everybody defaults and there's almost no equity when they do. and this is where i say they may have been going for broke, the moral hazard of taking a high-risk strategy in the early years, but they were going broke in these years. that is, you know the business is underwater. you just know that nobody has called you on it yet. they haven't made you declare bankruptcy and so you take all the cash out of it that you can until somebody finally closes you down. and for fannie mae and freddie mac, i have a brief anecdote. back in the '70s when i was at hud, i was supposed to be the prudential regulator, but, of course, that was only supposed to be 1% of my time. it was like with one eye shut. they really weren't going to be serious with prudential regulation. they had a lot of people involved with making frannie and freddie getting housing goals. it amounted to me making one call a year to david.

david, how are you doing today? >> it's great. >> as i look at your books you're $10 billion under water. yeah, who cares. our debt hasn't risen. c what different does it make? how many financial analysts do you have in that shop? he says i think there's one guy down there writing newsletters. i said how about legislative affairs and people, you know, in charge of the care and feeding of hud? he said there must be 50, 75, they're growing like crazy. that tells you what you really needed to know. they didn't face a bankruptcy con straight. so why, and this is the end of my story, but why it happened, why did the fm crisis become systemic? well, even through all this peshd, never reached the home ownership goal. got close to it, never reached the 70%. there was a new criteria that

was imposed in addition to all of the other affordable housing goals. the mission regulator said, well, you have to maintain at least a 50% market share against the so-called private label securitization. okay. so fannie mae and freddie mac were cooperating with the pls. they funded almost half of it, and they did this to meet the housing goals because those securities counted for the housing goals. at the same time they were competing with them for market share because they were required by their regulators to do it. so when the private -- i call them plss, when the private label securitizers went for broke if the first half of the decade, fannie and freddie went for broke in competition with them. when they went broke in the next three years, fannie and freddie went broke, okay? i have one slide left on fan fri and fred ddifreddie. had there been no private label

securitization market, fan fi and freddie could have still called a systemic crisis because they had no way of generating -- it's possible that politicians would have relieved them of that goal and just ignored it. with private label securitization going over the cliff, the market share mandate was going to force them to do this. now, there's been a lot of defenses that have since been offered for fannie mae and freddie mac. one is they followed and were led. when i tried that excuse with my mother, she said what did you do, i said everybody else was doing it so we did it, that excuse didn't work very well. if everybody else was jumping over a cliff to their death, would you jump over a cliff to their death? no. they weren't followers, they were leaders. except for one period when prudential regulation trumped

mission regulation. they had had two of the biggest gap financial scandals in history so they put a capital requirement on it. as soon as that was removed they again led the way. now, second defense was from the mission regulator was, well, okay, you know, so i pushed them over the cliff, but they would have done it anyway because i had them convinced there were tremendous profits to be made in this market. i haven't found evidence of the profits, but that was the notion, that they really believed there were profits there. i say it was a suicide mission. they were more likely to find 70 virgins in that suicide mission than they were to find profits for the loans that they were making when we're talking about 2006 to 2007. so the excuses really don't wash. now, the much tougher question is why did private label securitizers and how could they survive for eight years? and the unanswered questions,

why didn't the regulators stop them? how could they achieve comparable leverage to fannie and freddie to compete? why didn't the smart at-risk investors stop buying the securities? then the market would be shut down? how could everybody for eight years make up front book and cash profits in a money-losing operation? and why didn't the speculators stop them? if you can answer those five questions you will know why the pls was allowed to go on for so long. and the short answers are it had nothing to do with market discipline and market failure because there was no market discipline. markets had been replaced by regulation across the board. you have one or the other. and we had bad regulation in each case. the affordable housing goals trumped prudential regulation. and then i'll show why and how the s.e.c. and bank regulation arbitrage provided similar

leverage to these private label securitizers as fannie and freddie were able to achieve. the smart money was replaced by dumb money and then it was the regulatory accounting that allowed them to book fake prafts, that forced them to book fake profits that kept this whole model alive and in the end you can't short the government, which was what was driving the house prices up for that whole period of time. so basically what i'm going to give you now are really the confessions of somebody who is a former hud or a former freddie maccer but mostly a former label securitizers. how were their capital requirements set? anybody know? the financial crisis inquiry commission didn't tell you. they don't know because they're very opaque. and one of the reasons they're opaque is private label securitization wasn't created, it was created for ginny mae.

the government backed it. other countries just used debt and equity. the primary legal distinction is that other types of funding or financings and the securitization was an asset sale from day one. now, i know i'll run out of time so i will do this briefly. remember i told but that tax problem that equity was taxed. the whole reason they created the ginny mae security was because they needed a vehicle. ginny mae was exempt from all state laws and regulations that would allow it and nobody else to bypass those laws and create a national market but they weren't exempt from the requiir. they got an. if they had a passive trust they could pass it all through. so they created what investors said was the worst possible instrument of all time. 360 monthly cash flows and you

didn't know how much interest and principal was coming. it's not what investors wanted to buy. the origins of the private label securitizati securitization, we were working on legislation that would allow the private issuers to do what the public was doing, avoid tax and manage the cash flows in any way they wanted. . ann dougherty reviewed that whole legislation. we have a lot of guilty people here that i see. then i moved to freddie mac where we were also exempt from the rules and we did the first mortgage security that was tranched, that had different tranches for different investors. it was interest rate tranche, but it violated because we took the same cash flows and i made $10 million in profits because investors were willing to invest

more. i had a pool of underwater mortgages. i did fansing for gap but it was a sale for tax because i wanted to accelerate the tax loss and be able to write that off and it was cheaper financing than deposits. now why might you ask? because i overcollateralized it. if you're overcollateralized one thing you should be under collarizing something else. the price didn't because i was under collateralizing deposits and that's where the regulatory arbitrage comes from. i took that to michael milken and i said you know all those junk bonds you sold us, i'm going to turn them into aaa securities. he was apprehensive at the time, but we did the first collateralized bond obligation which did exactly that. and we'll see later that these techniques are what investment bankers use in the last crisis. we did the first asset back collateralized loan obligation, the key to the last one was we did the first cash flow bond. before that the rating agencies

would require you to post collateral in market to market. this was the first one in which they rated the bonds and said, the cash flow from the underlying mortgages has to be able to be sufficient to cover the interest on the debt and that's the way all other securitizations were done after that. then in the 1980s we had the basel risk requirements. now, having deposit insurance lowered your capital requirement from what had been historically a market rate of 16% down to 8% and that's what bob always called banks have a dueling charter with fannie and freddie, but regulatory arbitrage cut it from 8% to 4%. beyond that if you securitized it, you could get the same cash flows down to only 2% capital. with your debt costs not going up, if you increase your levera leverage eight-fold, you return

your increase. capital eight-field. if you lose money, you will lose eight times as much money. the regulatory arbitrage was all there. basically the lessons from the 1980s private label securitization was it was exactly the same thing as freddie and fannie. you could issue all the debt you wanted no matter how risky the loans were because you were using another form of the agency status that they had backed by deposit insurance and your loan rates weren't going up. so to get to the first subprime debacle, the legislation was passed and that provided more opportunities for regulatory arbitrage. basically what was allowed was multiclass securities, there were a million ways to do this, but you were trarchinching by ct

risk. they were doing it with subprime loans, but interestingly these subprime loans weren't eligible for finance by fannie and freddie because they had bad borrowers but they supposedly had a lot of equity in the house. so my first day on the job, i'm meeting the ceo of the bank subsidiary. and they're bragging about the profitability of these securitizations, and i look at it, and i say, well, you know, okay it's really profitable but where did the mortgages go? the mortgages are gone. who open owns them. the investment banker bought the retained interest from me on the day the deal closed. i said how could he pay you enough to buy them. she said we promised to buy them back the very next day at the same price. i said, well, the good news --

the bad news is that's called parking and that's what michael milken went to jail for. the good news is that his cell is now empty and i hear it's a very attractive cell but when the books close at the end of the year, they will come and get you, so then my job was immediately to get that junk off his books at the end of the year. i was trying to close a deal because i couldn't sell it without taking a huge hit. i had to spin out a publicly traded reit which i retained the management rights to, this is another technique the investment bankers use, and i could park it in a friendly place with a wink and nod, say don't worry, you will take losses but i'll make it up to you later. so the reason that the regulators had done this is there was a chicago savings and loan doing this hou-risk subprime lending and they were doing double leverage. they'd retain the residuals and the residuals would be leveraged 10 to 1.

on subprime loans it magnifies the losses. they had a loophole, if they purchased interest that regulatory capital doesn't apply. they figured we'll buy them and sell them and retain interest into purchase interest. so what happened was there was no point anymore of keeping these loans on the books. the regulators hated them on the books because they were lousy loans and they would have made you reserve if you left them there. we spun out the finance company, traded it as a finance company on the new york stock exchange we created charities and the lawyers and accountants created a sliver of ownership that was so small it was worthless. we took a loss for tax purposes for contribution to a charity and that's where the assets went. they disappeared from anybody's book. the finance companies held the retained subbosch nated interest. banks could buy this with 1.6%

cap. . banks had what they call structured investment vehicles which allowed them more leverage. that was like 1% capital. and this all started because everybody, economists, politicians, in the 1970s said that gse securities were liquid. well, the commercial paper is 30 days. gse securities for 30 years. they're marketable but marketability is ephemeral. they're not liquid. the whole structure was extremely fragile because they're issuing 30-day commercial paper and basically they had a put back to the bank. all it was was another form of regulatory arbitrage that got the capital requirements down below 1% to fund these pools of mortgages. so then funding subordinated interest was all you had left, and you could go to the junk bond market and to the stock market and enter this continuously every three months. each time you do a

securitization you're reporting profits but you're not getting any cash out. and so you could only go to the market, the junk bond market and the stock exchange, if you had book profits. now, where did the book profits come from? well, these retained interests were hypothetical cash flows. if everything went right, five to ten years down the road we're going to see some cash back. and the s.e.c. did two things. they said, well, you can present value those earnings to report the profits now and you're postponing the losses because you don't have to take loan loss reserves against the bay sets because nobody knows where the assets, and they did another thing. they said we want you you to discount those cash flows at 8%. so all the profits came from s.e.c. accounting, and when i used the market rate, the market rate on those securities for the retained interest was 35%. when you use that, the profits disappear. then i had my finance guys one models of cumulative default loss and they said everything is

going to default from day one. they never had a good security. it's not going to go into default. i said how can i keep on generating these profits? i had to book the consolidated earnings on my books and as cfo i didn't want any part of that, but i was forced to by the regulators so the one thing i could do was get my board to sell the stock. i said this -- the shorts are going to be out there and bring this shock down, it's going to crash. they agreed with me. month after month for almost three years and they got madder and madder because the stock just kept on going up in price and they were missing a bull market and they couldn't believe why i was selling. so finally i'm having a drink with my largest investor, and i say, well, look, just tell me off the record, you're my biggest investor and you know i'm selling this stock of this new york stock exchange company, and every time i sell, you buy. what is it that you know that i don't know? and he said, well, i know that i get a management bonus every year based on my performance,

and i have been getting bonuses based on riding a bull market and you haven't because your board hates you and my investors love me. i said, yes, but have you looked at the value of those residuals very closely? i figured he hadn't. he said, let me introduce you to dmitri my russian physicist. dmitri explains models of cash flow and credit loss that blew ours away. i said what's the bottom line here? he said they've been losing money since day one, they're going to default on all the securities. if you know this why are you buying? he said, well, i'll still making my bonus, we'll dump it all after the year end. this is a good game. the shorts can't short because i'm bigger than they are. i have more buying power than they have selling or shorting power. so they didn't make it to year end. what happened? russia defaulted. then the securitization markets froze up. when the securitization markets froze up we didn't have enough cash to keep this company going. the shareholders started selling, the bondholders stopped

funding the company and within about three months every single publicly traded subprime finance company declared bankruptcy. and the investors, of course, blamed the russians. they said, well, nobody could see this coming, and the s.e.c. hired goldman sachs to mark down the value of assets. they marked the residuals down to zero and the securities down about 50%. is this starting to sound familiar yet? then they hired all these lawyers to come sue me and i had to explain to them you made me. so what was different from what was already happening when we get to the year 2000? well, the borrowers were much worse. i have shown you the evidence of that. the regulatory arbitrage, that's much worse. the investor distorgs were much worse. the credit losses were greater, but the profits that everybody could generate were bigger than they ever were in that previous generation and they were cash profits in fannie and freddie joining the party. so there's a lot -- for the

senior investors, there was a huge global shortage shortage of senior securities, aaa and aa based on regulatory they said, well, let's take the jump -- we'll take the mezzanine bbb and make it into aaa. it's an easy thing to do. basically taking the mezzanine piece, which got thinner, the equity strips had to get bigger, but i'm talking about they went from two-thirds of a percent only up to 2%, relatively tiny and not enough to stop anybody, so everything was getting put into cdos during this period, up to 80% of the pls being put into cdos. and fannie mae and freddie mac are funding about half of the aaa, aaa senior pls because they meet the housing goals.

no down side risk, and even the pensioners would get many pensioners in state and local retirement funds would get an extra year pension benefit if the performance was good. and on the down side, the taxpayers guaranteed it. so they had a go for broke mentality. and, in fact, if you think about it, almost every state and local government retirement fund in the country assumes they're going to earn 8% real adjusted. the market rate on that, treasury tips, was only 2. so somehow they think they're going to make three times what the market rate is, four times, and they never do. so this money is pouring into the hedge funds, they've got to spend it somehow. wall street expands vertically. that is, they see the hedge fund business as being good to

manage. so they start sponsoring hedge funds. then the s.e.c. comes along and they say investment banks can leverage at twice what commercial banks were, 40 to 1, and that's not counting their off balance sheet things. so the investment banks started to buy up the loans, and buy up the lenders, because now they can put the securities they don't sell right on the balance sheet. this whole stuff about proprietary trading accounts really had nothing to do with that. they were doing what i did in the '80s, '90s, had to park these hard-to-sell assets someplace that retained interest and even the mezzanine. and who determined the price? well, the s.e.c. says well, we'll leave that up to the traders. so the traders could book what i would say were virtually worthless assets and booked them at par and then they booked huge yields on them they haven't earned and then they get multimillion dollar bonuses every year. $10 million a year was not a big deal for a trader. but nobody made any money yet. the commercial banks were doing an on balance sheet and off

balance sheet for the aaa and aa securities and also offered up the mezzanine and junior pieces. shadow banks got a lot of attention. they did nothing wrong. they were just victims of -- they weren't regulated, but they bought commercial paper, all the issues of commercial paper were regulated but based on the arbitrage story i'm talking about. so the huge cash profits all through this period, even though as we've said, we know the loans were bad. and we can see how everybody could make cash profits. but what i want to highlight is these excess bread securities. that was created because you had had a very low yield on the aaa, driven in part by fannie and freddie and this global demand for regulation, and you could assume a very high yield on the underlying loans, even though they weren't going to pay it so you created a security and as long as house prices kept on going up and the defaults were postponed, the subordination clauses triggered cash

disbursements. so by the end of this period of cash profits for all, unlike the previous debacle we had, nobody is cash constrained. everybody is making profits and has plenty of cash to keep the model going. so what happened was, they just kept on producing, 2004 through 2007, everything went into securities. hedge fund money doubled again, qu quadrup quadrupled, and again, most is state and local money. so virtually no smart money ahead of the aaas. they're funding 95, 98%. freddie and fannie say we're taking the zero risk piece. it wasn't the zero risk piece, it was most of the funding. might not have known it. so the last question really is, and then we'll wrap-up, shorting the subprime market. why didn't somebody stop it? just the shorts just sell. and it was technically feasible. you could do this with credit default swaps.

this got a lot of negative attention. it seems to me it almost worked perfectly. the cds contracts were written mostly by too big to fail banks and aig, but aig, the insurer didn't country them. a shift subsidiary regulated by the treasury which was eventually timothy geithner's responsibility was writing the credit default swaps. and there was a symmetrical capital treatment. the fed was given relief to the buyers of credit default swaps was which appropriate to do so long as the sellers were posting an equal a. capital. i doubt they were, because they don't ever quite work it that way. i would sthis would say this. supposedly according to chairman bernanke and secretary geithner, paid off 100% and won't lose a dime on the bailout, including aig. so i don't see what the problem was. but there was a huge price disconnect, because the price

that s.e.c. had them boog the value of these assets at was twice what they were worth. diplomat make any difference until somebody had to sell. bear stearns was the first time anybody sold, and the whole market, of course, crashed. so the last question we had is, why weren't the shorts short shortly after this whole bubble started? like in 2002, or 2004, why couldn't they stop it? because a lot of people say it was irrational exuberance everybody thought house prices were going up. a., there is absolutely no evidence in my mind that anybody based irrationally. everybody behaved rationally. there is no theory that says that's true. and even the leading nobel prize winner, behavioral economist, says even if everybody is irrational, the people who short securities are totally rational. so it doesn't take anybody else to be rational, only the shorts. so why didn't the shorts short.

there is a great book on that by michael lewis because they were shorting the government. and you can't short the government. we thought we learned that 20 or 30 years earlier. so i thought the funniest line in the fcic's report was they exonerat exonerated fannie mae and freddie mac and said the yields on their didn't go up, of course it shouldn't -- why should the yields on their debt go up? so this time is different is the title of a book. i'll save you from reading it by adding three words to the title. the point was, for 800 years of financial crisis, this time wasn't different. it's always the same thing. it's always been public fiscal policy folly that causes financial crisis, and the state and local governments are only a minor player because the mezzanine share was so low. but as i say, the liabilities are all greek to me. except i'm from california,

which is mostly spanish. california is too big to fail and too broke to bail. so that's the same thing spain is facing right now. we've already been through all of the problems of having all of these off balance sheet liabilities that don't have any capital. and what happens when the risks just get too great? so the only prescription is to enforce capital requirements. you've got to have capital to be able to back these risks. and that's fannie and freddie must go. why, there's no reason to have them if they're going to have market capital requirements. why have a monday opposist -- what's the point? and we all know, monopoly isn't supposed to be good. so that's getting a lot of discussion. jeannie mae and the home loan banks. ginnie mae didn't fail, but fha is deeply under water now. once you shift the risk from fannie mae to freddie mac, who knows how they'll bail that out. home loan banks never failed,

because they overco lateralized. that's why with when he went into indymac, the banks had half the collateral and there was nothing left for the fdic. this is my last slide. securitization should go, because it's inherently undercapitalized. and i would say that the capital requirements should be transparent, covered bonds have extra more capital requirements, but they tend to have overcollateralization, just like i did in my first bond deal, because the investors don't trust the regulators, the quality of the capital or the quality of the loans that an institution is providing. so they want excess collateral. and you know, that's -- you've got to have capital someplace. okay. i think we'll wrap that up. take questions. send hate mail to my e-mail. >> thank you, kevin. let me again note that both the papers from which this presentation