October 14, 2010, 7:30 pm
How Wall Street Hid Its Mortgage Mess
By WILLIAM D. COHAN, Opinionator
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The conventional wisdom has it that the Financial Crisis Inquiry Commission — the bipartisan group of wise men and women charged with uncovering what caused our recent economic meltdown and telling us what should be done to prevent a recurrence — is woefully out-of-touch and out-of-date. A Times article last month suggested that “an exodus of senior employees” from the commission and “internal disagreements” among those remaining could hamper efforts to produce a meaningful and useful report, which is due to be published in December.

But the conventional wisdom is often wrong, and this time will be no exception. I predict that not only will the commission’s report — and accompanying documents — reveal numerous causes of the crisis that others have overlooked, but also that it will have a significant impact on the regulations that still must be written by the Securities and Exchange Commission and the Treasury as part of the implementation on the Dodd-Frank financial reform law. In fact, the inquiry commission may have already played an essential role in beginning to bring fraudsters to justice.

A much-derided federal panel has produced clear evidence that investment banks kept secret from their clients the shaky nature of many mortgage-backed securities.

Consider what was revealed at one of the commission’s regional hearings, held in Sacramento on Sept. 23. Part of the hearing focused on the role that Clayton Holdings, a firm that reviews loan files on behalf of investment banks, played in the mortgage securitization process by which one home mortgage after another got packaged up into mortgage-backed securities by Wall Street and sold to investors all over the world. The banks hired Clayton to do some forensics — to examine the mortgages that went into the securities and determine if they complied with some basic level of credit underwriting guidelines and “client risk tolerances,” as well as with state and local laws. If a loan met the underwriting “guidelines,” Clayton would rate the loan “Event 1”; other ratings meant that the loan did not meet the guidelines, with varying degrees of flaws.

According to Vicki Beal, a senior vice president at Clayton who testified at the Sacramento hearing, one of the main services Wall Street paid Clayton for was a detailed examination of the loans that deviate “from seller underwriting guidelines and client tolerances.”

This is where things got interesting. Clayton provided the inquiry commission with documents that summarized its findings for the six quarters between January 2006 and June 2007, when mortgage-underwriting standards were arguably at their worst and the housing bubble was inflating rapidly. Of the 911,039 mortgages Clayton examined for its Wall Street clients — a sample of about 10 percent of the total mortgages that the banks intended to package into securities — only 54 percent were found to meet the underwriting guidelines. Standards deteriorated over time, with only 47 percent of the mortgages Clayton examined meeting the guidelines by the second quarter of 2007.

So, did Wall Street throw all those mortgages back into the pond as being too risky for securities they were going to sell to clients? Of course not — many were packaged right into their product. There were degrees of nefariousness: Some Wall Street firms were better about including higher-quality mortgages in their mortgage-backed securities than others. For instance, at Goldman Sachs, 77 percent of the nearly 112,000 mortgages reviewed met the guidelines, while at Citigroup only 58 percent did. At Lehman Brothers, which later filed for bankruptcy, 74 percent of the mortgages sampled and then packaged up as securities met underwriting guidelines.

In fact, the banks probably weren’t disappointed at all by the shaky status of many of these loans: in part because they could use the information that some of the mortgages were rotten to get a discount from the mortgage originators on the price paid for the entire portfolio. The people who should have been concerned were the investors who bought the securities from the Wall Street firms. But the amazing revelation of the Sacramento hearing was that the investment banks did not pass this very valuable information on to their customers.

“Investors were not given sufficient information to make the decisions that they needed to make to see if they were going to buy these securities,” testified Kurt Eggert, a professor at Chapman University School of Law in Orange, Calif. “They should have been given loan-level detail for every pool for which securities were issued. Current loan-level detail, not what was true weeks ago or a month ago. Instead, they got vague, boilerplate language about ‘underwriting,’ and that there were ‘substantial exceptions,’ whatever that means. They should have gotten the due diligence reports that we just heard described. Those reports existed. The exceptions were described and defined. Why weren’t investors given that information which was in the hands of the people that were selling the securities? Why weren’t they given the underwriting reports by the originators who knew what exceptions were given and why?”

These are very good questions. And while we await the Financial Crisis Inquiry Commission’s answers, the good news is that the news media have begun to pick up on the outrageous behavior its hearing revealed. The Times’ Gretchen Morgenson reported on that Clayton Holdings had in fact offered to make its data available to the three ratings agencies that rated mortgage-backed securities, but that each rejected Clayton’s offer. It seems they feared that if they revealed the flaws in the underwriting of the mortgages, they would lose other business from the investment banks that put the mortgage-backed securities together.

On Monday, Eliot Spitzer, the former New York governor turned talk-show host, called the inquiry commission’s revelations “fraud, plain and simple,” and said there is “a basis without any question for the most rigorous examination” of why Wall Street failed to disclose this valuable information to investors. His guest on CNN’s “Parker Spitzer”show that night was Joshua Rosner, a managing director at Graham Fisher & Co., an independent research firm. Mr. Rosner agreed with Spitzer’s assessment and said, “This is what happens when the children are in charge.” On Wednesday, Felix Salmon, a business columnist at Reuters, wrote that “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.”

So far, not a soul on Wall Street has been found to be criminally liable for the practices that led to the financial crisis. But thanks, in part, to the Financial Crisis Inquiry Commission, we are getting closer than ever to the day when the culprits will pay for what they did.

UPDATE, Oct. 15, 4:00 p.m.: In a surprising turn of events, Paul Bossidy, Clayton’s chief executive, wrote this letter to the F.C.I.C. on September 30, a week after the hearing, disavowing Beal’s sworn testimony.

About the Commission

In the wake of the most significant financial crisis since the Great Depression, the President signed into law on May 20, 2009, the Fraud Enforcement and Recovery Act of 2009, creating the Financial Crisis Inquiry Commission. The Commission was established to "examine the causes, domestic and global, of the current financial and economic crisis in the United States."

The 10 members of the bi-partisan Commission, prominent private citizens with significant experience in banking, market regulation, taxation, finance, economics, housing, and consumer protection, were appointed by Congress on July 15, 2009. The Chair, Phil Angelides, and Vice Chair, Bill Thomas, were selected jointly by the House and Senate Majority and Minority Leadership.

The FCIC is charged with conducting a comprehensive examination of 22 specific and substantive areas of inquiry related to the financial crisis. These include:

* fraud and abuse in the financial sector, including fraud and abuse towards consumers in the mortgage sector;
* Federal and State financial regulators, including the extent to which they enforced, or failed to enforce statutory, regulatory, or supervisory requirements;
* the global imbalance of savings, international capital flows, and fiscal imbalances of various governments;
* monetary policy and the availability and terms of credit;
* accounting practices, including, mark-to-market and fair value rules, and treatment of off-balance sheet vehicles;
* tax treatment of financial products and investments;
* capital requirements and regulations on leverage and liquidity, including the capital structures of regulated and non-regulated financial entities;
* credit rating agencies in the financial system, including, reliance on credit ratings by financial institutions and Federal financial regulators, the use of credit ratings in financial regulation, and the use of credit ratings in the securitization markets;
* lending practices and securitization, including the originate-to-distribute model for extending credit and transferring risk;
* affiliations between insured depository institutions and securities, insurance, and other types of nonbanking companies;
* the concept that certain institutions are 'too-big-to-fail' and its impact on market expectations;
* corporate governance, including the impact of company conversions from partnerships to corporations;
* compensation structures;
* changes in compensation for employees of financial companies, as compared to compensation for others with similar skill sets in the labor market;
* the legal and regulatory structure of the United States housing market;
* derivatives and unregulated financial products and practices, including credit default swaps;
* short-selling;
* financial institution reliance on numerical models, including risk models and credit ratings;
* the legal and regulatory structure governing financial institutions, including the extent to which the
structure creates the opportunity for financial institutions to engage in regulatory arbitrage;
* the legal and regulatory structure governing investor and mortgagor protection;
* financial institutions and government-sponsored enterprises; and
* the quality of due diligence undertaken by financial institutions;

The Commission is called upon to examine the causes of major financial institutions which failed, or were likely to have failed, had they not received exceptional government assistance.

In its work, the Commission is authorized to hold hearings; issue subpoenas either for witness testimony or documents; and refer to the Attorney General or the appropriate state Attorney General any person who may have violated U.S. law in relation to the financial crisis.

A report of the Commission's findings is due to the Congress, President and, most importantly, the American people on December 15, 2010.