Subprime Mortgages & the Housing Bubble

... What are some of the other stories that you found out there as you combed through the rubble of the financial crisis?

... The big banks were doing these enormous real estate transactions. The little banks ... a lot of times they would participate in syndicated loans from the big banks, often just taking it more or less on faith from the big banks. And as far as we could tell, there tended to be an adverse selection of what was shown to the really little banks.

You'd see $900 million syndication, and some little bank in Georgia would be in for $7 million of it. If this loan had been any good to begin with, the big banks would've syndicated it all among themselves. The little tiny banks had no business being in trivial participation relative to the size of the big loan. ...

... That's the big banks treating the little banks like suckers.

What happens is the big bank marketing desk naturally tries to sell it to other big banks first, because that's the quickest way to make a sale. If they can't get it sold to them, then it looked to me like they would keep going smaller and smaller to try to get it sold.

Because the big banks don't really want to keep paper on their books any more than they need to, they'll take it in, underwrite it in effect, but their real plan is to redistribute it and make a fee for doing it. That's what banking has really become.

But in this case, they're victimizing the little bank.

You can call it victimizing.

They're the greater fool in a sense.

I think they turned out to be the greater fool. Not all the loans were bad, but the little banks should've had the sense to understand if you can't fill a big loan from big banks, why are you coming to me in some little town in Georgia, offer me a few million dollar piece? Should've been a sanity check that said there's only one reason I can think of -- that's that the bigger banks didn't want it.

But if some guy with a nice suit comes down from Wall Street to sell you something, you're pretty impressed, I guess.

It depends on your point of view. I wouldn't have been so impressed. I would be thinking why is he coming to me for two pennies? ...

Let's stay with tales from the main street a little bit more.

The other thing that the little banks were doing -- they more or less had to do -- was finance the local shopping center developer, finance the little local developer of a small apartment house, finance the local office park, that kind of thing.

That's very much the lifeblood of the economy.

That's what they should be doing. What happened, though, was they began emulating the bigger banks, because the big people were starting to syndicate those loans into collateralized mortgage obligations. So suddenly the loan-to-value ratios were going up on those.

But the little banks didn't have much alternative, because in many territories, that's the industry. Take much of Florida. What is industry? What is business? It's largely real estate oriented. So when the syndicators of securitizations were paying higher loans-to-value, lower yields and stuff than the little banks, the little banks kept competing.

In that sense, the securitizations hurt them very directly because it affected the normal mainstream business that they would be doing in the normal course.

So those states that have real estate at the core of their economy, such as Southern California, Nevada, Arizona, Michigan even, and Florida, all were hit tremendously hard.

All were hit, but even ones where real estate isn't the main core, all of them have seashore communities or vacation communities where that's true. Even short of that, there's always a local developer, local something. Real estate is an important mainstay of a lot of the little banking institutions. ...

To put this into really simple language: The little banks got sold a bill of goods by the big boys at the big banks, and the regulators weren't watching out for them.

Interestingly, they weren't watching out for either side. They didn't watch out for what the big banks were doing with their own balance sheet, and they surely didn't watch out for what was happening to the balance sheets of the little banks. ...

... Explain to me how the moment happened when you sort of said, "Holy cow, this is insane!," and how long it took other bankers to come to that realization. ...

There was no magical "Eureka!" moment for me, but there was one that I recall. I was doing some work for a fund manager, and they were looking at a whole bunch of mortgage-backed securities, and they sent me a whole bunch of prospectuses to read.

As I was working through these prospectuses, I was almost getting a sense of deja vu, because there was usually a map of the United States which showed where the mortgages had come from. It was late at night, and I suddenly thought, "I've read that prospectus before." But then I went through them and said, "No, I haven't; this is a new one."

And then I realized why I had thought they were the same, [because] when you looked at the maps of the United States and where the mortgages were coming from, they were all coming from the same states. They were coming from California; they were coming from Florida; they were coming from Nevada; they're coming from Arizona and a few other states.

So I did something old-fashioned. I took a piece of transparent paper, drew maps of the United States, and copied each of those maps from each of the prospectuses. And I went to my client and laid them all on top of each other, and he said, "They're all from the same place." I said, "Exactly."

So what we are doing when we buy this stuff is we are taking massive bets on house prices continuing to rise in these particular states. And then I explained to him that when you looked at these mortgages, they didn't actually assume that house prices stayed stable; they were actually assuming that house prices would continue to go up steadily over time, because many of these mortgages had what were called teaser rates. Essentially the rates initially for the buyers, for the first year or two years, were very low, and then they would kick up.

And I said to the man that I was working for: "You're betting that, a, interest rates stay low, so when you get past the honeymoon period they will be able to refinance the mortgage and get another period of low rate. Or alternatively, you're assuming the house price is going to go up so quickly that they're going to be able to sell the price and reduce the mortgage in some shape or form and continue to make payments."

And he said to me, "How likely is this?" I said: "This is just like a Ponzi game. It depends on when somebody asks for their money back, and at that point, the whole game will unravel."

It unraveled relatively slowly, and there were some markers. The first marker was when the U.S. Federal Reserve started to put up interest rates, and as they started to put up interest rates, the housing bubble firstly peaked, and then started to slowly deflate. ...

I can remember the visceral change in the approach and attitude of people, because people for the first time homed in on this issue of what was going to happen to these mortgages if house prices came down. And at that stage, the Federal Reserve officials and the U.S. Treasury secretary were making soothing noises about how housing prices never have gone down consistently and how everything was fine.

Basically my reaction to that to somebody was, "If there's no fire, why do they keep saying there's no fire?" ... And when you looked through into the underlying mortgage market, you could see what the problem was. ...

Because there was no liquidity, as everybody started to try to exit this market, they couldn't, because it's like yelling "Fire!" in a theater where there aren't too many fire exits, because everybody's trying to get out.

And under those circumstances, what happened is the CDS prices, the fees you had to pay, blew out. At the same time, this index started to fall, and because they were completely in the public domain, people would look every day at these prices and find them dropping. People just literally panicked, and people started to want to sell. ...

All of that combined in a vicious cycle, forcing the price down, and that was the moment at which the whole game came to an end. Then it started to radiate out from the United States, and because these securities were held by people in Europe, in Asia, they started to feel the pain. That's when the whole global financial system started to gradually seize up. ...

Some would argue that banks are so essential to our lives that they are akin to utilities and therefore should be more heavily regulated than they are.

The problem isn't lack of regulation. Banking, I would argue, is the most heavily regulated industry in the world.

Regulations don't solve things. Supervision solves things. If we could figure out that the subprime thing was a train wreck that was coming, where were the regulators? ...

Everybody points the finger at the banks. That's great. They made their mistakes. But the job of the regulator is supposed to be safety and soundness.

The bank we bought in Florida, BankUnited, made a specialty out of the most toxic product that you can imagine. This was a specialty of theirs pre- our buying it and pre- the failure. What was the product? Adjustable rate mortgages. Subprime mortgages, generally pretty close to 100 percent loan-to-value with teaser rates in the beginning and then sharp ramp.

And who were their borrowers? Non-resident Latin Americans. Now I have nothing against Latin Americans, but to give a non-resident 100 percent loan-to-value loan when you know he's a bad credit and he's not even someone in your country.

That's a no-money-down loan.

Yeah, no-money-down loan to a foreigner. It doesn't make a lot of sense to me, and yet they put billions and billions of dollars of that on their portfolio over a period of years. Nobody stopped them. That kind of thing is an abject failure of supervision. ...

In April 2008, you put together a shopping list of small, struggling banks. ... What are you looking for out there, and what were you seeing? ...

There was similar diseases and different diseases. The littler banks were mostly not originating big securitizations, so that wasn't the nature of their activity. They were more of a buy-and-hold mentality, so they were buying subprime paper created by the big banks, and they were generating some for their own account.

So they were buying loans. They were taking on loans as their assets.

They were doing both. ... Remember, banks have been subject to the Community Redevelopment Act, the CRA. They really have kind of quotas, what they're supposed to do by way of what I would call very weak loans.

And many of them felt well, these were the subprime loan. I've got some kind of collateral. Maybe it's a little safer than some of the other kinds of loans that I need to make for community redevelopment purposes.

In both the cases, the government mandates what they were supposed to do from a sociological point of view, a societal point of view. Frankly, we're in total contradiction to fundamental soundness of the institutions. And as I said, they did the same thing with Fannie and Freddie. They gave them quotas.

But a bank didn't have to take these.

They have to take some sort of loan of that type. ... And what gave them some comfort was if they could simultaneously fulfill the governmental mandate and have something that at least somebody thought was a AAA security, well that's pretty good. So they fell into the trap.

A trap set by the government?

Inadvertently. The government's purpose, obviously, wasn't to set a trap. But I think it's something that we're seeing more and more, and especially nowadays with the consumer protection agency. They just put out an 800-page handbook, alerting the banks that are $15 billion and more what to expect when they come in and audit the bank.

Many of the things that they're going to be wanting the banks to do are quite adverse to the bank's profitability, maybe even to the soundness of the bank. So here you have the OCC [Office of the Comptroller of the Currency], FDIC on one side of things, and now you have the consumer protection agency potentially on the other side. ...

As chairwoman of the FDIC, did you get an opportunity to brief the president on your concerns?

Not in the Bush administration. It was pretty much done at the regulatory level.

So how high could you take your concerns, or who do you talk to?

We talked to other banking regulators at the Fed and the OCC [Office of the Comptroller of the Currency] and the OTS [Office of Thrift Supervision]. We raised our concerns with Treasury. We convened a series of roundtables in the spring of 2007. ...

First we pushed to strengthen lending standards at least that applied to banks for both subprime loans as well as what they call "nontraditional mortgages," which are mortgages that have negative amortization features. ...

We pushed for that and were not able to get a stronger standard for subprime until early summer of 2007. There was a lot of resistance from the industry as well as from other regulators to do that. There were so many loans that were already made that were bad; we knew they had to be restructured. Especially [with] these steep payment resets, we were going to start having a huge wave of foreclosures.

So we convened a series of roundtables with the other regulators: Treasury as well as the securitization industry, their accountants, the tax lawyers, the underwriters, the servicers. Everyone came in, and [we] were able to establish that there was legal authority to restructure these loans. ...

We thought these loans were going to get restructured, and then it just didn't happen. ... At that point the problem wasn't so much underwater mortgages, ... [it] was really unaffordable mortgages, because some of them couldn't even afford the initial payment, and they certainly couldn't afford the reset.

So we were pushing for interest rate reductions, converting them into fixed 30-year mortgages at low market rates as opposed to these really high basic rates that you would see with the subprime. ...

There was clear authority to lower interest rates. There was less legal authority to do principal write-downs. ...

So they can't change the terms of the contract because it's all tied up in some cluster of other securities?

Yes. You can't put enough emphasis on how the securitization model skewed economic incentives to make creditworthy loans to begin with, because you severed the origination process -- the entity that was actually deciding to make the loan -- from those who would actually own the loan. And because of that severance of economic interest, you ended up with a lot of very bad mortgages being originated.

But on the servicing end too it's been the same problem, because the entities servicing the loans -- those responsible for collecting the payments or working with the borrower if the loan becomes troubled -- those people are not the same people who own the loans. ...

During these roundtables we established that there was lots of legal authority to reduce interest rates, not so much legal authority to reduce the principal amount, so we were pushing very hard for significant interest rate reductions on a long-term, sustainable basis.

But you weren't able to get it done?

We were not. We got a lot of happy talk that they were going to do it and then--

Happy talk from?

From everybody. From the servicers, from the investors, from the Wall Street firms doing the securitizations. Everybody said: "It's going to get done. It's an obvious thing to do, and we're going to do it." And then it didn't.

This is the fall of 2007. The roundtables are in the spring, where we got everybody's buy-in to support loan restructuring. That fall, Moodys.com does a survey and finds out that less than 1 percent of delinquent subprime mortgages are being reworked. The vast majority are just going into foreclosure.

That was when I started going public, because I think there were a variety of reasons why this wasn't happening. The servicers were understaffed and didn't really care. They didn't own it, right? If anything, they had financial incentives to foreclosure. ... If you did a restructuring, whatever money they were owed in terms of fees and things had to be put into the restructured mortgage and it would be paid out over time. You do a foreclosure, they're paid off immediately.

And the investors were pushing back. I think not enough attention has been given to that. What we call the AAA investors -- the investors in the securitization trusts that had the most senior, the most protected interest of these pools of mortgages -- they didn't really care, because if the loans went into foreclosure, what they called the "lower tranches" were going to take the credit losses.

So if you reduced the interest rate, everybody in the securitization pool gets a reduced return. But if you go to foreclosure, for the most part the AAA investors are protected. ... The AAA investors, there's a lot of very powerful institutions. They didn't really see it as in their interest for these interest rates to be reduced. ...

So that was the banks and their clients?

Right. So the big bondholders. Fannie [Mae] and Freddie [Mac] held a tremendous amount of the AAA paper.

Pension funds? Insurance companies?

That's exactly right. ...

... You go forward with speeches. You say, "We have a huge problem on our hands" in one speech. What kind of support are you getting from any other part of the government?

Not much. I think we were getting some lip service.

So you’re the skunk in the room?

I was. Somebody called me that actually, said, "Skunk at the picnic." But I didn't feel like I had any other alternative. We had tried internal meetings. We had tried job owning. We'd tried interagency action. Again, these Wall Street firms and a lot of the originators who were funding these mortgages were outside of the insured banks.

We weren't the primary regulator of many of the big banks or thrifts that were doing this kind of lending, number one. And number two, a lot of it was being done completely outside of insured banks. Wall Street, of course, was completely beyond our reach. Those were securities firms.

We didn't really have legal power on our own to force people to do anything, so our only tool was really public advocacy and media pressure and public pressure to try to get it done. That was the strategy we decided to use.

Let's go back and begin with you at the Treasury Department in charge of financial institutions. [As] you start to look at the landscape out there, what do you see? What are your concerns?

Then it was really an issue of predatory lending. It was not mainstream banks and thrifts and big mortgage companies that were doing this. It was more the perimeter players in the markets.

We were starting to see a lot of abusive lending. These loans were targeted towards lower-income neighborhoods, and they would have very steep payment resets, very steep payment shock, so that really after a couple of years, the borrower could no longer afford the mortgage. That forced them into another refinancing.

We'd see situations where some of these mortgage originators would actually troll these neighborhoods for people that had equity in their house but also had damaged credit scores. They'd go in and they'd push market and say, "You've got this equity in your house. I'm going to give you 2/28s and 3/27s." They characterized them as fixed-rate loans. Well they were fixed for two or three years, and then there was this huge payment shock.

This is what we were seeing in 2001 and 2002 -- negative amortization features, steep prepayment penalties, so that you'd force them into refinancing and then you'd charge them a really steep prepayment penalty to refinance out of these loans that that had these steep presets.

You're churning the fees all the way along.

Absolutely. ... There had been some real problems in Baltimore, and Sen. [Paul] Sarbanes [D-Md.], who was the chairman of the Senate Banking Committee back then, had sponsored anti-predatory lending legislation.

When I went through my Senate confirmation hearing, in my meetings with him, he was really the one that alerted me to this. Treasury and the HUD [U.S. Department of Housing and Urban Development] had done a recent report on these issues, so there was a real need for legislation.

... [Then] the banks and thrifts started getting in on it too, unfortunately, as competitive pressures created this downward spiral on lending standards.

The [Federal Reserve] had regulatory authority to create rules for everybody, bank and non-bank, but they didn't want to use it. Ned Gramlick, who was at the Fed back then, was very concerned. He had pushed but wasn't getting anywhere, and there wasn't anything that was going to happen on the Hill because there were people making a lot of money off of this.

So we tried to get some of the better players in the industry together, the consumer groups and some of the securitization industry, to agree to a voluntary set of best practices that actually would be enforceable. Under FTC [Federal Trade Commission] rules, if you make a public statement that you adhere to certain principles and then don't do that, there is an enforcement mechanism that can apply.

That was met with somewhat mixed success because again, it required voluntary buy-in. …

But by and large, the lenders didn't want to go along with it?

They really didn't. I think the lenders were mixed. Some of the lenders did want them. I think they could see what was going on and the kind of pressure this was creating on them. They were losing market share to these predatory lenders.

I think the securitization industry was a real problem. Some of the Wall Street firms who were funding these loans because, I call the perimeter players, they didn't have funding of their own to fund the mortgages. They were getting it through securitization process from Wall Street, and Wall Street was making a lot of money off of it. We couldn't really get any buy-in from them. They wanted nothing to do with it.

So Wall Street is just shoving money down the pike?

Yes. ... They had a saying: I'll be gone, you'll be gone. So it was all volume-driven. Everybody was making their money up front passing off the risk to investors, those who bought these mortgage-backed securities. The investors weren't doing their due diligence. They were relying on the rating agencies.

The rating agencies weren't doing their due diligence either. They were saying: ... "Mortgages are safe, right? Historically [there have been] very low default rates on mortgages. These investments are fine," without looking underneath as to what the poor underwriting standards that were in these loans.

And for years you're complaining about this. ...

I am. This is 2001, 2002, and then I went to teach at the University of Massachusetts for four years and really wasn't that involved in those issues. But then when I came back in 2006, I had been certainly following the raging debate over states passing anti-predatory lending laws, because the federal government clearly wasn't doing anything. ...

When I came back in 2006 to chair the FDIC [Federal Deposit Insurance Corporation], the staff at the FDIC were also getting increasingly worried that the lending standards were deteriorating significantly, and it was not only laying the groundwork for a lot of mortgage defaults but also a huge correction in the housing market.

The problem with all easy lending is it was building the housing bubble. With all this free credit going out, it was creating artificial demand for people buying houses who had no business buying a house. So that fed the asset bubble as well … and as we've seen, that was going to have a huge impact on collateral values for banks and their loans, even with safe loans. ...

But was there a moment when you looked at this hard and sat around a table or on a conference call and said, "This doesn't make sense."

I think I'd like to say that we understood exactly what was going on and concluded that it wasn't a smart thing to do.

Why did you make that conclusion?

We didn't make that conclusion. We didn't know what was going on. ...

We knew how much people said they were making. We saw that UBS and Merrill Lynch had fixed-income and securitized products earnings that were growing faster than ours. And we asked ourselves the question: "What are we doing wrong? What are we missing? Have we not figured out how to lay off some of this risk? Have we not figured out how to manage the risk ourselves on our own balance sheet?"

And honestly, we couldn't figure it out. What we never imagined was that those other firms weren't doing anything at all. They were just taking the risk and sitting with it.

If you saw that you were getting beat, why didn't you jump in?

We would have been happy to jump in if we could have managed the risk, and we couldn't find a way to manage the risk. ...

But of course we didn't assume that other people were stupid. We didn't assume that other people were generating a loss in every transaction. We assumed that they found somebody to take the other side of the trade at a different price, or that they were able to buy these mortgages much cheaper.

So you felt you were getting beat?

We thought we were getting beat, and the temptation at that point -- there's probably one or two people who worked with me who thought it would be a good idea -- was to say: "We don't really understand what's going on here, but let's just do a little bit of business anyway, and we'll just hold some of the risk. And then once we own it, we'll see if we can figure out where to sell it."

Did you do that?

No.

You did do some early deals.

We did some deals. ... JPMorgan was not without its issues during the financial crisis. I think the thing that distinguished us from others is that our issues were all on a scale that ultimately we could handle. ...

You were in a management position, and your competitors beat you, and so you must have been frustrated that --

There was a lot of pressure.

There was pressure from top management.

There was pressure. Thankfully, I think I had supportive senior management. Jamie Dimon had bought Chase, JPMorgan Chase in 2004, and Bank One, and he was I think a very supportive risk-oriented manager, but he would ask the same questions I would: "Why are we falling behind in these areas?" ...

What did you tell him?

I told him as best we knew why we were falling behind. It's perhaps we're not clever enough, or perhaps we're not prepared to take the same risks that others are.

Saying you're not clever enough to Jamie Dimon isn't very reassuring.

No, but the fact is we didn't understand exactly why we were being beaten. …

How do we think about what's happened in Europe and where we are today?

I think there were two pieces in the way in which Europe has been affected by what's going on in America.

One is that Europe bought a lot of our toxic mortgages. Some estimates put it at close to 40 percent. ...

Why did Europeans buy so many toxic mortgages?

They bought so many toxic mortgages for a little bit of the same reason as American banks. They were taken up in the deregulation movement in the same way that America was. These toxic mortgages yielded a little higher return. The rating agency says these are fantastic, AAA.

A basic law in economics is there's no such thing as a free lunch, but they thought they'd found something that gave them a higher return without greater risk. ...

The second thing of course is that when the American economy went down, it had global consequences. You have financial troubles and real troubles on both sides of the Atlantic, global economic downturn. But in Europe, there is a stronger social protection system -- better unemployment insurance, sometimes called a safety net, better health insurance -- so that when the economy went down, the deficit, the government went up. ...

Does austerity by its imposition ensure these countries are going to sink deeper into debt and deeper into recession and more likely default?

Almost surely austerity will mean that these countries' economic position is going to get worse. ...

Why not just break it up and let these countries go back to their own currencies and forget the euro? ...

The process of going from here to there is going to be very painful. Argentina tells us a little bit about what might happen. When Argentina left this economic arrangement where its currency was fixed to the dollar, it caused an enormous amount of trauma. ... Unemployment went up in excess of 20 percent. It was really a very difficult, traumatic problem for the country. ...

In the case of the break of the euro, the consequences in the short-run are likely to be even more traumatic. Contracts have to be rewritten, reinterpreted. There will be legal disputes of enormous magnitude.

But I think for many of the countries, if they manage their economy correctly, they will work their way through this problem and it will provide the basis of a longer-term economic growth. ...

And what will the consequence be for the United States?

... The consequences for our financial system are very hard to determine, partly because our financial system is very nontransparent, very interlinked with that of Europe. ...

You can see the volatility in bank share prices as the travails of Europe go on that say the markets are really very worried about the impact on our financial system. An economic downturn of the magnitude that might occur in Europe will inevitably have a very serious impact on our economy.

Our economy is not yet out of the woods. In fact the CBO [Congressional Budget Office] study that recently was published suggests that we will not be back to full employment, to fully realizing our potential, until 2018. And that's assuming no European crisis. If there's a European crisis, that becomes a rosy scenario. ...

Underlying the whole crisis in 2008 was the number of ... subprime mortgages. How did innovative financial instruments or whatever you want to call them -- credit default swaps, collateralized debt obligations -- what did they contribute to the problems that we faced?

... It used to be that when you wanted to get a mortgage you would go to your bank. The bank would lend you the money. It would make a judgment about whether you could repay, because it would know that if you couldn't repay it would bear the losses.

But then there was this idea called securitization that arose that said they would originate the mortgage but then sell it to someone else, and that other person would have to bear the losses. But the idea was you put a lot of mortgages together and the probability that a very large fraction of them would have a problem at the same time was very low.

Except the reasoning behind this was flawed, because if there was a bubble, prices went up, then they would all go down. They would all have a problem. If the economy went into recession, many people would have a hard time repaying their mortgages.

So the underlying assumption that large numbers would [not] simultaneously be affected was just wrong. ...

In fact it was insured by the fact that they were forever putting more money into the housing market.

[The] securitization process itself is what fed the bubble, which in fact made it inevitable almost that there would be this problem of a large fraction of them collapsing, going into default at the same time. So they created the problem that actually brought them down. …

You needed to have the investment banks that would put these together, ... the CDOs and complex products. Now if you had thousands of mortgages in a product, no one could inspect to see whether each mortgage was a good one. It was all based on trust. ... So you created a system in which incentives were such as to make sure that the system failed.

Then you had the rating agencies being part of ... I would almost say a conspiracy. The rating agencies would look at these bundles -- they obviously couldn't look at each of the mortgages -- and they would say if you put together large numbers of mortgages that ought to have been graded each F, by putting them together they blessed them as if it was financial alchemy that converted lead into gold. In this case, it converted F-rated subprime mortgages into an A-rated security.

Why was that important? Because then you could sell this to a pension fund or to lots of other people who could only buy A-rated securities.

Then you had more money to send back to the originator to send back out and make more mortgages.

Exactly. And then make the price go high, and they'd look at this and say aren't we brilliant?

What is a synthetic CDO, and how did it make this whole mess worse?

A CDO is a collateralized debt obligation. It's essentially a mixture of lots of different assets -- that's the collateral -- that are put into a trust, or a company, and then that company issues securities. So it's basically a way of mixing together some kind of an investment to create a new investment.

And the way that it's typically done with subprime mortgages is that there's an arranger who goes out and buys up a bunch of subprime mortgages, and then will go to a bank, go to a credit rating agency, and say: How much of this can we say is safe? How much of it can we say is pretty safe? What kinds of ratings can we get for this group? That's a collateralized debt obligation. It's basically a mixture of subprime mortgages.

The key to a collateralized debt obligation is creating different layers of risk, sort of like the layers in a building, like the floors in a building where the top floors will be the safest, and then as you move down, the floors will be increasingly risky. …

The difference between a CDO and a synthetic CDO is that what you actually put into the building or the trust or the corporation is not real. What you put into the vehicle is synthetic. What do I mean by synthetic? By synthetic, people mean that you're putting side bets based on whether someone will default into the mix, instead of putting the actual bonds into the mix.

So for example, if I wanted to create a CDO based on my mortgage, I would put the actual mortgage, the physical claim on the mortgage, into the investment. And you would look to my payments themselves. If I wanted to create a synthetic CDO, I would have a bank enter into a side bet with another institution based on whether they thought I would keep making my mortgage payments. … And then we would take that side bet, that synthetic investment, and we would have the CDO be based on that side bet. …

The genius of the synthetic CDO was that if you found a CDO that worked, if you found a bunch of subprime mortgages in Riverside County, Calif., that could be bundled and resold in a way that would be attractive to investors, the fact that someone had done it one time in a cash CDO wouldn't stop you from doing it again, and again, and again. In synthetic CDOs, all you had to do was make a side bet based on what would happen to this group of people and their mortgages, and then take that contract -- which would be a side bet -- and have that be the basis of the CDO.

Explain how that caused the contagion, that sort of web that you were describing earlier that made everybody late.

One of the things that happened with synthetic CDOs was that there were certain pools of subprime mortgages which were regarded as the most attractive to use in CDOs. These were mortgages that were really cheap. They were very risky. But because of the credit ratings agency's models, they were going to get very high ratings.

Wall Street went nuts over those kinds of subprime mortgages. They were hungry for them. They wanted to use them as much as possible to create AAA-rated investments that looked like they were safe, but that still had a high return and a high yield.

And so one of the things that happened was the CDOs that were created increasingly were based on these very risky assets. These were the kinds of subprime mortgages that if there were a 30 percent decline in housing prices, they were all going to default. It wasn't the natural mix of mortgages throughout the country. They were highly focused, isolated in areas like California, Nevada, Florida. They were focused and isolated on people with low credit risk. They were focused and isolated on people who hadn't put any money down to buy their house. And these mortgages -- which were again, it's the synthetic idea -- they were being bet on over, and over, and over again. These were the ones which increasingly were populating the synthetic CDOs.

So what you were doing was creating a bunch of synthetic CDOs, all of which were doomed to fail if there was a 30 percent decline in housing prices. They didn't have the kind of protection that would necessarily be there if you were limited by reality, if you were limited by the fact that you have to put a real mortgage in here, and then it's gone. They used the kind of magic of being able to bet multiple times on these riskiest mortgages to massively increase the amount of risk in the entire system. …

So we get to a point where there's a big party going on before it all goes down. Who's bought into this idea that these synthetic CDOs are going to be the best thing since sliced bread?

I think certainly by 2006, almost everyone on Wall Street had bought into the idea that CDOs, synthetic CDOs, and in particular what were called super senior tranches of synthetic CDOs, meaning the safest parts of synthetic CDOs, were basically risk free.

This was the way the most senior people at the major banks were thinking about them. This is the way they were being disclosed, or not disclosed. Everyone was assuming that these kinds of instruments basically had zero risk.

There was a group at Goldman Sachs who looked at the risk exposure of the bank to these kinds of instruments in December of 2006, and they saw that there was quite a lot of risk there. And they more than other banks understood the risk exposure and reduced their risk. But really, Wall Street was still smoking the CDO dope into 2007 when the crisis began.

There were, on the other side of the market, a group of people who had taken the opposite bet. And those people understood the risk very well, and they made a fortune. They bet that the subprime mortgage related instruments were going to collapse. They were the other side of this two-sided bet.

But one of the great ironies, I think, of the financial crisis was that the senior people at the Wall Street banks apparently didn't understand or capture the magnitude of their own financial institutions' exposure to these risks, which is really stunning, if you think about it, that the people who are in charge of these banks don't know what will happen when there's a 30 percent decline in housing prices.

If you think about it, if you're the director or the CEO of a bank, isn't that the one thing you should understand? What will happen to my institution if the following financial variable changes by 30 percent? That kind of worst-case scenario analysis is why you're being paid millions of dollars. That's precisely what these people should have been doing.

And yet, if you believe them in the most charitable version of the story, they had no idea that their banks would be destroyed if housing prices declined 30 percent. They simply weren't able to figure it out. It was too complicated. That's what they say.

What do you think the real reason is?

I think that it's very plausible that the senior people did not understand these instruments, and didn't understand the risk. If you take Citigroup for example, Citigroup did not disclose the extent of its exposure to these super senior positions until relatively late in 2007. There were a whole series of meetings within Citigroup, a kind of fire drill of sorts within the company. At the highest levels, people were trying to figure out how much money they had lost or might lose, what their exposure was. They couldn't even figure this out.

So I actually find it very plausible that the senior people simply did not grasp the extent of the exposure. … I think people would like to believe that the senior executives were criminals. And I certainly think that there was a fair amount of activity that could be labeled "criminal" on Wall Street during this period of time. But I think in some ways, even the more troubling aspect of all of this is that people at the top of financial institutions genuinely believed that these incredibly complicated, Frankenstein instruments did not carry any risk. …

I do think there were several instances of absolutely reprehensible conduct that should be punished criminally. And I'm very hopeful that some of that will happen ultimately. But I think one of the most puzzling aspects of all this is that finance may have gotten too complicated for anyone to understand. That the managers of these large financial institutions in some ways have been given an impossible task that they won't be able to comprehend what it is their institutions are doing. And that is really, really scary. …

Before everything became kind of the tranching of mortgage-backed securities, there were just the corporate swaps. Which was the first one?

… The earliest swap involved the World Bank. … People might remember the old "Bank of Drexel," Drexel Burnham Lambert, where Michael Milken, the infamous financier worked. A client of Drexel's, Fred Carr, created this thing called a collateralized bond obligation, or back then, it was called a CBO. It was a new technology.

And what he did and the genius of it was to go out and buy a bunch of bonds that had junk bond ratings, meaning they're graded from AAA down to C or D, and he would buy low-rated bonds. But he would put them together and mix them together in a way that would guarantee that a certain portion of them would get the highest possible rating, would get an AAA-rating.

He did this using corporate bonds. It had nothing to do with mortgages or complicated derivatives. But it was a new, innovative technique that no one had used before.

I'm just trying to figure out how junk becomes AAA?

So if you take $100 worth of junk bonds, bonds that are rated BB, and you put them in a vehicle, like a trust or a company, and you tell investors in that trust or that company that half of you will have a superior claim to the other half. Half of you will recover first whatever there is available from these junk bonds, and then the other half of you will be subordinated. You'll only make money if there's $51 of the $100 worth of junk bonds that is repaid. Otherwise, you're wiped out.

The best analogy I can think of is to imagine a building that has 10 stories, and you're thinking about flood insurance and the risk of flooding. And there are rivers nearby and dams and levees. And historically, there have been floods. So the flood insurance on the lowest floors is going to have a lot of risk. But the flood insurance on the highest floors, maybe floors six through 10 would be viewed as virtually risk-free. So it's a similar idea with junk bonds, that if you put a group of them together and then you say: "OK, I've got $100 worth of junk bonds. You will be the most senior person. You will get paid first. And you only have to give me $50."

So that means as long as there's $50, as long as half of these junk bonds are still performing, you're going to get paid, and you're going to get paid with certainty. So if all you're buying is that top slice of the $50, then we have a rationale for calling that AAA.

So the thinking is we'll look at the likelihood of default in these various bonds, and then we'll say, okay, how high is the flood going to go in the building? What is the risk associated with the flood?

But there are rivers nearby.

There are rivers nearby, and there's always a concern. But it's high. It's floors six through 10. And so, you think that you have protection from the first set of defaults. … The metaphor may break down if you stretch it too much, but it's the same thing with subprime mortgages, right? This is where the math enters. …

The mathematics of a lot of these complicated models rely on that certain degree of relationships among these assets, that they won't be correlated one to one -- in other words, that not every single one of these subprime mortgages or corporate bonds is going to default at the same time.

When we look historically at why people have defaulted on their mortgages, it follows that kind of normal distribution. You can array it along a bell curve, just like people's heights or weights or other natural phenomena. People default on their mortgages because they lose their job or they get a divorce, or because someone dies. Those are things that historically have been normally distributed bell curves that we thought we could rely on.

And if you're building a structure like one of these 10-story buildings, and you're worried about the flood coming in, if you know that you have a bell curve distribution, you can say, OK, the average flood is going to go to the second floor. And there's a tiny, tiny chance that it goes to the fourth floor. But it's never going to go to the sixth or seventh floor. And the reason for that is we know that people who have even subprime mortgages aren't all going to die at the same time. They aren't all going to get divorces at the same time. They aren't all going to lose their jobs at the same time.

The big mistake that everyone made in the subprime crisis was not understanding that the subprime mortgages had all become correlated. What had happened was the nature of the subprime mortgages had changed, so that when people aren't putting any money down, when they have these unusual kinds of mortgages, and when they're subject to a risk of a 30 percent housing decline, that they're all going to default at the same time. That the river's going to flood, that all of the dams are going to break at exactly the same time, and that even the safest floors of the building, even floors nine and 10 at the very top, are going to be flooded. People didn't imagine that there was this degree of correlation in the markets. …

[Was there an aha moment when someone decided to create derivatives based on subprime mortgages?]

I don't think there's an aha moment. I think Wall Street moves typically as a herd, so that it's not necessarily one person inventing something. I remember when I had moved from First Boston to Morgan Stanley, and I created a new kind of derivative instrument based on Mexican peso, and I closed a deal, we finished a deal, during the day.

And by the end of the day, my former colleagues at First Boston had already faxed me a completed copycat version of the same deal that they had already completed with another client that had happened in a matter of hours. So these kinds of things happen very, very quickly, and they tend to happen in herds. …

But people in general on Wall Street started to realize that subprime mortgages could be collected and packaged in ways that looked like they weren't risky, and it became a kind of cycle as well. Once the mortgage originators, the people who make mortgages, realized that Wall Street could do this, they knew that they could then go out to people, and say: We'll offer you these mortgages, because we don't have to keep the risk associated with the mortgages. We can sell it on to Wall Street, which is creating these complicated financial products. And so it kind of built, and built, and built on itself once it had started.

Others did not. Why not?

Well, I think a number of reasons. I can't speak for obviously the actions of others, but I can speculate.

I think that first of all, typically the structures that became very problematic for people were structures where the nature of the risk that was being assumed was so-called "catastrophic," meaning that it was risk associated only with extreme losses in portfolios of underlying assets.

And to visualize or to imagine losses of that severity required one to make some very significant assumptions about the path of the economy, which were just not in people's minds. It required things like assuming that house prices in the United States fell by 25 percent.

Now we all know because it's happened that that was a realistic scenario. But on an a priori basis, people weren't thinking that way in 2006 or '07. And so I would say that lulled people into a false sense of security.

Secondly, the apparent compensation for risk on the face of it, if you didn't have in mind those types of scenarios, look very attractive indeed, meaning that you could get "well paid," in inverted commas, for assuming and carrying that risk, and the risk return proposition appeared better than the proposition of paying someone else to take it away.

I think that there was also an element of an assumption that conditions would just continue in the way that they were.

The value of an American house has never gone down, right?

As long as house prices never fell, these risks would never come home to roost. And that ultimately was obviously very flawed logic. …

When some of the subsequent facts came to light and it became clear what the risk management practices of others were and had been, it was very surprising not just to me, but to others who I had worked with both in the past and who were still at the company, it was very surprising to see tens and tens, if not hundreds in some cases, of billion of dollars of this risk being warehoused on the balance sheets of leveraged financial institutions. …

Then 2008 and the meltdown begins. Had you envisioned that this was going to bring down a couple of big investment banks?

We thought it was going to be bad.

You thought it was going to be bad when?

We thought it was going to be bad in 2006. ...

But did you imagine that these problems that you were seeing at the sort of ground level were going to infect Bear Stearns or other investment banks on Wall Street?

Yes, because of a different issue on capital. Another battle we were fighting with other regulators was on what was called the Basel II capital standards. Basically this was an international agreement to let banks, large financial institutions, pretty much decide for themselves what kind of capital they had to hold. ...

This is all about the banks juicing up their returns by taking out a lot of leverage so they can, with a little money down, get a lot of action?

That’s exactly right, can get a lot of big, big returns on equity. So we stopped Basel II for FDIC-insured banks. We successfully blocked it.

But the SEC [Securities and Exchange Commission] implemented it for securities firms. ... They were operating on very thin levels of leverage and they [had] high-risk balance sheets, so we were very aware that they were very thinly capitalized because of the Basel II debate. ...

You’re watching a meltdown begin. You're seeing all these homeowners in trouble. ... Then you're being told at the same time that your banks ought to be able to take out more loans in order to keep this machine going?

That's exactly right. It was crazy. Basel II was birthed during this so-called golden age of banking, when everybody got enamored with the idea of self-regulating, self-correcting markets. You didn't need regulation. Banks knew better than regulators how much leverage they should take on and what their risk was.

So it was delusional. But the golden age of banking was because of an asset bubble that popped. It wasn't a sustainable model.

... Nobody saw that there was a bubble building in housing except for a few people.

They didn't, and the irony was that the Fed … had regulatory tools at their disposal to reign it back. They could have set lending standards across the board for everybody. They didn't do that. …

Did you see this then playing out in the failure of major investment banks?

Absolutely.

But did you ever go to the Treasury and say, "You guys are going to watch these banks that are over-leveraged melt down in a matter of a month or a year from now"?

No, we never had that kind of a pointed discussion. They were really more general discussions about Basel II and the kind of leverage that large financial institutions -- and this is going on in Europe too. …

We didn't regulate investment banks. It was the SEC's responsibility, and you're always doing this delicate dance in terms of encroaching on other people's jurisdiction. ...

When you were looking at steel companies and putting together deals, there was a transformation going on in finance. How aware of it were you, and what was your take on what you were witnessing?

We were aware of it in the sense not that we were investors, but it was clear this subprime thing was getting a little bit nutsy towards around 2004, 2005.

I gave a talk at one of these securitization conferences in Florida. It's the first time I've never had any questions after, because I advanced my theory that the subprime thing was going to blow up, and here were people who were pretty much buyers or packagers of the paper.

At the end of the speech I asked were there any questions. There was not a single question. They couldn't wait to get me out of the room.

... All the way back in the '80s and '90s there is the advent of a lot of technological, financial engineering. People were able to do things they couldn't do in the past. Was that on your radar? ...

I don't think financial engineering as such is the problem. I think it's become a misused term. What it's really become at the peak of the frenzy was a polite way of describing the packaging of securities that should never have been bought into something that was saleable. So I think it was an abuse of the engineering.

The idea of securitization itself is a perfectly sensible idea, taking a lot of little scraps of paper that don't have much liquidity individually, making them into a larger instrument that could be traded -- to me that makes sense. And there should be, logically, a rate arbitrage.

Where I think it went wrong was in overreliance on black boxes and on little mathematical models, because the problem with models are they inherently assume that tomorrow will look a lot like yesterday. The fact is that at turning points, particularly crisis turning points, what really happens is tomorrow turned out not to look at all like yesterday or like today.

So there's an inherent flaw in models that they are inherently based on what had been. They don't really protect you against the so-called black swan events.

How is it that we came to rely so heavily on models?

Again, I don't think there's anything necessarily wrong with it. I think that what is wrong with it is thinking the model is the only reality and not allowing for real stress testing and real contingencies.

Rating agencies, for example, never went and did original field research in subprime. If they had walked into a Countrywide loan production office, they would've understood that this had much more resemblance to a Wall Street boiler shop than it did to somebody who was trying to figure out whether or not they should make a mortgage loan. ...

Why were there no incentives for the rating agencies to do that? How did we get things wrong to allow things to develop as they did?

I think that the models and the model salesmen were much more sophisticated than the people in the rating agencies. ... The people putting these things together are much higher-powered people than the people trying to analyze them at the rating agency.

And who are these people that are putting these things together and who are much more sophisticated?

It's Wall Street people, quants [quantitative analysts]. …

Some people have put a lot of blame on the compensation and incentives that were driving people to develop ever more sophisticated and complex financial instruments.

A lot of it goes back to the government. Between the Community Redevelopment Act, requiring banks to make what I would call very weak loans, and specific quotas that the Congress imposed on Fannie Mae and Freddie Mac, that created the market demand that really led to the subprime phenomenon.

But that doesn't explain the spread of this window dressing of balance sheets and whatnot. It doesn't address how it spread to Europe. Fannie and Freddie don't apply there. There's something larger it seems, just to me as an outsider, going on here.

I think the reason it became an export product is people rely, just as they relied too much on models, too much on rating agencies from a capital requirement point of view.

The way that they solved these allegedly AAA pieces of papers was to say this is AAA-certified by a couple of rating agencies, although they wouldn't like the word certified, and it yields 10 basis points more, it yields 20 basis points more, but it's the same risk.

So there became a very willing suspension of disbelief inspired by making a little extra spread.

The part I could never understand was this: How can the simple fact of slicing and dicing a package of securities make it worth 102 percent of its original face amount? Because that was what was really happening. ...

Was there a time when you sat down with a banker and asked for an explanation of that?

My job is not to grade the bankers or anybody else. My job is to deal with what's going on. ...

Since we did fairly well [to] visualize it coming, we were looking at what should we get ready to be buying when the bad thing occurs? Because that what our job is. Our job is not to be the policemen of the rating agencies. …

... So how were these CDSs used to enable riskier and riskier collateralized debt obligations [CDOs], loaded with subprime mortgages and more and more deals?

The whole complex of transferring risk had some unintended consequences. So we had credit default swaps, or credit insurance, where banks could insure their risk. We had these securitizations like collateralized debt obligations, where we were packaging up loans and selling them in different forms. So banks essentially now had this whole armory of where they could go and make loans and basically transfer the risk. ...

Since I wasn't going to be holding the risk, I could afford now to do two things. One, I could go down the risk. In other words, I could basically start to lend people money where I was less confident that they would pay me back. Why? Because I wouldn't be left with the risk. Somebody else would be left with the risk, and as long as I was confident I could sell it, I would do this. ...

The second element about this, which is quite important, is I could lend more. Even to people I was very comfortable would pay me back, there were constraints on how much I would lend to them. Now I could lend them vast sums of money, because I could transfer some of that out and keep some of that.

... What quickly happened is people got greedy, and there [were] two dynamics to that. The first dynamic to that was the banks themselves. The banks had built these gleaming factories for making money, these securitization, these risk-transfer engines. I remember going into the dealing room at a London bank and visiting some people in the securitization or risk-transfer business, and there was probably 100 people in there, and 40 of them were Ph.D.s with very great quantitative skills, and cutting and dicing these cash flows differently.

The overheads of running that 100 people was just massive, so they needed to push things through this factory very quickly. And they just couldn't do it with what the bank actually did. So what they started to do was build these enormous networks to, almost like a vacuum cleaner, vacuum up all the loans in the world. And if there wasn't sufficient loans in the world, what they were then doing was encouraging people to make loans.

So they would go and finance mortgage brokers or other people to make new loans. And like all things in life, there are a certain number of people out there who are creditworthy, but now it didn't matter, because you just had to have the raw materials for this engine, so you kept moving down the credit curve. So you lent to the people who were creditworthy, then the people who were less creditworthy.

And in the end, this entire market got to the stage [where] the joke was you could lend to a ham sandwich as long as they filled out the forms, and these loans basically became ones where they were stated income; people just stated their income. People sometimes didn't have to state their income, and they came to be known as liar loans, because you'd lie your way to a loan. And it was to keep this engine sort of going along the way.

Then, of course, the other thing is the investors. People forget that this was not purely bank-driven. It was driven by investors on the other side as well. Investors were looking for assets. Through the '80s and '90s, what we saw was a huge buildup in savings, and part of this was mandatory saving schemes. Like in the United States, you had IRAs or 401(k) accounts, and people were just saving for their retirement.

In Europe, the same thing was going on. In Asia, the same thing was going on. There was this vast growth in the amount of money looking for a home, and particularly the money that was conservative and wanted safe investments were looking for high-quality assets, like AAA-rated bonds. They became almost like an exorable force driving this market, and they had an endless appetite.

You sold them something, and they would say, "I want more." And also they became very sensitive as interest rates came down. They wanted more and more return. So the engineers in the middle of this are saying: "How do we do this? How do we get more loans? All right, we go and buy mortgage brokers and do that."

But then the next question is, "How do we create more return?" So we started to tweak the leverage and play games. So instead of just selling the loans to an insurance company, a pension fund or whatever, we then came up with more and more elaborate structures, where we created a CDO off a CDO, which came to be known as a CDO to the power of 2 [CDO-squared].

We created a CDO of a CDO of a CDO, a CDO to the power of 3. And all of these things were basically buying not loans but securitized loans, and then buying a securitization of a securitized loans, and creating these endless chains of risk to basically create AAA paper, but also give the investors the higher returns they wanted.

And what the investors often failed to grasp is that in trying to do that to meet the demand or yield or returns, we were increasing the leverage and the toxic nature of the risk that was underlying that, because on one side, effectively, the quality of the underlying loans we were using is going down. ... But basically at the same time, the amount of leverage or borrowing we use to create these structures is going up. It was absolutely a devil's brew, and it was really always going to end in tears, which it did.

... Who's buying this stuff?

I think the money that was coming into the market was coming initially from people like, obviously, pension funds, insurance companies, mutual funds investing people's savings. And interestingly enough, over time, as it internationalized, it started to come from banks and savers in all parts of the world.

And then of course we had a new player, which was the hedge funds, and the hedge funds started to get interested in these sorts of securities and this sort of space probably in the late '90s, early 2000s. ...

... What was it that you were seeing in 2007 that gave you the idea that there was an opportunity here, that there was going to be a collapse?

It was a lot of the models had a series of assumptions, and the most critical assumption with which we disagreed was they were trying to figure out what would be the annual rate of household appreciation. HPA, they were calling it: household price appreciation.

We thought you can't build a model on the theory that housing prices are always going to go up. That's not a rational model. And it's particularly not a rational model when you have now introduced much more leverage, because these are high loan-to-value ratio loans.

You had Fannie and Freddie, while they themselves felt they were only committing 70 percent or 80 percent loan-to-value, they were in fact writing 90 percent and 95 percent and even 100 percent in buying private sector mortgage insurance. But the primary risk was theirs.

They were in effect reinsuring with the PMI companies. We felt that that was clearly inflating the price of houses to have both subprime and normal loans be based on more or less 100 percent loan-to-value, whereas in the old days, people thought about 70 percent, 75 percent loan-to-value. Introducing the leverage had to mean more people were buying more expensive houses.

… What happened?

I think one of the defining characteristics of the business that we ran at JPMorgan was that we were, from the very beginning, very focused on insuring that the risks that we assumed were very carefully managed. …

We were always very focused on if we assume a risk, how do we distribute it, and obviously making sure we were distributing in an appropriate fashion to people who understood what they were doing and why. That goes without saying.

Consenting adults?

Yeah, exactly. And we did see many opportunities to take on risks indefinitely that at least in theory one could have argued to oneself, "Gosh, that's a very attractive risk. Why would I need to lay it off? Why not just keep it and earn the return associated with that?"

And we explicitly turned away from those paths because of a number of reasons, but primarily because we knew there were scenarios -- they were hard to imagine -- but we knew that the were scenarios where that risk accumulation could be extremely dangerous. And we were not in the business of assuming risks that subsequently could put our franchise, our company, our shareholders at risk. We were in an intermediation business. We were about making markets more efficient. We were not about investing in credit risk over the long run.

So what subsequently happened? I described the evolution of this single-name credit derivative product, buying and selling risk on individual companies. That evolved to buying and selling risk on portfolios of credit risk.

So you take a loan portfolio -- initially portfolios of corporate credit risk, so large, investment-grade corporations to whom a bank had lent -- and transactions occurred where those risks were transferred in the form of synthetic securitization or credit derivatives, which took on an entire tranche or slice of the risk of that portfolio and paid an investor to assume that risk.

Corporate credit portfolios have a characteristic of being relatively diverse, meaning that the event that can deteriorate the credit equality of one corporation often don't correlate with the events that can lead to a credit deterioration of another corporation. They're in different industries, different areas of the country. They might be operating overseas of not. They're fundamentally in different businesses. And so when you look at those portfolios of risk, it's reasonable to assume a high degree of diversification.

The next application of this same technology was to portfolios of consumer credit risk, and in particular mortgage-related credit risk. A big difference between mortgages and corporate loans is this diversification difference.

And it turns out that even if a portfolio of underlying mortgages is diverse from a geographic perspective, for example, it still has systematic risk in it which makes it vulnerable to certain events and makes all of those loans in that portfolio vulnerable to the same events, specifically a deterioration in house prices caused by a recession, an increase in interest rates caused by macroeconomic developments, a rise in unemployment caused by a recession, for example.

If those things occur on a severe enough basis, then an entire portfolio previously deemed diversified in fact will turn down all at once. And it was essentially the application of the credit derivative technology to this situation that led to problems.

And the bank, JPMorgan, walked away from all of this?

We did.

When did that happen? Take me there. You guys all looked at it and just said, "Whoa, I don't like where this is headed?"

Somewhere around 2002 to 2004, 2006 it really accelerated. And during that time, we were active in the mortgage markets ourselves; we were active in the derivative markets. We saw the opportunities here, but we could not get comfortable with the idea that the diversification in these portfolios was sufficient to justify the treatment of the risks.

So we steered away from assuming or warehousing those risks, or doing lots of business with other companies that themselves were predominantly in the business of assuming or warehousing those risks. And that meant that we missed a revenue opportunity, but that was okay because we couldn't get comfortable with it. And indeed, that's why we shied away from it.

As this began to devolve in 2005-2006, really, 2007, and the mortgage market peaks and starts to come down, what's going through your head?

... [We] saw that these transactions where we wondered where the risk was going, we now concluded that the risk wasn't going anywhere. There was no place for this risk to go. ... In other words, it was staying on somebody's balance sheet. ...

So now the bank is starting to sit on a lot of toxic debt.

That's right. And it became clear to us in 2007 that it wasn't just that perhaps we hadn't missed the point entirely in thinking that somebody else knew where this risk was going at a different price than we could see. Perhaps it was not going anywhere at all. It was sitting on bank balance sheets. And of course we felt very comfortable that we had not accumulated much of this risk.

We can put a complete lockdown on the incremental risk in these markets anywhere in the bank. Our lockdown was not perfect. We actually ended up in one sort of out-of-the-mainstream trading desk taking a position in subprime mortgages, which cost us a lot of money, and it was one of the big mistakes that we made, and it was a pure error of execution. We failed to live by our own edict. I mean, we put a bunch of rules down, and then we had a trader or a group that violated those rules. ...

... You got burned, but not badly.

Not badly. ...