Naming Culprits in the Financial Crisis

By GRETCHEN MORGENSON and LOUISE STORY
Published: April 13, 2011
http://www.nytimes.com/2011/04/14/business/14crisis.html?hp=&pagewanted=all
 
A voluminous report on the financial crisis by the United
States Senate -- citing internal documents and private
communications of bank executives, regulators, credit
ratings agencies and investors -- describes business
practices that were rife with conflicts during the
mortgage mania and reckless activities that were ignored
inside the banks and among their federal regulators.

The 650-page report, "Wall Street and the Financial
Crisis: Anatomy of a Financial Collapse," was released
Wednesday by the Senate Permanent Subcommittee on
Investigations, whose co-chairmen are Carl Levin, a
Michigan Democrat, and Tom Coburn, a Republican of
Oklahoma. The result of two years' work, the report
focuses on an array of institutions with central roles in
the mortgage crisis: Washington Mutual, an aggressive
mortgage lender that collapsed in 2008; the Office of
Thrift Supervision, a regulator; the credit ratings
agencies Standard & Poor's and Moody's Investors Service;
and the investment banks Goldman Sachs and Deutsche Bank.

"The report pulls back the curtain on shoddy, risky,
deceptive practices on the part of a lot of major
financial institutions," Mr. Levin said in an interview.
"The overwhelming evidence is that those institutions
deceived their clients and deceived the public, and they
were aided and abetted by deferential regulators and
credit ratings agencies who had conflicts of interest."

The bipartisan report includes 19 recommendations for
changes to regulatory and industry practices. These
include creating strong conflict-of-interest policies at
the nation's banks and requiring that banks hold higher
reserves against risky mortgages. The report also asks
federal regulators to examine its findings for violations
of laws.

The report adds significant new evidence to previously
disclosed material showing that a wide swath of the
financial industry chose profits over propriety during the
mortgage lending spree. It also casts a harsh light on
what the report calls regulatory failures, which helped
deepen the crisis.

Singled out for criticism is the Office of Thrift
Supervision, which oversaw some of the nation's most
aggressive lenders, including Countrywide Financial,
IndyMac and Washington Mutual, whose chief executive was
Kerry Killinger. Noting that the agency's officials viewed
the institutions it regulated as "constituents," the
report said that the office relied on bank executives to
correct identified problems and was reluctant to interfere
with "even unsound lending and securitization practices"
at Washington Mutual.

The report describes how two risk managers at the bank
were marginalized by its executives. One of them told the
committee that executives began providing the regulator
with outdated loss estimates as the mortgage crisis
widened. After the risk manager told regulators that the
estimates it had received were dated, Mr. Killinger fired
him.

From 2004 to 2008, for example, the regulatory office
identified more than 500 serious deficiencies at
Washington Mutual, yet did not force the bank to improve
its lending operations, according to the report. And when
the Federal Deposit Insurance Corporation, the bank's
backup regulator, moved to downgrade the bank's safety and
soundness rating in September 2008, John M. Reich, the
director of the Office of Thrift Supervision, wrote an
angry e-mail to a colleague. Referring to Sheila Bair, the
F.D.I.C. chairwoman, he wrote: "I cannot believe the
continuing audacity of this woman." Washington Mutual
failed two weeks later.

The office was abolished last year, and its operations
were folded into the Office of the Comptroller of the
Currency. Mr. Reich declined to comment. A lawyer for Mr.
Killinger did not respond to a request for comment.

The report was produced by the same Senate committee that
conducted an 11-hour hearing last April with Goldman
executives and employees of its mortgage unit, who
testified about their trading and securities underwriting
practices.

At the hearing, some lawmakers questioned Goldman's
assertion that it had not bet against the mortgage market
as real estate prices collapsed. And on Wednesday, Senator
Levin pointed out that his committee had found 3,400
places in Goldman documents where its officials used the
phrase "net short," a reference to negative bets.

"Why would Goldman deny what was so obvious, that they
were engaged in a huge short in the year 2007?" Senator
Levin asked in a press briefing Wednesday morning.
"Because they gained at the expense of their clients and
they used abusive practices to do it."

The report uncovered a new aspect of Goldman's mortgage
activity during 2007. That year, as Goldman tried to build
its bet against housing, the report says, it tried to
drive up the price of a mortgage index, a practice known
as squeezing the shorts. When the price of the index rose
sharply, the cost of betting against the mortgage market
fell. Goldman tried to put on the short squeeze, the
report noted, so that it could add to its negative bets
more cheaply and protect itself against the housing
collapse.

Because Goldman was a large dealer in the marketplace, it
had the power to drive prices in a certain direction. The
report quotes from the self-evaluation of Deeb Salem, a
mortgage trader, who wrote: "We began to encourage this
squeeze, with plans of getting very short again." He
added, "This strategy seemed do-able and brilliant."

Michael Swenson, head of trading in the structured product
group at Goldman and Mr. Salem's superior, also referred
to the short squeeze, according to Senate investigators.
In an e-mail, Mr. Swenson said that Goldman should "start
killing" investors who were betting against mortgages. In
testimony before the committee, however, he said he was
simply trying to add balance to the market.

Goldman abandoned its plan in June 2008 when two Bear
Stearns hedge funds collapsed because of bad mortgage
bets.

A Goldman spokesman said in a statement: "While we
disagree with many of the conclusions of the report, we
take seriously the issues explored by the subcommittee. We
recently issued the results of a comprehensive examination
of our business standards and practices and committed to
making significant changes that will strengthen
relationships with clients, improve transparency and
disclosure and enhance standards for the review, approval
and suitability of complex instruments."

The report also sheds new light on the bundling and
trading of mortgages at Deutsche Bank, which had also made
negative bets in that market.

Unlike Goldman, Deutsche Bank has not been accused of
wrongdoing by government investigators. But the Senate
report focuses on a trader named Greg Lippmann, who has
since left the bank to join a hedge fund.

Mr. Lippmann was vocally negative about housing as early
as 2005 and brought his idea of shorting the market to
professional investors on Wall Street. He described risky
mortgage securities before the crisis as "pigs," according
to the report. When he was asked to buy one such mortgage
security, he responded that he "would take it and try to
dupe someone," according to the report.

Mr. Lippmann persuaded Deutsche to let him build a large
short position, reaching $5 billion by 2007, the report
says. The bank still lost money on other positive mortgage
bets, but Mr. Lippmann's trade helped reduce the company's
overall loss.

The report focused on one Deutsche collateralized debt
obligation from 2006, called Gemstone VII, and described
how Deutsche and other banks made $5 million to $10
million for every deal like Gemstone they created. In 2006
and 2007, banks created about a trillion dollars of C.D.O.
deals -- the most complex type of mortgage security and the
instruments that sent the lending craze to dizzying
heights.

In e-mails provided to the committee, Mr. Lippmann called
the bank's operation a "C.D.O. machine" and characterized
such securities as a "Ponzi scheme." But when the
committee interviewed Mr. Lippmann, he backtracked, saying
that his colorful descriptions were used to defend his
negative view of the market.

In the Senate interview, Mr. Lippmann also said that he
thought he was the person who persuaded the American
International Group to stop writing insurance on mortgage
securities. He told the committee that the head of the
Deutsche Bank group that put together C.D.O.'s was upset
when Mr. Lippmann persuaded A.I.G. to exit the business in
2006. Without A.I.G. there to insure the instruments, it
would be harder to keep these lucrative factories humming.

Mr. Lippmann declined to comment on Wednesday.

Michele Allison, a spokeswoman for Deutsche Bank, said
that the e-mails and other documents cited in the report
indicated the divergent views within the bank about the
housing market. "Despite the bearish views held by some,
Deutsche Bank was long the housing market and endured
significant losses," she said in a statement.

___________________________________________

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