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 FINANCIAL CRISIS INQUIRY COMMISSION REPORT

Participants in the securitization industry realized that they needed to secure favor-
able credit ratings in order to sell structured products to investors. Investment banks
therefore paid handsome fees to the rating agencies to obtain the desired ratings. “The
rating agencies were important tools to do that because you know the people that we
were selling these bonds to had never really had any history in the mortgage busi-
ness. . . . They were looking for an independent party to develop an opinion,” Jim Calla-
han told the FCIC; Callahan is CEO of PentAlpha, which services the securitization
industry, and years ago he worked on some of the earliest securitizations. 
With these pieces in place—banks that wanted to shed assets and transfer risk, in-
vestors ready to put their money to work, securities firms poised to earn fees, rating
agencies ready to expand, and information technology capable of handling the job—
the securitization market exploded. By , when the market was  years old,
about  billion worth of securitizations, beyond those done by Fannie, Freddie,
and Ginnie, were outstanding (see figure .). That included  billion of automo-
bile loans and over  billion of credit card debt; nearly  billion worth of secu-
rities were mortgages ineligible for securitization by Fannie and Freddie. Many were
subprime. 
Securitization was not just a boon for commercial banks; it was also a lucrative
new line of business for the Wall Street investment banks, with which the commercial
banks worked to create the new securities. Wall Street firms such as Salomon Broth-
ers and Morgan Stanley became major players in these complex markets and relied
increasingly on quantitative analysts, called “quants.” As early as the s, Wall
Street executives had hired quants—analysts adept in advanced mathematical theory
and computers—to develop models to predict how markets or securities might
change. Securitization increased the importance of this expertise. Scott Patterson, au-
thor of The Quants, told the FCIC that using models dramatically changed finance.
“Wall Street is essentially floating on a sea of mathematics and computer power,” Pat-
terson said. 
The increasing dependence on mathematics let the quants create more complex
products and let their managers say, and maybe even believe, that they could better
manage those products’ risk. JP Morgan developed the first “Value at Risk” model
(VaR), and the industry soon adopted different versions. These models purported to
predict with at least  certainty how much a firm could lose if market prices

changed. But models relied on assumptions based on limited historical data; for
mortgage-backed securities, the models would turn out to be woefully inadequate.
And modeling human behavior was different from the problems the quants had ad-
dressed in graduate school. “It’s not like trying to shoot a rocket to the moon where
you know the law of gravity,” Emanuel Derman, a Columbia University finance
professor who worked at Goldman Sachs for  years, told the Commission. “The
way people feel about gravity on a given day isn’t going to affect the way the rocket
behaves.” 
Paul Volcker, Fed chairman from  to , told the Commission that regula-
tors were concerned as early as the late s that once banks began selling instead of
holding the loans they were making, they would care less about loan quality. Yet as