Where to start when trying to figure out how the banking industry got into the mess it's in today? And where, exactly, do we go from here?

Most of the past 17 years, post-S&L crisis, was a golden age for banks large and small, filled with new revenue sources, efficiency gains, product and technology innovations and relative tranquility. Lots of money was made, particularly during the housing boom, which was marked by a steady run of record quarterly profits, and virtually no bank failures.

And then it all came crashing down in a torrent of bad loans and falling real estate prices. The New York Stock Exchange had to temporarily halt trading of some stocks, and the Securities and Exchange Commission went so far as to suspend short selling of 19 key financial stocks in an effort to keep rumor and innuendo from crippling the financial system.

The crisis has been more evolutionary than sudden: Years of increasingly careless lending fueled skyrocketing real estate prices. Warning signs emerged, followed by a series of perilous predicaments. Each episode of the past 18 months has proven its own mini-drama, inspiring a wave of reactions-panic, foreboding and what-were-they-thinking headshakes.

The truth is, there's been no one culprit. Rather, the crisis that got its start in subprime mortgages and has spread like hemorrhagic fever through the industry has been a group effort. Banks and other lenders originated dicey loans and put loads of mortgage-backed securities on their balance sheets without knowing their true content. Investment banks packaged loans into securities, seemingly regardless of their quality, and paid credit ratings agencies to sign off on their values. Lawmakers, eager to promote homeownership, willingly looked the other way when questions were raised. Regulators arrived at the party late, and were largely ineffective. "We all got caught up in this assumption that real estate values would continue to go up, and that you could diversify and offload the risks by bundling loans together and selling them," says Kevin Fitzsimmons, a managing director for Sandler O'Neill & Partners. "No one ever dreamed that those loans would all go bad at once, and that the secondary market would collapse as a result."

While Fitzsimmons is correct that most in the industry were caught flat-footed, a tiny few were sounding the alarms early, such as Lewis Ranieri, the "godfather" of securitization. Ranieri helped create the process of packaging loans into pools and selling them as bonds to investors while working on Salomon Brothers' mortgage-trading desk in the late-1970s, and is given credit for coining the word "securitization." It was a wonderful concept, allowing banks to lend far more than their balance sheets could support-and to spread the risks of those loans-by tapping investors from around the world. Government policy makers, intent on home ownership, loved the idea. Fannie Mae and Freddie Mac thrived as conduits for those securities.

But by 2005, a good idea was showing signs of abuse, and Ranieri, then head of his own investment firm, warned of impending disaster. Growing numbers of people who shouldn't have qualified for mortgages got them anyway. An explosion of subprime, alt-A, no-doc and other specious loans got underway-well over $800 billion in 2006 alone, according to newsletter Inside Mortgage Finance-often underwritten on the basis of teaser rates that reset in two or three years. Perhaps worse, those loans were pooled into collateralized debt obligations, often without adequate disclosures.

At a December 2006 OTS-sponsored housing forum, Ranieri warned that this "massive proliferation of new products" was making it "very difficult for investors to accurately quantify the value and the risks" of those bonds. "No public securities market can long exist if it doesn't have true transparency," he said. "And we, I will argue vociferously, do not have true transparency." Ranieri's words proved prophetic.

So, how does the industry regain its footing? What is the path forward? The 10 key players and events that follow provide important lessons about what happened and why, and clues to how the future will unfold. In short, how the industry can, eventually, emerge stronger and healthier than it was before the crisis.

HSBC AND NEW CENTURY

The first widely acknowledged sign of trouble occurs on February 7, 2007, when New Century Financial, an Irvine, CA subprime lender that has symbolized the giddiness of the housing boom, reports a big fourth-quarter loss and says it must restate earnings for the previous three quarters because of inadequate reserves. Earlier that day HSBC Holdings, the London giant that in 2003 acquired consumer finance powerhouse Household International, announces that it expects to set aside $10.6 billion in additional reserves to address a souring subprime portfolio.

The fallout is swift and severe. New Century loses 36 percent of its market cap the next day, and pulls other subprime specialists-Novastar Financial, Fremont General and American Home Mortgage Investment-down with it. (Within two months New Century has filed for Chapter 11 protection amid a swirl of government investigations and investor lawsuits.) HSBC shares fall, too, although not nearly as much.

Bankers everywhere immediately feel more intense scrutiny. At an investor conference in Naples, FL, the next morning, Richard Davis, CEO of U.S. Bancorp, spends most of the Q&A portion of his presentation fielding queries about the Minneapolis-based bank's subprime exposure. "The concern was, 'How much subprime do you do? What is your risk of having what Household had?'" recalls Davis, who admits that he went in 30 minutes "from knowing something about our subprime exposure to knowing everything about it. ...I had to."

After the past 18 months, you'd be hard-pressed going forward to find a banker who isn't totally cognizant of the riskiest parts of his or her loan portfolio.

THE UPSHOT

True risk management is about more than models and analytics. Financial performance is tied to experience, judgment and the conviction to buck trends.

S&P, MOODY'S, FITCH, ET AL.

On July 10, 2007, the big credit rating agencies abruptly downgrade hundreds of mortgage-backed securities-many by several notches-sparking a liquidity crisis in the marketplace.

For years, the agencies have acted as the grease that lubes the securities markets, giving investors assurance about their purchases. The dirty little secret is that the issuers get previews of MBS assessments from multiple agencies, and then go with-and pay-the agency that offers the highest rating. Worse, those assessments often are done without access to complete information about the loan composition of those pools. The topper: the agencies also market advice to loan packagers-a blatant conflict of interest.

The downgrades create confusion. Like a game of hot potato, investors caught holding MBS issues with big subprime components are stuck. Liquidity becomes so scarce by mid-August that three European investment funds announce they can no longer price those assets. The crunch spreads to securities backed by other loan types, such as commercial real estate. Lenders are forced to hold more on their books, and have fits trying to value their portfolios under new mark-to-market accounting rules. They also begin to hoard capital, sparking a lending slowdown that impacts the entire economy.

Meanwhile, New York State Attorney General Andrew Cuomo launches an investigation of the agencies' enabling role in the meltdown. A settlement is announced in June, requiring the raters to dig deeper into the composition of securitization pools, disclose more of what they learn to investors and charge fees even if an investment bank doesn't select them to rate an MBS. The reforms "should begin to restore investor confidence" in securitizations, Cuomo says. That might eventually be the case, but for now the market remains sluggish.

THE UPSHOT

Credit ratings lose hallowed status, forcing a change in their business model and their relationship with players in the market.

THE SALE OF COUNTRYWIDE

The nation's largest mortgage company, Countrywide becomes an early posterchild of the crisis. In August, 2007, amid rising defaults, Bank of America pays $2 billion for a 16 percent stake to help shore up the company. Four months later, with one third of Countrywide's subprime portfolio in delinquency, BofA buys the rest for $2.5 billion in an all-stock transaction (it was announced at $4.1 billion), transforming the nation's largest bank into the biggest mortgage player, too. The price, at $4.25 per-share, is down more than 90 percent from Countrywide's early-2007 highs.

Countrywide's problems are a microcosm of what's occurring everywhere. Investment banks are demanding that lenders take back loans that have gone into default, arguing the borrowings were misrepresented. Lenders feel they have no choice-their relationships with those banks will be irreparably harmed if they say no-but eating bad loans eats into their earnings and capital, as well.

Despite the loss of shareholder value, CEO Angelo Mozilo cashes out some $166 million in shares during 2007, and stands to collect a big severance package. The SEC investigates, Mozilo testifies before Congress, where unseemly details-including more than $100 million in cash and accelerated options vesting, a lucrative consulting arrangement and continued use of the company jet-emerge. In the end, he gives back $37.5 million, but joins Citigroup's Charles Prince and Merrill Lynch's Stanley O'Neal as a paragon of CEO greed and incompetence. "The obvious question," says Rep. Henry Waxman (D-CA), "is how can a few execs do so well when their companies are doing so poorly?" It's a question that should be asked more rigorously in the future.

THE UPSHOT

Simply selling loans to investors doesn't make lenders immune from defaults. Banks must originate loans responsibly, whether they intend to hold them on the books or not.

ABU DHABI AND PRIVATE EQUITY

As losses mount, Citigroup turns to sovereign wealth funds for capital. In November, it sells $7.5 billion in equity to Abu Dhabi, and follows it up in January with a $14.5 billion fund-raising expedition that takes it to Kuwait and Singapore. Some in Congress wring their hands that U.S. banks are being sold off to sometimes-hostile governments looking for control. The situation is actually much less sinister than that: Citi needs money, and overseas governments are flush with it.

Citi's capital raise is among the first of many that highlight the industry's desperation. In April, National City (from a group led by Corsair Capital) and Washington Mutual (led by TPG) each raise about $7 billion in private equity-related money to help stay afloat. Wachovia goes to the well twice, selling $8.3 billion in preferred stock in January, and $7 billion more from a sale of common and convertible preferred in April.

In total, banks raised $290 billion in capital during the year that ended in June, according to SNL Financial, while many cut their dividends to preserve precious capital. Predictions vary, but the best guess is that plenty more fund-raising is yet to come. "The real head-scratcher is that no one knows how much capital is enough anymore," Fitzsimmons of Sandler O'Neill says. Unconventional sources will continue to supply much of it.

Among other things, the Abu Dhabi sovereign wealth fund is now owner of New York's iconic Chrysler Building.

THE UPSHOT

Capital raising is now a global game-regulation and jingoism be damned-and banks must be free to tap a range of investors. Transparency is what matters most.

BEAR STEARNS

In perhaps the strangest episode of the entire credit crisis, federal officials essentially force the once-powerful Bear Stearns to sell to JPMorgan Chase & Co. at a fire sale price of $2 per share.

The week of March 10, 2008, begins with a big downgrade of Bear Stearns MBS issues, and rumors of Bear's liquidity troubles begin to swirl. The next day, the New York Federal Reserve Bank announces that it will open its discount window to investment banks for the first time since the Great Depression. This draws criticism from the likes of former Fed Chairman Paul Volcker, who worry that banking regulators are expanding their mandate too far.

Despite that, the feds fear that a collapse could create a panic, and after three days of round-the-clock negotiations there's a Friday announcement that JPMorgan Chase will provide Bear with a secured lending facility, supported by the Fed's discount window for 28 days.

Over the weekend, however, the Fed backs out of its agreement. It's unclear where the order came from-Treasury Secretary Henry Paulson and Fed Chairman Ben Bernanke are the most likely suspects-but a "government official" tells Bear that it must accomplish a "stabilizing transaction" over the weekend, forcing management's hand.

After a weekend of cutthroat bargaining, only one suitor is left standing. JPMorgan will buy Bear, but only commits to the deal with $30 billion in special Fed funding that shields it from much of the risk. The price is later increased to about $10 per share-better terms for Bear shareholders, but still a long way off from the $172 per share it traded at less than two years earlier.

THE UPSHOT

The Fed as powerful dealmaker poses as many problems as it does solutions. Each time the Fed flexes its muscle, it will raise moral hazard questions, put taxpayers on the hook and compromise accountability of industry players.

KEN THOMPSON

CEOs are out of touch, over-fed and overly confident-but that may be changing. The list of CEOs who have paid the price for poor decisions and strategies continues to rise. Merrill Lynch's Stanley O'Neal "retired" last October, after admitting that dipping too far into subprime led to a $7.9 billion write-down; Citi's Charles Prince resigned under pressure a month later after recording a $3.55 billion loss; Mitchell Caplan got his walking papers as E-Trade wrestled with subprime issues; CEO James Cayne took it on the chin for playing in a bridge tournament and hitting the links as Bear Stearns went under.

For all that, Wachovia's Ken Thompson looks the worst. In May 2006, just as the housing market was beginning to look shaky, he pays $25.5 billion for Golden West Financial, an Oakland, CA-based thrift that specializes in so-called "Pick-A-Pay" option ARMs. To Thompson, it is the fulfillment of manifest destiny-the West Coast presence the Charlotte company has long coveted. To critics, it's a disaster in the making. Score one for the naysayers. This July, Wachovia announces $9.1 billion in second-quarter losses. In announcing the appointment of former Treasury undersecretary Robert Steel as the bank's new CEO, Wachovia chairman Lanty Smith concedes that the Golden West purchase was "a mistake." CFO Tom Wurtz is ousted; CRO Donald Truslow's exit follows shortly thereafter.

The hurried search that lands Steel underscores the lack of succession planning at many banks. Citi's Vikram Pandit gets the nod almost by default. E-Trade fumbles for months before naming Donald Layton as its chief. But boards are getting impatient with their institutions' struggles. A day after poor results are announced in July, TCF Financial replaces CEO Lynn Nagorske with chairman William Cooper, and Downey Financial CEO Daniel Rosenthal is swapped out for COO Thomas Prince.

THE UPSHOT

Succession planning stinks, and it shows. That these institutions lacked benchstrength at a time of crisis is reason enough for organizations to rethink succession strategies. CEO compensation should factor in long-term and risk-adjusted performance metrics.

INDYMAC

In July, Pasadena, CA-based IndyMac, a $32 billion-asset mortgage lender, becomes the fifth banking company to fail this year and the third-largest bank failure ever. Through early August, eight banks have gone under. Gerard Cassidy, an analyst with RBC Capital Markets, predicts the tally could eventually exceed 300-not all of them small institutions.

Many blame the IndyMac run-and its ensuing failure-on Sen. Charles Schumer, the New York Democrat, who sent a public letter to regulators in late June openly fretting that "IndyMac's financial deterioration poses significant risks to both taxpayers and borrowers." Schumer counters that the OTS was "asleep at the switch" and should get the blame.

The incident illustrates the tinder-dry vulnerability of banking companies to rumor and innuendo in a volatile market. The same month, BankAtlantic files a defamation suit against well-known analyst Richard Bove for an analysis of credit troubles that makes investors look askance at the company. Earlier, Citigroup analyst Prashant Bhatia warns that E-Trade could go bankrupt due to its subprime exposure, sparking a sharp sell-off.

THE UPSHOT

As evidenced by IndyMac and Bear Stearns, uncertainty is the path to panic and bank runs. Regulators grapple with how to respond, going so far as to suspend short selling of 19 financial stocks.

FANNIE AND FREDDIE

In July, the two mortgage giants-owners or guarantors of some $5.2 trillion, or about half of all U.S. mortgage debt-each lose more than 60 percent of their market caps in a one-week sell-off that threatens the stability of the entire financial system. In a dramatic July 15 emergency order, the SEC steps in to curb improper short selling in their shares for 30 days.

With home prices continuing to plummet and defaults rising, Fannie has reported $9.5 billion in losses over the past year, and Freddie another $5.5 billion. More capital is required-combined, the two have about $81 billion in capital, or just 1.6 percent of the loans they back. Freddie has cut its dividend sharply while discussing a $5.5 billion offering for months, but investors aren't stepping forward. The companies' status as publicly traded, government-sponsored entities complicates matters.

Sen. Charles Schumer declares the companies "are too important to go under," and most lawmakers agree. Their implicit government guarantee becomes explicit on July 30, when President Bush signs into law a rescue plan that allows Treasury to offer Fannie and Freddie an unlimited line of credit-and to buy stock in the two companies-over the next 18 months. The Congressional Budget Office says there's a 50-percent chance that Treasury won't need to do anything. The worst-case scenario: a five percent chance that the cost to taxpayers will be "more than $100 billion"-perhaps much more, some analysts warn. The law also creates a new, stronger regulator for the GSEs. Time will tell if it's more effective than its predecessor.

THE UPSHOT

The government is in the mortgage business, and taxpayers are on the hook for $6 trillion in GSE debt. The GSEs must be brought under control: nationalize them.

WASHINGTON'S MORTGAGE BAILOUT

Hailed as a centerpiece of the government's efforts to address the housing meltdown, the legislation signed by President Bush aims to keep some 325,000 borrowers in their homes by providing FHA insurance for up to $300 billion in new 30-year mortgages. It permanently bumps the conforming loan limit to $625,500 and provides $4 billion to states to buy and rehabilitate foreclosed properties.

Sounds good, but the deal comes with a couple catches. The FHA will insure $300 billion in new fixed-rate mortgages for troubled borrowers, but only if lenders agree to write-down loan balances to 90 percent of appraised values. Pressure also builds for a "voluntary" foreclosure moratorium by lenders. It's high drama in a political year, and will likely create some lasting change. Still, one pundit portrays the law as akin to "redoing the basement while the roof is leaking," and the costs to both the industry and taxpayers could be high.

THE UPSHOT

Politicians have to do something-anything-in an election year. But banks will have to decide if they're going to play ball.

MERRILL LYNCH CAPITULATES

On July 27, Merrill announces that it is selling a cache of mortgage-related CDOs, with a face value of $30.6 billion, for $6.7 billion. The move comes the same day the investment bank announces an $8.5 billion share offering to shore up its capital levels (it has raised $30 billion since December), and 11 days after reporting a $4.65 billion quarterly loss.

It's not exactly a sweetheart deal-Merrill lends vulture investor Lone Star Funds 75 percent of the purchase price and will write-off another $4.4 billion on its third quarter financials-for a sale that nets about 22 cents on the dollar. Even so, Wall Street cheers the sale, because it establishes a benchmark for banks perplexed by mark-to-market accounting issues. "You need capitulation-banks rapidly identifying and charging off problem assets," Fitzsimmons of Sandler O'Neill says. "Twenty-two cents looks awful, but now there's a number out there that could provide some kind of basis for other banks going forward."

THE UPSHOT

The balance-sheet cleansing begins. These bad mortgages aren't going to begin performing and recoup their value. The sooner banks admit this and rid themselves of this junk, the sooner the financial recovery can get underway.

Are we done yet? While some bankers-Jim Wells at SunTrust, for instance-report seeing small signs of improving credit quality, most agree that more pain is to come. In recent months, the crisis has spread to commercial real estate, home equity, credit cards and even prime mortgages, which JPMorgan Chase CEO Jamie Dimon told analysts in his July conference call "looks terrible. ...Our current expectation is...[prime mortgage] losses could triple from here." Such pessimism was confirmed by Freddie Mac CEO Richard Syron, who in August declared "neither we nor anyone else can predict when the national housing market will stop falling." Nouriel Roubini, a respected New York University economist who has accurately predicted much of the crisis, has warned that fixing the banking system could require a total taxpayer bailout of some $2 trillion.

It's all a tremendous embarrassment for an industry that only two years ago appeared to be sailing. In the end, it will be up to the banks to fix themselves. And as analyst Nancy Bush noted in a recent report, there's been little discussion of how operating models might be adapted to what she terms "the new realities of banking" laid bare by the real estate collapse. The question is, when will institutions be able to get out of crisis-management mode and begin to play offense? The sooner, the better. (c) 2008 U.S. Banker and SourceMedia, Inc. All Rights Reserved. http://www.americanbanker.com/usb.html/ http://www.sourcemedia.com/

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