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Monday, September 27, 2010

"Raters Ignored Proof of Unsafe Loans"

This sounds pretty fishy:

Raters Ignored Proof of Unsafe Loans, Panel Is Told, by Gretchen Morgenstern, NY Times: As the mortgage market grew frothy in 2006 ... 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. ...

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.

Mr. Johnson said he took this data to officials at Standard & Poor’s, Fitch Ratings and to the executive team at Moody’s Investors Service. “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?’ ” ... 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.” ...

Before assembling mortgage pools, brokerage firms hired independent analytical companies like Clayton to sample loans and flag any that were problematic. Clayton was one of two large due diligence companies that watched for loans that did not meet specifications like geographic diversity and the loan-to-value ratios..., as well as the credit scores and incomes of borrowers. ...

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 ... would have been for lenders ... 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... To be sure, the prospectuses ... 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. ...

    Posted by on Monday, September 27, 2010 at 12:24 AM in Economics, Financial System | Permalink  Comments (7)


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