You thought the foreclosure mess was bad? You’re right about that. But it gets so much worse once you start adding in a whole bunch of parallel messes in the world of mortgage bonds. For instance, as Tracy Alloway says, mortgage-bond documentation generally says that if more than a minuscule proportion of notes in a mortgage pool weren’t properly transferred, then the trustee for the bondholders can force the investment bank who put the deal together to repurchase the mortgages. And it’s looking very much as though none of the notes were properly transferred.
But that’s not even the biggest potential problem facing the investment banks who put these deals together. It also turns out that there’s a pretty strong case that they lied to the investors in many if not most of these deals.
I mentioned this back in September, and I’ve been doing a bit more digging since then. And I’m increasingly convinced that the risk to investment banks isn’t only one of dodgy paperwork; there’s also a serious risk of massive lawsuits from the SEC or other prosecutors, as well as suits from individual mortgage investors.
The key firm here is Clayton Holdings, a company which was hired by various investment banks — Goldman Sachs, Bear Stearns, Citigroup, Merrill Lynch, Lehman Brothers, Morgan Stanley, Deutsche Bank, everyone — to taste-test the mortgage pools they were buying from originators.
Here’s how it would work:
First, the bank would put in a winning bid for the pool of mortgages, with the intention of slicing it up into mortgage bonds and selling those bonds off to investors at a profit.
After submitting the winning bid, the bank would commission Clayton to take a closer look at a representative sample of loans in the pool. Clayton controlled as much as 70% of the market for this service, which is known as third-party due diligence. But Clayton’s not at fault here, and the problem is likely to apply no matter who performed this service.
The size of the representative sample would vary according to the size of the loan pool; it could be anywhere between 5% and 35% of the loans in the pool. Essentially, Clayton would go back to the loans, one by one, and re-underwrite them after the fact, checking that the originator’s underwriting standards were in fact being upheld.
Clayton would either accept or reject the loans it was looking at, according to whether or not they met underwriting standards. Here’s the results of what it found for one bank, Citigroup; the chart comes from this document filed with the Financial Crisis Inquiry Commission. I’m just using Citi as an example, here; all banks behaved in basically exactly the same way.
Look at the first line. Clayton reviewed 1,280 loans on behalf of Citigroup in the first quarter of 2006. Of those, it accepted 554 outright: they lived up to the originator’s underwriting standards. It also waived another 144, on the grounds that there were mitigating factors (a large downpayment, say). And it rejected 582 for a rejection rate of 45%.
This kind of information was valuable to Citigroup: it showed them that the quality of the loan pool was much lower than you’d think just by looking at the ostensible underwriting standards.
Armed with this information, Citigroup would do two things. First of all, it would take those 582 rejects and put most of them back to the underwriter. Essentially, they said, the loans weren’t as advertised, and they didn’t want them. But Citi would still keep some of them in the pool.
But remember that Clayton had tested only a small portion of the loans in the pool. So Citi knew that if there were a bunch of bad loans among the loans that Clayton tested, there were bound to be even more bad loans among the loans that Clayton had not tested. And those loans it couldn’t put back to the originator, because Citi didn’t know exactly which loans they were.
If there had been any common sense in the investment banks, that would have been the end of the deal. But there wasn’t. Rather than simply telling the originator that its loan pool wasn’t good enough, the investment banks would instead renegotiate the amount of money they were paying for the pool.
This is where things get positively evil. The investment banks didn’t mind buying up loans they knew were bad, because they considered themselves to be in the moving business rather than the storage business. They weren’t going to hold on to the loans: they were just going to package them up and sell them on to some buy-side sucker.
In fact, the banks had an incentive to buy loans they knew were bad. Because when the loans proved to be bad, the banks could go back to the originator and get a discount on the amount of money they were paying for the pool. And the less money they paid for the pool, the more profit they could make when they turned it into mortgage bonds and sold it off to investors.
Now here’s the scandal: the investors were never informed of the results of Clayton’s test. The investment banks were perfectly happy to ask for a discount on the loans when they found out how badly-underwritten the loan pool was. But they didn’t pass that discount on to investors, who were kept in the dark about that fact.
I talked to one underwriting bank — not Citi — which claimed that investors were told that the due diligence had been done: on page 48 of the prospectus, there’s language about how the underwriter had done an “underwriting guideline review”, although there’s nothing specifically about hiring a company to re-underwrite a large chunk of the loans in the pool, and report back on whether they met the originator’s standards.
In any case, it’s clear that the banks had price-sensitive information on the quality of the loan pool which they failed to pass on to investors in that pool. That’s a lie of omission, and if I was one of the investors in one of these pools, I’d be inclined to sue for my money back. Prosecutors, too, are reportedly looking at these deals, and I can’t imagine they’ll like what they find.
The bank I talked to didn’t even attempt to excuse its behavior. It just said that Clayton’s taste-testing was being done by the bank — the buyer of the loan portfolio — rather than being done on behalf of bond investors. Well, yes. That’s the whole problem. The bank was essentially trading on inside information about the loan pool: buying it low (negotiating for a discount from the originator) and then selling it high to people who didn’t have that crucial information.
This whole scandal has nothing to do with the foreclosure mess, but it certainly complicates matters. It’s going to be a very long time, I think, before the banking system is going to be free and clear of the nightmare it created during the boom.
Update: KidDynamite asks a good question in the comments: were the bond investors able to do their own due diligence on the loan pool? The answer is no, they weren’t — the prospectus did not include the kind of loan-level information which would enable them to do that.
To say *that* diligence was done, without disclosing the poor results of that diligence, suggests that the diligence produced favorable results regarding the quality of the loans. So it may be worse than a lie of omission – it sounds actively misleading regarding the quality of the pool.
This brings up memories of the SEC vs GS case again.
Felix – isn’t there a big difference between “due diligence” and “inside information?” it sounds to me like the bank did its due diligence and, as usual, the investors didn’t.
as you noted, Clayton’s testing was being done by the bank! the bond investors had every opportunity to do their own due diligence too, right?
As I understand it- former banker with no ax to grind- loans were tested against orignial guidelines and banks own standards (for purchases) not just guidelines- so numbers are skewed negative vs. guidlines. I’m no statiscian but given variance in sample sizes you cite- can’t draw valid statistical conclusions on pools. Looked at the report you cite that was on HP. It looked like only a small percentage of rejected loans were waived, many were rejected according to that report. Think plenty of lawyers and regulators have been looking at this stuff for a long time- much written about it. Clearly there were process breakdowns all over but this is not an open and shut matter in any case. Details on loans would seem to matter here like they do in put backs.
Part of the real issue I see is the MSM focusing on “no free ride for the banks=deadbeat mortgage holders get a free ride”. Nowhere have I seen a piece dealing with the investor loss. During this whole crisis the bankers have been painted as victims. The real victims are the investors. They should be getting the foreclosed properties or the opportunity to negotiate with the residents in the properties to get payment. If the bankers get their way they will take the properties, get the government to pay the old loans, and screw the bond holders. We used to call it fraud.
Excellent article, a shining light at last! This clearly shows why securitisation of mortgages is a bad thing, without which there would most likely not have been the size of problem we have ended up with.
As for having nothing to do with the foreclosure mess, that’s impossible to say without knowing more about the quality of borrowers and the type of underwriting going on. If Clayton’s re-underwriting did not reject borrowers on welfare benefits or on low fixed incomes who were taking temporarily discounted rates they could only just afford at the discounted rates, and if that underwriting did not look at what would happen when the discounted period ended, then although the due-diligence was correctly done it was asking the wrong questions.
I suspect there’s an element of naivety operating here though, as if everyone always expected it to be possible to switch to yet another discounted mortgage at the end of the current one. Since nobody in the banking community expected to be left holding the debt parcel when the music stopped, nobody cared what was in the package.
I have memories of SEC vs GS too. Mine are that I am still throughly convinced that Paulson had more info about the why he was shorting and what was placed in the CDOs the the investors.
And kid, if the bank said it had been vetted by the third party, and the bonds were rated way higher then they should have been, what kind of a transaction offer is that other then misleading and fraudulent.
Knowingly buying it low and selling it high is rather a nifty thing if the one going short is involved in the deal and knows this, wouldn’t you say? If you are failing to meet the quality benchmark that your portfolio prospectusis states to investors it has acquired, wouldn’t you say that was fraudulent?
Oh and I know you are going to answer…
“And the less money they paid for the pool, the more profit they could make when they turned it into mortgage bonds and sold it off to investors.”
This also means that banks had not only a financial incentive to take on the pools in general, but to specifically buy (to resell) pools with the highest amount of drek.
Most notes were not transferred to the custodian of the SPV (special purpose vehicle) that was created as the issuer of the securitized pool of mortgages. The reason is very simple: to expedite business. What is also very important to understand is that the legal language of the SPV which issues the MBS or any complicated securitized pool of mortgages, in most cases was not adequate. The inadequacy was in that the “transfer” of the pool of mortgages (notes essentially) from the loan originator to the SPV did not constitute a TRUE SALE!! As a result we have and will have more lawsuits (to the SPVs and the loan originators) etc…
Fascinating,
What was being written against these wonderful bonds?
If you guessed CDS’ you win.
The same banks that were selling these bond were also buying CDS converage for those same bonds (that they knew were drek).
We paid GS $10,000,000,000 through AIG for CDS insurance on bonds that they knew were losers (their due diligence should have proved that out). So they had their cake and at it too.
When will we see some banksters doing the perp walk?
kitty – doing due diligence is not a crime. When you do due diligence, you’re not bound to share that with your counterparty!
You’re absolutely right that in the Paulson case, Paulson did better research than his counterparties. That’s not a crime. In fact, the main goal of capital markets is probably to try to do better “work” than the guy on the other side of the trade – to do a better job evaluating the information that’s available.
Kirk Kerkorian sold 25-odd million shares of MGM stock today. Do you think that the buyers of that stock on the secondary offering have as much information about MGM as KK does? Hell no. Sold to you, sucka!
Felix – I now see your update. “The answer is no, they weren't "” the prospectus did not include the kind of loan-level information which would enable them to do that.”
Huh? you’re being an apologist for investors who bought stuff they couldn’t value? Sounds like we’re going to get back to the ratings agencies again with this discussion… but hey – look – if you as an investor cannot value something – YOU SHOULD NOT BUY IT. I don’t know how else to say it.
if the prospectus didn’t allow investors to evaluate the product, and they bought it anyway, well, what did they expect? another segment chasing easy money without doing their homework – we know how that works out (hint: it doesn’t)
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