the same party that had played a significant role in selecting those assets. reached a $550 million settlement with the SEC. acknowledged:

On July 14, 2010, Goldman In connection with the settlement, Goldman

The SEC contended that Goldman had failed to disclose to potential

2557

2558

2559

“[T]he marketing materials for the ABACUS 2007-AC1 transaction contained incomplete information. In particular, it was a mistake for the Goldman marketing materials to state

SEC Complaint against Goldman Sachs at 3. 10/26/2007 email from Goldman salesman to Michael Swenson, “ABACUS 2007-AC1 – Marketing Points

SEC Complaint against Goldman Sachs at 3. See SEC Complaint against Goldman Sachs. Pursuant to 15 U.S.C. §78j(b) and 17 C.F.R. §240.10b-5, the SEC alleged that Goldman and Mr. Tourre, “in

2553 2554 (INTERNAL ONLY) [T-Mail],” GS MBS-E-016034495. 2555 2556 2557 connection with the purchase or sale of securities or securities-based swap agreements, by the use of means or instrumentalities of interstate commerce or of the mails, directly or indirectly (a) employed devices, schemes or artifices to defraud; (b) made untrue statements of material facts or omissions of material facts necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading; or (c) engaged in transactions, practices or courses of business which operated or would operate as a fraud or deceit upon persons.” SEC Complaint against Goldman Sachs at 20-21. The SEC alleged that Goldman and Mr. Tourre “knowingly or recklessly misrepresented in the term sheet, flip book and offering memorandum for ABACUS 2007- AC1 that the reference portfolio was selected by ACA without disclosing the significant role in the portfolio selection process played by Paulson, a hedge fund with financial interests in the transaction adverse to IKB, ACA Capital and ABN. Goldman&Co and Tourre also knowingly or recklessly misled ACA into believing that Paulson invested in the equity of ABACUS 2007-AC1 and, accordingly, that Paulson’s interests in the collateral section process were closely aligned with ACA’s when in reality their interests were sharply conflicting.” SEC Complaint against Goldman Sachs at 21. Similar charged were filed pursuant to 15 U.S.C. § 77q(a)(1), (2) and (3). See SEC Complaint against Goldman Sachs at 19. 2558 SEC Complaint against Goldman Sachs at 2, 20, 21. 2559 Securities and Exchange Commission v. Goldman, Sachs & Co. and Fabrice Tourre, Case No. 10-CV-3229, (S.D.N.Y.), Consent of Goldman Sachs, (July 14, 2010), at 1, 2, 10 (hereinafter “Consent of Goldman Sachs”).

574

that the reference portfolio was ‘selected by’ ACA Management LLC without disclosing the role of Paulson & Co. Inc. in the portfolio selection process and that Paulson’s economic interests were adverse to CDO investors.”2560

Analysis. Goldman constructed Abacus 2007-AC1 to help a hedge fund short multiple

RMBS securities. Goldman allowed the hedge fund to play a significant role in the selection of the CDO’s referenced assets, while employing an outside portfolio agent to give the impression that the CDO assets were selected by a disinterested third party. Goldman failed to disclose the hedge fund’s investment objective and asset selection role to a credit rating agency that assigned AAA ratings to two tranches of the Abacus securities. Goldman also failed to provide full disclosure to the long investors to whom it sold the Abacus securities. In addition, Goldman failed to disclose to the investors a compensation arrangement that provided incentives for Goldman to minimize the premium payments into the CDO. Within six months, the Abacus securities began incurring losses and ratings downgrades. Goldman watched the long investors to whom it had sold the securities lose virtually all the funds they had invested, while the hedge fund it had assisted walked away with a profit of approximately $1 billion.

(iii) Additional CDO Conflicts of Interest

In addition to creating and failing to manage conflicts of interest arising from its design and

sale of CDO securities, Goldman at times allowed conflicts of interest to affect how it carried out key roles in the administration of its CDOs. liquidation agent in Hudson 1 and the collateral put provider in Timberwolf, illustrate the problems. In both cases, Goldman used its administrative roles to promote and enhance its own financial interests at the expense of the clients to whom it had sold the CDO securities.

Two examples, in which Goldman acted as the

2561

AA. Liquidation Agent in Hudson 1

In 2006 and 2007, several Goldman CDOs included provisions establishing a “liquidation

agent” to sell any poorly performing assets in the CDO. This feature appeared in Hudson Mezzanine 2006-1, which is examined in this Report, as well as Hout Bay 2006-1, Hudson High

2560 Consent of Goldman Sachs at 2. Despite this acknowledgment by Goldman as part of the settlement, when asked during the Subcommittee hearing if “a non-biased person [could] look at the facts [of Abacus 2007-AC1] as you see them and say there is a question of unethical behavior here,” David Viniar, the executive vice present and chief financial officer for Goldman, stated he “didn’t believe so.” April 27, 2010 Subcommittee Hearing at 125. 2561 Some of the administrative roles that Goldman filled in its CDOs, as described in its CDO agreements, included: Initial Purchaser, Synthetic Security Counterparty, Senior Swap Counterparty, Credit Protection Buyer, Liquidation Agent, Calculation Agent under U.S. Dollar Cash Flow Swap Transaction, Collateral Put Provider, CP Note Placement Agent, Portfolio CDS Counterparty, Hedge Counterparty - Cashflow Swap, Collateral Disposal Agent, Credit Default Swap Calculation Agent, Basis Swap Counterparty, and Basis Swap Calculation Agent. 2/18/2008 document prepared by Goldman Sachs, outlining the parties serving each role in Goldman underwritten CDOs, GS MBS 0000004337.

575

Grade 2006-1, Hudson Mezzanine 2006-2, and Anderson Mezzanine 2007-1. In each instance, Goldman served as the initial liquidation agent, although in several CDOs, it later transferred the role to a third party. In Hudson 1, Goldman’s dual roles as liquidation agent and sole short party in the CDO created a direct conflict of interest between Goldman and the clients to whom it sold the Hudson securities, which Goldman exploited by placing its own financial interests ahead of those of its clients.

2562

2563

2564

Designing the Liquidation Agent Role. According to Goldman, appointing a CDO liquidation agent was a “fairly novel idea” that was first implemented in the 2006 Hout Bay CDO. Peter Ostrem, then head of the CDO Origination Desk, oversaw the drafting of the liquidation agent feature. He told the Subcommittee that Goldman wanted to issue static portfolio CDOs, meaning CDOs whose assets did not change over time, but also wanted to protect investors from poorly performing assets. He explained that the liquidation agent feature was intended to be triggered by a specified event and provided the liquidation agent with “no discretion” other than to sell the poorly performing asset, which was referred to as a “Credit Risk Asset.” He explained that, without such a feature, poorly performing assets would “just stay there” in a CDO, further harming investors. could be performed by Goldman itself at a lower cost than retaining a traditional collateral manager.

The CDO Origination Desk also favored the approach, because it

2565

2566

The liquidation agent provisions established criteria for identifying “Credit Risk Assets” and

removing them from the CDO. In a July 2006 memorandum to the Goldman Mortgage Capital Committee, the CDO Origination Desk described the liquidation agent role as follows:

“As Liquidation Agent, Goldman will liquidate assets determined by the Trustee to be ‘Credit Risk Assets’ based on specific guidelines. Goldman will have 12 months to sell these assets. Sales will be made under a competitive bidding process, whereby we will solicit three outside bids and select the highest. Prior to executing Hout Bay 1, in which we also played the Liquidation Agent role, we spoke to multiple counterparties as to our role as Liquidation Agent. We received approval for our role in this transaction from legal and accounting. … Finally, we spoke with outside counsel, Wilmer Cutler, about potential issues related to the Investment Advisor Act. They are of the opinion that our role of Liquidation Agent does not cause us to be deemed an Investment Advisor based on the exception to the Advisors Act for a ‘limited grant of discretion.’”2567

2/18/2008 Goldman presentation, “CDO Transactions (July 1, 2006 - December 31, 2007) in which Goldman

Subcommittee interview of Darryl Herrick (10/13/2010). Subcommittee interview of Peter Ostrem (10/5/2010). Id. Although Mr. Ostrem helped design the liquidation agent feature, he was not employed by Goldman when its

2562 Sachs acted as underwriter,” GS MBS 0000004337, at 4340; 7/19/2007 Goldman document, “GS Liquidation Agent Role in ABS CDOs,” GS MBS-E-014055117. 2563 2564 2565 CDO assets were downgraded and triggered its liquidation agent duties. 2566 high grade structured product CDO Squared with Investec (UK) Limited,” GS MBS-E-013458155. 2567

See 7/17/2006 Goldman memorandum to the Mortgage Capital Committee, “Placing debt and equity on a static

Id.

576

One key issue discussed in the memorandum was whether, by assuming the role of liquidation agent, Goldman would trigger registration and disclosure obligations under the Investment Advisers Act of 1940. The CDO Origination Desk wrote:

“We have discussed Goldman’s role as Liquidation Agent internally with Tim Saunders [counsel in Goldman’s legal department] and externally with outside counsel, Wilmer Cutler. One concern about that role was whether Goldman would be viewed as an Investment Advisor. We specifically crafted Goldman’s role in Hout Bay 1 and in this case to eliminate both internal and external counsel’s concern about Goldman being treated as an Investment Advisor. The main factors that made Tim Saunders and Wilmer Cutler comfortable that Goldman will not be treated as an Investment Advisor were:

Goldman’s role is Liquidation Agent and not Collateral Manager. Goldman is engaged by the CDO to liquidate Credit Risk Assets and will receive an ongoing Liquidation Agent Fee for such services;
Goldman does not determine whether an asset is a Credit Risk Asset. Such determination is made by the CDO based on specific rules . . . ;
Goldman must liquidate such Credit Risk Assets within 12 months of such determination and the price received on such liquidation must be in the context of a three-bid process;
Goldman does not receive additional compensation and or control of the CDO for acting as a Liquidation Agent. …

We will build a provision in the deal documents to allow Goldman to resign as Liquidation Agent if appropriate notice is given and a replacement Liquidation Agent is in place.”2568

This memorandum indicates that, from its inception, the liquidation agent function was designed as a narrow, ministerial role, in part to avoid the legal obligations applicable under federal law to investment advisers.

The memorandum also indicated that “Credit Risk Assets” would be identified through

objective criteria. For example, in the CDO under review, the memorandum stated that Credit Risk Assets would be defined as “[a]ny asset that is downgraded by Moody’s or S&P below Ba2” and “[a]ny asset that is defaulted.”

2569

Credit Rating Downgrades. One year later, on July 19, 2007, after Mr. Ostrem had left

Goldman and Mr. Lehman had assumed responsibility for all Goldman-originated CDOs, he held a conference call with members of the CDO team and Goldman in-house legal counsel Tim Saunders,

2568 2569

Id. Id.

577

to discuss how to carry out Goldman’s CDO liquidation agent responsibilities. The prior week, Moody’s and S&P had suddenly downgraded hundreds of RMBS and CDO securities in the first of many mass downgrades. Those downgrades suddenly caused a number of assets in Goldman’s CDOs to qualify as Credit Risk Assets that had to be liquidated.

In advance of the conference call, Mr. Lehman’s staff prepared a two-page summary of

Goldman’s liquidation agent duties, the liquidation procedures specified in the CDO documents, the CDOs affected, and the assets that Goldman anticipated would be affected by the downgrades.

2570

Four days after the conference call, on July 23, 2007, Benjamin Case, who had been

assigned lead responsibility for carrying out Goldman’s liquidation agent functions, circulated a draft document describing Goldman’s role. It stated that Goldman’s goal as liquidation agent was:

“to attempt to maximize proceeds on the unwind of credit risk assets pursuant to the liquidation process governed by the CDO documents, rather than to liquidate at an arbitrary pre-specified time without regard to market conditions.”

2571

It identified the assets that had been classified as Credit Risk Assets and provided Goldman’s “Current Strategy” for handling them:

“– wait and continue to evaluate market conditions, rather than liquidating now.

upside is that continued short-covering by hedge funds anxious to monetize profits could cause minor rally (5-10 points)[.]
downside is that speed up of foreclosure process vs. current timeline expected by market could decrease IO value, or significant forced selling of similar names by CDO vehicles could push levels wider [lower prices].”

Hudson Liquidation Agent. Although the liquidation agent role was originally designed for use in Goldman’s “high grade” CDOs, where “there is substantially less credit risk in the assets vs. a mezzanine structured product CDO portfolio,” the feature was also added to some of its riskier mezzanine CDOs, including Hudson Mezzanine 2007-1 (Hudson 1). Hudson 1 was a synthetic CDO whose assets consisted entirely of CDS contracts referencing subprime RMBS or ABX assets with BBB or BBB- ratings. Goldman had selected 100% of the reference assets and held 100% of the short side of the CDO.

2572

Hudson 1’s marketing materials outlined Goldman’s liquidation agent role. The Hudson

marketing booklet, for example, told potential investors:

7/19/2007 Goldman document, “GS Liquidation Agent Role in ABS CDOs,” GS MBS-E-014055117. 7/23/2007 email from Mr. Case to Mr. Bieber, “CDO Liquidation Agent Role - Draft Talking Points -

2570 2571 INTERNAL USE ONLY,” GS MBS-E-015240358. 2572 “mezzanine” CDO is one in which the underlying assets carry credit ratings such as BBB or BBB-.

7/17/2006 Goldman memorandum to Mortgage Capital Committee, GS MBS-E-013458155, at 57. A

578

“Hudson CDOs are non-managed and static in nature and provide term non-recourse funding where Goldman Sachs acts as Liquidation Agent on an ongoing basis. The Liquidation Agent will be responsible for efficiently selling credit risk assets.”

2573

The Hudson term sheet provided additional information about the liquidation agent role and the “Credit Risk Assets” that would have to be liquidated:

“Goldman as Liquidation Agent, will liquidate any asset determined to be a ‘credit risk’ within 12 months of said determination. Credit Risk assets will include: any asset downgraded by Moody’s or S&P below Ba3 or BB-, any asset that is defaulted or would be experiencing a credit event as defined by the PAUG [Pay As You Go] confirm. There will be no reinvestment, substitution, discretionary trading or discretionary sales. After closing, assets that are determined to be ‘credit risk’ securities will be sold by the Liquidation Agent within one year of such determination.”

2574

The Hudson Offering Circular repeated that information and added:

“The Liquidation Agent will not have the right, or the obligation, to exercise any discretion with respect to the method or the price of any assignment, termination or disposition of a CDS Transaction; the sole obligation of the Liquidation Agent will be to execute such assignment or termination of a CDS Transaction in accordance with the terms of the Liquidation Agency Agreement. … [T]he Liquidation Agent shall have no responsibility for, or liability relating to, the performance of the Issuer or any CDS Transaction, Reference Obligation, Collateral Security or Eligible Investment.”2575

Goldman charged a 10 basis point ongoing fee for serving as the Hudson Liquidation Agent,2576 which resulted in its being paid a total fee of approximately $3.1 million.2577

While Goldman was marketing Hudson in 2007, a client asked why the liquidation agent

was “afforded up to 12 months to sell a credit risk asset.” Goldman’s contemporaneous response, but when asked the same question, Darryl Herrick, the Hudson deal captain, told the Subcommittee that there was “headline risk” associated with the downgrade of an asset, and twelve months gave Goldman “flexibility to try to get a better price later.” against discretionary trading by the liquidation agent, Mr. Herrick said that Goldman had

When asked whether the “flexibility” to delay a sale violated Hudson’s prohibition

The Subcommittee was unable to find

2578

2579

2573 2574 2575 2576 2577 2578 2579

10/2006 “Hudson Mezzanine 2006-1 Flipbook,” GS MBS-E-009546963, Hearing Exhibit 4/27-87. Goldman Sachs Hudson Mezzanine Funding 2006-1, LTD Preliminary Termsheet, GS MBS-E-001557869. 12/3/2006 Hudson Mezzanine 2006-1, LTD. Offering Circular, GS MBS-E-021821196 at 234. 10/2006 “Hudson Mezzanine 2006-1 Flipbook,” GS MBS-E-009546963, Hearing Exhibit 4/27-87. See Goldman Sachs response to Subcommittee QFR at PSI_QFR_GS0239. 10/6/2006 email from Michael Halevi to Olivia Ha, GS MBS-E-014338525. Subcommittee interview of Darryl Herrick (10/13/2010).

“discretion based on a rule,” and that the liquidation agent provisions had been vetted with the credit rating agencies which “probably wanted the deal to avoid forced sales.”

2580

579

Failure to Liquidate. In July 2007, after the credit rating agencies began the mass

downgrades of RMBS securities, the first RMBS securities underlying the Hudson CDO lost their investment grade ratings, and the CDS contracts referencing those assets qualified as Credit Risk Assets requiring liquidation. Hudson assets qualified as Credit Risk Assets. begun issuing bids to sell the assets at the best possible price and remove them from the Hudson CDO, but it did not.

Within three months, by October 15, 2007, over 28% of the

As liquidation agent, Goldman should have

2582

2581

In October 2007, Goldman began to contact Hudson investors to discuss transferring its

liquidation agent responsibilities to a third party. That transfer required investor consent. Benjamin Case took notes of two telephone conversations he had with a Hudson investor, National Australia Bank (NAB), discussing the issues. In the calls, Mr. Case explained why Goldman had yet to liquidate any of the Credit Risk Assets, explaining that Goldman was waiting for asset prices to improve. transaction that would extend the maximum liquidation period, as well as make other structural changes to the Hudson deal.

He also reported that Goldman was considering an amendment to the Hudson

2583

2585

2584

According to his notes, Mr. Case informed NAB that Goldman was seeking to transfer its

liquidation role to a third party with more liquidation experience, because that change:

“will be in the best interest of investors – the credit obligation term was originally written with the expectation that was unlikely to happen. … Good for several reasons:

Large institutional assets manager will be able to access more liquidity b/c [because] they can access other broker dealers and get good pricing[.]

Id. Mr. Herrick was not employed by Goldman when its CDO assets were downgraded and triggered its

1/3/2008 email from Shelly Lin to Mr. Sparks, GS MBS-E-021880171 (attached file, “Deal Summary,” GS

Id. at 2. The notes included the following: “[C]urrent distressed nature of the assets has been fully priced in and

Id. 10/15/2007 email from Naina Kalavar, “NAB/Hudson Mezz Update 2,” GS MBS-E-015738973. Mr. Case used

2580 liquidation agent duties.
2581 MBS-E-021880172). 2582 2583 this email to circulate his notes of the two telephone conversations. 2584 has not moved over the past 2 months – if unwound those cds would be at 80-90 points, that is % points to be paid up front to unwind swap – equiv of 20 cents to dollar in cash bond terms … Across entire universe of loans already in liquidation – been generally se[e]n 50-60-70 % recovery rates. Rates are not coming back high enough to make the market opt[i]mistic that bonds will come back to recover princi[pal]. … Our view that there is upside in waiting an[d] evaluating mtkt conditions before liquidating. … We think that the shorts may get impatient – minor rallies from short covering – domino effect/momentum creates a rally b/c shorts get nervous at little rally – this provides potential upside to waiting to liquidate.” 2585

Id. at 3. Such an amendment would require investor consent.

580

Even keeping the deal the way it is, the decision of when in the 12 month period to liquidate could be better handled by an experienced manager[.]
Potential amendment could be made to benefit the deal by giving more flexibility to agent.”2586

These notes indicate that, although Goldman was the architect of the Hudson CDO and selected itself to serve as liquidation agent at a fee of $3.1 million, when Goldman was called upon to execute its role, it believed the decision of when to liquidate the impaired assets “could be better handled by an experienced manager.”

According to Mr. Case’s notes, NAB sent Mr. Case an email asking if Goldman held any of

the Hudson investments: “does GS hold any of this?” Mr. Case responded:

“def own equity and different pieces of various tranches no [sic] exactly, but decent size and numbers of cl[a]sses on our books.”2587

Mr. Case apparently did not disclose that, in addition to its $6 million equity tranche, Goldman also held 100% of the short position in the $2 billion CDO, and that its short investment would increase in value as the Hudson assets lost value.

2588

According to Mr. Case’s notes, NAB replied by asking Goldman to provide more specific information about Goldman’s holdings in the transaction: “Could you please follow up with what Goldman holds?” When Mr. Case asked why NAB wanted that information, NAB responded: “Want to make sure you [Goldman] are making restructuring decisions for the right reasons – make sure serving the right interests.” According to his notes, Mr. Case replied: “Our intended goal of liquidation agent is to serve the best interests of the CDO – that is the duty of the liquidation agent – it is a policy and process.”2589

In November 2007, Goldman took initial steps to transfer its liquidation agent

2590

2591

responsibilities to a third party. At that point, Goldman had yet to liquidate any of the Hudson Credit Risk Assets. The nine assets that had become Credit Risks in July had already dropped significantly in value. One asset which, on July 16, had a value of 61% of its face (par) value, had fallen by November 1 to 16% of par. Another asset that, on July 16, had a value of 43% of par, had fallen in value by November 1 to 7% of par.

2592

2593

10/15/2007 email from Naina Kalavar, “NAB/Hudson Mezz Update 2,” GS MBS-E-015738973. Id. at 75. Id. at 76. Id. 11/9/2007 email from Mr. Case to Mr. Lehman, GS MBS-E-021876334. 2/29/2008 letter from Morgan Stanley to Goldman, HUD-CDO-00006877. Reference asset OOMLT 2006-2 M8. See 1/3/2008 email from Shelly Lin to Mr. Sparks, GS MBS-E-

2586 2587 2588 2589 2590 2591 2592 021880171 (attached file, “Deal Summary,” GS MBS-E-021880172). 2593 021880171 (attached file, “Deal Summary,” GS MBS-E-021880172).

Reference asset MSAC 2006-WMC2 B3. See 1/3/2008 email from Shelly Lin to Mr. Sparks, GS MBS-E-

581

At the end of November, Goldman reached an agreement with Trust Company of the West (TCW), subject to investor approval, in which Goldman would assign its liquidation agent duties to TCW, and TCW would “share back” 30% of the fees with Goldman. Subcommittee that Goldman’s decision to assign the liquidation agent rights to a third party was because liquidation was a non core business for Goldman, and TCW was better suited to liquidate the Credit Risk Assets. approval to assign the liquidation agent role to TCW, a Goldman representative explained to an investor the firm’s thinking:

On December 18, 2007, while Goldman was still seeking investor

Mr. Lehman told the

2594

2595

“GS [Goldman Sachs] is soliciting consent to assign GS role as liquidation agent to TCW bec[ause] when liquidation agent role was designed, it was very ‘out of the money’; now when the risk is very real, it is much more efficient to have a sophisticated collateral manager bec[ause] (i) TCW can access better liquidity than GS, ie get bids from the entire street (ii) real asset manager can pursue further amendments to the doc to make liquidation more efficient bec[ause] is not an asset [manager] under the investment act in 1940 and cannot act [sic] investment advisory services and can’t act with optimal discretion.”2596

On December 19, 2007, Morgan Stanley, the largest Hudson long investor with a $1.2

billion interest encompassing the entire super-senior tranche, to assign the liquidation agent rights to TCW. declined to consent to the transfer, because the liquidation agent role was ministerial, had no discretionary authority, and could quickly and easily be accomplished by Goldman. Stanley told the Subcommittee that it instead asked Goldman to begin liquidating the $596.5 million in Credit Risk Assets immediately, some of which had been designated as Credit Risks for five months, and all of which had declined in value.2600

was presented with a consent form Morgan Stanley told the Subcommittee that it had

Morgan

2599

2597

2598

On January 3, 2008, Daniel Sparks, the Mortgage Department head, was given a

spreadsheet listing the Credit Risk Assets in each of the CDOs in which Goldman was serving as the liquidation agent, including Hudson 1. The spreadsheet showed that, in Hudson, 44 assets were Credit Risks with a face value of $635 million, totaling about 30% of the asset pool.

2601

[SEE CHART NEXT PAGE: Credit Risk Assets, prepared by Goldman Sachs.]

See 11/29/2007 email from Mr. Case to Mr. Sparks, Mr. Lehman, and others, GS MBS-E-021876502. Subcommittee interview of David Lehman (9/27/2010). 12/18/2007 email from Lira Lee to [investor], GS MBS-E-021878556. See discussion of Hudson 1, above. 12/19/2007 email from Mr. Case to Nicole Martin of Morgan Stanley, GS MBS-E-021876172. Subcommittee interview of Morgan Stanley (8/6/2009). Id.
1/3/2008 email from Shelly Lin to Mr. Sparks, GS MBS-E-021880171 (attached file, “Deal Summary,” GS

2594 2595 2596 2597 2598 2599 2600 2601 MBS-E-021880172).

Credit Risk Assets (%)

35.00%

I Anderson • Hout Bay II Hudson High Grade

II Hudson Mezz 1

II Hudson Mezz 2

30.00% (,J c: 25.00% nI nI In G) I/) I/) <C

20.00%
15.00% c: e … () … 0 :::l 10.00%

~ 0

5.00%

0.00%

7/1/2007

7/31/2007

8/30/2007

9/29/2007 10/29/2007 11/28/2007 12/28/2007

Date

583

The spreadsheet also showed that the weighted average values of the Hudson assets had fallen dramatically, causing losses that could have been avoided had Goldman liquidated them sooner. The weighted average values had fallen from 45% of face (par) value in July, to a low of 15% on November 1, 2007, and were about 20% of par value on January 2, 2008.

2602

[SEE CHART NEXT PAGE: Weighted Average Levels, prepared by Goldman Sachs.]

Hudson Conflict of Interest. Despite the falling values and Morgan Stanley’s ongoing

request to initiate liquidation of the Credit Risk Assets as set out in the Hudson 1 agreement, Goldman still did not begin liquidating.

During January and February 2008, Morgan Stanley engaged in frequent communications with Goldman personnel, including Mr. Lehman who oversaw Goldman’s CDOs, and Mr. Case who oversaw the liquidation agent function, to initiate liquidation of the Hudson assets. The falling value of the Hudson assets caused sharp losses in Morgan Stanley’s $1.2 billion investment, leading Morgan Stanley to press for the Credit Risk Assets to be liquidated and removed from the CDO as soon as possible. In contrast, as the Hudson assets fell in value, Goldman, as the CDO’s sole short party, saw its short position become increasingly profitable. Goldman had little financial incentive to liquidate the Credit Risk Assets, because the more they fell in value, the more Goldman was able to maximize the profits from its short position in the CDO. Goldman’s dual roles as liquidation agent and short party, thus, created a conflict of interest that disadvantaged the long investors in the Hudson CDO, such as Morgan Stanley.2604

2603

Id. See, e.g., 1/16/2008 email from Nicole Martin to Mr. Lehman, GS MBS-E-022164848. Due to the extensive losses experienced by Hudson 1, by January 2008, Morgan Stanley was likely the only long

2602 2603 2604 investor whose investment was not completely extinguished.

Weighted Average Levels

60.00%

50.00%

40.00%

~ 30.00% oJ

20.00%

10.00%

0.00%

I Anderson

• Houl Bay o Hudson High Grade II Hudson Mezz 1

II Hudson Mezz 2

7/16/2007

8/15/2007

9/14/2007

10/14/2007 Date

11/13/2007

12/13/2007

585

Morgan Stanley personnel expressed increasing frustration with Goldman’s failure to liquidate the Hudson Credit Risk Assets, in both internal communications and with Goldman representatives. On January 16, 2008, for example, the key trader on Morgan Stanley’s Proprietary Trading Desk dealing with Hudson wrote to a colleague: “Had another call with [Goldman’s] sr. trader about GS’s liquidation agent role in the $1.2bn HUDSON deal. They insist they are NOT acting as a fiduciary per the docs in this deal.” On February 5, he sent Mr. Lehman an email: “[P]lease call when possible – $969mm now eligible to be liquidated post S&P do[w]ngrades.” 2606

2605

On February 6, the Morgan Stanley trader wrote to a colleague:

“[W]ent down the road with Goldman on liquidation agent assets (now ~$1bb of eligible assets post downgrades). They told me they will ‘continue to take my opinion under advisement’ but provided no course of action. I broke my phone. Will talk to [Morgan Stanley legal counsel] tomorrow but don’t think there is any probable way for us to force them to liquidate assets.”

2607

On February 7, the Morgan Stanley trader sent another email to Mr. Lehman:

“Spoke with Ben [Case] re: Hudson today. Goes without saying I remain very frustrated by the way GS is handling the liquidation agent role. There is almost $1bb of eligible assets in that deal now, every one of which has lost value since it was downgraded. No good reason to wait other th[a]n to devalue our position. It’s a shame …. [O]ne day I hope I get the real reason why you are doing this to me.”2608

According to Morgan Stanley, Goldman continued to explain its seven-month delay in

liquidating the Credit Risk Assets by asserting that the market would rebound during a rally to cover shorts, and it should wait to liquidate until asset prices rose. In a February 13, 2008 telephone call between Morgan Stanley and Goldman, for example, which was recorded and transcribed, Mr. Case stated:

“So I think, as we see the short covering wave kind of continue to proceed … it’s gonna get to the point where it’s in the best interest of the deal to start liquidating then. … I know we’ve talked about this twelve month period … it doesn’t seem like it’s gonna take till late in the twelve month process for the majority of these assets to get to that point.”2609

Morgan Stanley asked if there was anything beyond the “technical nature of the markets,” such as government intervention, to produce “any kind of real pop” that would improve the underlying

1/16/2008 email from John Pearce of Morgan Stanley to Michael Petrick, HUD-CDO-00004851. 2/5/2008 email from Mr. Pearce to Mr. Lehman and Nicole Martin, HUD-CDO-00004852. 2/6/2008 email from Mr. Pearce to Michael Petrick, HUD-CDO-00005146. 2/7/2008 email from Mr. Pearce to Mr. Lehman, HUD-CDO-00005147. Transcript of 2/13/2008 telephone call between Morgan Stanley and Goldman, HUD-CDO-00006894. See also

2605 2606 2607 2608 2609 2/28/2008 email from Sue Fertel-Kramer to Mr. Case and others, GS MBS-E-021881029.

586

fundamentals in the mortgage market. Mr. Case responded: “The chance that it could move in that direction, at least in the next few months . . . is de minimis I’d say.” Stanley’s representative again urged Goldman to begin the liquidation process: “Just so you know, my opinion stays the same, I’d like to see a bid list before three o’clock today.”2611

During the call, Morgan

2610

Morgan Stanley told the Subcommittee that the Hudson assets had been in near continuous

decline, and Goldman’s refusal to liquidate assets shortly after they became Credit Risk Assets allowed them to decline further, rather than limiting losses for bondholders. By February 21, 2008, Morgan Stanley had calculated that the liquidation delay had cost it $130.5 million; the next week it calculated the losses had increased to $150 million.

2612

Morgan Stanley told Goldman that by delaying the liquidation of the Credit Risk Assets,

Goldman was in violation of the terms in the Hudson 1 offering circular, in particular the provision: “The Liquidation Agent will not have the right, or the obligation, to exercise any discretion with respect to the method or the price of any assignment, termination or disposition of a … Credit Risk Obligation.” immediately initiate liquidation of $1 billion in Hudson Credit Risk Assets:

On February 29, 2008, Morgan Stanley sent Goldman a letter demanding that it

2613

“As Liquidation Agent, [Goldman] is currently responsible for liquidating approximately $1,000,000,000 of Credit Risk Obligations. The transaction documents clearly state that [Goldman] would not exercise investment discretion in its role as Liquidation Agent. [Goldman] has not yet liquidated a single Credit Risk Obligation, notwithstanding that some date back to August of 2007. The [Goldman] employee handling the liquidation has explained this by stating that he believes the price for these obligations will increase in the future and it is better for the deal to liquidate these obligations at a later date. …

The Liquidation Agency Agreement states that “the Liquidation Agent … shall not provide investment advisory services to the Issuer or act as the “collateral manager” for the Pledged Assets. …

While the Liquidation Agency Agreement provides that the Liquidation Agent must complete the process of liquidating the relevant assets within twelve months, it does not provide the Liquidation Agent with any right to delay the liquidation process based on the exercise of Investment discretion. To the contrary, the Liquidation Agency Agreement and the [Offering Circular] clearly state that no discretion or investment advisory services are ever to be provided by the Liquidation Agent.”2614

Transcript of 2/13/2008 telephone call between Morgan Stanley and Goldman, HUD-CDO-00006894.
Id. 2/21/2008 email from Vanessa Vanacker to Mr. Pearce, HUD-CDO-00004882. 2/29/2008 letter from Morgan

2610 2611 2612 Stanley to Goldman, HUD-CDO-00006877. 2613 Transactions by the Liquidation Agent Under Certain Circumstances,” GS MBS- E-021821196 at 241. See 2/29/2008 letter from Morgan Stanley to Goldman, HUD-CDO-00006877. 2614

12/3/2006 Hudson Mezzanine 2006-1, LTD. Offering Circular, section entitled, “Disposition of CDS

2/29/2008 letter from Morgan Stanley to Goldman, HUD-CDO-00006877 [emphasis in original].

587

Morgan Stanley concluded by “demanding only that [Goldman] fulfill its contractual duties as required by the Liquidation Agency Agreement and assign, terminate or otherwise dispose of the relevant CDS transaction forthwith.”

On March 10, 2008, Goldman responded:

“[Y]our letter is entirely mistaken in its suggestion that Goldman Sachs has somehow breached its obligations under the Liquidation Agency Agreement. As [Morgan Stanley’s] letter recognizes, Section 2(b) of the Liquidation Agency Agreement specifically provides that Goldman, acting as Liquidation Agent, has up to twelve months in which to assign, terminate or otherwise dispose of Credit Risk Obligations assigned to it for that purpose. Obviously, establishment of a liquidation period of that duration contemplates – and, indeed, embodies Hudson’s informed consent – that the Liquidation Agent will necessarily exercise judgement in determining when and how to dispose of Credit Risk Obligations assigned to it for that purpose. …

Nor does this expressly intended contractual latitude transform Goldman Sachs into a de facto ‘investment adviser’ to Hudson, as you suggest. The Agreement … in fact categorically disclaims that Goldman Sachs or its affiliates will be providing investment advisory services or otherwise acting as an adviser or fiduciary to Hudson by virtue of its liquidation services. That disclaimer is perfectly consistent with discretion routinely accorded to securities brokers in seeking to fulfill their obligation to obtain the best execution possible for their clients without making them ‘investment advisors.’” 2615

Several days before Goldman’s response letter was sent to Morgan Stanley, however, Goldman began liquidating the Credit Risk Assets in Hudson 1. On March 7, 2008, Goldman liquidated eight assets, followed by more on March 20 and 28, liquidating nearly one third of the eligible assets over the course of the month. In its role as liquidation agent, Goldman was required to solicit bids from at least three independent dealers for the Credit Risk Assets, and Morgan Stanley was given an opportunity to bid on many of the liquidated assets. proceeded over the next two months, from April through June. realized losses exceeded $800 million, and Hudson 1 went into default. Hudson’s remaining assets

On July 22, 2008, Hudson’s

Liquidation

2618

2616

2617

3/10/2008 letter from Goldman to Morgan Stanley, HUD-CDO-00006881. The letter also states: “Morgan

See 3/27/2008 email from Morgan Stanley to Goldman, HUD-CDO-00004378. On March 24, 2008, Goldman

2615 Stanley’s lack of standing even to advance many positions that are within the exclusive province of Hudson, and the preclusive effect on Morgan Stanley’s contentions of the Agreement’s broad exculpation and conflict waiver provisions provide sufficient response.” 2616 offered to unwind the Hudson 1 trade with Morgan Stanley by paying it 9% of the face (par) value of the Hudson securities. 3/24/2008 email from Goldman to Morgan Stanley, GS MBS-E-022012805. 2617 from Mr. Case, GS MBS-E-021880596. 2618 Dispositions of Assets,” HUD-CDO-00003155.

See, e.g., 3/27/2008 email from Morgan Stanley to Goldman, HUD-CDO-00004378. See also 3/20/2008 email

See 6/6/2008 letter from Goldman as liquidation agent, “Hudson Mezzanine Funding 2006-1, Ltd. - Certain

588

were liquidated in November 2008. Morgan Stanley’s losses from its Hudson investment exceeded $930 million.2619

Analysis. In several of the CDOs it constructed, Goldman established a new position of

liquidation agent and appointed itself to play that role for a substantial fee. In the case of Hudson 1, by taking on the role of liquidation agent at the same time it was the sole short party in the CDO, Goldman created a conflict of interest. When the Hudson 1 assets began falling in value, the long investors wanted the poorly performing assets liquidated as soon as possible; Goldman, on the other hand, benefitted financially the farther the assets fell in value since that allowed Goldman to maximize the value of its short position.

Goldman delayed liquidating the Credit Risk Assets, despite urgent requests from the largest Hudson investor, Morgan Stanley, placing its own financial interests ahead of the client to whom it had sold a $1.2 billion Hudson investment.

BB. Collateral Put Provider in Timberwolf

The second example of a conflict of interest affecting how Goldman carried out a CDO administrative function involves Goldman’s role as the collateral put provider in Timberwolf I. Synthetic CDOs like Timberwolf collected cash from the long investors that purchased its securities as well as from the short parties that paid CDS premiums to the CDO. A portion of the cash collected from the long investors was placed by the CDO into a “default swap collateral account” to be used if the CDO performed poorly and payments had to be made to the short parties. At one time, many CDOs used the cash in the default swap collateral account to purchase Guaranteed Investment Contracts (GICs), which guaranteed repayment of the principal and a fixed or floating interest rate for a fixed period of time. But in the years leading up to the financial crisis, CDO issuers sought to use the cash in the default swap collateral account to make investments that generated higher returns, in order to improve financial performance, obtain better credit ratings, and attract investors. To obtain those higher returns, CDO issuers began to invest the incoming cash in “default swap collateral securities.”

2620

Goldman’s synthetic CDOs generally invested in default swap collateral securities, and its CDO agreements typically set out parameters for the types of default swap collateral securities that could be purchased with investor funds, often requiring them to be high quality, low risk, liquid

2619 See 11/21/2008 letter from Goldman to Morgan Stanley, HUD-CDO-00005125. 2620 The amount of assets in the default swap collateral account was required to equal the total face (“notional”) value of the CDS entered into by the CDO. This arrangement provided assurance to the short parties that funds would be available if and when payments were due to them under the CDS. CDO agreements often required that the cash placed in the default swap collateral account be kept in very secure, short term, cash-like instruments such as Treasury notes or Certificates of Deposit (called “Eligible Investments”) until the cash was used to acquire default swap collateral or make payments to a short party. If any credit event resulted in payments from the default swap collateral account to the short parties under the CDS contracts, the long parties might not receive all of their principal investment at the maturity of the deal.

589

2621

investments. If the CDO had a collateral manager, the manager often selected the CDO’s default swap collateral securities. The returns earned by the default swap collateral securities often became an important component of the CDO’s income. The principal proceeds of the default swap collateral securities were typically re-invested in similar securities until the CDO matured or the proceeds were needed to make payments to short parties.

Goldman’s Dual Roles. In its synthetic CDOs, Goldman often took on two roles that

2622

and its collateral put provider. Goldman’s synthetic CDOs typically followed

affected the default swap collateral securities, acting as both the CDO’s primary CDS counterparty industry practice by making one entity the sole counterparty for all of the CDS contracts issued by the CDO. In Goldman CDOs, that party was generally Goldman Sachs International (GSI), a United Kingdom subsidiary that was wholly owned by Goldman. Typically, GSI was the sole party that entered into a CDS contract directly with the domestic and offshore companies that served as the issuers of the CDO’s securities (hereinafter collectively referred to as the “Issuer”). then acted as an intermediary for the Issuer by entering into a corresponding CDS contract with each party seeking to take a short position in the CDO. By inserting itself into the middle of the CDS transactions, GSI put Goldman’s financial standing behind the CDS contracts issued by the Issuer and improved the credit ratings assigned to and investor confidence in the CDO. If a credit event later took place, the Issuer was responsible for making payments to GSI, and GSI, whether or not it received sufficient payments from the Issuer, was responsible for making the payments owed to the short parties in the corresponding CDS contracts. Sometimes, instead of contracting with a third party, GSI kept some or all of the short positions in the CDO on behalf of Goldman itself.

GSI

2623

By acting as the primary CDS counterparty, GSI necessarily took the short side of each CDS contract it entered into with the Issuer. Those CDS contracts typically provided that, in the event of a specified credit event that required payment to GSI, GSI could collect a specified amount of funds from the Issuer. The Issuer paid its obligations to GSI by first drawing down any available cash in the default swap collateral account. If that cash was insufficient, GSI also had the right to identify one or more of the default swap collateral securities that together had a face (par) value equal to the amount owed to GSI. Those securities could then be sold and the sale proceeds used to

The parameters governing the type of default swap collateral securities that could be purchased with investor

2621 funds were generally outlined in the CDO agreement documents and offering memorandum. Typical criteria included: a AAA credit rating; a yield slightly greater than LIBOR; limitations on the maturation dates of the securities; and limited exposure to a single counterparty. Generally, the CDO agreement required that some of the default swap collateral be retained in Eligible Investments in order be able to fulfill any obligations or payments due in the short term. In CDOs reviewed by the Subcommittee, the default collateral securities were sometimes RMBS or CDO securities bearing AAA ratings. These securities often lost substantial value which the collateral put provider then had to absorb. 2622 3/27/2007 Timberwolf I, LTD. Indenture Agreement, at § 12.5(b), GS MBS-E-021825583 at 711. 2623 Typically a shell company incorporated in a foreign jurisdiction (often the Cayman Islands) and a shell company incorporated in the United States (often Delaware) served as the “Issuer” and “Co-Issuer,” respectively of the CDO. Generally, the financial institution that was underwriting the CDO, in this case Goldman, would arrange for the establishment of those entities. For simplicity, this section will refer to both companies as the “Issuer” of the CDO securities.

The Timberwolf Indenture agreement referred to this role as the “Synthetic Security Counterparty.” See

590

satisfy the amount owed to GSI under the CDS contracts. received from the sale proceeds to pay off the short parties in the corresponding CDS contracts. Since GSI’s financial obligations under the CDS contracts were dependent in part upon the quality of the default swap collateral securities, Goldman provided in the CDO agreement that those securities could be purchased only with the prior “consent” of GSI. This arrangement enabled Goldman to exert control over the selection of the default swap collateral securities.

GSI would then use the cash it

2624

In addition to acting as the primary CDS counterparty in the CDOs it constructed, Goldman often acted as the CDO’s default swap collateral put provider (hereinafter “collateral put provider”). The collateral put provider essentially guarantees the face (par) value of the CDO’s default swap collateral securities.2625

Since GSI was already acting as the primary CDS counterparty, the CDO indenture

agreement typically provided that, if the market value of any default collateral security selected by GSI to satisfy an amount owed to GSI fell below its face (par) value, then GSI suffered the market risk, and could not recover additional funds from the Issuer to make up for the security’s loss in value. GSI was still responsible, however, for making full payments to the short parties in the corresponding CDS contracts. This arrangement functioned effectively as a “put” agreement that guaranteed the face (par) value of the default swap collateral securities, and Goldman treated the arrangement as a put agreement.

Due to the dual roles played by GSI in its CDOs, many of Goldman’s CDO indenture

agreements did not contain an explicit put agreement, but simply constructed GSI’s CDS contracts to include the provisions that achieved the same result. For example, the Timberwolf Indenture agreement specified that the primary CDS counterparty in its CDS contract – GSI – bore the market risk associated with any default swap collateral sold to satisfy an obligation to that counterparty.

2626 In exchange for bearing the risk of not receiving the full payment owed to it from the sale of the default swap collateral securities, GSI received a discount – typically equal to 5 basis points – on the premiums GSI paid to the Issuer under the primary CDS contract. In a CDO deal of $1 billion, the premium discount would yield a “fee” of approximately $500,000. In most cases, however,

2627

Another option was for Goldman to take physical possession of the security. In a typical put agreement, the put provider guarantees to pay to the put purchaser the face (par) value of a

2624 2625 specified security upon delivery of the security, or pay to the put purchaser the difference between the security’s par value and actual market price when sold. In exchange for that protection, the put purchaser typically pays a fee to the put provider. In many of the CDS contracts associated with synthetic CDOs, as described above, GSI fulfilled the role of a put provider, by absorbing any shortfall between the face (par) value and market price of any default swap collateral securities sold to pay amounts owing to the short party in the CDS contract. 2626 accounting purposes, Goldman established a CDO Put Reserve, to account for potential losses that might result from its role as a collateral put provider in CDOs. 2627 Any subsequent losses resulting from Goldman’s role as the collateral put provider would reduce the profit resulting from that fee. In responses to Subcommittee questions for the record regarding 7 CDOs (Fort Denison, Camber 7, Timberwolf, Anderson Mezzanine, Point Pleasant, Hudson Mezzanine 2006-1, and Hudson Mezzanine 2006-2), Goldman reported that for most of the CDOs, the net profit was less than $500,000. One exception was Hudson Mezzanine 2006-1, which yielded a profit of approximately $1 million. See Goldman response to

See 3/27/2007 Timberwolf I, LTD. Indenture Agreement, at § 12.5(b), GS MBS-E-021825583 at 712. For

591

the CDO indenture agreements did not specifically cite the connection between GSI’s bearing the market risk of the default swap collateral sales and receiving a CDS premium discount. The CDO agreements simply included a reduced premium payment by GSI under the primary CDS contract with the Issuer.

2628

Timberwolf Conflict of Interest. In the Timberwolf CDO, GSI acted as both the primary

CDS counterparty and the collateral put provider. Documents provided to the Subcommittee show how these dual roles created a conflict between Goldman and the Timberwolf long investors, and how Goldman reacted by placing its interests before those of the clients to whom it had sold the Timberwolf securities.

In 2007, as the mortgage market deteriorated, the value of many types of default swap collateral securities also declined. Goldman became concerned that if the market value of the securities fell below par and a credit event occurred, those securities would provide insufficient funds to pay the amounts owed to GSI under its primary CDS contract with the Issuer. In addition, Goldman knew that the more the default swap collateral securities fell in value, the more of a shortfall Goldman would have to make up if GSI had to make payments to other short parties. Goldman wanted to maximize the value of the default swap collateral and what would be available

Subcommittee QFR at PSI_QFR_GS0249. For another CDO, Broadwick, Goldman also projected that the premium discount would yield a profit of more than $1 million, less any costs it might have to absorb in its role as put provider. See 4/12/2006 email from Peter Ostrem to John Little and Robert Leventhal, GS MBS-E-010808964 at 66-67 (“Can we agree on how we want to treat P&L [profit and loss] on Peloton relative to the put swap? We expect P&L of over $1mm [million] for the 5bp [basis point] reduction in the CDS premiums. … I propose we separately book the put swap at close to zero (contingent MTM risk on 2 yr AAA diversified portfolio where Goldman retains selection optionality seems low), but we are open to booking 1bp in negative put cost (i.e., -$200k).”). In some other CDOs, the projected put fee was about $500,000. 2628 1 and Point Pleasant, Goldman received a direct fee for acting as the collateral put provider. Goldman representatives told the Subcommittee that, because the put fee was “embedded” in the CDS agreement in some of the CDOs, Goldman’s operations group sometimes overlooked and failed to “book” the profit and loss associated with those put arrangements. When this oversight was discovered in 2007, Goldman identified 18 CDO put arrangements that had not been identified and accounted for in Goldman’s books. See 6/28/2007 email from Carly Scales to Phil Armstrong and Steve Schultz, GS MBS-E-015192547:

Timberwolf used this reduced premium approach, but in a few other instances, such as Hudson Mezzanine 2006-

“Current Put Option Booking State: 22 Deals with the Put Option Feature 4 Deals that do have a Put Option Booked:

For these trades, Ops [the operations group] knew about the Put as there was a confirmation and a trade booked. … 18 Deals that do not have a Put option Booked:
For these deals, there was no mention of a Put at all at the time of closing. …
The Put option was embedded into the deal documents (Indenture, Offering Circular, etc – both of which are reviewed by outside counsel and GS legal as a normal course of business – but are not reviewed by Operations.)
For these trades, an intermediation fee was being taken on the CDS trades, but no specific Put was booked in our systems.
The original explanation from the desk was the intermediation fee was being taken for the risks associated with standing in between the Street and the deal with no mention of the Put.”

• C

•

to make all of the payments needed pursuant to Goldman’s own short positions as well as any payments it would need to make to other short parties.

592

In the late spring of 2007, Goldman began to closely monitor the value of the default swap

2629

2630

On June 20, 2007, Matthew Bieber, a Goldman

collateral securities in its synthetic CDOs. employee on the CDO Origination Desk and the deal captain of the Timberwolf CDO, sent an email to his colleagues requesting information on CDOs that Goldman had “significant exposure to in terms of default swap collateral.” Mr. Bieber identified 17 possible CDOs where the default swap collateral securities may have lost value and stated: “we need to get Dan [Sparks, the Mortgage Department head,] a list this morning.” the Subcommittee that he did not recall why he had sent it or why he had to deliver the list to Mr. Sparks that same day, but he said he did recall that the decline in the value of the default swap securities was an issue. In response to the email, Goldman employees associated with the various CDOs submitted lists of the existing default swap collateral securities with their par and market values.

When asked about this email, Mr. Bieber told

2631

2632

As the mortgage market worsened, Goldman’s attention to the value of the default collateral securities increased. On July 18, 2007, the Goldman Credit Department sent an email to Mr. Bieber indicating that Goldman had large, valuable short positions in six of the CDOs it had originated, but that the department needed to monitor the value of the default swap collateral securities in each CDO to understand Goldman’s “exposure” under the CDS contracts:

“From our discussion earlier today, we were able to verify the MTM [mark to market] exposures on the below CDOs against what we have in our credit systems (they are in fact as large as we mentioned). Our next step is understanding how the collateral pools are performing in each of the deals. Would you be able to give us a summary of the current marks and default writedowns for the below deals? This would help us in monitoring the collateralization in relation to our exposure from CDS.”

2633

The next day, July 19, 2007, Mr. Bieber informed David Lehman, who then oversaw

Goldman’s CDOs, that the Credit Department had asked the ABS Desk in the Mortgage Department to “mark” the value of all of the default swap collateral securities in the Goldman-originated CDOs

One reason Goldman was so concerned about the value of the default swap collateral securities was because

6/20/2007 email from Matthew Bieber to Goldman colleagues, GS MBS-E-001912772 (“Below are the deals I

2629 those securities included AAA rated RMBS securities whose values were declining in line with the entire mortgage market. 2630 recall us having significant exposure to in terms of default swap collateral. Who is responsible for each of the deals? We need to get Dan a list this morning. If there are any missing, please let me know.”). 2631 Hudson High Grade; Hudson Mezzanine 1; Hudson Mezzanine 2; Fortius I; Fortius II; Camber 7; Hout Bay; Point Pleasant; Timberwolf; Anderson Mezzanine; Altius I; Altius III; and Altius IV. 2632 2633 positions were: Hudson Mezzanine 1; Timberwolf; Camber 7; Hudson Mezzanine 2; GSC ABS Funding 2006-3G; and Anderson Mezzanine.

Subcommittee interview of Matthew Bieber (10/21/2010). 7/18/2007 email from Alfa Kiflu, GS MBS-E-001866507. The six CDOs in which Goldman had large short

Id. Mr. Bieber listed the following CDOs: Adirondack 1; Adirondack 2; Coolidge Funding; Broadwick;

593

to “get a sense of the MV [market value] supporting the deals[’] obligation to pay us, if necessary.”

2634

Later that same day, another Credit Department official sent an email message to Mr.

Lehman similar to the one that had been sent to Mr. Bieber:

“We understand that you are responsible for marking the collateral in relation to the below CDOs. Is that true? If so, can you please put us on your distribution list for these. We have some sizeable in the money swap positions (i.e. cdo owes GS) and Credit needs to monitor these positions vs. collateral market value.”2635

With respect to Timberwolf, on July 25, 2007, Fabrice Tourre, a Goldman employee on the Mortgage Department’s Correlation Trading Desk, circulated an internal Goldman analysis showing that the weighted average value or “mark” of Timberwolf’s default swap collateral securities had declined over 3%. Mr. Tourre suggested to his colleagues that as Timberwolf’s default swap collateral securities matured, the resulting cash proceeds should not be re-invested in new securities, but instead be retained as cash:

During the same period, the value of Goldman’s short position had increased.

2636

“We need to start monitoring MtM [mark to market value] of the CDS collateral for the Wolf, given how much in the money the CDS are - right now, average bid side for the AAA cash bonds is approx 96.89 - per Mahesh analysis below. Matt/Mehesh - maybe we should look at the collateral reinvestment provisions in this deal - ideally principal proceeds on the CDS collateral should not be reinvested but I guess Greywolfe [sic] has discretion on this, right?”2637

In response, Mr. Bieber noted that the same situation applied to all of Goldman’s CDOs; the declining value of the default swap collateral securities was increasing Goldman’s exposure, and a weekly monitoring program was being set up. He also noted that it would be difficult for Goldman to oppose re-investment of the cash proceeds from maturing securities across the board:

“CDS across all of our transactions are in the money. We’ve had conversations at length with credit regarding our exposure to the default swap collateral and are setting ourselves up for weekly monitoring/pricing of the default swap collateral across the cdo business.

“We have discretionary approval over default swap collateral, however, it will be difficult for us to take the non-reinvestment approach.”2638

2634 2635 2636 2637 2638

7/19/2007 email from Matthew Bieber to David Lehman, GS MBS-E-011178225. 7/19/2007 email from Patrick Welch, GS MBS-E-001866507. 7/25/2007 email from Fabrice Tourre, GS MBS-E-001989091. Id. Greywolf Capital was the collateral manager of the Timberwolf CDO. 7/25/2007 email from Matthew Bieber, GS MBS-E-001989091.

594

The next day, on July 26, 2007, the collateral manager of one of Goldman’s CDOs sought

approval to purchase some new default swap collateral securities. A Goldman employee responded: “We are going to pass on this bond. Given current market conditions, we’d like to keep some cash in the default swap collateral.” A few days later, after receiving more requests to approve the purchase of new default swap collateral securities, Mr. Bieber asked Mr. Lehman for a meeting to discuss how to proceed:

2639

“Have gotten several requests today for reinvestment (Greywolf on TWOLF and TCW on DS7 [Davis Square 7]). Would like to sit down this evening to discuss how we’re going to respond as this comes up.”

2640

In early August, Goldman conducted an internal analysis to assess the decrease in the return

to the CDOs if the default swap collateral was kept in cash rather than re-invested in securities. 2641 As expected, that analysis showed that using the cash in the default swap collateral account to buy new securities would yield a larger return and more money for the CDO investors. But buying new securities also meant that Goldman, as the primary CDS counterparty and collateral put provider, would bear the risk if those securities later declined in market value. If the securities’ market value fell below their par value, but had to be sold to make payments to the CDOs’ short parties, Goldman would have to absorb any shortfall in the course of making the required payments to the short parties. Goldman’s risk would be mitigated, however, if the default swap collateral was kept in cash, since cash is not subject to the same market fluctuation. The result was that Goldman benefitted more if the CDO default swap collateral was kept in cash, but the CDO investors benefitted more if the collateral was kept in securities. In short, what was best for Goldman clashed with what was best for the investors to whom Goldman had sold the Timberwolf securities.

2642

Subsequent documents show that Goldman placed its financial interests before those of the

CDO investors by taking actions to keep the CDO default swap collateral in cash, rather than securities. On August 21, 2007, Mr. Bieber sent an email to Mr. Lehman asking about what Goldman had decided regarding re-investment of the cash collateral: “Was there any further discussion over the past few days on what were going to be doing? With the 25th coming up, I suspect a bunch of managers are going to be looking to put cash to work.” responded: “Nothing further – I think our gameplan remains to build cash for now.” Mr. Bieber replied: “Ok. I think we should be proactive in letting managers know, then, rather than waiting for them to come to us for approval and then denying.” Mr. Lehman agreed.

Mr. Lehman

2643

7/26/2007 email from Shelly Lin, GS MBS-E-015232129. 7/30/2007 email from Matthew Bieber to David Lehman, GS MBS-E-001867239. See 8/6/2007 email from Connie Kang to David Lehman, GS MBS-E-001992556; 8/9/2007 email from Mahesh

2639 2640 2641 Ganapathy to David Lehman, Matthew Bieber, and Jonathan Egol, GS MBS-E-001930307; 8/12/2007 email from Mahesh Ganapathy to David Lehman and Matthew Bieber, GS MBS-E-001930343; 8/13/2007 email from Mahesh Ganapathy to Matthew Bieber, David Lehman, and Jonathan Egol, GS MBS-E-001930571. 2642 the same securities could be obtained at a price lower than their par value, their yield (return on investment) increased as long as they continued to meet their scheduled principal and interest payments. This was another potential benefit to the long investors which conflicted with the interest of Goldman, the short party.
2643

In addition, since the yield of most default swap collateral securities was linked to their “face (par) value,” when

8/21/2007 email from Matthew Bieber to David Lehman, GS MBS-E-011273913.

595

Greywolf Objections. Over the next three or four weeks, Goldman continued to refuse to consent to the purchase of new default swap collateral securities by the collateral managers of its CDOs.

2644

At first, Goldman delayed telling Greywolf, Timberwolf’s collateral manager, what it had

decided. In late August and early September, Joseph Marconi, a Greywolf executive, former Goldman employee, and key member of the Greywolf team managing Timberwolf, sent Goldman several requests to buy new default swap collateral securities, without receiving a response. On September 6, 2007, a Goldman employee on the CDO Origination Desk forwarded one of the requests to Mr. Bieber with the comment: “Guess we can’t delay talking to him anymore.” 2645 Bieber informed Mr. Marconi that Goldman would no longer approve the purchase of additional default swap collateral securities for Timberwolf. When informed of Goldman’s decision, Mr. Marconi protested in an email to Mr. Lehman, who was Mr. Bieber’s supervisor:

Mr.

“David: I would like to have a call with you to discuss the purchase of Default Swap Collateral into Timberwolf. I understand you are traveling this week. Let me know when you will have some time to talk. In response to the attached message, Matt [Bieber] told me that GS will not approve the purchase of any additional Default Swap Collateral into Timberwolf. While GS does have consent rights regarding the purchase of Default Swap Collateral, a blanket refusal to approve any assets is inappropriate, inconsistent with the parties’ original expectations and will negatively impact the performance of both the debt and equity issued by Timberwolf. Give me a call when you can.”2646

When asked by Subcommittee what he meant when he wrote that “a blanket refusal to approve any assets is inappropriate, inconsistent with the parties’ original expectations and will negatively impact the performance of both the debt and equity issued by Timberwolf,” Mr. Marconi explained that if Goldman wouldn’t approve any new purchases as the default swap collateral securities matured, the CDO would have an increasing amount of cash on hand that would produce less income for Timberwolf than if that cash were invested in new securities.

2647

Later on September 6, 2007, Mr. Lehman telephoned and spoke with Mr. Marconi. Neither

he nor Mr. Marconi recalled exactly what was discussed, but the following day Mr. Marconi sent Mr. Lehman an email that repeated Greywolf’s objections to Goldman’s decision not to consent to the purchase of new default swap collateral securities:

See 9/21/2007 email from Marty Devote of Aladdin Capital Management to Benjamin Case, GS MBS-E

2644 022138816 (“We, at the direction of Connie and Roman [Goldman employees], have not been reinvesting CDS collateral as it matures. We’ve brought the topic up a few times over the past few months with your team. Last I heard, you were re-evaluating the market, and would come back to us with a breakdown of acceptable replacements. As the cash balances continue to grow, I’d like to address this issue, as the amount of cash drag is beginning to become meaningful.”). 2645 2646 2647

9/6/2007 email from Roman Shimonov to Matthew Bieber, GS MBS-E-000765873. 9/6/2007 email from Joe Marconi to David Lehman, GW 107909. Subcommittee interview of Joseph Marconi (Greywolf Capital) (10/19/2010).

596

“David: As we discussed yesterday, I believe that your refusal to approve the purchase of any additional Default Swap Collateral into Timberwolf is unreasonable and inconsistent with the way the transaction structure was originally presented to us. We were told that the purpose of the approval rights was to permit GS to review specific assets and approve or disapprove specific assets based on their relative credit merits. If we thought for a second that you had the right to prohibit all new purchases indefinitely, we would have implemented the much simpler GIC [Guaranteed Investment Contract] structure that is used in most other synthetic CDOs and CDO^2 transactions and thereby locked in a fixed spread to LlBOR for the term of our transaction. Also, the Timberwolf CDS economics include an ongoing fee to GS for the put swap component of the trade; we would not have agreed to those terms if we thought you had this option. Finally, I believe that if anyone on the deal team thought you had this option, it would have been clearly disclosed in the OM [Offering Memorandum]. Especially given current market conditions, I am surprised that you are taking a position that will directly result in less cash flow being available to debt and equity investors. As I said yesterday, we recognize the impact of current market conditions and, even before I spoke with Matt, I was suggesting we collectively focus on shorter average life AAA RMBS for the deal and I specifically solicited feedback on securities where GS would be comfortable. I continue to be surprised by your response.”2648

When asked by the Subcommittee why he sent such a strongly worded email to Goldman regarding its refusal to approve the reinvestment of Timberwolf’s cash collateral, Mr. Marconi responded: “We felt strongly about this. We had an obligation to investors to do the right thing.”2649

Mr. Marconi told the Subcommittee that Goldman had rationalized its decision by

contending that it was less risky to have more cash and fewer securities. Mr. Marconi also told the Subcommittee that Greywolf felt Goldman’s blanket refusal to approve the purchase of additional securities was inconsistent with the terms of the CDO, and if anyone at Greywolf had believed that Goldman possessed that authority, Greywolf would have structured the deal differently. addition, Mr. Marconi’s September 6 email pointed out that Goldman was receiving an “ongoing fee” to serve as the collateral put provider and undertake the risk of guaranteeing the par value of the default swap collateral securities. The email stated that Greywolf would not have agreed to pay that fee to Goldman if it had thought Goldman could use its approval authority to stop the purchase of all default swap collateral securities and mitigate the risk it was being paid to bear.

2650

The exchanges between Greywolf and Goldman brought into question the proper

interpretation of Section 12.5 of the Timberwolf Indenture agreement which required the CDO to purchase default swap collateral which satisfied certain criteria and which received the “consent” of and was not “objected to” by Goldman as the “Synthetic Security Counterparty.” The issue was

2651

9/7/2007 email from Joe Marconi to David Lehman, GW 107909. Subcommittee interview of Joseph Marconi (Greywolf Capital) (10/19/2010). Id. Section 12.5(b) of the Timberwolf Indenture agreement stated: “The Synthetic Securities shall be structured as

2648 2649 2650 2651 ‘pay-as-you-go’ credit default swaps. As part of the purchase of each Synthetic Security on or before the Closing Date, the Issuer will be required to purchase Default Swap Collateral which satisfies the Default Swap Collateral

597

whether that authority allowed Goldman to block the purchase of all default swap collateral securities and essentially limit the default swap collateral to cash. In a July 2007 email, Mr. Bieber wrote: “We have discretionary approval over default swap collateral, however, it will be difficult for us to take the non-reinvestment approach.” matter, Goldman’s legal counsel sent a written statement indicating the Indenture agreement authorized Goldman’s actions:

But when the Subcommittee asked about the

2652

“Section 12.5 of the Indenture for the Timberwolf CDO confers on the Secured Party the right to consent to the selection and reinvestment of default swap collateral. It is the position of Goldman Sachs that neither Section 12.5 of the Indenture nor any other relevant deal documents impose any obligation on the Secured Party to consent to reinvestment of default swap collateral, either on a case-by-case basis or generally.”2653

Goldman’s internal documents show that on September 7, 2007, the day after the email

exchange between Mr. Marconi and Mr. Lehman, Mr. Bieber scheduled a meeting with Goldman’s legal counsel and a key compliance officer to discuss the issue. His email stated:

“Pls see email we received below – wanted to get your take on what response (if any) we should craft. This is related to the default swap collateral account in Timberwolf used to collateralize the exposure we have to the CDO on the CDS contracts that are the assets in TWOLF.”2654

The meeting was scheduled for 1:15 p.m. that same day, copy of the Offering Memorandum and “the operative documents that contain our rights/obligations with respect to the Collateral.”

and one of the counsels requested a

2655

2656

The Subcommittee did not locate any documents recounting exactly what was discussed at the meeting. The default swap collateral issue involved a significant number of Goldman CDOs, affected Goldman’s relationships with investors and other financial firms serving as collateral managers of its CDOs, and entailed substantial financial risk for Goldman. Yet, when asked about

Eligibility Criteria set forth in the related Synthetic Security and the inclusion of which has been consented to by the Synthetic Security Counterparty in the amount required to secure the obligations of the Issuer in accordance with the terms of the related Synthetic Security which shall be in at least an amount equal to the Aggregate Reference Obligation Notional Amount. The Synthetic Security Counterparty shall have consent rights with respect to the Default Swap Collateral and no Default Swap Collateral objected to by the Synthetic Security Counterparty may be purchased by the Issuer. Default Swap Collateral shall be credited to the Default Swap Collateral Account. The amount payable by the Issuer to the Synthetic Security Counterparty under a Synthetic Security shall not exceed the Default Swap Collateral.” 3/27/2007 Timberwolf I, LTD. Indenture Agreement, GS MBS-E-021825583 at 711. 2652 2653 2654 021881077. 2655 2656

7/25/2007 email from Matthew Bieber, GS MBS-E-001989091. 1/7/2011 email from Goldman counsel to the Subcommittee. 9/7/2007 email from Matthew Bieber to Tim Saunders, Susan Helfrick, and Jordan Horvath, GS MBS-E-

Id. 9/7/2007 email from Susan Helfrick to Matthew Bieber, Tim Saunders, and Jordan Horvath, GS MBS-E-

598

it, the key participants said they could not recall whether the meeting took place, what was discussed at the meeting if it did take place, or what determinations were reached regarding Goldman’s authority or actions. The participants who could not recall the meeting included Mr. Bieber, the Timberwolf deal captain; Tim Saunders, counsel from Goldman’s legal department; Susan Helfrick, another legal counsel; and Jordan Horvath, the compliance officer. Mr. Saunders, the lead Goldman legal counsel on the matter, informed the Subcommittee that he had “no present recollection of the circumstances surrounding any disagreement between Goldman Sachs and Greywolf Capital Management LP regarding Goldman Sachs’ right to consent to reinvestment of default swap collateral in Timberwolf.” Subcommittee that he did not recall whether Goldman developed any specific strategy limiting the type of default swap collateral securities that could be purchased for its CDOs.2658

Mr. Bieber, the Timberwolf deal captain, told the

2657

However, documents obtained by the Subcommittee indicate that the meeting did take place, and Goldman did develop a strategy to respond to Greywolf’s concerns. On September 7, 2007, the same day as the meeting, Mr. Lehman sent a email to Mr. Bieber stating:

“U spoke w[ith] [Jonathan] egol? What ab[ou]t legal/compliance[?] Just make sure Dan [Sparks] is ok w[ith] it[.] Also I do th[in]k we sh[oul]d be consistent across deals . . . so if slmas and credit cards are ‘ok’ I th[in]k we tell our mgrs [managers] that . . . maybe 2 y[ea]rs and shorter.”2659

Mr. Bieber responded: “Spoke with legal/compliance. Not doing anything w/o [without] discussing with dan [Sparks] first. Agree with the point on consistency.”2660

Also on September 7, 2007, Jonathan Egol, head of the Mortgage Department’s Correlation Trading Desk, sent an email to Mr. Lehman and others suggesting that Goldman identify a narrow set of very safe asset backed securities that it could propose to Greywolf as possible default swap collateral securities, such as AAA rated securities backed by credit card receivables or student

Mr. Saunders, Ms. Helfrick, and Mr. Horvath provided signed statements to the Subcommittee to the same

2657 effect. See written statements submitted to the Subcommittee by Timothy Saunders (12/22/2010), Susan Helfrick (1/7/2011), and Jordan Horvath (1/7/2011). Although Mr. Lehman was not invited to the meeting, he told the Subcommittee that he generally recalled having discussions with his colleagues, including Goldman’s legal department, about the general issue of default swap collateral, but did not recall his conversation with Mr. Marconi. He also submitted a statement to the Subcommittee saying he had no recollection of whether the meeting took place or, if a meeting was held, what was discussed or decided. Written statement of Mr. Lehman (1/26/2011). Mr. Sparks, the head of the Mortgage Department, told the Subcommittee that while he had a general knowledge of the issue regarding default swap collateral securities, he had no recollection of any meeting or decisions made. Subcommittee interview of Daniel Sparks (1/13/2011). 2658 2659 to “slmas” is to asset backed securities that were issued by Sallie Mae and backed by pools of student loans. 2660

Subcommittee interview of Matthew Bieber (10/21/2010). 9/7/2007 email exchange between David Lehman and Matthew Bieber, GS MBS-E-000766414. The reference

Id.

2661

loans. to speak first with Mr. Sparks, head of the Mortgage Department.2662

Mr. Bieber sent an email the same day indicating he supported that approach, but wanted

599

Subsequent documents indicate that Goldman reversed its initial position and decided to

consent to the purchase of more default swap collateral securities. However, Goldman appeared to narrow the class of asset backed securities that it would consent to be acquired as default swap collateral. On September 10, 2007, Mr. Bieber sent an email to Mr. Lehman reporting:

“Managed to catch up with Dan [Sparks] just now … we’re going to put together a list of SLMA floaters in our inventory to show Joe [Marconi at Greywolf]. Going over w/ Dan tomorrow before sending anything externally.”

2663

Goldman also sent a short list of commercial mortgage backed securities (CMBS) in its inventory that it would consent to be acquired for Timberwolf.

2664

Over the next two weeks, Goldman sent a list of acceptable securities to two more collateral

2665

managers of its CDOs. On October 15, 2007, Mr. Bieber provided virtually the same list to a Goldman colleague together with a short explanation of some of the criteria used to identify the securities:

9/10/2007 email from Matthew Bieber to David Lehman, GS MBS-E-000765316. “SLMA” refers to asset

9/7/2007 email from Jonathan Egol to Michael Swenson and David Lehman, GS MBS-E-000765854.
See 9/7/2007 email from Matthew Bieber to David Lehman, GS MBS-E-000766414 (“I need to speak with

2661 2662 dan… we’re thinking about offering some 1-3 year SLMAs.”). 2663 backed securities that were issued by Sallie Mae and backed by pools of student loans. 2664 9/25/2007 email from Matthew Bieber to Joe Marconi, GS MBS-E-000766338. The action taken by Goldman to stop the purchase of new default swap collateral securities was not the only instance in which it attempted to exert control over the collateral in the CDOs it constructed. In the case of the Broadwick CDO, for example, when some investors were entitled to the return of some collateral, Goldman attempted to have the CDO pay them with securities rather than cash, so that the CDO would preserve the cash in its collateral account. The Broadwick collateral manager objected and complained in an email sent to Mr. Sparks, stating in part:

“In case I wasn’t clear on the call, our three main points would be:

The aim of the collateral account was to provide LIBOR and not add additional risk to the deal.
GS said they would take market risk and clearly represented that to us and to the ratings agencies.
The only way the deal works, and the way the deal was marketed and explained to us, is that paydowns are equivalent to partial terminations. We do not believe you have any right to refuse to release excess cash that is no longer needed as collateral, and we do not believe you have the right to release bonds into the waterfall ever, and certainly not when cash exists. Perhaps the way you did these deals changed over time and you are comparing our deal to ones which you marketed or structured later/differently? I look forward to hearing from you.”

Documents show that a list of assets was sent to Aladdin Capital Management and Trust Company of the West.

11/20/2007 email from Ron Beller to Matthew Bieber, GS MBS-E-013746516. 2665 See 9/24/2007 email from Benjamin Case to Marty Devote of Aladdin Capital Management, GS MBS-E 022138816; 9/20/2007 email from Matthew Bieber to Vincent Fiorillo of Trust Company of the West, GS MBS-E-022141026-

600

“Here are the shelves we’d like to use for default swap collateral reinvestment. RMBS: CBASS, GSAA, GSAMP, JPMAC, WFHET CARDS: AMXCA, BACCT, BOIT, MBNAS, CCCIT,CHAIT, DCMT AUTOS: COPAR, DCMOT, FORDO, HAROT, HDMOT, NALT, USAOT STUDENT LOANS: ACCSS, GCOE, KSLT, NCSLT, SLMA (FFELP)

In addition to the default swap collateral constraints in the docs for each transaction, also looking to securities that are (a) floating rate (b) monthly pay (c) senior-most bond in capital structure (d) avg life of less than or equal to 2 years (e) currently amortizing. Please let me know if you have any questions.”2666

All of the listed securities consisted of AAA rated securities backed by residential

mortgages, credit card receivables, automobile loans, or student loans, and had an expected maturity of two years or less. It appears as if Goldman was restricting the selection of default swap collateral securities to a limited list of assets that it believed were likely to maintain their par value in order to minimize its financial exposure.

After indicating it would allow these new purchases, Goldman maintained tight control over

the actual purchases made by the collateral managers. A September 27, 2007 email exchange between Mr. Marconi of Greywolf and Mr. Bieber of Goldman, for example, demonstrates Goldman’s intense monitoring effort:

Mr. Marconi: “Matt: I am seeing this list from another dealer. Can I assume that I can buy any name on your approved list?” … Mr. Bieber: “No-we need to give approval on a security by security basis.”

2667

When asked about these matters, both Mr. Sparks and Mr. Lehman characterized the default

swap collateral securities issue as a minor issue. Mr. Lehman informed the Subcommittee that he did not recall significant debate with collateral managers on the matter. difference between keeping the collateral in cash and investing in securities was minimal and characterized the whole issue as “structured finance gymnastics.” But information supplied by Goldman to the Subcommittee on seven Goldman-originated CDOs shows that, due to its duties as collateral put provider and the declining value of the CDOs’ default swap collateral securities, Goldman eventually lost over $1 billion.2670

Mr. Sparks said the yield

2668

2669

10/15/2007 email from Matthew Bieber to Matthew Verrochi, GS MBS-E-015732147. The list had one more

9/27/2007 email from Joe Marconi to Matthew Bieber, GW 108645. Written statement of David Lehman (1/26/2011). Subcommittee interview of Daniel Sparks (1/13/2011). The seven CDOs were Fort Denison, Camber 7, Timberwolf, Anderson Mezzanine, Point Pleasant, Hudson

2666 RMBS security than the lists sent to the collateral managers. 2667 2668 2669 2670 Mezzanine 2006-1, and Hudson Mezzanine 2006-2. Goldman lost $1.018 billion from acting as the collateral put provider for their default swap collateral securities. See Goldman response to Subcommittee QFR at PSI_QFR_GS0280.

601

Analysis. In its synthetic CDOs, Goldman arranged for its subsidiary, GSI, to act as both the primary CDS counterparty and the collateral put provider. Goldman also arranged for GSI to receive a fee for serving as the collateral put provider, through paying reduced premiums in connection with the CDS contracts it entered into with the CDOs. Despite this fee, Goldman took actions to evade its responsibilities as the collateral put provider, including by refusing to approve the purchase of new default swap collateral securities whose values might decline below par value. Instead, Goldman tried to force the CDOs to keep their collateral in cash. While this effort provided more protection for Goldman’s financial interest as the short party, it worked to the disadvantage of the CDO investors because it produced lower returns for the CDOs than the purchase of default swap collateral securities.

When the Timberwolf collateral manager objected, Goldman backed down and allowed the

purchase of a narrow range of very safe, short term asset backed securities as collateral for Timberwolf and other CDOs. Goldman’s conduct in the Timberwolf CDO demonstrates how a financial institution that plays multiple roles in a CDO can develop conflicts of interest and attempt to manipulate the CDO to place its own financial interests before those of the investors to whom it sold the CDO securities.

602

(6) Analysis of Goldman’s Conflicts of Interest

The Goldman Sachs case study identifies a number of practices that raise conflict of

interest concerns. Those practices include the following.

Shorting Its Own Securities. In Hudson, Anderson, and Timberwolf, Goldman marketed CDO securities to clients, took a substantial portion of the short side of the CDO, bet the CDO would fall in value, and profited from its short position at the expense of the clients to whom it sold the securities.

Failing to Disclose Key Information to Investors. In Hudson, Anderson, and Timberwolf, Goldman represented to potential investors that its interests “were aligned” with theirs or advertised its retention of a portion of the CDO’s equity tranche, without disclosing that it had an even larger short position in the CDO and held a financial interest directly adverse to the investors to whom it was selling the CDO securities.

Misrepresenting Source of Assets. In Hudson, Goldman provided 100% of the

CDO assets using CDS contracts it controlled and priced, transferred $1.2 billion of risk from its own inventory to the CDO, and told investors the assets had been “sourced from the Street,” when they had been supplied solely by Goldman and not priced from transactions with third parties.

Failing to Disclose Client Involvement. In Abacus, Goldman enabled a client who was shorting the CDO to help select the CDO’s assets, solicited investors to buy the Abacus securities without disclosing the short party’s asset selection role or investment objective, and helped the client gain a $1 billion profit at the expense of the investors to whom Goldman sold the securities.

Minimizing Premiums. In Abacus, Goldman entered into an undisclosed

agreement with the sole short party to accept a fee for arranging low premium payments by the short party to the CDO, even though low premium payments meant less money for the long investors to whom Goldman had sold the Abacus securities.

Selling Securities Designed to Fail. Goldman sold Hudson and Abacus securities to clients knowing the securities were designed to fall in value and benefit the short party, which was a client in the case of Abacus and itself in the case of Hudson.

Delaying Liquidation. In Hudson, Goldman was paid a fee to serve as the

liquidation agent, but delayed liquidating assets that were losing value for eight months, enhancing its financial gain as the CDO’s short party at the expense of the long parties whose losses would have been staunched if the assets had been liquidated.

603

Misrepresenting Assets. In Anderson, when clients asked how Goldman got

“comfortable” with poor quality New Century loans in the CDO, Goldman worked to dispel those concerns and failed to disclose its own discomfort with New Century loans and that it held 40% of the short side of the CDO, betting its assets would lose value.

Taking Immediate Post-Sale Markdowns. In Timberwolf, Goldman knowingly sold Timberwolf securities to clients at prices above its own book values and then, often within days or weeks of a sale, marked down the value of the sold securities, causing clients to incur quick losses and requiring some to post higher margin or cash collateral.
Evading Put Obligation. In Timberwolf, Goldman was paid a fee to serve as the collateral put provider, but refused for two months to allow the purchase of default swap collateral securities, even though they meant better returns for long investors, because Goldman did not want to assume the risk that the collateral securities might lose value.
Using Poor Quality Loans in Securitizations. Goldman provided securitization

services and warehouse accounts to lenders with a history of issuing high risk, poor quality loans, and knowingly included poor quality loans in Goldman-originated RMBS and CDO securities.

Concealing Its Net Short Position. From late 2006 through most of 2007,

Goldman engaged in a relentless effort to sell the CDO and RMBS securities it underwrote, without disclosing to the clients it solicited that Goldman was simultaneously shorting the subprime market and betting it would lose value.

These practices raise a wide range of ethical and legal concerns. This section examines the key issues of whether Goldman had a legal obligation to disclose to clients the existence of material adverse information, including conflicts of interest, when selling them RMBS and CDO securities; whether Goldman had material adverse interests that should have been disclosed to investors; and whether Goldman had an obligation not to recommend securities that were designed to lose value. Many of these issues hinge upon the proper treatment of financial instruments, such as credit default swaps and CDOs, which enable an investment bank to bet against the very same securities it is selling to clients.

(a) Securities Laws

To protect fair, open, and efficient markets for investors, federal securities laws impose a range of specific disclosure and fair dealing obligations on market participants, depending upon the securities activities they undertake. In the matters examined by the Subcommittee, the key roles under the securities laws include market maker, underwriter, placement agent, broker- dealer, and investment adviser.

604

Market Maker. A “market maker” is typically a dealer in financial instruments that

stands ready to buy and sell a particular financial instrument on a regular and continuous basis at a publicly quoted price.2671 A major responsibility of a market maker is filling orders on behalf of customers. Market markers do not solicit customers; instead they maintain buy and sell quotes in a public setting, demonstrating their readiness to either buy or sell the specified security, and customers come to them. For example, a market maker in a particular stock typically posts the prices at which it is willing to buy or sell that stock, attracting customers based on the competitiveness of its prices. This activity by market makers helps provide liquidity and efficiency in the trading market for that security.2672 Market makers do not keep the financial instruments they buy and sell in their own investment portfolio, but instead keep them in their sales portfolio or “trading book.”

Market makers have among the most narrow disclosure obligations under federal

securities law, since they typically do not actively solicit clients or make investment recommendations to them. Their disclosure obligations are generally limited to providing fair and accurate information related to the execution of a particular trade.2673 Market makers are also subject to the securities laws’ prohibitions against fraud and market manipulation. In addition, they are subject to legal requirements relating to the handling of customer orders, for example using best execution efforts when placing a client’s buy or sell order.2674

Underwriter and Placement Agent. Underwriters and placement agents have greater

disclosure obligations than market makers, because in this role they are actively soliciting customers to buy new securities they have helped an issuer bring to market.

When securities are offered to the public for sale, they are typically underwritten by one

An underwriter is typically hired by the issuer of the new

or more investment banks, each of which is a broker-dealer registered with the Financial Industry Regulatory Authority (FINRA).2675 securities to help the issuer register the securities with the SEC and conduct a public offering of the securities. The underwriter typically purchases the securities from the issuer, holds them on its books, conducts the public offering, and bears the financial risk until the securities are sold to the public.

2671 Section 3(a)(38) of the Securities Exchange Act of 1934 (“The term ‘market maker’ means any specialist permitted to act as a dealer, any dealer acting in the capacity of block positioner, and any dealer who, with respect to a security, holds himself out (by entering quotations in an inter-dealer communications system or otherwise) as being willing to buy and sell such security for his own account on a regular or continuous basis.”); see also SEC website, http://www.sec.gov/answers/mktmaker.htm; see also FINRA website, FAQs, “What Does a Market Maker Do?” 2672 SEC website, http://www.sec.gov/answers/mktmaker.htm. 2673 1/2011 “Study on Investment Advisers and Broker-Dealers,” study conducted by the U.S. Securities and Exchange Commission, at 55, http://www.sec.gov/news/studies/2011/913studyfinal.pdf, (hereinafter “SEC Study on Investment Advisers and Broker-Dealers”). 2674 See Goldman response to Subcommittee QFR at PSI_QFR_GS0046.
2675 FINRA is the largest independent self-regulatory organization for securities firms doing business in the United States. FINRA has been delegated authority by the SEC and a number of securities exchanges to regulate the broker-dealer industry. Its stated mission is “to protect America’s investors by making sure the securities industry operates fairly and honestly.” See FINRA website, http://www.finra.org.

http://finra.atgnow.com/finra/categoryBrowse.do.

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Investment banks can also act as “placement agents,” assisting those seeking to raise

money through a private offering of securities by helping them design the securities, produce the offering materials, and market the new securities to investors. Placement agents are also registered broker-dealers. While public offerings of securities are required to be registered and filed with the SEC, private offerings are made to a limited number of investors and are exempt from SEC registration. In the securitization industry, RMBS securities are generally sold through public offerings, while CDO securities are generally sold through private placements.

Whether acting as an underwriter or placement agent, a major part of the investment

bank’s responsibility is to solicit customers to buy the new securities being offered. Under the securities laws, an issuer selling new securities to potential investors has an affirmative duty to disclose material information that a reasonable investor would want to know.2676 In addition, under securities law, a broker-dealer acting as an underwriter or placement agent is liable for any material misrepresentation or omission of material fact made in connection with a solicitation or sale of securities to an investor.2677

The Supreme Court has held that a fact is material if there is a “substantial likelihood that

the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available.”2678 The SEC has provided this additional guidance:

“‘The question of materiality, it is universally agreed, is an objective one, involving the significance of an omitted or misrepresented fact to a reasonable investor.’ ‘[T]he reaction of individual investors is not determinative of materiality, since the standard is objective, not subjective.’ ‘[M]ateriality depends on the significance the reasonable investor would place on the withheld or misrepresented information.’ Although in general materiality is primarily a factual inquiry, ‘the question of materiality is to be resolved as a matter of law when the information is ‘so obviously important [or

2676 See, e.g., SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 201 (1963) (“Experience has shown that disclosure in such situations, while not onerous to the advisor, is needed to preserve the climate of fair dealing which is so essential to maintain public confidence in the securities industry and to preserve the economic health of the country.”). See also SEC Study on Investment Advisers and Broker-Dealers at 51 [citations omitted] (“Under the so-called ‘shingle’ theory … a broker-dealer makes an implicit representation to those persons with whom it transacts business that it will deal fairly with them, consistent with the standards of the profession. … Actions taken by the broker-dealer that are not fair to the customer must be disclosed in order to make this implied representation of fairness not misleading.”).
2677 See Sections 11 and 12 of Securities Act of 1933. See also Rule 10b-5 of the Securities Exchange Act of

See also SEC v. Capital Gains Research Bureau, Inc., 375 U.S. at 200 (“Failure to disclose material facts must be deemed fraud or deceit within its intended meaning, for, as the experience of the 1920’s and 1930’s amply reveals, the darkness and ignorance of commercial secrecy are the conditions upon which predatory practices best thrive.”). See also Goldman response to Subcommittee QFR, at PSI_QFR_GS0046.
2678 Basic v. Levinson, 485 U.S. 224, 231-32 (1988) (quoting TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976)).

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unimportant] to an investor, that reasonable minds cannot differ on the question of materiality.’”2679

Unlike when a broker-dealer is acting as a market maker, a broker-dealer acting as an

underwriter or placement agent has an obligation to disclose material information to every investor it solicits, including the existence of any material conflict of interest or adverse interest.
This duty arises from two sources: the duties of an underwriter specifically, and the duties of a broker-dealer generally, when making an investment recommendation to a customer.

With respect to the duties of an underwriter, the First Circuit has observed that

underwriters have a “unique position” in the securities industry:

With respect to a broker-dealer, the SEC has held:

The SEC has also stated that, if a broker intends to sell a security from its own inventory and recommends it to a customer, “the broker dealer must disclose all material facts.”2682

To help broker-dealers understand when they are obligated to disclose to investors

material information, including any material adverse interest, FINRA has further defined the term “recommendation”:

2679 In the Matter of David Henry Disraeli and Lifeplan Associates, Securities Exchange Act Rel. No. 34-2686 (December 21, 2007) at 10-11 [citations omitted]. 2680 SEC v. Tambone, 550 F.3d 106, 135 (1st Cir. 2008) [citations omitted]. 2681 In the Matter of Richmark Capital Corporation, Securities Exchange Act Rel. No. 48757 (Nov. 7, 2003) (citing Chasins v. Smith Barney & Co., Inc., 438 F.3d 1167, 1172 (2d. Cir. 1970) (“The investor… must be permitted to evaluate overlapping motivations through appropriate disclosures, especially where one motivation is economic self-interest”). See also SEC Study on Investment Advisers and Broker-Dealers at 55. In this recent study examining the disclosure obligations of broker-dealers and investment advisers, the SEC has explained:
“Generally, under the anti-fraud provisions, a broker-dealer’s duty to disclose material information to its customer is based upon the scope of the relationship with the customer, which is fact intensive.” According to the SEC, when a broker-dealer acts as an order taker or market maker in effecting a transaction for a customer, the broker- dealer generally does not have a duty to disclose information regarding the security or the broker-dealer’s economic interest. The duty to disclose this information is triggered, however, when the broker-dealer recommends a security. Id. 2682 SEC Study on Investment Advisers and Broker-Dealers at 56, n.252.

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Goldman’s own compliance manual essentially incorporates this guidance and instructs Goldman personnel that a proactive effort to sell a specific investment to a specific customer constitutes a recommendation of that investment.2684

Once a broker-dealer, acting in the role of an underwriter or placement agent, has made

an investment recommendation and triggered the duty to disclose any material adverse interest to a potential investor, it must disclose not only that the adverse interest exists, but also the “nature and extent” of the adverse interest.2685 In addition, it is not enough to inform a customer that the underwriter or placement agent “may” have an adverse interest if, in fact, the adverse interest already exists.2686 Further, there is no indication in any law or regulation that the obligation to disclose material adverse information is diminished or waived in relation to the level of sophistication of the potential investor.2687

2683 FINRA Notice to Members 96-60. 2684 See 2/1/2001 Goldman document, “United States Policies for the Preparation, Supervision, Distribution and Retention of Written and Electronic Communications,” at 9, GS MBS 0000035799. 2685 See ,e.g., In the Matter of Arleen Hughes, Securities Exchange Act Rel. No. 4048 (Feb. 1948) (holding a broker-dealer, who is also a registered investment adviser, violated the anti-fraud provisions of the federal securities laws by failing to at minimum disclose the “nature and extent” of its adverse interest); In the Matter of Edward D. Jones & Co., L.P., Exchange Act Rel. No. 50910 (Dec. 22, 2004) (settled order), at 21(broker-dealer consents to an order finding that disclosure to its customers was inadequate, because it failed to disclose the full nature and extent of its agreement, including “information about the source and the amount of the revenue sharing payments to [the broker-dealer] and the dimensions of the resulting potential conflicts of interest”). 2686 See, e.g., SEC v. Czuczko, Case No. CV06-4792 (USDC CD Calif.), Order Granting Plaintiff’s Unopposed Motion for Summary Judgment (Dec. 5, 2007). In Czuczko, the defendant, who offered online investment advice, included a disclaimer on his website advising that officers, directors, employees and members of their families “may, from time to time, trade in these securities for their own accounts” [emphasis in original]. Id. at 8. Relying on SEC v. Blavin, 760 F.2d 706 (6th Cir. 1985), the court held such an assertion “is itself a material misstatement because the Defendant knew he, his father, and his business partner did trade in the stocks and had a biased interest in the recommended stocks” [emphasis in original]. Czuczko, at 8. 2687 See FINRA Rules 2210(d)(1)(A) and 2211(a)(3) and (d)(1) (by rule all institutional sales material and correspondence may not “omit any material fact or qualification if the omission, in the light of the context of the material presented, would cause the communications to be misleading.”); and FINRA Rule 2310 and IM-2310-3 (suitability obligation to institutional customers). See also Hanly v. SEC, 415 F.2d 589, 596 (2d Cir. 1969) (holding that sophistication and knowledge of a broker’s customers do not warrant a less stringent standard of conduct under federal securities laws); Spatz v. Borenstein, 513 F. Supp. 571, 580 (N.D. Ill. 1981) (finding investors’ experience does not mitigate a broker’s duty to fully and truthfully disclose material facts, nor does the potential for investors to discover information not disclosed by a prospectus vitiate any legal liability stemming from a failure to disclose material facts); Department of Enforcement v. Kesner, FINRA Complaint No. 2005001729501 (February 26, 2010) (finding sophistication of investors does not relieve a securities representative from disclosing material facts to investors).

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Suitable Investment Recommendations. In addition to requiring disclosure of material

adverse information, federal securities laws and FINRA rules prohibit broker-dealers from making investment recommendations that would be unsuitable for any customer.2688

In a recent study, the SEC explained: “[W]hile the suitability obligation under the federal

securities laws arises from the anti-fraud provisions, the SRO [Self Regulatory Organization]
rules are grounded in concepts of ethics, professionalism, fair dealing, and just and equitable principles of trade.”2689 For example, FINRA Rule 2010, providing Standards of Commercial Honor and Principles of Trade, states: “A member, in the conduct of its business, shall observe high standards of commercial honor and just and equitable principles of trade.”2690

A broker-dealer violates the suitability rule if it makes a recommendation that “is

unsuitable for any investor, regardless of the investor’s wealth, willingness to bear risk, age or other individual characteristics.”2691 Under the applicable case law and FINRA rules, a broker- dealer is also obligated “to have an ‘adequate and reasonable basis’ for any security or strategy recommendation that it makes.”2692

Suitability rules are intended to prevent abuses that contributed to the stock crash of 1929 and the Great Depression of the 1930s, when Senators investigating investment bank activities at the time wrote the following:

“[Investors] must believe that their investment banker would not offer them the bonds unless the banker believed them to be safe. This throws a heavy responsibility upon the banker. He may and does make mistakes. There is no way that he can avoid making mistakes because he is human and because in this world, things are only relatively secure. There is no such thing as absolute security. But while the banker may make mistakes, he

2688 SEC Study on Investment Advisers and Broker-Dealers at 61. 2689 Id.
2690 FINRA Rule 2010. See also Study on Investment Advisers and Broker-Dealers at 55 (broker-dealers also have an obligation under the federal securities laws and FINRA rules to deal fairly with their customers). 2691 F.J. Kaufman and Co., Securities Exchange Act Rel. No. 27535 at 5 (December 13, 1989). 2692 SEC Study on Investment Advisers and Broker-Dealers at 63 [citations omitted]. The suitability rule also requires the broker to determine that the specific security recommended is appropriate based on the customer’s financial situation and needs. FINRA Rule 2310. The suitability obligation clearly applies to institutional customers, FINRA IM-2310-3 (suitability obligations to institutional customers require members have a reasonable basis for recommending a particular security or strategy), but may not apply when a broker-dealer solicits another broker-dealer to buy an investment since, under FINRA Rules, the term “customer” does not include a broker or dealer. FINRA Manual, 0120 Definition. On the other hand, the term “customer” has been given a broad definition under the securities case law. See, e.g., Department of Enforcement v. Zayed, FINRA Complaint No. 2006003834901 (August 19, 2010) (“Cases interpreting the term ‘customer’ in the securities context have viewed the term broadly to encompass individuals or entities that have some brokerage or investment relationship with the broker-dealer. Specifically, courts have rejected the argument that an account is necessary to establish an investor’s status as a customer.” [citations omitted]). When the Subcommittee asked Mr. Blankfein whether he believed there was a difference between a “customer” and a “client,” Mr. Blankfein said he had “never distinguished” between the two terms. Subcommittee deposition of Lloyd Blankfein (12/15/2009), Hearing Exhibit 4/27-176 [Sealed Exhibit].

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must never make the mistake of offering investments to his clients which he does not believe to be good.”2693

Investment Advisers. For investment banks that act, not just as a broker-dealer,

underwriter, or placement agent, but also as an investment adviser to their customers, federal securities laws impose still a higher legal duty. When acting as an investment adviser, the law imposes a fiduciary obligation on the investment bank to act in the “best interests of its clients.”2694 A person qualifies as an “investment adviser” under the Investment Advisers Act if that person: provides advice regarding securities, is in the business of providing such advice, and provides that advice for compensation.2695 A broker-dealer, however, is excluded from the Investment Advisers Act if the performance of its investment advisory services is “solely” incidental to its business as a broker-dealer, and the broker-dealer does not receive “special compensation” for providing those advisory services.2696 Because Goldman appears to have acted primarily as an underwriter, placement agent, or broker-dealer in carrying out its securitization activities, this section analyzes Goldman’s conduct in that context and not in the context of an investment adviser.2697

(b) Analysis

One key issue is whether Goldman was acting as a market maker versus an underwriter

or placement agent when it recommended that its clients purchase its CDO and RMBS securities, since those roles have different disclosure and suitability obligations under the law. A second key issue is whether Goldman withheld material adverse information when recommending its securities to its clients, including the fact that it was shorting the securities it was selling. A third key issue is whether Goldman violated its obligation to make suitable investment recommendations when urging customers to purchase securities that Goldman knew were designed to lose value.

(i) Claiming Market Maker Status

Given its active role in the securitization markets, Goldman assumed a variety of roles in

the development, marketing, and trade of RMBS and CDO products. At times, it acted as a market maker responding to client orders to buy and sell RMBS and CDO products. In addition, from 2006 to 2007, Goldman originated and served as an underwriter or placement agent for 27 CDOs and 93 RMBS securitizations, and sold the resulting RMBS and CDO securities to a broad range of clients around the world.

2693 6/16/1934 “Stock Exchange Practices,” Report of the Senate Committee on Banking and Currency, S. Rep. 73- 1455, at 88 (quoting “Who Buys Foreign Bonds,” Foreign Affairs (1/1927)).
2694 SEC Study on Investment Advisers and Broker-Dealers at 15-16. 2695 Id. 2696 Id. 2697 The Subcommittee did not examine the extent to which Goldman was acting as an investment adviser within the meaning of the Investment Advisers Act when recommending that various customers buy its RMBS and CDO securities.

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In public statements and testimony regarding the financial crisis, Goldman has often

highlighted its role as a market maker and downplayed its role as an underwriter or placement agent in the securitization markets.2698 example, Goldman executives repeatedly highlighted the firm’s role as market makers – buying and selling RMBS and CDO securities at the request of clients – while deemphasizing that the firm also originated new securities and affirmatively solicited clients to buy those new securities.

In the April 27, 2010 Subcommittee hearing, for

In an exchange with Senator Susan Collins, for example, executives from Goldman’s

Mortgage Department were asked questions about whether they were investment advisers with a fiduciary duty to their clients. While not denying this duty, they emphasized their role as market makers with more limited client obligations:2699

Senator Collins: Thank you, Mr. Chairman. I would like to start my questioning by asking each of you a fundamental question. Investment advisers have a legal obligation to act in the best interests of their clients. Mr. Sparks, when you were working at Goldman, did you consider yourself to have a duty to act in the best interests of your clients?

Mr. Sparks: Senator, I had a duty to act in a very straightforward way, in a very open way with my clients. Technically, with respect to investment advice, we were a market maker in that regard. But with respect to being a prudent and a responsible participant in the market, we do have a duty to do that.

Senator Collins: Mr. Swenson?

Mr. Swenson: I believe it is our responsibility as market makers to provide a market- level bid and offer to our clients and to serve our clients and helping them transact at levels that are fair market prices and help meet their needs.

Mr. Tourre made similar representations in his prepared testimony to the Subcommittee:

“Between 2004 and 2007, my job was primarily to make markets for clients. I made markets by connecting clients who wished to take a long exposure to an asset – meaning they anticipated the value of the asset would rise – with clients who wished to take a short exposure to an asset – meaning they anticipated the value of the asset would fall. I

2698 See, e.g., 3/1/2010 letter from Goldman’s legal counsel to the Financial Crisis Inquiry Commission, GS-PSI-01310 (discussing Goldman Sachs’ “Role as a market maker” in detail and distinguishing it, in a much shorter description, from its underwriting and placement roles). Although the letter acknowledged that Goldman acted as an underwriter and placement agent for RMBS and CDO transactions, it also suggested that those transactions were commonly designed in response to client inquiries and did not discuss efforts by the firm to solicit customers to buy the securities: “Goldman Sachs’ CDOs … were initially created in response to the request of a sophisticated institutional investor that approached the firm specifically seeking that particular exposure.
Reverse inquiries from clients were a common feature of this market.”
2699 April 27, 2010 Subcommittee Hearing Transcript at 26-27.

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was an intermediary between highly sophisticated professional investors – all of which were institutions. None of my clients were individual, retail investors.”2700

In another exchange, when Subcommittee Chairman Levin asked Goldman CEO Lloyd

Blankfein about the firm’s duty as an underwriter and placement agent to disclose its adverse interests when selling its CDO securities to potential investors, Mr. Blankfein responded that market makers had no such disclosure obligations:

Senator Levin: You are betting against the very security that you are selling to that person. You don’t see any problem? You don’t see that you have to disclose, when you have put together a deal and you go looking for people to buy those securities, it just adds insult to injury when your people think it is a pile of junk. But the underlying injury is that you have determined that you are going to keep the opposite position from the security that you are selling to someone. You just don’t see any obligation to disclose that. That is what seems to be coming through here.

Mr. Blankfein: I don’t believe there is a disclosure obligation, but as a market maker, I am not sure how a market would work if it was premised on the assumption that the other side of the market cared what your opinion was about the position they were taking.

Senator Levin: Do they have a belief that you, at least when you are going out peddling securities, that you want that security to succeed? Don’t they have that right to assume that if you are going out selling securities, that you have a belief that that is something which would be good for that client?

Mr. Blankfein: I think we have to have a belief, and we do have a belief that if somebody wants an exposure to housing –

Senator Levin: They don’t want – you are out there selling it to them. You are out there selling these securities. This isn’t someone walking in the door.

Mr. Blankfein: Again, I want –

Senator Levin: You are picking up the phone. You are calling all these people. You don’t tell them that you think it is a piece of junk. You don’t tell them that this is a security which incorporates or which in some way references a whole lot of bad stuff in your own inventory – bad lemons, they were called. … You are out there looking around for buyers of stuff, whether it is junk or not junk, where you are betting against what you are selling. You are intending to keep the opposite side. This isn’t where you are just selling something from your inventory. This is where you are betting against the very product you are selling, and you are just not troubled by it. That is the bottom line.
There is no trouble in your mind –

2700 Prepared statement of Fabrice Tourre, April 27, 2010 Subcommittee Hearing at 1.

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Mr. Blankfein: Senator, I am sorry. I can’t endorse your characterization.

Senator Levin: It is a question, not a characterization. I am saying, you are not troubled.

Mr. Blankfein: I am not troubled by the fact that we market make as principal and that we are the opposite – when somebody sells, they sell to us, or when they buy, they buy from us.2701

Although Goldman representatives routinely emphasized the firm’s role as a market maker, when asked directly if the firm also functioned as an underwriter or placement agent when selling the CDO securities it originated, its executives agreed that in some circumstances, the firm played that role:

Senator Pryor: OK. But let me ask this: When you are selling a security such as a CDO, my understanding is you are not a market maker. Isn’t it true that you are placement agent and as a placement agent you have a duty of full disclosure?

Mr. Sparks: Senator, that is correct.2702

Similarly, in a written response to a Subcommittee question asking about the firm’s role in relation to Anderson, Hudson 1, Timberwolf and other CDOs, Mr. Blankfein wrote: “Goldman Sachs or an affiliate served as a placement agent.”2703

Despite this acknowledged fact, Goldman continued to claim it was a market maker with

limited disclosure and client obligations. On May 1, 2010, for example, less than a week after the Subcommittee’s April 27 hearing, an article entitled, “Goldman Sachs’ Lloyd Blankfein Defends ‘Market Maker’ Firm on ‘Charlie Rose’ Show,” described Mr. Blankfein’s statements on the televised show as follows:

“Asked by Rose whether Goldman investment advisers had ever bought securities from the firm, sold them to clients, and then bet against those same securities, Blankfein paused. And after a solid six seconds of silence, sought to explain … Goldman’s role as a ‘market maker.’

‘We’re like a machine, that lets people buy and sell what they want to buy and sell’ Blankfein said. ‘That’s not the advisory business. That’s just a facility for market making.’”2704

2701 April 27, 2010 Subcommittee Hearing at 137-138. 2702 Id. at 53.
2703 Goldman response to Subcommittee QFR at PSI_QFR_GS0026.
2704 “Goldman Sachs’ Lloyd Blankfein Defends ‘Market Maker’ Firm On ‘Charlie Rose Show,’” Huffington Post (5/1/2010), http://www.huffingtonpost.com/2010/05/01/goldman%1esachs%1elloyd%1eblank_n_559606.html (video of Charlie Rose interview of Lloyd Blankfein embedded).

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During the interview, Mr. Blankfein compared Goldman’s activity to that of the New York Stock Exchange, claiming that the firm was a market maker taking buy and sell orders from clients.2705
At one point, Mr. Rose asked: “Has there ever been a time when Goldman’s investment advisers bought securities from Goldman for a client and at the same time Goldman was simultaneously shorting it?” Mr. Blankfein responded: “I have to explain, see this is a problem. As a market maker, we are buying and selling a thousand times a minute, probably.” Mr. Blankfein also stated during the interview: “If we believed it would fail, the security wouldn’t work, we would not sell it.”2706

(ii) Soliciting Clients and Recommending Investments

Under federal securities law and FINRA Rules detailed above, when a broker-dealer,

acting as an underwriter or placement agent brings a specific security to the attention of a particular customer, it is considered to be recommending the security to that customer and has an obligation to disclose all material adverse information to that customer, including any adverse interest that a reasonable investor would consider material in considering the broker-dealer’s recommendation. Despite Goldman’s frequent efforts to characterize its CDO and RMBS sales efforts as a market making activity in response to client demand, Goldman’s internal documents, emails, and interviews indicate that, from late 2006 through 2007, Goldman was not always responding to client demand, but was also aggressively soliciting customers in an attempt to sell its CDO and RMBS products.

In December 2006, for example, Goldman CFO David Viniar instructed the Mortgage Department to reduce its long position in mortgage related assets, including by selling RMBS and CDO products on its books.2707 effort to sell to clients the bulk of the RMBS and CDO products in its inventory. The Subcommittee saw no evidence that this intensive selling campaign was undertaken in response to client demand. To the contrary, the evidence shows that the sales effort was undertaken at the request of senior management, despite what was then waning investor interest in securitization products.

The Mortgage Department responded with a concerted

In December 2006, on the same day Mr. Viniar directed the Mortgage Department to

reduce its long assets, Kevin Gasvoda, head of the desk that handled RMBS securities, told his staff to “move stuff out even if you have to take a small loss.”2708 In January 2007, Mr. Sparks, head of the Mortgage Department, asked a senior executive to compliment the CDO Origination Desk head and his staffer for their efforts to sell a specific CDO’s securities over the prior

2705 Id. 2706 April 30, 2010 Transcript of The Charlie Rose Show at 12-14. Mr. Blankfein made similar claims the following week on CNBC’s “Power Lunch” during a one-on-one interview with David Faber. May 7, 2010 Transcript of Power Lunch at 4. 2707 See, e.g., 12/14/2006 email from Daniel Sparks to Thomas Montag, “Subprime risk meeting with Viniar/McMahon Summary,” GS MBS-E-009726498, Hearing Exhibit 4/27-3; Subcommittee interview of David Viniar (4/13/2010).
2708 12/14/2006 email from Kevin Gasvoda to his staff, “Retained bonds,” GS MBS-E-010935323, Hearing Exhibit 4/27-72.

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month: “They structured like mad and traveled the world, and worked their tails off to make some lemonade out of some big old lemons.”2709 In March 2007, Mr. Sparks emailed a call for “help” to Goldman’s top sales managers around the world to “sell our new issues – CDOs and RMBS – and to sell our other cash trading positions.”2710 He wrote: “I can’t over state the importance to the business of selling these positions and new issues. … Priority 1 – sell our new issues and cash positions.”2711 In April 2007, the Mortgage Department issued one of many sales directives to Goldman’s global sales force, placing a priority on selling certain CDO securities in its inventory, including securities from Anderson, Timberwolf, Point Pleasant, and Altius CDOs, and Mr. Sparks recommended providing large sales credits for those able to complete the sales.2712

The documents also show that Goldman personnel worked relentlessly to identify

possible clients and pitch CDO securities to them. In March 2007, for example, the Syndicate Desk contributed a list of “non-traditional buyers” that could be targeted for CDO sales, writing that “we continue to push for leads.”2713 A Goldman sales manager suggested targeting European and Middle Eastern banks and hedge funds.2714 In New York, a Goldman sales representative recounted that the Abacus CDO security “has been showed to selected accounts for the past few weeks. Those selected accounts previously declined participating in Anderson mezz, Point Pleasant, and Timberwolf.”2715

When CDO sales slowed in May 2007, the Mortgage Department produced a new

“target” list of four primary and 35 secondary clients for CDO sales.2716 A few days later, a Goldman salesperson reported that he planned to contact a hedge fund about Timberwolf and Point Pleasant securities, noting that the customer was “[n]ot expert[] in this space at all but [I] made them a lot of money in correlation dislocation and will do as I suggest.”2717 In Australia, a Goldman sales representative contacted an Australian hedge fund, Basis Capital, and mounted a sustained effort to sell it $100 million in Timberwolf securities, overcoming investor concerns to make the sale.2718

In Korea, a Goldman sales representative attempting to sell $56 million in

2709 1/31/2007 email from Daniel Sparks to Tom Montag, “MTModel,” Hearing Exhibit 4/27-91. 2710 3/9/2007 email exchange between Mr. Sparks and sales managers, “help,” GS MBS-E-010643213.
2711 Id. 2712 4/19/2007 email from Daniel Sparks to Bunty Bohra, GS MBS-E-010539324, Hearing Exhibit 4/27-102. 2713 3/21/2007 email from Syndicate, “Non-traditional Buyer Base for CDO ASEX,” GS MBS-E-003296460, Hearing Exhibit 4/27-78. 2714 3/9/2007 email exchange between Mr. Sparks and sales managers, “help,” GS MBS-E-010643213, Hearing Exhibit 4/27-76. 2715 3/30/2007 email from Fabrice Tourre to Mr. Sparks and others, GS MBS-E-002678071. 2716 5/20/2007 Goldman presentation, “Mortgage Department, May 2007,” GS MBS-E-010965212. See also
3/1/2007 email from Michael Swenson, “names,” GS MBS-E-012504595 (SPG Trading target list tiered according to likelihood of purchasing); 2/14/2007 email to Matthew Bieber, “Timberwolf I, Ltd. – Target Account List,” GS MBS-E-001996121 (list of U.S. accounts “we should be directly targeting” for Timberwolf sales); 3/2/2007 email from David Lehman, “ABX/Mtg Credit Accts,” GS MBS-E-011057632 (mortgage credit business shared with SPG Trading Desk “a fairly lengthy list of accounts that are considered to be ‘key’”).
2717 5/24/2007 email from Ysuf Aliredha to Mr. Sparks and others, “Priority Axes,” GS MBS-E-001934732.
2718 See, e.g., 5/20/2007 email from George Maltezos to Mr. Lehman, “T/wolf and Basis,” GS MBS-E-001863555; 5/22/2007 email from Mr. Maltezos to Basis Capital, JUL 000685.

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Timberwolf securities to a Korean life insurance firm was encouraged to “Get ‘er done” and “go for it” by his superiors when he informed them “we are pushing on our personal relationships to get this done.”2719

These and other documents show that, in late 2006 and 2007, Goldman was not acting as

primarily a market maker responding to client demand when it originated and sold Hudson, Anderson, Timberwolf, and Abacus securities, or when it sold other RMBS and CDO assets that senior management wanted to remove from the firm’s books due to their declining values and increasing risk. Instead, Goldman was acting as an underwriter, placement agent, or broker- dealer, aggressively soliciting its clients to purchase the CDO and RMBS products that senior management wanted to eliminate from its inventory.

(iii) Failing to Disclose Material Adverse Information

Goldman’s marketing and solicitation efforts to sell Hudson, Anderson, Timberwolf, and

Abacus securities, along with other CDO and RMBS assets, to clients raise multiple questions about whether Goldman met its obligation to disclose material adverse information to potential investors. A related question is whether Goldman met its obligation to avoid material misrepresentations and omissions of material facts when recommending the purchase of those securities. One key issue is whether Goldman’s failure to disclose its shorting activities, which would enable it to profit from a decline in the value of the very securities Goldman was recommending to its clients to purchase, qualified as an “omitted fact” that “would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available” about the security being recommended by Goldman.2720

Taking the Short Side of a CDO. In the four CDOs examined in this Report, Goldman took 100% of the short side of Hudson, 40% of the short side of Anderson, and 36% of the short side of Timberwolf.2721 In each of these CDOs, Goldman also made a relatively small investment in the long side of the CDO by initially retaining all or a portion of its equity tranche, allowing Goldman to claim an “interest” in the CDO’s long term success.2722 Goldman did not intend to make any investment in the CDO itself, and instead enabled the client that had requested construction of the CDO and played a key role in selecting its assets to hold 100% of the short side of the CDO.

In Abacus,

2719 6/7/2007 email from Omar Chaudhary to Mr. Sparks and others, GS MBS-E-001866450, Hearing Exhibit 4/27-104. 2720 Basic v. Levinson, 485 U.S. 224, 231-32 (1988) (quoting TSC Industries v. Northway, 426 U.S. 438, 449 (1976)). Utilizing the SEC’s guidance, the issue could also be framed as evaluating “the significance the reasonable investor would place on the withheld or misrepresented information.” 2721 Goldman Response to Subcommittee QFR at PSI_QFR_GS0192. 2722 Typically, the equity tranche, which is the first to incur any losses sustained by a securitization, is retained by the originator. Equity tranches are typically not rated by the credit rating agencies and often not sold to third parties.

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Goldman did not accurately or fully disclose its short interest in Hudson, Anderson, or Timberwolf to potential investors.2723 Instead, the CDOs’ offering materials advised potential investors, in difficult to understand language, that a Goldman affiliate “may” adopt a financial interest or investment position adverse to the investors when, in fact, Goldman had already determined to do so. In a section entitled, “Certain Conflicts of Interest,” for example, the Hudson 1 Offering Circular stated in part:

“Certain Conflicts of Interest. Various potential and actual conflicts of interest may arise from the overall activities of the Credit Protection Buyer, the overall underwriting, investment and other activities of the Liquidation Agent, the Senior Swap Counterparty and the Collateral Put Provider, their respective affiliates and its clients and employees and from the overall investment activity of the Initial Purchaser, including in other transactions with the Issuer. The following briefly summarizes some of these conflicts, but is not intended to be an exhaustive list of all such conflicts.

“The Credit Protection Buyer and Senior Swap Counterparty. GSI [Goldman Sachs International] will be the initial Credit Protection Buyer and the initial Senior Swap Counterparty. The following briefly summarizes some potential and actual conflicts of interests related to the Credit Protection Buyer and Senior Swap Counterparty, but the following isn’t intended to be an exhaustive list of all such conflicts. …

“GSI and/or any of its affiliates may invest and/or deal, for their own respective accounts for which they have investment discretion, in securities or in other interests in the Reference Entities, in obligations of the Reference Entities or in the obligors in respect of any Reference Obligations or Collateral Securities (the “Investments”) or in credit default swaps (whether as protection buyer or seller) …. In addition, GSI and/or any of its affiliates may invest and/or deal, for their own respective accounts or for accounts for which they have investment discretion, in securities (or make loans or have other rights) that are senior to, or have interests different from or adverse to, any of the Investments and may act as adviser to, may be lenders to, and may have other ongoing relationships with, the issuers or obligors of Investments and obligations of any Reference Entities.”2724

This disclosure indicates that GSI or an affiliate “may invest and/or deal” in securities or

other “interests” in the assets underlying the Hudson CDO, and “may invest and/or deal” in securities that are “adverse to” the Hudson “investments.” The Offering Circular, however, misrepresented Goldman’s investment plans. At the time it was created in December 2006, Goldman had already determined to keep 100% of the short side of the Hudson CDO and act as

2723 In Abacus, Goldman also failed to disclose the role of the hedge fund in the Abacus asset selection process.
See Abacus section C(5)(b)(ii)DD, above.
2724 12/3/2006 Goldman Offering Circular, “Hudson Mezzanine 2006-1, LTD.,” at 56, GS MBS-E-021821196.
The Goldman offering circulars for Timberwolf and Anderson contain similar sections. See 3/23/2007 Goldman Offering Circular, “Timberwolf I, LTD.,” GS MBS-E-021825371 at 427; 3/16/2007 Goldman Offering Circular, “Anderson Mezzanine Funding 2007-1, LTD.,” GS MBS-E-000912574, at 623.

the sole counterparty to the investors buying Hudson securities, thereby acquiring a $2 billion financial interest that was directly adverse to theirs.2725

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A federal court has held that disclosing a potential adverse interest, when a known

adverse interest already exists, can constitute a material misstatement to investors.2726 In the case of the Hudson CDO, much of the profit Goldman obtained would be generated from the losses incurred by clients that bought Hudson securities, creating an actual, undisclosed adverse interest. This construct, in which Goldman’s profits depended in part upon its clients’ losses, created a clear conflict of interest between Goldman and the clients to whom it was selling the Hudson securities, once Goldman had decided to become a short party in the CDO it was simultaneously marketing.

In another part of the Offering Circular, Goldman stated that GSI would serve as the sole

counterparty to the CDO, but that disclosure was made in the context of a common industry practice in which the CDO originator or its designate typically took the entire short side of the transaction in the first instance and was the only party that dealt directly with the shell corporation actually issuing the CDO’s securities. The CDO originator, or its designate, then acted as an intermediary between the shell corporation and the other broker-dealers buying short positions in the CDO on behalf of themselves or a customer. By placing itself in the middle of each CDS contract, the originator or its designate provided stronger financial backing for the CDS contracts being issued by the CDO and obtained more favorable credit ratings for the CDO securities. In the CDOs examined by the Subcommittee, Goldman followed industry practice by designating its affiliate, GSI, as the initial sole counterparty in the Hudson, Anderson, and Timberwolf CDOs.2727 Hudson CDO would likely have assumed that GSI planned to sell its initial short position to other parties, since that was industry practice. What Goldman failed to disclose to those customers is that it planned to hold (or already held) all or a substantial portion of the short side of the CDO as a proprietary investment adverse to the interests of the customers to whom Goldman was selling the CDO securities. Had those customers known of Goldman’s substantial short investment, they would likely have understood that Goldman viewed the very CDO securities it was recommending they purchase as likely not to perform.

Customers learning of GSI’s role as the initial sole counterparty in the

2725 See, e.g., Goldman response to Subcommittee QFR at PSI_QFR_GS0192 and PSI_QFR_GS00235.
2726 See, e.g., SEC v. Czuczko, Case No. CV06-4792 (USDC CD Calif.), Order Granting Plaintiff’s Unopposed Motion for Summary Judgment (Dec. 5, 2007) (finding defendant made a material misstatement to potential investors when he disclosed that officers, directors, employees and members of their families “may” trade in the stocks recommended on his website, without disclosing that he, his father, and business partner were trading in those stocks and had an interest in them). See also In the Matter of Arleen Hughes, Securities Exchange Act Rel. No. 4048 (Feb. 1948) (holding a broker-dealer, who is also a registered investment adviser, had to disclose the “nature and extent” of its adverse interest); In the Matter of Edward D. Jones & Co., L.P., Exchange Act Rel. No. 50910 (Dec. 22, 2004) (settled order), at 21 (disclosure inadequate for failing to disclose full nature and extent of the broker-dealer’s conflict of interest).
2727 Goldman sometimes referred to this position as the “Credit Protection Buyer” or “Synthetic Security Counterparty.”

Goldman’s failure to disclose its short interest was further compounded when it told

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investors that its interests “were aligned” with those of the long investors or when it advertised its retention of a portion of the CDO’s equity tranche. The Hudson marketing booklet stated:
“Goldman Sachs has aligned incentives with the Hudson program by investing in a portion of equity and playing the ongoing role of Liquidation Agent.”2728 What made the statement misleading and what Goldman failed to disclose in the booklet was that its $6 million equity investment2729 was far outweighed by its $2 billion short investment.2730 In addition, Goldman later used its liquidation agent position to benefit its short investment at the expense of the long investors in Hudson.2731 In Anderson, talking points prepared for the Goldman sales force advocated telling investors: “Goldman is underwriting the equity and expects to hold up to 50%.”2732 What the talking points left out was that Goldman’s $21 million equity investment in Anderson was less than one sixth the size of its $135 million short position.2733 In Timberwolf, the marketing booklet stated that Goldman was purchasing 50% of the equity tranche, and the collateral manager Greywolf was purchasing the other 50%.2734 Again, the booklet failed to disclose that Goldman’s equity investment was far outweighed by its short investment.2735 In each CDO, Goldman withheld from investors information that it had a more significant financial interest in seeing the CDO decline in value than increase in value. In light of its short investments, Goldman’s claims that its interests were aligned with, rather than adverse, to the investors to whom it was selling the CDO securities were misleading.

Shorting the Subprime Market. Goldman also failed to disclose to clients that, at the

same time it was recommending investments in Goldman-originated RMBS and CDO securities, it was committing billions of dollars to short the same types of securities, as well as their underlying assets,2736 and even some of the lenders whose mortgage pools were included or referenced in the securities.2737 In February 2007, Goldman’s net short totaled about $10 billion.2738 this omitted information – that Goldman was heavily shorting the same types of investments it was recommending – “would have been viewed by the reasonable investor as having

In June 2007, its net short reached about $13.9 billion. A significant issue is whether

2728 10/2006 Hudson Mezzanine Funding 2006-1, LTD., GS MBS-E-009546963, at 966, Hearing Exhibit 4/27-87.
2729 See Goldman response to Subcommittee QFR at PSI_QFR_GS0223. 2730 See, e.g., 10/30/2006 email from Mr. Ostrem, “Great Job on Hudson Mezz,” GS MBS-E-0000057886, Hearing Exhibit 4/27-90. 2731 See discussion of Goldman’s actions as the Hudson liquidation agent, above. 2732 3/13/2007 email from Mr. Ostrem to Scott Wisenbaker and Matthew Bieber, GS MBS-E-000898410, Hearing Exhibit 4/27-172.
2733 See Goldman response to Subcommittee QFR at PSI_QFR_GS0192.
2734 Timberwolf flipbook, GS MBS-E-000676809, Hearing Exhibit 4/27-99a.
2735 Goldman purchased its share of the Timberwolf equity tranche in March 2007, actually held it for only two months, and then, in May, sold it to Greywolf. See also Goldman response to Subcommittee QFR at PSI_QFR_GS0226.
2736 See, e.g., 6/5/2007 email from Benjamin Case to David Lehman, GS-MBS-E-001919861 (indicating Goldman was shorting some of the assets underlying Timberwolf using CDS contracts outside of the CDO). 2737 See, e.g., Goldman spreadsheet produced in response to a Subcommittee QFR, at GS MBS 0000037361 (identifying lenders whose stock Goldman shorted).
2738 See discussion of Goldman’s net short positions, section C(4)(b), above.

specific CDOs as well as the subprime mortgage market as a whole, Goldman failed to disclose other arrangements which created conflicts of interest and undisclosed financial interests that were adverse to its clients. Concerning Abacus, Goldman failed to disclose a compensation arrangement in which Goldman agreed to accept a fee for arranging low premium payments by the short party; those lower payments disadvantaged the long investors by reducing cash payments to the CDO. Concerning Hudson, Goldman failed to disclose that its dual roles as liquidation agent and sole short party meant that it could delay liquidating Hudson assets that were losing value and simultaneously increase the value of its short position; that same action increased the losses of the long investors. In Timberwolf, Goldman failed to disclose that it viewed its role as collateral put provider allowed it to refuse to consent to the purchase of default swap collateral securities and avoid any risk that the securities would decline in value – the very risk the long investors were paying Goldman a fee to assume.2740 In each CDO, Goldman took actions that created an undisclosed conflict of interest between itself and the investors to whom it recommended and sold the CDO securities.

These types of arrangements, when undisclosed, can result in conflicts of interest that disadvantage investors. The existence, nature, and extent of such arrangements are the type of material adverse information that the securities laws were designed to ensure were accurately described and disclosed to investors.

(iv) Making Unsuitable Investment Recommendations

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significantly altered the ‘total mix’ of information made available” about the securities Goldman was recommending.2739

Other Adverse Information. In addition to its failure to disclose that it was shorting

In addition to the disclosure issues, Goldman’s efforts to sell Hudson, Anderson,

Timberwolf, and Abacus securities raise a set of issues related to whether Goldman met its obligation to engage in fair dealing with its clients and avoid recommending investments that were unsuitable for any investor. The focus here is on Goldman’s sale of CDO securities that were designed to lose value, either because the short party selected the assets or the assets were so poor that Goldman knew or should have known they would perform poorly or fail, yet marketed them to customers anyway.

2739 That Goldman’s own investment decisions might be material information for an investor is demonstrated by a court ruling in a famous case in the 1970s, in which Goldman, an exclusive dealer, was sued by an investor who alleged that Goldman had sold it Penn Central notes without disclosing, among other things, that Goldman had recently reduced and placed limits on its own inventory of those same notes. Alton Boxboard v. Goldman, Sachs and Company, 560 F.2d 916 (8th Cir. 1977). Although the court decided the case on another basis, the Eighth Circuit found that the materiality of the undisclosed facts alleged was a question to be decided by a trier of fact.
The court took note of the testimony from two sophisticated institutional purchasers concerning Goldman’s reduction of inventory in Penn Central notes. Id at n.10. One sophisticated investor “testified that this information would have been a ‘red flag’ to him, and had he known of Goldman Sachs’ inventory decision, he would have wanted notes from another issuer.” Id. The other witness “stated he would have been concerned about such information and would have conveyed it to his customers, because it indicated that Goldman, Sachs did not have confidence in … [the] notes.” Id. 2740 Each of these matters is discussed in detail, above.

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As detailed earlier, broker-dealers are required to deal fairly with their customers and observe high standards of honor in the conduct of their business.2741 When a broker-dealer, acting as an underwriter, makes an investment recommendation to a client, it is implicit that the broker-dealer has a reasonable basis to believe that the issue is sound.2742 A broker-dealer is also required “to have an ‘adequate and reasonable basis’ for any security or strategy recommendation that it makes.”2743 Broker-dealers are barred from offering investments that are unsuitable for any investor.2744 Goldman itself, in response to a Subcommittee question, has acknowledged that broker-dealers owe a “general suitability” obligation to its institutional investors, and “[t]his suitability duty requires the broker-dealer to determine, in the first instance, that the transaction is suitable for at least some investors.”2745 Despite those requirements, the evidence gathered by the Subcommittee indicates that Goldman did not view any of the four CDOs examined in this Report as sound investments for the clients to whom it sold the securities.2746

Selection of Assets by Short Party. Internal documents and emails from Goldman

indicate that both Abacus and Hudson were designed with the expectation they would lose value and produce a profit for the short side of the CDOs. The sole short party in Abacus was the Paulson hedge fund; the sole short party in Hudson was Goldman itself.

With respect to Abacus, Goldman knew that the Paulson hedge fund wanted to take

100% of the short side and would profit only if the CDO lost value, yet allowed the hedge fund to play a major but hidden role in selecting the CDO assets.2747 The Goldman employee with lead responsibility for Abacus, Fabrice Tourre, called it a “weak quality portfolio.”2748 The Paulson hedge fund executive who participated in the asset selection process acknowledged he selected assets that he expected would not perform well.2749 A Moody’s executive who oversaw CDO ratings when Abacus was rated – and testified that he did not know of Paulson’s role in the Abacus asset selection process – explained that “[i]t just changes the whole dynamic of the structure where the person who is putting it together, choosing it, wants it to blow up.”2750 When Goldman began to publicly market the Abacus securities, Ed Steffelin, a Senior trader at GSC who had declined Goldman’s request that his firm serve as the CDO’s portfolio selection agent, sent an email to Peter Ostrem, head of Goldman’s CDO Origination Desk, stating: “I do not have to say how bad it is that you guys are pushing this thing.”2751 Subcommittee what he meant by that comment, Mr. Steffelin said that he believed the Abacus

2741 SEC Study on Investment Advisers and Broker-Dealers at 55. 2742 SEC v. Tambone, 550 F.3d 106, 135 (1st Cir. 2008) [citations omitted]. 2743 SEC Study on Investment Advisers and Broker-Dealers at 63 [citations omitted]. 2744 Id. at 61. 2745 See Goldman response to Subcommittee QFR at PSI_QFR_GS0048.
2746 See, e.g., 1/23/2007 email from Fabrice Tourre to Marine Serres, GS MBS-E-003434918, Hearing Exhibit 4/27-62 (Tourre wrote: “[S]tanding in the middle of all these complex, highly levered, exotic trades he [Mr. Tourre] created without necessarily understanding all the implications of these monstruosities [sic] !!!”). 2747 See discussion of Abacus in section C(5)(b)(ii)DD, above. 2748 12/18/2006 email from Fabrice Tourre, “Paulson,” GS MBS-E-003246145, Hearing Exhibit 4/27-107. 2749 SEC deposition of Paolo Pellegrini (12/3/2008). PSI-Paulson-04 (Pellegrini Depo)-0001, at 175-76.
2750 April 23, 2010 Subcommittee Hearing Transcript at 64. 2751 2/27/2007 email from Ed Steffelin to Peter Ostrem, GS MBS-E-009209654.

When asked by the

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CDO created “reputational risk” for the collateral manager industry and the whole market.2752
When Mr. Tourre later sought to book two CDS contracts referencing the Abacus securities, a Goldman salesman wrote: “seems we might have to book these pigs.”2753

As planned, once issued, the Abacus securities quickly lost value. In October 2007, six months after the Abacus securities were issued, the credit rating agencies downgraded them, and a Goldman salesperson noted: “This deal was number 1 in the universe of CDO’s that were downgraded by Moody’s and S&P. 99.89% of the underlying assets were downgraded.”2754 The three investors that bought Abacus securities together lost more than $1 billion, while the Paulson hedge fund, as the sole short party, recorded a corresponding $1 billion profit.2755 In July 2010, Goldman agreed to settle a securities fraud complaint brought by the SEC by paying a fine of $550 million and “acknowledging it was a mistake for the Goldman marketing materials to state that the reference portfolio was ‘selected by’ ACA Management, LLC without disclosing the role of Paulson & Co. Inc. in the portfolio selection process and that Paulson’s economic interests were adverse to CDO investors.”2756

With respect to Hudson, Goldman designed the CDO from its inception as a way to

transfer the risk of loss associated with ABX assets from Goldman’s inventory to the Hudson investors.2757 Goldman documents state, for example, that Hudson was “initiated by the firm as the most efficient method to reduce long ABX exposures,”2758 and the CDO was an “exit for our long ABX risk.”2759 Goldman created and took the short side of $2 billion in single name CDS contracts referencing RMBS securities that it wanted to short, and sold them to the Hudson CDO. The end result was that Goldman wrote 100% of the CDS contracts that made up Hudson’s assets and took 100% of the short side of the CDO, which meant that Goldman would profit if the CDO fell in value. Goldman marketed the CDO without disclosing its status as the sole short party, instead telling investors that its interests were “aligned” with theirs. The Hudson securities immediately began losing value. Within a year, while the holders of the Hudson securities lost virtually their entire investments, Goldman’s profits reached $1.7 billion, which it then used to offset other mortgage related losses.

In both CDOs, Goldman took actions that disguised that the transactions were designed to

lose value. In Abacus, Goldman omitted mention of the Paulson hedge fund’s involvement in the asset selection process and hired a well known third party portfolio agent, ACA

2752 Subcommittee interview of Ed Steffelin (12/10/2010). 2753 4/15/2007 email from Cactus Raazi to Daniel Chan, “Dan: ABACUS 07-AC1,” Hearing Exhibit 4/27-82.
2754 10/26/2007 email from Goldman salesman to Michael Swenson, “ABACUS 2007-AC1 – Marketing Points (INTERNAL ONLY) [T-Mail],” GS MBS-E-016034495.
2755 Securities and Exchange Commission v. Goldman Sachs, Case No. 10-CV-3229 (S.D.N.Y.), Complaint (April 16, 2010). 2756 SEC v. Goldman, Sachs & Co. and Tourre, Case No. 10-CV-3329 (BSJ) (S.D.N.Y.), Consent of Defendant Goldman, Sachs & Co (July 14, 2010). 2757 See discussion of Hudson CDO in section C(5)(b)(ii)AA, above. 2758 Goldman response to Subcommittee QFR at PSI_QFR_GS0249.
2759 9/20/2006 email from Arbind Jha to Josh Birnbaum, GS MBS-E-012685289.

Management, to “leverage ACA’s credibility.”2760 In Hudson, Goldman omitted that it had written all of the CDO’s CDS contracts and it referenced $1.2 billion in ABX assets in Goldman’s own inventory, and instead told investors that Hudson’s assets were “sourced from the Street” and Hudson was “not a Balance Sheet CDO.”2761

Goldman marketed the Abacus and Hudson securities to clients knowing that each CDO had been designed to lose value and produce a profit for the short party. Given that information, Goldman marketed CDOs that it knew or should have known were not suitable for any investor.

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Selection of Poor Quality Assets. Similar concerns apply to Goldman’s origination and marketing of the Anderson and Timberwolf CDOs, which contained such poor quality assets that Goldman knew or should have known that they would perform poorly or fail. Yet Goldman recommended them to investors anyway. The issue is whether, by recommending that investors purchase the Anderson and Timberwolf securities, Goldman violated its fair dealing obligation and recommended investments that were not suitable for any investor.

With respect to Anderson, Goldman personnel knew before marketing its securities that the CDO had poor quality assets that were losing value. Nearly 45% of the referenced RMBS securities in Anderson were dependent upon loans issued by New Century, while another 7% depended upon loans issued by Fremont, two subprime lenders known, including by Goldman personnel, for issuing poor quality loans and poorly performing RMBS securities.2762 On February 24, 2007, Goldman personnel calculated that the assets in the Anderson warehouse account had already lost $60 million in value from the time they were purchased.2763 In response, Mr. Sparks, the Mortgage Department head, decided to cancel the CDO.2764 Later, he changed his mind and rushed Anderson to market with only $305 million of the $500 million in assets that had been planned. Goldman was the largest short party, with 40% of the short interest in Anderson.

Anderson issued its securities on March 20, 2007. Goldman knew at the time that both New Century and Fremont were in financial distress.2765 In addition, the week before, Goldman had conducted reviews of both a New Century and a Fremont loan pool on the firm’s books, and found that 26% of the New Century loans2766 and 50% of the Fremont loans2767

2760 3/12/2007 Goldman memorandum to Mortgage Capital Committee, “ABACUS Transactions sponsored by ACA,” GS MBS-E-002406025, Hearing Exhibit 4/27-118. 2761 10/2006 Hudson Mezzanine Funding 2006-1, LTD., GS MBS-E-009546963, at 978, Hearing Exhibit 4/27-87. 2762 See discussion of Anderson CDO in section C(5)(b)(ii)BB, above. Another 8% were dependent upon loans issued by Countrywide. 2763 2/24/2007 email from Deeb Salem to Michael Swenson and others, GS MBS-E-018936137. 2764 2/24/2007 email from Mr. Sparks to Mr. Ostrem and others, GS MBS-E-001996601, Hearing Exhibit 4/27-95. 2765 See, e.g., 2/8/2007 email from Craig Broderick to Mr. Sparks and others, GS MBS-E-002201486 (calling New Century’s announcement that it would restate its earnings “a materially adverse development”); 3/14/2007 Goldman email, “NC Visit,” GS MBS-E-002048050 (stating Fremont still has cash “but not for long”); 3/13/2007 email from Mr. Ostrem to Scott Wisenbaker and Matthew Bieber, GS MBS-E-000898410, Hearing Exhibit 4/27- 172 (providing talking points for selling Anderson securities to customers). 2766 3/13/2007 email from Manisha Nanik, “New Century EPDs,” GS MBS-E-002146861, Hearing Exhibit 4/27-

reviewed had

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deficiencies and should be returned to the lender for refunds. Goldman nevertheless continued to market the Anderson securities. When some potential investors expressed concerns about Anderson’s underlying assets, in particular the New Century loans, Goldman tried to dispel those concerns even while harboring its own low opinion of New Century loans.2768 Goldman managed to sell approximately $102 million in Anderson securities to nine investors who lost virtually their entire investments within a year.2769

With respect to Timberwolf, Goldman personnel knew that the CDO’s assets had begun losing value almost from the time they were acquired.2770 Timberwolf was a CDO2 transaction comprised of 56 different CDO assets with over 4,500 unique underlying securities.2771 In February 2007, Mr. Sparks told a senior Goldman executive that it was a deal “to worry about,” and that its assets had already incurred such significant losses that they had exhausted the share of the warehouse risk held by Goldman’s partner in the transaction.2772 Despite that loss in value, Goldman continued with the issuance of the Timberwolf securities in March 2007. By May, a special CDO valuation project undertaken by the Mortgage Department found that the Timberwolf’s assets had lost still more value.2773 Despite its lower internal valuation, Mr. Sparks advised Goldman senior executives that his CDO pricing strategy was to “take the write- down, but market at much higher levels” to avoid “leaving some money on the table.”2774

During the spring and summer of 2007, Goldman aggressively marketed Timberwolf securities to investors around the world, eventually selling about $853 million in Timberwolf securities to 12 investors.2775 Goldman sold the securities at prices substantially above its internal book values for the Timberwolf securities. After making a sale, Goldman then, sometimes only days or weeks later, marked down the value of the securities it had sold, resulting in investors realizing losses and sometimes requiring the investor to post additional cash margin or collateral.2776 In September 2007, an internal Goldman analysis found that, in just six months, Timberwolf’s AAA rated securities had lost 80% of their value. One of Goldman’s senior executives monitoring Timberwolf pronounced it “one shitty deal.”2777 The CDO was liquidated in October 2008, and the investors who purchased Timberwolf securities lost virtually their entire investments.

2767 3/14/2007 Goldman email, “NC Visit,” GS MBS-E-002048050. 2768 See, e.g., 3/6/2007 email from Joshua Bissu to Mr. Ostrem and Mr. Bieber, GS MBS-E-014597705 (talking points for Goldman personnel to respond to investor concerns about the New Century loans). 2769 See e.g., Goldman response to Subcommittee QFR at PSI_QFR_GS0223. 2770 See, e.g., 9/17/2007 email from Christopher Creed, “Timberwolf,” GS MBS-E-000766370, Hearing Exhibit 4/27-106 (showing price for Timberwolf securities dropped from $94 on 3/31/2007 to $87 on 4/30/2007). 2771 8/23/2007 email from Jay Lee to Mr. Lehman and others, GS MBS-E-001927784. 2772 2/26/2007 email exchange between Mr. Sparks and Mr. Montag, GS MBS-E-019164799, Hearing Exhibit 4/27-71.
2773 5/20/2007 email from Paul Bouchard, “Materials for Meeting,” GS MBS-E-001863725.
2774 5/14/2007 email from Mr. Sparks to Mr. Montag and Mr. Mullen, GS MBS-E-019642797.
2775 See, e.g., Goldman response to Subcommittee QFR at PSI_QFR_GS0223. 2776 See, e.g., example involving Basis Capital in discussion of Timberwolf in section C(5)(b)(ii)CC, above. 2777 6/22/2007 email from Mr. Montag to Mr. Sparks, “Few Trade Posts,” GS MBS-E-010849103, Hearing Exhibit 4/27-105.

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Goldman CEO Lloyd Blankfein said publicly about the firm’s securities: “If we believed

it would fail … the security wouldn’t work, we would not sell it.”2778 But Goldman marketed the Anderson and Timberwolf securities to clients knowing that each CDO had poor quality assets that were continually losing value. It marketed them at the same time it was investing on the short side of the CDOs and the subprime mortgage market as a whole, and its Mortgage Department head was telling his staff that it was “Game Over” and time to “get out of everything.”2779 Within a year, the Anderson and Timberwolf securities were virtually worthless. Given what Goldman knew when marketing Anderson and Timberwolf, Goldman was recommending investments that were most likely not suitable for any investor.

This analysis examines Goldman’s conduct in the context of the law prevailing in 2007.

Since then, the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 has established new conflict of interest prohibitions that would apply to this type of conduct, including Section 621 which bars any underwriter or placement agent of an asset backed security from engaging in any transaction “that would involve or result in any material conflict of interest with respect to any investor in a transaction arising out of such activity.”

(7) Goldman’s Proprietary Investments

When reviewing the conflict of interest issues related to Goldman’s mortgage related activities in 2006 and 2007, another issue examined by the Subcommittee was the extent to which Goldman’s Mortgage Department was engaged in proprietary trading.2780

In a

In 2007, Goldman was not a commercial bank, and proprietary trading was not illegal.

The issue that concerned the Subcommittee was the extent to which its proprietary activities may have contributed to the conflicts of interest that affected how Goldman operated.2781

2778 April 30, 2010 transcript of The Charlie Rose Show, at 14. 2779 3/12/2007 Goldman Firmwide Risk Committee, “March 7th FWR Minutes,” GS MBS-E-00221171, Hearing Exhibit 4/27-19; 3/3/2007 email from Mr. Sparks, “Call,” GS MBS-E-010401251, Hearing Exhibit 4/27-14.
2780 Until its repeal in 1999, the Glass-Steagall Act prohibited banks from engaging in proprietary trading. Glass- Steagall Act, Section 16. The Act’s prohibition on proprietary trading was weakened over the years and finally repealed by the Financial Services Modernization Act of 1999, P.L. 106-102 (1999). Since Goldman did not become a bank holding company until 2008, neither the Glass-Steagall prohibition nor its repeal affected its activities during the time period examined by the Subcommittee.
2781 Financial institutions that trade for their own accounts at the same time that they conduct trades on behalf of their clients may experience conflicts of interest. See, e.g., 4/23/2010 letter from John Reed, former Chairman and CEO of Citigroup, to Senators Merkley and Levin (“When a firm is focused on market gain through proprietary trading, it too often will employ every available device to achieve those gains B including take advantages of clients and putting the firm at risk.”); In re Merrill Lynch, Pierce, Fenner & Smith, Incorporated, Exchange Act Rel. No. 34-63760, Admin. Proc. 3-14204 (Jan. 25, 2011) (settling allegations that Merrill Lynch’s proprietary traders misused information about their customers’ trading); 7/19/2005 speech by Annette Nazareth before the Securities Industry Association Compliance and Legal Division Member Luncheon (discussing increased potential for conflicts of interest). In 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act, P.L. 111-603, restored the prohibition on proprietary trading by banks, subject to certain exceptions. See Section 619, amending the Bank Holding Company Act of 1956, to be codified at 12 U.S.C. §1851. Regulations implementing Section 619, also known as the Merkley-Levin provisions after the Senators who authored them or the Volcker Rule after former Federal Reserve Chairman Paul Volcker who championed the ban, are due by October 2011.

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recently issued “Report of the Business Practices Committee,” Goldman reaffirmed as its first business principle: “Our clients’ interests always come first.”2782 Contrary to that statement, however, Goldman documents showed its employees repeatedly expressing concern about the firm’s interests, but rarely mentioning or placing a priority on the interests of its clients. In fact, after Goldman announced record profits for its Mortgage Department in the third quarter of 2007, when many of its clients were suffering substantial losses from the mortgage investments they purchased from Goldman, Peter Kraus, co-head of the Investment Banking Division, wrote the following to Goldman CEO Lloyd Blankfein:

“I met with 10+ individual prospects and clients … since earnings were announced. The institutions don’t and I wouldn’t expect them to, make any comments like ur good at making money for urself but not us. The individuals do sometimes, but while it requires the utmost humility from us in response I feel very strongly it binds clients even closer to the firm, because the alternative of take ur money to a firm who is an under performer and not the best, just isn’t reasonable. Clients ultimately believe that association with the best is good for them in the long run.”2783

The tension between Goldman’s efforts to make money on behalf of itself versus on behalf of its clients raises a number of conflict of interest concerns, particularly when its efforts to profit from shorting the mortgage market or particular RMBS or CDO securities occurred simultaneously with its efforts to market mortgage related securities to its clients.

Goldman’s Proprietary Activities. Until recently, when asked about the extent of the

firm’s proprietary activities, Goldman generally claimed that its proprietary investments contributed only approximately 10% of the firm’s profits.2784 In January 2011, however, Goldman announced in an SEC filing that it was changing the categories under which it reported income. Goldman added a new category called “Investments and Lending” to segregate the firm’s proprietary investment income from the income it derived from activities undertaken on behalf of clients.2785 Based on earnings reported in January 2011 for Goldman=s full fiscal year 2010, the proprietary investment income recorded under “Investments and Lending” accounted

2782 1/2011 “Report of the Business Standards Committee,” at 1. In May 2010, at Goldman’s annual shareholders’ meeting, CEO Lloyd Blankfein announced the formation of a Business Standards Committee to conduct an extensive review of the firm’s business standards and practices to determine the extent to which the firm was adhering to its own written “Business Principles,” and to make appropriate recommendations. Id. The Committee’s January 2011 report provided recommendations in the areas of Client Relationships and Responsibilities, Conflicts of Interest, Structured Products, Transparency and Disclosure, Committee Governance, and Training and Professional Development. 2783 9/26/2007 email to Mr. Blankfein, “Fortune: How Goldman Sachs Defies Gravity,” GS MBS-E-009592726, Hearing Exhibit 4/27-135. 2784 See, e.g., 1/21/2010, The Goldman Sachs Group Inc., 4Q 2009 Earnings Call Transcript, Q&A (CFO David Viniar states that, in most years, proprietary trading accounts for “10% roughly plus or minus a couple of percent.”), http://seekingalpha.com/article/183723-the-goldman-sachs-group-inc-q4-2009-earnings-call-transcript?part=qanda.
2785 1/11/2011 Goldman Form 8-K filed with the SEC (announcement of change in reporting categories).
Goldman’s change in its reporting categories implemented one of the recommendations outlined in Goldman’s “Report of the Business Standards Committee” published in January 2011.

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for $7.5 billion, or about 20% of Goldman’s net revenues.2786 Goldman did not specify how it defined proprietary investments and lending for purposes of its earnings report, nor what desks or activities contributed to the total, how it calculated the reported amount, or why it was double the amount cited a year earlier.

To date, three Goldman units have been identified as engaging explicitly in investments on behalf of the firm. One, based in New York, is called Goldman Sachs Principal Strategies or “GSPS,” which Goldman is reportedly in the process of dismantling.2787 The second is the Global Macro Proprietary Trading Desk, which had traders in New York and London and reportedly invested in foreign exchange markets, interest rate markets, stocks, commodities and other fixed income markets.2788 The third, according to Goldman, is the Special Situations Group or SSG, which is reportedly engaged primarily in long term investments on behalf of the firm and clients, with little short term trading or sales activities.2789

Proprietary Activities in the Mortgage Area. In the mortgage area, until 2005,

Goldman had a dedicated proprietary investment desk in the Mortgage Department called the Principal Finance Group, often referred to as Principal Investments.2790 According to Goldman personnel, that desk specialized in long term investments on behalf of Goldman in assets such as distressed mortgages and credit card and energy receivables, but only rarely engaged in short term trading.2791 In 2005, Principal Investments was folded into the Special Situations Group (SSG), which was then a Goldman business unit located in Asia and not part of the Mortgage Department.2792 operated without a desk that was explicitly dedicated to proprietary trading during 2006 and

After Principal Investments personnel moved to SSG, the Mortgage Department

When asked whether the Mortgage Department engaged in proprietary activities during 2006 and 2007, Goldman executives and traders in the Mortgage Department generally resisted providing a direct answer, declined to identify any proprietary trades or investments, and

2786 See 1/19/2011 Goldman press release on 2010 earnings, available at www2.goldmansachs.com.
2787 Subcommittee interview of David Viniar (4/13/2010). See also “More Goldman Traders to Exit for Funds,” Financial Times (1/9/2011). Goldman may be eliminating the desk in response to the Dodd-Frank prohibition on proprietary trading. 2788 See “Goldman to Shut Global Macro Trading Desk,” New York Times (2/16/2011). Goldman may be eliminating this desk in response to the Dodd-Frank prohibition on proprietary trading. 2789 Subcommittee interview of Darryl Herrick (10/13/2010). To the extent that its activities are limited to long term investments, the SSG unit would not be affected by the Dodd-Frank prohibition on proprietary trading which applies only to trading accounts used “principally for the purpose of selling in the near term (or otherwise with the intent to resell in order to profit from short-term price movements),” and does not affect long term investments. See Section 619(h)(6). Under Section 620 of the Dodd-Frank Act, banking regulators are also conducting an 18-month review of all permitted bank investment activities, both long and short term, to gauge the risk of each activity, any negative effect the activity may have on the safety and soundness of the banking entity or the U.S. financial system, and the “appropriateness” of each activity for a federally insured bank. 2790 Subcommittee interview of Darryl Herrick (10/13/2010). 2791 Id. 2792 Id.

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declined to estimate or calculate how much of the Mortgage Department=s 2007 revenues or profits were proprietary.

When asked about particular transactions, Goldman executives or traders often described them as examples, not of “proprietary trading,” but “principal trading” in which Goldman acted as a market maker. Goldman personnel told the Subcommittee that to fulfill the firm’s role as a market-maker, Goldman used its own capital to amass an inventory of assets in anticipation of customer demand, and acted as a “principal” when building that inventory. They indicated that the mortgage related assets were acquired for the purpose of accommodating existing or anticipated client buy and sell orders and not to produce proprietary profits for the firm.

At the same time, several Goldman executives and traders told the Subcommittee that all of Goldman’s trading desks, including those in the Mortgage Department, were given discretion to trade some amount of the firm’s capital within certain limits.2793 Daniel Sparks told the Subcommittee: “We told [the Firmwide Risk Committee] what we wanted to do, and they told us how much we could do.”2794 Joshua Birnbaum said that the amount of proprietary trading that a desk was allowed to do depended upon certain risk limits, but could not recall a specific or typical dollar amount of any risk limit assigned to the Mortgage Department as a whole or to any of its trading desks for proprietary trading purposes.2795 Goldman’s Chief Risk Officer Craig Broderick told the Subcommittee that the firm did not distinguish between “proprietary” versus other types of risk, because the aggregate risk levels would be the same.2796 Mr. Broderick said that the firm’s proprietary trading, outside of GSPS, was “embedded” in the routine business conducted by various trading desks and was not specifically segregated as “proprietary.”2797

Until enactment of the Dodd-Frank Act in 2010, federal securities law contained no

statutory or regulatory definition of proprietary trading by banks and generally did not require firms to identify or monitor their proprietary investments.2798 The Subcommittee investigation found that the terms “proprietary” and “prop” were commonly used in the financial services industry to describe business performed on behalf of, or for the benefit of, a financial firm itself,

2793 Subcommittee interviews of Mr. Sparks (4/15/2010); Mr. Birnbaum (4/22/2010); and Mr. Broderick (4/9/2010).
See also 12/17/2007 email from Michael DuVally to Mr. Sparks, “WSJ Responses,” GS MBS-E-013821884 (“Some traders are allowed to express their own market views using the firm’s capital.”).
2794 Subcommittee interview of Daniel Sparks (4/15/2010). 2795 Subcommittee interview of Joshua Birnbaum (4/22/2010). 2796 Subcommittee interview of Craig Broderick (4/9/2010). 2797 Id. Goldman’s Chief Financial Officer David Viniar provided similar information in response to questions from the Financial Crisis Inquiry Commission, indicating that Goldman did not specifically “break out” its proprietary trading from its other business results. See FCIC Hearing, Testimony of David Viniar (7/2/2010), www.fcic.gov. 2798 The Dodd-Frank Act defines “proprietary trading” as “engaging as a principal for the trading account of [a] banking entity . . . in any transaction to purchase or sell, or otherwise acquire or dispose of, any security, any derivative, any contract of sale of a commodity for future delivery, any option on any such security, derivative, or contract or any other security or financial instrument that the appropriate Federal banking agencies … may, by rule … determine.” 12 U.S.C. ‘ 1851(h)(4). The Act further defines “trading account” as one used for “near term” trading or for capturing profits from “short term price movements.” Section 1851(h)(6). These provisions are subject to further refinement through implementing regulations.

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while the term “flow” was used to refer to market-making transactions involving, or for the benefit of, the firm’s customers.2799

A number of internal Goldman documents in 2006 and 2007, used the terms “prop” and

“flow” when referring to mortgage related activities. In a 2006 email to Goldman senior executives, for example, Mr. Sparks, the Mortgage Department head, used the terms when criticizing a decision by Morgan Stanley to move its most experienced mortgage traders from its mortgage department’s “franchise” desk to a dedicated proprietary desk.2800 Mr. Sparks argued against Goldman=s doing the same by claiming exposure to customer trades or “flows” made mortgage traders “more effective” in their proprietary trades:

“Morgan Stanley is going overboard by taking most of their experienced and known traders out of the franchise. We should keep our franchise leaders in the seats and continue to allow them to take prop views B the customer flows they see make them more effective.”2801

This email shows, not only that Mr. Sparks and other Goldman executives used the terms “prop” and “flow,” but they also knew Goldman mortgage traders were handling both customer and proprietary transactions at the same time.

In November 2007, Mr. Sparks received an email from the Mortgage Department’s

business manager, John McHugh, indicating that proprietary trades made up a substantial portion of the Department’s activities.2802 In the email, Mr. McHugh provided Mr. Sparks with a draft of the Department=s 2008 business plan which included a description of the projected business activities of the Structured Product Group – the Mortgage Department trading desk that then handled RMBS, CDO, and other mortgage related trading activities. Under the heading, “Prop vs. Flow,” the draft plan stated: “Prop/flow components of SPG Trading will be roughly equal.”2803 Security] p&l [profit and loss],” the draft business plan stated:

Under another section entitled, “Assumptions/ Initiatives in ABS [Asset Backed

2799 See, e.g., description of proprietary trading in Deutsche Bank’s 3/26/2008 Form 20-F filed with the SEC at 24 (“Within Corporate Banking & Securities, we conduct proprietary trading, or trading on our own account, in addition to providing products and services to customers. Most trading activity is undertaken in the normal course of facilitating client business. For example, to facilitate customer flow business, traders will maintain long positions (accumulating securities) and short positions (selling securities we do not yet own) in a range of securities and derivative products, reducing this exposure by hedging transactions where appropriate. While these activities give rise to market and other risk, we do not view this as proprietary trading. However, we also use our capital to exploit market opportunities, and this is what we term proprietary trading.”).
2800 4/13/2006 email from Mr. Sparks to Messrs. Cohn, Sobel, and Mullen, “Morgan Super Traders Worry Hedge Funds,” GS MBS-E-016187625.
2801 Id. See also Glenn Bedwin, International Research Director, Thomson Financial, Trading for Investors Forum, Financial News Supplement at 14 (2004) (noting the value of “information [banks] gain from looking at the flow going through their desk”). 2802 11/16/2007 email from John McHugh to Mr. Sparks, “FICC 2008 business plan presentation to Firm,” GS MBS-E-013797964. 2803 Id.

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“Good prop opportunity capitalizing on selling pressure, selective distressed asset purchases. Expect prop flow split to be roughly 50/50.”2804

The draft business plan suggests that fully half the 2008 SPG and ABS activities were expected to involve proprietary investments.

When the Subcommittee asked Mr. Sparks about the “prop/flow components of SPG

Trading” in the Department’s 2008 draft business plan, Mr. Sparks indicated that he was not sure what his business manager meant and was unable to estimate what percentage of the SPG Trading Desk’s activities was spent on proprietary trades.2805 In a later written response to Subcommittee questions about the email, Mr. Sparks wrote: “‘Prop’ or ‘proprietary’ can mean different things to different people.” He continued that Mr. McHugh=s email appeared to use “prop” to refer to investments made with a longer holding period, such as months or years, while “flow” seemed to refer to investments with a shorter holding period:

“Defined this way, both ‘prop’ and ‘flow’ trades can involve customers, although sometimes the term ‘proprietary’ is used to describe business that does not involve a customer. (Sometimes proprietary is used to describe any activity that involves use of a firm’s own capital.).”2806

Goldman’s Net Shorts As Proprietary Investments. Goldman’s practice of embedding

its proprietary trading activities within the ordinary trading conducted on its market-making mortgage trading desks, together with its unwillingness to estimate its proprietary activities, made it difficult to determine the extent of the proprietary trading that took place within the Mortgage Department from 2006 to 2007.2807 by the Mortgage Department from late 2006 to late 2007 appear to have been undertaken to advance the financial interests of the firm, rather than primarily to make markets for clients.

Nonetheless, many of the transactions undertaken

Several factors suggest that transactions undertaken to build and profit from Goldman’s two large net short positions in 2007 were completed for Goldman’s own benefit, rather than on

2804 Id. 2805 Subcommittee interview of Daniel Sparks (10/3/2010).
2806 Daniel Sparks response to Subcommittee QFR at PSI-QFR_GS0452.
2807 The difficulties associated with distinguishing between proprietary trading and market making activities are examined in a recent study by the new Financial Stability Oversight Council (FSOC), an intra-governmental council established by the Dodd-Frank Act, comprised of ten regulators in the financial services sector, and charged with identifying risks and responding to emerging threats to U.S. financial stability. See FSOC FAQs, www.treasury.gov; 1/2011 “Study & Recommendations on Prohibitions on Proprietary Trading & Certain Relationships with Hedge Funds & Private Equity Funds” (hereinafter “FSOC Study”), at 22-44. The FSOC Study observed: “Absent robust rules and protections, banking entities may have the opportunity to migrate existing proprietary trading activities from the standalone business units that are presently recognized as ‘proprietary trading” into more mainstream ‘sales and trading’ or other operations that engage in permitted activities.” Id. See also “Proprietary Trading Goes Under Cover: Michael Lewis,” Bloomberg, (10/27/2010) (quoting a bank trader who reportedly said “from here on out, if he wants to take a proprietary position … he will argue that he bought the position because a customer wanted to sell the position, and he was providing liquidity”).

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behalf of its clients. First, the two net short positions – totaling $10 billion in February and $13.9 billion in June 2007 – were far larger than a financial institution would establish simply to meet anticipated client demand.2808 positions was also outsized. As indicated earlier, the Mortgage Department typically contributed only about 2% of Goldman’s total net revenues, yet in 2007, it was allowed to continually exceed its permanent Value-at-Risk (VAR) limit and incur up to 54% of firmwide risk. The Subcommittee uncovered no evidence to suggest that Goldman incurred and sustained that disproportionately high level of risk to accommodate client demands or to hedge positions taken on to accommodate clients.

Second, the magnitude of the risk attached to those short

A third factor indicating the net short positions were proprietary in nature was how long Goldman held onto them. For example, the Mortgage Department maintained a $9 billion ABX AAA short for six to nine months in 2007. While that short was initially used to hedge certain long positions held by various Mortgage Department desks, it was retained even after those long positions were sold off or written down. Mr. Sparks later described the ABX AAA short as “disaster insurance” in case the subprime market collapsed.2809 The Subcommittee found no evidence indicating that the $9 billion short was maintained over such a long period of time to accommodate client demand.

A fourth factor indicating Goldman’s net short positions were proprietary in nature was the Mortgage Department’s affirmative effort to solicit clients to buy RMBS and CDO assets in its inventory.2810 The Subcommittee saw no evidence that this sales activity was undertaken to accommodate client demand; to the contrary, the documents show that the Mortgage Department’s sales efforts took place amid a deteriorating mortgage market and waning investor interest in mortgage related products.2811

Still another indicator that the Mortgage Department’s net shorts were proprietary was

On another occasion in March 2007, a Goldman employee

that, when clients expressed interest in acquiring certain short positions, Goldman at times refused to accommodate their requests. For example, in June 2007, when Goldman began building its second large net short position, its Mortgage Department refused client requests to purchase the short side of CDS contracts with Goldman: “Really don=t want to offer any [shorts to customers]” and “too late!”2812

2808 These totals include Goldman’s net shorts from both its mortgage trading and CDO securitization activities. 2809 Subcommittee interview of Daniel Sparks (4/15/2010). 2810 See, e.g., documents cited in Section C(4)(b) (sales efforts to reduce Goldman’s $6 billion long position) and Section C(5)(a)(iii) (sales efforts to reduce Goldman-originated RMBS and CDO securities), above. 2811 See, e.g., emails noting difficult sales environment. 1/31/2007 email from Mr. Sparks to Mr. Montag, “MTModel,” Hearing Exhibit 4/27-91 (making “lemonade out of some big old lemons”); 3/9/2007 email from Mr. Sparks to Mr. Schwartz and others, GS MBS-E-010643213, Hearing Exhibit 4/27-76 (“team is working incredibly hard and is stretched”); 3/27/2007 email from Mr. Ostrem to Mr. Bieber, GS MBS-E-000907935, Hearing Exhibit 4/27-172 (congratulating Mr. Bieber for “an excellent job pushing to closure these deals in a period of extreme difficulty”); 6/11/2007 email from Mr. Montag, GS MBS-E-001866144 (after a sale of Timberwolf securities, telling the sales team they had done an “incredible job B just incredible”). 2812 6/10/2007 email from Michael Swenson, “CDS on CDOs,” GS MBS-E-012568089; 6/13/2007 email from sales, “CDO protection,” GS MBS-E-012445931. See also 9/7/2007 Fixed Income, Currency and Commodities Annual Individual Review Book, Salem 2007 Self-Review, GS-PSI-03157 at 71 (in his self-evaluation Mr. Salem

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told Goldman’s Chief Risk Officer Mr. Broderick that the Mortgage Department was no longer buying subprime assets: “Just fyi not for the memo, my understanding is that desk is no longer buying subprime. (We are low balling on bids.).”2813 Refusing client requests and lowballing bids to avoid purchases indicate that the Goldman Mortgage Department was not acting as a market maker to accommodate client demand.

Perhaps the strongest indicator that Goldman’s large net short positions were proprietary investments are the statements made by Goldman’s own executives and traders. Goldman’s head ABX trader, Joshua Birnbaum, described the Department’s decisions in February and June to build and profit from its net short positions, not as efforts to accommodate anticipated client demand, but as investments made on behalf of the firm to produce large profits:

“Whereas execution of strategies has clearly been a concerted team effort, I consider myself the initial or primary driver of the macro trading direction for the business. I would highlight 3 major calls here:

Dec-Feb: … The prevailing opinion within the department was that we should just ‘get close to home’ and pare down our long. … I concluded that we should not only get flat, but VERY short. … [W]e all agreed the plan made sense. … [W]e implemented the plan by hitting on almost [every] single name CDO protection buying opportunity in a 2- month period. Much of the plan began working by February when the market dropped 25 points and our profitable year was underway. …
Jun-Jul: the BSAM [Bear Stearns Asset Management failure] changed everything. I felt that this mark-to-market event for CDO risk would begin a further unraveling in mortgage credit. Again, when the prevailing opinion in the department was to remain close to home, I pushed everyone on the desk to sell risk aggressively and quickly. We sold billions of index and single name risk such that when the index dropped 25pts in July, we had a blow-out p&l [profit & loss] month, making over $1Bln that month. …

We made money: a) taking large directional views, the direction of which we changed several times, b) … betting the bad names would get much worse vs. the good ones, c) shorting CDOs, d) capturing the index to single name basis … among other things.”2814

wrote that his desk sold short positions on single name CDS contracts only to customers that could provide Goldman with useful information: “We were very aggressive with pricing and only shared risk [short positions] with smart guys if they gave us insight on names to go short or go long in return.”). 2813 3/2/2007 email exchange between Mr. Broderick and Patrick Welch, GS MBS-E-009986805, Hearing Exhibit 4/27-63. 2814 9/26/2007 EMD Reviews, Joshua Birnbaum Self-Review, GS-PSI-01975, Hearing Exhibit 4/27-55c. Mr. Birnbaum’s comments indicate that Goldman’s proprietary activities extended to its CDO activities. As explained earlier, while Abacus 2007-AC1 was undertaken in response to a client request, Hudson 1 was conceived by the Mortgage Department as a way to transfer risk associated with poorly performing ABX assets in its inventory.
Goldman supplied 100% of the CDS contracts that made up Hudson’s assets, took 100% of the short side, and profited at the expense of the Hudson investors. In October 2006, Mr. Ostrem, head of the CDO Origination Desk, wrote to Mr. Sparks that a client was upset, because it knew “Hudson Mezz (GS prop deal) is pushing their deal back,” clearly identifying Hudson as a “prop” or proprietary transaction. 10/16/2006 email from Mr. Ostrem to Mr. Sparks, GS MBS-E 010916991, Hearing Exhibit 4/27-59. See also 2/25/2007 email exchange between Peter Ostrem and Matthew Bieber, at GS MBS-E-001996601, Hearing Exhibit 4/27-95 (Mr. Ostrem proposed allowing a hedge

In a later presentation put together to propose a new compensation arrangement for the SPG Trading Desk’s trading activities, Mr. Birnbaum was unequivocal that the net shorts the desk had acquired were not hedges to offset risk, but “outright” short investments to produce profits:

In his 2007 self-evaluation, Michael Swenson, head of the Mortgage Department=s SPG

Trading Desk, described the net short positions undertaken by the firm in this way:

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“It should not be a surprise to anyone that the 2007 year is the one that I am most proud of to date. … extraordinary profits (nearly $3bb [billion] to date). … I directed the ABS desk to enter into a $1.8 bb short in ABS CDOs that has realized approx. $1.0bb of p & l [profit and loss] to date. … [W]e aggressively capitalized on the franchise to enter into efficient shorts in both the RMBS and CDO space.”

Mr. Swenson’s description of the net short position he “directed” to be built in CDOs and

the resulting $1 billion in profit makes no reference to client demands. Mr. Salem, a trader on the ABS Desk, was equally clear in his 2007 self-evaluation that the desk made a deliberate bet on the direction of the mortgage market: “Mike, Josh, and I were able to learn from our bad long position at the end of 2006 and layout the game plan to put on an enormous directional short.”2816 Each of these three Mortgage Department employees played a key role in building the firm’s net short positions. Their own statements indicate that they perceived acquiring the 2007 net short positions to be for the benefit of the firm, and not to build an inventory of assets to respond to anticipated client demand.

Other internal documents also portray the net short positions as decisions made by the

firm to advance its own financial interests. In an internal presentation to the Goldman Board of Directors regarding the “Subprime Mortgage Business,” for example, the Mortgage Department wrote that, in the first quarter of 2007, “GS reverse[d] long market position through purchase of

fund to include assets in Anderson and then short them, but Mr. Bieber thought Mr. Sparks would want to “preserve that ability for Goldman”); 12/29/2006 email from Mr. Birnbaum to Mr. Lehman, GS MBS-E-011360438, Hearing Exhibit 4/27-5 (when discussing certain proposed CDO deals that would generate $1 to $3 billion in short positions and reference certain RMBS securities, Mr. Birnbaum stated: “On baa3 [RMBS securities with credit ratings of BBB-], I’d say we definitely keep it for ourselves. On baa2 [RMBS securities with BB ratings], I’m open to some sharing to the extent that it keeps these customers engaged with us.”).
2815 10/3/2007 “SPG Trading B 2007,” presentation prepared by Joshua Birnbaum with input from other SPG employees, but which was not ultimately provided to senior management, GS MBS-E-015654036, at 44 [emphasis in original]. Mr. Birnbaum reaffirmed his analysis in a 2010 written response to Subcommittee questions. See Mr. Birnbaum’s response to Subcommittee QFR at PSI_QFR_GS0509. 2816 9/7/2007 Fixed Income, Currency and Commodities Annual Individual Review Book, Salem 2007 Self-Review, GS-PSI-03157, at 71.

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single name CDS and reductions of ABX.”2817 In September 2007, the Goldman Board of Directors summarized its mortgage business this way: “Although broader weakness in the mortgage markets resulted in significant losses in cash position, we were overall net short the mortgage market and thus had very strong results.”2818 Talking points prepared for CFO David Viniar prior to a March 2007 earnings call with analysts stated: “The Mortgage business’ revenues were primarily driven by synthetic short positions.”2819 to the SEC, Goldman wrote:

In an October 2007 letter sent

“[W]e are active traders of mortgage securities and loans and … we may choose to take a directional view of the market …. For example, during most of 2007, we maintained a net short sub-prime position and therefore stood to benefit from declining prices in the mortgage market.”2820

In an October 2007 internal presentation to another Goldman unit, Chief Risk Officer Craig Broderick wrote:

“So what happened to us? … In market risk B you saw in our 2nd and 3rd qtr results that we made money despite our inherently long cash positions. – because starting early in ‘07 our mortgage trading desk started putting on big short positions … and did so in enough quantity that we were net short, and made money (substantial $$ in the 3rd quarter) as the subprime market weakened.”2821

In a November 2007 email to his colleagues, Goldman CEO Lloyd Blankfein wrote: “Of course we didn’t dodge the mortgage mess. We lost money, then made more than we lost because of shorts.”2822 transactions were undertaken to accommodate existing or anticipated client trades.

None of these internal documents suggests that the Mortgage Department’s net short

In January 2011, the new Financial Stability Oversight Council (FSOC) issued a study that focused, in part, on criteria that can be used to distinguish between proprietary and market

2817 3/26/2007 Presentation to Goldman Board of Directors, “Subprime Mortgage Business,” GS MBS-E- 005565527, Hearing Exhibit 4/27-22. 2818 9/17/2007 Board of Directors Meeting Financial Summary, GS MBS-E-009776907, Hearing Exhibit 4/27-42. 2819 3/9/2007 email from Sheara Fredman to David Viniar and others, GS MBS-E-009762678, Hearing Exhibit 4/27-16. When preparing a later internal presentation, in October 2007, Dan Sparks was even more blunt: “The desk benefitted from a proprietary short position in CDO and RMBS single names.” 10/5/2007 draft of “Business Unit Townhall Presentation, Q3 2007,” prepared by Mr. Sparks, Hearing Exhibit 4/27-47. Mr. Sparks removed this phrase from the final version of the presentation and told the Subcommittee he had been mistaken to include it in the earlier draft. 2820 10/4/2007 letter from Goldman to the SEC, GS MBS-E-009758287, Hearing Exhibit 4/27-46.
2821 10/29/2007 presentation by Craig Broderick to the Tax Department, GS MBS-E-010018512, Hearing Exhibit 4/27-48. See also 10/5/2007 draft presentation by Mr. Sparks, for a Business Unit Townhall meeting, GS MBS-E- 013703468, Hearing Exhibit 4/27-47 (“The desk benefited from a proprietary short position in CDO and RMBS single names.”). 2822 11/18/2007 email from Mr. Blankfein, “NYT,” GS MBS-E-009696333, Hearing Exhibit 4/27-52.

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making activities.2823 Applying those recently developed criteria to the Mortgage Department’s 2007 activities also supports viewing that activity as the result of proprietary rather than market making activities. For example, the Mortgage Department was building its net shorts with the expectation that they would appreciate in value rather than provide assets to facilitate customer transactions; the position created risks out of proportion to those necessary to accommodate customer demand; the Mortgage Department actively and aggressively solicited clients to build its short positions; the Mortgage Department accumulated an unpredictable inventory profile in terms of volume and in relation to customer demand; and it had a relatively low inventory turnover with the bulk of the profits derived from inventory appreciation when Goldman covered its shorts.

Advocating More Proprietary Trading. One last set of documents shines additional light on the role of proprietary investments in the Goldman Mortgage Department in 2006 and

As indicated earlier, for several years, Goldman’s Mortgage Department had a proprietary trading desk, Principal Investments, that was explicitly and exclusively dedicated to engaging in transactions for the benefit of the firm. In 2005, it was moved to the SSG unit. Internal Goldman documents show that some in the Mortgage Department wanted to revive that desk, increase the amount of proprietary trading in the mortgage area, or claim a greater share of the proprietary profits created by the Mortgage Department for the firm.

In August 2006, for example, the CDO Origination Desk proposed that Goldman

establish a formal proprietary trading fund or proprietary trading operation within the Mortgage Department to conduct mortgage related transactions on behalf of the firm. In an August 2006 email, Peter Ostrem, the CDO Origination Desk head, made the proposal to Mr. Sparks, the Mortgage Department head:

“Let’s do our own fund. SP [Structured Product] CDO desk. Big time. GS [Goldman Sachs] commits to hold proportion of equity outright. This could be big. … I need real leverage. Got some structured ideas too. When can we talk strategy for an hour or so?”2824

Mr. Sparks responded: “Next week. In the meantime calm the blank down.”2825 Later the same day, he later wrote to Mr. Ostrem: “Not going to happen.”2826 When asked about these emails, Mr. Sparks told the Subcommittee that Goldman decided not to allow the Mortgage Department to set up its own hedge fund or explicit proprietary trading desk.2827

2823 1/2011 “Study & Recommendations on Prohibitions on Proprietary Trading & Certain Relationships with Hedge Funds & Private Equity Funds,” at 22-44. 2824 8/10/2007 email from Mr. Ostrem to Mr. Sparks, “Leh CDO Fund,” GS MBS-E-010898470. 2825 Id. 2826 8/10/2007 email from Mr. Sparks to Mr. Ostrem, “Leh CDO Fund,” GS MBS-E-010898476. 2827 Subcommittee interview of Daniel Sparks (10/4/2010).

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In March 2007, after a series of large trades with the Harbinger hedge fund on the ABS Desk, Deeb Salem, an ABS trader, emailed Mr. Birnbaum, Mr. Swenson, and Mr. Chin with a proposal for a proprietary CDO:

“Am I crazy to be thinking we might want to grow the harbinger trade and do our own abs desk cdo. There’ll be so much juice in it. It would blow out. We could sell supersenior and maybe some equity. Then the remaining mezz would be a cover of a couple hundred million of our cdo short. Haven’t crunched the numbers, but I’m guessing we’d effectively cover well north of 1000 plus own some call rights. Or we also keep the equity and own it for free.

To select the portfolio, we look at the underlying rmbs deals in our cdo shorts. And replicate that as best as possible.”2828

Mr. Birnbaum replied: “I like it.”2829 Mr. Swenson responded: “Love it we will give dan [Sparks] a heart attack.”2830 Two months later, in June 2007, Mr. Swenson wrote Mr. Salem:
“Talk to me now things are developing - dan wants you to be the epicenter of the subprime universe which is not a bad position to be in.”2831

Mr. Salem replied:

“That’s fine. My number 1 concern is that it[’]s traded by the right people bc [because] the opportunity is huge. It’s a product that needs to be traded as a prop product. … U need to be in charge and we need prop minded guys involved.”2832

That same month, however, the Bear Stearns’ hedge funds collapsed due to losses from their subprime holdings. In July, the mass ratings downgrades took place, and the RMBS subprime market began to shut down as well. The Subcommittee saw no evidence that the proprietary CDO proposed by Mr. Salem was carried out.

In July 2007, Mr. Birnbaum, Goldman’s head ABX trader, remarked that Goldman was

giving John Paulson, the head of the Paulson Partners hedge funds, “a run for his money” in shorting the mortgage market, and claimed Goldman was “No. 2” behind the Paulson hedge funds in profiting from a massive net short position.2833 In October 2007, Mr. Birnbaum drafted a proposal that the SPG Trading Desk be compensated in accordance with a hedge fund model, rather than through Goldman’s bonus pool, so the desk could obtain a portion of the proprietary profits it was generating.2834

He discussed the proposal with other Mortgage Department

2828 3/3/2007 email from Mr. Salem, “Another idea . . .,” GS MBS-E-012511081. 2829 Id. 2830 Id. 2831 6/7/2007 email from Mr. Swenson to Mr. Salem, “Fyi,” GS MBS-E-012444245. 2832 Id. 2833 7/12/2007 email from Mr. Birnbaum, GS MBS-E-012944742, Hearing Exhibit 4/27-146 (“He’s definitely the man in this space, up 2-3 bil on this trade. We were giving him a run for his money for a while but now are a definitive #2.”). 2834 See slides prepared by Mr. Birnbaum, “SPG Trading B 2007,” GS MBS-E-015654036 -50.

D. Preventing Investment Bank Abuses

Developments over the past two years offer a number of ways to address problems

Proprietary trading was not prohibited by law in 2007, and Goldman was free to and did engage in billions of dollars in mortgage related trades for its own account. The Goldman case study also demonstrates how proprietary trading, when undertaken at the same time as trading on behalf of clients, can give rise to conflicts of interest between the bank’s financial interests and those of its clients. The new proprietary trading and conflict of interest restrictions in the Dodd- Frank Act are designed to address and reduce these conflicts.

identified in the Goldman Sachs and Deutsche Bank case studies. The success of those alternatives will depend in large part upon how they are implemented, and the degree to which the market disruptions caused by the financial crisis convince investment banks to realign their use of structured finance products, curb their proprietary trading, and respect the interests of their clients. Success will also depend upon sensible implementation of the measures enacted into law by the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act).

Three key provisions involve proprietary investments, conflicts of interest, and a new study of permitted banking activities.

affiliates, including any investment banks,2837 are prohibited by the Dodd-Frank Act from engaging in proprietary trading, subject to certain provisions allowing them to continue to serve clients and reduce risks. 2838 The proprietary trading ban will still allow banks, for example, to continue to engage in transactions as market makers for clients, hedge their risks, and maintain very limited investments in private funds they sponsor or manage for others.2839

activities. It explicitly bars any proprietary trading activity that “would involve or result in a material conflict of interest … between the banking entity and its clients, customers, or

Proprietary Trading Restrictions. Commercial banks, their holding companies, and

The Dodd-Frank Act contains several measures that affect investment banking practices.

(1) New Developments

personnel, but did not present it to senior management.2835 The Mortgage Department personnel who helped build the net shorts nevertheless received substantial compensation for their 2007 efforts.2836

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The proprietary trading provision also addresses conflicts of interest and high risk

2835 Mr. Birnbaum response to Subcommittee QFR at PSI_QFR_GS0509. 2836 Mr. Birnbaum, for example, received $17 million in 2007. Subcommittee interview of Joshua Birnbaum (4/22/2010). 2837 Two of the largest U.S. investment banks, Goldman Sachs and Morgan Stanley, are currently structured as bank holding companies and so are subject to the ban on proprietary trading. 2838 Section 619 of the Dodd-Frank Act (creating a new §13(a) in the Banking Holding Company Act of 1956). 2839 Id. at §13(d)(1).

Investment banks that have no bank affiliation are not subject to the law’s proprietary

counterparties,” or that would result “in a material exposure by the banking entity to high-risk assets or high-risk trading strategies.” 2840 Those express limitations are intended to reduce not only the risk of proprietary trading losses, but also the conflicts of interest that arise when a bank-affiliated investment bank enters into an activity that allows it to profit at the expense of its clients.

trading prohibition. If, however, an investment bank is designated by the newly-created Financial Stability Oversight Council as a systemically critical firm, the Dodd-Frank Act would subject its proprietary trading to additional capital requirements and quantitative limits. Those restrictions are intended to ensure large investment banks have sufficient safeguards in place when engaging in risky proprietary activities to prevent them from damaging the U.S. financial system as a whole or necessitating a taxpayer bailout if they get into financial trouble.

Private Fund Restrictions. To ensure that the proprietary trading restrictions are

effective, the Dodd-Frank Act prohibits banks and their affiliates, including any investment banks, from bailing out any private fund they advise or sponsor, including an affiliated hedge fund or private equity fund. 2841 This prohibition would apply, for example, to Deutsche Bank and its affiliated hedge fund, Winchester Capital, which made a large proprietary investment in mortgage related products. 2842 These restrictions would not apply to investment banks that are not affiliated with a bank. If, however, the investment bank is designated as a systemically critical firm, it would become subject to additional capital charges to account for the risk that it
may end up bailing out a private fund. The private fund provision also addresses the issue of eliminating any unfair advantage that banks may have from being able to rely on the special privileges of being a bank to implicitly guarantee a private fund, and ensures that a federally insured bank will not be put at risk if an affiliated private fund suffers losses.2843

described the link between proprietary trading and conflicts of interest as follows:

Conflict of Interest Prohibitions. In 2009, one well known investment adviser

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“Proprietary trading by banks has become by degrees over recent years an egregious conflict of interest with their clients. Most if not all banks that prop trade now gather information from their institutional clients and exploit it. In complete contrast, 30 years ago, Goldman Sachs, for example, would never, ever have traded against its clients. How quaint that scrupulousness now seems. Indeed, from, say, 1935 to 1980, any banker who suggested such behavior would have been fired as both unprincipled and a threat to the partners’ money.”2844

2840 Id. at §13(d)(2). 2841 Id. at §13(d)(1)(G) and (I); (d)(4); and (f). 2842 Id. See section discussing Deutsche Bank, above.
2843 Id. See, e.g., 6/12/2010 Cambridge Winter Center report, “Test Case on the Charles,” (explaining how State Street Bank bailed out the funds it managed, but then itself needed several emergency taxpayer-backed programs). 2844 “Lesson Not Learned: On Redesigning Our Current Financial System,” GMO Newsletter Special Topic, at 2 (10/2009), available at http://www.scribd.com/doc/21682547/Jeremy-Grantham.

Study of Banking Activities. Section 620 of the Dodd-Frank Act directs banking

The Dodd-Frank Act contains two conflict of interest prohibitions to restore the ethical

bar against investment banks and other financial institutions profiting at the expense of their clients. The first is a broad prohibition that applies in any circumstances in which a firm trades for its own account, as explained above.2845 The second, in Section 621, imposes a specific, explicit prohibition on any firm that underwrites, sponsors, or acts as a placement agent for an asset backed security, including a synthetic asset backed security, from engaging in a transaction “that would involve or result in any material conflict of interest” with an investor in that security.2846 Together, these two prohibitions, if well implemented, will protect market participants from the self-dealing that contributed to the financial crisis.

regulators to review what types of banking activities are currently allowed under federal and state law, submit a report to Congress and the Financial Stability Oversight Council on those activities, and offer recommendations to restrict activities that are inappropriate or may have a negative effect on the safety and soundness of a banking entity or the U.S. financial system. This study could evaluate, for example, the use of complex structured finance products that are difficult to understand, have little or no track record on performance, and encourage investors to bet on the failure rather than the success of financial instruments.

related to approval of new products and standards of business conduct,2847 the banking agencies, SEC, and CFTC may update and strengthen existing guidance on new structured finance products. In 2004, after the collapse of the Enron Corporation, the banking regulators and SEC proposed joint guidance to prevent abusive structured finance transactions. 2848 This guidance, which was not finalized until January 2007, was issued in a much weaker form.2849 The final guidance eliminated, for example, warnings against structured finance products that facilitate deceptive accounting, circumvention of regulatory or financial reporting requirements, or tax evasion, as well as detailed guidance on the roles that should be played by a financial institution’s board of directors, senior management, and legal counsel in approving new products and on the documentation they should assemble.

financial crises, this Report makes the following recommendations.

Structured Finance Guidance. In connection with provisions in the Dodd-Frank Act

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(2) Recommendations

To prevent investment bank abuses and protect the U.S. financial system from future

2845 Section 621 of the Dodd-Frank Act (creating a new § 27B(a) in the Securities Act of 1933). 2846 Id. at § 621. 2847 Section 717 and Title IX of the Dodd-Frank Act. 2848 “Interagency Statement on Sound Practices Concerning Complex Structured Finance Activities,” 69 Fed. Reg. 97 (5/19/2004).
2849 “Interagency Statement on Sound Practices Concerning Elevated Risk Complex Structured Finance Activities,” 72 Fed. Reg. 7 (1/11/2007) (issued by the Office of the Comptroller of the Currency; Office of Thrift Supervision; Federal Reserve System; Federal Deposit Insurance Corporation; and Securities and Exchange Commission).

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Review Structured Finance Transactions. Federal regulators should review the

Narrow Proprietary Trading Exceptions. To ensure a meaningful ban on

Design Strong Conflict of Interest Prohibitions. Regulators implementing the

conflict of interest prohibitions in Sections 619 and 621 should consider the types of conflicts of interest in the Goldman Sachs case study, as identified in Chapter VI(C)(6) of this Report.

Study Bank Use of Structured Finance. Regulators conducting the banking