A Critical Witness in the Wall Street Sausage Factory

Banks used Clayton's quality-assurance info to make more money, investors be damned

Chalk this one up to things I’m not smart enough to understand: Why isn’t this pure-D fraud and why hasn’t someone paid for it?

The New York Times’s Gretchen Morgenson reports today that Clayton Holdings, which ought to be a linchpin in any case against Wall Street, told credit raters that the loans they were rating were misleading.

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?’ ” 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.

In the High Bubble era, Clayton reviewed nearly a million home loans that Wall Street wanted to package into securities. It found that a stunning 46 percent of them did not meet underwriting standards the banks claimed they used. Worse (emphasis mine):

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.

What’s the lawyerly excuse for that one?

Goldman Sachs smarmily tells Morgenson that its figures, which were a bit better than the average—but still terrible—show that “the firm had done a better job than its peers.” God bless her—Morgenson twists the knife on that one:

Throughout this period, Goldman Sachs was also betting against the mortgage market for its own account, according to documents provided to government investigators.

The Huffington Post’s Shahien Nasiripour, who as far as I can tell was the first person in the press to report on last week’s testimony to the Financial Crisis Inquiry Commission (Morgenson appears to be just the second), gets a good quote on that:

“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…

“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.”

Rosner is referring to the fact that Wall Street used the information provided by Clayton to squeeze lenders on the price they paid for their loans. But Wall Street didn’t disclose the info it had to investors and it didn’t lower prices accordingly. Rather than use the Clayton info to inform its clients, Wall Street, including Goldman Sachs, Deutsche Bank, Citigroup, and Morgan Stanley, used this to make more money off them. Talk about information asymmetry.

It’s worth noting that the Clayton angle has been out there for two-and-a-half years—it’s no new story. Andrew Cuomo zeroed in on Clayton back then. But it’s taken this long for this information to come out.

Morgenson has been on this scandal for a while. Check her June column for more on this:

But some on Wall Street went further than simply peddling loans they knew were bad, according to the people briefed on some investigators’ findings. They say the firms used these so-called scratch-and-dent loans to increase their profits in the securitization process.

When due-diligence reports turned up large numbers of defective loans — known as exceptions — the banks used this information to negotiate a lower price on the mortgages they bought from the original lenders.

So, instead of paying 99 cents on the dollar for the problem loans, the firm would force the lender to accept 97 cents or perhaps less. But the firm would still sell the mortgage pool to investors at 102 cents or higher, as was typical on high-quality loan pools.

And nobody’s gone to jail for it or been arrested.

The question is whether the small-print legalese that Wall Street made sure to bury in its thousand-page prospectuses is enough to cover its rear end. The answer ought to be a resounding no.

The Clayton story is critical because they were right in the assembly line of the sausage factory and they saw how bad the meat was. They told them, but no one on the sell side wanted to hear it. Wall Street and the raters both knew and they didn’t disclose it. And all of us are paying the consequences now.

Good for Morgenson and Nasiripour for reporting on this new info, which shows the crookedness in a new light. Boo to the rest of the press for not.

Get to it.

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Ryan Chittum is a former Wall Street Journal reporter, and deputy editor of The Audit, CJR's business section. If you see notable business journalism, give him a heads-up at rc2538@columbia.edu. Follow him on Twitter at @ryanchittum.