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

Counsel

ZACHARY I. SCHRAM

Counsel

DANIEL J. GOSHORN

Counsel

DAVID H. KATZ

Counsel

ALLISON F. MURPHY

Counsel

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

Law Clerk

BRITTANY CLEMENT

Law Clerk

DAVID DeBARROS

Law Clerk

ERIN HELLING

Law Clerk

HELENA MAN

Law Clerk

JOSHUA NIMMO

Intern

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”] 
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WALL STREET AND THE FINANCIAL CRISIS:

Anatomy of a Financial Collapse 

TABLE OF CONTENTS

I. 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

(3) Inflated Credit Ratings: Case Study of Moody’s and Standard & Poor’s. . . . . . . . . . 5

(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
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(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

1. Ensure “Qualified Mortgages” Are Low Risk. . . . . . . . . . . . . . . . . . . . . . . . . . . 160 

2. Require Meaningful Risk Retention. .............................. ... 160

3. Safeguard Against High Risk Products. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160

4. 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
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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

1. Complete OTS Dismantling...................................... ... 241

2. Strengthen Enforcement......................................... ... 241

3. Strengthen CAMELS Ratings. ................................... ... 242

4. Evaluate Impacts of High Risk Lending. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 242

V. 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

(1) Increasing High Risk Loans and Unaffordable Housing. . . . . . . . . . . . . . . . . . . . . . . 259

(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

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

(3) Recommendations. ................................................ ... 316

1. Rank Credit Rating Agencies by Accuracy. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 316 

2. Help Investors Hold CRAs Accountable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 316

3. Strengthen CRA Operations. .................................... ... 316

4. Ensure CRAs Recognize Risk. ................................... ... 316

5. Strengthen Disclosure. ......................................... ... 317

6. Reduce Ratings Reliance. ....................................... ... 317

VI. INVESTMENT BANK ABUSES: 

CASE STUDY OF GOLDMAN SACHS AND DEUTSCHE BANK.............. ... 318

A. Background. ........................................................ ... 321

(1) Investment Banks In General......................................... ... 321

(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
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(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

1. Review Structured Finance Transactions.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 639

2. Narrow Proprietary Trading Exceptions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 639

3. 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 

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

A. Subcommittee Investigation

In November 2008, the Permanent Subcommittee on Investigations initiated its 

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 
2

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.

B. Overview

(1) High Risk Lending: 

Case Study of Washington Mutual Bank

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 
3

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.
4

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 
5

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.

(3) Inflated Credit Ratings:

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

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 
6

(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.”
7

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. 

(4) Investment Bank Abuses: 

Case Study of Goldman Sachs and Deutsche Bank

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. 
8

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 
9

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 
10

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.

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

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 
11

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.
12

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

1. 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. 

2. 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.

3. 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.
13

4. 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. 

5. 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

1. 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.

2. 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. 

3. 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.

4. 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

1. 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.

 

2. 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.
14

3. 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.

4. 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.

5. 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.

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

reliance on privately issued credit ratings. 

Recommendations on Investment Bank Abuses 

1. 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.

2. Narrow Proprietary Trading Exceptions. To ensure a meaningful ban on 

proprietary trading under Section 619, any exceptions to that ban, such as for marketmaking or risk-mitigating hedging activities, should be strictly limited in the 

implementing regulations to activities that serve clients or reduce risk. 

3. 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. 

4. 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. 
15

II. BACKGROUND

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

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

 This broad-based approach meant that when a bank 

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.

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

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 GlassSteagall 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).

and exempted investment bank holding companies from direct federal 

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.
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-basedcapital-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 brokerdealers 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
17

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, brokerdealers, 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. 

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

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.

 

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

credit cards. Id. 
18

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

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

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 

 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.
19

to specialize in issuing loans to subprime borrowers and became known as subprime lenders.16

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.

 

Subprime loans provided new fuel for the securitization engines on Wall Street.

17 Some financial institutions reduced that 

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

 

 

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.
20

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 

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

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 

34% of all loan originations in 2006.

 Because higher risk loans required 

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.

22 Altogether from 2000 to 2007, U.S. lenders originated 

about 14.5 million high risk loans.23

 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).

The majority of those loans, 59%, were used to refinance 

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.
21

an existing loan, rather than buy a new home.24

“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.”

 In addition, according to research performed by 

GAO, many of these borrowers:

25

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.26

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. 

 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.

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

 24 7/28/2009 “Characteristics and Performance of Nonprime Mortgages,” GAO, Report No. GAO-09-848R at 24, 

Table 3.

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 

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.
22

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.
23

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

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 

histories, but with aggressive underwriting that increased the risk of the loan.

 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.

31 For example, Alt 

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. 
24

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%.35

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.
25

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.

 
26

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
27

default or incur losses.

37

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

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. 

(Moody’s); Standard & Poor’s Financial Services LLC (S&P); and Fitch Ratings Ltd. (Fitch).

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

repaid and so qualifies as a safe investment.

38 

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

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

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.

 

40

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.

 Financial instruments bearing AAA through BBB- ratings are generally 

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.

41

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 

 Banks are also 

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. 

 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.
28

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 
29

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 
30

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 

from $30,000 to $750,000 to rate the tranches of a CDO.

 

45 Surveillance fees generally ranged 

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

 42 11/1997 Comptroller of the Currency Administrator of National Banks Comptroller’s Handbook, “Asset 

Securitization,” at 11.

 S&P’s revenue also increased. S&P’s gross 

revenues for RMBS and mortgage related CDO ratings quadrupled, from over $64 million in 

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.)
31

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.”50 In 2003, the SEC reported that “the potential 

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.52

From 2004 through the first half of 2007, Moody’s and S&P provided AAA ratings to a 

majority of the RMBS and CDO securities issued in the United States, sometimes providing 

AAA ratings to as much as 95% of a securitization.

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

thousands of downgrades of RMBS and CDO ratings, the first mass downgrades in U.S. history.

53 By 2010, analysts had determined that 

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-
32

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.
33

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

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.

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)).
34

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

 

 – to track their investments and maintain sufficient 

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.

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.
35

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 

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 Borrowing from longstanding practice in commodities 

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

 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.

 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 

64 For more information, see Chapter VI, section discussing Deutsche Bank.
36

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 

short the mortgage market.

 

68 Goldman Sachs had helped to build an active mortgage market in 

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

E. Market Oversight

to ensure its continued existence.

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/investmentprograms/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/investmentprograms/cpp/Pages/capitalpurchaseprogram.aspx and an example of a transactions report at 

http://www.treasury.gov/initiatives/financial-stability/briefing-room/reports/tarptransactions/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).
37

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.
38

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.
39

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, 

and placement agents. Most were also subject to oversight by state securities regulators.79 The 

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 

any type of swap, including credit default swaps. This prohibition took effect in 2000, with 

enactment of the Commodity Futures Modernization Act (CFMA).

82

 77 See SEC website, “About the SEC: What We Do,” 

The key statutory section 

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 

www.sec.gov. 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.
40

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 

practices related to high risk home loans.88 Even then, the regulators issued voluntary guidance 

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 
41

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

effectively unable to enforce state laws prohibiting abusive mortgage practices against federallychartered banks and thrifts.

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.
42

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 stakeholders 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.
43

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 

worth hundreds of billions of dollars.

100 According to FHA data, as of 2011, nearly 20% of all 

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-

343. 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.
44

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

collapse.

 

102 In some instances, the Federal Reserve created new programs, such as its Agency 

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

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:

 In other 

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.

– 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.
45

– 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 
46

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

was on.

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

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.
47

Financial Crisis Timeline104

 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.

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
48

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.”).
49

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
50

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.

1. 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.

2. 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”).
51

3. 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.

4. 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.

5. 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.

6. 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

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

 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.
52

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.
53

of 2007.”109 The retail channel was also used to originate substantial numbers of home equity 

loans and home equity lines of credit. 

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.
54

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

 111 See 6/11/2007 chart entitled, “Capital Markets Division Growth,” JPM_WM03409858, Hearing Exhibit 4/13-

47c.

 Long Beach typically qualified borrowers 

according to whether they could afford to pay the initial, low interest rate rather than the later, 

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.
55

higher interest rate.118 For “interest-only” loans, monthly loan payments were calculated to 

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%).
56

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 WCC worked with two other bank 

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 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 WCC closed its doors 

in December 2007, after the securitization markets collapsed. 

(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.
57

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. 

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

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 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.
58

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.

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

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.

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

 137 “Washington Mutual CEO Kerry Killinger: $100 Million in Compensation, 2003-2008,” chart prepared by the 

Subcommittee, Hearing Exhibit 4/13-1h.

 

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.

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.
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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.
60

(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 In his memorandum to the Board, Mr. Killinger 

predicted continuing growth opportunities for the bank:

“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 

mortgages,152 and embarked upon a new strategy to push the company’s growth, focused on 

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.
61

“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

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

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

“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

 153 See 3/15/2004 OTS Report of Examination, at OTSWMS04-0000001509, Hearing Exhibit 4/16-94 [Sealed 

Exhibit].

 

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.

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).
62

(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 The January 2005 presentation 

contained a slide defining “Higher Risk Lending”:

“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

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

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

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.
63

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

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

expanded underwriting criteria and multiple risk layering:

“Expanded Criteria

-‘No Income’ loan documentation type

-All Manufactured Housing loans ...

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

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.

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

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”).
64

(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 meaning from less 

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:

2005 WaMu Gain on Sale

Margin by Product

in bps171

Government 13

Fixed 19

Hybrid/ARM 25

Alt A 40

Option ARM 109

Home Equity 113

Subprime 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].
65

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.
66

“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.
67

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.
68

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.
69

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.
70

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 His memorandum expressed no hesitation or qualification as to whether the 

high risk home lending strategy was still operative in 2006. The memorandum stated:

“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].
71

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

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].

Fixed

$69B

33%

Hyb/ARM

$28B

13%

Option ARM

$63B

31%

Subprime

$34B

16%

Home Equity

$4B

2%

Govt

$8B

4%

Alt-A

$1B

0%

2005 Fixed

$4B

2%

Hyb/ARM

$38B

17%

Option ARM

$63B

23%

Subprime

$70B

30%

Home Equity

$30B

13%

New Product

$13B

5%

Alt A 

$24B 

10%

2008

$206 Billion $232 Billion
72

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 

2006. ... 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”).
73

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 

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 

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

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.
74

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.
75

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).
76

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.
77

After a short hiatus, WaMu allowed Long Beach to resume securitizing subprime loans in 

2004.216 An internal WaMu memorandum, later prepared by a WaMu risk officer who had been 

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. 
78

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 The 

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:

“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 

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.

 This 

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 
79

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 These unexpected repurchases 

were significant enough that Washington Mutual Inc., Long Beach’s parent company, made 

special mention of them in its 2005 10-K filing:

“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

 

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.”). 

 WaMu told OTS 

that making Long Beach a subsidiary would give the bank greater control over Long Beach’s 

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).
80

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.”

 

236 Mr. Rotella, however, expressed hope that operations 

would improve: 

“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.
81

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 Another 10% of the repurchases resulted from 

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.

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.
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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.
83

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

was “not a viable exit strategy” and noted:

“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).” 

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

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

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.
84

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 The mass 

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. 

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

criticizing Long Beach’s poor loan origination and underwriting practices.259 By that 

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:

 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.
85

“[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

 260 Id. at JPM_WM02548940-41.

 WaMu President Steve Rotella 

also acknowledged the inability of WaMu management to resolve the problems at Long Beach:

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.
86

“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. 

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

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.
87

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 In 2004, 

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:

“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. 
88

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 The IG report also 

found:

“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_Benjamin00020408_001, Hearing Exhibit 4/16-9. 281 4/2010 IG Report, at 23, Hearing Exhibit 4/16-82. 282 Id. at 23.
89

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.
90

“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

 291 Id. at 58615.

 The bank’s acceptance of 

unverified income information came on top of its use of loans with other high risk features, such 

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

14.

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.
91

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 

58611. 

297 April 13, 2010 Subcommittee Hearing at 41.
92

“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 Still another layer of risk was 

added to these loans by permitting the borrowers to have credit scores as low as 620. 

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%).
93

“$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

 303 6/13/2006 email from Cheryl Feltgen to David Schneider who forwarded it to Steve Rotella, 

JPM_WM01311922-23. 

 In addition, in 2005, WaMu 

personnel informed OTS that, since 2004, the bank had not been qualifying its Option ARM 

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.
94

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 After the NTM Guidance was issued, a WaMu analyst calculated 

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:

“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.
95

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.”

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

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.

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 On top of those risks, WaMu 

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. 

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 

(c) Loan Fraud

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-inCharge 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.
96

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 

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 A November 2005 memorandum summarizing the review stated that it 

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

 317 11/17/2005 WaMu internal memorandum, “So. CA Emerging Markets Targeted Loan Review Results,” 

JPM_WM01083051, Hearing Exhibit 4/13-22a.

 It also stated that the 

fraud findings did not differ between loans originated by WaMu’s own loan officers and loans 

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.
97

originated by third party brokers and brought to the loan centers.

323 The presentation also stated 

that the fraud uncovered by the review was found to be “preventable with improved processes 

and controls.” 

The presentation indicated that the loan fraud involved primarily “misrepresentation of 

loan qualifying data,” including misrepresentations of income and employment, false credit 

letters and appraisal issues.324 The presentation included a few examples of misrepresentations, 

including:

“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 The message 

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.

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. 
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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

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 She asked 

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.

Over the next two years, the Downey and Montebello head loan officers, Messrs. 

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 

In June 2007, however, the fraud problem erupted again. That month, AIG, which

provided mortgage insurance for some of WaMu’s residential mortgages, contacted the bank 

with concerns about material misrepresentations and fraudulent documents included in 

 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. 
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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.

Seven months later, in April 2008, CFI and the Audit department issued a 12-page 

memorandum with their findings.337 The memorandum not only confirmed the presence of fraud 

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:

“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 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

 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.

 The memorandum reported that one individual 

believed that David Schneider “was made aware of these findings” and wanted Risk Mitigation 

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.
100

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 He “thought the matter 

was handled or resolved.” The WaMu memorandum concluded:

“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 The OTS Examiner-in-Charge 

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 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-

25.

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.
101

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 CFI then interviewed the loan officers, sales associates, and 

personnel at the WaMu “loan fulfillment center” (LFC) that processed Westlake Village loan 

applications.

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-ofmonth 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-willclose-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.
102

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 He went on to work in the mortgage industry 

arranging residential loans.

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

 354 Subcommittee interview of Brian Minkow (2/16/2010).

 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. 

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

Another sobering internal WaMu report, issued in September 2008, a few weeks before 

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”:

“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.
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(d) Steering Borrowers to High Risk Option ARMs

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-onsale 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 The first focus group 

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 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. ...

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 

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].
106

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.
107

“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 “lowdoc” 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

In September 2006, WaMu introduced pricing incentives for Option ARMs in the 

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

 372 6/5/2006 “e-Flash” from Steve Stein to Retail Production Sales, JPM_WM03246053.

 In addition, from November 2006 through January 2007, e-Flashes sent to 

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 

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.

 As long as home prices were appreciating, most borrowers were able to refinance if 

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). 
109

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 Once housing prices stopped rising, 

however, refinancing became difficult. At recast, many people found themselves in homes they 

could not afford, and began defaulting in record numbers.

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%).
110

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.
111

“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).
112

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%

1. Achieve Net Income - $340 MM for 2007

2. HL [Home Loan] Product Sales (Incl. Conduit)

1. Home Equity - $18B

2. Subprime - $32B

3. Option ARM - $33B

4. Alt A - $10B

3. Customer Satisfaction (Total HL) – 55%”403

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

 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).

 On the other hand, she described David Schneider, her 

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).
113

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

 405 1/3/2007 email from Cheryl Feltgen, “Year-End 2006 Message for the Home Loans Risk Management Team,”

Hearing Exhibit 4/13-73.

 According to 

Mr. Cathcart, in 2007, the bank made bonus distributions more dependent on the performance of 

406 Id. 407 Id. 408 Subcommittee Interview of Ronald Cathcart (2/23/2010).
114

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 He 

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

 409 Id. 

 Mr. Schneider approved the product, and 

Ms. Feltgen ultimately signed off on it. She told the Subcommittee that it was a high risk 

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. 
115

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

about his marginalization by senior management.415 He said that he initially had extensive 

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.

Mr. Cathcart told the Subcommittee that regulators were also given out-of-date loss 

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).
116

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 

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. 
117

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 

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. 

 It also conducted whole loan sales and credit card 

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 AssetLiability 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.
118

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 It also sold WaMu loans to Fannie 

Mae and Freddie Mac. WCC personnel marketed WaMu and Long Beach loans both in the 

United States and abroad. 

Before WCC was able to act as a sole underwriter, WaMu and Long Beach worked with 

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

 431 Id.

 The QSPE then issued RMBS securities secured by future cash 

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 

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).
119

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-

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.

 
120

__
121
122

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. 

Long Beach Securitizations. In April 2005, an internal email sent by an OTS regulator 

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:

“[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 

2003. For specific ARM deals, LBMC made the top 10 worst deal list from 2000 thru 

2002. 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.
123

“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.
124

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.
125

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: 

“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.”453

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.
126

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.

On Thursday, September 14, 2006, John Drastal, then Senior Managing Director of 

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: 

 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.
127

“David,

“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.
128

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.”

Four days later, on Sunday, February 18, Mr. Schneider replied to the email chain by 

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:

“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.
129

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:

1. db [David Beck] - please select the potential sample portfolios - along the lines we 

discussed at the mbr [Monthly Business Review]

2. cf [Cheryl Feltgen] - please run credit scenarios

3. db - coordinate with finance on buy/sell analysis

4. 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.
130

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.
131

A WaMu risk analyst, Robert Shaw, replied the same day and identified specific factors 

that were driving delinquencies in the Option ARM portfolio: 

“Cheryl,

I reviewed the HFI [Hold for Investment] prime loan characteristics that contributed to 

rising 60+ delinquency rates468 between 1/06 - 1/07 [January 6 and 7]. The results of this 

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.

Later that same day, Ms. Feltgen forwarded Mr. Shaw’s email to Mr. Beck, Mr. Chen, 

and Mr. Ellson. Her email carried the subject line: “Some thoughts on target population for 

potential Option ARM MTA loan sale.” She wrote:

“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.
132

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 The email was copied to Mr. Beck, Ms. Feltgen and others, and showed 

that the implementation of the plan was underway:

 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.
133

“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

1. 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 

gets popularity)

c. Foreign Nationals (Risk based pricing applied, but difficult to sale due to FICO 

problems)

d. FICO less than 620, except employee loans in which case FICO can be restated after closing.

e. 3-4 units (excessive S & P level hit calls for portfolio execution)

2. 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].
134

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.

On March 9, 2007 the Market Risk Committee met and approved the Option ARM 

proposal. The minutes of that meeting describe the changes that had been proposed:

“- 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.
135

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

 480 Mr. Schneider and Mr. Beck were asked about this matter at the hearing. See April 13, 2010 Subcommittee 

Hearing at 75-82.

 As of February 2010, more than half of the loans in WMALT Series 2007-OA3 

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.
136

were delinquent, and more than a quarter were in foreclosure.487 All of the investment grade 

ratings have been downgraded to junk status, and the investors have incurred substantial losses. 

(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

 487 “Select Delinquency and Loss Data for Washington Mutual Securitizations,” chart prepared by the 

Subcommittee, Hearing Exhibit 4/13-1g.

 Among the advantages that WaMu 

believed it gained from its relationship with Fannie Mae were help with balance sheet 

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. 
137

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.
138

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 In January 2005, in a document comparing the proposals from Fannie and 

Freddie, WaMu wrote:

“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, gfe[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.
139

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 In a list of “asks ... to cement our 

relationship” with Freddie Mac, WaMu indicated, among other issues, that it would press 

Freddie Mac to buy more subprime and “lower quality loans”:

 “Credit ...

• WM [WaMu] wants FRE [Freddie Mac] to expand the eligibility of lower 

quality loans to ensure WM is ‘market competitive’. ...

 Non-prime

• 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 

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.”).

 WaMu President Steve Rotella 

504 Id. 505 Id. 506 Id. 507 Id. 508 Id. [italics in original omitted].

509 Id. at JPM_WM03200454.
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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:

“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.

 

513 Later that year, Freddie Mac paid a $125 million civil 

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

When asked at the Subcommittee hearing to define Washington Mutual’s relationship 

with Fannie Mae and Freddie Mac, Mr. Rotella provided the following response:

Both GSEs also 

changed their senior management.

“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/PreviewFHFAWWW/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.
141

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

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

 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.

 Most of those loans were fixed rate mortgages, but they also included the higher 

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 
142

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 

(in billions)

Sold to Fannie Mae 

(in billions)

Percent of Total WaMu 

Originations Sold to GSEs

2000 $ 0 $ 7.1 14%

2001 $ 1.4 $ 35.3 20%

2002 $ 0.2 $ 95.7 29%

2003 $ 2.2 $ 174.3 40%

2004 $ 1.1 $ 25.9 10%

2005 $ 34.6 $ 20.3 20%

2006 $ 32.3 $ 11.2 23%

2007 $ 31.8 $ 8.2 29%

2008 $ 20.8 $ 2.1 70%

TOTAL $ 124.4 $ 380.1 27.3%

Source: Inside Mortgage Finance

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.
143

F. Destructive Compensation Practices

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

 532 See “Washington Mutual CEO Kerry Killinger: $100 Million in Compensation, 2003-2008,” chart prepared by 

the Subcommittee, Hearing Exhibit 4/13-1h.

 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 

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.
144

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

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).
145

“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.
146

WALK-UP MUSIC

FOR DAVID SCHNEIDER

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.
147

“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 It was also an opportunity to meet WaMu’s top executives, 

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.

(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).
148

including the need to implement incentive compensation programs to place greater 

emphasis on loan quality.”548

(a) Long Beach Account Executives

Despite the years of internal and external audits that found a lack of internal controls at 

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

The 2004 Long Beach Incentive Plan also introduced a contingent compensation program 

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-

25.

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.
149

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.
150

-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

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

In order to promote high risk, high margin products, WaMu paid its loan consultants 

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 Even in 2007, WaMu’s compensation plan 

continued to incentivize volume and high risk mortgage products.

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”).
151

(c) Loan Processors and Quality Assurance Controllers

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

Documents obtained by the Subcommittee confirm Ms. Kosch’s recollections. A 

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:

“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

Mr. Rotella responded that he thought WaMu executives would want more of their 

bonuses in cash:

“[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,” http://sacramento.fbi.gov/dojpressrel/pressrel08/sc061908a.htm. 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.
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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

WaMu filed its executive compensation plan with the SEC, as required. The exclusion of 

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:

“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.
155

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).
156

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 
157

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 The 

FDIC Chairman Sheila Bair testified: 

“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.
158

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 One of the provisions imposes a 5% risk retention 

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:

“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). 
159

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. 
160

(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.

1. 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. 

2. 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.

3. 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.

4. 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. 

5. 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.
161

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

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 regulators overseeing WaMu. That memorandum stated: 

“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

“Chief Executive Officer Kerry K. Killinger (“Killinger”), Chief Operating

 The FDIC complaint stated: 

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.

1. 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. 

2. 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.

3. 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.

4. 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.

5. 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.

6. 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.

7. 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.

8. 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. 

9. 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).
166

In 2009, OTS oversaw about 765 thrift-chartered institutions.600

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.

 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. 

(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

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.”

 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.

602 To 

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

 600 2009 OTS Annual Report, “Agency Profile,” 

 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. 

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

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.

 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. 

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).
169

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:

“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 
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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:

“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.”609

 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].
171

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

The result was the bank’s January 2005 High Risk Lending Strategy, discussed in the 

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

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

 616 “WaMu Product Originations and Purchases by Percentage – 2003-2007,” chart prepared by the Subcommittee, 

Hearing Exhibit 4/13-1i.

 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 

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.

Fixed

64%

Other ARM

17%

Option 

ARM

7%

Subprime

5%

Home 

Equity

7%

2003

Fixed

23%

Other 

ARM

30%

Option 

ARM

18%

Subprime

5%

Home 

Equity

24%

2007
173

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,

 

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.

requiring each WaMu 

employee to oversee more than 2,400 third party brokers.

(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.
174

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.

 

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 

 

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. 

 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 

0001216. 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.
175

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

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, 

another thrift with high risk loans, failed and was taken over by the FDIC.631 In response, 

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

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).

The parent holding company supplied 

an additional $2 billion in capital to the bank. 

634 On July 15, OTS and the 

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

On August 1, 2008, the FDIC informed OTS that it thought WaMu should be 

downgraded to a 4 CAMELS rating, signaling it was a troubled bank exhibiting unsafe and 

unsound practices.

 

638 OTS strongly disagreed.639

 630 See 7/21/2008 letter from FDIC to OTS, FDIC_WAMU_000001730, Hearing Exhibit 4/16-59.

 Also on August 1, OTS provided WaMu with 

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, 

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.
176

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

By August 25, OTS and WaMu reached agreement on the terms of the MOU, but it was 

not actually signed until September 7, 2008.

 As 

the agencies argued amongst themselves, the bank’s condition continued to deteriorate. 

641 Apart from the capitalization plan, OTS Deputy 

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 

cash from WaMu’s coffers, leading to a second liquidity crisis.

 

645 On September 18, the FDIC 

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,” FDICEM_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_Scott00065461_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.
177

(3) OTS Identification of WaMu Deficiencies

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

(a) Deficiencies in Lending Standards

 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.

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-toincome 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.
178

“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].
179

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 

underwriting exceptions and with issues that evidence lack of compliance with Bank policy.”655

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

In August 2005, the OTS ROE for the year indicated that the lending standards problem 

had not been resolved: 

“[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].
180

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.”

 

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.”

 Many of the loans made in 

this time period would later default.

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].
181

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.
182

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 “DoubleDouble.”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).
183

“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

At another point, the ROE warned: “Ensure cost-cutting measures are not impacting critical risk 

management areas.”668

Another OTS examination that focused on WaMu’s holding company identified multiple 

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.”669

Its concern about WaMu’s risk management practices prompted, in part, OTS’ 

requirement that WaMu commit its high risk lending strategy to paper and gain explicit approval 

from the Board of Directors.

 

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 OTS continued to express 

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 subgroup 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:

“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.
185

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 reassess 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].
186

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 

whether similar conditions are systemic throughout the organization.”

 

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:

 The memorandum 

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.”

“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_Benjamin00020408_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.
187

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.

 Despite this 

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].
188

dramatic criticism, OTS found in the next year’s examination that WaMu had continued to use 

noncompliant automated appraisals.694

To address the issue, WaMu decided in mid-2006 to outsource its appraisal function to 

two vendors: eAppraiseIT and Lender Service Incorporated (LSI).

 Before any enforcement action was taken, WaMu 

management agreed to cease using automated appraisals by October 2006.

695 Calling the move “Project 

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

The Decision to Outsource. WaMu’s decision to outsource the appraisal function 

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.

 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. 

698 Though the bank had repeatedly delayed taking action or failed to respond 

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.702

 694 5/23/2006 OTS Memo 2, “Safety and Soundness Examination,” at OTSWME06-039 0000205.

 A 

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 

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.
189

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.

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.”

 The complaint stated in part:

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.
190

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

“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?”

 In November 2007, when the director of 

OTS, John Reich, was presented with his agency’s investigation plan, he responded:

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.

 

715 

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 By this point, the recommendation was too late and the issue was 

moot. 

 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_John00040045_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.
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(d) Deficiencies Related to Long Beach 

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

“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.”

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:

719

Despite these severe underwriting and operational problems, Long Beach resumed 

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. 
192

“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.
193

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 debtto-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.

725 OTS also determined that Long Beach’s newly created 

portfolio of subprime loans “had attributes that could result in higher risk” than WaMu’s existing 

subprime loan portfolio.726

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,” 

they recommended approving WaMu’s purchase of the company with certain conditions.

 

727 

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.

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”).

 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 

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). 
194

$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

“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.”

 In a June 2006 internal email to his colleagues, the OTS Regional Deputy Director 

wrote:

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.”

 

735 At a hearing of the 

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

 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.
195

(e) Over 500 Deficiencies in 5 Years 

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

“[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.”

 The FDIC Inspector 

General, Jon Rymer, agreed:

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-forinvestment 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.
196

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

“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.”

 He explained: 

749

(4) OTS Turf War Against the FDIC

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

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.

 The same outcome was not accomplished until two months later in September when no 

other options remained, and OTS worked with the FDIC to make it happen.

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).
197

regulator,751

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. 

OTS officials employed a variety of tactics to limit the FDIC oversight of the bank, 

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. 

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). 
198

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, 

with A being the best rating and E the worst.

 

755 The FDIC IG explained the difference between 

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.

 As 

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.
199

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

CAMELS 

Composite Rating

LIDI 

Rating

January 2004 2 B

July 2004 2 B/C

January 2005 2 B/C

July 2005 2 B/C

January 2006 2 B/C

July 2006 2 B/C

March 2007 2 B/C

June 2007 2 C

September 2007 2 C

December 2007 2 C

March 2008 3 D

June 2008 3 E

September 2008 4 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.

 

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 

 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.

 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.
200

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.”762 The letter urged OTS to impose a “corrective program” that 

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

“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.”

 In a separate email, Scott 

Polakoff, a senior OTS official called the FDIC letter “inappropriate and disingenuous”: 

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.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 

 The head of OTS sent an email to the head 

of the FDIC responding that “rating WaMu a 4 would be a big error”: 

 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.
201

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.”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 

 Two weeks later, the bank failed.

 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_Scott00065461_001, Hearing Exhibit 4/16-68.
202

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.
203

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

“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.

 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: 

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-

0001.

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.
204

FDIC, as we have in the past.”779

After discussing the Finn letter in an internal email, the FDIC Assistant Regional 

Director, George Doerr, wrote to his colleagues:

 Mr. Finn wrote that because WaMu’s CAMELS rating was a 2 

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.”

“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.
205

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 examinerin-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

 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.

 The FDIC explained to 

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. 

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.
206

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).
207

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,”793

Mr. Reich: I think basically and fundamentally it was who was the primary Federal 

regulator.

Mr. Reich stressed that the key point he was trying to convey was that OTS was WaMu’s 

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’ hardedged 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,” FDICEM_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.
208

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.
209

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”:
210

“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 selfregulation.”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.”798 At the Subcommittee hearing, Mr. Reich

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

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_John00025837_001, Hearing Exhibit 4/16-78. 799 April 16, 2010 Subcommittee Hearing at 36. 800 Id. at 5 (opening statement of Senator Levin).
211

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 

2008. 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.”).
212

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 ‘overmeeting’ 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.
213

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

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:

 Their report explicitly 

recommends against OTS’ relying on a bank’s systems in the future to track compliance.

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.
214

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 

that they will re-issue this memo without the ‘Criticism.’ It will be a ‘Recommendation.’”809 His 

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 

findings and presented them to WaMu’s Chief Risk Officer and the President of Home Loans.811

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 

ignored. WaMu took until April 2008 to produce a report documenting its findings.

 

No one, however, informed OTS, and WaMu took no action to stop the fraudulent loans.

812

 808 April 16, 2010 Subcommittee Hearing at 60-61.

 WaMu 

also initially resisted providing the report to OTS, claiming it was protected by attorney-client 

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.
215

privilege.813

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. 

 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. 

(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).
216

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_Benjamin00020408_002, Hearing Exhibit 4/16-9. 818 Id. at Franklin_Benjamin-00020408_001.
217

“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.
218

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.”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 

regulators should “not discourage lenders from offering these products.”

 He also noted 

that OTS sometimes made an exception to that rule for loans held for sale.

824 It also stated that 

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 

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.

 

827 He also wrote that OTS needed to 

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.

 In August, several OTS officials discussed over email how to prevent the 

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.
219

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, 2006.831

• evaluate a borrower’s ability to fully repay a prospective loan, including any balance 

increase from negative amortization; 

 The final version did not 

fully reflect the recommendations of OTS on negatively amortizing loans. Among other matters, 

it called on banks to:

• 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.
220

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

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 

institutions “should” do, not something they “must” do.833 According to a written summary by

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 

not yet complying with the new standards when issuing Option ARMs.

835 The OTS review 

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

In April 2007, the FDIC asked OTS for permission to conduct its own review of WaMu 

loan files to evaluate the bank’s compliance with the NTM Guidance.

 The review contained no recommendations for actions to ensure 

WaMu changed its procedures.

838 OTS refused, however, 

to provide the FDIC with access to the relevant loan files and effectively blocked the review.

839

 832 Subcommittee interviews of Sheila Bair (4/5/2010) and George Doerr (3/30/2010). 

 

The FDIC Assistant Regional Director George Doerr told the Subcommittee that when he 

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).
221

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.”842 When he made that suggestion in March 2007, OTS 

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

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:

Instead of using the NTM Guidance as an opportunity to 

strengthen WaMu’s lending standards and reduce its loan risk, OTS chose to delay its 

implementation.

“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%).
222

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.”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.”

 Later the same day, Mr. Dochow wrote: 

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.
223

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.850 At the Subcommittee hearing, virtually every witness condemned stated income

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

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.”).
224

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.
225

“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.”

 

858 At the same time, an internal FDIC analysis of the bank identified a 

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

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).
226

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.).
227

loans, mostly from Long Beach, as well as about $115 billion in Option ARM loans.862

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:

 Internal 

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. 

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 

investors, and that these investors will bear the brunt of a bursting housing bubble.”864

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.”865

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, FDICEM_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.
228

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.”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.

 OTS was two years too late, however; the 

secondary market for subprime securities collapsed four months later.

(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

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.

 A lower CAMELS rating would have represented one of the strongest 

actions that OTS and the FDIC could have taken, because it would have required changes from 

WaMu. 

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.”

 Treasury IG Thorson focused in particular on the 2 rating assigned to WaMu’s high 

risk home loans:

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. 
229

satisfactory risk management practices.”872

“[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.”

 He noted that OTS gave management this positive 

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: 

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.
230

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.
231

could have triggered additional panic and loss of confidence in the U.S. banking system and 

financial markets. 

(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

 878 1/2009 Center for Responsible Lending report, “The Second S&L Scandal,” at 1, Hearing Exhibit 4/16-84.

 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 

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.
232

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.

 

886 In addition, the SEC charged that CEO Angelo Mozilo had violated his federal 

disclosure obligations and engaged in insider trading.

887

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 

that the bank was more prudent than its competitors.889 The SEC complaint cited, for example,

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-tovalue 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

 883 OCC, “Annual Report: Fiscal Year 2009,” http://www.occ.gov/static/publications/annrpt/2009AnnualReport.pdf. 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.
233

Later he warned that the bank was “flying blind” on the ultimate delinquency rate and should 

consider selling the loans.892

“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.”

 The SEC complaint also stated:

893

On October 15, 2010, the SEC announced a record settlement with the three Countrywide 

executives.894 Mr. Mozilo agreed to pay $22.5 million to settle the disclosure fraud allegations 

and $45 million to settle the insider trading allegations, bringing his total settlement to $67.5 

million.895

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 

keep their homes.

He also agreed to be permanently barred from serving as an officer or director of a 

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.

896 In August 2010, Countrywide and some former executives agreed to pay 

$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

 892 Id. at ¶ 68-69.

 IndyMac specialized in two types of high risk home loans, Alt A loans which 

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 

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/organizationalstructure/ig/Documents/oig09032.pdf (hereinafter “IG Report on IndyMac Bank”).
234

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

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 

into 2008, eventually reaching $1.55 billion and triggering a liquidity crisis at the bank.

 

900 In 

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 

subprime mortgage business practices.

 

902 Those problems included adopting an overly narrow 

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

After IndyMac’s failure, the Treasury Inspector General conducted a review and issued a 

report evaluating OTS’ oversight efforts.

Neither OTS nor the FDIC ever took a public enforcement action against the bank. 

906 The report attributed IndyMac’s collapse to its 

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

 899 Id. at 7.

 According to the Inspector 

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/wpsrv/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.
235

General, OTS typically relied on the “cooperation of IndyMac management to obtain needed 

improvements” – which was usually not forthcoming – to remedy identified problems.909

In February 2011, the SEC charged three former senior IndyMac executives with 

securities fraud for misleading investors about the company’s deteriorating financial 

condition.910 The SEC alleged that the former CEO and two former CFOs participated in the 

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

FDIC-insured depository institution since 1984.912 At the time of its collapse, IndyMac had $32 

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

(c) New Century 

 

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

 909 Id. at 38.

 By 2007, New Century had approximately 7,200 

employees, offices across the country, and a loan production volume of $51.6 billion, making it 

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/organizationalstructure/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-cv00931-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

In 2007, after the company announced its intent to restate its 2006 financial results, 

investors lost confidence in the company, its stock plummeted, and New Century collapsed. In 

April 2007, it filed for bankruptcy.

 Because it did not accept deposits or have 

insured accounts, it was not overseen by any federal or state bank regulator.

918 In February 2008, the bankruptcy examiner released a 

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

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 

violated federal securities laws and committed fraud.

 Like WaMu, New Century had engaged in a number of harmful mortgage 

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. 

920 Among other matters, the complaint 

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.

 

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.

 The SEC alleged that, while the company’s financial disclosures 

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 

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.”
237

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

In July 2010, the three former New Century executives settled the SEC complaint for 

about $1.5 million, without admitting or denying wrongdoing.

 The complaint charged the New Century 

executives with downplaying the riskiness of the company’s loans and concealing their high 

delinquency rates. 

928 Each also agreed to be barred 

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

 926 SEC Complaint against New Century Executives at 3.

 In June 

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).
238

2008, Fremont General Corporation declared bankruptcy under Chapter 11 and has since

reorganized as Signature Group Holdings, Inc.

936

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 

had deposits that were federally insured, Fremont was also regulated by the FDIC.937 The March 

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 loanto-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.”

 

940 Fremont later reported receiving default notices on $3.15 billion in subprime 

mortgages it had sold to investors.941

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.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 

 The bank was then sold to CapitalSource, Inc. 

 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 SubPrime 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).
239

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

E. Preventing Regulatory Failures

 The fact is that each of these lenders issued billions of dollars in high risk, poor 

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. 

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. 
240

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

Revised Interagency Agreement. A second important change is that the interagency 

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.”

 Although some OTS officials claim the law intended OTS to be a merger 

partner with the OCC, the statute is clear in its intent to abolish OTS, rather than effect a merger 

of equals. 

946

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.

 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

 945 See, e.g., Section 312 of the Dodd-Frank Act.

 Compared to the 2002 version, the revised agreement explicitly provides 

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.

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.”).
241

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

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.

 Under this new system, banks with 

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.

952

(2) Recommendations

 

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.

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.

1. 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.

2. 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. 

 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.
242

3. 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.

4. 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.
243

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 The July mass downgrades sent the value of mortgage related securities

plummeting, precipitated the collapse of the RMBS and CDO secondary markets, and perhaps 

more than any other single event triggered the financial crisis. 

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.”
244

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).
245

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.

1. 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.

2. 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.

3. 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”).
246

CDO securities, delaying thousands of rating downgrades and allowing those

securities to carry inflated ratings that could mislead investors.

4. 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.

5. 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.

6. 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.

7. 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.

8. Statutory Bar. The SEC is barred by statute from conducting needed oversight into 

the substance, procedures, and methodologies of the credit rating models.

9. 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.
247

B. Background

(1) Credit Ratings Generally

Credit ratings, which first gained prominence in the late 1800s, are supposed to provide 

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

The United States has three major credit rating agencies: Moody’s, S&P, and Fitch

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.

 

958 

Paying for Ratings. Prior to the 1929 crash, credit rating agencies made money by 

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:

“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 

1929. ... The rating business remained stagnant for decades.”959 

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.

Credit Ratings. Credit ratings use a scale of letter grades, from AAA to C, with AAA 

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).

 Financial 

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 
248

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.

Investors often rely on credit ratings to gauge the safety of a particular investment. A 

former senior credit analyst at Moody’s explained that investors use ratings to:

“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

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 The rationale behind these legal requirements is to require or 

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).
249

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. 
250

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

“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.”

 Without investment grade ratings, Wall Street firms would have had a much 

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:

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.
251

Arrangers. For RMBS, the “arranger” – typically an investment bank – initiated 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.

In addition to data on the assets, the arranger provided a proposed capital structure for the 

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 To create that hierarchy, the arranger placed the pool’s 

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.

A second common form of credit enhancement was “over-collateralization.” In this 

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. 

Still another common form of credit enhancement was the creation of “excess spread,”

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 

 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.
252

purpose. Any funds not actually spent on expenses would provide an additional financial 

cushion to absorb losses, if necessary.

Credit Rating Models. After the arranger submitted the pool information, proposed 

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. 

The major RMBS credit rating model at Moody’s was called the Mortgage Metrics 

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.

To derive the default or loss rate for an RMBS pool of residential mortgages, the CRA 

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. 

For riskier loans, the model required a larger cushion to protect investment grade tranches

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.

In addition to using quantitative models, Moody’s analysts also took into account 

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 
253

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

Credit Analysis. After obtaining the model’s projections for the cushion or 

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. 

In addition to evaluating an RMBS pool’s expected default and loss rates, credit 

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

The process for assigning credit ratings to cash CDOs followed a similar path. CRA 

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 

 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.
254

securities included within a CDO. Instead, both models simply relied on the credit rating already 

assigned to those securities.979 

After calculating the CDO’s default and loss rates and the cushion or subordination 

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. 

Evidence gathered by the Subcommittee indicates that it was common for a CRA analyst 

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.

Rating Recommendations. After completing analysis of a proposed financial 

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 The entire rating 

process typically took several weeks, sometimes longer for novel or complex transactions. 

RMBS and CDO Groups. Moody’s and S&P had separate groups and analysts 

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

 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. 

 Each group responsible for 

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 

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. 
255

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. 

During the years reviewed by the Subcommittee, at Moody’s, the CEO and Chairman of 

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. 

Within both the RMBS and Derivatives Groups, in 2007, Moody’s had 15 RMBS 

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.

Meaning of Ratings. The purpose of a credit rating, whether stated at first issuance or 

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

 982 3/14/2008 compliance letter from S&P to SEC, SEC_OCIE_CRA_011218-59, at 32-34, and at 43-44.

 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 

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).
256

the financial crisis, the numbers of downgrades and upgrades for structured finance ratings were 

substantially lower.986

(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

Revenues increased dramatically over time as well. Moody’s gross revenues from 

RMBS and CDO ratings more than tripled in five years, from over $61 million in 2002, to over 

$260 million in 2006.

993

 986 See, e.g., 3/26/2010 “Fitch Ratings Global Structured Finance 2009 Transition and Default Study,” prepared by 

Fitch. 

 S&P’s revenue increased even more. In 2002, S&P’s gross revenue for 

RMBS and mortgage related CDO ratings was over $64 million and increased to over $265

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. 
257

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

Both companies also saw their share prices shoot up. The chart below reflects the 

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.

 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. 
258

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

 1000 See “The McGraw-Hill Companies, Inc.,” Google Finance, 

 Upper and middle managers also did well. Moody’s 

managing directors made between $385,000 to about $460,000 in compensation in 2007, before 

http://www.google.com/finance?q=mcgraw+hill. 1001 3/19/2008 Moody’s 2008 Proxy Statement, “Summary Compensation Table.” 1002 Id.
259

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, PSIMOODYS-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.
260

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.
261

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).
262

initial interest rates or interest-only features, often taking a second lien on an already mortgaged 

home.1013

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.1015 

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.

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.
263

(2) Mass Downgrades

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 Housing prices then began to decline,

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:

“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

 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).

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.

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.
264

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 This volume of rating downgrades was

unprecedented in U.S. financial markets.

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 decisionmaking 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 MOODYSPSI2010-0046899-900). 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, “Preempting bad press on the subprime situation,” Hearing Exhibit 4/23-52c.
265

Although neither Moody’s nor S&P produced documentation on its internal decisionmaking 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.
266

“[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). 
267

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

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.”)

Vintage Prime 

Fixed

Prime 

ARM

Alt-A 

Fixed

Alt-A 

ARM

Option 

ARM

Subprime

2004 3% 9% 10% 17% 50% 11%

2005 39% 58% 73% 81% 76% 53%

2006 81% 90% 96% 98% 97% 93%

2007 92% 90% 98% 96% 97% 91%
268

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. 
269

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.”1040 Another employee 

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

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.
270

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

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 

pressure has mounted to feed the origination machine.”1043 Another S&P director in the same 

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, PSIS&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&PRFN-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)).
271

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/pubsurvey-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/statsservices/publications/fcs_report2006/financial-crimes-report-to-the-public-2006-pdf/view.
272

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.
273

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).
274

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

 1056 3/19/2000 email from Catherine Gerst to Debra Perry, Moody’s Chief Administrative Officer, PSI-MOODYSRFN-000039. 

At the Subcommittee 

hearing, another former Moody’s senior analyst, Richard Michalek, described a meeting that he 

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. 
275

had with Mr. Clarkson shortly after he was promoted to head of the Structured Finance Group. 

Mr. Michalek stated:

“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.
276

‘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.

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].
277

On another occasion, in response to a 2005 email stating that S&P’s ratings model 

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

A 2004 email chain among members of the S&P Analytical Policy Board, which set 

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 After a colleague reassured her that he did not believe it would cause a loss of 

business, she reiterated her concerns, noting, “I think the criteria process must include 

appropriate testing and feedback from the marketplace.”

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

 1068 3/23/2005 email from Frank Parisi to Thomas Warrack, and others, Hearing Exhibit 4/23-5.

 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: 

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. 
278

“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. 

The type of blatant pressure exerted by some investment bankers is captured in a 2006 

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:

“[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.
279

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.” 

On still another occasion in 2004, several S&P employees discussed the pressure to make 

their ratings profitable rather than just accurate, especially when their competitor employed 

lower rating standards:

“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.
280

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.

The same pressure was applied to Moody’s analysts. In an April 2007 email, for 

example, a SunTrust Bank employee told Moody’s: 

“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-MOODYSRFN-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-RFN000032.

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.
282

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-RFN000019. 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 
283

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.
284

“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 

An S&P senior director responded:

“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

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.
285

“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.
286

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

This analyst’s claim was corroborated by the Moody’s Managing Director who was his superior 

at the time.

1109 

At the Subcommittee’s April 23 hearing, Yuri Yoshizawa, the Senior Managing Director

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. 
287

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-RMBS0419014-53, 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-

98. 

1115 April 23, 2010 Subcommittee Hearing at 66-67.
288

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.
289

“[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. 
290

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

 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.

 In 2005, a Moody’s employee survey 

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, PSIStandard&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 According to Mr. Witt, Moody’s model, which then used the “Binomial 

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.

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.
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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 Two years earlier, in May 2005, an S&P analyst complaining about a rating 

decision wrote: 

“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 
295

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).
296

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.

Surveillance Obligations. Both Moody’s and S&P were obligated by contract to 

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.

 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 Instead S&P, for example, sent out a June 2006 email 

announcing that no retests would be done:

 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-OCIERMBS-0364942-46, at 43.
299

“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]. 
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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 

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 

The Subcommittee also found evidence suggesting that investment banks may have 

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:

“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-RFN000017. 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.
302

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

It is unclear whether this screening actually took place.

Questions continued to be raised internally at S&P about the retesting issue. In March 

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 

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 But by then, residential mortgages were already defaulting in 

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

 1174 April 23, 2010 Subcommittee Hearing at 35.

 

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 

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.” 
304

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

 1177 2008 SEC Examination Report for Moody’s Investor Services Inc., PSI-SEC (Moodys Exam Report)-14-0001-

16, at 4. 

 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 

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.
305

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.
306

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,” PSIS&P-RFN-000012. 

1191 10/31/2006 S&P internal email, “A CDO Director resignation,” PSI-S&P-RFN-000001.
307

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-ofdate 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. 

Resource-Starved Surveillance. Resource shortages also impacted the ability of the 

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.

At Moody’s, for example, a 2007 email disclosed that about 26 surveillance analysts 

were responsible for tracking over 13,000 rated CDO securities:

“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.
308

securities during her tenure, her emails indicate otherwise.1194 In emails sent over a two-year 

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: 

“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:

“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.
309

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 According to Mr. D’Erchia, the executive managing 

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: 

“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.
310

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. 

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 

 

http://www.fbi.gov/stats-services/publications/fiff_04. 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/statsservices/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.
311

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

Yet when Moody’s and S&P initiated the mass downgrades of RMBS and CDO 

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:

“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.”). 
312

‘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:

“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.
313

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

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

In 2002, the Senate Committee on Governmental Affairs examined the collapse of the 

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:

 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.
314

“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

The Credit Rating Agency Reform Act, which was signed into law in September 2006, 

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 Those regulations were designed to take effect in September 2007.

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 

 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.
315

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.
316

f. amendments to federal statutes removing references to credit ratings and credit rating 

agencies in order to reduce reliance on ratings;

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.”1236

 (3) Recommendations

To further strengthen the accuracy of credit ratings and reduce systemic risk, this Report 

makes the following recommendations.

1. 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.

 

2. 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.

3. 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.

4. 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.

 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.
317

5. 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.

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

reliance on privately issued credit ratings. 
318

 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.

 See, e.g., 2/2011 chart, “Goldman Sachs Expected Profit from RMBS Securitizations,” prepared by the U.S. 1238

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.

 See “Banks’ Self-Dealing Super-Charged Financial Crisis,” ProPublica (8/26/2010), 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.

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.

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 1238

securitization. Those fees contributed substantial revenues to the investment banks which set 1239

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
319

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

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, describing some of those securities as “crap” and “pigs.” At one point, Mr. Lippmann
320

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.
321

 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.

 See Section 16 of the Banking Act of 1933, Pub. L. 73-66 (also known as the Glass-Steagall Act). 1241

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 brokerdealers 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

1240

prohibitions against proprietary trading. One reason for keeping the sectors separate was to 1241

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.

Glass-Steagall was repealed in 1999, after which the barriers between banks, brokerdealers, 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. 
322

 Section 3(a)(38) of the Securities Exchange Act of 1934 states: “The term “market maker” means any specialist 1242

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.

 See SEC website, 1243 http://www.sec.gov/answers/mktmaker.htm; FINRA website, FAQs, “What Does a Market

Maker Do?” http://finra.atgnow.com/finra/categoryBrowse.do.

 1/2011 “Study on Investment Advisers and Broker-Dealers,” study conducted by the U.S. Securities and 1244

Exchange Commission, at 55, http://www.sec.gov/news/studies/2011/913studyfinal.pdf.

 See Responses to Questions for the Record from Goldman Sachs at PSI_QFR_GS0046. 

1245

(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

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

1242

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 1243

particular security to have multiple market makers who competitively quote the security. 

Market makers generally use the same inventory of assets to carry out both their marketmaking 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 makers are also subject to the securities laws’ prohibitions against fraud and 1244

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

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
323

 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 socalled ‘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.”). 

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. 

1246

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:
324

 SEC v. Tambone, 550 F.3d 106 (1st Cir. 2008) [citations omitted]. 1247

 Section 11 of the Securities Act of 1933, codified at 15 U.S.C. § 77a. 1248

 In the Matter of Richmark Capital Corporation, Securities Exchange Act Rel. No. 48758 (Nov. 7, 2003) (citing 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 selfinterest”)).

 FINRA Notice No. 96-60. 

1250

 See FINRA Rules 2210(d)(1)(A) and 2211(a)(3) and (d)(1) (by rule all institutional sales material and 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-

“[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.”1247

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.” 

1249

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
325

3 (suitability obligation to institutional customers).

 CDO squared transactions will generally be referred to in this Report as “CDO .” Some Goldman materials also 1252 2

use the term “CDO^2.” 

(3) Structured Finance Products

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. Some investment banks also assembled “synthetic CDOs,” which did 1252

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. 

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. 
326

 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.

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 1253

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
327

 Subcommittee Interview of Joshua Birnbaum (4/22/2010); Subcommittee Interview of Rajiv Kamilla

1254

(10/12/2010). 

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 1254

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. 

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. 
328

 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).

 See “Banks’ Self-Dealing Super-Charged Financial Crisis,” ProPublica (8/26/2010), 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.

 See, e.g., discussion of the Hudson CDO, below; Subcommittee interview of Daniel Sparks (4/15/10) (Goldman 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).

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,

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 1256

RMBS and CDO securities from their own holdings to the investors they were soliciting to buy

the CDO securities. By selling the CDO securities to investors, the investment banks profited 1257

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
329

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. 
330

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).

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 
331

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 

To understand how Deutsche Bank continued to issue and market CDO securities even as

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. 

Gemstone 7 was a hybrid CDO containing or referencing a variety of high risk, subprime 

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. 

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.
332

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.
333

(1) Subcommittee Investigation and Findings of Fact

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.

1. 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.

2. 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.

3. 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.

4. 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.

5. 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. 
334

(2) Deutsche Bank Background

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

Total Annual CDO Issuance

2000-2009

Year

Total CDO Issuance

($ in billions)

2000 67.99 

2001 78.45 

2002 83.07 

2003 86.63 

2004 157.82 

2005 251.27 

2006 520.64 

2007 481.60 

2008 61.89 

2009 4.34 

 

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/banksself-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).
335

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 

$1 and $1.5 billion,

 

1265 and generated large fees for investment banks in the range of $5 to $10 

million per CDO.1266

CDOs at Deutsche Bank. From 2004 to 2008, Deutsche Bank issued 47 asset backed 

CDOs for a total securitization of $32.2 billion.

 To handle these transactions, a number of large investment banks 

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. 

1267 According to analysts, in both 2006 and 

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), 
336

At Deutsche Bank, five different parts of the Securitized Product Group played key roles

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. 

The CDO Group had two co-heads, Michael Lamont and Michael Herzig, and

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+

Talks+to+End+Bond+Probe. See also 10/2006, “CDO Primary Update Progress Report,” prepared by Deutsche 

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-

37. 
337

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 

Mr. Lippmann was well known in the CDO marketplace as a trader. He had joined 

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 

2006. 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

 

(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.
338

• 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-

43. 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-

06. 
339

• 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 AssetBacked 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

 1279 8/23/2006 email from Greg Lippmann to Michael Lamont and Richard D’Albert, DBSI_PSI_EMAIL01605465.

(12/04/2006)

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.
340

• 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)

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 

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

 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”).

 Mr. Lippmann also told the Subcommittee that while he knew that the 

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 

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).
341

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, PSIDeutsche_Bank-32-0001-04. 

1295 Id. 
342

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 He said that he explained at the time 

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.

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 

severity. 

• Default of subprime mortgages are also strongly negatively correlated with home 

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. 
343

• Nearly $440 billion subprime mortgages will experience payment shocks in the next 3 

years.

• Products that may be riskier than traditional home equity/subprime mortgages have 

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 Mr. Lippmann said that, in or 

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.

Building the Short Position. Mr. Lippmann told the Subcommittee that he used some 

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 

Mr. Lippmann told the Subcommittee that he spent much of 2006 pitching his clients to 

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

 1301 9/2005 “Shorting Home Equity Mezzanine Tranches, A Strategy to Cash in on a Slowing Housing Market,” 

DBSI_PSI_EMAIL00502892-29.

Mr. Lippmann 

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. 
344

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 

Although Mr. Lippmann was unsuccessful in convincing AIG to short RMBS and CDO 

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 

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

 1308 5/12/2005 email from Rocky Kurita to Greg Lippmann, DBSI_PSI_EMAIL00054826.

 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 

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. 
345

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 and continued to execute shorts for them, while 

building his desk’s proprietary short position.

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. 
346

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. 
347

“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). 
348

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 

difficult to sell: “[T]he equity and the AAA were the parts we found difficult to place.”1332 Mr.

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

“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 

 Instead of getting out of the CDO business, however, he said, a new 

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:

a daisy chain that solved one problem but created another: 

Each new CDO had its own risky pieces. Banks created yet other CDOs to buy 

those.”1334

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.
349

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-

55.

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.
350

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

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

 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. 

 

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. 

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. 
351

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 

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

 1348 1/2007 Gemstone 7 Debt Investor Presentation, at 17, DBSI_PSI_EMAIL01980000-60.

Deutsche Bank and HBK shared the risk 

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 socalled 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.
352

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, coheaded 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 Trading Desk, headed by Greg Lippmann, participated in 

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. 

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 

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.

HBK told investors in its sales presentation that “HBK has retained 100% of the equity 

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 
353

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

 vigilant investor that maximizes value through intensive analysis and surveillance.” 1/2007 Gemstone 7 Debt 

Investor Presentation, DBSI_PSI_EMAIL01980000-60 at 23.

 According to HBK and Deutsche Bank 

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).
354

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 All three also stated that the engagement agreement did 

not require Deutsche Bank to analyze the quality of the assets being purchased or how those 

assets were expected to perform.

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). 
355

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 

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. 

HBK told the Subcommittee that it selected good quality bonds using a very complex 

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 HBK provided this description for the Subcommittee regarding the tools it used in 

the asset selection process:

“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. 
356

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). 
357

(c) Gemstone Risks and Poor Quality Assets

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 The Credit Report noted the following business risks for 

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 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 securities1392were not 

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. 

 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.
358

The Offering Circular did, however, describe in detail a number of significant risks 

associated with RMBS securities. For example, it stated:

• “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 

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.

Long Beach-Fremont-New Century Bonds. A substantial portion of the cash and 

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

 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.

 Loans by these lenders were among the first to collapse. 

According to Moody’s, these three originators, plus WMC Corporation, accounted for 31% of 

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).
359

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 

During the period when securities were being assembled for the Gemstone 7 warehouse

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 

7. 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

 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.

One week earlier, on November 29, 2006, when asked by a bank colleague 

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. 
360

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

Mr. Lippmann made similar negative remarks about RMBS securities containing 

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 

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. 

 On March 2, 2007, a client sent an email to Mr. Lippmann stating: “[T]hey are 

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-

02. 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, 
361

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 

7. 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

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

 

“this stinks though I didn’t mention it.” 5/29/2007 email from Greg Lippmann to Danielle Pluthero at Deutsche 

Bank, DBSI_PSI_EMAIL02532365. 

 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.

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.
362

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

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 

A third example involved securities issued by Ameriquest Mortgage Securities Inc. 

(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

 1420 8/26/2006 email from Greg Lippmann to Richard Axilrod, DBSI_PSI_EMAIL01618236. 

 

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 

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, PSIDeutsche_Bank-32-0001-04. 
363

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 Sean Whelan, co-head of the 

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.

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). 
364

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

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

 1434 Subcommittee interview of M&T (9/20/2010). 

 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 

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. 
365

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, 

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

 1442 Id. at 24. 

 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

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/newcenturys-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.
366

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), 

 

http://www.marketwatch.com/story/index-ofsubprime-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. 
367

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

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). 
368

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

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

On January 23, 2007, Mr. Kamat learned that HBK’s marks showed a loss of 0.9% or 

$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.
369

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 However, Deutsche Bank’s trading desk was one of 

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.

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. 
370

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 New Century comprised 15% of Gemstone 7. 

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

 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. 
371

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 Initial Rating: Date 1st Downgrade: Date 2nd Downgrade: Date 3rd Downgrade: Date

Class A-1a AAA: March 15, 2007 A+: Feb. 5, 2008 BB+: July 11, 2008 CC: August 19, 2009

Class A-1b AAA: March 15, 2007 B-: Feb. 5, 2008 CC: July 11, 2008 n/a

Class A-2 AAA: March 15, 2007 AA-: Nov. 21, 2007 CCC-: Feb. 5, 2008 CC: July 11, 2008

Class B AA: March 15, 2007 BBB: Nov. 21, 2007 CC: Feb. 5, 2008 n/a

Class C A: March 15, 2007 B-: Nov. 21, 2007 CC: Feb. 5, 2008 n/a

Class D BBB: March 15, 2007 CCC+: Nov. 21, 2007 CC: Feb. 5, 2008 n/a

Class E BB+: March 15, 2007 CCC: Nov. 21, 2007 CC: Feb. 5, 2008 n/a

Preference 

Shares Not rated

Source: S&P

 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. 
372

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

 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. 

In August 2006, when an 

investor asked Mr. Lippmann about Magnetar, he responded that it was a “Chicago based hedge 

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).
373

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

 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. 

 In one of the deals, Deutsche Bank 

worked with Elliot Advisors, a hedge fund that bought the equity tranche in the CDO and 

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 Europeanbased 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.
374

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 An internal 

Deutsche Bank email explained one of the 2005 START CDOs as follows: 

“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.
375

$700 million in Gemstone 7 securities which then failed within months, leaving the bank’s 

clients with worthless investments.

This case history raises several concerns. The first is that Deutsche Bank allowed the 

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.
376

 “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”).

 See, e.g., Responses to Questions for the Record from Goldman Sachs, including Lloyd C. Blankfein; David A.

1512

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.” 

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, 1511

the Subcommittee gathered additional information in post-hearing interviews and through posthearing questions for the record.1512
377

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.

1. 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. 

2. 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. 

3. 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. 

4. 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. 

5. 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. 

6. 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.
378

 The background information about Goldman in this section was taken from several sources. See “Profile, 1513

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).

 During 2006 and 2007, Goldman’s headquarters were at 85 Broad Street in Manhattan. In 2010, the firm moved 1514

its headquarters to 200 West Street in Manhattan. See “Morgan Stanley May Lease Old Goldman Sachs Building,”

Bloomberg (10/18/2010).

 See Goldman Sachs Form 10-K for the fiscal year ending Nov. 30, 2007, filed with the SEC on 1/28/2008, at 64; 1515

11/30/2007 “SPG Trading Mortgages Weekly Metrics 30-November-2007,” GS MBS-E-015646485.

 See supra note 1513. 

1516

 Id. 1517

 “Prime brokers” are generally large broker-dealers that provide a special set of services to special clients, 1518

including securities lending, leveraged trade execution, and cash management. See definition of “prime brokerage”

at Investopedia.com.

 See supra note 1513. 

1519

(2) Goldman Sachs Background

Goldman Sachs was established in 1869 as an investment bank. Originally a private 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 1514

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

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, structuring and financing deals for customers from its own capital, and 1518

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
379

 Subcommittee interviews of David Viniar (4/13/2010), Craig Broderick (4/9/2010), and Daniel Sparks 1520

(4/15/2010).

 2/6/2007 Goldman Sachs Form 10-K filing with the SEC. 1521

 Id. 1522

 Id. 1523

 Id. 1524

 Id. 1525

 Subcommittee interview of Daniel Sparks (4/15/10). 1526

 Id. 1527

 Id. 1528

 Id. 1529

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

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: 1521

Fixed Income, Currency and Commodities (FICC); Equities; and Principal Investments. FICC 1522

had five principal businesses: commodities; credit products; currencies; interest rate products;

and mortgage related securities and loan products and other asset backed instruments.

1523

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

1524

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. 

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 1526

Sobel, who had run the Mortgage Department prior to Mr. Sparks. He next reported to 1527

Richard Ruzika, who was then co-head of Commodities. In late 2006, Mr. Sparks began 1528

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 1529
380

 Id. 1530

 “North America Mortgages,” chart prepared by Goldman Sachs, GS MBS-E-007818849 (showing organization 1531

of Mortgage Department). 

 Id. 1532

 See, e.g., 6/27/2006 email from Brian O’Brien to John Cassidy, “Conduit Sellers and u’writing guides,” GS 1533

MBS-E-004060914. 

 Subcommittee interview of Michael Swenson (4/16/2010). 1534

 4/22/2010 Goldman Sachs Form 8-K filing with the SEC. Of the 23 Abacus CDOs, 16 contained primarily 1535

mortgage related assets.

began reporting to Donald Mullen, who was head of U.S. Credit Sales & Trading, and Mr.

Mullen in turn reported to Mr. Montag.1530

 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 1532

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.

1533

The SPG Trading Desk was headed by Michael Swenson. It was further subdivided 1534

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.”
381

 “North America Mortgages,” chart prepared by Goldman, GS MBS-E-007818849 (showing organization of 1536

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.

 See discussion of the disclosure obligations of broker-dealers, underwriters, and placement agents, above. The 1537

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. 

 “North America Mortgages,” chart prepared by Goldman, GS MBS-E-007818849 (showing organization of 1538

Mortgage Department).

 “Mortgages Organizational Structure,” chart prepared by Goldman Sachs, GS MBS-E-010872812. 1539

 Id. 1540

 Undated chart prepared by Goldman for the Subcommittee, GS-PSI-00172. 1541

 Undated chart prepared by Goldman for the Subcommittee, GS MBS 0000021129 and GS MBS 0000004276. 1542

 Id. 1543

 Id. 

1544

The CDO Origination Desk was headed by Peter Ostrem. This desk structured and 1536

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. Goldman maintained an inventory of RMBS and CDO securities to carry out 1537

activities for its clients and proprietary trading for the firm.

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 1538

coordinated Goldman’s sales efforts and the issuance of different securities across different

desks. 

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. As a result, the SPG Trading Desk had responsibility for 1539

selling new Goldman-originated CDO securities as well as engaging in secondary trading of preexisting CDOs and RMBS securities, related credit default swaps (CDS), ABX trading,

correlation trading, property derivatives, CMBS, and other asset backed securities.1540

In 2006 and 2007, the Residential Whole Loan Trading Desk underwrote 93 RMBS

worth $72 billion. The CDO Origination Desk acted as a placement agent and underwrote 1541

approximately 27 mortgage based CDOs worth $28 billion. Of the 27 CDOs, 84% were

1542

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 1544

synthetic CDO known as Anderson Mezzanine 2007-1; and $1 billion hybrid CDO known as

Timberwolf I. 
382

 See net short chart prepared by the Subcommittee, below; 9/17/2007 Presentation to GS Board of Directors, 1545

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.

 7/25/2007 email from Mr. Viniar to Mr. Cohn, “Private & Confidential: FICC Financial Package 07/25/07,” GS 1546

MBS-E-009861799, Hearing Exhibit 4/27-26.

 10/2007 Global Mortgages, Business Unit Townhall at 4-5, GS MBS-E-013703463, Hearing Exhibit 4/27-47. 1547

 4Q07 Fact Sheet prepared for David Viniar, GS MBS-E-009724276, Hearing Exhibit 4/27-159. 

1548

 See discussion of risk limits, VAR measurements, and risk reports, below. 

1549

(3) Overview of Goldman Sachs Case Study

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

warehouse inventory. The second net short, referred to by Goldman Chief Financial Officer

1545

David Viniar as “the big short,” peaked in June at $13.9 billion. As a result of this net short, 1546

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. Altogether in 2007, Goldman’s net short positions from derivatives 1547

generated net revenues of $3.7 billion. These positions were so large and risky that the 1548

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. At one point in 2007, Goldman’s Value-at-Risk measure

1549
383

 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).

 11/18/2007 email from Lloyd Blankfein, “RE: NYT,” GS MBS-E-009696333, Hearing Exhibit 4/27-52. 

1551

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
384

 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. 

 See, e.g., 10/17/2006-10/18/2006 email from Tom Montag to Daniel Sparks, “3 things,” GS MBS-E- 1553

010917469 (acquisition of a large net long position described as “slipp[ing] up a bit”). In an email to Goldman CoPresident 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

payment that outweighs the cost of the short party’s premium payments. However, the short 1552

party does not have to wait for a credit event in order to realize a gain on its CDS contract. 

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

and the firm. In October 2006, the Mortgage Department designed a synthetic CDO called 1553
385

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. 

 For more information about the Hudson CDO, see below. 1554

 See, e.g., 12/7/2006 email from Tom Montag, GS MBS-E-009756572 (“I don’t think we should panic regarding 1555

ABX holdings”).

 12/14/2006 email from Daniel Sparks, “Subprime risk meeting with Viniar/McMahon Summary,” GS MBS-E- 1556

009726498, Hearing Exhibit 4/27-3.

 Subcommittee interview of David Viniar (4/13/2010). 1557

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. While this

1554

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. 

1555

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

1556

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

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
386

 3/10/2007 email to Daniel Sparks, “Mortgage Presentation to the board,” GS MBS-E-013323395, Hearing 1558

Exhibit 4/27-17. 12/13/2006 Goldman email, “Subprime Mortgage Risk,” Hearing Exhibit 4/27-2.

 8/23/2007 email from Tom Montag, “Current Outstanding Notional SN ames,” GS MBS-E-010621231. 1559

 11/13/2007 Goldman email, GS MBS-E-010023525 (attachment, 11/14/2007 “Tri-Lateral Combined 1560

Comments,” GS MBS-E-010135693-715 at 695). 

 9/7/2007 Fixed Income, Currency and Commodities Annual Individual Review Book, Self-Review of Deeb 1561

Salem, GS-PSI-03157-80 at 72 (hereinafter “Salem 2007 Self-Review”).

 Id. 1562

2007, a $16 billion reversal. A senior Goldman executive later described a net short position 1558

of $3 billion in subprime mortgage backed securities as “huge and outsized.” But Goldman’s

1559

net short position in February 2007 was $10 billion – more than triple that size.

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 1560

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. 

Attempted Short Squeeze. In May 2007, the Mortgage Department’s Asset Backed

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.1561

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 1562

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.

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
387

 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). 

 For more information about the mass rating downgrades, see Chapter V, above. See also 7/10/2007 Goldman 1564

email, “GS Cashflow/Abacus CDOs Mentioned in S&P Report on CDO Exposure to Subprime RMBS,” GS MBS-E001837256.

 10/2007 Global Mortgages, Business Unit Townhall at 4-5, GS MBS-E-013703463, Hearing Exhibit 4/27-47. 1565

 Quarterly Breakdown of Mortgage P/L, GS MBS-E-009713204 at 205. Goldman’s gross revenues from all 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.

 Swenson self evaluation, Hearing Exhibit 4/27-55b. 1567

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 1563

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. 

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 1564

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.”

Big Short Profits. In response, the Mortgage Department began another round of

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. By the end of 2007, the SPG Trading Desk in the 1565

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. The head of the SPG Desk, Michael Swenson, later 1566

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. His colleague, Joshua Birnbaum who 1567

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
388

 Birnbaum self evaluation, Hearing Exhibit 4/27-55c. 1568

 Id. 1569

 Quarterly Breakdown of Mortgage P/L, GS MBS-E-009713204 at 205. 

1570

 5/11/2007 email from Daniel Sparks, “You okay?,” GS MBS-E-019659221. 1571

... get flat, but get VERY short.” He wrote: “[W]e implemented the plan by hitting on almost 1568

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 1571

executives, including Mr. Cohn and Mr. Viniar, Mortgage Department personnel, controllers, and
389

 Id.; 5/14/2007 email from David Lehman, “Gameplan – asset model analysis,” GS MBS-E-001865782 (last 1572

email in a longer email chain). 

 Id.; 5/14/2007 email from Elisha Weisel, “Modelling Approaches for Cash ABS CDO/CDO^2,” GS MBS-E- 1573

001863618.

 5/14/2007 email from Tom Montag to Daniel Sparks, GS MBS-E-019642797. 

1574

 5/11/2007 email from Harvey Schwartz to Daniel Sparks, Tom Montag, and others, GS MBS-E-010780864. 

1575

 5/20/2007 email, “Viniar Presentation - Updated,” GS MBS-E-010965211 (attached file, “Mortgages 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-E010951926.

 5/19/2007 “Mortgages CDO Origination – Retained Positions & Warehouse Collateral, May 2007,” Goldman 1577

presentation, GS MBS-E-010951926.

 Compare 5/19/2007 “Mortgages CDO Origination – Retained Positions & Warehouse Collateral, May 2007,” 1578

Goldman presentation, GS MBS-E-010951926, with 5/20/2007 “Mortgages Department, May 2007,” Goldman

presentation, GS MBS-E-010965212.

others held a meeting and developed a “Gameplan” for a CDO valuation project. The 1572

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. 

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.” Another Goldman senior executive, Harvey Schwartz,

1574

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.” At the same time, Goldman’s Chief Credit Risk Officer Craig 1575

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. 

On May 20, 2007, the Gameplan results were summarized in an internal presentation.1576

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

1577

also written that Goldman’s CDOs were expected “to underperform,” but that statement was

removed from the final presentation given to senior executives. 

1578

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
390

 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).

 See discussions of Hudson, Anderson, Timberwolf, and Abacus sales efforts, below. 1580

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 1580

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.

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. 
391

 10/2006 Goldman Sachs report, “Hudson Mezzanine Funding, 2006-1, LTD.,” at 4, GS MBS-E-009546963, 1581

Hearing Exhibit 4/27-87.

 Id. 1582

 For more information on this pricing mismatch, see the Hudson discussion, below. 1583

 12/3/2006 Hudson Mezzanine 2006-1, LTD. Offering Circular, GS MBS- E-021821196 at 251 (emphasis 1584

added). 

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. In its

1581

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. 

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 1583

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. 

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.
392

 2/6/2008 email from John Pearce to Michael Petrick, HUD-CDO-00005146. 

1585

 2/7/2008 email from John Pearce to David Lehman, HUD-CDO-00005147. 1586

 In April 2007, the month after Anderson issued its securities, New Century announced it would have to restate 1587

its earnings. It declared bankruptcy soon after. For more information about New Century, see Chapter IV, section

E(2)(c).

 See, e.g., 3/2007 Goldman internal email, GS MBS-E-002146861, Hearing Exhibit 4/27-77 (“I recommend 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. . .”). 

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.” He also sent an email to the head of Goldman’s CDO Desk saying: 1585

“[O]ne day I hope I get the real reason why you are doing this to me.” Morgan Stanley lost

1586

nearly $960 million on its Hudson investment.

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. Inside Goldman, staff were

1587

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 1588

in the Anderson CDO were also performing poorly, and at one point, Goldman personnel estimated
393

 3/16/2007 GSI Risk Committee Memo, “GSI Warehousing for Structured Product CDOs,” GS MBS-E- 1589

001806010.

 3/12/2007 email from Robert Black to Matthew Bieber and others, GS MBS-E-000898037. 1590

 See Goldman response to Subcommittee QFR at PSI_QFR_GS0223 and PSI_QFR_GS0235. 

1591

 Among other assets, Goldman sold $15 million in certain Abacus securities to the Timberwolf CDO. Goldman 1592

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. 

its warehouse assets had fallen in value by $22 million. Due to the asset quality problems, the 1589

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. 

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,

and recommended using Anderson securities as collateral security in other CDOs. In the end, 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 2

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
394

 2/26/2007 email between Tom Montag and Daniel Sparks, GS MBS-E-019164806. 

1593

 3/2007 Goldman internal email chain, GS MBS-E-001800634. 1594

 See, e.g., 6/2007-8/2007 Goldman internal emails, “Timberwolf Sales Efforts,” Hearing Exhibit 4/27-166; 1595

3/2007 Goldman internal email, “GS Syndicate Structured Product CDO Axes,” Hearing Exhibit 4/27-100. 

 4/19/2007 email chain between Daniel Sparks and Bunty Bohra, GS MBS-E-010539324, Hearing Exhibit 4/27- 1596

102 (Mr. Bohra responds, “[w]e have done that with Timberwolf already.”).

 5/14/2007 email from Edwin Chin, GS MBS-E-012553986. 1597

obligation. Goldman rushed Timberwolf to market, and it closed on March 27, 2007, 1593

approximately six weeks ahead of schedule. Almost as soon as the Timberwolf securities were 1594

issued, they too began to lose value. 

 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 1595

salesperson who sold Timberwolf securities, only to find out that large sales credits had already

been offered. In May, while Goldman was internally lowering the value of Timberwolf, it 1596

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 1597

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. 

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
395

 6/2007 Goldman internal email to Daniel Sparks, Hearing Exhibit 4/27-105. 1598

 In synthetic CDOs, the cash proceeds from the sales of the CDO securities were used to purchase “collateral 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.

 9/17/2007 email from Matthew Bieber to Christopher Creed, GS MBS-E-000766370, Hearing Exhibit 4/27-106. 1600

 6/2007 Goldman document, “CDO Platform Overview,” at 31, GS MBS-E-001918722 (“ABACUS is the 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.

 3/12/2007 Goldman internal memorandum to Mortgage Capital Committee, “ABACUS Transaction sponsored 1602

by ACA,” GS MBS-E-002406025, Hearing Exhibit 4/27-118. 

one shitty deal.” Despite that comment, Goldman continued to market Timberwolf securities to 1598

its clients. 

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. Although 1599

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. 

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 1601

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
396

 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. 

 April 27, 2010 Subcommittee Hearing at 82. 1604

 Subcommittee interview of Laura Schwartz (ACA) (4/23/2010). See also In the Matter of Abacus 2007-AC1 1605

CDO, File No. HO-10911 (SEC), Statement of Laura Schwartz (January 21, 2010), ACA ABACUS 00004406 at

408. (hereinafter “Statement of Laura Schwartz”).

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 1603

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.

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

achieve its investment objective. After establishing those parameters, Paulson worked with the 1604

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
397

 3/12/2007 Goldman memorandum to Mortgage Capital Committee, “ABACUS Transaction sponsored by 1606

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.

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 1606

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. 

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

1934. 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.
398

 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. 

 9/19/2006 email chain between Joshua Birnbaum and Daniel Sparks, “ABX,” GS MBS-E-012683946. 1609

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 1609

Security (ABS) Trading Desk within SPG should get out of its existing positions or “doubledown.” After the first meeting, Mr. Birnbaum emailed Mr. Swenson:
399

 Id. 1610

 Goldman responses to Subcommittee QFRs at PSI_QFR_GS0239. For more information on Hudson, see 1611

section C(5)(b)(ii)AA., below. 

 3/10/2007 email to Daniel Sparks, “Mortgage presentation to the Board,” GS MBS-E-013323395, Hearing 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.

 The ABX Index actually consisted of five separate indices. Each index tracked a different set of RMBS 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.

 Subcommittee interview of Joshua Birnbaum (10/1/2010); Subcommittee interview of Rajiv Kamilla

1614

(10/12/2010). 

“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

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. Investors could enter into CDS contracts that used a particular ABX Index as the 1613

“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
400

 6/20/2006 email from David Lehman, “Mortara Nomination – ABX/CMBX Indices,” GS MBS-E-014038810 1615

(attached file, “2006 Mike Mortara Award for Innovation Nomination Template for ABX & CMBX Indices,” GS

MBS-E-014038811 at 6 (hereinafter “Mortara Award Submission”)). 

 Id. at 8. 

1616

 6/20/2006 email from “Equities and FICC Communications” to “All Equities and FICC,” Mike Mortara Award for 1617

Innovation,” GS MBS-E-010879020 [original email]. 

 Mortara Award Submission at 2. 1618

Id. at 3-4. See also 8/30/2006 Fixed Income, Currency and Commodities Individual Review Book for Rajiv K.

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”). 

Kamilla 2007 Review at 19. In 2007, Mr. Kamilla was named a Managing Partner at Goldman. 1620

 Daniel Sparks, the Mortgage Department head, viewed Mr. Birnbaum as a talented trader, writing in October 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.”).

In internal documents, Goldman described itself as “the leader and principal driver in the

creation of” the ABX Index. In July 2006, Joshua Birnbaum, Rajiv Kamilla, David Lehman, 1615

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 1616

“recognize[d] the creative, forward-looking, and entrepreneurial contributions of an individual or

team” within the equities or fixed income divisions. The Mortgage Department personnel wrote 1617

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 1618

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

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
401

 Subcommittee interview of Joshua Birnbaum (4/22/2010). Throughout 2006, Mr. Birnbaum was also working 1622

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-E013492538. 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).

 The ABX Index began trading in January 2006. Goldman’s position in the ABX Index was flat when the Index 1623

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”).

 Mr. Birnbaum’s acquisition of a large net long position in the ABX was viewed negatively by Goldman senior 1624

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.”).

subprime mortgage market, and favored the firm’s building a net short position. However, 1622

during 2006, Goldman’s overall ABX position was net long, not net short.

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 1623

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 1624
402

 See, e.g., 12/15/2006 email from David Viniar to Tom Montag, “Subprime Risk Meeting with Viniar/McMahon 1625

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-E002201668, 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”).

 Subcommittee interview of Peter Ostrem (10/5/2010); Subcommittee interview of Darryl Herrick (10/13/2010).

1626

 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.”).

 Subcommittee interview of Peter Ostrem (10/5/2010). 1628

 6/8/2006 email from Darryl Herrick to Peter Ostrem, “**GS ABS** RMBS CDS Lineup,” GS MBS-E- 1629

016445770. 

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 1627

increase the CDO Desk’s business by producing as many marketable CDOs as possible. Darryl 1628

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.” 

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
403

 Subcommittee interview of Daniel Sparks (4/15/2010); Subcommittee interview of Peter Ostrem (10/5/2010). 1630

 See 5/19/2007 Goldman presentation, “Mortgages CDO Origination – Retained Positions & Warehouse 1631

Collateral, May 2007,” GS MBS-E-010951926 (“average ramp period 6-9 months”).

 See, e.g. 3/7/2007 and 3/13/2007 internal emails, “Timberwolf I, Ltd. Preliminary Offering Circular,” GS MBS- 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.”).

 Subcommittee interview of Daniel Sparks (4/15/2010); Subcommittee interview of David Lehman (4/12/2010). 1633

 See, e.g., 3/16/2007 Goldman memorandum from Mitch Resnick and Peter Ostrem to GSI Risk Committee, 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).

 3/16/2007 Goldman memorandum from Mitch Resnick and Peter Ostrem to GSI Risk Committee, “GSI 1635

Warehousing for Structured Product CDOs,” GS MBS-E-001806010.

 Id. 1636

 2/28/2007 email from David Rosenblum to Peter Ostrem, “Pete– pls send me cob 2/28 MTM for SP CDO WH’s 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-E001800683 (“FYI Liquidating 3 warehouses tomorrow.”); 2/22/2007 email from Daniel Sparks to Tom Montag, GS

packaged into a CDO. Each CDO was designed to include or reference hundreds of millions or 1630

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. Goldman and 1631

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.

When assembling a CDO, Goldman generally opened an internal “warehouse account” for

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

1632

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 1633

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.

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. For example, as of March 16, 2007, Goldman calculated that its CDO warehouses 1634

contained $4.7 billion in mortgage related assets. After deducting potential liabilities assumed 1635

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 1636

the risks posed by the subprime mortgage related assets in the CDO warehouse accounts.

1637
404

MBS-E-010989710 (“There are a few deals that look tough now, including a A-rated CDO of CDOs with Greywolf

[Timberwolf]”).

 12/7/2006 email chain between Daniel Sparks and Tom Montag, “More thorough response,” GS MBS-E- 1638

010931324. 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. 

 12/7/2006 email chain between Tom Montag and David Viniar, GS MBS-E-009756572. 1639

 Subcommittee interview of David Viniar (4/13/2010). 1640

 12/14/2006 email from Daniel Sparks, “Subprime risk meeting with Viniar/McMahon Summary,” GS MBS-E- 1641

009726498, Hearing Exhibit 4/27-3.

 Id. See also 12/15/2006 email from David Viniar to Tom Montag, GS MBS-E-009726498, Hearing Exhibit 1642

4/27-3.

 Subcommittee interview of David Viniar (4/13/2010), Daniel Sparks (4/15/2010), and David Lehman 1643

(4/12/2010).

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 1638

complained to CFO David Viniar about the Mortgage Department’s lack of aggressiveness in

trying to reduce its net long ABX position:

“[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. At the meeting, Mr. Viniar and other 1641

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. 

1642

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
405

 Subcommittee interview of David Viniar (4/13/2010).

1644

 Id. 1645

 Id. In terms of risk reduction, taking on offsetting short positions to reduce long positions does not necessarily 1646

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.”).

 12/14/2006 email from Daniel Sparks, “Subprime risk meeting with Viniar/McMahon Summary,” GS MBS-E- 1647

009726498, Hearing Exhibit 4/27-3. “Residuals” refers to the equity positions that Goldman had retained from the

RMBS and CDO securitizations it originated. 

 12/14/2006 email from Tom Montag to David Viniar, GS MBS-E-009726498, Hearing Exhibit 4/27-3. 1648

that is neither significantly short nor long. Mr. Viniar told the Subcommittee that, by telling the 1644

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. 1645

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

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: 

1. Reduce exposure, sell more ABX index outright, basis trade of index vs. CDS too large.

2. Distribute as much as possible on bonds created from new loan securitizations and clean

previous positions.

3. Sell some more resid[ual]s

4. Mark [the value of assets in] the CDO warehouse more regularly ...

5. Stay focused on the credit of the originators we buy loans from and lend to

6. 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)

7. 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

asking: “is this a fair summary?” Mr. Viniar replied: “Yes.” Mr. Viniar noted: 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
406

 12/15/2006 email from David Viniar to Tom Montag, GS MBS-E-009726498, Hearing Exhibit 4/27-3. 1649

 See 1/5/2007 “Notionals (ABX convention)” chart, taken from “Index and Single Name Position History 2006 1650

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.

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 1650

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. 

[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-E010214410.]
Prepared by the U.S. Senate Permanent Subcommittee on Investigations, February 2011. 

Derived from Goldman Sachs document, GS MBS-E-010214410.

-4,000,000,000

-2,000,000,000

0

2,000,000,000

4,000,000,000

6,000,000,000

8,000,000,000

10,000,000,000

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

Notionals (ABX convention)

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

 12/14/2007 email from Mr. Gasvoda, “Retained bonds,” GS MBS-E-010935323, Hearing Exhibit 4/27-72. 

1651

 2/9/2007 email exchange between Kevin Gasvoda and sales syndicate, “GS Syndicate RMBS Axes 1652

(INTERNAL),” GS MBS-E-010370495, Hearing Exhibit 4/27-73.

 2/11/2007 email exchange between Lloyd Blankfein and Tom Montag, “Mortgage Risk – Credit residential,” GS 1653

MBS-E-009686838, Hearing Exhibit 4/27-130.

 Id. 1654

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
409

 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.

 3/26/2007 Goldman presentation to Board of Directors, “Subprime Mortgage Business,” GS MBS-E- 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.

 3/2/2007 email from Patrick Welch to Craig Broderick, “Audit Committee Package_Feb 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. 

 4/22/2007 email from Kevin Gasvoda, “Resi credit QTD/YTD P&L and positions,” GS MBS-E-010474983. 1658

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.” While those 1656

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.

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
410

 The Mortgage Department also worked to sell assets from its CDO warehouse accounts, an issue discussed in 1659

part below and in part in connection with the Report’s section on Goldman’s CDO activity.

 Subcommittee interview of Michael Swenson (4/16/2010). 1660

 Id. By adopting the strategy of offsetting the long positions with similar, but not necessarily identical short 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.

 Salem 2007 Self-Review, GS-PSI-03157 at 71-72. 1662

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

1659

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 1660

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 1661

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.1662
411

 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. 

 2/12/2007 email from Daniel Sparks, “Post today,” GS MBS-E-009763506. 1664

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
412

 2/14/2007 email from Daniel Sparks, “Post,” GS MBS-E-009635410, Hearing Exhibit 4/27-8. 1665

 3/21/2007 email from Daniel Sparks to Tom Montag, GS MBS-E-010629379, Hearing Exhibit 4/27-21. See 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!”).

 2/8/2007 email from Daniel Sparks, “Post,” GS MBS-E-002201668, Hearing Exhibit 4/27-7. 1667

 Id.; see also 3/10/2007 email from Mr. Dinias to Daniel Sparks, “Mortgage Presentation to the board,” GS 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.

 9/26/2007 2007 EMD Reviews, Joshua Birnbaum Self-Review, Hearing Exhibit 4/27-55c. In his self-review, 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.

 Id. 1670

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:

“[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/BBBindex. ... 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 

short position, employing aggressive strategies. Mr. Birnbaum, Goldman’s ABX trader, later 1668

wrote: “I concluded that we should not only get flat, but get VERY short.” He wrote that he 1669

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

1670
413

 Id. 1671

 Id. 1672

 Salem 2007 Self-Review at GS-PSI-03157 at 71-72. 1673

 Subcommittee interview of Deeb Salem (10/6/2010). 1674

 3/12/2007 Mortgage Capital Committee memo, “ABACUS Transaction to be Lightly-Managed by Lion 1675

Capital,” at 2, GS MBS-E-002665382, Hearing Exhibit 4/27-150.

 See 3/10/2007 email from Mr. Dinias to Daniel Sparks, “Mortgage Presentation to the board,” GS MBS-E- 1676

013323395, Hearing Exhibit 4/27-17; 3/11/2007 email from Daniel Sparks, “Risk Changes Over Quarter,” GS MBSE-010400546, Hearing Exhibit 4/27-18; 3/27/2007 presentation to GS Board of Directors, “Subprime Mortgage

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

positions in the subprime mortgage market. By the end of the first quarter in 2007, it had built a 1676
414

Business,” at 8, GS MBS-E-005565527, Hearing Exhibit 4/27-22 [footnote omitted].

 Salem 2007 Self-Evaluation [emphasis in original]. 1677

 8/23/2007 email from Tom Montag, “Current Outstanding Notional SN ames,” GS MBS-E-010621231. 1678

 2/8/2007 email from Bill McMahon, “VaR limit for Mtg SPG,” GS MBS-E-009980807. 1679

 2/23/2007 Goldman internal document, “Mortgage VaR Change (Q1’07 vs. Q4’06),” GS MBS-E-010037310, 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.

 Id. 1681

 2/23/2007 Goldman internal document, “Mortgage VaR Change (Q1’07 vs. Q4’06),” GS MBS-E-010037310, 1682

Hearing Exhibit 4/27-12.

 2/14/2007 email from Mr. Gmelich to Tom Montag, GS MBS-E-016165580. 1683

$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.” A Goldman senior 1677

executive, Thomas Montag, later referred to a net short position of $3 billion in subprime mortgage

backed securities as “huge and outsized.” Goldman’s net short position in February 2007 was 1678

more than three times that size.

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. In November 2006, the Department’s reported VAR was 1679

$13 million, well below its limit. By late February 2007, however, its VAR had reached $85 1680

million – an increase of over 550%. 

1681

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.” On 1682

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:

“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
415

 Id. 1684

 2/22/2007 email from Daniel Sparks to Messrs. Birnbaum, Swenson and Lehman, “Block size tranche protection 1685

offers for Paulson or others,” GS MBS-E-010381411. 

 Id. 1686

 Subcommittee interview of Joshua Birnbaum (4/22/2010) (Mr. Birnbaum wanted to continue to hold the short 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).

 2/21/2007 email chain from Daniel Sparks, “Mortgages today,” GS MBS-E-010381094, Hearing Exhibit 4/27- 1688

10. 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

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

Mortgage Department’s $10 billion net short position by covering $3 billion. Mr. Sparks 1685

communicated the decision to personnel on the SPG Desk: 

“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, the Mortgage Department took 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:

“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
416

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.

 2/22/2007 email from Richard Ruzika to Tom Montag and Daniel Sparks, GS MBS-E-010381967. 1689

 Subcommittee interview of Michael Swenson (4/16/2010). 1690

 Id. 1691

 Id. 1692

 A similar situation existed at the time in the market for commercial mortgage backed securities (CMBS). In a 1693

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].

 2/25/2007 email from Daniel Sparks to Tom Montag, “Questions you had asked,” GS MBS-E-010987763. 

1694

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. That meant the SPG Trading Desk 1690

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

1691

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 1692

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. The Mortgage Department’s inability to cover its single name shorts concerned 1693

Messrs. Montag and Ruzika, who continued to press for quick progress. 

 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
417

 2/27/2007 email from Richard Ruzika to Tom Montag, Justin Gmelich, and Daniel Sparks, GS MBS-E- 1695

002204942.

 Id. 1696

 2/27/2007 email from Daniel Sparks, “Opcom Directive,” GS MBS-E-017250218. 1697

 2/27/2007 email from Daniel Sparks, “Goals,” GS MBS-E-010387086, Hearing Exhibit 4/27-11. 1698

 See, e.g., 2/22/2007 Goldman internal emails, GS MBS-E-018938493, GS MBS-E-018940734; 2/27/2007 email 1699

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.

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 1695

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.”1697

He also sent the SPG and CDO Desk managers a set of “Goals”:

“Reduce risk. That means:

(1) get m[o]re super-seniors done on CDOs or take other steps to reduce CDO pipeline

risk;

(2) cover more single name shorts BBB- and BBB

(3) reduce the basis trade between BBB- index and BBB- single names

(4) reduce the index/index trades in A and AAA.”1698

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. By taking the long side in those contracts, the Mortgage 1699

Department was able to cover its shorts by the same amount. 
418

 2/28/2006 Goldman internal memorandum, “Firmwide Risk Committee: February 28th FWR Minutes, ”GS 1700

MBS-E-009687468, Hearing Exhibit 4/27-13 [sic - correct year is 2007]. 

 Id. See also 2007 Swenson Self-Review (“we prudently covered $5bb of single-name shorts at the all time lows 1701

at the time back in February”), Hearing Exhibit 4/27-55b.

 3/5/2007 email from Tom Montag, GS MBS-E-010393092. Goldman COO Gary Cohn expressed concern that a 1702

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-

15. 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.

 3/9/2007 email to David Viniar, “Mortgage Talking Points for Earnings Call,” GS MBS-E-009762678, Hearing 1703

Exhibit 4/27-16.

 9/17/2007 Presentation to GS Board of Directors, Residential Mortgage Business at 5, GS MBS-E-001793840, 1704

Hearing Exhibit 4/27-41.

On February 28, 2007, Mr. Sparks reported at a Firmwide Risk Committee meeting on the

Mortgage Department’s progress in reducing its VAR. The committee minutes reflect that Mr. 1700

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
419

 3/17/2007 email from Daniel Sparks and Tom Montag, “Cactus Delivers,” GS MBS-E-009632839. 1705

 Id. Mr. Montag’s comment suggests that he may have wanted the Mortgage Department to reduce the size of 1706

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. 

 3/14/2007 email from David Lehman, “ABS Trading - Subprime risk,” GS MBS-E-010397102. 1707

 Id. 1708

 See “Notionals (ABX convention),” chart attached to 5/23/2007 email from Kevin Kao to Joshua Birnbaum, 1709

“RMBS Subprime risk history as of 18May07,” GS MBS-E-012890599.

 See, e.g., 3/8/2007 email from Mr. Sparks, “Mortgage Risk,” GS MBS-E-002206279, Hearing Exhibit 4/27-75 1710

(noting Mortgage Department’s $9 billion short position on the AAA ABX index).

 Subcommittee interview of Daniel Sparks (4/15/2010), David Lehman (4/12/2010), Joshua Birnbaum 1711

(4/22/2010), and Michael Swenson (4/16/2010).

 See chart entitled “Goldman Sachs Mortgage Department Total Net Short Position, February-December 2007 in 1712

$ Billions,” prepared by the Subcommittee, April 2010, updated January 2011, derived from Goldman Mortgage

Strategies and Mortgage Department Top Sheets. 

 Subcommittee interview of Daniel Sparks (10/3/2010). 1713

“did a fantastic job for the desk by bringing in $1.2BB [billion] in A-rated single names today.”1705

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

That same day, March 14, 2007, in response to his request, the Mortgage Department sent

Mr. Ruzika a detailed breakdown of its subprime mortgage holdings. It disclosed that, despite 1707

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

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-E012890600.]

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, but the CDS contracts appear to have been held at a 1711

relatively constant level of $9 billion from some time in 2006 until July 2007. Mr. Sparks told 1712

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. 

1713
Prepared by the U.S. Senate Permanent Subcommittee on Investigations, February 2011. 

Derived from Goldman Sachs document, GS MBS-E-012890600.

60

65

70

75

80

85

90

95

100

105

-6,000,000,000

-4,000,000,000

-2,000,000,000

0

2,000,000,000

4,000,000,000

6,000,000,000

8,000,000,000

10,000,000,000

19-Jan18-Feb20-Mar19-Apr19-May18-Jun18-Jul17-Aug16-Sep16-Oct15-Nov15-Dec14-Jan13-Feb15-Mar14-Apr14-May13-Jun

Index Price

Notionals (ABX convention)

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

 8/17/2007 Goldman internal chart, “RMBS Subprime Notional History (Mtg Dept.),” GS MBS-E-012928391, 1714

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. 

 When shown the chart during his interview, Mr. Sparks told the Subcommittee he was unfamiliar with it and 1715

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.

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 1714

approximately $9 billion net short until early July 2007, when the value turned sharply upward.1715

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. 

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.
422

 3/4/2007 email from Kevin Gasvoda to Daniel Sparks, “Quick thoughts on ABX AAA risk,” GS MBS-E- 1716

010398072.

 Id. Despite Mr. Gasvoda’s suggestion that he might try to cover a portion of the $8 billion net short, the AAA 1717

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.

 Goldman’s hedging practice was that each desk was responsible for its own hedges. Accordingly, different 1718

desks would not necessarily share information about their respective hedges, even if both were hedging with the

same product, such as an ABX short.

 3/5/2007 email from Cyrus Pouraghabagher, “ABX hedges for Resi businesses,” GS MBS-E-012085546. 1719

 Id. 1720

 2/28/2007 email from Jonathan Egol to Fabrice Tourre, “Hedges Status Report,” GS MBS-E-002628642. 1721

 The report from Mr. Gasvoda’s group may have inadvertently omitted a particular loan book that was holding 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.

 3/8/2007 email from Daniel Sparks, “Mortgage Risk,” GS MBS-E-002206279, Hearing Exhibit 4/27-75. 

1723

“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.

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 1718

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 1719

AAA ABX “hedges.” A few days earlier, with respect to the CDO Origination Desk’s holdings, 1720

Mr. Egol had remarked: “Love that huge AAA abx short.” 

1721

Although the $7 billion figure reported by Mr. Gasvoda’s group on March 5 was $1 billion

less than the $8 billion reported the day before, and the $2.25 billion reported by the CDO 1722

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:

“[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
423

 Id. See also 8/23/2007 email from Tom Montag to Lloyd Blankfein, GS MBS-E-009585951, Hearing Exhibit 1724

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.

 3/4/2007 email Kevin Gasvoda to Daniel Sparks, “Quick thoughts on ABX AAA risk,” GS MBS-E-010398072 1725

(“ we get good jump risk . . . Net, think this is a good position to have on given downside protection and relatively

light upside pain.”).

 Subcommittee interview of Daniel Sparks (4/15/2010). 1726

 Id. 

1727

 Id. 1728

 See 8/17/2007 Goldman internal chart, “RMBS Subprime Notional History (Mtg Dept.),” GS MBS-E- 1729

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 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). 

 See 8/17/2007 Goldman internal chart, “RMBS Subprime Notional History (Mtg Dept.),” GS MBS-E- 1731

012928391, Hearing Exhibit 4/27-56a.

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

When asked about the Gasvoda email which described the AAA ABX short as an

inexpensive “jump risk,” Mr. Sparks told the Subcommittee that the email was referring to 1725

acquiring “jump insurance” against a sudden, huge loss arising from the total default of an asset.1726

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. Since AAA rated RMBS securities were typically the safest of the RMBS 1727

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

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. The $9 billion AAA ABX 1729

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. As those long assets were sold or written down, however, no apparent steps were taken 1730

to unwind or remove the $9 billion AAA ABX hedge. By June 2007, it remained almost 1731

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
424

 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).

 Id. at 4. 1733

 Id. at 8 [footnotes defining CDO and CDS omitted]. 1734

 9/17/2007 Presentation to Goldman Sachs Board of Directors, Residential Mortgage Business, at 5, GS MBS-E- 1735

001793840, Hearing Exhibit 4/27-41.

 3/26/2007 Goldman Sachs presentation to Board of Directors, “Subprime Mortgage Business,” GS MBS-E- 1736

005565527, Hearing Exhibit 4/27-22. 

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-billiondollar 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

presentation to Goldman’s Board of Directors regarding the firm’s subprime mortgage business.1732

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. The 1733

presentation noted, among other measures, the following steps:

“– 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 1736

innovation,” which in this context included ABX, CDO, and CDS instruments, had magnified the

risk in the U.S. mortgage market.
425

 See, e.g., Salem 2007 Self-Review. 1737

 See, e.g. 4/5/2007 email from Deeb Salem, “let’s sell ~200mm in Baa2 protection . . .,” GS MBS-E-004516519 1738

(Mr. Swenson’s reply: “Make that 500mm”).

 Deeb Salem 2007 Self-Review [emphasis in original]. 1739

 Subcommittee interview of Deeb Salem (10/6/2010). 1740

 Id. 1741

(c) Attempted Short Squeeze

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

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 1738

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 selfevaluation 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 1740

reading his self-evaluation as a description of an intended short squeeze put too much emphasis on

“words.”1741
426

 5/25/2007 email from Michael Swenson to Edwin Chin and Deeb Salem, GS MBS-E-012443115. 1742

 5/29/2007 email from Michael Swenson to Deeb Salem, “they want to think about doing this again,” GS MBS- 1743

E-012561798.

 Subcommittee interview of Michael Swenson (10/8/2010). 1744

 Goldman’s CDS collateral agreements were usually bilateral, meaning collateral could flow either way, to the 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.

 5/21/2007 email from Deeb Salem to Michael Swenson and Edwin Chin, “A few things pain-related,” GS MBS- 1746

E-021887795 [ellipses in original].

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 1744

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

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
427

 Id. 1747

 5/21/2007 email to Edwin Chin, “Edwin–Important–Stanfield levels,” GS MBS-E-012570169. 1748

 Id. 1749

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 1749

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. 

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
428

 5/24/2007 email from Stanfield, “Our thoughts on single-name RMBS CDS,” GS MBS-E-012891722. 1750

 5/31/2007 email from sales to Edwin Chin and Deeb Salem, “Stark CDO CDS potential trade 5/31,” GS MBS- 1751

E-012443662.

 Id.; see also, e.g., “Valuation & Pricing Related to Transactions with AIG,” prepared by Goldman in response to 1752

inquiry by the Financial Crisis Inquiry Commission, GS MBS 0000039096.

 5/31/2007 Goldman email chain, “Stark CDO CDS potential trade 5/31,” GS MBS-E-012443675. Mr. Swenson 1753

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. 

 6/7/2007 Goldman internal email chain, “BSAM Post,” GS MBS-E-011184213. 1754

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. In response, the ABS 1754

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
429

 6/7/2007 email from Deeb Salem to Michael Swenson and Edwin Chin, GS MBS-E-012444252. 1755

 Id. 1756

 Id. 1757

 Id. 1758

 6/8/2007 email from Michael Swenson to Benjamin Case, Edwin Chin, and Deeb Salem, “CDO CDS protection 1759

offers,” GS MBS-E-012551726.

 6/10/2007 email from Michael Swenson to Deeb Salem, Edwin Chin, and salesman, “CDSs on CDOs,” GS 1760

MBS-E-012551460.

 Id. 1761

 6/13/2007 email from sales, “CDO protection,” GS MBS-E-012445931. 1762

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.” Mr. 1756

Salem continued:

“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.” Mr. Swenson was less equivocal: “Really don’t want to

1760

offer any.” On June 13, 2007, a Goldman salesman emailed SPG personnel: “[Customer] is

1761

looking to buy protection on cdos.” Mr. Salem replied: “too late!” 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
430

 6/11/2007 Goldman email chain, “Please advise – Client challenging marks,” GS MBS-E-018947548. 1763

 6/12/2007 email from controllers, “CDS,” GS MBS-E-012445404. 1764

 6/19/2007 email from controllers, “A3 subprime bonds in transition account,” GS MBS-E-012458169. Mr. 1765

Swenson replied: “Tier 4 bonds talk to Deeb [Salem].” 

 See Markowski v. SEC, 274 F.3d 525, 527-28 (D.C. Cir. 2001) (Congress determined that “‘manipulation’ may 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.

 PSI Net Short Position Chart; 8/17/2007 Goldman chart, “RMBS Subprime Notional History (Mtg Dept.),” GS 1767

MBS-E-012928391, Hearing Exhibit 4/27-56a. 

 7/25/2007 email from Mr. Viniar to Mr. Cohn, “Private & Confidential: FICC Financial Package 07/25/07,” GS 1768

MBS-E-009861799, Hearing Exhibit 4/27-26.

“Trading has agreed to change ... marks.” The next day, June 12, 2007, a Goldman 1763

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

1764

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 May 2007 attempted short squeeze described in Mr. Salem’s performance selfevaluation 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 1766

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.” 

 

(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 1767 1768
431

 See 6/7/2007 Goldman email chain, “BSAM Post,” GS MBS-E-011184213. 

1769

 Id. Some have suggested that the financial problems experienced by the Bear Stearns hedge funds were caused 1770

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 AG, 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]

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. After reviewing the hedge funds’ assets, one Goldman 1769

employee remarked:

“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
432

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-E001919600; 6/27/2007 email from Mr. Sparks to Mr. Viniar, “CDO^2s,” GS MBS-E-009747489. 

 6/8/2007 email to Daniel Sparks, “Heads Up – rates market volatile,” GS MBS-E-010796702. 1771

 Id. 1772

 6/8/2007 email from Joshua Birnbaum, “* ABX Markets 07-1, 06-2, 06-1: 11:00 a.m.,” GS MBS-E-012900708. 1773

 6/12/2007 email to Craig Broderick, “BSAM Bullet Points,” GS MBS-E-009967117. 1774

 Id. A month later, on July 17, 2007, Mr. Sparks reported to Mr. Mullen and Mr. Montag that the Bear Stearns 1775

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. 

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. “Given the recent correlation of risk assume this is not a good sign for 1771

RMBS/ABS spreads.” Later that day, when another trader complained about “getting crushed” 1772

in the ABX market, Mr. Birnbaum replied: “Patience, patience. The CDO unwind has only

begun.” 

1773

Around June 12, 2007, public news accounts indicated that the two Bear Stearns funds

were unable to meet collateral calls on their subprime mortgage backed securities holdings. The 1774

funds also devalued their Net Asset Valuations (NAVs) to significantly lower levels, which

effectively triggered the funds’ total collapse. 

1775
433

 6/12/2007 email to Craig Broderick, “BSAM Bullet Points,” GS MBS-E-009967117. 1776

 See 6/22/2007 emails from David Lehman, “BSAM Repo Summary,” GS MBS-E-001916435. See also 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).

 6/22/2007 email from Tom Montag to Daniel Sparks, “Few Trade Posts,” GS MBS-E-010849103 (Mr. Montag: 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.”).

 At the time, a trader from another bank stated in a market update: “[T]he BSAM [Bear Stearns Asset 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.

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

attempt to organize a “workout” solution to stabilize the funds. While those efforts were 1776

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

dollar, respectively, for the two Timberwolf tranches. Goldman also bought a few other RMBS 1777

and CDO assets, which it immediately sold. The attempt to organize a workout solution for the 1778

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

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
434

 9/26/2007 2007 MD Reviews, Joshua Birnbaum Self-Review, GS-PSI-01956, Hearing Exhibit 4/27-55c. The 1780

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.

 This presentation was drafted to support a proposal that the SPG traders be compensated in a manner similar to 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. 

 10/3/2007 “SPG Trading – 2007,” presentation by Joshua Birnbaum, GS MBS-E-015654036 [emphasis in 1782

original]. See also Birnbaum responses to Subcommittee QFRs at PSI_QFR_GS0509. 

 6/29/2007 emails between Michael Swenson and David Lehman, “ABS Update,” GS MBS-E-011154528. 1783

 7/10/2007 Goldman internal email, “GS Cashflow/Abacus CDOs Mentioned in S&P Report on CDO Exposure

1784

to Subprime RMBS,” GS MBS-E-001837256.

 See id. 1785

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, Mr. Birnbaum wrote that, after the Bear Stearns funds collapsed, SPG’s 1781

Trading Desks went net short outright and that the shorts were not a hedge for long positions:

“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. The 1784

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 1785

12, 2007, when still more RMBS and CDO ratings downgrades were announced, Mr. Birnbaum
435

 7/12/2007 email from Joshua Birnbaum, “ABX Markets 07-1, 06-2, 06-1: 12:00 p.m.,” GS MBS-E-012944742, 1786

Hearing Exhibit 4/27-146.

 7/27/2007 email to Tom Montag, Daniel Sparks, and Donald Mullen, “Structured Products Weekly Update – 1787

7/27/07,” GS MBS-E-010876357.

 7/20/2007 email from Gary Cohn to Lloyd Blankfein, “Private & Confidential: FICC Financial Package 1788

07/20/07,” GS MBS-E-009648405, Hearing Exhibit 4/27-24.

 7/24/2007 email from David Viniar to Lloyd Blankfein, “Daily Estimate 07-24-07 – Net Revenues $74M,” GS 1789

MBS-E-009690033, Hearing Exhibit 4/27-25.

 7/29/2007 email from Daniel Sparks to Tom Montag, “Correlation information you asked for,” GS MBS-E- 1790

010876594, Hearing Exhibit 4/27-27.

 9/26/2007 2007 EMD Reviews, Joshua Birnbaum Self-Review, GS-PSI-01975, Hearing Exhibit 4/27-55c. 1791

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.” On July 24, 2007, the Mortgage 1788

Department posted a profit of $83 million for the day, while the firm’s overall net revenue for the

day was only $74 million. Mr. Viniar forwarded the report to Mr. Blankfein with a note saying: 1789

“Mergers, overnight asia and especially short mortgages saved the day.” On July 29, 2007, Mr.

Sparks reported to Messrs. Montag and Mullen:

“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
436

 8/11/2007 email from David Lehman, “Japan exposure to CDOs,” GS MBS-E-001929202. 1792

 8/23/2007 email from Tom Montag to Gary Cohn and David Viniar, “Harbinger Post,” GS MBS-E-009739009. 

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”).

 The one short position the Mortgage Department did not attempt to cover was its $3 billion net short in BBB and 1794

BBB- rated RMBS securities, as discussed below.

 8/5/2007 email from Michael Swenson, “great week,” GS MBS-E-012376888, Hearing Exhibit 4/27-28. 1795

 Id. 1796

 Id. 

1797

 8/8/2007 email from Tom Montag to Michael Swenson and David Lehman, GS MBS-E-011088957. 1798

 8/9/2007 email from Tom Montag, GS MBS-E-009640293. 1799

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.” On August 23, 2007, Mr. 1792

Montag reported to Messrs. Cohn and Viniar: “We ... bought back almost 9 billion of aaa abx

over last two weeks.”1793

From mid-July through the end of August, the Mortgage Department also covered a range

of other shorts. On August 5, 2007, Mr. Swenson reported a “phenomenal week”:

1794

“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.” The next day, August 9, 2007, Mr. 1798

Montag reported to his colleagues: “mortgages bought back 1 billion of 3 billion short in AAA

indices at 1⁄2 to 1 point better than yesterday.”1799
437

 8/11/2007 emails between Donald Mullen and David Lehman, “Japan exposure to CDOs,” GS MBS-E- 1800

001929202.

 Id. See also 8/11/2007 email from Daniel Sparks to Tom Montag and Donald Mullen, “GSC ms prop/Paulson 1801

swap,” GS MBS-E-010673306 (“We need to keep buying AAA ABX, and now we can start looking to cover some

CDO CDS”).

 8/20/2007 email exchange between Daniel Sparks and Tim Montag, “Hsbc loans,” GS MBS-E-010681855. 1802

 8/14/2007 email from Michael Swenson, “ABS Summary for Week Ended August 10 ,” GS MBS-E- 1803 th

010678428.

 Id. 1804

 8/19/2007 email from Tom Montag, “Mtg Department Weekly Update,” GS MBS-E-010681647. 1805

 Id. 1806

 Id. Not everyone at Goldman agreed that the risk of loss on AAA was “remote.” On July 29, 2007, Mr. 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

On August 11, 2007, reports of firms having to sell CDO securities in Asia prompted Mr.

Mullen to ask: “Did we cover to[o] soon? Looks like more selling at the higher end of cap

stack” Mr. Lehman replied: “Don’t th[in]k so – we haven’t covered any CDO risk (we have 1800

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.”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

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

cheap .... [W]ant to scale into a large long.” Mr. Sparks agreed: “[T]he AAA ABX index is a 1803

great opportunity and we continue to like it.” On August 19, 2007, Mr. Lehman reported that 1804

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 1805

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 1806

AAA CDOs),” was “remote.” 

1807
438

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. 

 Subcommittee interview of Joshua Birnbaum (4/22/2010). 1808

 Id. 1809

 Id. 1810

 8/14/2007 email from Daniel Sparks, “Fw: Post,” GS MBS-E-010678053, Hearing Exhibit 4/27-30. 1811

 See 8/14/2007 email from Gary Cohn to Daniel Sparks, “Fw: Post,” GS MBS-E-010678053, Hearing Exhibit 1812

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”).

 8/15/2007 email from Daniel Sparks, “Post,” GS MBS-E-009740784, Hearing Exhibit 4/27-32. 

1813

 8/20/2007 email from Daniel Sparks to Gary Cohn, David Viniar, Jon Winkelried, Tom Montag, and Donald 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

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

1808

covering the BBB/BBB- net short position in August would have amounted to leaving money on

the table. He explained that the Mortgage Department thought that buying a proportionate 1809

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

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[.]” Senior executives reacted with skepticism. Mr. Sparks 1811 1812

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

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
439

[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.”).

 8/21/2007 email from Joshua Birnbaum, “Potential large subprime trade and impact on firmwide VAR,” GS 1815

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).

 Id. 1816

 See 8/21/2007 email from Mr. Montag to Mr. Birnbaum, GS MBS-E-010682736 (“FYI. I think it would be 1817

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”).

 8/21/2007 email from Bill McMahon, “Potential large subprime trade and impact on Firmwide VAR,” GS MBS- 1818

E-012606879.

 8/21/2007 email from Joshua Birnbaum, “Potential large subprime trade and impact on firmwide VAR,” GS 1819

MBS-E-016359332, Hearing Exhibit 4/27-34

On August 21, 2007, Mr. Birnbaum presented the Mortgage Department’s plan to buy up to

$10 billion in AAA rated RMBS securities. The plan had dual objectives, to profit from the 1815

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 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. Mr. McMahon wrote: 1817

“What are we holding against the 3.5b mezz shorts right now? Why don’t we just cover the

shorts?” Co-President Gary Cohn emailed Messrs. Mullen, Winkelried, and Montag: “I do like 1818

the idea but you[r] call.” Before any further discussion took place, however, events overtook 1819

the debate.
440

 8/15/2007 email from Gary Cohn, “Trading VaR $165mm,” GS MBS-E-009778573. 

1820

 7/21/2007 email from Daniel Sparks to Donald Mullen, Tom Montag, and others, “Mortgages Estimate,” GS 1821

MBS-E-009640287.

 See id. (noting $50 million down trading day, followed by a day in which the AAA index accounted for half of 1822

the day’s profit).

 Id. 1823

 8/9/2007 email from Joshua Birnbaum to Deeb Salem, GS MBS-E-012927140. 1824

 8/8/2007 email from Tom Montag to Michael Swenson and David Lehman, GS MBS-E-011311633. Mr. 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.

 8/9/2007 email from Joshua Birnbaum to Deeb Salem, GS MBS-E-012927140. 1826

(e) “Get Down Now”

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. For example, while the Mortgage Department 1822

showed a profit of $71 million on July 21, 2007, it showed a loss of $100 million on August

1823

8. Upon hearing of that loss, Mr. Montag asked “so who lost the hundy?” Mr. Birnbaum 1824 1825

wrote to a colleague: “I’m sure the AAA ABX is being blamed as the reason the dept was down

100 yest[erday].” While some in the Mortgage Department disagreed with the use of VAR as a 1826
441

 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-E009993267 (“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).

 For more information on the Mortgage Department’s VAR levels, see below. 

1828

 On August 7, 2007, a senior risk executive wrote to Messrs. Cohn, Viniar, and McMahon: “We are doing a 1829

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. 

 See, e.g., 8/21/2007 email from Joshua Birnbaum, “Potential large subprime trade and impact on firmwide 1830

VAR,” GS MBS-E-016359332, Hearing Exhibit 4/27-34 (favoring preservation of the $3.5 billion BBB/BBBshort).

 Risk controller Robert Berry explained to Messrs. Viniar, McMahon, and Broderick that VAR was becoming 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 –

measure of risk, the gyrations in daily profit and loss figures demonstrated that the $9 billion net 1827

short posed real risk to Goldman. 

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. The $113 million figure exceeded the 1828

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

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. But the Mortgage Department’s VAR level proved to be both intractable and highly 1830

unpredictable. It also contributed to record high levels of firmwide VAR, a figure carefully 1831
442

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.

 See, e.g., 8/15/2007 email from Michael Dinias, “Hedge Analysis cob 8/13/07,” GS MBS-E-010678553 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).

 8/15/2007 email from Gary Cohn, “Trading VaR $165mm,” GS MBS-E-009778573. Mr. Viniar agreed. Two 1833

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 MBSE-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-E009756424.

 On August 22, 2007, Mr. Montag emailed Mr. Blankfein: “[W]e are covering a number of shorts in mortgages 1834

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 MBSE-009585951, Hearing Exhibit 4/27-37.

 8/23/2007 email from Michael Swenson, “Harbinger Post,” GS MBS-E-009739009. 1835

 8/23/2007 email from Daniel Sparks, “Current Outstanding Notional SN ames,” GS MBS-E-010621231. 1836

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, when Goldman’s Co-President Gary Cohn intervened. On August 15, 2007, the 1832

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.” 

1833

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. On August 23, 2007, Mr. Swenson 1834

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.” 

1835

But even after that $400 million sale, Mr. Sparks reported to Mr. Montag: “[W]e are short

... about $3BB single names.” Mr. Montag responded that the $3 billion net short position was 1836

“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
443

 Id. 1837

 8/23/2007 email exchange between Tom Montag and Daniel Sparks, “Current Outstanding Notional SN ames,” 1838

GS MBS-E-010621324.

 8/23/2007 email exchange between Gary Cohn and Lloyd Blankfein, “Trading VaR $133mm,” GS MBS-E- 1839

009643469.

 Id. Goldman senior executives continued to monitor the Mortgage Department’s actions. For example, on 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.”

 12/2007 Quarterly Market Risk Review, GS MBS-E-009586222, Hearing Exhibit 4/27-54f (third quarter 1841

mortgages average VAR was $68 million; fourth quarter mortgages average VAR was $75 million).

 Subcommittee interview of David Viniar (4/13/2010); Subcommittee interview of Daniel Sparks (4/15/2010); 1842

Subcommittee interview of Joshua Birnbaum (4/22/2010).

 8/21/2007 email from Michael Swenson, “Mortgage Commentary for Firmwide Risk Committee,” GS MBS-E- 1843

010619375 (“Current SPG Trading Desk Position Summary: – RMBS AAA – long $2.2bb”); Michael J. Swenson,

responses to Subcommittee QFRs at PSI_QFR_GS0474. 

 In the week of December 6, 2007, the Mortgage Department’s risk managers noted “an increase in net short 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).”).

and outsized.” At the end of the trading day on August 23, Mr. Montag asked Mr. Sparks: 1837

“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. On August 23, 2007, Mr. Cohn forwarded a VAR report to CEO Lloyd Blankfein: 1839

“The message got through.” Mr. Blankfein responded: “Good job.” Mr. Cohn wrote: “Down 40

in 2 days.”1840

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. In addition, although 1841

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 1842

RMBS securities and continued to hold and strategically sell off its BBB and other short 1843

positions through the end of 2007.1844
444

 Salem 2007 Self-Review. 1845

 Id. [emphasis in original]. 1846

 Id. Mr. Salem described the trading strategies as follows: 1847

“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!

(f) Profiting from the Big Short: Making “Serious Money”

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) 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”;

(b) 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

(c) 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

(d) 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
445

“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 subprime 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 ....

“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.

 See, e.g., 10/11/2007 email from Michael Swenson to Donald Mullen, “Early post on P and L,” GS MBS-E- 1848

016031234, Hearing Exhibit 4/27-69. For more information about this downgrade, see Chapter V.

 Id. 1849

 Id. 1850

 10/12/2007 email exchange between Michael Swenson and Donald Mullen, “P and L,” GS MBS-E-018936577, 1851

Hearing Exhibit 4/27-68.

 Id. 1852

 See 10/3/2007 Goldman presentation, “SPG Trading – 2007,” GS MBS-E-015654036. See also 11/16/2007 1853

Goldman chart, “Mortgages Weekly Metrics 16-November-2007,” GS MBS-E-015863620 (“P&L YTD Annl

3,742,461”).

 See, e.g., 4/2010 “Goldman Sachs Mortgage Department Total Net Short Position, February - December 2007 in 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.

In October 2007, after the credit rating agencies downgraded hundreds of CDO

securities, Mr. Swenson wrote to Mr. Mullen that the downgrades would eventually cause

1848

defaults in many CDO securities that Goldman had shorted, meaning that Goldman’s “CDS

protection premiums paid out will go to zero,” and Goldman would receive substantial CDS 1849

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.” 

1850

Indeed, the Mortgage Department made $110 million the very next day. Mr. Swenson 1851

explained: “65mm was from yesterday’s downgrades which lead to the selloff.” Mr. Mullen

replied: “Great day!” By the end of 2007, the Mortgage Department had brought in

1852

approximately $3.7 billion in net revenues from its SPG Trading Desk.1853

(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
446

 Id. 1855

 See 2/26/2007 Mortgage Department Top Sheet, GS MBS-E-010388545, and 6/25/2007 Mortgage Department 1856

Top Sheet, GS MBS-E-010850895, Hearing Exhibit 4/27-162.

 Subcommittee interview of Daniel Sparks (4/15/2010). 1857

 Id.; 2/26/2007 email to Daniel Sparks, Michael Swenson, and others, “New cross desk Top Sheet risk report,” 1858

GS MBS-E-010386051.

 Subcommittee interview of Daniel Sparks (4/15/2010). 1859

 Subcommittee discussions with Goldman Controller staff on Responses to Questions for the Record and related 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-E010674894 (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. 

various subprime asset classes on a daily basis throughout most of 2007. Those records indicate 1855

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

(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 1857

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

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. The Goldman Controller’s office told the 1859

Subcommittee that Goldman did not maintain any other type of comprehensive daily report

regarding the Mortgage Department’s net positions in various asset classes. 

1860
447

 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). 

 The balance of the page provided detail regarding the amount of each asset class held by each of the Mortgage 1862

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.

 See chart entitled, “Goldman Sachs Mortgage Department Total Net Short Position, February-December 2007 in 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”). 

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. The top line of the 1861

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 1862

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

[SEE CHART NEXT PAGE: Goldman Sachs Mortgage Department

Total Net Short Position, prepared by the Permanent Subcommittee

on Investigations.]
Goldman Sachs Mortgage Department Total 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 

-5.0 

-10.0 

-15.0 

10/5/0 

Prepared by the U.S. Senate Permanent Subcommittee on Investigations, April 2010. Updated January, 2011. 

Derived from Goldman Sachs Mortgage Strategies, Mortgage Dept Top Sheets provided by Goldman Sachs. 

11/5/07 12/5/07 
449

 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.

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.

451

 See Birnbaum responses to Subcommittee QFRs at PSI_QFR_GS0509. Subcommittee interview of Joshua 1865

Birnbaum (10/1/2010). 

 Subcommittee interview of Joshua Birnbaum (10/1/2010); Subcommittee interview of Michael Swenson 1866

(10/8/2010).

 Subcommittee interview of Joshua Birnbaum (10/1/2010). 1867

 Id. 1868

 Id. Mr. Swenson made similar statements in his second Subcommittee interview. “Were we ever net short? It’s 1869

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).

 As noted above, the risk management and controller areas at Goldman kept their own daily reports based on the 1870

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.

Some Goldman representatives told the Subcommittee that they objected to both the

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. For example, in a 2010 interview with the Subcommittee, Mr. Birnbaum 1865

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. He 1866

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 1868

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

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 1870

“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
452

 In general, positions were expressed in market values for all liquid assets and in “hedge equivalents” of illiquid 1871

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-E010690523 (“Market value of bonds/loans, bond equiv mkt val for synthetics.”).

 See e.g., 3/5/2007 email from Daniel Sparks to Tom Montag and others, GS MBS-E-010646842 (“We think the 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”).

 1/10/2011 Concordance search of all documents produced to the Subcommittee by Goldman for the phrase “net 1873

short.”

 Subcommittee interview of Joshua Birnbaum (10/1/2010). 1874

notional amount of the positions. By using the market values of positions in each asset class on 1871

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

the Subcommittee by Goldman. Since Mr. Birnbaum claimed that one could never really say 1873

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, 1874

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.

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
453

 8/5/2007 email from David Lehman to Tom Montag, “Mtg Department Weekly Update,” GS MBS-E- 1875

010671564.

 Id. 1876

 Id. 1877

 See, e.g., 8/23/2007 email from Tom Montag to Daniel Sparks, “Current Outstanding Notional in SN ames,” GS 1878

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”).

 Subcommittee interview of David Viniar (4/13/2010). 1879

 See, e.g., Testimony of David Viniar, April 27, 2010, Subcommittee Hearing at 98, 99-100; 4/7/2010 Blankfein 1880

& Cohn Letter to Shareholders (quoted in 4/2010 Goldman report, “Risk Management and the Residential Mortgage

Market,” at 12, Hearing Exhibit 4/27-161).

 9/26/2007 email from Lloyd Blankfein, “Fortune: How Goldman Sachs Defies Gravity,” GS MBS-E- 1881

009592726. 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. 

• 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. While these documents did not provide an 1876

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

Email correspondence among Goldman’s senior executives also routinely referred to the

Mortgage Department’s net short positions in “billions.” CFO David Viniar told the 1878

Subcommittee that a loss (or gain) in the amount of even $25 million was considered “large” and

would immediately be brought to his attention. By that standard, net revenues of $2 billion 1879

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. 

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. Mr. 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 1881

later. On October 4, 2007, Mr. Birnbaum prepared on behalf of the SPG Trading Desk a
454

 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. 

 10/3/2007 Goldman presentation, “SPG Trading – 2007,” GS MBS-E-015654036 [emphasis in original]. 1883

 See Birnbaum responses to Subcommittee QFRs at PSI_QFR_GS0509. 

1884

 2/28/2007 email from David Rosenblum to Peter Ostrem, “Pete– pls send me cob 2/28 MTM for SP CDO WH’s 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).

 Id. 1886

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. The presentation, which Mr. Birnbaum prepared to 1882

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:

“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 1885

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.” In addition, in a 1886

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
455

 2/12/2007 email from Daniel Sparks, “Post today,” GS MBS-E-002202310. 1887

 Id.; PSI Net Short Chart. 1888

 Subcommittee interview of Craig Broderick (4/9/2010). See also Philippe Jorion, “Value at Risk: The New 1889

Benchmark for Managing Financial Risk,” at 20, (3d ed. 2007).

 See Mortgage Department Quarterly Average VAR. (Third Quarter 2006 - $13 million; Fourth Quarter 2006 - 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-E009590673, 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.

 8/9/2007 email from Joshua Birnbaum to Deeb Salem, “MarketRisk: Mortgage Risk Report (cob 08/08/2007),” 1891

GS MBS-E-012927202.

 2/27/2007 email from Richard Ruzika to Tom Montag and others, GS MBS-E-002204942; 8/15/2007 email 1892

from Gary Cohn, “Trading VaR $165mm,” GS MBS-E-016344758; Subcommittee interview of Joshua Birnbaum

(10/1/2010).

positions. In a third example, after conclusion of the CDO valuation project, all of the 1887

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. These Goldman 1888

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.

(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 1890

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

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

1892

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.
456

 Subcommittee interview of Craig Broderick (4/9/2010). 1893

 8/8/2007 email from Tom Montag to David Lehman and Michael Swenson, GS MBS-E-011311633. 1894

 Subcommittee interview of David Viniar (4/13/2010). 1895

 Mr. Birnbaum frequently argued that VAR, or at least Goldman’s then-current model of VAR, was an 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.

 Subcommittee interview of Craig Broderick (4/9/2010). 1897

 The Mortgage Department had other risk limits aside from VAR, including Credit Spread Widening or “CSW,” 1898

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). 

The firm tolerated the exceptionally high levels of VAR generated by the Mortgage

Department, despite the risks reflected in those high VAR levels. On the few days when the 1893

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

million loss in a single day, Mr. Montag asked: “Okay, who lost the hundy?” Mr. Viniar told 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

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 1897

relevant business unit and trading desk operations to ensure that their respective trading activities

did not exceed pre-determined risk limits. Separate VAR limits were set for the firm as a whole 1898

and for each division. The division then allocated its VAR limit among each department or
457

 9/2006-12/2007 Goldman Sachs Quarterly Market Risk Review, “Market Risk Management & Analysis,” 1899

Hearing Exhibits 4/27-54a-f and GS MBS-E-010674895.

 11/13/2007 Goldman email, GS MBS-E-010023525 (attachment, 11/14/2007 “Tri-Lateral Combined 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.

 Id. 

1901

 Id. The reference to the 30th floor was to the floor on which Goldman’s senior executives then had their offices 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).

 Subcommittee interview of Joshua Birnbaum (10/1/2010); Subcommittee interview of Craig Broderick 1903

(4/9/2010).

 Subcommittee interview of Joshua Birnbaum (10/1/2010). 1904

 See, e.g., 2/8/2007 email from Michael Dinias to Robert Berry, and Craig Broderick, GS MBS-E-009980807; 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

business area within a division. Some trading desks within a department also had assigned risk

limits.

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. Goldman’s Firmwide Risk Committee 1899

(FWRC) was co-chaired by David Viniar and its weekly meetings were often attended by CoPresident Gary Cohn and CEO Lloyd Blankfein. In preparation for a meeting with regulators, 1900

Goldman senior executives noted that the Mortgage Department was discussed at every meeting of

the FWRC throughout 2007. Goldman also noted that risk “[l]imits are set by the FWRC. 1901

Decisions regarding, e.g., short positions in mortgages taken by business units but with full

knowledge of the 30th floor.”1902

Goldman executives told the Subcommittee that, in general, risk limits were firm and

compliance was mandatory. At the end of each day, department and divisional personnel, their 1903

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

existing risk measures. Some of these proposals were adopted and some were not. But from 1905
458

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).

 See, e.g., 8/21/2007 email from Tom Montag to Gary Cohn, GS MBS-E-016344758; 8/21/2007 email from 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.

 See generally “The Risks of Financial Modeling: VaR and the Economic Meltdown,” before the U.S. House of 1907

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.

 See id. Based on these factors, VAR is generally lower if a desk has many small and non correlated (well 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.

 Market Risk Management & Analysis, Quarterly Market Risk Review, December 2006, GS MBS-E-009583144, 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).

 2/8/2007 email from Michael Dinias, “VaR limit for Mtg SPG,” GS MBS-E-009980807. 1910

 Id. 

1911

 Id. 1912

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

VAR Levels Show Net Short. The primary factors that influence VAR are: (1) the

relative size and correlation of positions, and (2) the volatility of trading. While VAR is 1907

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 1908

VAR levels over time can also provide information about the general magnitude and direction of

trading positions.

In the fourth quarter of 2006, the Mortgage Department’s permanent VAR limit was $20

million, of which it consumed only $13 million. Early the next year, on February 5, 2007, the 1909

Mortgage Department exceeded its limit with a VAR of $20.5 million. On February 8, 2007, a 1910

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. A senior manager concurred and increased the Mortgage Department’s 1911

permanent VAR limit to $35 million, which remained the Mortgage Department’s “permanent”

limit throughout 2007. 

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%
459

 Subcommittee interview of Craig Broderick (4/9/2010). 1913

 2/27/2007 email from Richard Ruzika to Tom Montag, others, GS MBS-E-002204942; Subcommittee interview 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-E009742070 (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]”).

 Subcommittee interview of Joshua Birnbaum (10/1/2010). 1915

 8/9/2007 email from Joshua Birnbaum to Deeb Salem, “MarketRisk: Mortgage Risk Report (cob 08/08/2007),” 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. 

 2/8/2007 email from Michael Dinias, “FW: VaR limit for Mtg SPG,” GS MBS-E-009980807. 1917

 2/13/2007 email, “MarketRisk: End of Day Summary - cob 02/12/2007,” GS MBS-E-009716432; see also 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”). 

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 1913

stated that the VAR levels were being driven by Goldman’s large net short positions.1914

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. With notable exceptions in late February and late August 2007, 1915

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.”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 1917

days later, on February 12, the Department’s VAR hit $49 million. On February 14, the 1918
460

 2/14/2007 email, “MarketRisk: End of Day Summary - cob 02/13/2007,” GS MBS-E-009763394 (“Mortgages 1919

VAR is over its $35mm limit. Temporary $50mm limit was granted until cob 02/20/2007.”).

 2/20/2007 email, “MarketRisk: End of Day Summary - cob 02/16/2007,” GS MBS-E-009724779. 2/22/2007 1920

email, “MarketRisk: End of Day Summary - cob 02/21/2007,” GS MBS-E-009762741 (Mortgages VAR on 2/20 was

63 million). 

 Id. (“Mortgages VAR has a temporary $60mm limit until cob 2/27/2007.”). 1921

 2/26/2007 email, “MarketRisk: End of Day Summary - cob 2/23/2007,” GS MBS-E-009720057; 2/27/2007 1922

email, “MarketRisk: End of Day Summary - cob 2/26/2007,” GS MBS-E-009764685.

 2/27/2007 email, “MarketRisk: End of Day Summary - cob 2/26/2007,” GS MBS-E-009764685 (“Mortgages 1923

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. 

 2/27/2007 email from Richard Ruzika to Tom Montag, others, GS MBS-E-002204942. 1924

 3/1/2007 email, “MarketRisk: End of Day Summary - cob 02/28/2007,” GS MBS-E-009757430. 

1925

 3/2007 Goldman “Quarterly Market Risk Review, Market Risk Management & Analysis,” GS MBS-E- 1926

009685934, Hearing Exhibit 4/27-54c.

 4/2010 Goldman report, “Risk Management and the Residential Mortgage Market,” Hearing Exhibit 4/27-161. 1927

 12/2006 Goldman “Quarterly Market Risk Review, Market Risk Management & Analysis,” GS MBS-E- 1928

009583144, Hearing Exhibit 4/27-54b.

Department was assigned a new “temporary” limit of $50 million that would expire on February

20. By February 20, however, the Department’s VAR was $63 million, well in excess of its 1919

temporary limit of $50 million. So the Department was assigned a new temporary limit of $60 1920

million – a level it was already exceeding – until February 27. Instead of dropping below the 1921

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

1922

27, the Department was given yet another temporary limit of $90 million through the end of the

month. But the precipitous rise in VAR apparently alarmed Goldman’s Operating Committee, 1923

which ordered the Department to reduce the size of its net short position to $4.5 billion. The 1924

Department responded immediately and, by February 28, had reduced its VAR to $81 million.1925

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

1926

Mortgage Department’s activities have historically resulted in only about 2% of the firm’s net

revenues. At the end of 2006, the Mortgage Department’s VAR of $14 million contributed only 1927

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
Goldman Sachs Mortgage Department Value at Risk (VaR)

December 2006 - December 2007 (in $ Millions)

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.

0

20

40

60

80

100

120

Mortgage Department VaR

Mortgage Department Permanent VaR Limit

Mortgage Department Temporary VaR Limit
462

 3/2007 Goldman Quarterly Risk Review, “Market Risk Management and Analysis,” GS MBS-E-009685958, 1929

Hearing Exhibit 4/27-54.

 8/14/2007 Market Risk Report, Mortgage Portfolio Summary, GS MBS-E-012380294, Hearing Exhibit 4/27-35 1930

(Mortgage Structured Products, VAR 110.1 on 8/14/07, Percentage Contribution to Firmwide VaR 53.8%).

 2/27/2007 email from Richard Ruzika to Tom Montag and Daniel Sparks, GS MBS-E-002204942; 8/15/2007 1931

email from Gary Cohn, “Trading VaR $165mm,” GS MBS-E-016344758. 

 8/16/2007 email from Jon Winkelried to Daniel Sparks, “Mort P&L Explanation,” GS MBS-E-010680327-330; 1932

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.

 8/16/2007 email from Jon Winkelried to Daniel Sparks, “Mort P&L Explanation,” GS MBS-E-010680327-330. 1933

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. During the rest of 2007, the 1929

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. 

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 1932

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: 

“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
463

 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

 6/28/2007 email from David Lehman to Daniel Sparks, GS MBS-E-010623720. 1935

 See 8/16/2007 email from Jon Winkelried to Daniel Sparks, “Mort P&L Explanation,” GS MBS-E-010680327- 1936

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.

 2/26/2007 Market Risk Report, Mortgage Risk Portfolio Summary, GS MBS-E-010388177. 1937

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. Goldman’s senior executives would have no reason to take such large risks if 1936

they were seeking only the small spread arbitrage available from market-making activities for

customers. 

On February 26, 2007, the Mortgage Department’s VAR reached a quarterly high of $85.4

million. On February 22, Mr. Sparks had told Messrs. Swenson, Lehman, and Birnbaum that 1937

they would have to cover $2 billion in subprime mortgage related net short positions that same
464

 2/22/2007 email from Daniel Sparks, “FW: Block size tranche protection offers for [redacted] or others,” GS 1938

MBS-E-010381411. 

 2/27/2007 email from Richard Ruzika to Tom Montag, Justin Gmelich, and Daniel Sparks, GS MBS-E- 1939

002204942.

 Id.

1940

 Subcommittee interview of Joshua Birnbaum (10/1/2010); see also 2/22/2007 email from Mr. Ruzika to Mr. 1941

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”).

 8/9/2007 email from Deeb Salem to Joshua Birnbaum, “MarketRisk: Mortgage Risk Report (cob 08/08/2007),” 1942

GS MBS-E-012927200.

 Id.; Subcommittee interview of Joshua Birnbaum (10/1/2010). 1943

 8/9/2007 email from Joshua Birnbaum to Deeb Salem, “MarketRisk: Mortgage Risk Report (cob 08/08/2007),” 1944

GS MBS-E-012927200.

 Id. 1945

 Id. 1946

day. On February 27, 2007, Mr. Ruzika wrote Mr. Sparks and others: “I want to see us getting 1938

the short down to 4.5 bil[lion] net.” Later that day, Mr. Ruzika forwarded the “OpCom 1939

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

1940

the SPG Trading Desk’s actions in February were taken to reduce the level of VAR.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. On the same day, August 9, Mr. 1943

Birnbaum sent an email to the ABS Desk trader, Mr. Salem:

“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
465

 Id. 1947

 Subcommittee interview of Joshua Birnbaum (10/1/2007). 1948

 Id. 1949

 8/15/2007 email from Daniel Sparks, “Trading VaR $165mm,” GS MBS-E-016344758; See, e.g., 8/15/2007 1950

email from Michael Dinias, “Hedge Analysis cob 8/13/07,” GS MBS-E-010678553 (analyzing 6 potential VARreducing 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).

 See, e.g., 8/14/2007 Goldman Market Risk Report, GS MBS-E-010679220; 8/21/2007 email from 1951

MarketRisk,“MarketRisk: End of Day Summary - cob 8/20/07,” GS MBS-E-009740158.

 8/21/2007 email from MarketRisk, “MarketRisk: End of Day Summary - cob 8/20/07,” GS MBS-E-009740158. 1952

 8/15/2007 email from Gary Cohn, “Trading VaR $165mm,” GS MBS-E-016344758. 1953

 See, e.g, 8/28/2007 email from MarketRisk, “MarketRisk: End of Day Summary - cob 8/28/07," GS MBS-E- 1954

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).

 Subcommittee interview of Craig Broderick (4/9/2010). 1955

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

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 1948

all of SPG Trading’s BBB/BBB- shorts, because they believed the ABX Index for BBB and BBBrated RMBS securities would fall further in coming months, so covering the entire short

immediately would amount to leaving significant money on the table. The Department’s 1949

traders, analysts, and risk managers designed and executed specific transactions over the month of

August to lower VAR, but they were unsuccessful. 

1950

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

1951

Firmwide VAR of $167 million on August 17, 20, and 21, all of which exceeded the Firmwide

VAR limit of $150 million. On August 15, 2007, Goldman’s Co-President Gary Cohn issued 1952

his order: “[G]et down now.” In response, the Mortgage Department began selling and covering 1953

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. The Risk Reports recording these VAR levels 1954

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
466

 9/28/2007 Goldman 1956 Market Risk Report, GS MBS-E-009926240.

 See 4/3/2007 Goldman Sachs Group Inc. Form 10-Q at 79 (first quarter 2007 Average Daily VAR reported as 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). 

 See 10/9/2007 Goldman Sachs Group Inc. Form 10-Q at 66. See also, e.g., “How Goldman Sachs Defies 1958

Gravity,” Fortune (9/20/2007).

 9/19/2007 Goldman internal document, “Third Quarter 2007 Earnings Call Script for David Viniar,” GS MBS- 1959

E-009779213, Hearing Exhibit 4/27-45.

 9/17/2009 email to Daniel Sparks, “Mortgage commentary on Q3 earnings call,” GS MBS-E-009853301, 1960

Hearing Exhibit 4/27-44.

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. The lower

1956

Firmwide VAR figures that resulted from the Mortgage Department’s VAR reductions were

publicly reported in Goldman’s quarterly financial reports.1957

(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. On September 19, 2007, in a conference call with 1958

financial analysts on Goldman’s third quarter results, Goldman’s CFO, David Viniar, highlighted

the performance of the Mortgage Department:

“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
467

 9/17/2007-9/18/2007 Goldman Sachs Board of Directors Meeting, “Financial Summary, Quarter Ended August 1961

31, 2007,” GS MBS-E-009776900, Hearing Exhibit 4/27-42.

 10/5/2007 Goldman presentation, “Global Mortgages Business Unit Townhall Q3 2007,” GS MBS-E- 1962

013703463, Hearing Exhibit 4/27-47.

 Id. 

1963

 Id. 1964

 4/2010 “Goldman Sachs: Risk Management and the Residential Mortgage Market,” report prepared by Goldman 1965

Sachs, Hearing Exhibit 4/27-161.

 10/5/2007 Goldman presentation, “Global Mortgages Business Unit Townhall Q3 2007,” GS MBS-E- 1966

013703463, Hearing Exhibit 4/27-47.

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.” Under the heading of “Performance Drivers (Net Revenues),” Mr. Sparks 1962

wrote:

“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 1964

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

In his draft presentation, Mr. Sparks wrote that the “desk benefited from a proprietary short

in CDO and RMBS single names.” In industry parlance, a “proprietary” position is one 1966

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
468

 “Global Mortgages Business Unit Townhall Q3 2007,” Final version, GS MBS-E-013668603. 1967

 Subcommittee interview of Daniel Sparks (10/4/2010). In his subsequent responses to the Subcommittee’s 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.

 10/29/2007 “Contagion and Crowded Trades,” Goldman Sachs Tax Department Presentation, GS MBS-E- 1969

010018511, Hearing Exhibit 4/27-48 [emphasis in original].

 Joshua Birnbaum Self-Review, Hearing Exhibit 4/27-55c. The figures cited for ABS synthetics and ABS (both 1970

cash and synthetics) are apparently both included within the total of $3 billion profit cited for the SPG Trading Desk

as a whole.

 Id. Mr. Birnbaum also wrote: “During this period, I would also add that the ABS team contributed significantly 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.

revised the line to read that the desk benefitted from “strong results from trading long correlation

and net short bias.” When asked why he had originally written that “the desk benefitted from a 1967

proprietary short,” Mr. Sparks told the Subcommittee that the language was inaccurate.

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
469

 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.

 Salem 2007 Self-Review. 

1973

 See description of Mr. Salem’s single name trading strategies, above. 1974

 10/4/2007 letter from Goldman Sachs to the SEC, GS MB S-E-009758287, Hearing Exhibit 4/27-46 [emphasis 1975

added].

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
470

 11/7/2007 letter from Goldman Sachs to the SEC, GS MBS-E-015713460, Hearing Exhibit 4/27-50. 1976

 11/13/2007 Goldman email, GS MBS-E-010023525 (attachment, 11/14/2007 “Tri-Lateral Combined 1977

Comments,” GS MBS-E-010135693-715 at 694). 

 Id. 1978

 “Goldman Doesn’t Plan Significant Mortgage Writedown,” Bloomberg (11/13/2007); see also 11/13/2007 email 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). 

 “Goldman Sachs Rakes in Profit in Credit Crisis,” New York Times (11/19/2007). 1980

 11/18/2007 email from Lloyd Blankfein, “RE: NYT,” GS MBS-E-009696333, Hearing Exhibit 4/27-52. 

1981

Goldman’s Co-President, Gary Cohn, replied to Mr. Blankfein’s message, adding, “We were just smaller in the toxic

products” Id.

 11/7/2007 Goldman document, “How Did GS Avoid the Mortgage Crisis?,” GS MBS-E-009713204, Hearing 1982

Exhibit 4/27-51.

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,” Mr. Blankfein sent an email to his colleagues stating: “Of course we didn’t dodge the 1980

mortgage mess. We lost money, then made more than we lost because of shorts.”1981

Goldman also prepared for public use a corporate statement entitled, “How Did GS Avoid

the Mortgage Crisis? Our Response.” The statement was prepared for Mr. Viniar’s use in 1982
471

 Id. 1983

 Id. 

1984

 See 11/30/2007 “SPG Trading Mortgages Weekly Metrics 30-November-2007,” GS MBS-E-015646485. 1985

 See Goldman Sachs Form 10-K for the fiscal year ending Nov. 30, 2007, filed on 1/28/2008, at 64; see also 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.

 April 27, 2010 Subcommittee Hearing at 96. See also 235, 252, 345. 1987

 Id. at 98. 1988

 11/30/2007 “SPG Trading Mortgages Weekly Metrics 30-November-2007,” GS MBS-E-015646485. 1989

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 1983

significant writedowns in the value of its long mortgage inventory had resulted in a “weak” second

quarter for mortgages, Goldman wrote:

“[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

were approximately $3.7 billion. In fiscal year 2007, Goldman’s total net revenues were 1985

approximately $46 billion, and its net earnings (after tax) were approximately $11.6 billion.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.” He insisted that its 2007 net short position in 1987

the mortgage market “was not a large short,” and was largely offset by its long positions, 1988

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. Those profits sustained 1989

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.
472

 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.

 7/25/2007 email from David Viniar to Gary Cohn, “Private & Confidential: FICC Financial Package 07/25/07,” 1991

GS MBS-E-009861799, Hearing Exhibit 4/27-26.

 10/3/2007 Goldman presentation, “SPG Trading – 2007,” GS MBS-E-015654036. 1992

 Goldman also highlighted losses it suffered in 2008, related to its mortgage business, particularly mortgage 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.

 Gregory Zuckerman, The Greatest Trade Ever (2009); Michael Lewis, The Big Short (2010). 1994

In contrast, other major Wall Street banks reported losses in the third quarter of 2007,

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 1990

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, 1994

had described Goldman’s own massive net short position as the “greatest trade ever” as early as July
473

 7/20/2007 email from Joshua Birnbaum, “ABX Markets 07-02, 07-01, 06-2, 06-1: 3:00 p.m.,” GS MBS-E- 1995

012962076 (Mr. Birnbaum: “greatest trade ever . . . I have a huge short . . .”).

 7/12/2007 email from Joshua Birnbaum, “ABX Markets 07-1, 06-2, 06-1: 12:00 p.m.,” GS MBS-E-012944742, 1996

Hearing Exhibit 4/27-146.

 10/3/2007 Goldman presentation, “SPG Trading – 2007,” GS MBS-E-015654036; Birnbaum Self-Review, 1997

Hearing Exhibit 4/27-55c.

 See 9/17/2007 Goldman presentation to Board of Directors, “Residential Mortgage Business, Global Impact of 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.

 See, e.g., April 27, 2010 Subcommittee Hearing, testimony of Lloyd Blankfein at 132 and David Viniar at 98. 

1999

 4/7/2010 Blankfein & Cohn, Letter to Shareholders (quoted in Hearing Exhibit 4/27-161 at 12). 2000

 4/2010 Goldman report, “Risk Management and the Residential Mortgage Market,” Hearing Exhibit 4/27-161. 2001

 Id. 2002

2007. Earlier in the year, Mr. Birnbaum had also described Goldman as the market leader in

1995

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.” When preparing his case for SPG traders to be paid additional 1996

compensation for their 2007 efforts, Mr. Birnbaum again made a comparison to Paulson: “RMBSrelated revenues: #1 on the street by a wide margin. #2 in the world behind Paulson Partners.”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 1998

downplay the size of its short position and the impact on its profits. In particular, Goldman 1999

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 April 2010, Goldman posted a statement on its website entitled, “Goldman Sachs: Risk

Management and the Residential Mortgage Market.” In the statement’s Executive Summary, 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 mortgagerelated 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
474

 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).

 April 27, 2010 Subcommittee Hearing at 132. 2004

 Id. at 98. 2005

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:

– “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
475

 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.

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

value of about $100 billion. Goldman designed the structure of each securitization, including the 2006

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.
476

 See Goldman Sachs response to Subcommittee QFR at PSI_QFR_GS0252, at 0262. 2007

 For a detailed discussion of these obligations under federal securities laws, see Section (6)(a), below. 2008

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

personnel to sell a specific investment to a specific customer constituted a recommendation of that

investment. Under federal securities law, when acting as an underwriter, placement agent, or 2007

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.
477

(a) Background

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. 
478

 See 12/7/2006 email from Daniel Sparks to Tom Montag, “Subprime Volatility,” GS MBS-E-010931233. 

2009

 12/13/2006 Firmwide Risk Committee December 13 Minutes, GS MBS-E-009582963-64. 2010

 For more information about this December 14 meeting, see discussion in Section C(4)(b), above. 2011

(ii) Goldman’s Negative Market View

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- 2011

dollar net short positions in 2007, essentially betting that subprime mortgage related assets would

fall in value. 

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:
479

 2/8/2007 email from Daniel Sparks, “Post,” Hearing Exhibit 4/27-7. 2012

 2/14/2007 email from Daniel Sparks to himself, “Risk,” GS MBS-E-002203268. 2013

 2/21/2007 email exchange between Daniel Sparks and Jon Winkelried, “Mortgages today,” GS MBS-E- 2014

010381094, Hearing Exhibit 4/27-10.

 2/26/2007 emails between Tom Montag and Daniel Sparks, “Questions you had asked,” GS MBS-E-019164799. 2015

“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 GSissued 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 CoPresident 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 2

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
480

 3/3/2007 email from Daniel Sparks, “Call,” Hearing Exhibit 4/27-14. 2016

 3/12/2007 Goldman Firmwide Risk Committee, “March 7th FWR Minutes,” GS MBS-E-00221171, Hearing 2017

Exhibit 4/27-19; see also 3/7/2007 email from Daniel Sparks to himself, “Risk Comm,” GS MBS-E-002212223.

 3/8/2007 email from Daniel Sparks, “Mortgage risk,” Hearing Exhibit 4/27-75. 2018

 1/29/2007 email from Jon Egol to Fabrice Tourre, GS MBS-E-002620292. Mr. Tourre responded: “‘The 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-E003249991. 

 2/11/2007 email from Jon Egol, “Index Tranche Pricing Study - 08Feb07.xls,” GS MBS-E-002640951. See also 2020

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-E009685430 (“The housing slowdown has the risk now not be[ing] offsetting [sic] by stronger capital spending. Both

On March 3, 2007, Mr. Sparks made notes after a telephone call: “Things we need to do ....

Get out of everything.” On March 7, 2007, Mr. Sparks again reported to Goldman’s Firmwide 2016

Risk Committee on accelerating problems in the subprime mortgage market:

“– ‘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 2019

discussing plans to issue an Abacus CDO with a Correlation Desk Trader, Fabrice Tourre, Mr. Egol

repeated that assessment as his own:

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
481

growth and the market are DEAD if that’s the case.”) [emphasis in original]. 

 3/8/2007 email from Daniel Sparks, “Mortgage risk,” Hearing Exhibit 4/27-75. 2021

 See also emails expressing concerns about the CDO market in particular. 6/27/2007 email from Jonathan Sobel, 2022

“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.”). 

 See also Section C(4)(b) of this chapter, above. 2023

 12/14/2007 email from Kevin Gasvoda, “Retained bonds,” GS MBS-E-010935323, Hearing Exhibit 4/27-72. 

2024

See also 2/8/2007 email from Kevin Gasvoda to Tom Montag, “Mortgage risk – credit residential,” at 2, GS MBS-E010372233, Hearing Exhibit 4/27-74 (seven weeks later, Mr. Gasvoda reported transferring the remaining Goldmanoriginated RMBS securities to the mortgage trading desk to sell: “moving retained bonds out of primary desk hands

and into 2ndry desk.”). 

On March 8, 2007, in an email to senior management, Mr. Sparks listed a number of “large

risks I worry about.” At the top of the list was “CDO and Residential loan securitization 2021

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 Goldmanoriginated securitizations. By February 9, 2007, the Goldman sales force reported a substantial 2024
482

 2/9/2007 email exchange between Kevin Gasvoda and sales syndicate, “GS Syndicate RMBS Axes 2025

(INTERNAL),” GS MBS-E-010370495, Hearing Exhibit 4/27-73.

 2/23/2007 “Significant Cash Inventory Change (Q1’07 vs. Q4’06),” datasheet prepared by Goldman, GS MBS- 2026

E-010037311, Hearing Exhibit 4/27-12.

 See, e.g., 3/8/2007 email from Daniel Sparks, “Mortgage risk,” GS MBS-E-002206279, Hearing Exhibit 4/27- 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).

 2/8/2007 email from Kevin Gasvoda to Daniel Sparks, “Post,” GS MBS-E-002201668, Hearing Exhibit 4/27-7 2028

(“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. 2029

 Id. 2030

number of sales, and by the end of February, Goldman’s controllers reported that Goldman’s

2025

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. 

2026

In addition, during the first quarter of 2007, the Mortgage Department drastically slowed its

RMBS origination business and its purchase of whole loans and RMBS securities. Those actions 2027

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.

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. On February 9, 2007, Mr. Sparks reported a $30 million writedown on non 2028

performing loans. Mr. Ruzika responded: “Ok, you’ve been communicating the write down was

2029

coming. Let’s go through the residual risk and make sure we get to the correct number for the

quarter.” Residual risk referred to the non rated equity tranches that underwriters like Goldman 2030

often retained from the RMBS securitizations they originated; those tranches were also written
483

 2/13/2007 email from Richard Ruzika to Gary Cohn, “Catch Up,” GS MBS-E-019794071. Mr. Cohn forwarded 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 markeddown mortgage residuals).

 See Goldman Sachs response to Subcommittee QFR at PSI_QFR_GS0039. 2032

 Id. 2033

 Using loan data, the U.S. mortgage industry had developed anticipated default rates, including EPDs, for 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.

 See, e.g., 3/26/2007 “Subprime Mortgage Business,” Goldman presentation to Board of Directors, at 3-5, GS 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).

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. It also made about $40 million in repurchase 2032

claims for unsecuritized loans, and recovered about $17 million. 

2033

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

2034

subprime lenders began to experience financial distress due to unprecedented waves of repurchase

requests that drained their cashflows.2035

 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
484

 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).

 See, e.g., 1/8/2007 email from Daniel Sparks, “Color on the Sub Prime Market,” GS MBS-E-002195434 (after 2037

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).”).

 2/2/2007 email from Daniel Sparks to Messrs. Montag, Ruzika, and Viniar, GS MBS-E-002201050, Hearing 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). 

and did not attempt to identify and weed out all deficient mortgages. Instead, Goldman 2036

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 2037

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.

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
485

 2/27/2007 email from Christopher Gething, “Our Expansion,” GS MBS-E-010387242 (expansion of St. 2039

Petersburg office to accommodate staff for loan repurchase effort).

 See, e.g. 3/2007 Goldman email chain, “RE: NC Visit,” GS MBS-E-002048050 (mentioning four different third 2040

party “vendors” conducting loan reviews for the loan repurchase effort and stating: “We’re off to other vendors at

this point.”).

 See 3/9/2007 email from Kevin Gasvoda, “priorities,” GS MBS-E-002211055 (listing priority mortgage 2041

originators as Accredited, Fremont, New Century, and Novastar); 3/14/2007 Goldman email, “NC Visit,” GS MBSE-002048050 (identifying New Century, Fremont and Long Beach); 6/29/2007 email from Ed Chavez,

“Countrywide Investigation Review Update,” GS MBS-E-002134411.

 3/2/2007 email to Craig Broderick, “Audit Committee Package_Feb 21_Draft_Page.ppt,” GS MBS-E- 2042

009986805, Hearing Exhibit 4/27-63. 

 3/7/2007 email from Daniel Sparks, “Originator exposures,” GS MBS-E-002206279, Hearing Exhibit 4/27-75. 2043

 3/12/2007 email from Daniel Sparks, “Subprime Opportunities,” GS MBS-E-004641002. See also 4/15/2007 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). 

 3/13/2007 email from Manisha Nanik, “New Century EPDs,” GS MBS-E-002146861, Hearing Exhibit 4/27-77. 2045

The review of the New Century loan pool found:

“– 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

To manage its loan repurchase campaign, Goldman expanded an operations center in St.

Petersburg, Florida, and made extensive use of third party due diligence firms hired to review its 2039

securitized loan pools. Goldman instructed the firms to “re-underwrite” every loan in pools of 2040

mortgages purchased from specific lenders, including New Century, Fremont, Long Beach, and later

Countrywide. 

2041

By March 2007, the average EPD rate for subprime loans in Goldman’s inventory had

climbed from 1% of aggregate volume to 5%, a dramatic increase. On March 7, 2007, Mr. 2042

Sparks described Goldman’s exposure as follows:

“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
486

(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. 2046

 3/14/2007 Goldman email, “NC Visit,” GS-MBS-E-002048050. See also 3/21/2007 email from Daniel Sparks 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). 

 See Goldman Sachs response to Subcommittee QFR at PSI_QFR_GS0040. 2048

 3/14/2007 Goldman email, “NC Visit,” GS-MBS-E-002048050. See also 8/10/2007 email from Michelle Gill,

2049

“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).

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. In March 2007, however, New Century stopped paying Goldman’s claims due 2046

to insufficient cash, and the loan repurchase team sought advice from Mr. Gasvoda:

“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. nd

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 2048

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 2049
487

 6/29/2007 email from Ed Chavez, “Countrywide Investigation Review Update,” GS MBS-E-002134411. 2050

 See Goldman Sachs response to Subcommittee QFR at PSI_QFR_GS0040. The five mortgage originators to 2051

which Goldman directed the most repurchase requests were First Franklin, New Century, Fremont, Greenpoint, and

Long Beach. Id.

 2/15/2007 email from Loren Morris of Goldman Sachs to David Schneider of WaMu and others, GS MBS-E- 2052

002142424, Hearing Exhibit 4/13-69b.

 See, e.g., Goldman response to Subcommittee QFR at PSI_QFR_GS0040; 3/8/2007 email from Daniel Sparks to 2053

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.”).

 New Century, for example, declared bankruptcy in April 2007. In re New Century TRS Holdings, Inc., Case 2054

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.

 See, e.g., 1/3/2011 Bank of America press release, “Bank of America Announces Fourth-Quarter Actions,” 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).

 See 2/2/2007 Goldman memorandum to the Mortgage Capital Committee, “Agenda for Monday, February 5, 2056

2007,” GS MBS-E-002201064; 2/5/2007 Mortgage Capital Committee Memorandum regarding GSAMP Trust

2007-FM2, GS MBS-E-002201055-58.

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

Goldman made a total of about $34 million in repurchase requests to Long Beach, a

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. Goldman pressed both Long Beach and its parent Washington 2051

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’s loan repurchase campaign recovered substantial funds from some lenders,

2053

but little or none from others. Non performing loans that were not repurchased by the lender 2054

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

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
488

 See discussion of Goldman’s loan repurchase effort, above. In addition, in the prior month, a Goldman 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.

 In re Fremont Investment & Loan, Docket No. FDIC-07-035b, Order to Cease and Desist (March 7, 2007). 2058

 See Standard & Poor’s 2059 www.globalcreditportal.com. 

 3/23/2007 Goldman memorandum to members of the Mortgage Capital Committee, “Agenda for Monday, 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.”).

 See discussion of Goldman’s loan repurchase effort, above. Earlier in March, a Goldman review of a different 2061

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.

 In re New Century TRS Holdings, Inc., Case No. 07-10416 (KJC) (US Bankruptcy Court, District of Delaware). 2062

 See Standard & Poor’s 2063 www.globalcreditportal.com. 

millions of dollars in deficient loans to the lender, and regulators ordered Fremont to stop issuing 2057

subprime loans. Goldman marketed and sold the RMBS securities to clients. Within seven 2058

months, by October 2007, the rating downgrades began; by August 2009, every tranche of the

GSAMP securities had been downgraded to junk status.

2059

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. Goldman approved this 2060

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 securitization was approved for issuance in April 2007, 2061

the same month New Century declared bankruptcy. Goldman marketed and sold the RMBS 2062

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

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:
489

 4/11/2007 email to Jon Egol, “GSAMP 2006-S3 – Computational Materials for Wachovia (external),” GS MBS- 2064

E-003322028 [emphasis in original].

“ 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
490

 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.

 4/2010 “Goldman Sachs Long Cash Subprime Mortgage Exposure, Investments in Subprime Mortgage Loans, 2066

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. 

$2.4 billion, a two-thirds reduction. The graph below, which was prepared by the Subcommittee 2065

using the data provided by Goldman to the SEC, illustrates the rapid decline in Goldman’s subprime

holdings.2066

[SEE CHART NEXT PAGE: Goldman Sachs Long Cash Subprime

Mortgage Exposure, prepared by the Permanent Subcommittee on

Investigations, Hearing Exhibit 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

7.815

8

10121416

Investments

Mortgage Lo

Investments

Mortgage Ba

Long Cash SuExposure (To

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 (E

0.462

7.2

2.4

2.862

0246

Exposure (To

Securities)
492

 1/31/2007 email from Daniel Sparks to Tom Montag, “MTModel,” Hearing Exhibit 4/27-91. 2067

 See, e.g., 2/25/2007 emails between Daniel Sparks and Tom Montag, “Questions you had asked,” GS MBS-E- 2068

019164799. 

 See 2/23/2007 email from Daniel Sparks, “Mortgages today,” GS MBS-E-009759477 (“We liquidated 3 CDO 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.”).

 2/25/2007 emails between Daniel Sparks and Tom Montag, “Questions you had asked,” GS MBS-E-019164799. 2070

 See, e.g., 3/8/2007 email from Daniel Sparks to Mr. Winkelried and others, GS MBS-E-002206279, Hearing 2071

Exhibit 4/27-75 (Mortgage Department is “rushing to get deals rated”). See also discussions of Anderson and

Timberwolf CDOs, below. 

 See 6/1/2007 email from David Lehman, “CDO Update,” GS MBS-E-001866889 (referring to “liquidated 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. 

 6/22/2007 email from David Lehman, “Few trade posts,” GS MBS-E-010848985. 

2073

BB. CDO Sell Off 

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

origination pipeline. As part of that review, Mr. Sparks cancelled four pending CDOs that had 2068

acquired some but not all of the assets needed for the CDOs to go to market. On February 25, 2069

2007, Mr. Sparks reported to Mr. Montag and Mr. Ruzika:

“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,

Timberwolf, and Point Pleasant, which issued their securities in March and April 2007. In May 2071

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. On June 22, 2007, Mr. 2072

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, 1⁄2 of which is Long Beach paper - continue to work.”2073
493

 Between the fall of 2006 and mid-2007, Goldman originated 14 CDOs, which included or referenced many 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. 

 3/9/2007 email exchange between Daniel Sparks and sales managers, “help,” GS MBS-E-010643213, Hearing 2075

Exhibit 4/27-76.

 Id. 2076

 Id. 2077

 Id. 2078

 3/12/2007 email from David Lehman, “**Internal** Three focus axes for SP CDOs/SPG Trading,” GS MBS-E- 2079

021895601. 

 Id. 2080

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

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 2075

dialogue about “reaching the next wave of players here and abroad.” 

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.” The following week, Mr. Lehman issued three new sales directives or “axes” to the 2078

Goldman sales force placing a priority on selling securities from the Anderson, Timberwolf, and

Hudson CDOs: 

2079

“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
494

 3/21/2007 email from syndicate, “Non-traditional Buyer Base for CDO AXES,” GS MBS-E-003296460, 2081

Hearing Exhibit 4/27-78.

 3/30/2007 email from Fabrice Tourre to Daniel Sparks, David Lehman, and others, GS MBS-E-002678071, 2082

Hearing Exhibit 4/27-80.

 4/11/2007 email from syndicate, “GS Syndicate Structured Product CDO Axes (INTERNAL),” GS MBS-E- 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.” 

 4/19/2007 email from Daniel Sparks to Bunty Bohra, GS MBS-E-010539324, Hearing Exhibit 4/27-102. Mr. 2084

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?”).

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: 

“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. Dissatisfied with the pace of 2083

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 2084

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.”

“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
495

 See, e.g., 5/11/2007 email from Tom Montag to Daniel Sparks, GS MBS-E-019648100. 

2085

 5/11/2007 email from Daniel Sparks to Richard Ruzika, “You okay?,” GS MBS-E-019659221. 2086

 Id. (“We had a meeting today with viniar, don [Mullen], mcmahon, my team, controllers, gary [Cohn] on the 2087

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). 

 5/14/2007 email from David Lehman, “Gameplan – asset model analysis,” GS MBS-E-001865782 (last email in 2088

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).

 5/14/2007 email from Tom Montag to Daniel Sparks, GS MBS-E-019642797. 

2089

 5/20/2007 email from Lee Alexander to Daniel Sparks, Donald Mullen, Lester Brafman, and Michael Kaprelian, 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-Evalue of its CDO holdings. Goldman needed accurate values, not just to establish its CDO sales

2085

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. The Gameplan called for the Mortgage Department, 2087

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. 

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
496

010787603. 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

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. 

 The writedowns were required, in part, because the assets in the CDO warehouses had generally been marked at

2091

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. 

 Id. 2092

 5/20/2007 email from Lee Alexander to Daniel Sparks, Donald Mullen, Lester Brafman, Michael Kaprelian, 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.

 Id. The four identified customers appear to be ones which the sales force felt it had the greatest likelihood of 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. 

 The client list drawn up pursuant to the Gameplan was a stark example of actions taken by Goldman to target 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-Epresentation 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 2091

expressed concern about Goldman-originated CDO securities, especially its two CDO transactions,

2

Timberwolf and Point Pleasant, since “[t]he complex structure of these positions makes them

difficult to value and distribute.” The presentation estimated that the market value of those CDO 2092

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.”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 2094

attached a list of 35 other target customers with notes regarding the status of efforts to sell them

CDO securities in the past.2095
497

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 $$$, vs. buy-and-hold ratingbased buyers who we should be focused on a lot more to make incremental $$$ 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.

 5/19/2007 Goldman presentation, “Mortgages CDO Origination – Retained Positions & Warehouse Collateral, 2096

May 2007,” GS MBS-E-010951926.

 5/19/2007 email from Daniel Sparks, “Mortgages CDO Origination Presentation,” GS MBS-E-010973174 (Mr. 2097

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]”).

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”: 2

“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,

but did not change the phrase, “the desk expects it to underperform.” The same phrase appeared 2097
498

 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-E010952331; 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).

 5/17/2007 email from Daniel Sparks to Tom Montag, “Ostrem is resigning,” GS MBS-E-019654926. 2099

 5/11/2007 email from Daniel Sparks, “You okay?,” GS MBS-E-019659221 (“I’m going to make a change in the 2100

responsibility of the business away from Ostrem to david lehman (with Swenson helping).”). 

 5/19/2007 email to David Lehman, “congratulations, but seems like you have a lot of work ahead of you,” GS 2101

MBS-E-018921924.

 Id. 2102

 5/19/2007 email from Jon Egol to Daniel Sparks, GS MBS-E-018921924. 

2103

in several earlier versions of the presentation as well, but was removed from the final version sent to

Mr. Viniar. 

2098

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. Mr. Sparks named as his 2099

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.” Mr. Lehman 2101

asked Mr. Egol: “What do u th[in]k he means by ‘lot of work to do?’” Mr. Egol responded: 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.
499

 5/20/2007 email from David Lehman, “ABX hedges – Buy order,” GS MBS-E-011106690 (“begin unwinding 2104

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”).

 Subcommittee interview of David Lehman (9/27/2010). 2105

 5/24/2007 email from Yusuf Aliredha to Mr. Sparks, Mr. Lehman, and others, “Priority Axes,” GS MBS-E- 2106

001934732. 

 Id. 2107

 4/27/2007 email from George Maltezos, Goldman Australia sales, to Jon Egol, “utopia,” GS MBS-E- 2108

003305101. 

 5/20/2007 email from George Maltezos to David Lehman, “T/wolf and Basis,” GS MBS-E-001863555. 2109

 See Goldman Sachs response to Subcommittee QFR at PSI_QFR_GS0226. 

2110

 5/30/2007 email from David Lehman, “Timberwolf – Order from Tokyo Star Bank,” GS MBS-E-001934058. 

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.

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 2104

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 2105

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. 

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 2106

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

A couple of weeks before the CDO valuation project, Goldman’s Australia sales

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 2108

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.

investment adviser, purchased $40 million in AA Timberwolf securities. On May 30, Mr. 2110

Lehman announced the sale of $20 million in AAA Timberwolf securities to Tokyo Star Bank in

Japan. 

2111
500

 6/11/2007 email from syndicate, “GS Syndicate Structured Product CDO Axes (INTERNAL USE ONLY),” GS 2112

MBS-E-001914921-24.

 Id. 2113

 Id. See also “New Investors Board the Asian CDO Train,” Creditflux (6/1/2007) (noting that while non bank 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).

 6/13/2007 email from Goldman Sachs Japan sales, “**GS SP CDO Axes** – Asia Trade Update (INTERNAL 2115

USE ONLY),” GS MBS-E-010803888 [emphasis in original].

 6/13/2007 email from Goldman Sachs Japan sales, “**GS SP CDO Axes** – Asia Trade Update (INTERNAL 2116

USE ONLY),” GS MBS-E-011212260. 

 6/18/2007 email from David Lehman, “$20mm Point Pleasant trade w/ TK Star Bank,” GS MBS-E-011136832. 2117

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 2113

Japan sales then.”2114

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
501

 Id. 2118

 6/18/2007 email from Goldman Sachs Japan sales, “Point Pleasant 07-A1 // Tokyo Star Bank (internal use 2119

only),” GS MBS-E-001920459 [emphasis in original].

 See Goldman Sachs response to Subcommittee QFR at PSI_QFR_GS0226; 7/24/2007 email from [Taiwan], 2120

“7/23 CDO/RMBS requests from Taiwan,” GS MBS-E-011198375, Hearing Exhibit 4/27-67.

 Id. 2121

 8/15/2007 email from Donald Mullen, “Post,” GS MBS-E-009740784, Hearing Exhibit 4/27-32. 

2122

 8/17/2007 email from Michael Swenson, “Twolf super seniors,” GS MBS-E-001927791. 2123

 8/23/2007 email from Jon Egol, “*** SP CDO/Correlation Desk Super Senior Axes *** (INTERNAL USE 2124

ONLY), GS MBS-E-011310717. 

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.” That same day, the 2118

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:

“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

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 2122

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 2123

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 2124

his opinion of the directive, the head of Japan sales office expressed skepticism about sales to Asian

customers: 

“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
502

 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.

 9/5/2007 email from Michael Swenson, “Refresh of Axe Priorities,” GS MBS-E-010684858. 2126

 Id. 2127

 Id. 2128

 9/6/2007 email from Daniel Sparks to syndicate desk, “Refresh of Axes Priorities,” GS MBS-E-010685200. 2129

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

Desk issued a “Refresh of Axe Priorities” to its entire sales force. The directive placed a priority 2126

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:

“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, 2128

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

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
503

 3/1/2010 letter from Goldman Sachs to the Financial Crisis Inquiry Commission, GS-PSI-01310 at 16. 2130

 4/19/2007 email from Daniel Sparks, “*UPDATE* GS Syndicate Structured Product CDO Axes,” GS MBS-E- 2131

010539324, Hearing Exhibit 4/27-102.

 Subcommittee interview of David Viniar (4/13/2010) and Craig Broderick (4/9/2010). 2132

 See, e.g., 2/2007 Goldman email chain, “FYIs,” GS MBS-E-002339552 (regarding residential credit scratch & 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”).

 See, e.g., 2/12/2007 email from Daniel Sparks, “Post today,” GS MBS-E-009763506 (New Century “claim[s] 2134

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.”). 

 Subcommittee interview of David Lehman (4/12/2010). 2135

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 2131

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.

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. In practice, many of its mortgage 2132

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 2133

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 2134

of any asset held longer than a specified period of time, in order to encourage its trading desks to

sell their aged assets. 

2135
504

 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 BashPolley, “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-E009763506 (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-E009882064.

 See, e.g., 8/10/2007 Goldman memorandum, “Summary of German Bank US Sub Prime Exposure,” GS 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). 

During 2007, Goldman’s markdowns of the value of its CDO securities became a source of

dispute with its customers. Some clients were negatively affected in a variety of ways when 2136

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.
505

 5/11/2007 email from Craig Broderick, “CDOs - Mortgages,” Hearing Exhibit 4/27-84. 

2138

 Id. The reference to the “30th floor” was the floor on which Goldman’s most senior executives had office space 2139

in its New York headquarters.

 5/11/2007 email from Harvey Schwartz to Daniel Sparks, Tom Montag, and others, GS MBS-E-010780864. As 2140

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.

 5/11/2007 chain of email exchanges among Messrs. Mullen, Schwartz, Montag, and Sparks, GS-MBS-E- 2141

010780849, Hearing Exhibit 4/27-103. 

 Id. 2142

 See, e.g., discussion of Timberwolf CDO, below. 2143

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.” Later that day, in an 2140

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, 2141

not to “slow or delay” efforts to sell the CDO securities, if the sales force received “strong bids.”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
506

 See Section (3)(a), above. 2144

 4/2010 “Goldman Sachs Mortgage Department Total Net Short Position, February - December 2007 in $ 2145

Billions (including All Synthetic and Cash Positions in Mortgage Related Products),” Hearing Exhibit 4/27-162.

 See 7/25/2007 email from Arbind Jha to Kevin Kao, “Cash bonds,” GS MBS-E-011128623 (“huge changes in 2146

marks today”).

 7/29/2007 email from Daniel Sparks to Tom Montag, “Problem,” GS MBS-E-010876595 (“[w]e probably 2147

should have taken more time to put through the CDO monster remark”). 

 7/29/2007 email from Daniel Sparks to Mr. Mullen, “Problem,” GS MBS-E-010876565. 2148

 7/29/2007 email from Daniel Sparks to Tom Montag, “Problem,” GS MBS-E-010876595 (“we rushed it because 2149

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.”).

 See 7/31/2007 email chain between Tom Montag and Lloyd Blankfein, “Mortgage Derivative Collateral 2150

Disputes – 7/31 Update (COB 7/27 marks),” GS MBS-E-009691545.

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, which Mr. Sparks called “the CDO 2146

monster remark.” In an email to Mr. Mullen, Mr. Sparks wrote: “We made massive mark 2147

adjustments this week, pushed them through because of basis and counterparty exposure.” In a 2148

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

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
507

 Id. 2151

 Id. By late August, Goldman had instituted a system that required senior management pre-approval for large 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. 

 Id. 2153

 8/16/2007 email from Daniel Sparks, “Mort P&L explanation,” GS MBS-E-010680327. Since Goldman took 2154

the entire net short side in many of its Abacus CDOs, the customers’ losses translated directly into gains for

Goldman.

 Id. The Correlation Trading Desk reported $145 million in total profits, which were then offset by losses on 2155

other mortgage desks. 

 8/16/2007 email from Jon Egol to Michael Swenson, “Projected Corr Customers winners/losers from single- 2156

name mark changes,” GS MBS-E-011092473, Hearing Exhibit 4/27-33.

Stanley, and Deutsche Bank, among others. It stated: “The overall derivative collateral dispute

amount is now $7.0 billion.” The email also noted that the total in dispute from the prior week 2151

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!!!” 

2152

Mr. Blankfein responded: “Make sure they prioritize weaker credits where our risk is

threatening.” In other words, Mr. Blankfein directed Goldman personnel to focus on disputes 2153

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. The Mortgage 2154

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

observability better recently, rest is from outright shorts.” Also on August 16, 2007, Mr. Egol 2155

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.” 

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
508

 See, e.g., 5/11/2007 email from Craig Broderick, “CDOs - Mortgages,” GS MBS-E-009976918, Hearing Exhibit 2157

4/27-84; see also 8/10/2007 Goldman internal memorandum, “Summary of German Bank US Sub Prime Exposure,”

GS MBS-E-009994305.

 10/12/2007 email to Daniel Sparks, “US ABS SS Intermediation Trades,” GS MBS-E-013706095, Hearing 2158

Exhibit 4/27-70. 

 Id. 2159

 7/24/2007 email from [Taiwan], “7/23 CDO/RMBS requests from Taiwan,” GS MBS-E-011198375, Hearing 2160

Exhibit 4/27-67. 

 8/2/2007 email from Stacy Bash-Polley to Messrs. Montag, Mullen, Schwartz, and Sparks, “Marks Summary,” 2161

GS MBS-E-013349723.

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 2161

summary of client concerns included the following:
509

 Id. 2162

 6/21/2007 email from Mr. Sparks to Lester Brafman, “Repo,” GS MBS-E-010847490. 2163

 The Subcommittee did identify at least one instance of a mark change. Goldman’s China sales representative 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-E011068490. Mr. Chin moved the mark in question from 95 to 98, and wrote: 

“–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.” Mortgage Department personnel dismissed such criticisms out of hand. One 2163

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.”

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
510

“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.

 8/6/2007 email from David Lehman to Japan sales, “RE: Tokyo Star,” GS MBS-E-001927891. 2165

 Id.

2166

 6/6/2007 email from David Lehman to Japan sales, “Point Pleasant Marks – request from Tokyo Star Bank,” GS 2167

MBS-E-001912408-10 at 9.

 9/26/2007 Goldman Sachs 2007 Performance Review for Michael Swenson, “Reviewee’s Feedback,” GS-PSI- 2168

02399, Hearing Exhibit 4/27-55b.

 11/20/2007 email from Thomson IFR - ABS, “ABS: Market Tense as Goldman Predicts RMBS CDO Problems 2169

to Drag On,” GS MBS-E-013782989.

 Id. 2170

 Id. 2171

 See 9/17/2007 Goldman presentation to Board of Directors, “Residential Mortgage Business, Global Impact of 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,”

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 2165

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 2166

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.’” In his 2007 2167

performance self-evaluation, the head of the SPG Trading Desk, Michael Swenson, wrote:

“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

In November 2007, Goldman analysts issued a research report to clients about the crisis in

the mortgage market. Goldman predicted that the mortgage market crisis was likely to continue 2169

and would have serious implications for a significant number of financial institutions: “Writedowns and losses will continue to mount .... [M]anagements will need to repair some seriously

damaged balance sheets.” Goldman estimated that industry-wide losses reflecting markdowns in 2170

subprime mortgage CDOs would approach $150 billion, of which about $40 billion would be taken

in the third and fourth quarters of 2007. 

2171

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
511

GS MBS-E-013746511 (discussing “what would happen upon an ACA bankruptcy (which is the most likely scenario

in our opinion).”).

 See 6/21/2007 email from Fabrice Tourre, “Post on ACA,” GS MBS-E-002562148. See also ACA Financial 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.

 April 27, 2010 Subcommittee Hearing at 66. 2174

 Id. 2175

 Id. 2176

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 Goldmanoriginated 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

2174

some things happening,” and that Goldman itself was betting against the mortgage market. 2175

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?” Senator Tester and Mr. Sparks then 2176

had the following exchange: 

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?
512

 Id. Mr. Sparks went on to say: “I mentioned we made some bad business decisions. These deals performed 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. 

 See 5/19/2007 draft Goldman presentation, “Mortgages CDO Origination – Retained Positions & Warehouse 2178

Collateral, May 2007,” GS MBS-E-010951926. 

 2/8/2007 email from Mr. Sparks, “Post,” Hearing Exhibit 4/27-7. 

2179

 3/3/2007 email from Mr. Sparks, “Call,” Hearing Exhibit 4/27-14. 

2180

 3/8/2007 email from Mr. Sparks, “Mortgage risk,” Hearing Exhibit 4/27-75. 

2181

 3/12/2007 Goldman memorandum to Firmwide Risk Committee, “March 7th FWR Minutes,” GS MBS-E- 2182

00221171, Hearing Exhibit 4/27-19.

 2/21/2007 email from Daniel Sparks to Jon Winkelried, “Mortgages today,” GS MBS-E-010381094, Hearing 2183

Exhibit 4/27-10.

 April 27, 2010 Subcommittee Hearing at 66. The Anderson, Timberwolf, and Abacus 2007-AC1 CDOs were 2184

issued in March and April 2007. 

 4/27/2007 email from Deeb Salem to Michael Swenson, GS MBS-E-012432706 (6 of 20 deals in ABX Index 2185

put on watch or downgraded). 

 7/10/2007 email to George Maltezos, “GS Cashflow/ABACUS CDOs Mentioned in S&P Report on CDO 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%).

 Id. 2187

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 2178

the CDO market at the time, including emails in which Mr. Sparks described the subprime market

as “bad and getting worse,” and directed Goldman’s mortgage traders to “get out of 2179

everything,” and “stay on the short side.” He wrote, among other things: “Game over,” 2180 2181 2182

“bad news everywhere,” and “the business is totally dead.” As Senator Tester noted, many of 2183

Mr. Sparks’s dire predictions were made before three of the four CDOs discussed at the hearing

were even offered to customers.

2184

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

2185

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. For example, when Moody’s and 2186

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. Ultimately, all of the CDOs discussed at

2187

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: 
513

 10/26/2007 email from Goldman salesman to Michael Swenson, “ABACUS 2007-AC1 – Marketing Points 2188

(INTERNAL ONLY) [T-Mail],” GS MBS-E-016034495. 

 See “List of WaMu-Goldman Loans Sales and Securitizations,” Hearing Exhibit 4/13-47b. 2189

 2/13/2006 Goldman chart, “Current Warehouse Facilities and Funded Balances,” GS MBS-E-001157934. 

2190

 See Chapters III and IV, above. 2191

“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 2189

Beach had a $2 billion warehouse account with Goldman, which was the largest of Goldman’s

warehouse accounts at that time. 

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. Similar EPD problems 2191

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
514

 See, e.g., 4/14/2005 OTS email, “Fitch,” OTSWME05-012 0000806, Hearing Exhibit 4/13-8a. 2192

 2/8/2007 email from Goldman analyst to Mr. Sparks, Mr. Gasvoda, and others, “2006 Subprime 2nds Deals 2193

Continue to Underperform **INTERNAL ONLY**,” GS MBS-E-003775340, Hearing Exhibit 4/27-167d.

 5/17/2007 email from Deeb Salem to Michael Swenson, “FW: LBML 06A,” GS MBS-E-012550973, Hearing 2194

Exhibit 4/27-65.

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 2193

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. 

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.
515

 See 2195 wamusecurities.com. 

 For more information about Fremont, see Chapter IV, Section D(2)(d). 2196

 3/7/2007 Fremont General Corporation 8-K filing with the SEC. 2197

 11/16/2006 Goldman internal email, “ACA and Freemont [sic] deal,” Hearing Exhibit 4/27-173. 

2198

 3/14/2007 Goldman email, “NC Visit,” GS-MBS-E-002048050. 

2199

 Id.; see also 8/10/2007 email from Michelle Gill, “Fremont - Incremental Information,” GS MBS-E-009860358 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).

 See Goldman Sachs response to Subcommittee QFR at PSI_QFR_GS0040. 2201

 2/20/2007 Goldman memorandum to Mortgage Capital Committee, “Request for renewal of the existing $1 2202

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.”

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

Fremont RMBS. The second example involves Fremont Loan & Investment, another

subprime lender notorious for issuing poor quality loans. In March 2007, Fremont reported in an 2196

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

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.” One loan pool review 2199

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. Goldman eventually made about $46 million in repurchase requests to Fremont, which 2200

was one of the top five mortgage originators from whom Goldman made repurchase requests in

2006 and 2007.2201

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. In March 2007, at the same time it was sending millions of dollars in loan repurchase 2202

requests to Fremont, Goldman securitized over $1 billion in Fremont subprime loans in one of its
516

 See 2/2/2007 Goldman memorandum to the Mortgage Capital Committee, “Agenda for Monday, February 5, 2203

2007,” GS MBS-E-002201064; 2/5/2007 Mortgage Capital Committee Memorandum regarding GSAMP Trust

2007-FM2, GS MBS-E-002201055 - 58.

 1/24/2007 S&P internal email, “Quick Question: Fremont,” Hearing Exhibit 4/23-93b. See also 2/1/2007 S&P 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).

 1/24/2007 S&P internal email, “RE: Quick Question: Fremont,” Hearing Exhibit 4/23-93c. 2205

 4/17/2010 S&P downgrade of GSAMP Trust 2007-FM2 containing Fremont mortgages, Hearing Exhibit 4/23- 2206

93f.

 See 3/21/2007 Goldman spreadsheet, “RMBS CDS Trade History 19Jan06 - 19Mar07 v3,” GS MBS-E- 2207

013648130.

 See Standard & Poor’s 2208 www.globalcreditportal.com. 

 In some cases, Goldman used assets from its own inventory or warehouse accounts, so that it could transfer 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.

warehouse accounts, originating GSAMP Trust 2007-FM2. At Goldman’s request, Moody’s and 2203

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 2204

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.” Both 2205

agencies gave AAA ratings to the top five tranches of the securitization. 

2206

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. Seven months later, by October 2007, the ratings downgrades had begun; by August

2207

2009, every tranche in the GSAMP securitization had been downgraded to junk status.

2208

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 2209

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
517

 Mezzanine subprime RMBS assets are RMBS securities that carry a credit rating of BBB or BBB- or CDS 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.

 The ABX Index tracks the performance of a designated basket of 20 subprime RMBS securitizations. It consists 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.

 10/2006 Goldman document, “Hudson Mezzanine Funding 2006-1, Ltd.,” Hearing Exhibit 4/27-87. The first 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. 

 Id. For more information about Goldman’s role as the liquidation agent in Hudson, see Section C(5)(b)(iii)AA, 2213

below.

 In synthetic CDOs, the cash proceeds from the sales of the CDO securities were used to purchase “collateral 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.

 See 2/18/2008 Goldman document, “CDO Transactions (July 1, 2006 - December 31, 2007) in which Goldman 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.

their assets; marketed and sold the CDO securities; designated the value of the CDO securities preand 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

referenced mezzanine subprime RMBS assets and assets linked to the ABX Index. This CDO 2210 2211

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

2212

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 2213

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, senior swap

2214

counterparty, and credit protection buyer. In Hudson 1, Goldman took 100% of the short side of 2215

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.
518

 See Goldman response to Subcommittee QFR at PSI_QFR_GS0239. 2216

 9/20/2006 email from Arbind Jha to Josh Birnbaum, GS MBS-E-012685289. See also 9/20/2006 Firmwide 2217

Risk Committee Minutes, GS MBS 0000004472.

 See 10/24/2006 email from Jonathan Sobel to Tom Montag, Dan Sparks, and others, GS MBS-E-010919930 2218

(“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.”). 

 Subcommittee interview of Michael Swenson (4/16/2010). Mr. Swenson told the Subcommittee that Goldman 2219

had been long “several billion” in ABX in September 2006. 

 8/9/2006 Firmwide Risk Committee Minutes, GS MBS-E-009682590; Subcommittee interview of Joshua 2220

Birnbaum (10/1/2010). Mr. Birnbaum recalled a “directive” to reduce ABX exposure in the summer of 2006. 

 See, e.g., 9/21/2006 email from Jonathan Sobel to Tom Montag, “ABX wider again today,” GS MBS-E- 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.”).

 9/19/2006 email from Jonathan Sobel to Daniel Sparks, Michael Swenson, and Josh Birnbaum, GS MBS-E- 2222

012683946. 

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 2216

Risk Committee meetings also stated that Hudson 1 was an “exit for our long ABX risk.”2217

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

Conceiving Hudson 1. In the months leading up to the creation of Hudson 1, Goldman had

accumulated billions of dollars in ABX assets referencing mezzanine subprime RMBS securities.2219

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. After several 2220

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. 

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. Mr. 2222

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
519

 9/19/2006 email from Josh Birnbaum to Michael Swenson, GS MBS-E-012683946. Mr. Sobel also informed 2223

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. 

 Subcommittee interview of Peter Ostrem (10/5/2010). 2224

 Id.; Subcommittee interview of Darryl Herrick (10/13/2010). 2225

 9/19/2006 calendar invite from Michael Swenson, GS MBS-E-012328194. 2226

 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.

 9/20/2006 email from Michael Swenson to Jonathan Sobel, GS MBS-E-012328203. See discussion of selection 2228

of 60 single names by Mr. Herrick and Mr. Salem, below. 

 9/20/2006 Firmwide Risk Committee Minutes, GS MBS 0000004472; 9/20/2006 email from Arbind Jha to Josh 2229

Birnbaum, GS MBS-E-012685289.

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.” After the meeting, around 8:00 p.m., Mr. Ostrem sent his CDO team an email 2226

announcing “Hudson Mezz - new”: 

“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

2229

Goldman senior executive Thomas Montag, discussing the Mortgage Department’s ABX losses and
520

 9/21/2006 email from Jonathan Sobel to Tom Montag, GS MBS-E-009739145. 

2230

 See, e.g., 10/16/2006 email from John Li to Darryl Herrick, “Call Arbind Jha,” GS MBS-E-018209595 2231

(“Regarding Hudson Mezz Risk issue”).

 9/20/2006 email from Arbind Jha to Josh Birnbaum, GS MBS-E-012685289. When asked about this email and 2232

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).

 10/12/2006 email from Arbind Jha, “Re: Risk Issue,” Hearing Exhibit 4/27-88. 2233

 9/20/2006 Firmwide Risk Committee Minutes, GS MBS 0000004472. 2234

 See, e.g., 3/23/2007 “CDO Rating Factors: Inclusion of Tranched ABX Indices in ABS CDOs,” Moody’s, 2235

Document No. SF95049. 

 The ABX 06-1 Index and the ABX 06-2 Index each tracked a completely different set of 20 RMBS 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

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

A Goldman risk officer, Arbind Jha, began contacting Goldman mortgage traders and CDO

personnel for regular Hudson updates. In fact, the day after the ABS and CDO teams came up 2231

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.” On another occasion, Mr. Jha asked

2232

Darryl Herrick: 

“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. Prior to that, the major 2234

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. CDS that used an ABX index as 2235

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.

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
521

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. 

 A “single name CDS” contract uses a single security as its reference obligation, such as a specific RMBS 2237

security.

 For simplicity, all 20 assets in each of the ABX baskets were given the same weighted price in Hudson 1. 

2238

 See, e.g., 4/27/2007 email from Fabrice Tourre to Michael Swenson, Deeb Salem, and Edwin Chin, GS MBS-E- 2239

012432742. 

 Mr. Swenson described this situation in his testimony before the Subcommittee: “Throughout 2006, numerous 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.

 Goldman decided to price the single name assets at one point below the median ABX trading price. See 2241

9/21/2006 email from Darryl Herrick to Deeb Salem, Michael Swenson, Joshua Birnbaum, Peter Ostrem, and Edwin

Chin, GS MBS-E-012685645.

contracts, each of which used as its reference obligation one of the subprime mezzanine RMBS

securities tracked by the ABX indices. Goldman’s ABS Desk took the short position in each of 2237

those 80 contracts, while Goldman’s CDO Origination Desk took the long position. By taking 2238

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. By 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.

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. In 2006, at the time Hudson was being constructed, the 2240

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 2241

Hudson to purchase the single name CDS contracts at the lower ABX prices, which meant it could
522

 See 10/2/2006 email from Darryl Herrick to Michael Swenson, Joshua Birnbaum, Deeb Salem, Peter Ostrem, 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. 

 The gain generated by the CDS single name contracts was retained on the books of the ABS Desk, and created a

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.”).

 Subcommittee interview of Darryl Herrick (10/13/2010). See also 10/8/2006 email from Darryl Herrick to a 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.”).

 See 9/19/2006 email from Darryl Herrick to Deeb Salem, Peter Osterm, others, GS MBS-E-011402123, with 2245

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

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

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
523

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). 

 See, e.g., Goldman response to Subcommittee QFR, PSI_QFR_GS0192. 2246

 Goldman used the cash paid into Hudson 1 to purchase “collateral securities,” as discussed further below. 2247

 See 10/30/2006 email from Peter Ostrem, GS MBS-E-0000057886, Hearing Exhibit 4/27-90 (“Super senior note 2248

($1.2bln in size) was executed in the first week of the transaction and was a key driver of this deal[’]s success.”). 

 The $1.2 billion investment made by Morgan Stanley did not correspond to the CDO’s $1.2 billion in CDS 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.

 Subcommittee interview of Darryl Herrick (10/13/2010). See further discussion of Morgan Stanley investment 2250

in Section C(5)(b)(iii)AA, below. 

 9/27/2006 email from Michael Swenson to Crystal Young, GS MBS-E-012328848. Mr. Swenson told the 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). 

 9/28/2006 email from Darryl Herrick, GS MBS-E-014042217, with attachments GS MBS-E-014042218 and GS 2252

MBS-E-014042220. 

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. Because Hudson 1 contained only CDS contracts, it was entirely “synthetic”; it 2246

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 2248

the $2 billion CDO, while Goldman took the short side. As part of its agreement to invest in

2249

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

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.” The invitees included Daniel Sparks, Jon Sobel, 2251

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.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
524

 9/30/2006 email from Darryl Herrick to Peter Ostrem, Benjamin Case, and Matthew Bieber, GS MBS-E- 2253

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.

 10/2006 Hudson Mezzanine Funding 2006-1, LTD., GS MBS-E-009546963, at 966, Hearing Exhibit 4/27-87. 

2254

 Id. at 966, 978. 2255

the CDO Origination Desk including Benjamin Case and Matthew Bieber. The executive 2253

summary of the marketing booklet described Goldman’s Hudson CDO program generally and

Hudson 1 in particular:

“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
525

 See Goldman response to Subcommittee QFR, at PSI_QFR_GS0223. 2256

 Barron’s Dictionary of Finance and Investment Terms defines “the Street” as “referring to the financial 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.” 

 Subcommittee interview of Andrew Davilman (9/30/2010). 2258

 Subcommittee interview of Morgan Stanley (6/24/2010). 2259

 The Subcommittee asked Mr. Ostrem whether he considered the Hudson 1 assets to be the RMBS securities or 2260

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).

 Subcommittee interview of Deeb Salem (10/6/2010). 2261

 Subcommittee interview of David Lehman (9/27/2010); Subcommittee interview of Matthew Bieber 2262

(10/21/2010).

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. However, that $6 million equity 2256

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.

 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. Indeed, a former Goldman salesperson 2257

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 2258

“sourced from the Street” to mean assets acquired from a variety of different broker-dealers.

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. Deeb Salem, a Goldman mortgage trader who selected 2260

40% of the assets in Hudson 1, described “the Street” as simply “short hand for all brokerdealers.” David Lehman, who became the head of the CDO Origination Desk after Mr. Ostrem, 2261

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.”2262
526

 12/3/2006 Hudson Mezzanine 2006-1, LTD. Offering Circular, GS MBS-E-021821196. 2263

 Id. at 021821241. 2264

 See, e.g., 9/19/2006 email from Michael Swenson to Thomas Cornacchia and Joshua Birnbaum, GS MBS-E- 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.

 9/27/2006 email from Michael Swenson to Joshua Birnbaum, GS MBS-E-012689798. 

2266

 12/3/2006 Hudson Mezzanine 2006-1, LTD. Offering Circular, GS MBS-E-021821196, at 021821229. This 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

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 2263

statement that no independent third party had reviewed the prices at which the CDS contracts were

sold to Hudson 1. In addition to lacking third party verification, no external counterparty had 2264

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. 

Internally, while Hudson 1 was being constructed, Goldman personnel acknowledged that

they were using a novel pricing approach. At one point, Mr. Swenson sent an email to Mr. 2265

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 2266

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. 

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
527

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. 

 Goldman intermediated between other broker-dealers and the CDO vehicle in Anderson Mezzanine Funding 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. 

 12/3/2006 Hudson Mezzanine 2006-1, LTD. Offering Circular, GS MBS- E-021821196, at 021821251. 

2269

 10/16/2006 email exchange between Daniel Sparks and Peter Ostrem, GS MBS-E-010916991 (“Cambridge is 2270

upset that we are delaying their deal. They know that Hudson Mezz (GS prop deal) is pushing their deal back.”). 

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. The disclosure provided by Goldman contained boiler 2268

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:

“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), total return swaps or other instruments enabling

credit and/or other risks to be traded that are linked to one or more Investments.” 

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
528

 Firmwide Risk Committee meetings were often chaired by David Viniar and frequently attended by Lloyd 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”). 

 10/25/2006 email from Jonathan Sobel to David Viniar and Gary Cohn, GS MBS-E-009757821. 2272

 10/12/2006 email from Thomas Cornacchia to Peter Ostrem and others, GS MBS-E-0000066413. 

2273

 10/26/2006 email from Arbind Jha, “MarketRisk: Mortgage Risk Report (cob 10/25/2006),” GS MBS-E- 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.

 10/11/2006 Goldman internal email, “FW: Hudson Mezz,” GS MBS-E-017502610, Hearing Exhibit 4/27-170c. 

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.’”).

 10/19/2006 email from Mitchell Resnick to Jonathan Egol, Darryl Herrick, and David Rosenblum, GS MBS-E- 2276

009557391. “HGS1” refers to Abacus HGS1, a CDO where Goldman, as in Hudson 1, held 100% of the short 2

interest.

Goldman senior executives closely followed Hudson’s development and sale. Hudson was

discussed, for example, at five different Firmwide Risk Committee meetings attended by senior

Goldman executives. Mortgage Department executives also sent progress reports to the senior 2271

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. During discussions over the best price at which to market the CDO’s equity tranche, a 2272

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.” On October

2273

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

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
529

 10/20/2006 email from Paul Carrett to Darryl Herrick, GS MBS-E-018321286 [emphasis in original]. 2277

 10/11/2006 email from Darryl Herrick to Michael Swenson, David Lehman, and Josh Birnbaum, GS MBS-E- 2278

0000030518. 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).

 10/12/2006 email from Michael Swenson to David Rosenblum and Peter Ostrem, GS MBS-E-0000030518. 2279

 10/25/2006 email from Jonathan Sobel to David Viniar and Gary Cohn, GS MBS-E-009757821. 2280

 Subcommittee interview of Darryl Herrick (10/13/2010). 2281

 Subcommittee interview of Darryl Herrick (10/13/2010). When asked if it was common to divide unsold 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].”).

Another Goldman salesman emailed Mr. Herrick on the CDO Desk, telling him: 

“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.” Mr. 2278

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.”2279

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 2281

were split between the CDO Origination Desk and ABS Trading Desk. 

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
530

 10/30/2006 email from Peter Ostrem, “Great Job on Hudson Mezz,” GS MBS-E-0000057866, Hearing Exhibit 2283

4/27-90. 

 Goldman told the Subcommittee that Hudson experienced a gross gain of $1.697 billion offset by a loss of $1.39 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.

 See Goldman response to Subcommittee QFR at PSI_QFR_GS0239. 2285

 Id. 

2286

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,

all of which was at the expense of the Hudson investors. As the value of the RMBS securities 2284

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. That $304 2285

million gain was also at the expense of the investors to whom Goldman had sold the Hudson

securities.

 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 2286

ABS Desk warehouse account that contained both the long ABX assets and the 80 offsetting single
531

 Id. 

2287

 Id., at PSI_QFR_GS_0280. 2288

 3/4/2006 email from Fabrice Tourre to George Maltezos, others, GS MBS-E-006638833. 

2289

 See Goldman response to Subcommittee QFR, at PSI_QFR_GS0211. 

2290

 11/21/2008 letter from Goldman to Morgan Stanley, HUD-CDO-00005125. 2291

 See Goldman response to Subcommittee QFR, at PSI_QFR_GS0223 and PSI_QFR_GS0235. 2292

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 2288

recorded a profit from Hudson 1 of more than $1.35 billion.

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.” Six months later, the credit rating 2289

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

Morgan Stanley, the largest Hudson investor, lost $930 million. As other investors 2291

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 2292

liquidated by Goldman. Today, Hudson securities are worthless.

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.
532

 “Mezzanine” CDS assets reference securities that carry a credit rating of BBB or BBB-. Mezzanine assets are 2293

riskier than AAA, AA, and A rated assets, but less risky than those that carry, for example, BB, B, or CCC ratings. 

 Some documents indicate the CDO was slated to be Hudson Mezzanine 2006-2. But in December 2006, 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. 

 9/25/2006 Goldman memorandum to the Mortgage Capital Committee, GS MBS-E-013475756-62 (hereinafter 2295

“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). 

 9/25/2006 MCC Memorandum, GS MBS-E-013475756-62. 2296

 See Goldman response to Subcommittee QFR at PSI_QFR_GS0434. Goldman noted in its QFR response that 2297

the information used for its response had been voluntarily provided by Goldman employees. 

 5/10/2006 email from Curtis Willing to David Solomon and Dan Holland, GS MBS-E-013870906-7. The Elliot 2298

Bridge Fund eventually invested in Anderson. 

 4/17/2006 email from Curtis Willing to David Solomon and Dan Holland, GS MBS-E-013870906-7. 

2299

 5/14/2006 and 5/10/2006 emails from Dan Sparks to Curtis Willing, GS MBS-E-013870906-7. 

2300

BB. Anderson Mezzanine Funding 2007-1 

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. To execute the Anderson CDO, Goldman 2293

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.

The CDO was originally conceived as part of the Hudson series of non-managed, proprietary

CDOs in which Goldman acted as the principal. But Goldman decided to enlist GSC to take part 2294

in structuring the $500 million CDO. 

2295

Partnering on Anderson. GSC Partners was founded by Alfred C. Eckert, III, a former

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 2296

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. In the 2297

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, 2298

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.” After being 2299

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
533

 9/25/2006 MCC Memorandum, GS MBS-E-013475756-62. 

2301

 8/8/2006 email from Edward Steffelin to Peter Ostrem and others, “GS/GSC EB Prop deal,” GS MBS-E- 2302

000904603. 8/8/2006 email from Peter Ostrem to Edward Steffelin, Joshua Bissu and others, GS MBS-E000904603 (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. 

 Subcommittee interview of Edward Steffelin (12/10/2010). 2303

 See 3/5/2007 emails between Matthew Bieber and Joshua Bissu, GS MBS-E-014605918. 

2304

 See 3/6/2007 email from Joshua Bissu to Matthew Bieber and Peter Ostrem, GS MBS-E-014597705. 2305

 8/8/2006 email from Edward Steffelin to Peter Ostrem and others, “GS/GSC EB Prop deal,” GS MBS-E- 2306

000904603. 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. 

 10/31/2006 email from Curtis Willing, GSC Trades, GSC-CDO-FCIC-0029698; 10/31/2006 email from Deeb 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). 

 10/31/2006 email from Shelly Lin to Joshua Bissu and Matthew Bieber, GS MBS-E-016473768. See also 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). 

 Subcommittee interview of Matthew Bieber (10/20/2010); Subcommittee interview of Edward Steffelin 2309

(12/10/2010). 

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 2301

for the CDO. Later on, Goldman consulted with GSC on whether to liquidate or underwrite 2302

Anderson, and allowed GSC to participate in pricing issues, while GSC at times assisted in 2303 2304

marketing Anderson.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 2306

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 2307

$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.” 

2308

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
534

 Id. 2310

 See Goldman response to Subcommittee QFR at PSI_QFR_GS0192. 

2311

 This number was compiled using a list of referenced securities supplied by Goldman at QFR_PSI_GS0192 and 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%. 

 See, e.g., 1/4/2007 Goldman presentation, “Sub-Prime Mortgage Lenders - Update,” GS MBS-E-009978840-59, 2313

Hearing Exhibit 4/27-169.

 See discussion of Goldman’s net short position, Section C(4), above. 2314

recollection of the asset selection process, beyond each party selecting some RMBS securities and

the other having veto rights. 

2310

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 brokerdealers 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, and was building a large short position against the same types of BBB rated

2313

RMBS securities referenced in Anderson. By February 2007, the value of subprime RMBS 2314

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. 

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
535

 2/8/2007 email from Craig Broderick to Daniel Sparks, David Viniar, others, GS MBS-E-002201486. 2315

 3/8/2007 email from Daniel Sparks to senior executives, GS MBS-E-002206279, Hearing Exhibit 4/27-75. 

2316

 2/23/2007 email from Daniel Sparks to senior executives, GS MBS-E-009759477. 

2317

 2/25/2007 email from Daniel Sparks to Tom Montag, GS MBS-E-019164799. See also 2/23/2007 email from 2318

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.”).

 2/28/2007 email from David Rosenblum to Peter Ostrem, GS MBS-E-001800707. 

2319

 2/24/2007 email from Deeb Salem to Michael Swenson, Edwin Chin, and Josh Birnbaum, GS MBS-E- 2320

018936137-38.

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 2317

in certain warehouse accounts. Two days later, on February 25, 2007, Mr. Sparks informed senior

executives of the possibility of liquidating Anderson: 

 “[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 2320

colleagues this explanation of why the losses in the CDO warehouse accounts were growing so

rapidly:

“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
536

 2/24/2007 email from Peter Ostrem to colleagues, GS MBS-E-010383828-29. 2321

 2/24/2007 email from Daniel Sparks to Peter Ostrem, others, GS MBS-E-001996601, Hearing Exhibit 4/27-95. 

2322

 2/25/2007 Goldman internal email chain, GS MBS-E-001996601, Hearing Exhibit 4/27-97. 

2323

 Id. 2324

 Id. 2325

 3/2/2007 email from Jon Egol to Daniel Sparks and others, GS MBS-E-010637566, Hearing Exhibit 4/27-97. 

2326

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

to convince Mr. Sparks to reverse his decision. Messrs. Ostrem and Bieber assembled a list of 2323

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 2324

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

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. Mr. 2326
537

 3/2/2007 email from Daniel Sparks to Jon Egol and others, GS MBS-E-010637566, Hearing Exhibit 4/27-97. 2327

 3/2/2007 email from Jon Egol to colleagues, “Re: Abacus AC1,” GS MBS-E-002676413, Hearing Exhibit 4/27- 2328

64. 

 3/13/2007 email from Peter Ostrem to Scott Wisenbaker and Matthew Bieber, GS MBS-E-000898410, Hearing 2329

Exhibit 4/27-172. 

 In mid-March, Mr. Ostrem informed the GSI Risk Committee that Goldman’s estimated losses on the assets in 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.

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. One potential investor wrote to a Goldman sales representative 2330

explaining its decision not to purchase the Anderson securities: 

“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
538

 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.” 

 3/16/2007 email from Russell Brocato to Scott Wisenbaker, GS MBS-E-000902498, Hearing Exhibit 4/27-172. 

2332

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.” 

 3/14/2007 email from Matthew Bieber to Scott Wisenbaker and others, GS MBS-E-000908336, Hearing Exhibit 2333

4/27-172 (“Looking like both dcp and terwin out. New Century issues.”).

 3/13/2007 email from Wendy Rosenfeld at Rabobank to Olivia Ha at Goldman, GS MBS-E-000898417, 2334

Hearing Exhibit 4/27-172. 

 3/6/2007 email from Joshua Bissu to Matthew Bieber and Peter Ostrem, GS MBS-E-014597705. 

2335

 3/8/2007 email from Daniel Sparks to senior executives, GS MBS-E-002206279, Hearing Exhibit 4/27-75. 2336

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 2332

disclose to these investors that it had almost canceled the CDO, due to its assets’ falling values.

Of particular concern for investors was the concentration of New Century mortgages in

Anderson. On March 13, 2007, a potential investor, Rabobank, asked Goldman sales 2333

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?” Goldman and GSC prepared a list of 2334

talking points with which to respond to the investor:

“- 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
539

 3/13/2007 email from Manisha Nanik to Loren Morris, “New Century EPDs,” at GS MBS-E-002146861, 2337

Hearing Exhibit 4/27-77. See also 2/2/2007 email from Matthew Nichols to Kevin Gasvoda and others, GS MBS-E005556331 (“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.”). 

 3/1/2007 email from Scott Wisenbaker to Peter Ostrem and Matthew Bieber, GS MBS-E-000893661, Hearing 2338

Exhibit 4/27-172. 

 2/2007 Anderson Mezzanine Funding 2007-1, Ltd. Debt Marketing Book, GS MBS-E-000855351. 

2339

 2/2007 Anderson Mezzanine Funding 2007-1, Ltd. Equity Marketing Book, GS MBS-E-000892557-598 at 560, 2340

569.

 2/2007 Anderson Mezzanine Funding 2007-1, Ltd. Debt Marketing Book, GS MBS-E-000855351. Anderson 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-E001996601, Hearing Exhibit 4/27-95. 

 Subcommittee interview of Matthew Bieber (10/21/2010). 2342

 Subcommittee interview of Edward Steffelin (12/10/2010). The marketing materials also stated that the 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. 

 Id. Despite GSC’s not being listed as having helped select the Anderson assets, some investors appeared to be 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.”).

for repurchase “if possible.” Goldman also did not disclose to the investor that it was shorting 2337

40% of the Anderson CDO. 

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.” This clarification was necessary, because although GSC’s role 2338

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 2339

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 “cosponsored 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 2340

to GSC were removed from the final documents. Mr. Bieber told the Subcommittee that he did 2341

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, 2342

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 “coselecting.” Mr. Steffelin said that although GSC had the ability to suggest assets and veto others,

2343

he felt that “co-selecting” implied a level of control over the portfolio that GSC didn’t have.2344
540

 3/12/2007 email from Robert Black to Matthew Bieber, others, GS MBS-E-000898037. 2345

 Id. 2346

 3/20/2007 email from Peter Ostrem to Matthew Bieber and others, GS MBS-E-000906269, Hearing Exhibit 2347

4/27-172.

 3/27/2007 email from Peter Ostrem to Matthew Bieber, GS MBS-E-000907935, Hearing Exhibit 4/27-172. 2348

 See Goldman response to Subcommittee QFR at PSI_QFR_GS0223 and PSI_QFR_GS0235. 

2349

 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. 

 See Goldman response to Subcommittee QFR at PSI_QFR_GS0223 and PSI_QFR_GS0235. 

2351

 See Goldman response to Subcommittee QFR at PSI_QFR_GS0239. 

2352

 1/3/2008 email from Shelly Lin to Mr. Sparks, GS MBS-E-021880171 (attached file, “Deal Summary,” Excel 2353

Spreadsheet showing credit ratings for Anderson).

 See Goldman response to Subcommittee QFR at PSI_QFR_GS0223 and PSI_QFR_GS0235. 

2354

Despite the poor reception by investors, Goldman continued “pushing the axe” with its sales

force to sell Anderson securities. Mr. Bieber identified and monitored potential investors and 2345

attempted to sell Anderson securities to pension funds and place Anderson securities in other

Goldman CDOs as collateral securities. On March 20, 2007, when Mr. Bieber reported selling 2346

$20 million in Anderson securities, his supervisor, Mr. Ostrem, responded with the single word:

“Profit!” In a separate email a week later, Mr. Ostrem told Mr. Bieber he did “an excellent job 2347

pushing to closure these deals in a period of extreme difficulty.”2348

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, 2349

Moneygram, and GSC which purchased the entire $11 million class D portion of the CDO. 

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, and collected $2 million in CDS 2351

premiums while it warehoused Anderson assets.2352

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. GSC then sold back 2353

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

2354

to BB. In the end, the Anderson investors were wiped out and lost virtually their entire investments. 

Analysis. Goldman constructed the Anderson CDO using CDS contracts referencing

subprime RMBS securities, the majority of which were issued by subprime lenders like New
541

 2/2007 Timberwolf I, Ltd. Marketing Book, GS MBS-E-000676809, Hearing Exhibit 4/27-99a. 2355

 For more information about Goldman’s actions as the collateral put provider for Timberwolf, see Section 2356

(iii)(BB), below.

 2/2007 Timberwolf I, Ltd. Marketing Book, GS MBS-E-000676809, Hearing Exhibit 4/27-99a. 2357

 Subcommittee interview of Joseph Marconi (10/19/2010). 2358

 Greywolf eventually purchased the entire equity tranche in Timberwolf. See Goldman response to 2359

Subcommittee QFR at PSI_QFR_GS0223 and PSI_QFR_GS0235. 

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, 2

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 2355

provider. Timberwolf was initiated in the summer of 2006, and closed in March 2007. 2356

Partnering with Greywolf. Greywolf Capital Management was founded by a team of

former employees of Goldman’s fixed income trading division. It had experience in constructing 2357

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 2 2358

negotiated a risk sharing agreement, and worked through the profitability of the CDO under 2

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.

Greywolf agreed to purchase half of the Timberwolf equity tranche, sharing that risk with

Goldman. In addition, Greywolf agreed to share with Goldman the risk of the assets being 2359

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.
542

 Subcommittee interview of Joseph Marconi (10/19/2010). 2360

 In some cases, Goldman was permitted to “top-up” the deal, taking the short side on an additional $5 million in 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. 

 Joseph Marconi told the Subcommittee that well over half the assets were obtained through auctions, while just a 2362

few were negotiated. Subcommittee interview of Joseph Marconi (10/19/2010).

 See Goldman response to Subcommittee QFR at PSI_QFR_GS0192. 2363

 The Abacus securities were cash assets. However, due to the synthetic nature of the Abacus CDOs, Goldman 2364

retained a short interest in $15 million in Abacus securities. 

 Timberwolf had about one dozen short parties of which Goldman was the largest. See Goldman response to 2365

Subcommittee QFR at PSI_QFR_GS0223 and PSI_QFR_GS0235. 

 A total of 84 CDS contracts produced the 51 unique reference assets. See Goldman response to Subcommittee 2366

QFR at PSI_QFR_GS0192. 

 8/23/2007 email from Jay Lee to Matthew Bieber, David Lehman, and others, GS MBS-E-001927784. 2367

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. Once Greywolf finished its credit 2360

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 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. In some instances, after circulating a list for bids, a broker-dealer responded to Greywolf’s 2361

request with a price for a single name CDS on a similar CDO security, which Greywolf analyzed

and sometimes agreed to acquire.

2362

Timberwolf’s single name CDS and CDO securities were acquired from 12 different brokerdealers. Goldman was the single largest source of assets, providing 36% of the assets by value, 2363

including $15 million in single name CDS contracts naming Abacus securities. As a result, 2364

Goldman held 36% of the short interest in Timberwolf. Altogether, Timberwolf contained 56 2365

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 2366 2

securities, and each CDO or CDO security contained or referenced its own RMBS, CMBS, or CDO 2

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 2367

CDO assets in Timberwolf were privately issued and often had little or no publicly available

information on the underlying assets they contained.
543

 2/26/2007 email exchange between Tom Montag and Daniel Sparks, GS MBS-E-019164799. 

2368

 2/26/2007 email exchange between Tom Montag and Daniel Sparks, GS MBS-E-010989241. 

2369

 3/7/2007 email from Gaelyn Sharp, GS MBS-E-001800634. 2370

 3/2007 email chain, “Timberwolf I, Ltd. Preliminary Offering Circular,” GS MBS-E-001800634. 2371

 3/9/2007 email from Daniel Sparks, “Re: Help,” GS MBS-E-010643213, Hearing Exhibit 4/27-76. 2372

 According to Goldman personnel interviewed by the Subcommittee, the Syndicate coordinated sales efforts 2373

between the CDO Origination Desk and the CDO sales force. 

 See, e.g., 4/11/2007 Goldman internal email, “GS Syndicate Structured Product CDO Axes (INTERNAL),” 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.

 2/14/2007 email from Robert Black to Matthew Bieber and others, GS MBS-E-001996121. 

2375

By the time Greywolf and Goldman were nearing completion of the acquisition of the

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 2

big and how dangerous?” Mr. Sparks responded: “[R]oughly 2bb [billion], and they are the 2368

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

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 2373

force a list of “Senior CDO Axes” or sales directives on a weekly and sometimes daily basis, many

of which placed a priority on selling Timberwolf securities. As early as February, the Goldman 2374

sales force developed “broader lists” of clients to target for Timberwolf sales. After exhausting 2375
544

 3/21/2007 email from Robert Black, “Non-tradition Buyer Base for CDO AXES,” GS MBS-E-003296460, 2376

Hearing Exhibit 4/27-78.

 3/2007 Goldman internal email chain, GS MBS-E-010643213, Hearing Exhibit 4/27-76. 2377

 3/28/2007 Goldman email from the Syndicate, GS-MBS-E-000740958, Hearing Exhibit 4/27-100. 2378

 See, e.g., 4/11/2007 email from Daniel Sparks, GS MBS-E-010533482, Hearing Exhibit 4/27-101. 2379

 4/19/2007 email from Daniel Sparks to Bunty Bohra, GS MBS-E-010539324, Hearing Exhibit 4/27-102. 

2380

 3/8/2007 email from Harvey Schwartz, GS MBS-E-010643213, Hearing Exhibit 4/27-76. 

2381

 3/9/2007 email from Daniel Sparks, GS MBS-E-010643213, Hearing Exhibit 4/27-76. 2382

 See Goldman response to Subcommittee QFR at PSI_QFR_GS0223 and PSI_QFR_GS0235. 

2383

 In fact, the decline had begun within a month after Timberwolf closed in late March. 9/17/2007 email from 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). 

those initial lists, Goldman sales personnel began to target “non-traditional” buyers as well as 2376

clients outside of the United States. The sales force had some early successes. On March 28, 2377

2007, for example, the Syndicate included a note in one of the axe sheets:

“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

that Timberwolf “is our priority.” On one occasion, on April 19, 2007, Mr. Sparks suggested to 2379

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

2380

informed in response: “[W]e have done that with timberwolf already.” 

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 2381

the need for the sales team and traders to work together. He wrote: 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. Goldman personnel also knew that the value of the 2383

Timberwolf securities, and the value of their underlying assets, were falling. 

2384
545

 5/11/2007 email from Daniel Sparks to Richard Ruzika, GS MBS-E-019659221. Mr. Sparks also noted that he 2385

had a meeting with David Viniar, Don Mullen, and Gary Cohn to discuss the issue. 

 5/11/2007 email from David Lehman, GS MBS-E-003361238. For more information on this CDO valuation 2386

project, see Section C(5)(a)(iii)BB, above.

 5/11/2007 email from Craig Broderick, “CDO’s - Mortgages,” GS MBS-E-009976918, Hearing Exhibit 4/27- 2387

84.

 5/11/2007 email from Harvey Schwartz to Daniel Sparks, Tom Montag, and others, GS MBS-E-010780864. 2388

 5/11/2007 email from Donald Mullen to Daniel Sparks, GS MBS-E-010780849, Hearing Exhibit 4/27-103. 2389

 Id. at GS MBS-E-010780848-49. 2390

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 2

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 2387

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. 

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.” In an email to Mr. 2388

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.” The executives also agreed, however, not to “slow or delay” 2389

efforts to sell Timberwolf securities if they got “strong bids.”2390

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:
546

 5/13/2007 email from Paul Bouchard to David Lehman, Daniel Sparks, and others, GS MBS-E-003361238. 2391

 Id. 2392

 5/20/2007 email from Paul Bouchard, “Materials for Meeting,” GS MBS-E-001863725. 

2393

 5/14/2007 email from Elisha Weisel, “Modeling Approaches for Cash ABS CDO/CDO^2,” GS MBS-E- 2394

001863618. 

 5/20/2007 email from Lee Alexander to Daniel Sparks, Donald Mullen, Lester Brafman, and Michael Kaprelian, 2395

“Viniar Presentation - Updated,” GS MBS-E-010965211 (attached file “Mortgages V4.ppt,” “Mortgages

Department, May 2007,” GS MBS-E-010965212).

 Id. At least two drafts of the presentation also stated about Timberwolf and Point Pleasant that “the complexity 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-E010952331; 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).

 5/20/2007 email from Lee Alexander to Daniel Sparks, Donald Mullen, Lester Brafman, and Michael Kaprelian, 2397

“Viniar Presentation - Updated,” GS MBS-E-010965211 (attached file “Mortgages V4.ppt,” “Mortgages

Department, May 2007,” GS MBS-E-010965212 at 14).

“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

“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 2394

Sunday, May 20, 2007, the Mortgage Department presented its findings in a 9:00 p.m. conference

call with CFO David Viniar and others. The presentation’s executive summary expressed 2395

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, 2396

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.” 

2397

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
547

 Id. at 24. 2398

 Polygon had already purchased Timberwolf securities prior to the drafting of the presentation, and was 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. 

 5/20/2007 email from Lee Alexander to Daniel Sparks, Donald Mullen, Lester Brafman, and Michael Kaprelian, 2400

“Viniar Presentation - Updated,” GS MBS-E-010965211 (attached file “Mortgages V4.ppt,” “Mortgages

Department, May 2007,” GS MBS-E-010965212 at 31).

 See Goldman response to Subcommittee QFR at PSI_QFR_GS0223 and PSI_QFR_GS0235. 

2401

 5/14/2007 email from Daniel Sparks to Tom Montag and Donald Mullen, GS MBS-E-019642797. 

2402

 5/26/2007 email from Michael Swenson to others, GS MBS-E-012443166 (attached file, “ABS Sec_0525,” GS 2403

MBS-E-012443167). 

 These prices indicate a percentage of security’s face (par) value. A price of $80 would be 80% of par or 80 2404

cents on the dollar. 

 See Goldman response to Subcommittee QFR at PSI_QFR_GS0223 and PSI_QFR_GS0235; 6/1/2007 email 2405

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 2

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). 

CDO securities, focused on four hedge fund clients: Basis Capital, Fortress, Polygon, and 2

Winchester Capital. The Goldman sales force apparently felt those four hedge funds were the 2398

clients most likely to buy the CDO securities, and two of them, Basis Capital and Polygon, did 2

subsequently purchase Timberwolf securities. An appendix to the presentation identified another 2399

35 clients for targeted sales efforts and provided an assessment of the CDO sales efforts for each.2400

Several of those clients later purchased Timberwolf securities. 

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. For example, Goldman marked down the AAA rated

2403

Timberwolf A2 securities to a value of $80. At the same time, Goldman continued to market 2404

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. On May 25, Goldman also marked the AA rated 2405

Timberwolf B securities to an internal value of $65.00. Over a month later, Goldman sold $9
548

 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.

 5/14/2007 email from Edwin Chin, GS MBS-E-012553986. 2407

 Mr. Birnbaum responded directly to Mr. Swenson: “what a beautiful quote.” Id. 2408

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
549

 6/6/2007 email from David Lehman, GS MBS-E-001936955. 2409

 6/6/2007 email from Daniel Sparks, GS MBS-E-001922156. Mr. Lehman further responded: “thk abt this - if 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.

 5/20/2007 email from George Maltezos, Goldman Australia sales, to David Lehman, “T/wolf and Basis,” GS 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.”).

 5/22/2007 email from George Maltezos to John Murphy of Basis Capital Management, JUL 000685. 

2412

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. Don Mullen responded: “Does this give any 2409

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

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
550

 See. e.g., 5/30/2007 email from George Maltezos to John Murphy and Stuart Fowler, JUL 002032. 

2413

 See Goldman response to Subcommittee QFR at PSI_QFR_GS0223 and PSI_QFR_GS0235. 

2414

 See 5/1/2007 email from Macdara Molloy to Phillipa Chen, GS MBS-E-002003102. 2415

 Id. 2416

 5/30/2007 email from George Maltezos to John Murphy and Stuart Fowler at Basis Capital, JUL 002032. 

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.

 6/12/2007 email from Sahil Sachdev to George Maltezos, GS MBS-E-001912398. 

2418

 6/12/2007 email from George Maltezos, PSI-Basis_Capital_Group-03-0001. Mr. Maltezos emailed Mr. 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. 

find financing for the purchase price. Second, Basis Capital was concerned about the value of its 2413

existing CDO investment with Goldman. On April 19, 2007, Basis Capital had purchased BBB 2

rated Point Pleasant securities at a price of $81.72. Goldman had provided the financing for this 2414

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 2415

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. 

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, 2417

2007, Goldman again marked down the value of the Point Pleasant securities to $75, and again

asked Basis to post more cash collateral. When Basis Capital asked Mr. Maltezos to justify the 2418

lower value, Mr. Maltezos wrote: 

“[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
551

 The most recent Point Pleasant sale had been $40 million worth of the AAA rated A2 securities, which sold on 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. 

 Internally, Goldman had marked down the value of the Point Pleasant securities to $50.00. The much higher bid 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-E012443166 (attached file, “ABS Sec_0525,” GS MBS-012443167).

 6/12/2007 email from Stuart Fowler to George Maltezos, GS MBS-E-001912398. 2422

 Id. 

2423

 6/13/2007 email from Daniel Sparks to George Maltezos, David Lehman, and Jon Egol, GS MBS-E-002006149. 2424

The reference to the “senior guys on 30” is to Goldman’s senior executives who had offices on the 30 floor of the th

Goldman headquarters in New York.

 6/13/2007 email from George Maltezos to Stuart Fowler and John Murphy at Basis Capital and others, GS 2425

MBS-E-001918603.

 6/13/2007 email from George Maltezos, PSI-Basis_Capital_Group-02-0001. 

2426

In fact, no such sales had taken place, and the lower value could not be justified by any sales

transactions. The lower mark was instead related to Goldman’s CDO valuation project in May, 2420

which had concluded that its CDO securities had lost significant value. 2 2421

 

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?” Mr. Maltezos responded: “Stuart – I assure you no 2422

foul here,” and offered to set up some “1-on-1 time with the trading desk” to discuss pricing.2423

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 2425

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:

“[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
552

 6/13/2007 email from David Lehman to Tom Montag, GS MBS-E-001914580. 2427

 Id. 2428

 Goldman response to Subcommittee QFR at PSI_QFR_GS0223 and PSI_QFR_GS0235. 

2429

 7/4/2007 email exchange among David Lehman, George Maltezos, and others, GS MBS-E-001990127. 

2430

 Id. 2431

 7/4/2007 email from David Lehman, GS MBS-E-001990127. 2432

 7/12/2007 email from Jon Egol, GS MBS-E-001866391. On the same day, Goldman’s internal marks for the 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. 

 7/13/2007 email from David Lehman, “Re: Basis,” GS MBS-E-001866391 at 93. 2434

 Id. at 91. 

2435

 7/16/2007 email from Jon Egol, “Re: Basis,” GS MBS-E-010169281. Goldman also marked down Basis 2436

Capital’s Point Pleasant securities to $10, from an initial purchase price of $81.72. 

 7/12/2007 Goldman datasheet, “Warehouse SP CDO positions and hedges_7-12-07,” GS MBS-E-001866482. 

2437

 7/24/2007 email from David Lehman to others, GS MBS-E-013449641. 2438

 7/31/2007 letter from Goldman Sachs International to Basis Capital, “Event of Default Under ISDA Master 2439

Agreement,” JUL 003958. 

Timberwolf securities and $50 million in AA rated Timberwolf securities. Mr. Lehman told Mr. 2427

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.” 

2428

The Timberwolf sale to Basis Capital was finalized on June 18, 2007. Goldman provided 2429

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. Basis Capital 2430

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 2431

what the precedent there is here – does GS need (outside of the client issue) to provide the below

info to justify our prices???” After Goldman provided additional information, Basis Capital 2432

appeared to agree to post the additional collateral. 

Eight days later, on July 12, Goldman again marked down the value of the Timberwolf

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 2433

required Basis Capital to post substantially more cash collateral with the firm. On July 13, 2007, 2434

Basis Capital told Goldman that one of its funds was “in real trouble.” On July 16, Goldman 2435

again marked down Basis Capital’s securities to prices of $55 for AAA and $45 for AA. These 2436

prices matched Goldman’s internal valuations. By the end of July, Basis Capital was forced to 2437

liquidate its hedge fund. Goldman bought back the Timberwolf securities from Basis Capital on 2438

July 31, at prices of $30 and $25.2439

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
553

 5/24/2007 email from Yusuf Aliredha to Mr. Sparks, Mr. Lehman, and others, “Priority Axes,” GS MBS-E- 2440

001934732. 

 Id. 

2441

 6/5/2007 email from Benjamin Case to David Lehman, GS MBS-E-001919861. 2442

 Id. 

2443

 Id. 2444

 6/1/2007 email from Jay Lee to David Lehman, Matthew Bieber, and others, GS MBS-E-010958182. 

2445

 Id. 

2446

 Id. 

2447

do as I suggest. Would like to show stuff today if possible.” Mr. Lehman told the sales associate 2440

that he was available to get on the telephone with the clients, and forwarded him the Timberwolf

offering circular and marketing materials. 

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. The plan was to target 2 2442

“institutional buyers that can take larger bite size than traditional CDO buyers ... for example Asian

banks and insurance companies.” Mr. Case also noted that Goldman was shorting “51 CDO 2443

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

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. 2445

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:

“[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”:
554

 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. 

 6/7/2007 emails from Daniel Sparks and David Lehman, GS MBS-E-001866450, Hearing Exhibit 4/27-104. 

2449

 See Goldman response to Subcommittee QFR at PSI_QFR_GS0223 and PSI_QFR_GS0235. 

2450

 See Goldman response to Subcommittee QFR at PSI_QFR_GS0223. 2451

 6/10/2007 email from Daniel Sparks to Omar Chaudary and Bunty Bohra, GS MBS-E-010971809. 

2452

 6/11/2007 email from Tom Montag, GS MBS-E-001866144. 2453

 6/11/2007 email exchange between Syndicate and David Lehman, GS MBS-E-001914921-24. 2454

 6/13/2007 email from Japan sales office, GS MBS-E-011212260. 

2455

 6/22/2007 email exchange between Tom Montag and Daniel Sparks, “Few Trade posts,” Hearing Exhibit 4/27- 2456

105.

 Id. 2457

 6/25/2007 email from Daniel Sparks to Tom Montag, and others, GS MBS-E-010952698. 2458

“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 2449

office did get it done, and Goldman sold another $56 million in Timberwolf securities to Hungkuk

Life at a price of $84.50. The sales representative was awarded the 7% sales credit. Mr. 2450 2451

Sparks wrote to the sales office: “you boys are awesome and many people are noticing.” Mr. 2452

Montag, a senior Goldman executive monitoring the Timberwolf sales, told the mortgage team it

had done an “incredible job – just incredible.”2453

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.” Two days later, on June 13, 2007, the Japan sales office reported 2454

over $250 million in new sales of Goldman’s CDO securities, including Timberwolf.2455

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 2456

$300 million in Timberwolf securities. Mr. Montag responded: “boy that timeberwo[l]f was one

shitty deal.”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

2458

the group that Goldman would probably have to lower the values of the CDO assets over the next
555

 6/26/2007 email from Deeb Salem to Michael Swenson, GS MBS-E-012371112. 2459

 Id. 

2460

 Goldman’s internal price was then $55, 23% less. See 7/12/2007 Goldman datasheet, “Warehouse SP CDO 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. 

 7/6/2007 email from Mitchell Resnick to David Lehman, GS MBS-E-001866752. 2462

 See Goldman response to Subcommittee QFR at PSI_QFR_GS0223 and PSI_QFR_GS0235. 

2463

 5/7/2007 Goldman email chain between Elisha Wiesel and others, “RE: Timeberwolf Analysis,” GS 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. 

 7/16/2007 email to David Lehman, “Carlyle,” GS MBS-E-011050254. 2465

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. Mr. Montag 2459

remained focused on Timberwolf, responding: “[h]ow are twolf sales doing?”2460

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. Goldman trader

2461

Mitchell Resnick asked Mr. Lehman “to pay him well on this.” Mr. Ceder was paid an 8% sales

2462

credit. That was Goldman’s last Timberwolf sale, even though its Syndicate continued to list the 2463

CDO as a top sales priority for months afterward.

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.”2464

Another Goldman employee, discussing a potential buyer of Timberwolf, warned:

“[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 resourceconstrained will not be good enough.” 

2465
556

 5/7/2007 email from Elisha Wiesel, GS MBS-E-004735378. 

2466

 7/7/2007 email from Stuart Fowler, GS MBS-E-011183045. 2467

 7/31/2007 email from Matthew Bieber to David Lehman, “FW: Requesting Compliance Approval,” GS MBS-E- 2468

001920215.

 8/7/2007 email from Jay Lee to others, GS MBS-E-001927858. 

2469

 8/7/2007 email from David Lehman to others, GS MBS-E-001927858. 2470

 See 6/6/2007 email from David Lehman, GS MBS-E-001936955. Mr. Lehman stated: “thk abt this – if we 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.” 

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 2468

sales office told a sales associate who was seeking information about Goldman’s marks for Tokyo

Star Bank:

“[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 2471

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
557

 7/11/2007 email from David Lehman, “CDO Marks,” GS MBS-E-013427046 [emphasis in original]. 2472

 7/16/2007 email from David Lehman to Matthew Bieber, GS MBS-E-001913775. 2473

 See 7/17/2007 email from David Lehman to Daniel Sparks, GS MBS-E-010857643 (with attachment GS MBS- 2474

E-010857644). 

 9/17/2007 email from Tom Montag, GS MBS-E-000766371, Hearing Exhibit 4/27-106. 2475

 9/17/2007 email from Christopher Creed, GS MBS-E-000766370, Hearing Exhibit 4/27-106. 2476

 Id. 2477

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

“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 2473

would cost Goldman $140 million to unwind Timberwolf, and the conclusion was to “Hold Off.”2474

Instead of unwinding, Goldman continued its sales push. 

In September 2007, Mr. Montag asked for data tracking the drop in prices for a Goldman

CDO that experienced a dramatic fall in value, such as Timberwolf. In response, a Goldman 2475

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%:

“3/31/07 94-12

4/30/07 87-25

5/31/07 83-16

6/29/07 75-00

7/31/07 30-00

8/31/07 15-00

Current 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.]
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 11/26/2

6080

100120140

Price

Timberwolf Marks, Axes, and Sales

Sales ofTWOLF‐3/13/07:A1A‐ $99.45

A1B‐ $100A1C‐ $99.71A1D‐ $100INC‐ $100

Sales

M

Prepared by the U.S. Senate Permanent Subcommittee on Investigations, February 2011. Derived from Goldman Sachs document, GS MBS-E-000779366.

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 11/26/2

0

20406080

100120140

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 11/26/2

Price

Timberwolf Marks, Axes, and Sales

Sales ofTWOLF‐3/13/07:A1A‐ $99.45

A1B‐ $100A1C‐ $99.71A1D‐ $100INC‐ $100

Sales

M
559

 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.

 See Goldman response to Subcommittee QFR at PSI_QFR_GS0030. 2479

 Id. at PSI_QFR_GS0239. 2480

 Id. at PSI_QFR_GS0030. 

2481

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.
560

 See 3/23/2007 Goldman document, “Abacus 2007-AC1,” at 11, GS MBS-E-002807082, Hearing Exhibit 4/27- 2482

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”).

 4/2/2007 email from Fabrice Tourre, “ABACUS 07-AC1,” GS MBS-E-002011152 (Abacus 2007-AC1 assets 2483

are “fully-identified, with no reinvestment, removals, substitutions or discretionary trading”).

 Goldman internal documents sometimes describe it as the underwriter for Abacus 2007-AC1, and sometimes as 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.”).

 2/27/2007 email from Curtis Willing, “ABACUS 2007 AC1, Ltd. -- New Issue Announcement (144a/RegS),” 2485

GS MBS-E-009209654.

 3/12/2007 Goldman memorandum to Mortgage Capital Committee, “ABACUS Transaction sponsored by 2486

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.”).

 Goldman’s additional roles included acting as the basis swap counterparty, the basis swap calculation agent, the 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-E002406025, Hearing Exhibit 4/27-118.

 3/12/2007 Goldman memorandum to Mortgage Capital Committee, “ABACUS Transaction sponsored by 2488

ACA,” GS MBS-E-002406025, Hearing Exhibit 4/27-118; April 27, 2010 Subcommittee Hearing at 421.

 Goldman considered its Abacus platform, which commenced in 2004, to be “market-leading.” 4/2/2007 email 2489

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.

DD. Abacus 2007-AC1 

Abacus 2007-AC1 was a $2 billion synthetic CDO whose reference obligations were BBB

rated mid and subprime RMBS securities issued in 2006 and early 2007. It was a static CDO,

2482

meaning once selected, its reference obligations did not change. It was the last in a series of 16 2483

Abacus CDOs referencing RMBS securities designed by Goldman. Goldman served as the

underwriter or placement agent, the lead manager, and the protection buyer, and also acted 2484 2485 2486

in other roles related to the CDO. Unlike previous Abacus CDOs, Abacus 2007-AC1 used a 2487

third party to select its assets, referring to it as the portfolio selection agent.2488

Designing Single Tranche CDOs. Abacus CDOs were known as single tranche CDOs, a

structure pioneered by Goldman through its Abacus platform. Goldman used this structure to 2489

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
561

 “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. 

 3/12/2007 Goldman memorandum to Mortgage Capital Committee, “ABACUS Transaction sponsored by 2491

ACA,” GS MBS-E-002406025, Hearing Exhibit 4/27-118. 

 Goldman trading datasheet, GS MBS 0000004276 (showing closing dates and trade details on various CDOs, 2492

including Abacus).

 3/12/2007 Goldman memorandum to Mortgage Capital Committee, “ABACUS Transaction sponsored by 2493

ACA,” GS MBS-E-002406025, Hearing Exhibit 4/27-118. 

 Id. 2494

to loss. Abacus also enabled investors to short a selected group of RMBS or CDO securities at 2490

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.” Between 2004 and 2007, Goldman issued 16 Abacus deals 2491

referencing RMBS securities, including Abacus 2007-AC1, which together had an aggregate value

of $13 billion.2492

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 2493

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:

“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:
562

 2/7/2007 email from Fabrice Tourre, GS MBS-E-003277939, Hearing Exhibit 4/27-114. 2495

 See also 12/18/2006 email from Fabrice Tourre, “Re: Paulson,” GS MBS-E-003246145 (a series of email 2496

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.”). 

 Subcommittee interview of Fabrice Tourre (4/24/2010). Mr. Tourre also told the SEC that he believed

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. 

 Subcommittee interview of Fabrice Tourre (4/24/2010). 2498

 See, e.g., 12/10/2006 email from Fabrice Tourre to David Lehman, GS MBS-E-003453843, Hearing Exhibit 2499

4/27-142.

 Subcommittee interview of Fabrice Tourre (4/24/2010); 2/21/2007 email from Fabrice Tourre to David Lehman, 2500

GS MBS-E-011359460-61, Hearing Exhibit 4/27-115.

 SEC deposition of Paolo Pellegrini (12/3/2008), PSI-Paulson-04 (Pellegrini Depo)-0001, at 82-85, 175. 2501

“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 2496

addition, during his Subcommittee interview, Mr. Tourre made it clear that he was aware of the

Paulson investment strategy. 

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. However, Paolo Pellegrini, 2500

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 2501

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:
563

 12/18/2006 email from Fabrice Tourre, “Paulson,” GS MBS-E-003246145; 12/20/2006 email from Fabrice 2502

Tourre, GS MBS-E-002534649.

 1/10/2007 Goldman internal email, GS MBS-E-002480520, Hearing Exhibit 4/27-108; 1/9/2007 email from 2503

Fabrice Tourre, “For ACA,” GS MBS-E-002480516. 

 

2504 12/18/2006 Goldman internal email, GS MBS-E-003246145-46.

 Mr. Egol also suggested HBK as a possible portfolio selection agent. 12/18/2006 email from Fabrice Tourre, 2505

“Re: Paulson,” GS MBS-E-003246145.

“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 equallysized 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
564

 Id. An email indicates that, in late December 2006, Mr. Tourre was contemplating several possible portfolio 2506

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.

 See, e.g., 1/4/2007 email from Fabrice Tourre to Daniel Sparks, “Paulson post,” GS MBS-E-002526707 (On 2507

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.

 1/29/2007 email from Fabrice Tourre, GS MBS-E-003248998, Hearing Exhibit 4/27-112. 2509

 2/27/2007 email from Ed Steffelin to Peter Ostrem, “FW: ABACUS 2007-AC1, Ltd. -- New Issue 2510

Announcement (144a/RegS),” GS MBS-E-009209654.

 Subcommittee interview of Edward Steffelin (12/10/2010). 2511

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 2507

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:

“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.” When asked by 2510

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

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
565

 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).

 At the Subcommittee hearing, Mr. Tourre testified that Paulson produced the portfolio selection criteria. 

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.

 Subcommittee interview of Fabrice Tourre (4/24/2010). 2514

 Paolo Pellegrini told the SEC that Paulson’s selection criteria for Abacus 2007-AC1 included RMBS with a 2515

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), PSIPaulson-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

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 2513

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, 2514

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 2515
566

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%).

 1/29/2007 email from Fabrice Tourre to Peter Ostrem and others, GS MBS-E-003248998, Hearing Exhibit 4/27- 2516

112; Goldman Sachs Submission at 12 (citing Gerst Tr. 13-14).

 See 1/9/2007 email from Gail Kreitman to Laura Schwartz, GS MBS-E-007974381. 2517

 Id. 2518

 See 3/22/2007 email from Sihan Shu to Fabrice Tourre and David Gerst, GS MBS-E-003010587. 2519

 3/12/2007 Goldman memorandum to Mortgage Capital Committee, “ABACUS Transaction sponsored by 2520

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.

 3/12/2007 Goldman internal memorandum to Mortgage Capital Committee, “ABACUS Transaction sponsored 2521

by ACA,” GS MBS-E-002406025, Hearing Exhibit 4/27-118.

 See “Abacus 2007-AC1 Reference Portfolio,” chart prepared by Subcommittee. See also 1/5/2007 email from 2522

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-E003026086; 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.

rated BBB by S&P or Baa2 by Moody’s. Goldman sent Paulson a database and spreadsheet 2516

listing the securities that met Paulson’s criteria. Paulson used that database to select 123 2517

securities, and Goldman forwarded the resulting list to ACA. Over the next two months, a series 2518

of negotiations and meetings took place to finalize selection of the reference assets and the structure

of the CDO. 

On March 22, 2007, ACA and Paulson agreed on the final $2 billion reference portfolio for

Abacus 2007-AC1. The assets consisted of 90 Baa2 rated mid and subprime RMBS securities 2519

issued after January 1, 2006. The RMBS securities were “equally-sized,” each with a $22.22 2520

million notional value. Each asset in the final reference portfolio was approved by both Paulson 2521

and ACA. Of the final 90 RMBS securities, 49 had been initially proposed by Paulson, and 41 had

been initially proposed by ACA.2522
567

 Goldman Supp. Submission at 10, 13. 

2523

 Id. at 10. 2524

 SEC deposition of Paolo Pellegrini (12/3/2008), PSI-Paulson-04 (Pellegrini Depo)-0001, at 175-76. 2525

 3/12/2007 Goldman memorandum to Mortgage Capital Committee, “ABACUS Transaction sponsored by 2526

ACA,” at 3, GS MBS-E-002406025, Hearing Exhibit 4/27-118.

 5/8/2007 email from Fabrice Tourre to Josh Birnbaum, GS MBS-E-003611826, Hearing Exhibit 4/27-123. 2527

 3/23/2007 Goldman document, “Abacus 2007-AC1,” at 11-12, GS MBS-E-002807082, Hearing Exhibit 4/27- 2528

120.

 4/26/2007 Goldman Sachs Offering Circular, “Abacus 2007-AC1, Ltd.,” at 2, GS MBS-E-001918034. 2529

Goldman characterized Paulson’s participation in the asset selection process as one in which

the hedge fund merely “express[ed] [its] views” about the reference portfolio, which often

2523

happens in synthetic CDO transactions. The evidence indicates, however, that Paulson did more 2524

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:

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

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.” In an email to a colleague, however, Mr. Tourre wrote that the portfolio had been

2526

selected by “ACA/Paulson.” The Abacus Marketing book identified ACA as the portfolio 2527

selection agent for the CDO, and stated that the portfolio selection agent had selected the reference

assets. The Abacus Offering Memorandum stated: “The Initial Reference Portfolio will be 2528

selected by ACA Management, L.L.C.” 

2529

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:
568

 3/12/2007 email from Jorg Zimmerman (IKB) to Michael Nartey, GS MBS-E-002683134. 2530

 3/12/2007 email from Fabrice Tourre to Jonathan Egol, GS MBS-E-002648826. 2531

“[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 2531

selection agent, might or might not agree to, but only about what the Paulson hedge fund might

agree to.

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.
569

 April 23, 2010 Subcommittee Hearing at 63-64. 2532

 See 3/23/2007 Goldman document, “Abacus 2007-AC1,” at 14, GS MBS-E-002807082, Hearing Exhibit 4/27- 2533

120. 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. 

 Subcommittee interview of Laura Schwartz (ACA) (4/23/2010). 2534

 2/12/2007 “CDO Asset ‘Management’ Proposal for Abacus 2007-AC1,” submitted to ACA Commitments 2535

Committee, at 2, ACA-ABACUS-0000121560-66.

 2/23/2007 handwritten notes of Laura Schwartz, ACA Managing Director of CDO asset management, ACA 2536

ABACUS 00004171 at 173.

 4/10/2007 email from ACA Managing Director Laura Schwartz, ACA-ABACUS-0000006327. 2537

 1/10/2007 email from Fabrice Tourre to Laura Schwartz, GS MBS-E-002480520, Hearing Exhibit 4/27-108. 2538

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

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. According to ACA, it 2534

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

2536

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

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.” The ACA Managing 2538

Director told the Subcommittee that the “[0]%-[9]%” tranche identified in the Transaction
570

 

2539 Subcommittee interview of Laura Schwartz (4/23/2010). See also Statement of Laura Schwartz, ACA ABACUS

00004406 at 408. 

 Id. See also 1/10/2007 email from Fabrice Tourre to Laura Schwartz, “Transaction Summary,” GS MBS-E- 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). 

 3/23/2007 ACA/Goldman document, “Abacus 2007-AC1,” ACA-ABACUS-002807082, Hearing Exhibit 4/27- 2541

120; Statement of Laura Schwartz, ACA ABACUS 00004406 at 408.

 Statement of Laura Schwartz, ACA ABACUS 00004406 at 408. 2542

 Subcommittee interview of Fabrice Tourre (4/24/2010). 2543

 April 27, 2010 Subcommittee Hearing at 44. 2544

Summary matched the general description of an equity tranche, and the wording suggested that

someone had already committed to buy it. She explained that it was typical for a CDO sponsor 2539

to purchase the equity tranche, and she believed that Paulson, as the Abacus “sponsor,” had

committed to buy that tranche. The Abacus Marketing book also specified that the “First Loss” 2540

tranche of the CDO, of a “[+10%]” size, was “Not Offered” for sale. The ACA Managing 2541

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.” She thought that investor was the Paulson hedge 2542

fund.

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.
571

 Id. at 86. 2545

 ACA Financial Guaranty Corp. v. Goldman Sachs & Co., Index No. 650027/2011 (N.Y. Sup.), Complaint 2546

(January 6, 2011), at 1, 23 (hereinafter “ACA Complaint against Goldman Sachs). 

 April 27, 2010 Subcommittee Hearing at 86. 2547

 See 3/12/2007 Goldman memorandum to Mortgage Capital Committee, “ABACUS Transaction sponsored by 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

Mr. Tourre: Yes.2545

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

provide Paulson with CDS contracts containing premium payments below a certain level. The 2548
572

“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.

 SEC Complaint against Goldman Sachs at 18. See Credit Default Swap Insurance Policy, ACA ABACUS 2549

00001593. ACA complaint against Goldman Sachs at 15, 16. 

 See Goldman trading datasheet, GS MBS 0000004276 (showing closing dates and details on various deals, 2550

including Abacus).

 5/8/2007 email exchange between Joshua Birnbaum and Fabrice Tourre, “Post on Paulson and ABACUS 07- 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.

 The CDS contracts were executed between Goldman Sachs International and Paulson Credit Opportunities 2552

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. 

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 2549

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 2550

largest investor, taking the long side of a $909 million CDS contract referencing the super senior

portion of the CDO. Goldman took the short side of the CDS contract, which it then transferred 2551

to Paulson.2552
573

 SEC Complaint against Goldman Sachs at 3. 2553

 10/26/2007 email from Goldman salesman to Michael Swenson, “ABACUS 2007-AC1 – Marketing Points 2554

(INTERNAL ONLY) [T-Mail],” GS MBS-E-016034495. 

 SEC Complaint against Goldman Sachs at 3. 2555

 See SEC Complaint against Goldman Sachs. 2556

 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 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. 

 SEC Complaint against Goldman Sachs at 2, 20, 21. 2558

 Securities and Exchange Commission v. Goldman, Sachs & Co. and Fabrice Tourre, Case No. 10-CV-3229, 2559

(S.D.N.Y.), Consent of Goldman Sachs, (July 14, 2010), at 1, 2, 10 (hereinafter “Consent of Goldman Sachs”).

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. On October 26, 2007, a Goldman employee 2553

sent an email about Abacus 2007-AC1 with an assessment even more negative than that of the SEC: 

“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

On April 16, 2010, the SEC filed a complaint against Goldman and Mr. Tourre, alleging

their actions constituted securities fraud. The SEC specifically alleged violations of Section 2556

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. The SEC contended that Goldman had failed to disclose to potential 2557

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. On July 14, 2010, Goldman 2558

reached a $550 million settlement with the SEC. In connection with the settlement, Goldman 2559

acknowledged:

“[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
574

 Consent of Goldman Sachs at 2. Despite this acknowledgment by Goldman as part of the settlement, when asked 2560

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.

 Some of the administrative roles that Goldman filled in its CDOs, as described in its CDO agreements, included: 2561

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. 

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. Two examples, in which Goldman acted as the 2561

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.

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
575

 2/18/2008 Goldman presentation, “CDO Transactions (July 1, 2006 - December 31, 2007) in which Goldman 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.

 Subcommittee interview of Darryl Herrick (10/13/2010). 2563

 Subcommittee interview of Peter Ostrem (10/5/2010). 2564

 Id. Although Mr. Ostrem helped design the liquidation agent feature, he was not employed by Goldman when its

2565

CDO assets were downgraded and triggered its liquidation agent duties. 

 See 7/17/2006 Goldman memorandum to the Mortgage Capital Committee, “Placing debt and equity on a static 2566

high grade structured product CDO Squared with Investec (UK) Limited,” GS MBS-E-013458155. 

 Id. 2567

Grade 2006-1, Hudson Mezzanine 2006-2, and Anderson Mezzanine 2007-1. In each instance, 2562

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.

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 2563

liquidation agent feature. He told the Subcommittee that Goldman wanted to issue static 2564

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. The CDO Origination Desk also favored the approach, because it 2565

could be performed by Goldman itself at a lower cost than retaining a traditional collateral

manager. 

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
576

 Id. 2568

 Id. 2569

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,
577

 7/19/2007 Goldman document, “GS Liquidation Agent Role in ABS CDOs,” GS MBS-E-014055117. 

2570

 7/23/2007 email from Mr. Case to Mr. Bieber, “CDO Liquidation Agent Role - Draft Talking Points - 2571

INTERNAL USE ONLY,” GS MBS-E-015240358. 

 7/17/2006 Goldman memorandum to Mortgage Capital Committee, GS MBS-E-013458155, at 57. A 2572

“mezzanine” CDO is one in which the underlying assets carry credit ratings such as BBB or BBB-.

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 2572

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.

Hudson 1’s marketing materials outlined Goldman’s liquidation agent role. The Hudson

marketing booklet, for example, told potential investors: 
578

 10/2006 “Hudson Mezzanine 2006-1 Flipbook,” GS MBS-E-009546963, Hearing Exhibit 4/27-87. 

2573

 Goldman Sachs Hudson Mezzanine Funding 2006-1, LTD Preliminary Termsheet, GS MBS-E-001557869. 2574

 12/3/2006 Hudson Mezzanine 2006-1, LTD. Offering Circular, GS MBS-E-021821196 at 234. 

2575

 10/2006 “Hudson Mezzanine 2006-1 Flipbook,” GS MBS-E-009546963, Hearing Exhibit 4/27-87. 2576

 See Goldman Sachs response to Subcommittee QFR at PSI_QFR_GS0239. 2577

 10/6/2006 email from Michael Halevi to Olivia Ha, GS MBS-E-014338525. 

2578

 Subcommittee interview of Darryl Herrick (10/13/2010). 2579

“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.” The Subcommittee was unable to find 2578

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.” When asked whether the “flexibility” to delay a sale violated Hudson’s prohibition 2579

against discretionary trading by the liquidation agent, Mr. Herrick said that Goldman had
579

 Id. Mr. Herrick was not employed by Goldman when its CDO assets were downgraded and triggered its

2580

liquidation agent duties. 

 1/3/2008 email from Shelly Lin to Mr. Sparks, GS MBS-E-021880171 (attached file, “Deal Summary,” GS 2581

MBS-E-021880172). 

 Id. 

2582

 10/15/2007 email from Naina Kalavar, “NAB/Hudson Mezz Update 2,” GS MBS-E-015738973. Mr. Case used 2583

this email to circulate his notes of the two telephone conversations.

 Id. at 2. The notes included the following: “[C]urrent distressed nature of the assets has been fully priced in and 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.”

 Id. at 3. Such an amendment would require investor consent. 2585

“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

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. Within three months, by October 15, 2007, over 28% of the 2581

Hudson assets qualified as Credit Risk Assets. As liquidation agent, Goldman should have 2582

begun issuing bids to sell the assets at the best possible price and remove them from the Hudson

CDO, but it did not.

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 2583

liquidate any of the Credit Risk Assets, explaining that Goldman was waiting for asset prices to

improve. He also reported that Goldman was considering an amendment to the Hudson 2584

transaction that would extend the maximum liquidation period, as well as make other structural

changes to the Hudson deal. 

2585

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:

1. Large institutional assets manager will be able to access more liquidity b/c [because] they

can access other broker dealers and get good pricing[.]
580

 10/15/2007 email from Naina Kalavar, “NAB/Hudson Mezz Update 2,” GS MBS-E-015738973. 2586

 Id. at 75. 2587

 Id. at 76. 2588

 Id. 2589

 11/9/2007 email from Mr. Case to Mr. Lehman, GS MBS-E-021876334. 

2590

 2/29/2008 letter from Morgan Stanley to Goldman, HUD-CDO-00006877. 

2591

 Reference asset OOMLT 2006-2 M8. See 1/3/2008 email from Shelly Lin to Mr. Sparks, GS MBS-E- 2592

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- 2593

021880171 (attached file, “Deal Summary,” GS MBS-E-021880172). 

2. 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[.]

3. 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.

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: 2588

“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

responsibilities to a third party. At that point, Goldman had yet to liquidate any of the Hudson 2590

Credit Risk Assets. The nine assets that had become Credit Risks in July had already dropped 2591

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, 2592

had fallen in value by November 1 to 7% of par.

2593
581

 See 11/29/2007 email from Mr. Case to Mr. Sparks, Mr. Lehman, and others, GS MBS-E-021876502. 2594

 Subcommittee interview of David Lehman (9/27/2010). 2595

 12/18/2007 email from Lira Lee to [investor], GS MBS-E-021878556. 

2596

 See discussion of Hudson 1, above. 

2597

 12/19/2007 email from Mr. Case to Nicole Martin of Morgan Stanley, GS MBS-E-021876172. 

2598

 Subcommittee interview of Morgan Stanley (8/6/2009). 2599

 Id. 

2600

 1/3/2008 email from Shelly Lin to Mr. Sparks, GS MBS-E-021880171 (attached file, “Deal Summary,” GS 2601

MBS-E-021880172). 

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. Mr. Lehman told the 2594

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. On December 18, 2007, while Goldman was still seeking investor 2595

approval to assign the liquidation agent role to TCW, a Goldman representative explained to an

investor the firm’s thinking:

“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, was presented with a consent form 2597

to assign the liquidation agent rights to TCW. Morgan Stanley told the Subcommittee that it had 2598

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. Morgan 2599

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

 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.]
Credit Risk Assets (%) 

35.00% 

30.00% 

G) I Anderson (,J 

c: 

nI 25.00% • Hout Bay 

nI 

In II Hudson High Grade 

-

G) 20.00% 

I/) II Hudson Mezz 1 

I/) 

<C II Hudson Mezz 2 

- 15.00% c: 

e ... 

:::l 

() 10.00% ... 

0 

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

 Id. 2602

 See, e.g., 1/16/2008 email from Nicole Martin to Mr. Lehman, GS MBS-E-022164848. 

2603

 Due to the extensive losses experienced by Hudson 1, by January 2008, Morgan Stanley was likely the only long 2604

investor whose investment was not completely extinguished. 

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 2603

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
60.00% 

50.00% 

40.00% 

~ 30.00% 

oJ 

20.00% 

10.00% 

0.00% 

7/16/2007 

Weighted Average Levels 

I Anderson 

• Houl Bay 

o Hudson High Grade 

II Hudson Mezz 1 

II Hudson Mezz 2 

8/15/2007 9/14/2007 10/14/2007 11/13/2007 12/13/2007 

Date 
585

 1/16/2008 email from John Pearce of Morgan Stanley to Michael Petrick, HUD-CDO-00004851. 2605

 2/5/2008 email from Mr. Pearce to Mr. Lehman and Nicole Martin, HUD-CDO-00004852. 2606

 2/6/2008 email from Mr. Pearce to Michael Petrick, HUD-CDO-00005146. 

2607

 2/7/2008 email from Mr. Pearce to Mr. Lehman, HUD-CDO-00005147. 2608

 Transcript of 2/13/2008 telephone call between Morgan Stanley and Goldman, HUD-CDO-00006894. See also 2609

2/28/2008 email from Sue Fertel-Kramer to Mr. Case and others, GS MBS-E-021881029. 

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: 2605

“[P]lease call when possible – $969mm now eligible to be liquidated post S&P do[w]ngrades.” 

2606

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
586

 Transcript of 2/13/2008 telephone call between Morgan Stanley and Goldman, HUD-CDO-00006894. 

2610

 Id. 2611

 2/21/2008 email from Vanessa Vanacker to Mr. Pearce, HUD-CDO-00004882. 2/29/2008 letter from Morgan 2612

Stanley to Goldman, HUD-CDO-00006877. 

 12/3/2006 Hudson Mezzanine 2006-1, LTD. Offering Circular, section entitled, “Disposition of CDS 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. 

 2/29/2008 letter from Morgan Stanley to Goldman, HUD-CDO-00006877 [emphasis in original]. 2614

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.” During the call, Morgan

2610

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

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.” On February 29, 2008, Morgan Stanley sent Goldman a letter demanding that it 2613

immediately initiate liquidation of $1 billion in Hudson Credit Risk Assets:

“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
587

 3/10/2008 letter from Goldman to Morgan Stanley, HUD-CDO-00006881. The letter also states: “Morgan 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.” 

 See 3/27/2008 email from Morgan Stanley to Goldman, HUD-CDO-00004378. On March 24, 2008, Goldman 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. 

 See, e.g., 3/27/2008 email from Morgan Stanley to Goldman, HUD-CDO-00004378. See also 3/20/2008 email 2617

from Mr. Case, GS MBS-E-021880596. 

 See 6/6/2008 letter from Goldman as liquidation agent, “Hudson Mezzanine Funding 2006-1, Ltd. - Certain 2618

Dispositions of Assets,” HUD-CDO-00003155. 

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

2616

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. Liquidation 2617

proceeded over the next two months, from April through June. On July 22, 2008, Hudson’s 2618

realized losses exceeded $800 million, and Hudson 1 went into default. Hudson’s remaining assets
588

 See 11/21/2008 letter from Goldman to Morgan Stanley, HUD-CDO-00005125. 

2619

 The amount of assets in the default swap collateral account was required to equal the total face (“notional”) 2620

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. 

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 2620

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.” 

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
589

 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.

 The Timberwolf Indenture agreement referred to this role as the “Synthetic Security Counterparty.” See 2622

3/27/2007 Timberwolf I, LTD. Indenture Agreement, at § 12.5(b), GS MBS-E-021825583 at 711. 

 Typically a shell company incorporated in a foreign jurisdiction (often the Cayman Islands) and a shell company 2623

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. 

investments. If the CDO had a collateral manager, the manager often selected the CDO’s default 2621

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

affected the default swap collateral securities, acting as both the CDO’s primary CDS

counterparty and its collateral put provider. Goldman’s synthetic CDOs typically followed 2622

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”). GSI 2623

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.

 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
590

 Another option was for Goldman to take physical possession of the security. 2624

 In a typical put agreement, the put provider guarantees to pay to the put purchaser the face (par) value of a 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. 

 See 3/27/2007 Timberwolf I, LTD. Indenture Agreement, at § 12.5(b), GS MBS-E-021825583 at 712. For 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.

 Any subsequent losses resulting from Goldman’s role as the collateral put provider would reduce the profit 2627

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

satisfy the amount owed to GSI under the CDS contracts. GSI would then use the cash it 2624

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. 

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
591

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. 

 Timberwolf used this reduced premium approach, but in a few other instances, such as Hudson Mezzanine 2006- 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: 

• “Current Put Option Booking State: 22 Deals with the Put Option Feature

C 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.”

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
592

 One reason Goldman was so concerned about the value of the default swap collateral securities was because 2629

those securities included AAA rated RMBS securities whose values were declining in line with the entire mortgage

market. 

 6/20/2007 email from Matthew Bieber to Goldman colleagues, GS MBS-E-001912772 (“Below are the deals I 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.”).

 Id. Mr. Bieber listed the following CDOs: Adirondack 1; Adirondack 2; Coolidge Funding; Broadwick; 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.

 Subcommittee interview of Matthew Bieber (10/21/2010). 2632

 7/18/2007 email from Alfa Kiflu, GS MBS-E-001866507. The six CDOs in which Goldman had large short 2633

positions were: Hudson Mezzanine 1; Timberwolf; Camber 7; Hudson Mezzanine 2; GSC ABS Funding 2006-3G;

and Anderson Mezzanine. 

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. 

In the late spring of 2007, Goldman began to closely monitor the value of the default swap

collateral securities in its synthetic CDOs. On June 20, 2007, Matthew Bieber, a Goldman 2629

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 2630

swap collateral securities may have lost value and stated: “we need to get Dan [Sparks, the

Mortgage Department head,] a list this morning.” When asked about this email, Mr. Bieber told 2631

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 2632

various CDOs submitted lists of the existing default swap collateral securities with their par and

market values. 

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
593

 7/19/2007 email from Matthew Bieber to David Lehman, GS MBS-E-011178225. 

2634

 7/19/2007 email from Patrick Welch, GS MBS-E-001866507. 

2635

 7/25/2007 email from Fabrice Tourre, GS MBS-E-001989091. 

2636

 Id. Greywolf Capital was the collateral manager of the Timberwolf CDO. 2637

 7/25/2007 email from Matthew Bieber, GS MBS-E-001989091. 2638

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%. During the same period, the value of Goldman’s short position had increased. 2636

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:

“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
594

 7/26/2007 email from Shelly Lin, GS MBS-E-015232129. 2639

 7/30/2007 email from Matthew Bieber to David Lehman, GS MBS-E-001867239. 

2640

 See 8/6/2007 email from Connie Kang to David Lehman, GS MBS-E-001992556; 8/9/2007 email from Mahesh 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.

 In addition, since the yield of most default swap collateral securities was linked to their “face (par) value,” when 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. 

 8/21/2007 email from Matthew Bieber to David Lehman, GS MBS-E-011273913. 2643

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 2639

purchase of new default swap collateral securities, Mr. Bieber asked Mr. Lehman for a meeting to

discuss how to proceed:

“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 2642

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. 

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.” Mr. Lehman 2643

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.
595

 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.”). 

 9/6/2007 email from Roman Shimonov to Matthew Bieber, GS MBS-E-000765873. 2645

 9/6/2007 email from Joe Marconi to David Lehman, GW 107909. 2646

 Subcommittee interview of Joseph Marconi (Greywolf Capital) (10/19/2010). 2647

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.” Mr. 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:

“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:
596

 9/7/2007 email from Joe Marconi to David Lehman, GW 107909. 2648

 Subcommittee interview of Joseph Marconi (Greywolf Capital) (10/19/2010). 2649

 Id. 2650

 Section 12.5(b) of the Timberwolf Indenture agreement stated: “The Synthetic Securities shall be structured as 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

“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. In 2650

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.

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
597

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.

 7/25/2007 email from Matthew Bieber, GS MBS-E-001989091. 

2652

 1/7/2011 email from Goldman counsel to the Subcommittee. 2653

 9/7/2007 email from Matthew Bieber to Tim Saunders, Susan Helfrick, and Jordan Horvath, GS MBS-E- 2654

021881077.

 Id. 2655

 9/7/2007 email from Susan Helfrick to Matthew Bieber, Tim Saunders, and Jordan Horvath, GS MBS-E- 2656

021881084. 

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.” But when the Subcommittee asked about the 2652

matter, Goldman’s legal counsel sent a written statement indicating the Indenture agreement

authorized Goldman’s actions:

“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, and one of the counsels requested a 2655

copy of the Offering Memorandum and “the operative documents that contain our rights/obligations

with respect to the Collateral.”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
598

 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). 

 Subcommittee interview of Matthew Bieber (10/21/2010). 2658

 9/7/2007 email exchange between David Lehman and Matthew Bieber, GS MBS-E-000766414. The reference

2659

to “slmas” is to asset backed securities that were issued by Sallie Mae and backed by pools of student loans.

 Id. 2660

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.” Mr. Bieber, the Timberwolf deal captain, told the 2657

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

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
599

 9/7/2007 email from Jonathan Egol to Michael Swenson and David Lehman, GS MBS-E-000765854. 

2661

 See 9/7/2007 email from Matthew Bieber to David Lehman, GS MBS-E-000766414 (“I need to speak with 2662

dan... we’re thinking about offering some 1-3 year SLMAs.”). 

 9/10/2007 email from Matthew Bieber to David Lehman, GS MBS-E-000765316. “SLMA” refers to asset 2663

backed securities that were issued by Sallie Mae and backed by pools of student loans.

 9/25/2007 email from Matthew Bieber to Joe Marconi, GS MBS-E-000766338. The action taken by Goldman 2664

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:

 1. The aim of the collateral account was to provide LIBOR and not add additional risk to the deal.

 2. GS said they would take market risk and clearly represented that to us and to the ratings agencies.

3. 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.” 

11/20/2007 email from Ron Beller to Matthew Bieber, GS MBS-E-013746516.

 Documents show that a list of assets was sent to Aladdin Capital Management and Trust Company of the West. 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-

27. 

loans. Mr. Bieber sent an email the same day indicating he supported that approach, but wanted

2661

to speak first with Mr. Sparks, head of the Mortgage Department.2662

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

managers of its CDOs. On October 15, 2007, Mr. Bieber provided virtually the same list to a 2665

Goldman colleague together with a short explanation of some of the criteria used to identify the

securities:

 
600

 10/15/2007 email from Matthew Bieber to Matthew Verrochi, GS MBS-E-015732147. The list had one more 2666

RMBS security than the lists sent to the collateral managers.

 9/27/2007 email from Joe Marconi to Matthew Bieber, GW 108645. 2667

 Written statement of David Lehman (1/26/2011). 2668

 Subcommittee interview of Daniel Sparks (1/13/2011). 2669

 The seven CDOs were Fort Denison, Camber 7, Timberwolf, Anderson Mezzanine, Point Pleasant, Hudson 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.

“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. Mr. Sparks said the yield 2668

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 2669

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
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.

1. 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.

2. 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.

3. 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. 

4. 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.

5. 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.

6. 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.

7. 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

8. 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. 

9. 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.

10. 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.

11. 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.

12. 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, brokerdealer, 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 

or more investment banks, each of which is a broker-dealer registered with the Financial Industry 

Regulatory Authority (FINRA).2675

 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?” 

 An underwriter is typically hired by the issuer of the new 

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.

http://finra.atgnow.com/finra/categoryBrowse.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. 
605

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 

1934. 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)).
606

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:

“[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.”2680

With respect to 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.”2681 

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 brokerdealer 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.
607

“[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.”2683

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).
608

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 brokerdealer 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].
609

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. 
610

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 In the April 27, 2010 Subcommittee hearing, for 

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 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 marketlevel 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.
611

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. 
612

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). 
613

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 The Mortgage Department responded with a concerted 

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.

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

 2705 Id.

 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 

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.
614

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

 2709 1/31/2007 email from Daniel Sparks to Tom Montag, “MTModel,” Hearing Exhibit 4/27-91.

 In Korea, a Goldman sales representative attempting to sell $56 million in 

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.
615

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 brokerdealer, 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 In Abacus, 

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. 

 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.
616

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. 
617

the sole counterparty to the investors buying Hudson securities, thereby acquiring a $2 billion 

financial interest that was directly adverse to theirs.2725 

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 Customers learning of GSI’s role as the initial sole counterparty in the 

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.

 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.”
618

Goldman’s failure to disclose its short interest was further compounded when it told 

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

 2728 10/2006 Hudson Mezzanine Funding 2006-1, LTD., GS MBS-E-009546963, at 966, Hearing Exhibit 4/27-87. 

 In June 2007, its net short reached about $13.9 billion. A significant issue is whether 

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 

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.
619

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 

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 

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.
620

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

 2741 SEC Study on Investment Advisers and Broker-Dealers at 55.

 When asked by the 

Subcommittee what he meant by that comment, Mr. Steffelin said that he believed the Abacus 

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.
621

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.
622

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.

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.

reviewed had 

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-

77.
623

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 writedown, 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. 
624

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 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.

 In a 

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. GlassSteagall 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. 
625

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

 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.

 Based on earnings reported in January 2011 for Goldman=s full fiscal year 

2010, the proprietary investment income recorded under “Investments and Lending” accounted 

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. 
626

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 After Principal Investments personnel moved to SSG, the Mortgage Department 

operated without a desk that was explicitly dedicated to proprietary trading during 2006 and 

2007.

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.
627

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

 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.”). 

 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, 

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.
628

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 Under another section entitled, “Assumptions/ Initiatives in ABS [Asset Backed 

Security] p&l [profit and loss],” the draft business plan stated:

 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.
629

$ “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 Nonetheless, many of the transactions undertaken 

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.

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”).
630

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 Second, the magnitude of the risk attached to those short 

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. 

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 

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.

 On another occasion in March 2007, a Goldman employee 

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 
631

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:

1. 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. ...

3. 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 
632

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: 

“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.”2815

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:

“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. 
633

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 In an October 2007 letter sent 

to the SEC, Goldman wrote:

“[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 None of these internal documents suggests that the Mortgage Department’s net short 

transactions were undertaken to accommodate existing or anticipated client trades. 

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-E005565527, 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-E013703468, 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.
634

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 

2007. 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).
635

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

 2828 3/3/2007 email from Mr. Salem, “Another idea . . .,” GS MBS-E-012511081.

 He discussed the proposal with other Mortgage Department 

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.
636

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

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 DoddFrank Act are designed to address and reduce these conflicts. 

D. Preventing Investment Bank Abuses 

Developments over the past two years offer a number of ways to address problems 

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).

(1) New Developments

The Dodd-Frank Act contains several measures that affect investment banking practices. 

Three key provisions involve proprietary investments, conflicts of interest, and a new study of 

permitted banking activities. 

Proprietary Trading Restrictions. Commercial banks, their holding companies, and 

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

The proprietary trading provision also addresses conflicts of interest and high risk 

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 

 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).
637

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.

Investment banks that have no bank affiliation are not subject to the law's proprietary 

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 

Conflict of Interest Prohibitions. In 2009, one well known investment adviser 

described the link between proprietary trading and conflicts of interest as follows:

“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.
638

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. 

Study of Banking Activities. Section 620 of the Dodd-Frank Act directs banking 

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.

Structured Finance Guidance. In connection with provisions in the Dodd-Frank Act 

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.

(2) Recommendations

To prevent investment bank abuses and protect the U.S. financial system from future 

financial crises, this Report makes the following recommendations.

 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).
639

1. 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.

2. Narrow Proprietary Trading Exceptions. To ensure a meaningful ban on 

proprietary trading under Section 619, any exceptions to that ban, such as for marketmaking or risk-mitigating hedging activities, should be strictly limited in the 

implementing regulations to activities that serve clients or reduce risk. 

3. 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. 

4. 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. 

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