Naming Culprits in the Financial Crisis

IMAGE Senator Carl Levin, Democrat of Michigan, Left, Susan Walsh/ Associated Press; left, and
IMAGE Kerry Killinger, the ex-chief executive of Washington Mutual. Right, Mark Wilson/Getty Images

The report singled out the bank for blame.

A voluminous report on the financial crisis by the United States Senate — citing internal documents and private communications of bank executives, regulators, credit ratings agencies and investors — describes business practices that were rife with conflicts during the mortgage mania and reckless activities that were ignored inside the banks and among their federal regulators.

IMAGE John Reich, top, formerly of the Office of Thrift Supervision.

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

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

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

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

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

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

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

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

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

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

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

The report uncovered a new aspect of Goldman’s mortgage activity during 2007. That year, as Goldman tried to build its bet against housing, the report says, it drove down the cost of shorting the mortgage market by squeezing those who had made negative bets. Goldman tried to put on the squeeze, the report noted, so that it could add to its negative bets more cheaply and protect itself against the housing collapse.

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

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

Goldman abandoned its plan in June 2007 when two Bear Stearns hedge funds collapsed because of bad mortgage bets.

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

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

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

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

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

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

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

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

Mr. Lippmann declined to comment on Wednesday.

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

A version of this article appeared in print on April 14, 2011, on page B1