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Raters Ignored Proof of Unsafe Loans, Panel Is Told
Gretchson Morgenson, NY Times
As the mortgage market grew frothy in 2006 — leading to a housing bubble that nearly brought down the banking system two years later — ratings agencies charged with assessing risk in mortgage pools dismissed conclusive evidence that many of the loans were dubious, according to testimony given last week to the Financial Crisis Inquiry Commission.
The commission, a bipartisan Congressional panel, has been holding hearings on the origins of the financial crisis. D. Keith Johnson, a former president of Clayton Holdings, a company that analyzed mortgage pools for the Wall Street firms that sold them, told the commission on Thursday that almost half the mortgages Clayton sampled from the beginning of 2006 through June 2007 failed to meet crucial quality benchmarks that banks had promised to investors.
Yet, Clayton found, Wall Street was placing many of the troubled loans into bundles known as mortgage securities.
“We went to the ratings agencies and said, ‘Wouldn’t this information be great for you to have as you assign tranche levels of risk?’ ” Mr. Johnson testified last week. But none of the agencies took him up on his offer, he said, indicating that it was against their business interests to be too critical of Wall Street. “If any one of them would have adopted it,” he testified, “they would have lost market share.”
In the aftermath of the financial crisis, which has required billions of dollars in taxpayer money to bail out Wall Street, ratings agencies have been sharply criticized for failing to properly assess the securities they were reviewing, and federal regulators are investigating the agencies for the role they played in the credit crisis.
It has been more than four years since Mr. Johnson and his colleagues at Clayton Holdings started noting that disturbing numbers of mortgages did not meet the lending criteria promised to investors in prospectuses used to market the securities.
Details of what Wall Street firms knew about the loans they were selling to investors, and when they knew it, are still trickling out in regulatory actions and private lawsuits.
The Massachusetts attorney general recently accused Morgan Stanley of deceptive practices in its financing of mortgage lenders during this period, saying that the firm had knowingly placed dubious mortgages into securitized pools. Morgan Stanley settled with the attorney general in June and paid $102 million. The facts in that case relied on Clayton reports of loan quality commissioned by Morgan Stanley.
But until Mr. Johnson’s testimony last week, it was largely unknown that the ratings agencies had been told that vast numbers of loans were being packaged as securities even though they failed to meet underwriting standards.
According to testimony last week, from January 2006 to June 2007, Clayton reviewed 911,000 loans for 23 investment or commercial banks, including Citigroup, Deutsche Bank, Goldman Sachs, UBS, Merrill Lynch, Bear Stearns and Morgan Stanley..
Some 28 percent of the loans sampled over the period were outright failures — that is, they were unable to meet numerous underwriting standards and did not have positive factors that compensated for their failings. And yet, 39 percent of these troubled loans still went into mortgage pools sold to investors during the period, Clayton’s figures showed.
A Goldman Sachs spokesman said the percentage of deficient loans that went into its pools was smaller than Clayton’s average, indicating that the firm had done a better job than its peers.
Because these loan samples were provided to the Wall Street investment banks that commissioned them, they could see throughout 2006 and into 2007 that the mortgages they were financing and selling to investors were becoming increasingly sketchy.
The results of the Clayton analyses were not disclosed to investors buying the loan pools. Instead, Wall Street firms used the information to pressure the lenders issuing the most troubled loans to accept a lower price for them, according to prosecutors who have investigated these cases.
A more proper procedure, analysts said, would have been for lenders like these — New Century Financial and Fremont Investment and Loan among them — to buy back the problem loans and replace them with higher-quality mortgages. But because these companies did not have enough capital to do that, they were happy to sell the troubled mortgages cheaply to the brokerage firms.
Since Wall Street firms were paying lower prices for the troubled loans, they could have passed along those discounts to customers, reducing investor risk. But Wall Street charged investors the same high prices associated with better-quality loans, thereby increasing their own profits on the problematic securities, according to a law enforcement official and executives with Wall Street companies. To be sure, the prospectuses detailing the types of loans in these pools contained brief warnings that some of the mortgages might not meet stated underwriting standards. But few investors probably realized that huge portions of the pools had failed to meet the benchmarks.
The Clayton figures took into account only small samples of the loan pools that were sold to investors. The 911,000 loans Clayton analyzed over the 18-month period were roughly 10 percent of the total number of mortgages in the securities it was contracted to review.
As a result, it is very likely that many of the loans that were not sampled also failed to meet underwriting standards but were packaged into the securities anyway.
Gretchson Morgenson, NY Times
i’m not surprised, the downfall of capitalism will always be greed.
that’s why regulation is important, because at the end of the day
private company execs have only their best interests in hand.
(google Goldman Sachs or Bernie Madoff for reference)