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 FINANCIAL CRISIS INQUIRY COMMISSION REPORT

These institutions had relied for their operating cash on short-term funding
through commercial paper and the repo market. But commercial paper buyers and
banks became unwilling to continue funding them, and repo lenders became less and
less willing to accept subprime and Alt-A mortgages or mortgage-backed securities
as collateral. They also insisted on ever-shorter maturities, eventually of just one
day—an inherently destabilizing demand, because it gave them the option of with-
holding funding on short notice if they lost confidence in the borrower.
Another sign of problems in the market came when financial companies began to
report more detail about their assets under the new mark-to-market accounting rule,
particularly about mortgage-related securities that were becoming illiquid and hard
to value. The sum of more illiquid Level  and  assets at these firms was “eye-
popping in terms of the amount of leverage the banks and investment banks had,” ac-
cording to Jim Chanos, a New York hedge fund manager. Chanos said that the new
disclosures also revealed for the first time that many firms retained large exposures
from securitizations. “You clearly didn’t get the magnitude, and the market didn’t
grasp the magnitude until spring of ’, when the figures began to be published, and
then it was as if someone rang a bell, because almost immediately upon the publica-
tion of these numbers, journalists began writing about it, and hedge funds began
talking about it, and people began speaking about it in the marketplace.” 
In late  and early , some banks moved to reduce their subprime expo-
sures by selling assets and buying protection through credit default swaps. Some,
such as Citigroup and Merrill Lynch, reduced mortgage exposure in some areas of
the firm but increased it in others. Banks that had been busy for nearly four years cre-
ating and selling subprime-backed collateralized debt obligations (CDOs) scrambled
in about that many months to sell or hedge whatever they could. They now dumped
these products into some of the most ill-fated CDOs ever engineered. Citigroup,
Merrill Lynch, and UBS, particularly, were forced to retain larger and larger quanti-
ties of the “super-senior” tranches of these CDOs. The bankers could always hope—
and many apparently even believed—that all would turn out well with these super
seniors, which were, in theory, the safest of all.
With such uncertainty about the market value of mortgage assets, trades became
scarce and setting prices for these instruments became difficult.
Although government officials knew about the deterioration in the subprime
markets, they misjudged the risks posed to the financial system. In January ,
SEC officials noted that investment banks had credit exposure to struggling subprime
lenders but argued that “none of these exposures are material.” The Treasury and

Fed insisted throughout the spring and early summer that the damage would be lim-
ited. “The impact on the broader economy and financial markets of the problems in
the subprime market seems likely to be contained,” Fed Chairman Ben Bernanke

testified before the Joint Economic Committee of Congress on March . That same
day, Treasury Secretary Henry Paulson told a House Appropriations subcommittee:
“From the standpoint of the overall economy, my bottom line is we’re watching it
closely but it appears to be contained.” 