Government report blames regulators and financial institutions for economic crisis

By Zachary A. Goldfarb and Brady Dennis
Washington Post Staff Writers
Thursday, January 27, 2011; 9:42 PM

The official U.S. government report on what caused the financial crisis casts blame on Goldman Sachs for fueling the subprime mortgage bubble, Merrill Lynch for not telling investors about the true state of its financial condition and the Federal Reserve for failing to stop dangerous lending practices.

The report released Thursday by the Financial Crisis Inquiry Commission, a congressionally appointed panel that has spent the past 18 months investigating the causes of the worst financial calamity in generations, spares virtually no one in assigning culpability.

Released to the public online and in the form of a 633-page paperback, the report does not contain any major revelation that would fundamentally alter popular perceptions of the crisis. But it weaves together many different strains of information, garnered with subpoena powers that allowed the commission to collect testimony from dozens of insiders and review the internal documents of federal regulators and banks.

"This report exposes facts, identifies responsibility, unravels myths and helps us understand how this crisis could have been avoided. It is our best attempt to record history, not to rewrite it, nor allow it to be rewritten," commission chairman Phil Angelides, the former treasurer of California, said at a news conference Thursday morning.

The commission said it referred potential violations of law to the Justice Department or to state attorneys general, but it did not provide more specifics.

The report was approved by Angelides and five other members of the panel appointed by the congressional Democratic leadership. The Republican minority on the panel opposed the report and released two dissents. The political schism has cast doubt on whether the document will stand as the definitive historical account of the crisis.


While the report is scathing in its review of Wall Street, what's notable is how hard it comes down on federal regulators for missing warning signs, fighting turf wars and being shortsighted overall. "We conclude the government was ill-prepared for the crisis, and its inconsistent response added to the uncertainty and panic in the financial markets," the report says.

The panel places considerable blame on the Federal Reserve for failing to use its powers to stop banks from taking part in massive amounts of high-risk mortgage lending. The Fed committed a "pivotal failure to stem the flow of toxic mortgages, which it could have done by setting prudent mortgage-lending standards," the report says. "The Federal Reserve was the one entity empowered to do so and it did not."

The report also questions the Fed's decision not to save Lehman Brothers from collapse in the fall of 2008.

Fed Chairman Ben S. Bernanke has said the Fed did not have the authority to bail out Lehman, because there was no certainty of being paid back. But the report says the law does not require loans to be "fully secured," which the Fed's top lawyer acknowledged in an internal memo.

The report also paints an unflattering picture of other regulators, including the Securities and Exchange Commission and banking overseers, the Office of the Comptroller of the Currency, and the Office of Thrift Supervision.

The SEC, which had primary oversight over major investment banks, "failed to restrict their risky activities and did not require them to hold adequate capital and liquidity for their activities, contributing to the failure or need for government bailouts of all five of the supervised investment banks during the financial crisis," the report says.

Investment banks

The report shines a harsh light on Wall Street's most storied name, Goldman Sachs, which survived the financial crisis with few dents to its business.

The report says Goldman played a key role by providing billions of dollars in loans to subprime mortgage lenders and then bundling tens of billions of dollars in risky loans into investments.

At the same time, the report said, Goldman was involved in fancy financial engineering - the creation of investment products that let people speculate on whether mortgage investments would rise or fall in value. Goldman itself often bet against the investments it created and sold to others.

"These new instruments would yield substantial profits for investors that held a short position," the report says. "They also would multiply losses when housing prices collapse."

Once the financial system began to slide, Goldman aggressively pressured the failing insurance giant American International Group to repay loans at terms worse than other companies were demanding.

"It would pursue AIG relentlessly with demands from collateral based on marks that were initially well below those of other firms," the report says, "while AIG and its management struggled to come to grips with the burgeoning crisis."

The report also raises questions about whether Merrill Lynch, later bought by Bank of America, told investors about the company's plight as legally required. In late 2006 and early 2007, Merrill began to understand the massive risks associated with its exposure to subprime mortgages. But on conference calls with investors and analysts, executives said the company's finances would not be impaired.

Shadow markets

The report highlights the bailout of AIG to illustrate the mounting risk posed by large, interconnected financial firms operating beyond the sight of regulators.

AIG was one of the world's largest and most revered insurance firms. But its little-known Financial Products unit had cashed in on its parent company's pristine AAA rating to amass a vast portfolio of risky but lucrative derivatives contracts known as credit-default swaps, which essentially were insurance policies on mortgage-related securities.

But because Financial Products operated within the "shadow" markets outside the realm of federal regulation, the company was not required to set aside money to protect against possible losses, and regulators were blind to the risks within the firm.

The vast derivatives market - AIG was merely one of numerous firms that built massive portfolios of complex financial instruments - amplified risk throughout the financial system by multiplying any losses. Investors and officials could not tell how leveraged and under-capitalized some firms had become.

When the housing bubble burst and AIG lost its AAA credit rating, Financial Products could not meet its obligations to its trading partners to post billions in collateral. With AIG teetering on the edge of bankruptcy, federal officials feared that its collapse would drag down other firms and could lead to a worldwide financial panic.

"The existence of millions of derivatives contracts of all types between systemically important financial institutions - unseen and unknown in this unregulated market - added to uncertainty and escalated panic, helping to precipitate government assistance to those institutions," the report says.

Fannie Mae, Freddie Mac

The report tackles the role of Fannie Mae and Freddie Mac, the mortgage finance giants taken over by the government in the fall of 2008, and wades into the debate over whether they were the chief villains or simply co-conspirators. This question is what most divided the Republican and Democratic members of the commission.

The report calls the firms "kings of leverage" that borrowed $75 for every dollar they had reserved as a financial cushion, and it chastises the companies' regulator, now called the Federal Housing Finance Agency, for failing to stop the companies' march into the subprime mortgage market.

"The risk practices of Fannie Mae . . . led to its fall: practices undertaken to meet Wall Street expectations for growth, to regain market share, and to ensure generous compensation for its employees," the report says.

Fannie and Freddie were not the first to pursue subprime mortgages. They "followed rather than led Wall Street and other lenders," the report says. It adds that Fannie and Freddie's pursuit of subprime mortgages was driven only in part by demands from policymakers that the companies fulfill the goal of boosting homeownership among low-income and minority groups.

Republicans argue that Fannie and Freddie, pressured to buy risky mortgages to fulfill these social mandates, were primary instigators of the subprime boom.

In a separate dissent, Peter J. Wallison, a fellow at the American Enterprise Institute, wrote that "if the U.S. government had not chosen this policy path - fostering the growth of a bubble of unprecedented size and an equally unprecedented number of weak and high-risk residential mortgages - the great financial crisis of 2008 would never have occurred."


The three Republican members of the panel other than Wallison issued a joint dissent that called the conclusions in the majority's report far too broad.

"Not everything that went wrong during the financial crisis caused the crisis," the three wrote, adding that the majority's findings amounted to "more an account of bad events than a focused explanation of what happened and why. When everything is important, nothing is."

They criticized the panel's conclusions as failing to focus more on the global nature of the crisis and for overstating the role lax regulation played in the economic calamity. By "failing to distinguish sufficiently between causes and effects, the majority's report is unbalanced and leads to incorrect conclusions about what caused the crisis," they wrote.

In contrast, the dissenting Republicans offered a more pointed assessment. They boiled down the causes of the crisis into a 10-item list, which includes the credit and housing bubbles; the proliferation of subprime and other high-risk mortgages; excessive risk and massive leveraging; failures in the credit rating and securitization process; and the interconnected nature of many large financial firms.

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