At little noticed hearing this week in Sacramento, Calif., a firm hired by
Wall Street to analyze mortgages given to borrowers with poor credit, which
were then packaged and sold to investors during the boom years, revealed
that as much as 28 percent of those loans failed to meet basic underwriting
standards — and Wall Street knew all along reports the Huffington Post.

Even worse, when the firm flagged those loans for potential issues Wall Street
banks ignored its recommendation nearly half the time and likely purchased
those loans anyway, selling them to unwitting investors who were never told
that the biggest home loan due diligence firm in the country had found
potential defects in these mortgages.

These revelations give a better picture of what many have likely known for
years: Wall Street firms knew they were buying lead yet passed it off as
gold to investors who had no knowledge of the alchemy behind the scenes. But
it also has real-world implications: the data released Thursday could
bolster pension funds and other investors in their pursuit to force Wall
Street banks to take back the bogus mortgages they peddled. An untold number
of lawsuits have been filed in the wake of the subprime mortgage crisis and
subsequent housing market collapse. Thus far, Wall Street has been winning
that battle.

Clayton Holdings, a Connecticut-based firm that analyzes home mortgages for
banks, hedge funds, insurance companies and government agencies, provided
its data Thursday to theFinancial Crisis Inquiry Commission a bipartisan panel created by Congress to investigate the roots of the worst financial crisis since the Great Depression. The FCIC held its last public hearing in Sacramento, the home of the panel’s chairman, where two current and former top Clayton executives testified under oath about the firm’s role in the mortgage securitization chain.

Within the height of the boom in 2006 and the period prior to its immediate
end during the first six months of 2007, Clayton inspected home loans for
Wall Street firms and government-backed mortgage giant Freddie Mac. Clayton
looked at loans that the companies wanted to purchase from mortgage
originators like New Century Financial, Countrywide Financial, and Fremont
Investment & Loan. The company examined 911,039 mortgages, documents show.

The clients included Bank of America and JPMorgan Chase, the nation’s two
biggest banks by assets which together have about $4.4 trillion; Citigroup,
Deutsche Bank, Goldman Sachs, Morgan Stanley, Bear Stearns and Lehman
Brothers. Clayton controlled about 50 to 70 percent of the market, Keith
Johnson, the firm’s former president, told the crisis panel.

Clayton, though, typically looked at roughly 10 percent of the pool of
mortgages available for purchase, Vicki Beal, a senior vice president at the
firm, said in response to a question by panel chairman Phil Angelides. But
during the frenzied last months of the boom, when lenders and securitizers
were trying to sell off as much as they could before the market collapsed,
that figure reached as low as 5 percent.

Of the 911,000 loans that Clayton scrutinized, 72 percent either met the
mortgage seller’s standards and other guidelines set by the buyer of the
mortgages, typically Wall Street firms, or they had off-setting factors that
allowed Clayton to give them a passing grade, like if the borrower who took
out the mortgage put a lot of money down or had a very high income.

28 percent failed to meet those standards. Of those 255,802 mortgages
that Clayton flagged for what were a variety of reasons, Wall Street ended
up waiving in 100,653 of them, or 39 percent of those loans that did not
meet basic standards. Wall Street firms didn’t share this with investors.

“This should have raised red flags,” said Guy Cecala, publisher of Inside
Mortgage Finance , a leading trade publication and data provider.

“To our knowledge, prospectuses do not refer to Clayton and its due
diligence work,” Beal told the FCIC in prepared remarks. “Moreover, Clayton
does not participate in the securities sales process, nor does it have
knowledge of our loan exception reports being provided to investors or the
rating agencies as part of the securitization process.”

Johnson said that Clayton “looked at a lot of prospectuses” — documents
given to potential investors outlining what comprises the deal — and that
the firm wasn’t aware of any disclosure to investors of Clayton’s “alarming”
findings, Johnson said.

These reports Clayton generates are “the property of our clients and provided
exclusively to our clients. When Clayton provides its reports to its
clients, its work on those loans is generally completed — Clayton is not
involved in the further processes of securitizing the loans and does not
review nor opine on the securitization prospectus,” Beal said.

Throughout questioning by Angelides, Beal acknowledged that, because the firm
was checking roughly 10 percent of the mortgages Clayton’s clients were
looking to purchase, one could say that Wall Street firms waived in as many
as 1 million loans that Clayton had initially rejected.

Angelides told the current and former Clayton executives that it appeared
that securities issuers — Wall Street firms — didn’t examine the other 90
to 95 percent of loans that comprised a pool waiting to be securitized and
sold to investors. Johnson agreed with him.

Johnson said that he heard that some market participants
operated under a “three strikes, you’re out rule” — if bad loans were
flagged by Clayton, sellers and issuers would have Clayton take out another
5 to 10 percent sample to check the pool again. Angelides hinted that when
done three times, it would be incredibly unlikely that Clayton would again
discover those individual questionable loans, and that they’d find their way
into securitization deals. Johnson agreed.

“What the standard practice, supposedly, and best practices call for is if
you do a sampling and you show problems, you go back and take a bigger slice
and keep going until you find out the true extent of the issue and the
problem,” Cecala said.

That didn’t happen.

“If issuers had been scrutinizing all the collateral in a security and only
putting in loans that met actual underwriting and documentation
requirements, a lot of these deals wouldn’t have gotten done,” said Cecala.
“But as a practical matter that didn’t happen. Most of the loans that were
originated got thrown in securities one way or another.”

Also, Johnson told the crisis panel that he thought the firm’s findings should
have been disclosed to investors during this period. He added that he saw
one European deal mention it, but nothing else.

The firm’s findings could have been “material,” Johnson said, using a legal
adjective that could determine cause or affect a judgment.

It’s unclear whether the firms ended up buying all of those loans, or
whether Wall Street securitized them all and sold them off to investors.

“Clayton generally does not know which or how many loans the client
ultimately purchases,” Beal said. That likely will be the subject of
litigation and investigations going forward.

“This should have a phenomenal effect legally, both in terms of the ability
of investors to force put-backs and to sue for fraud,” said Joshua Rosner,
managing director at independent research consultancy Graham Fisher & Co.

The original buyers of these securities could sue for fraud; distressed
investors, who buy assets on the cheap, could force issuers to take back the
mortgages and swallow the losses.

“I don’t think people are really thinking about this,” Rosner said. “This is
not just errors and omissions — this appears to be fraud, especially if
there is evidence to demonstrate that they went back and used the due
diligence reports to justify paying lower prices for the loans, and did not
inform the investors of that.”

Beal testified that Clayton’s clients use the firm’s reports to “negotiate
better prices on pools of loans they are considering for purchase,” among
other uses.

Almost $1.7 trillion in securities backed by mortgages not guaranteed by the
government were sold to investors during those 18 months, according to
Inside Mortgage Finance. Wall Street banks sold much of that. At its peak,
the amount of outstanding so-called non-agency mortgage securities reached
$2.3 trillion in June 2007, according to data compiled by
Bloomberg.

The potential for liability on the part of the issuer “probably does give an
investor more grounds for a lawsuit than they would ordinarily have”, Cecala
said. “Generally, to go after an issuer you really have to prove that they
knowlingly did something wrong. This certainly seems to lend credibility to
that argument.’

Less than $1.4 trillion remain as investors refused to buy new issuance and
the mortgages underpinning existing securities were either paid off or
written off as losses, Bloomberg data show.

“This appears to be a massive fraud perpetrated on the investing public on a
scale never before seen,” Rosner added.

New York Attorney General Andrew Cuomo, who’s running for governor,
reportedly launched an investigation and granted Clayton immunity in
exchange for information on what Wall Street knew and when, according to
press reports in January 2008. A spokesman for the state prosecutor didn’t
return a Friday call seeking comment.

Clayton, for example, analyzed about 10,200 loans for Bank of America. It
found problems in 30 percent of them. Of those, the bank waived about a
quarter.

For Credit Suisse, Clayton found that 37 percent of the 56,300 loans it
reviewed failed to conform to standards. It waived in a third of those.

Clayton discovered that 42 percent of the pool of loans Citigroup wanted to
buy didn’t meet standards, and that nearly a third of those were waived in
anyway. Citi is the nation’s third largest bank by assets and one still
owned by taxpayers.

JPMorgan Chase and Goldman Sachs had rejection rates of 27 and 23 percent,
respectively. JPMorgan’s waiver rate was 51 percent. Goldman Sachs, often
derided for its practices during the boom and bust, had a waiver rate of 29
percent, far below the 39 percent average Clayton experienced.

Among the firms with the worst records are Morgan Stanley, Deutsche Bank and
Freddie Mac.

About 35 percent of the 66,400 loans Deutsche wanted to buy were marked for
having some kind of deficiency; the bank waived half of them. Morgan’s
63,000 loans had a rejection rate of 37 percent; 56 percent of them were
waived in. Clayton rejected 35 percent of the loans government-owned Freddie
Mac wanted to buy. The firm, one half of the mortgage duo now owned by
taxpayers and costing the Treasury hundreds of billions of dollars, waived
in 60 percent of those loans.

Neal, though, testified that Deutsche was one of its tougher clients when it
came to checking mortgages. Because of its rigorous guidelines, that’s
likely why the German lender had such a high rejection rate, she said.

These particular firms were among the biggest issuers of so-called non-agency
mortgage-backed securities in 2006 and the first half of 2007. Goldman
issued about $65 billion in these securities, Inside Mortgage Finance data
show. JPMorgan issued about $61 billion. Morgan Stanley sold about $49
billion, followed closely by Deutsche which sold $46 billion and Credit
Suisse which issued $40 billion. Bank of America and Citigroup were next,
selling $37 billion and $35 billion, respectively, data show.

The spokesman for Citi, Morgan, Deutsche, and Goldman declined to comment.
Representatives for Freddie Mac and JPMorgan didn’t respond to requests for
comment.

But none of this should be new to savvy market players. Clayton had been
warning about these issues for years, Cecala said.

“We have regular conversations with Clayton and Clayton would make the claim
that they were seeing a lot of bad loans in their examinations and not many
people were acting on it,” Cecala said. “And clearly, the only way we could
have the problems that we experienced is if people actually ignored
problems. It’s not like these were bad loans that suddenly turned bad. There
were problems from day one and someone should have known it.

“Clayton was very frustrated that a lot of people never really acted on
[their findings],” said Cecala. “Clayton would report that a lot of times
they found problems in loan samples and not only did the issuer not want
them to sample any more, which would have cost more money, but they didn’t
act on the information they uncovered.”

Issuers, which hired Clayton to perform due diligence, didn’t want to pay
for more sampling. They also wanted to pump out as many deals as quickly as
possible, Cecala added.

But, he cautioned, investors weren’t necessarily paying attention to these
kinds of details.

“Keep in mind that investors ultimately bought a deal almost exclusively
based on the rating, and not the issuer’s decision [regarding] what loans to
put in or what loans not to put in,” Cecala said. “Historically there’s been
very little recourse back to the issuer for problems with securities down
the road and the bottom line is if you can get it past the ratings services
you’re more or less home free.”

These three big credit rating agencies that dominate the market — Standard
and Poor’s, Moody’s Investors Service and Fitch Ratings — had a chance to
use Clayton’s information during this time, but declined, Johnson testified.

He told the crisis commission that Clayton had meetings with S&P in 2006 and
with Fitch and Moody’s in 2007. “All of them thought this was great,”
Johnson testified.

The rating agencies declined. The reason why, Johnson said, was because
if a rating agency bought Clayton’s services it would have likely been more
stringent. That, in turn, would cause it to lose market share because Wall
Street issuers would have just gone to an easier rating agency.

These rating agencies began requiring such third-party due diligence in 2007
after a state attorney general stepped in, Johnson said. By then, though, it
was too late.

“Keep in mind that the rating services basically based a lot of their rating
decisions not on an examination of every loan or the collateral, but
basically on representations from the issuer,” Cecala said. “That was the
system we had in place.”

Cecala said it was “highly unlikely” that Wall Street firms shared Clayton’s
findings with the rating agencies.

“We could have…stopped the factory from producing,” Johnson lamented.

This information was obtained from the Huffington Post.
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