Financial Crisis Inquiry Commission

From Manal Mehta  of Branch Hill Capital:


I cannot do this justice by attempting to summarize – full transcript for session 3 appears below these 3 selected quotes (important bits are boldfaced and highlighted).  Please note that the FCIC – the Financial Crisis Inquiry Commission – was established by Congress and signed into law by the President on May 20, 2009.  The Commission was established to “examine the causes, domestic and global, of the current financial and economic crisis in the United States.”  The testimony that appears below was under oath and part of the official record.

For a video of this hearing, click on: and fast forward to the 2:58 marker for Session 3.

Quote 1 on what happens to defective mortgages and how they end up in securitizations anyway:

MR. JOHNSON: I think it goes to “three strikes, you’re out” rule.

CHAIRMAN ANGELIDES: So this was a case of — okay, three strikes.

MR. JOHNSON: I’ve heard that even used. Try it once, try it twice, try it three times, and if you can’t get it out, then put –

CHAIRMAN ANGELIDES: Well, the odds are pretty good if you are sampling 5 to 10 percent that you’ll pop through. When you said the good, the bad, the ugly, the ugly will pop through.

Quote 2 on Wow – Deutsche Bank didn’t want the report showing how many defective mortgages they were securitizing – could expose them to liability:

CHAIRMAN ANGELIDES: Can I ask just one quick follow-up very quickly? I have a note that — I think from you, Ms. Beal, in your interview you said you did take the trending reports at Deutsche Bank, but they didn’t really like the product because I think they were concerned that if it got in the hands of the wrong people, it would be misunderstood, so they were concerned about what you were showing them?

MS. BEAL: Yes. We took the reports to Deutsche Bank and their transaction management team that we worked with day-to-day, they were overall very positive, as were most of our — all of our clients that we spoke with. They liked that we had the capability to start developing reports to use the data to show them trends. They were giving feedback on how to make the reports more meaningful. In the instance of Deutsche Bank, one of their senior managers joined the meeting and he took a look at it. And understanding the process that Deutsche Bank used where they had a — grade more loans as a material exception based on their client tolerances, and then took away that discretion from Clayton to grade loans 2s with compensating factors so that they wanted to look at the loans. So there again we were generating more Level 3 loans. They showed more loans graded than the 2-W and the 2-T. And he was concerned that the reports could be misunderstood, which we agree with that concern because that was our beta version. We understood we needed to standardized the reports, so that –

CHAIRMAN ANGELIDES: Of course information is information. If it’s properly presented, people can make determinations.

MS. BEAL: Yes.

Quote 3 on how due diligence was used to negotiate lower prices for pools than disclose to investors:

COMMISSIONER GEORGIOU: And that feeds a little into what I think Ms. Beal and Mr. Johnson said, which is that your analysis at Clayton was utilized frequently by the securitizers to bargain down the price of the pool of loans that they were purchasing from the originators, but that didn’t necessarily translate into that information being utilized to structure the ultimate pool of loans that was put into the securities up the line.

Of course, you didn’t really know what they did with that; is that correct, Ms. Beal?

MS. BEAL: That’s correct. We didn’t know what they did with the data we gave them and the results.

MR. JOHNSON: Back in the ’80s sample sizes were closer to 50, 100 percent.

VICE CHAIRMAN THOMAS: Oh, well, that’s entirely different.

MR. JOHNSON: Right. All I am saying in the 2000 to 2000 period, sample sizes got lower. I think we were used to basically help negotiate the purchase price between a buyer and a seller.


CHAIRMAN ANGELIDES: Thank you very much. Let’s do this: I think we will start with you, Mr. Johnson, today. And thank you all three of you for your written testimony which has been entered into the record. And Mr. Johnson and other witnesses, we are going to ask you to give up to 5 minutes of oral testimony. There is a light here which you can look at and when it turns to yellow, that means you have one minute so you should begin to sum up. And when it gets to red, that means your time is up.  So Mr. Johnson, let’s start with you.

MR. JOHNSON: Thank you.

Chairman Angelides, Vice Chairman Thomas, and members of the Commission, my name is Keith Johnson and 23 I have been in the financial services and banking industry for 30 years. From 1986 to 2000, I was employed by Bank United of Texas where I held a variety of executive positions involving finance, capital markets, loan origination, securitization and servicing.  In 2000, Bank United was sold to Washington Mutual where I became their chief operating officer of WaMu’s commercial segment. In mid-2003, I was asked to assist the existing management of Long Beach Mortgage. And in 2005, while remaining employed at WaMu, I became the acting president of Long Beach for approximately nine months. In May of 2006, I left WaMu and became President and Chief Operating Officer of Clayton Holdings, the largest residential loan due diligence and securitization surveillance company in United States and Europe. And I left Clayton at the beginning of 2009 shortly after we sold it to a private real estate investment fund. I thank the commission for the invitation to appear, and I hope that my testimony will assist in your efforts to better understand the cause of the financial crisis. The Commission has asked me to address several topics related to loan securitization, mortgage brokers, and their related impact to the Sacramento region and other communities in the Central Valley.

In my opinion, this crisis is not the result of a single cause but a combination of significant factors operating at the same time and feeding each other. Low interest rates, increased housing goals, creative securitization, lack of assigning liability, compromised warehouse lending, flawed rating industry process, relaxed and abusive lending practices, rich incentives, shortfalls on regulation and enforcement provided the fuel to inflate home prices and excess borrowing by consumers.

Now, in addition to the factors I previously mentioned, improvements in technology, credit scoring, and financial engineering transformed the traditional lending platforms into financial factories. Several of these factories were originating, packaging, securitizing, and selling at the rate of $1 billion a day.

The quality control processes failed at a variety of stages during the manufacturing, distribution, and ongoing servicing. Traditional regulatory examination procedures were not able to evaluate either processing exceptions nor the resulting cumulative risk.

The lack of accountability and failure by many parties to present value the pain allowed the process to continue. And lastly, the lingering impact and transformation has been the starting of practical solutions between borrowers facing financial hardship and the investors with principal at risk.

Now, many will blame this crisis on growth of securitization, but I believe that securitization was flawed and abused but it can and will be beneficial to the public as it provides a vehicle for lenders to sell loans in exchange for the capital necessary to make additional loans.

Hopefully, this crisis will lead to reform of commonsense improvements to bring back a prudent, robust securitization market. Now, as it relates to doing business with mortgage brokers, I can share with you my experience at Long Beach and observations while at Clayton. Unlike most mortgage companies that contain multiple origination channels — retail, telephone, refinance — Long Beach was a subprime lender that relied 100 percent on mortgage brokers.

Broker-originated loans was and can be a viable loan production channel. The model serves a purpose in helping those financial institutions reach out to unbanked and underbanked areas; however, performance data has shown us that the broker model became flawed with greed, fraud, and deception.

Low barriers of entry, lack of regulatory supervision or enforcement coupled with rich incentives 3 for production created in an environment that contributed to the surge in default. Now, during my period of time at Clayton, I was able to observe an operation of close to 40 of the largest mortgage originators and servicers in the United States. Too late to be effective, it became obvious to all that the only way to correct the broker model was to shut it down and wait for regulatory reform and enforcement.

Recent regulatory changes have been made to improve the broker channel and I would encourage 14 additional supervision and enforcement. For me, one of the underlying conflicts with the broker model is the question whom does the broker work for. The main problem is that counter-to-counter 18 perception, brokers do not represent the borrowers who pay them for advice. Instead, they are more like independent salespeople who are often paid this much by the lenders in addition to the borrowers. When brokers are paid commissions by both parties to a loan transaction, confusion results about who the broker actually worked for. In my opinion, the broker should be acting as a fiduciary of the borrower and have the responsibility for making sure that the borrower understands and benefits from the transaction by receiving fair terms.

My criticism of this approach is that implementing it will have an adverse effect on low-to-moderate income applicants, and I would suggest to you that the benefits would tilt toward the consumer with alternatives to encourage financial institutions to invest in this low-to-moderate housing. Now, as it relates to the Sacramento and the other communities in the Central Valley, I have three areas of concern. Special servicing: Effective loan servicing, foreclosure avoidance, and loss mitigation are necessary to help the families work through their financial hardships.

Servicer incentives and the lack borrowing of financial literacy and the threat of investor litigation are limiting this effective action. Current servicing fees provide little to no

20 economic incentive for the servicers to spend time, money, and effort with the borrower to arrive at a fair solution. For some servicers, the most profitable path is to move the loan to foreclosure. And Special Servicing should be engaged which has incentives to cure defaults and avoid foreclosure.

My recommendation is all future securitizations including Fannie, Freddie and FHA, is that once a loan goes 90 days delinquent, the special servicer will evaluate the collateral and borrower’s financial conditions and perform a low-cost solution that will take into consideration loan modification, short sale, deed in lieu. The special servicer would then be compensated at market rates.

As to the financial literacy, I’ve worked with —

CHAIRMAN ANGELIDES: Can you wrap up, please?


CHAIRMAN ANGELIDES: I know you’re almost there, so if you can wrap up and make your remaining

15 points.

MR. JOHNSON: As to financial literacy, much needs to be done to improve that. In the last fear I have — relates to investors, that there is impact with a structural waterfall has created a conflict, not allowing investors to have the prudent thing.  Two other areas for this area in Sacramento is foreclosed home inventories. Empty homes do not pay the salaries of teachers, police officers, and fire departments. And this unsold inventory leads me to my third, which is the availability of credit. My recommendation on that is something that I found that worked in Texas during the recession is the loans to facilitate the sale of foreclosed homes could be an active program by those banks and GSEs that are actively the investor today. With that, I look forward to your questions.

Thank you.

CHAIRMAN ANGELIDES: Thank you very much.  Ms. Beal.

MS. BEAL: Thank you, Chairman Angelides and members of the Commission. I am Vicki Beal, senior vice president of Clayton Holdings, the nation’s largest provider of mortgage due diligence services. We have been asked by the commission to describe the due diligence process, its benefits and its limitations.

Clayton’s principle due diligence clients are financial institutions, and more recently government

agencies, private equity firms, and hedge funds. We are retained by our clients to review samples of closed loan pools that they are considering for purchase. Clayton is not retained by its clients to provide an opinion as to whether a loan is a good loan or a bad loan. Rather, our clients use Clayton’s due diligence to identify issues with loans, negotiate better prices on pools of loans they are considering for purchase, and negotiate expanded representations and warranties in purchase and sale agreements from sellers.

The type and scope of our due diligence work is dictated by our clients based on their individual objectives. Clients select the sample, generally 10 to 20 percent of the pool, and decide if the sample is to be random or adverse. Clayton typically reviews a sample of loans against the seller or originating institution’s guidelines and the client’s tolerance. Clayton reviews for: (1) Adherence to seller credit underwriting guidelines and client risk tolerances; (2) compliance with federal state and local regulatory laws, and; (3) the integrity of the electronic loan data provided by the seller to the prospective buyer. This review is commonly referred to as a “credit and compliance review.”

As part of this review, we grade each loan for credit and compliance using grades of: Event 1, loans that meet guidelines; Event 2, loans that do not meet guidelines but have sufficient compensating factors; and Event 3, loans that do not meet guidelines and have insufficient compensating factors. Clayton’s fees are not contingent on our findings or our grades.

The work product produced by Clayton is comprised of loan level data reports and loan exception reports and is the property of our clients. An important part of our due diligence services is providing exception reports; that is, reports of loans with deviation from seller underwriting guidelines and client tolerances. However, the number of reported exceptions should not be viewed in isolation. Exceptions must be reviewed in conjunction with the corresponding underwriting guidelines and client tolerances.

Simply stating a Clayton grade of Event 1 does not mean a loan is good or is likely to perform, nor does a Clayton grade of Event 3 mean that a loan is bad and is not likely to perform. Moreover, it may not be possible to draw an apples-to-apples comparison of deals from different clients or different sellers.Exceptions to underwriting guidelines can vary from being severe — such as the valuation of a property not being supported by an appraisal, stated income not being reasonable for the job, or missing critical documents in a file such as HUD-1, loan application, or an appraisal — to benign, such as a debt-to-income ratio of less than 5 percent or loan-to-value exception of 5 percent or less, or a credit score that’s within an acceptable tolerance; for example, 650 score is required, 640 is the actual credit score. It’s also important to understand what Clayton does not do. Clayton does not confirm the authenticity of information in the file. The loan has already closed and due diligence firms historically have relied on the documentation within the file for the review.

Clayton does not know whether a loan was placed into a securitization, the type of securitization, or if it was held in portfolio by the client. Clayton does not tell clients which loans to buy or not buy. Clayton does not participate in the actual trading or pricing of loans. Clayton does not participate in the structuring or rating of a security.

There are many improvements that need to be made throughout the mortgage industry which will help 18 restore investor confidence and rebuild the mortgage market. Clayton fully supports the American Securitization Forum, ASF, and Security Industry and Financial Markets Association, SIFMA, who are making significant contributions to the development of asset securitization markets that investors will have confidence in.

Specifically in the area of due diligence, we have seen the rating agencies adopt specific improvements that relate to mortgage securitization which call for: Independent third-party pre-securitization review of samples of underlying mortgage loans, and including disclosure to investors of all exceptions; (2) Standardized post-securitization forensic reviews, and; (3) Expanded loan-level data reporting of initial mortgage pool and ongoing loan performance.

I would be pleased to answer any questions you may have.

CHAIRMAN ANGELIDES: Thank you very much, Ms. Beal. Mr. Eggert.

MR. EGGERT: Thank you. And I appreciate the opportunity — Is that better?

CHAIRMAN ANGELIDES: That’s much better.

MR. EGGERT: I appreciate the opportunity to testify and I admire all the time that you are spending on this. It’s an important job that you are doing. Your charge is not only to explain what happened but also to explain why so few of the people that caused it to happen have so far suffered any significant repercussions.

And it’s important to realize this is not the first time that subprime has collapsed. It collapsed once in the late ’90s. This is the second time. And the job we have before us is how to make sure that it does not collapse again. So I have three points in five minutes.

My first point is that there is a tremendous lack of transparency in the securitization of loans that’s one of the primary reasons that investors bought those securities based by so many bad loans. Investors were not given sufficient information to make the decisions that they needed to make to see if they were going to buy these securities. They should have been given loan-level detail for every pool that was — for which securities were issued. Current loan-level detail, not what was true weeks ago or a month ago.

The underwriting that — they were given disclosures about underwriting that were vague and they weren’t told what I think was true about significant portion of subprime underwriting, which is the main underwriting that some subprime lenders did was: “Will this loan be securitized? If it will be securitized, I will make the loan.”

That’s how they underwrote — or that’s how many firms underwrote loans and that was not disclosed to investors. Instead, they were told that the lender has an underwriting program and it makes some exceptions. Investors should have been told not only that exceptions were made, but should have been given specific information for each exception in the pool that they were purchasing securities for. They should have been told what the exact exception was, how many exceptions there were, why each exception was given, and whether there were any mitigating factors for those exceptions. 13 Pools — some pools of loans had exceptions in 50 to 80 percent of the loans. The exceptions took over or were an incredibly important part of the pool information, but investors weren’t given that information. Instead, they got vague, boilerplate language about underwriting, and that there were substantial exceptions. Whatever that means.

They should have gotten the due diligence reports that we just heard described. Those reports existed. The exceptions were described and defined. Why weren’t investors given that information which was in the hands of the people that were selling the securities? Why weren’t they given the underwriting reports by the originators who knew what exceptions were given and why? Investors need that kind of information to get — to make good decisions. They also needed better waterfall information. Investors often didn’t know exactly how the waterfall structure worked. Waterfalls can be very complicated as far as which security gets paid off first, and there needed to be better description of that.

My second point is that securitization encourages the bargaining down of due diligence. We have seen due diligence in the kind of the reports we are talking about. Why only 10 to 20 percent of the loans were examined? Why that small number? Earlier, before the crash, many more — a much larger sample was done. Why not 100 percent? What would happen is originators would say to Wall Street, “If you want to buy our loans, you need to look at fewer of them. You need to do less due diligence, and we don’t want to buy back as many loans that you find.” So we saw this bargaining down of due diligence.

Also, we saw at each level what happened with securitization is risk was pushed to its maximum. So brokers told appraisers essentially, “We want you to inflate your appraisal.”  Wall Street reverse-engineered the rating system so that they knew exactly what pool they needed to assemble to get the rating they wanted. So they assembled the riskiest possible pool that would get the ratings that they needed. And so at each level the riskiest loan was made, brokers with yield spread premiums would push borrowers to accept a higher interest rate, Wall Street was pushing the credit rating agencies to give better ratings to back worse pools. And so at every single level, risk was pushed

to the maximum, and that led to a brutal structure and the subprime collapse that we saw.

Thank you, and I look forward to you questions.

CHAIRMAN ANGELIDES: Thank you very much. I was about to ask you to wrap up and you did it. Before we go to questions, I would like to make an acknowledgment, and I would like to acknowledge that my father, Jerry Angelides, and my mother, Helen Angelides, are in the audience. Welcome, mom and dad.

So I will begin the questioning of the witnesses. And let me start, actually, Mr. Johnson, with you. You were with Washington Mutual you were sent in essentially to take over and, I guess, get Long Beach Savings in shape. And you made the determination that it couldn’t be gotten in shape is what I understand. I think you talked about — and by the way, I think this is very relevant to Sacramento because, at least from the information you have seen, Washington Mutual is the third largest lender in this market.  There was an extraordinarily high failure rate on their subprime loans.

But you talked a lot, I know, in interviews with our staff, and you mentioned in your testimony about this notion of the financial factory. Long Beach was 100 percent dependent on mortgage brokers. I think you described that system as the heroin of subprime. You said the broker model became flawed with greed, fraud, and deception.

You said that — in your interview with our staff — you realized in hindsight that there were systemic issues; in other words, the fraud and the incentives were totally out of whack. What could have been done in the run-up to the crisis other than shut down these enterprises? What could have been done, regulatory or business practices, to put a halt to what you clearly saw were destructive practices?

MR. JOHNSON: First I want to correct, I did not shut Long Beach down when I was there.

CHAIRMAN ANGELIDES: No, you left. I meant to say —

MR. JOHNSON: (Inaudible) — after that.

CHAIRMAN ANGELIDES: No, but you made a comment, I think, today that your view was the broker model should have been shut down.

MR. JOHNSON: Once I got to Clayton and I could  see the broker model being used by almost 40 of the largest originators, you saw the same problems. As an operator, you know, we try to put in all the right risk controls. We bought every third-party fraud system we could find. But these were just force fields in which people can walk right through and commit a fraud.  I think that it really gets down to the relaxed underwriting guidelines probably should have never come out, the stated income, the 100 percent loan-to-values; however, there was a need for that based on the raw materials for securitization. Companies were being encouraged to provide that for securitization product. I guess that could have stopped if the right data was going to rating agencies to perhaps change the subordination levels whereby that risk would have been graded a little bit more harsh and the profits would have stopped.

So to me, there is a variety of points in the factoring of this product that we could have present valued the pain. Whether it’s the rating agency side, whether it’s in the enforcement side. When we caught fraud, very little was done. Very little could be pointed to to discourage brokers and brokers could simply go to the next financial institution down the line.

CHAIRMAN ANGELIDES: Very quick question for you, Mr. Eggert. Clearly, there was a breakdown in the system. But didn’t investors let themselves down also by not asking for the requisite information?

MR. EGGERT: Well, I think investors did ask for the information and were, in essence, told, “Take it or leave it.”


VICE CHAIRMAN THOMAS: They could leave it.

MR. EGGERT: And some did leave it. Some investors relied on credit rating their ratings and they shouldn’t have in retrospect. But I think they weren’t given the information to realize how suspect many of the ratings were. I think some savvy investors realized there was a big problem. Some were savvy enough even to go short on the on the securities that were being produced. But at a certain point I think what happened was Wall Street realized some investors were getting turned off by what

3 they were producing and so they responded by saying, “We have to find other investors who haven’t figured this out yet.”

CHAIRMAN ANGELIDES: Right. I will make an observation. There is a chain here and it does start with borrower and it ends with investor. Just an observation I will make.

MR. EGGERT: I think that’s entirely accurate.

CHAIRMAN ANGELIDES: Now, let me — so the reason — the focus really of the reason I wanted to, in a sense, have this discussion was one of the questions I get a lot in this community is: “How did what happened here turn into a financial crisis?”

And I think this world of how loans were originated, you know, moved from broker to originator to securitizer to investor, and then of course packaged and repackaged is something that’s of tremendous interest to people.

And I would like to ask you, Mr. Johnson, you, Ms. Beal, some questions about the work that Clayton did because I think one of the things we have been looking at is the declining underwriting standards. But I think one of the essential issues is also that as underwriting standards declined, was there even a failure to meet those underwriting standards? So there are some charts I would like to ask you about so I would like to enter in the record just so I can talk to you about these, I think, the staff provided and, actually, you provided them to us, so I think you are very familiar with them. These are the trending reports that talk about due diligence. So I want to see if I’ve this right just in terms of my understanding. Clayton was hired by issuers, securitizers to do due diligence. My understanding is you had about 20 percent of the market. And from the first — is that about right?

MS. BEAL: That’s — yes.

MR. JOHNSON: Out of all the securitizations done, only 20 percent of which were done by third-party issuers. So Clayton would only be working on third-party issuers. We would never work on a securitization, like, perhaps Bank of America would do or Countrywide or Chase. And of that 20 percent, our market share was probably 50 to 70 percent of that due diligence.

CHAIRMAN ANGELIDES: All right. So my understanding is from first quarter of 2006 through second quarter of 2007, which is kind of the heat of the subprime market, you reviewed about 911,000 loans. And my understanding is the simple sizes were normally 5 to 10 percent or were they smaller?

MS. BEAL: They were running about 10 percent.

CHAIRMAN ANGELIDES: All right. So it’s fair to say if you looked at 911,000 loans, roughly it’s a punitive pool of about 9 million loans, correct?

MS. BEAL: Correct.

CHAIRMAN ANGELIDES: And my understanding is you reviewed those loans for compliance with underwriting standards; in other words, if they were originated here in Sacramento by Washington Mutual or Long Beach, you would look to whether or not the loans conformed to that lender’s underwriting standards as well as any “overlay standards” that the issuer would put on top?

MS. BEAL: That’s correct.

CHAIRMAN ANGELIDES: And you were looking for certain things or certain safeguards or standards, correct?

MS. BEAL: That’s correct.

CHAIRMAN ANGELIDES: All right. And then my understanding is that in that period you rated about 54 percent 1s, meaning they met all the standards, correct? And I understand your admonition that that’s 1 not necessarily good bad loan bad (sic), that’s whether they meet the standard or not.

MS. BEAL: Yes, the 54 percent would have met the seller’s guidelines and any client tolerances or 5 overlays.

CHAIRMAN ANGELIDES: Correct. And another 18 percent might have missed something but there was a compensating factor. So in my simple mind, maybe the loan to value was a little high above the standard, but that person had substantial cash, that kind of thing; is that a fair assessment?

MS. BEAL: That’s correct.

CHAIRMAN ANGELIDES: But then there were another 28 percent that you initially rejected, and I 15 guess that’s because they didn’t meet the standards. But then I guess the issuer securitizers decided to “waive those back in.” 39 percent on average. Why did they waive them back in?

MS. BEAL: The 11 percent or the 39 percent of the waiver rate. The 39 percent is the percentage of loans initially flagged as 3s that were waived back in. And the 11 percent is the overall out of the 911,000.

CHAIRMAN ANGELIDES: Can I ask a question?

MS. BEAL: Yes.

CHAIRMAN ANGELIDES: So originally you rated 3 or rejects 28 percent of them –

MS. BEAL: Yes.

CHAIRMAN ANGELIDES: — but then that number gets reduced to 11 percent by the issuers; is that —

MS. BEAL: Yes.

CHAIRMAN ANGELIDES: And that was because they made a business decision? They looked at the loans individually? How did that all work?

MS. BEAL: Yes, they look at the loans individually and they make business decisions. And this was also our two Ws, which meant that they coded the loans as a waiver. And it was also our two Ts, which were side letters, meaning they would give the seller 30 days to cure maybe missing documents or something they could look at to see if the exception was acceptable.

And then they would let us know that these would be two Ws or two Ts.

CHAIRMAN ANGELIDES: Can I ask a question? Do you have any information that they would have sampled the other 90 or 95 percent of the loans?

MS. BEAL: No, I don’t have that information.

CHAIRMAN ANGELIDES: So would I be off if I said, “Gee, they’re failing initially 255,000 loans,” 24 you times that by 9 in the pool, or 9 million, you might have 2.3 million loans that initially failed by your standards and when that was reduced down, you still had a million failures out of that 9 million. Is that my, kind of, rough math?

MS. BEAL: Yes.

CHAIRMAN ANGELIDES: All right. Interesting. I would like to ask a couple of questions. So these trending charts were prepared for what reason? Were they prepared — did they show a decline in understanding standards? What did they show during that critical period of 2006 to 2007? What is happening in the market as these loans are being moved up the chain?

MS. BEAL: What we did notice was that it was declining originator guidelines. And then as the guidelines were declining, we saw that our clients were increasing their tolerances; in other words, they were putting more credit overlays. As — you know, there was stated income, they were telling us look for reasonableness of that income, things like that. They were also —

CHAIRMAN ANGELIDES: Does that mean they — so the standards were going down, but were they then adding some protections against standards going down?

MS. BEAL: Yes, they were raising the bar. They were raising the guidelines themselves.

CHAIRMAN ANGELIDES: So you have two things working here, you have underwriting standards going down

and the issuers, in a sense, mitigating some of that?

MS. BEAL: Yes, yes.

CHAIRMAN ANGELIDES: Okay. That’s interesting. Let me ask this question of you, Mr. Johnson. My understanding is you actually went to the rating agencies at one point because I think you thought you had a product to sell, correct? Which is — this goes back to enlightened self-interest — that you thought this information would be interesting to them. Would you talk about that a little and what their reaction was?

MR. JOHNSON: Sure. We thought that these exception-tracking mechanism, we are the only firm in the country that has it and I still believe the only firm that does today — was a great product to show clients how their manufacturing quality is. Good managers manage exceptions and try to get that down, try to get that — CHAIRMAN ANGELIDES: So you thought it was a management tool?

MR. JOHNSON: I thought it was first a management tool that managers could try to get that 54 percent closer to 100 percent and that this would be a good tool. Then we went to the rating agencies and said, “Wouldn’t this information be great for you to have as you assign tranche levels of risk?” Again, if they would have accepted it, I think this is one way of paying within present value because they could have — for good originators with great quality had better subordination levels than middle and worse originators. And therefore, the market economics would have forced those people out of the equation. We started meetings with — in 2006 with S&P, Fitch, and then in 2007 we met with the executive team of Moodys. All of them thought this was great. All of  them thought this would be wonderful to have. None of them would have adopted it at that time, for the most part being that: A, we were only 20 percent of the market third party. If any one of them would have adopted it during that period of time, they would have probably lost market share —

CHAIRMAN ANGELIDES: They would have lost market share to each other?

MR. JOHNSON: Issuers would have gone to the easier channel. It should be noted in 2007 after the Attorney General came into the picture all three said that third-party independent due diligence is going to be required going forward.

CHAIRMAN ANGELIDES: So when I look at some of these waiver rates and I see Deutsche Bank waiving back in 50 percent of the failures, is that because they are tougher or because they are waiving them bank in? On the other hand, Goldman looks like it has one of the lower reject rates and they are waiving in less. Is that because they are more stringent on the review?

MS. BEAL: Well, there are two things. Deutsche Bank was one of our clients that had very strict credit overlays. They had us looking at many more reasons for making a loan a 3, and then they also took away during that period Clayton’s ability to make loans a 2 with compensating factors. In a lot of cases they would say either it’s a 1 or it’s a 3. So you do see that with Deutsche Bank. You see more loans being generated as 3s so that they would go back to them for their review. They also were pooling third-party services around valuations, made use of fraud tools, occupancy checks, so they were layering on other tools in addition to the due diligence. And the point about Goldman and some of the other clients that you see, it could be that they weren’t quite as robust in their credit overlays. It could also be a mix of the sellers that they were buying loans from. So you know, there are many there. And then also one other point I would like to make in this is that this was a beta version of the trending reports. It was raw data, this summary report, it hadn’t been scrubbed. It wasn’t an apples-to-apples comparison just as we’re saying –

CHAIRMAN ANGELIDES: You didn’t standardize it, so it was reflective of each institution, right?

MS. BEAL: Yes, that’s correct.

CHAIRMAN ANGELIDES: All right. So I am going to just pose something then I want to turn to other commissioners and then I want to come back at the end because this is an area I would like to hear my colleague’s questions around these issues. But there seems to be kind of three points here as I looked at this. One is, from what I can tell, it doesn’t look like your information ever migrated to disclosure. I know you didn’t prepare it for that purpose, but this wasn’t disclosed. What you read in the disclosure is some of these loans, a significant amount, may be exceptions but there is compensating factors. What’s not revealed is the actual data, so it appears not to have been available to investors. Is that — would that be your —

MR. JOHNSON: We are not aware of — and we looked at a loft prospectuses — of any of our

information –

CHAIRMAN ANGELIDES: — ever popping through.

MR. JOHNSON: — going through the prospectus. And one of our recommendations was that a table should be included in the future that simply said, you know,due diligence — independent chosen due diligence achieved a 95 percent confidence level in certain attributes with an error of, you know, 2 or 3 percent was performed. And that way rating agencies would have it and investors could acknowledge and then you could grade good, bad, and ugly issuers.

CHAIRMAN ANGELIDES: Secondly, it appears as though you did a sample of 5 to 10 percent, but it looks like the other 90 percent were never faxed. So I am thinking if I am a securitizer, even forgetting whether it’s 28 percent failed or 11 percent failed, what is happening here, they got a sample of 10 percent. I know 11 percent of those fail. I kick those out. But as to the other 90 percent, I don’t do nothing?

MS. BEAL: Right.

CHAIRMAN ANGELIDES: Does the silence mean I got it right?

MR. JOHNSON: Did you ask a question or is this a statement?

CHAIRMAN ANGELIDES: Is that an accurate statement?

MR. JOHNSON: That’s an accurate statement.

CHAIRMAN ANGELIDES: All right. And the final thing is I just want to note that I looked, I guess the examiner for the New Century bankruptcy and a former regulatory compliance person in Fremont said there was also practice of even if loans were kicked out they were put back in another securitization. Are you familiar with that or not?

MR. JOHNSON: I think it goes to “three strikes, you’re out” rule.

CHAIRMAN ANGELIDES: So this was a case of — okay, three strikes.

MR. JOHNSON: I’ve heard that even used. Try it once, try it twice, try it three times, and if you can’t get it out, then put –

CHAIRMAN ANGELIDES: Well, the odds are pretty good if you are sampling 5 to 10 percent that you’ll pop through. When you said the good, the bad, the ugly, the ugly will pop through.

All right. Final question, and that is: You made a comment at one point, I think it was public comment about you felt like a potted plant. And not you personally, but due diligence folks. In this whole process you felt like you were producing information and –

MR. JOHNSON: Right. I think it was when we looked at these reports here, we saw that — 54 percent was alarming to me personally, you know, I can say this. And I didn’t realize what –

CHAIRMAN ANGELIDES: 54 percent were making the initial grade?

MR. JOHNSON: Right. And so I don’t know what our role was. Back in the old days, in the ’80s, due diligence — and I was a big buyer of loans — is really simple. It’s good loan, bad loan. When you bought the loan, I owned it, it went in my portfolio. If it went delinquent in fault, I had to be personally liable and answer to a guy named Lou Raneire.

In this case here I think the liability got pushed all the way out to the investor and we got away from the practice of good loan, bad loan. Just “Does it meet the guideline? Does it mean meet the ugly guideline? Oh, 54 percent do, okay.” Again, I don’t –

CHAIRMAN ANGELIDES: This wasn’t the gold standard of underwriting guidelines, correct?

MR. JOHNSON: Our value added really came in compliance with Clayton.

CHAIRMAN ANGELIDES: Whether regulatory compliance?

MR. JOHNSON: Right. Because liability can be a sign to an issue if they did something wrong with

regulatory compliance.

CHAIRMAN ANGELIDES: So they paid attention to that?

MR. JOHNSON: 100 percent attention.

CHAIRMAN ANGELIDES: Oh, that’s an — I hadn’t planned —

MR. JOHNSON: When liability —

CHAIRMAN ANGELIDES: So you are telling me that the credit standards, they kind of said, “Thank you very much.” When it came to regulatory standards compliance, I assume that’s consumer regulatory, other standards, because they had liability, they sat up and paid attention?

MR. JOHNSON: Would you disagree? I think we were always — compliance issues to me, when we found a

problem, most of our clients would just not buy those loans. When there was an underwriting issue, there could be some negotiation between the buyer and the seller.

CHAIRMAN ANGELIDES: All right. Well, thank you.  Did you want to comment on that, Ms. Beal?

MS. BEAL: No, I agree. And I think that over time that is an area where the sellers improved as they were originating loans was in regulatory compliance. So I think that’s, in my opinion, why some kind of regulatory guidelines around credit standards may make the market react that same way to credit underwriting.

CHAIRMAN ANGELIDES: Thank you.  Mr. Vice Chairman.


Mr. Chairman.

Mr. Johnson, in your testimony on page 2 where — the first major paragraph where you think there isn’t a monocausal aspect of this. I think based upon everything that we have looked over time: (1) That tends to be the answer for almost everything. As someone once said, there are people who have very straight, simple answers for things and they are wrong. It tends to be a multitude of factors.

However, when we were in Bakersfield, I have a friend who ace director of a bank and if you meet him on the street he is kind of a cowboy farmer. Trouble is he has a Harvard MBA in business. And he said, “We brought in these guys who supposedly understood these securities things and I asked them to explain them to me.” And when they were done he said, “I didn’t understand what they said so get rid of them.”  So he didn’t engage in those activities because he couldn’t understand them. And I have to tell you that based upon the testimony presented as to what the Clayton folk do, I am clear on what you don’t do, but when I go through the list of what you don’t do, I am trying to figure out what I get for my money.  And is it possible to give me a one- or a two-sentence explanation of what I got for my money if I hired you?

MR. JOHNSON: I no longer work there.

VICE CHAIRMAN THOMAS: Well, you mean they’ve changed the philosophy since you were there, or do you prefer to have the one who’s still doing it?

MR. JOHNSON: No, I think there is no longer securitization, so we’re —

VICE CHAIRMAN THOMAS: Right. It’s dead. But I mean, at some point people were paying you a lot of money for this.

MR. JOHNSON: I would say hindsight — in the ’80s I hired Clayton to tell me if the loan is a good loan or bad loan because I was securitized and I was putting it on my bank’s balance sheet.

VICE CHAIRMAN THOMAS: Notwithstanding all the things you don’t do, sample percentage, 5 percent, et cetera? I am just curious. I guess people –

MR. JOHNSON: Back in the ’80s sample sizes were closer to 50, 100 percent.

VICE CHAIRMAN THOMAS: Oh, well, that’s entirely different.

MR. JOHNSON: Right. All I am saying in the 2000 to 2000 period, sample sizes got lower. I think we were used to basically help negotiate the purchase price between a buyer and a seller.

VICE CHAIRMAN THOMAS: So you used, a little bit like the rating agencies where “Just give me the AAA and I am comfortable, don’t explain to me what the AAA means.” It was a kind of a Good Housekeeping seal of approval aspect to it?

THE DEPONENT: Now, we were never asked to make a pie, we were just simply — we were third-party contractors saying, “Look at 1,000 loans and give us a grade,” and then we were out of it. We didn’t know what got into the securities, we really didn’t — we were just simply showing, “Here is our exceptions.” And now in hindsight, if you look at almost a million loans, you know, that 54 percent to me says there is a quality control issue in the factory. And it took until 2007 to be able to produce this report, but that’s the breakdown that probably led to my quote in the paper, that I didn’t see much value added in our approach.

VICE CHAIRMAN THOMAS: Yeah, okay. It just, again, reinforces my belief there’s a niche market for almost anything and so I appreciate that. Mr. Eggert, you used as a footnote an article that you had in the Connecticut Law Review May 2009 of “The Great Collapse: How Securitization Caused the Subprime Meltdown.”

I was always fascinated with Charles Beard’s “Economic Interpretation of the Constitution” because I thought at the time that he wrote it in terms of the market analysis it was insightful, it was very clever, and a lot of the stuff I think nowadays we take for granted. But what I couldn’t do was get over the hump of not 50 percent, not 60 percent, not 90 percent – 100 percent of the Constitution was based upon economics, which is, you know, basically the Marxist position. The monocausal aspect always concerns me. So was this a zippy title to catch attention, “How Securitization Caused the Subprime Meltdown,” or would you qualify that and say it really wasn’t necessarily securitization, it was the way in which it was used and there were a lot of other factors that led to the meltdown? Because you say it caused it.

MR. EGGERT: Well, in my article – I understand your title can’t say everything that your article wants to say. In my article I do note that there were other causes as well but that the structure –

VICE CHAIRMAN THOMAS: But you wanted them to read it to find that out so you put that out to grab them; is that it?

MR. EGGERT: Well, I put that very early on in the article, but it was — and also, when you talked about a cause, there are but-for causes which I think securitization was a but-for cause of the — of the meltdown. I don’t think it was the only cause. I think there are other attributes, but I think it clearly was a primary cause.

VICE CHAIRMAN THOMAS: And you focused on private-label securitization?

MR. EGGERT: Right. And there are — a lot of things that are securitized haven’t exhibited the same problems we have seen in the private-label mortgage market. Credit card securitization has been much more stable. And I want to be clear that what I was focusing on was private-label mortgage securitization in that article.

VICE CHAIRMAN THOMAS: So it’s not securitization as a structure or a method to multiply? See, I tend to agree with Mr. Johnson’s argument as to securitization not being bad. Securitization has created a lot of positives.

MR. EGGERT: But you can — my point in the article is you can structure securitization in bad ways and the way that private-mortgage securitization was done was structured poorly and so it was built into the structure of that form of securitization.

And one of the things that I am hoping your report will produce and the regulatory change that we are seeing now will demonstrate is a better way to structure this type of mortgage securitization. VICE CHAIRMAN THOMAS: I think everybody agrees that almost any other way would have been better. I mean, you could have thrown a dart at a board and taken whatever it said and put it in. So I mean, that’s kind of a given.

But you said just a minute ago in response to something that these people who were doing this would find other investors who haven’t figured this out yet.

I just have to say through your whole testimony I had this feeling that you really thought that it was causal; that these are really a bunch of people who knew what they were doing and they were motivated by clearly, for want of a better term, sinister behavior. When we’ve interviewed a lot of them, the one thing that floored me the most is that the CEOs running a lot of these big operations making millions of dollars a year, didn’t know what they were doing. One of them didn’t even know there had to be collateral calls against the securities that they had.

Do you really believe these were knowledgeable people who were working in the shadows structuring these documents for the, I guess, the pure sake of making money, or was it a lot of people didn’t fully understand what was going on?

MR. EGGERT: When you’re talking about the motivations, I mean, clearly, for many of the people in the structure, the primary motivation was to make money. They were in business to make money.


MR. EGGERT: And I am not arguing that that’s bad at all.

VICE CHAIRMAN THOMAS: You are not a Marxist, good.

MR. EGGERT: What I am arguing, though, is you have to set up the system so that people’s desire to make money is channeled in such a way that the result isn’t all these bad loans, all the foreclosures. And so for me it’s how do we structure the system to correct the incentive problem?

VICE CHAIRMAN THOMAS: But it isn’t necessarily the securitization aspect?

MR. EGGERT: It’s the way it was structured.

VICE CHAIRMAN THOMAS: Sure. Anybody can talk about that. We could have done it the old-fashioned way and had the loans go to community banks, then we could have taken the debt of community banks and securitized it. Or we could have run it through a REIT structure, a real estate investment trust structure.

You know, there are a lot of ways to securitize product. It just happened to occur this way because it was fairly efficient and all of those check points along the way didn’t do their job. Not only the government — federal government regulators, state regulators, but people who were paid good money to rate them, people who were paid good money to carry out various activities. I think everybody agrees it just broke down. So that’s good because it would really be hard for me — some people say, “Gee, well, let’s go back to the glad days. Let’s go back to the 1950s.” The world

won’t operate that way anymore and you can’t take it back to that. But if it’s now down to saying if we are going to do things, transparency is critical on anything, knowledge and assistance in making decisions, even requiring people to hang on to some of what it is they are trying to sell. I always wanted in those westerns when the guy was selling snake oil, someone in the audience would say, “Well, you take a big swig first and then I will think about it,” and then just let them put a little bit of what they are selling on their selves or in themselves. And to try to carry this theme in a slightly different way –

CHAIRMAN ANGELIDES: Yield some more time? What do you want —

VICE CHAIRMAN THOMAS: Yeah, just another minute or two.


VICE CHAIRMAN THOMAS: Mr. Johnson, when you were –

CHAIRMAN ANGELIDES: We are on Sacramento casual time.

VICE CHAIRMAN THOMAS: Okay. Levy time. I am with you. We’ve heard over and over again that really good — in fact, we just heard it in an earlier panel, that really good intentions — I mean, the no docs for people that get aggravated to have to filling forms when they got more than enough money to buy and sell the institution they wanted to get a loan out of, was a clever way to not have to put people who were willing to take a loan through the grinder until you saw what happened with them. And obviously, I think you had some things to say about affordable housing goals and Freddie Mac and Fannie Mae in terms of what very well could have started out as good intentions, and once you start structuring good intentions and you have to hit a mark on good intentions, it really influences behavior. And you had something to say about that.

MR. JOHNSON: I think you may be referring to a specific transaction that I was asked about in my summer testimony.


MR. JOHNSON: Let me talk a little bit about that. In 2003, as mortgage rates had declined and the refi market had exploded, it was difficult for the GSEs to meet their affordability goals.

VICE CHAIRMAN THOMAS: Admirable as though they may be.

MR. JOHNSON: Right. And I believe the goal is a simple calculation where’s it’s just a number of loans, low to moderate, divided by the total number of loans.

VICE CHAIRMAN THOMAS: That was devised by Congress.

MR. JOHNSON: Excuse me?

CHAIRMAN ANGELIDES: That was devised by Congress, so it couldn’t be too complicated.

MR. JOHNSON: No, it is a very simple calculation. But the one unique concern that was written into the regulations that small balance multifamily loans would act as a multiplier to that affordability credit. And when I was a chief operating officer for the commercial segment at Clayton — I am sorry, at WaMu, many don’t realize that we were the largest multifamily lender in the nation, primarily in California. And it’s a model that was beautiful back then, I think it’s still beautiful today, and it’s well run by Chase. Most of our multifamily was small balance, 2 million and below, 35 units, it all qualified under this definition.

So every year when the GSEs had an issue, they would come to WaMu and ask for a transaction. And in 2003 I received a call from Freddie Mac wanting to arrange a deal — a very large deal, largest we’ve ever done — for $6 billion in multifamily. Small balance. And 6 billion in multifamily is about 4,000 loans. But the 4,000 loans if you think the average is 35 units in each loan, is — then you multiply that double, you can actually get 280,000 affordability units would be the numerator, and 4,000 would be the denominator.

So when GSE and you’re struggling to hit your affordability goals, this was a unique transaction to perhaps get you over the threshold.

VICE CHAIRMAN THOMAS: So it was a quota maker?

MR. JOHNSON: Yes, it was a quota maker.

VICE CHAIRMAN THOMAS: Driven by quota?

MR. JOHNSON: Exactly. And it became very obvious to us at that they were very serious about making that number. We had not done a lot of business with Freddie Mac Freddie Mac was not a strategic partner at that time with WaMu, became later. When they originally asked me to do the transaction for 6 billion, I think I asked for: “We will do it only if Freddie Mac will sell me $10 million of commercial mortgage-backed securities, but sell it to me at a price that WaMu could make a risk-adjusted return of 18 to 20 percent.”  They came back with a “We can’t do that” because the price would be below where they have it on the books and it would cause a mark-to-market issue and they don’t need another accounting issue. “What else” –

VICE CHAIRMAN THOMAS: We find out later.

MR. JOHNSON: “So what else would you take, Mr. Johnson?” And I asked for $100 million in cash. And the swap is nothing more than me giving paper and they, in return, giving paper. There is no change of ownership in terms of the loss. WaMu still received the unilateral right to collapse the security after one year. And as a result, those assets continued to be for — accounted on our books and records as loans. Now, I want you to know that we were, at WaMu, skeptical about doing the transaction for $100 million, which is the swap, so we insisted and received confirmation that this transaction was reviewed and approved by their board of directors, their auditors, their lawyers, and disclosed in their financial statements as well as disclosed in ours.

VICE CHAIRMAN THOMAS: So how broadly can I say that that transaction was based almost totally on their need to make quota?

MR. JOHNSON: 100 percent. There was no economic incentive behind it.

VICE CHAIRMAN THOMAS: That’s 100 percent, all right. Because we have had some concern about the role of GSEs driving particular aspects of the housing and mortgage market at this time. I appreciate that testimony.

CHAIRMAN ANGELIDES: I would like to ask before we go to Ms. Murrin, just a quick follow-up. Do you know how that portfolio performed?

MR. JOHNSON: That portfolio is pristine. That multifamily — small balance multifamily in California was a product that I wish I could take credit for as the commercial CFO. It started with Amonston and Great Western and performed better than single family over a 45-year record. And again, it’s located in areas of high barriers of entry, so — for housing, so people continue to rent in those and it has performed incredibly well. I believe the security was collapsed and is now part of ownership by Chase.

CHAIRMAN ANGELIDES: Again, one last thing just for clarification. I want to return to something Ms. Beal said. So Deutsche Bank rejected more loans. So my understanding is you really did your — this is an interesting phenomenon. We’re talking about transparency. I think the Vice Chair asked some good questions about what was the transparency up the chain. And we have heard about this notion of asymmetric transparency, that, you know, the person who is making the sale has more information. Just to be clear, you did the due diligence in this instance so that the issuer who is going to sell it into the marketplace who is buying it from Countrywide or New Century, they could use your information to bargain the price, correct?

MS. BEAL: Correct.

CHAIRMAN ANGELIDES: Okay. And even though they failed loans, that doesn’t necessarily mean they were kicked out of securitizations, correct, or you don’t have knowledge of that?

MS. BEAL: I don’t have knowledge of that.

CHAIRMAN ANGELIDES: Do you have any direct knowledge, Mr. Johnson?

MR. JOHNSON: I’ve no direct knowledge.

CHAIRMAN ANGELIDES: All right. Thank you.  Ms. Murren.

COMMISSIONER MURREN: Thank you, Mr. Chairman, and thanks to all of you for spending time here with us today. I would like to talk a little bit about corporate culture. And in particular, Mr. Johnson, I think you have a unique vantage point in that regard. In reading through your biography, it appears that you were at Arthur Anderson for a period of time. Although you did leave there well before the firm collapsed, I would note that the firm collapsed in part because of inaction as a result of some of what its clients’ behaviors were. And from there went on to Texas to United

Savings Association which ultimately itself collapsed and was seized by the FDIC in part because of enforcement action brought as it relates to its mortgage portfolio. And you mentioned earlier that Clayton holdings actually did some work for you while you were there; is that correct?

MR. JOHNSON: No. United Savings collapsed, but I really spent most of my career with Bank United which bought it from the Southwest Plan. And we bought it about 20 billion, I think, from the RTC. We were a very successful institution, went public, and then was sold for, I think, $2 billion to WaMu.

COMMISSIONER MURREN: And would you comment on your underwriting standards when you were both at —

well, I guess all three places?

MR. JOHNSON: Well, at Bank United we looked at doing subprime and we passed. We were only a prime shop. We were a broker shop, too, for a while, just 100 percent broker channel and it did work primarily here in California. I would say some of that probably worked because home prices can hide — if they increase they can hide a lot of underwriting flaws. But we at Bank United had hardly any credit issues during that period of time from ’86 to 2000.

COMMISSIONER MURREN: And could you comment in each of those roles how your compensation was determined? I know at Washington Mutual that much of your compensation was based on firm performance and aggregate, but can you break down the elements of firm performance for me, please?

MR. JOHNSON: For my compensation personally?

COMMISSIONER MURREN: Yes, or executives broadly. It’s up to you.

MR. JOHNSON: My compensation was based primarily on the overall company Washington Mutual, or Bank United at the time. I was not paid any incentives on volume or, you know, yield spread premiums like, you know, loan officers or brokers were.

COMMISSIONER MURREN: Understood. But were those targets based in part on expectations that the company would grow, or if it stayed static would you –

MR. JOHNSON: It was mostly based on return on equity and profit, not asset size per se or volume, my personal targets weren’t. That may be an incentive that was done, pushed down to the loan originators in the divisions that they had to grow, you know, say, Los Angeles market from 50 million to 75 million. So that would have been one of their metrics, not personally one

of mine.

COMMISSIONER MURREN: But profit would be a dollar figure or a growth in profit?

MR. JOHNSON: Both. Probably mostly a dollar figure, a target to hit for my division, my segment, and then usually for the overall company. So my compensation would have been half in cash, salary, bonus, and half probably in equity.

COMMISSIONER MURREN: And the profit figure would have been same level as the prior year?

MR. JOHNSON: Usually above the level have the prior year.

COMMISSIONER MURREN: So effectively it was you were paid in part on growth?

MR. JOHNSON: Absolutely.

COMMISSIONER MURREN: Did you say “absolutely”?

MR. JOHNSON: Yes. I don’t recall a year where we — well, I’ll take it back. At WaMu there was probably a year that we said maintaining was probably growth given the market.

COMMISSIONER MURREN: And based on looking at return on equity, would you say that leverage played a role in that at all?

MR. JOHNSON: The entitiesthat I worked at?


MR. JOHNSON: Leverage did play a role in our growth as a bank, yes.

COMMISSIONER MURREN: So commenting now on your experience as a variety of different firms, could you talk a little bit about the accountability of executives who either themselves are part of the process where we end up in a situation where so many bad loans are in the system, either as a participant because you are in the market, or as an observer because you are evaluating the loans themselves. It sounds as though the reaction that all of you are having — or both of you — is that you were paid to do a job and your job was simply to determine whether or not these particular loans fit the criteria of the banks themselves. And I can certainly understand that. But to what extent — given the history and your observation of how some of these firms can fail, did you feel any sense of obligation to note that there was apparently a problem, that these loans were being sold to firms who were then turning around and marketing them as perhaps something they weren’t or certainly without full disclosure? You are a sophisticated guy.

MR. JOHNSON: I don’t — during the middle of the bubble, I don’t think you would come to the realization at that time. You know, we did what we thought was appropriate. We weren’t sure exactly what loans went into securitizations. In 2006, when we saw the declining exceptions and the 54 percent, that number came to us in 2007, we took action. We went to the rating agencies. Not all for the benefit of goodwill, for a profit as well as, you know, building our business. But I think we took the — we also went back to our clients with these reports for each one of them and said, “Look, this is what you are doing and this would could be a very viable tool for you to use as you manage your factory going forward. And you could take this tool and perhaps create broker score cards and correspondence score cards, and create score cards on your own loan officers to make you a better manager.” That’s basically what we were trying to do.

COMMISSIONER MURREN: Did you have those conversations yourselves or yourself?

MR. JOHNSON: We broke up the conversations. I did a few. I did Goldman Sachs, Morgan Stanley, I probably did a few others, but most of them were very receptive on receiving this type of data and saying they want to become a better, you know, issuer, a better securitizer. Unfortunately, when we were able to get this data, the market was sort of crashing.


CHAIRMAN ANGELIDES: Can I ask just one quick follow-up very quickly? I have a note that — I think from you, Ms. Beal, in your interview you said you did take the trending reports at Deutsche Bank, but they didn’t really like the product because I think they were concerned that if it got in the hands of the wrong people, it would be misunderstood, so they were concerned about what you were showing them?

MS. BEAL: Yes. We took the reports to Deutsche Bank and their transaction management team that we worked with day-to-day, they were overall very positive, as were most of our — all of our clients that we spoke with. They liked that we had the capability to start developing reports to use the data to show them trends. They were giving feedback on how to make the reports more meaningful. In the instance of Deutsche Bank, one of their senior managers joined the meeting and he took a look at it. And understanding the process that Deutsche Bank used where they had a — grade more loans as a material exception based on their client tolerances, and then took away that discretion from Clayton to grade loans 2s with compensating factors so that they wanted to look at the loans. So there again we were generating more Level 3 loans. They showed more loans graded than the 2-W and the 2-T. And he was concerned that the reports could be misunderstood, which we agree with that concern because that was our beta version. We understood we needed to standardized the reports, so that –

CHAIRMAN ANGELIDES: Of course information is information. If it’s properly presented, people can make determinations.

MS. BEAL: Yes.

CHAIRMAN ANGELIDES: All right. Mr. Georgiou.

COMMISSIONER GEORGIOU: Professor Eggert, I would like to start with you, if I could. There is a central question that we have been looking at on this Commission for some time which concerns the issue of securitization.  I think we can all stipulate that the notion of securitization, qua securitization by itself is somewhat neutral. That is, it was intended to and enables the raising of capital from a disbursed way from investors all over the world and disperses risk all over the world and enables the spreading of risk and the spreading of certain loans or other obligations far and wide. The question, I guess, we are troubled about is whether in this particular run-up of securitization and the utilization of it in connection with the mortgage securitization market, the extent to which that was based on incentives that enabled the creation of a super structure of securitizations that created part of the risk and was one of the causes of the financial crisis. And I guess I would like you — if I could, I would like to give you an opportunity to tell us why as I read your testimony you believe that it did. And I would also like you, if you could, to identify who it is that you think believes the opposite.

That is, that who it is that we could inquire from that would tell us that in their view a securitization wasn’t a significant factor in the run-up to the crisis.

MR. EGGERT: Well, I think it would be hard to find somebody who says that it was uninvolved; however, there has been a debate between what is more important in the boom and bust and whether it’s securitization or housing prices.

There is an argument out there that what we saw was a boom in mortgages caused by housing prices, and then when housing prices started dropping, that that’s what led to the mortgage bust, more than

securitization. I don’t know that there is anyone who would say securitization was uninvolved, but there is the argument out there that says it wasn’t securitization so much as a housing price issue. I don’t happen to agree with that. I think it was more caused by securitization and that to some extent even the housing price bubble was a product of securitization. That it wasn’t — that wasn’t all that was there, but that if you look at the markets that were the most bubble markets, they were ones where securitization was widely used. As far as the structure of securitization, while I agree that different forms of securitization can be structured differently and that not all forms exhibit the grave problems that we have seen, there are some aspects of securitization that are kind of universal that are kind of hard-coded into the whole process that it’s hard to figure out how to work around.

For example, the whole element of securitization is that you take something of value and you put it in a pool of securities and then you sell securities to investors who weren’t present at the creation of whatever it was.

By doing that, you have almost inevitable information loss. The person who makes the initial loan will know more than the investor who buys the security about that loan, even if they — just because they have met the borrower.

So when you are designing the new structure, what you have to do is try to figure out how to minimize that information loss, but I don’t think you can eliminate it. So I think by and large what we have to do is recognize the structural flaws in securitization and try to create a structure that minimizes those flaws, recognizing that we can’t completely eliminate them.

COMMISSIONER GEORGIOU: But one thing you say in your testimony is that it’s too facile to just characterize the lack of skin in the game and the lack of transparency as being the only difficulties presented by the securitization of mortgages that led to the problems, but that there were other aspects of it that led to the diminution in underwriting standards and to the creation of bad loans. And I wish you could speak to that.

MR. EGGERT: I think that’s very important because if you look at people who are trying to fix it, to a great extent they’re focusing on those two aspects. And I don’t want to say those aren’t important aspects. I think they are. But as we have seen, you — there are other issues as well that are, I think, very important and have to be addressed as well. So for example, one of the things that securitization did in the private mortgage label market was it caused pushing to the risk of in every level of the system. And for example, if you take a — if you’re rating corporate securities — I am not a securities guy so I am coming to this from the mortgage market, but my understanding is if you are rating corporate securities, you will have securities you will create sort of bands of risk and so some will be AAA some will be A. And within those bands, the securities can kind of exist all throughout that band. Some AA will be almost AAA, some will be at the bottom, but there will be a range. When you are securitizing mortgages, though, the people who are arranging them could make the security, the resulting securities at the bottom of whatever range they were. If you have a pool of – you know, access to a lunch of loans, the question for the Wall Street firm was: “What is the worst pool of loans that we can assemble to get the ratings that we want? And what is the lowest number of credit enhancements we can add to get that level?” And the effective securitization is that you will have — when you are making investment grade loans, you’ll make — you know, the weakest level of investment grade loans is that the credit rating agencies will bless. That’s part of the securitization process. And I don’t see anyone trying to address that issue.

COMMISSIONER GEORGIOU: And that feeds a little into what I think Ms. Beal and Mr. Johnson said, which is that your analysis at Clayton was utilized frequently by the securitizers to bargain down the price of the pool of loans that they were purchasing from the originators, but that didn’t necessarily translate into that information being utilized to structure the ultimate pool of loans that was put into the securities up the line.

Of course, you didn’t really know what they did with that; is that correct, Ms. Beal?

MS. BEAL: That’s correct. We didn’t know what they did with the data we gave them and the results.

COMMISSIONER GEORGIOU: Back to Dr. Eggert, if I could. This is an important point for us and I am trying to get to what — what utilization was made of the originally distributed model that structurally impaired the process and led to a greater degree of risk. And I don’t know that I have your views on that very fully.

MR. EGGERT: Okay. Well first of all, I’m not a — I don’t have a doctorate, so if you could call me “professor.”

COMMISSIONER GEORGIOU: All right. Got you. Very well.

MR. EGGERT: People with a doctorate frown on those of us without. But as far as I would like to note, it’s interesting, the testimony about the use of these due diligence reports and how securitization changed the use. Back when people were buying to hold, due 25 diligence was something that they did so they wouldn’t buy bad loans. Under securitization, due diligence was something that they did so they could get a better price on pools of loans. It wasn’t a way to –

COMMISSIONER GEORGIOU: By better price on a pool of loans by identifying some of the poor loans they’d have to pay less for.

MR. EGGERT: Right. By telling the originators, “I’ll still buy it, but I won’t pay as much because of the due diligence problems.” It’s a very different result than “I won’t buy the bad loans.”

COMMISSIONER GEORGIOU: Right. But doesn’t that go, to some extent, to the skin-in-the-game notion; that is, if you are either originating loans or purchasing loans that you actually wish to see paid back, you wouldn’t do it if you were holding them. If you could pass them along at 100 percent at full par, you would do so if you could sell them for that. But if you actually had to hold them, then you could run the risk that has already been disclosed to you by the due diligence information that they could fail. So that wouldn’t make economic sense if you actually had a hold — a long hold position with regard to some significant portion of those loans with those securities, correct?

MR. EGGERT: I think that —

CHAIRMAN ANGELIDES: Do you want another minute?


MR. EGGERT: I think that’s correct. And I think you see that both in the origination and also in the securitization. Originators have their own issues with, say, housing appraisals. It used to be when originators held loans, they wanted an accurate appraisal because it protected them against risk of default. Once there’s securitizing, housing appraisals are just a hurdle you have to jump over so you can securitize it. So their interest was, instead of having an accurate housing appraisal, was having an inflated one because it made it easier to securitize loans. If they are forced to retain risk, then they would have a greater interest in doing real underwriting, having accurate housing appraisals. And so I think that’s a central of element of the fix that needs to be


COMMISSIONER GEORGIOU: Mr. Johnson, you raised your hand to make a comment.

MR. JOHNSON: I just want to clarify that I don’t know of any Wall Street issuer in my history that ever wanted to find loans with exceptions to go back and negotiate a lower price to profit on their securitization. In fact, as earlier — like, in 2000 to 2005 probably the seller had more power than the Wall Street issuer because the seller — if you weren’t going to buy at Wall Street firm A at par or 101, I got another one down the street who will pay 101 and take the loans with you. I do think that what happened is exceptions got higher, Wall Street got smarter, and then priced those loans cheaper. I don’t believe that was the model. I just want to go on record. No one ever came to us and said, “Hey, we’re funding a bunch of bad loans.”

COMMISSIONER GEORGIOU: No, I am not suggesting that but they would utilize your information in part to  price the loans they purchased?


COMMISSIONER GEORGIOU: Right. Okay. Thank you very much.


COMMISSIONER THOMPSON: Mr. Eggert, I am not a doctor, either, so we can smile at one another. You are not suggesting that securitization is bad; you are suggesting that the process by which it was

executed during this bubble period was perverse; is that fair or not?

MR. EGGERT: I am not suggesting — securitization, like –

COMMISSIONER THOMPSON: I want to get at what you think the real issue is. Is it the process that’s broken or is it a product that shouldn’t exist? What are you telling us?

MR. EGGERT: Securitization has flaws and it has good points. And what we have to do to re-start securitization is to minimize and fix the flaws as much as possible, recognizing that they will still exist. But as it existed from 2006, 2007, the flaws were much greater than the value. We have to work on the flaws to try to turn that around. I think it’s important to recognize that lending — mortgage lending people have sort of villainized subprime lending. There is a usefulness to lending to people who are not prime borrowers. Even people who are prime borrowers, if they can afford a house, should be able to buy that. So we have to figure out how to make good loans to non-prime borrowers, not the kind of loans that were made and that have exploded. So that’s the challenge is how to set up the system in order to encourage better lending to non-prime borrowers.

COMMISSIONER THOMPSON: So you make the point that it would be good if people had current information about the status of the loans that were in those portfolios. So how practical, really, is that?

MR. EGGERT: If you look at the — well, first of all, that information exists. I mean, people are keeping track of the status of loans all the time. The question is how practical it is to disclose. And there we are having an interesting conversation between the association of mortgage investors — whatever they are called — and the Wall Street firms talking about how current the information should be, what information should be provided, and I think that’s an important discussion. But it’s clear that we can have better disclosure than we had. I think everybody — I think even Wall Street agrees that it can be done better and will be. But the question is how we balance the cost of, you know, making sure everything is completely up-to-date and versus giving investors the information that they need. And that’s a decision that is going on right now and is an important one.  The other thing we had to include in that discussion is making sure that we don’t disclose so much information that borrower’s privacy is violated. That’s another factor that has to be balanced in the equation.

COMMISSIONER THOMPSON: Mr. Johnson, you talked about the incredible transaction that happened with Freddie. Was that typical or not?

MR. JOHNSON: We had done several other ones in earlier years but much smaller.


MR. JOHNSON: Atypical. We did a similar transaction with Fannie Mae the same year for the same amount, 6 billion and charged them nothing.

COMMISSIONER THOMPSON: Charged them nothing?

MR. JOHNSON: Charged them nothing.

COMMISSIONER THOMPSON: The logic for that?

MR. JOHNSON: They were a strategic partner we agreed to work better on multifamily transactions. Washington Mutual wanted to buy and own adjustable rate multifamily and Washington Mutual could not originate fixed rate and hold them on our books, so we wanted to sell that to Fannie Mae. So that was the pre quo quo.  Also, I would say the executives at Fannie Mae were not ones that you could negotiate 100 million. The executives at Freddy Mac at that time were in chaos and it was —

COMMISSIONER THOMPSON: Management matters.

MR. JOHNSON: Management matters and Dan Lundgren (sic) never have thought of paying us that type

of money.

COMMISSIONER THOMPSON: So that transaction with Freddie was atypical?

MR. JOHNSON: Yes. And that’s why we asked for it to be disclosed, be reported to their board to make sure their legal counsel signed off. We wanted that done because it just didn’t make economic sense to us.

COMMISSIONER THOMAS: But in the end, it worked out for everybody — you, Freddie, and those who were a part of the process at the borrowing end?

MR. JOHNSON: It had no impact on our borrower. It was just a swap of paper. Swap of paper. There’s nothing economically changed, the list stayed with us, the yield stayed with us. It was, “You get the affordability credits and we get 100 million.”

COMMISSIONER THOMPSON: I wish I could have been a part of that transaction.

MR. JOHNSON: It had no impact on my bonus.

COMMISSIONER THOMPSON: So can you distinguish — you talk about private-label securities that’s non-GSE ; is that right?


COMMISSIONER THOMPSON: So will you spend any time with us here this afternoon on your observations about the GSEs in this whole process?

MR. EGGERT: Well, I think — I think the GSEs played a role in the process in two regards: (1) is the way that they securitized prime loans; and the other is the way that they invested in subprime loans. There are some who argue that Fannie and Freddie were a primary cause of the subprime meltdown and I don’t agree with that. I think my concern about them is they didn’t do enough to prevent the problem rather than they caused the problem.

COMMISSIONER THOMPSON: So what evidence do you have that would suggested they didn’t cause the problem?

MR. EGGERT: Well, part of it is their subprime presence was decreasing. During the period that —

COMMISSIONER THOMPSON: So they were losing shares?

MR. EGGERT: They were losing market shares during the time when the problems were mounting. If they were the cause, them losing shares should have meant that the problem was abated, but instead it was growing dramatically as they lost shares. When they were more active in the subprime market in, say, 2004. Things were better than they were in 2006 when you were less active.  So I think if you track Fannie’s participation, it’s hard for me to say they were the cause. But again, I think it’s unfortunate that they didn’t do something which they could have done if they had stayed more active, which is be the cop on the beat that says these subprime securities stink and this system has to be reformed. And they should have been shouting that and demanding change, but I didn’t hear that in 2006.

COMMISSIONER THOMPSON: Thank you very much.

CHAIRMAN ANGELIDES: All right. We — just one wrap-up question because we have to move on and I just have a question which is I am looking at a standard disclosure and it says, “On a case-by-case basis, the originator” — you know, put in the company’s name — “may determine that based on compensating factors, a prospective mortgagor not strictly qualified under the underwriting guidelines warrants an underwriting exception.” It goes on to say, some, a substantial a significant number of mortgage loans included in the loan pool represent such exceptions. Weren’t investors entitled to know the basic due diligence information. I mean, the issuers had it. Weren’t they entitled to know? Was there — wasn’t that something that should have been in the marketplace?

MR. JOHNSON: That has been our argumentative for 2006 and 2007 is that we thought it should. The only time I found one is — I think I saw a European securitization which did disclose due diligence was done and they’d laid out the exceptions to LTV, et cetera. So I believe the market is going toward that now, and that is the boilerplate we looked at and said, you know, exceptions could be material. Well, is material 4 percent or is material, you know, 60 percent?

CHAIRMAN ANGELIDES: If I know that 10 percent had been sampled and X percent failed, I would at least think that was a big enough sample to give me a magnitude of challenge.

MR. JOHNSON: In my opinion as a businessman, not wearing the Clayton hat or the Long Beach hat or anything, I think the exceptions were an indicator. I was very proud of this report that we did come up with. And that, to me, this is one of the areas is that if we worked with better we could have helped present value the pain and stopped the factory from producing.

CHAIRMAN ANGELIDES: Well, thank you very, very much. As I said, one of the big questions I always get in this community is: “How did it come — go from here to there?” You’ve at least given us something to think about for people to hear and understand about how these simple mortgages that people used to buy or refinance their homes, migrated on their way to Wall Street and around the world. Thank you very much. We are going to take literally — everyone in the audience, we’re going to take a 2-minute break while this next panel is assembled. We’re going to catch up some time. Two minutes.

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