Wall Street and the Financial Crisis: Anatomy of a Financial Collapse


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, |1238| and from $5 to $10 million to act as the placement agent for a CDO securitization. |1239| Those fees contributed substantial revenues to the investment banks which set 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 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 Sachs 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 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.


1237. 3/4/2011 "U.S. Mortgage- Related Securities Issuance" and 1/1/2011 1237 "Global CDO Issuance," charts prepared 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. [Back]

1238. See, e.g., 2/2011 chart, "Goldman Sachs Expected Profit from RMBS Securitizations," prepared by the U.S. Senate Permanent Subcommittee on Investigations using Goldman- produced documents for securitizations from 2005- 2007 (underlying documents retained in Subcommittee file); 3/21/2011 letter from Deutsche Bank counsel, PSI- Deutsche_Bank- 32- 0001. [Back]

1239. 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, 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. [Back]

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E. Preventing Inflated Credit Ratings A. Background

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