fcic final report, part 2, chapter 3, securitization and derivatives

8/7/2019 FCIC Final Report, Part 2, Chapter 3, Securitization And Derivatives

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SECURITIZATION AND DERIVATIVES

CONTENTS

Fannie Mae and Freddie Mac: “The whole army o lobbyists”.............................

Structured fnance: “It wasn’t reducing the risk” ...................................................

The growth o derivatives: “By ar the most signifcant event

in fnance during the past decade”...................................................................

FANNIE MAE AND FREDDIE MAC:

“THE WHOLE ARMY OF LOBBYISTS”

The crisis in the thrit industry created an opening or Fannie Mae and Freddie Mac,the two massive government-sponsored enterprises (GSEs) created by Congress tosupport the mortgage market.

Fannie Mae (ofcially, the Federal National Mortgage Association) was charteredby the Reconstruction Finance Corporation during the Great Depression in tobuy mortgages insured by the Federal Housing Administration (FHA). The new gov-

ernment agency was authorized to purchase mortgages that adhered to the FHA’s un-derwriting standards, thereby virtually guaranteeing the supply o mortgage creditthat banks and thrits could extend to homebuyers. Fannie Mae either held the mort-gages in its portolio or, less oten, resold them to thrits, insurance companies, orother investors. Ater World War II, Fannie Mae got authority to buy home loansguaranteed by the Veterans Administration (VA) as well.

This system worked well, but it had a weakness: Fannie Mae bought mortgages by borrowing. By , Fannie’s mortgage portolio had grown to . billion and itsdebt weighed on the ederal government. To get Fannie’s debt o o the government’sbalance sheet, the Johnson administration and Congress reorganized it as a publicly traded corporation and created a new government entity, Ginnie Mae (ofcially, theGovernment National Mortgage Association) to take over Fannie’s subsidized mort-gage programs and loan portolio. Ginnie also began guaranteeing pools o FHA and

VA mortgages. The new Fannie still purchased ederally insured mortgages, but itwas now a hybrid, a “government-sponsored enterprise.”

Two years later, in , the thrits persuaded Congress to charter a second GSE,Freddie Mac (ofcially, the Federal Home Loan Mortgage Corporation), to help the

thrits sell their mortgages. The legislation also authorized Fannie and Freddie to buy “conventional” xed-rate mortgages, which were not backed by the FHA or the VA.

Conventional mortgages were sti competition to FHA mortgages because borrow-ers could get them more quickly and with lower ees. Still, the conventional mort-gages did have to conorm to the GSEs’ loan size limits and underwriting guidelines,such as debt-to-income and loan-to-value ratios. The GSEs purchased only these“conorming” mortgages.

Beore , Fannie Mae generally held the mortgages it purchased, protingrom the dierence—or spread—between its cost o unds and the interest paid onthese mortgages. The and laws gave Ginnie, Fannie, and Freddie anotheroption: securitization. Ginnie was the rst to securitize mortgages, in . A lenderwould assemble a pool o mortgages and issue securities backed by the mortgagepool. Those securities would be sold to investors, with Ginnie guaranteeing timely payment o principal and interest. Ginnie charged a ee to issuers or this guarantee.In , Freddie got into the business o buying mortgages, pooling them, and thenselling mortgage-backed securities. Freddie collected ees rom lenders or guaran-teeing timely payment o principal and interest. In , ater a spike in interest ratescaused large losses on Fannie’s portolio o mortgages, Fannie ollowed. During thes and s, the conventional mortgage market expanded, the GSEs grew in im-portance, and the market share o the FHA and VA declined.

Fannie and Freddie had dual missions, both public and private: support the mort-gage market and maximize returns or shareholders. They did not originate mort-gages; they purchased them—rom banks, thrits, and mortgage companies—andeither held them in their portolios or securitized and guaranteed them. Congressgranted both enterprises special privileges, such as exemptions rom state and localtaxes and a . billion line o credit each rom the Treasury. The Federal Reserveprovided services such as electronically clearing payments or GSE debt and securi-

ties as i they were Treasury bonds. So Fannie and Freddie could borrow at rates al-most as low as the Treasury paid. Federal laws allowed banks, thrits, and investmentunds to invest in GSE securities with relatively avorable capital requirements andwithout limits. By contrast, laws and regulations strictly limited the amount o loansbanks could make to a single borrower and restricted their investments in the debtobligations o other rms. In addition, unlike banks and thrits, the GSEs were re-quired to hold very little capital to protect against losses: only . to back theirguarantees o mortgage-backed securities and . to back the mortgages in theirportolios. This compared to bank and thrit capital requirements o at least o mortgages assets under capital standards. Such privileges led investors and creditorsto believe that the government implicitly guaranteed the GSEs’ mortgage-backed se-curities and debt and that GSE securities were thereore almost as sae as Treasury bills. As a result, investors accepted very low returns on GSE-guaranteed mortgage-

backed securities and GSE debt obligations.Mortgages are long-term assets oten unded by short-term borrowings. For

example, thrits generally used customer deposits to und their mortgages. Fannie

SE CUR I TI Z AT I ON AND DERIVAT IVES

bought its mortgage portolio by borrowing short- and medium-term. In ,when the Fed increased short-term interest rates to quell inlation, Fannie, like the

thrits, ound that its cost o unding rose while income rom mortgages did not. By the s, the Department o Housing and Urban Development (HUD) estimatedFannie had a negative net worth o billion. Freddie emerged unscathed be-cause unlike Fannie then, its primary business was guaranteeing mortgage-backedsecurities, not holding mortgages in its portolio. In guaranteeing mortgage-backed securities, Freddie Mac avoided taking the interest rate risk that hit Fannie’sportolio.

In , Congress provided tax relie and HUD relaxed Fannie’s capital require-ments to help the company avert ailure. These eorts were consistent with lawmak-ers’ repeated proclamations that a vibrant market or home mortgages served thebest interests o the country, but the moves also reinorced the impression that thegovernment would never abandon Fannie and Freddie. Fannie and Freddie wouldsoon buy and either hold or securitize mortgages worth hundreds o billions, thentrillions , o dollars. Among the investors were U.S. banks, thrits, investment unds,and pension unds, as well as central banks and investment unds around the world.Fannie and Freddie had become too big to ail.

While the government continued to avor Fannie and Freddie, they toughenedregulation o the thrits ollowing the savings and loan crisis. Thrits had previously dominated the mortgage business as large holders o mortgages. In the Financial In-stitutions Reorm, Recovery, and Enorcement Act o (FIRREA), Congressimposed tougher, bank-style capital requirements and regulations on thrits. By con-trast, in the Federal Housing Enterprises Financial Saety and Soundness Act o ,Congress created a supervisor or the GSEs, the Ofce o Federal Housing EnterpriseOversight (OFHEO), without legal powers comparable to those o bank and thritsupervisors in enorcement, capital requirements, unding, and receivership. Crack-

ing down on thrits while not on the GSEs was no accident. The GSEs had showntheir immense political power during the drating o the law. “OFHEO wasstructurally weak and almost designed to ail,” said Armando Falcon Jr., a ormer di-rector o the agency, to the FCIC.

All this added up to a generous ederal subsidy. One study put the value o that subsidy at billion or more and estimated that more than hal o these bene-ts accrued to shareholders, not to homebuyers.

Given these circumstances, regulatory arbitrage worked as it always does: themarkets shited to the lowest-cost, least-regulated havens. Ater Congress imposedstricter capital requirements on thrits, it became increasingly protable or them tosecuritize with or sell loans to Fannie and Freddie rather than hold on to the loans.The stampede was on. Fannie’s and Freddie’s debt obligations and outstanding mort-gage-backed securities grew rom billion in to . trillion in and

. trillion in .

The legislation that transormed Fannie in also authorized HUD to prescribeaordable housing goals or Fannie: to “require that a reasonable portion o the cor-poration’s mortgage purchases be related to the national goal o providing adequate

F INANCIAL CR I S I S INQUIRY COMMISS ION R EPORT

housing or low and moderate income amilies, but with reasonable economic returnto the corporation.” In , HUD tried to implement the law and, ater a barrage o

criticism rom the GSEs and the mortgage and real estate industries, issued a weakregulation encouraging aordable housing. In the Federal Housing EnterprisesFinancial Saety and Soundness Act, Congress extended HUD’s authority to set a-ordable housing goals or Fannie and Freddie. Congress also changed the language tosay that in the pursuit o aordable housing, “a reasonable economic return . . . may be less than the return earned on other activities.” The law required HUD to consider“the need to maintain the sound nancial condition o the enterprises.” The act nowordered HUD to set goals or Fannie and Freddie to buy loans or low- and moderate-income housing, special aordable housing, and housing in central cities, rural areas,and other underserved areas. Congress instructed HUD to periodically set a goal oreach category as a percentage o the GSEs’ mortgage purchases.

In , President Bill Clinton announced an initiative to boost homeownershiprom . to . o amilies by , and one component raised the aordablehousing goals at the GSEs. Between and , almost . million householdsentered the ranks o homeowners, nearly twice as many as in the previous two years.“But we have to do a lot better,” Clinton said. “This is the new way home or theAmerican middle class. We have got to raise incomes in this country. We have got toincrease security or people who are doing the right thing, and we have got to makepeople believe that they can have some permanence and stability in their lives even asthey deal with all the changing orces that are out there in this global economy.” Thepush to expand homeownership continued under President George W. Bush, who,or example, introduced a “Zero Down Payment Initiative” that under certain cir-cumstances could remove the down payment rule or rst-time home buyers withFHA-insured mortgages.

In describing the GSEs’ aordable housing loans, Andrew Cuomo, secretary o

Housing and Urban Development rom to and now governor o NewYork, told the FCIC, “Aordability means many things. There were moderate incomeloans. These were teachers, these were reghters, these were municipal employees,these were people with jobs who paid mortgages. These were not subprime, preda-tory loans at all.”

Fannie and Freddie were now crucial to the housing market, but their dual mis-sions—promoting mortgage lending while maximizing returns to shareholders—were problematic. Former Fannie CEO Daniel Mudd told the FCIC that “the GSEstructure required the companies to maintain a ne balance between nancial goalsand what we call the mission goals . . . the root cause o the GSEs’ troubles lies withtheir business model.” Former Freddie CEO Richard Syron concurred: “I don’tthink it’s a good business model.”

Fannie and Freddie accumulated political clout because they depended on ederal

subsidies and an implicit government guarantee, and because they had to deal withregulators, aordable housing goals, and capital standards imposed by Congress andHUD. From to , the two reported spending more than million on lob-bying, and their employees and political action committees contributed million

SE CUR I TI Z AT I ON AND DERIVAT IVES

to ederal election campaigns. The “Fannie and Freddie political machine resistedany meaningul regulation using highly improper tactics,” Falcon, who regulated

them rom to , testied. “OFHEO was constantly subjected to maliciouspolitical attacks and eorts o intimidation.” James Lockhart, the director o OFHEO and its successor, the Federal Housing Finance Agency, rom through, testied that he argued or reorm rom the moment he became director andthat the companies were “allowed to be . . . so politically strong that or many yearsthey resisted the very legislation that might have saved them.” Former HUD secre-tary Mel Martinez described to the FCIC “the whole army o lobbyists that continu-ally paraded in a bipartisan ashion through my ofces. . . . It’s pretty amazing thenumber o people that were in their employ.”

In , that army helped secure new regulations allowing the GSEs to count to-ward their aordable housing goals not just their whole loans but mortgage-relatedsecurities issued by other companies, which the GSEs wanted to purchase as invest-ments. Still, Congressional Budget Ofce Director June O’Neill declared in that“the goals are not difcult to achieve, and it is not clear how much they have aectedthe enterprises’ actions. In act . . . depository institutions as well as the Federal Hous-ing Administration devote a larger proportion o their mortgage lending to targetedborrowers and areas than do the enterprises.”

Something else was clear: Fannie and Freddie, with their low borrowing costs andlax capital requirements, were immensely protable throughout the s. In ,Fannie had a return on equity o ; Freddie, . That year, Fannie and Freddieheld or guaranteed more than trillion o mortgages, backed by only . billiono shareholder equity.

STRUCTURED FINANCE:

“IT WASN’T REDUC ING THE RI SK”

While Fannie and Freddie enjoyed a near-monopoly on securitizing xed-rate mort-gages that were within their permitted loan limits, in the s the markets began tosecuritize many other types o loans, including adjustable-rate mortgages (ARMs)and other mortgages the GSEs were not eligible or willing to buy. The mechanismworked the same: an investment bank, such as Lehman Brothers or Morgan Stanley (or a securities afliate o a bank), bundled loans rom a bank or other lender into se-curities and sold them to investors, who received investment returns unded by theprincipal and interest payments rom the loans. Investors held or traded these securi-ties, which were oten more complicated than the GSEs’ basic mortgage-backed secu-rities; the assets were not just mortgages but equipment leases, credit card debt, autoloans, and manuactured housing loans. Over time, banks and securities rms usedsecuritization to mimic banking activities outside the regulatory ramework or

banks. For example, where banks traditionally took money rom deposits to makeloans and held them until maturity, banks now used money rom the capital mar-kets—oten rom money market mutual unds—to make loans, packaging them intosecurities to sell to investors.

For commercial banks, the benets were large. By moving loans o their books,the banks reduced the amount o capital they were required to hold as protection

against losses, thereby improving their earnings. Securitization also let banks rely less on deposits or unding, because selling securities generated cash that could beused to make loans. Banks could also keep parts o the securities on their books ascollateral or borrowing, and ees rom securitization became an important source o revenues.

Lawrence Lindsey, a ormer Federal Reserve governor and the director o the Na-tional Economic Council under President George W. Bush, told the FCIC that previ-ous housing downturns made regulators worry about banks’ holding whole loans ontheir books. “I you had a regional . . . real estate downturn it took down the banks inthat region along with it, which exacerbated the downturn,” Lindsey said. “So we saidto ourselves, ‘How on earth do we get around this problem?’ And the answer was,‘Let’s have a national securities market so we don’t have regional concentration.’ . . . Itwas intentional.”

Private securitizations, or structured nance securities, had two key benets to investors: pooling and tranching . I many loans were pooled into one security, a ew de-aults would have minimal impact. Structured nance securities could also be slicedup and sold in portions—known as tranches—which let buyers customize their pay-ments. Risk-averse investors would buy tranches that paid o rst in the event o de-ault, but had lower yields. Return-oriented investors bought riskier tranches withhigher yields. Bankers oten compared it to a waterall; the holders o the seniortranches—at the top o the waterall—were paid beore the more junior tranches.And i payments came in below expectations, those at the bottom would be the rstto be let high and dry.

Securitization was designed to benet lenders, investment bankers, and investors.Lenders earned ees or originating and selling loans. Investment banks earned ees

or issuing mortgage-backed securities. These securities etched a higher price than i the underlying loans were sold individually, because the securities were customizedto investors’ needs, were more diversied, and could be easily traded. Purchasers o the saer tranches got a higher rate o return than ultra-sae Treasury notes withoutmuch extra risk—at least in theory. However, the nancial engineering behind theseinvestments made them harder to understand and to price than individual loans. Todetermine likely returns, investors had to calculate the statistical probabilities thatcertain kinds o mortgages might deault, and to estimate the revenues that would belost because o those deaults. Then investors had to determine the eect o the losseson the payments to dierent tranches.

This complexity transormed the three leading credit rating agencies—Moody’s,Standard & Poor’s (S&P), and Fitch—into key players in the process, positioned be-tween the issuers and the investors o securities. Beore securitization became com-

mon, the credit rating agencies had mainly helped investors evaluate the saety o municipal and corporate bonds and commercial paper. Although evaluating proba-bilities was their stock-in-trade, they ound that rating these securities required anew type o analysis.

SE CUR IT I Z AT I ON AND DERIVAT IVES

Participants in the securitization industry realized that they needed to secure avor-able credit ratings in order to sell structured products to investors. Investment banks

thereore paid handsome ees to the rating agencies to obtain the desired ratings. “Therating agencies were important tools to do that because you know the people that wewere selling these bonds to had never really had any history in the mortgage busi-ness. . . . They were looking or an independent party to develop an opinion,” Jim Calla-han told the FCIC; Callahan is CEO o PentAlpha, which services the securitizationindustry, and years ago he worked on some o the earliest securitizations.

With these pieces in place—banks that wanted to shed assets and transer risk, investors ready to put their money to work, securities rms poised to earn ees, ratingagencies ready to expand, and inormation technology capable o handling the job—the securitization market exploded. By , when the market was years old,about billion worth o securitizations, beyond those done by Fannie, Freddie,and Ginnie, were outstanding (see gure .). That included billion o automo-bile loans and over billion o credit card debt; nearly billion worth o secu-rities were mortgages ineligible or securitization by Fannie and Freddie. Many weresubprime.

Securitization was not just a boon or commercial banks; it was also a lucrativenew line o business or the Wall Street investment banks, with which the commercialbanks worked to create the new securities. Wall Street rms such as Salomon Broth-ers and Morgan Stanley became major players in these complex markets and reliedincreasingly on quantitative analysts, called “quants.” As early as the s, WallStreet executives had hired quants—analysts adept in advanced mathematical theory and computers—to develop models to predict how markets or securities mightchange. Securitization increased the importance o this expertise. Scott Patterson, au-thor o The Quants, told the FCIC that using models dramatically changed nance.“Wall Street is essentially oating on a sea o mathematics and computer power,” Pat-

terson said.

The increasing dependence on mathematics let the quants create more complexproducts and let their managers say, and maybe even believe, that they could bettermanage those products’ risk. JP Morgan developed the rst “Value at Risk” model(VaR), and the industry soon adopted dierent versions. These models purported topredict with at least certainty how much a rm could lose i market priceschanged. But models relied on assumptions based on limited historical data; ormortgage-backed securities, the models would turn out to be woeully inadequate.And modeling human behavior was dierent rom the problems the quants had ad-dressed in graduate school. “It’s not like trying to shoot a rocket to the moon whereyou know the law o gravity,” Emanuel Derman, a Columbia University nanceproessor who worked at Goldman Sachs or years, told the Commission. “Theway people eel about gravity on a given day isn’t going to aect the way the rocket

behaves.”

Paul Volcker, Fed chairman rom to , told the Commission that regula-tors were concerned as early as the late s that once banks began selling instead o holding the loans they were making, they would care less about loan quality. Yet as

these instruments became increasingly complex, regulators increasingly relied on thebanks to police their own risks. “It was all tied up in the hubris o nancial engineers,but the greater hubris let markets take care o themselves,” Volcker said. VincentReinhart, a ormer director o the Fed’s Division o Monetary Aairs, told the Com-mission that he and other regulators ailed to appreciate the complexity o the new -nancial instruments and the difculties that complexity posed in assessing risk.

Securitization “was diversiying the risk,” said Lindsey, the ormer Fed governor.“But it wasn’t reducing the risk. . . . You as an individual can diversiy your risk. The sys-tem as a whole, though, cannot reduce the risk. And that’s where the conusion lies.”

THE GROWTH OF DERIVATIVES: “BY FAR THE MOST

SIGNIFICANT EVENT IN FINANCE DURING THE PAST DECADE”

During the nancial crisis, leverage and complexity became closely identied withone element o the story: derivatives. Derivatives are nancial contracts whose pricesare determined by, or “derived” rom, the value o some underlying asset, rate, index,

In the 1990s, many kinds of loans were packaged into asset-backed securities.

SOURCE: Securities Industry and Financial MarketsAssociation

curities

Outstand

IN BILLIONS OF DOLLARS

$1,000

’85 ’90’87’86 ’88 ’89 ’91 ’92 ’94 ’96 ’98’93 ’95 ’97 ’99

NOTE: Residential loans do not include loans securitized by government-sponsored enterprises.

Manufactured housing

Automobile

Credit card

Equipment

Student loans

Home equity

and other residential

Figure .

or event. They are not used or capital ormation or investment, as are securities;rather, they are instruments or hedging business risk or or speculating on changes

in prices, interest rates, and the like. Derivatives come in many orms; the most com-mon are over-the-counter-swaps and exchange-traded utures and options. They may be based on commodities (including agricultural products, metals, and energy products), interest rates, currency rates, stocks and indexes, and credit risk. They caneven be tied to events such as hurricanes or announcements o government gures.

Many nancial and commercial rms use such derivatives. A rm may hedge itsprice risk by entering into a derivatives contract that osets the eect o price move-ments. Losses suered because o price movements can be recouped through gainson the derivatives contract. Institutional investors that are risk-averse sometimes useinterest rate swaps to reduce the risk to their investment portolios o ination andrising interest rates by trading xed interest payments or oating payments withrisk-taking entities, such as hedge unds. Hedge unds may use these swaps or thepurpose o speculating, in hopes o proting on the rise or all o a price or interestrate.

The derivatives markets are organized as exchanges or as over-the-counter (OTC)markets, although some recent electronic trading acilities blur the distinctions. Theoldest U.S. exchange is the Chicago Board o Trade, where utures and options aretraded. Such exchanges are regulated by ederal law and play a useul role in pricediscovery—that is, in revealing the market’s view on prices o commodities or ratesunderlying utures and options. OTC derivatives are traded by large nancial institu-tions—traditionally, bank holding companies and investment banks—which act asderivatives dealers, buying and selling contracts with customers. Unlike the uturesand options exchanges, the OTC market is neither centralized nor regulated. Nor is ittransparent, and thus price discovery is limited. No matter the measurement—trad-ing volume, dollar volume, risk exposure—derivatives represent a very signicant

sector o the U.S. nancial system.The principal legislation governing these markets is the Commodity ExchangeAct o , which originally applied only to derivatives on domestic agriculturalproducts. In , Congress amended the act to require that utures and options con-tracts on virtually all commodities, including nancial instruments, be traded on aregulated exchange, and created a new ederal independent agency, the Commodity Futures Trading Commission (CFTC), to regulate and supervise the market.

Outside o this regulated market, an over-the-counter market began to developand grow rapidly in the s. The large nancial institutions acting as OTC deriva-tives dealers worried that the Commodity Exchange Act’s requirement that tradingoccur on a regulated exchange might be applied to the products they were buyingand selling. In , the CFTC sought to address these concerns by exempting cer-tain nonstandardized OTC derivatives rom that requirement and rom certain other

provisions o the Commodity Exchange Act, except or prohibitions against raudand manipulation.

As the OTC market grew ollowing the CFTC’s exemption, a wave o signicantlosses and scandals hit the market. Among many examples, in Procter & Gamble,

a leading consumer products company, reported a pretax loss o million, thelargest derivatives loss by a nonnancial rm, stemming rom OTC interest and oreign

exchange rate derivatives sold to it by Bankers Trust. Procter & Gamble sued BankersTrust or raud—a suit settled when Bankers Trust orgave most o the money thatProcter & Gamble owed it. That year, the CFTC and the Securities and Exchange Com-mission (SEC) ned Bankers Trust million or misleading Gibson Greeting Cardson interest rate swaps resulting in a mark-to-market loss o million, larger thanGibson’s prior-year prots. In late , Orange County, Caliornia, announced it hadlost . billion speculating in OTC derivatives. The county led or bankruptcy—thelargest by a municipality in U.S. history. Its derivatives dealer, Merrill Lynch, paid million to settle claims. In response, the U.S. General Accounting Ofce issued a re-port on nancial derivatives that ound dangers in the concentration o OTC deriva-tives activity among major dealers, concluding that “the sudden ailure or abruptwithdrawal rom trading o any one o these large dealers could cause liquidity prob-lems in the markets and could also pose risks to the others, including ederally insuredbanks and the nancial system as a whole.” While Congress then held hearings on theOTC derivatives market, the adoption o regulatory legislation ailed amid intense lob-bying by the OTC derivatives dealers and opposition by Fed Chairman Greenspan.

In , Japan’s Sumitomo Corporation lost . billion on copper derivativestraded on a London exchange. The CFTC charged the company with using deriva-tives to manipulate copper prices, including using OTC derivatives contracts to dis-guise the speculation and to nance the scheme. Sumitomo settled or millionin penalties and restitution. The CFTC also charged Merrill Lynch with knowingly and intentionally aiding, abetting, and assisting the manipulation o copper prices; itsettled or a ne o million.

Debate intensied in . In May, the CFTC under Chairperson Brooksley Bornsaid the agency would reexamine the way it regulated the OTC derivatives market,

given the market’s rapid evolution and the string o major losses since . TheCFTC requested comments. It got them.Some came rom other regulators, who took the unusual step o publicly criticiz-

ing the CFTC. On the day that the CFTC issued a concept release, Treasury Secretary Robert Rubin, Greenspan, and SEC Chairman Arthur Levitt issued a joint statementdenouncing the CFTC’s move: “We have grave concerns about this action and itspossible consequences. . . . We are very concerned about reports that the CFTC’s ac-tion may increase the legal uncertainty concerning certain types o OTC deriva-tives.” They proposed a moratorium on the CFTC’s ability to regulate OTCderivatives.

For months, Rubin, Greenspan, Levitt, and Deputy Treasury Secretary LawrenceSummers opposed the CFTC’s eorts in testimony to Congress and in other publicpronouncements. As Alan Greenspan said: “Aside rom saety and soundness regula-

tion o derivatives dealers under the banking and securities laws, regulation o deriv-atives transactions that are privately negotiated by proessionals is unnecessary.”

In September, the Federal Reserve Bank o New York orchestrated a . billionrecapitalization o Long-Term Capital Management (LTCM) by major OTC

derivatives dealers. An enormous hedge und, LTCM had amassed more than trillion in notional amount o OTC derivatives and billion o securities on .

billion o capital without the knowledge o its major derivatives counterparties orederal regulators. Greenspan testied to Congress that in the New York Fed’s

judgment, LTCM’s ailure would potentially have had systemic eects: a deault by LTCM “would not only have a signicant distorting impact on market prices butalso in the process could produce large losses, or worse, or a number o creditorsand counterparties, and or other market participants who were not directly in-

volved with LTCM.”

Nonetheless, just weeks later, in October , Congress passed the requestedmoratorium.

Greenspan continued to champion derivatives and advocate deregulation o theOTC market and the exchange-traded market. “By ar the most signicant event innance during the past decade has been the extraordinary development and expan-sion o nancial derivatives,” Greenspan said at a Futures Industry Association con-erence in March . “The act that the OTC markets unction quite eectively without the benets o [CFTC regulation] provides a strong argument or develop-ment o a less burdensome regime or exchange-traded nancial derivatives.”

The ollowing year—ater Born’s resignation—the President’s Working Group onFinancial Markets, a committee o the heads o the Treasury, Federal Reserve, SEC, andCommodity Futures Trading Commission charged with tracking the nancial systemand chaired by then Treasury Secretary Larry Summers, essentially adoptedGreenspan’s view. The group issued a report urging Congress to deregulate OTC deriv-atives broadly and to reduce CFTC regulation o exchange-traded derivatives as well.

In December , in response, Congress passed and President Clinton signedthe Commodity Futures Modernization Act o (CFMA), which in essencederegulated the OTC derivatives market and eliminated oversight by both the CFTC

and the SEC. The law also preempted application o state laws on gaming and onbucket shops (illegal brokerage operations) that otherwise could have made OTC de-rivatives transactions illegal. The SEC did retain antiraud authority over securities-based OTC derivatives such as stock options. In addition, the regulatory powers o the CFTC relating to exchange-traded derivatives were weakened but not eliminated.

The CFMA eectively shielded OTC derivatives rom virtually all regulation oroversight. Subsequently, other laws enabled the expansion o the market. For exam-ple, under a amendment to the bankruptcy laws, derivatives counterpartieswere given the advantage over other creditors o being able to immediately terminatetheir contracts and seize collateral at the time o bankruptcy.

The OTC derivatives market boomed. At year-end , when the CFMA waspassed, the notional amount o OTC derivatives outstanding globally was . tril-lion, and the gross market value was . trillion. In the seven and a hal years rom

then until June , when the market peaked, outstanding OTC derivatives in-creased more than sevenold to a notional amount o . trillion; their gross mar-ket value was . trillion.

Greenspan testied to the FCIC that credit deault swaps—a small part o the

market when Congress discussed regulating derivatives in the s—“did createproblems” during the nancial crisis. Rubin testied that when the CFMA passed

he was “not opposed to the regulation o derivatives” and had personally agreed withBorn’s views, but that “very strongly held views in the nancial services industry inopposition to regulation” were insurmountable. Summers told the FCIC that whilerisks could not necessarily have been oreseen years ago, “by our regulatory ramework with respect to derivatives was maniestly inadequate,” and that “the de-rivatives that proved to be by ar the most serious, those associated with credit deaultswaps, increased old between and .”

One reason or the rapid growth o the derivatives market was the capital require-ments advantage that many nancial institutions could obtain through hedging withderivatives. As discussed above, nancial rms may use derivatives to hedge theirrisks. Such use o derivatives can lower a rm’s Value at Risk as determined by com-puter models. In addition to gaining this advantage in risk management, such hedgescan lower the amount o capital that banks are required to hold, thanks to a amendment to the regulatory regime known as the Basel International Capital Ac-cord, or “Basel I.”

Meeting in Basel, Switzerland, in , the world’s central banks and bank supervisors adopted principles or banks’ capital standards, and U.S. banking regulatorsmade adjustments to implement them. Among the most important was the require-ment that banks hold more capital against riskier assets. Fateully, the Basel rulesmade capital requirements or mortgages and mortgage-backed securities looserthan or all other assets related to corporate and consumer loans. Indeed, capital re-quirements or banks’ holdings o Fannie’s and Freddie’s securities were less than orall other assets except those explicitly backed by the U.S. government.

These international capital standards accommodated the shit to increased lever-age. In , large banks sought more avorable capital treatment or their trading,

and the Basel Committee on Banking Supervision adopted the Market Risk Amend-ment to Basel I. This provided that i banks hedged their credit or market risks usingderivatives, they could hold less capital against their exposures rom trading andother activities.

OTC derivatives let derivatives traders—including the large banks and investmentbanks—increase their leverage. For example, entering into an equity swap that mim-icked the returns o someone who owned the actual stock may have had some up-ront costs, but the amount o collateral posted was much smaller than the uprontcost o purchasing the stock directly. Oten no collateral was required at all. Traderscould use derivatives to receive the same gains—or losses—as i they had bought theactual security, and with only a raction o a buyer’s initial nancial outlay. WarrenBuett, the chairman and chie executive ofcer o Berkshire Hathaway Inc., testiedto the FCIC about the unique characteristics o the derivatives market, saying, “they

accentuated enormously, in my view, the leverage in the system.” He went on to callderivatives “very dangerous stu,” difcult or market participants, regulators, audi-tors, and investors to understand—indeed, he concluded, “I don’t think I could man-age” a complex derivatives book.

A key OTC derivative in the nancial crisis was the credit deault swap (CDS),which oered the seller a little potential upside at the relatively small risk o a poten-

tially large downside. The purchaser o a CDS transerred to the seller the deault risko an underlying debt. The debt security could be any bond or loan obligation. TheCDS buyer made periodic payments to the seller during the lie o the swap. In re-turn, the seller oered protection against deault or specied “credit events” such as apartial deault. I a credit event such as a deault occurred, the CDS seller would typi-cally pay the buyer the ace value o the debt.

Credit deault swaps were oten compared to insurance: the seller was described asinsuring against a deault in the underlying asset. However, while similar to insurance,CDS escaped regulation by state insurance supervisors because they were treated asderegulated OTC derivatives. This made CDS very dierent rom insurance in at leasttwo important respects. First, only a person with an insurable interest can obtain aninsurance policy. A car owner can insure only the car she owns—not her neighbor’s.But a CDS purchaser can use it to speculate on the deault o a loan the purchaser doesnot own. These are oten called “naked credit deault swaps” and can inate potentiallosses and corresponding gains on the deault o a loan or institution.

Beore the CFMA was passed, there was uncertainty about whether or not stateinsurance regulators had authority over credit deault swaps. In June , in re-sponse to a letter rom the law rm o Skadden, Arps, Slate, Meagher & Flom, LLP,the New York State Insurance Department determined that “naked” credit deaultswaps did not count as insurance and were thereore not subject to regulation.

In addition, when an insurance company sells a policy, insurance regulators re-quire that it put aside reserves in case o a loss. In the housing boom, CDS were soldby rms that ailed to put up any reserves or initial collateral or to hedge their expo-sure. In the run-up to the crisis, AIG, the largest U.S. insurance company, would ac-cumulate a one-hal trillion dollar position in credit risk through the OTC market

without being required to post one dollar’s worth o initial collateral or making any other provision or loss. AIG was not alone. The value o the underlying assets orCDS outstanding worldwide grew rom . trillion at the end o to a peak o . trillion at the end o . A signicant portion was apparently speculative ornaked credit deault swaps.

Much o the risk o CDS and other derivatives was concentrated in a ew o the very largest banks, investment banks, and others—such as AIG Financial Products, aunit o AIG—that dominated dealing in OTC derivatives. Among U.S. bank holdingcompanies, o the notional amount o OTC derivatives, millions o contracts,were traded by just ve large institutions (in , JPMorgan Chase, Citigroup, Banko America, Wachovia, and HSBC)—many o the same rms that would nd them-selves in trouble during the nancial crisis. The country’s ve largest investmentbanks were also among the world’s largest OTC derivatives dealers.

While nancial institutions surveyed by the FCIC said they do not track rev-enues and prots generated by their derivatives operations, some rms did provideestimates. For example, Goldman Sachs estimated that between and o itsrevenues rom through were generated by derivatives, including to

o the rm’s commodities business, and hal or more o its interest rate and cur-rencies business. From May through November , billion, or , o

the billion o trades made by Goldman’s mortgage department were derivativetransactions.

When the nation’s biggest nancial institutions were teetering on the edge o ail-ure in , everyone watched the derivatives markets. What were the institutions’holdings? Who were the counterparties? How would they are? Market participantsand regulators would nd themselves straining to understand an unknown battleeldshaped by unseen exposures and interconnections as they ought to keep the nan-cial system rom collapsing.

fcic final report, part 2, chapter 3, securitization and derivatives

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