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xxiv FINANCIAL CRISIS INQUIRY COMMISSION REPORT

While many of these mortgages were kept on banks’ books, the bigger money came
from global investors who clamored to put their cash into newly created mortgage-re-
lated securities. It appeared to financial institutions, investors, and regulators alike that
risk had been conquered: the investors held highly rated securities they thought were
sure to perform; the banks thought they had taken the riskiest loans off their books;
and regulators saw firms making profits and borrowing costs reduced. But each step in
the mortgage securitization pipeline depended on the next step to keep demand go-
ing. From the speculators who flipped houses to the mortgage brokers who scouted
the loans, to the lenders who issued the mortgages, to the financial firms that created
the mortgage-backed securities, collateralized debt obligations (CDOs), CDOs
squared, and synthetic CDOs: no one in this pipeline of toxic mortgages had enough
skin in the game. They all believed they could off-load their risks on a moment’s no-
tice to the next person in line. They were wrong. When borrowers stopped making
mortgage payments, the losses—amplified by derivatives—rushed through the
pipeline. As it turned out, these losses were concentrated in a set of systemically im-
portant financial institutions.
In the end, the system that created millions of mortgages so efficiently has proven
to be difficult to unwind. Its complexity has erected barriers to modifying mortgages
so families can stay in their homes and has created further uncertainty about the
health of the housing market and financial institutions.

• We conclude over-the-counter derivatives contributed significantly to this
crisis. The enactment of legislation in 2000 to ban the regulation by both the federal
and state governments of over-the-counter (OTC) derivatives was a key turning
point in the march toward the financial crisis.
From financial firms to corporations, to farmers, and to investors, derivatives
have been used to hedge against, or speculate on, changes in prices, rates, or indices
or even on events such as the potential defaults on debts. Yet, without any oversight,
OTC derivatives rapidly spiraled out of control and out of sight, growing to  tril-
lion in notional amount. This report explains the uncontrolled leverage; lack of
transparency, capital, and collateral requirements; speculation; interconnections
among firms; and concentrations of risk in this market.
OTC derivatives contributed to the crisis in three significant ways. First, one type
of derivative—credit default swaps (CDS)—fueled the mortgage securitization
pipeline. CDS were sold to investors to protect against the default or decline in value
of mortgage-related securities backed by risky loans. Companies sold protection—to
the tune of  billion, in AIG’s case—to investors in these newfangled mortgage se-
curities, helping to launch and expand the market and, in turn, to further fuel the
housing bubble.
Second, CDS were essential to the creation of synthetic CDOs. These synthetic
CDOs were merely bets on the performance of real mortgage-related securities. They
amplified the losses from the collapse of the housing bubble by allowing multiple bets
on the same securities and helped spread them throughout the financial system.
Goldman Sachs alone packaged and sold  billion in synthetic CDOs from July ,