Gretchen Morgenson had an excellent column in yesterday’s Times that gets at one of the core issues if criminal cases on Wall Street are ever to be brought for the financial crisis it fueled.
The large banks that provided money to mortgage originators during the mania hired outside analytics firms to conduct due diligence on the loans that Wall Street bought, bundled into securities and sold to investors.
These analysts looked for loans that failed to meet underwriting standards…
The analysts would take their findings back to the Wall Street firms packaging the securities; the reports were not made available to investors.
In 2006-07, amid the mortgage craze, more loans didn’t meet the criteria. But instead of requiring lenders to replace these funky mortgages with proper loans, Wall Street firms kept funneling the junk into securities and selling them to investors, investigators have found.
In other words, Wall Street knew it was bundling bad (and potentially fraudulent) loans into securities and selling them off for a tidy profit. To make it worse, Morgenson reports they hired these analytics firms to find the bad loans so they could pay less for them. Wall Street, of course, didn’t pass on the savings to its customers, so it got higher profit margins on bad loans.
We knew the incentive system was all screwed up on Wall Street. The originate and distribute model, the heads-I-win/tails-I-don’t-lose pay model,
But if these investigations pan out, this one would be the most blatantly unethical—and, hopefully, illegal—of them all.
I say “hopefully” because Morgenson reports these securitization disclosures (which ran to hundreds of pages, of course) said “in legalese, that the deals might contain ‘underwriting exceptions’ and those exceptions could be “material.”
The thing about all this is it’s nothing new. The Times wrote about Wall Street looking the other way on subprime lending shenanigans it financed way back in 2000, in a fantastic story by Diana Henriques and Lowell Bergman where they wrote this:
The early waves of scandal from the subprime industry a decade ago prompted Congress in 1994 to adopt legislation requiring greater disclosure by high-cost lenders, but federal action to enforce those laws has been rare. Indeed, the Federal Trade Commission filed the first disciplinary cases under the 1994 law just last summer.
And yet none of these legal problems seems to shake Wall Street’s faith in First Alliance or most of the other large subprime lenders that have been the targets of consumer advocates’ complaints. To be sure, the high-yield mortgage market grew a bit jittery in late 1998, after revelations of some subprime lenders’ questionable accounting practices. But last year, there were more than 200 separate deals totaling more than $75 billion — less than in 1998 but more than in any other previous year.
Michael Hudson wrote about it for The Wall Street Journal in the summer of 2007 in his great piece “How Wall Street Stoked the Mortgage Meltdown.” Here’s a nice quote from that, in testimony to Congress, no less:
Lehman, one of Wall Street’s biggest players in the subprime boom, says it has gone to great lengths to screen loans for fraud and vet the lenders it works with. “No financial institution would knowingly want to make or securitize a loan that it expected would later go into default,” David Sherr, Lehman’s head of securitized products, told Mr. Menendez and other senators. “Rather, the success of mortgage-backed securities as an investment vehicle depends upon the expectation that homeowners generally will make their monthly payments, since those payments form the basis for the cash flows to bondholders.”
Recall, too, that liability for their securitized products was behind the freakout over Georgia’s anti-predatory-lending laws, which the Bush administration nullified in 2003 at the behest of the banks. Here’s Audit Inspector General Dean Starkman on that:
In 2002, Georgia passed an anti-predatory lending law that had all the usual provisions—it forbade deceptive practices in the disclosure of basic terms, curbed pre-payment penalties that kept borrowers from refinancing or selling their homes, banned usurious interest, etc.—but it also had a twist: it extended liability for violation of the new law to any player in the lending chain, including Wall Street houses that bundled the loans into securities and pension funds that bought them, and left potential damages open-ended.
One can only wonder what might have happened if those reselling mortgages had known they would be liable for how the mortgages were created.
It’s also worth remembering that most of these Wall Street firms had their own in-house subprime operations. They owned them, controlled them, and profited from them. Perhaps that’s one way around the legalistic ass-covering in the securities offerings documents. Dean summed a lot of this stuff up in his “Boiler Room” cover story in 2008:
Indeed, it is surprising today to remember that most of the big Wall Street firms, to skip the middleman and so desperate for new loans to turn over, bought and expanded their own retail subprime lending operations as the boom heated: Lehman had bnc Mortgage LLC; Merrill Lynch had First Franklin; Deutsche Bank bought Chapel Funding; and so on. Bear Stearns bought Encore Credit Corp. as late as February 2007, unwinding it a few months later.
How much of this went on at the Wall Street-owned shops?
There are lots of bodies still buried here, you can bet on that.
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 firstname.lastname@example.org. Follow him on Twitter at @ryanchittum.