Wall Street often shelved damaging subprime reports

WASHINGTON (Reuters) - Investment banks that bundle and sell home mortgages often commissioned reports showing growing risks in subprime loans to less creditworthy borrowers but did not pass much of the information to credit rating agencies or investors, Wall Street sources said.

A foreclosed house for sale is pictured in the Green Valley Ranch neighborhood in Denver, Colorado, July 26, 2007. The Green Valley area in northeast Denver is one of the areas hardest hit with foreclosures. REUTERS/Rick Wilking

The mortgage consultants, known as “due-diligence firms”, were hired by investment banks to make sure blocks of mortgages conform to the mortgage seller’s own standards. The studies provided a first glimpse of loan quality for ratings agencies and investors who do not normally see the full reports.

As the U.S. housing boom reached its crescendo in 2006 and investors showed a strong appetite for mortgages, lenders relaxed their underwriting standards, and millions of borrowers with poor credit records were able to obtain subprime mortgages as a result.

Default rates on many of those subprime mortgages are now rising, some borrowers face foreclosure on their homes, and investors in the mortgages face losses.

"If all the information about these investments was properly disclosed, our client would have made different decisions...and, specifically, not bought these investments," said Dale Ledbetter, a Florida attorney suing Credit Suisse Group CSGN.VX on behalf of an insurer that lost money on mortgage bond investments.

Now some of the firms that prepared those damaging due-diligence reports say their work should be turned over to investors so they understand the underlying assets better.

“I am sure there is a value in those reports,” said Joe Andrea, a partner with Opus Capital Markets Consultants of Chicago but due diligence firms like his are not empowered to release the reports, he added.

While subprime mortgage security prospectuses warned about the perils of such loans in recent years, they did not enumerate the findings of due diligence reports.

Ledbetter’s suit, filed on behalf of Bankers Life Insurance Co., claims that the investment bank failed to perform or disclose proper due diligence on the mortgages it sold to investors. One of those investments was downgraded five times from early 2005 to late 2006.

Credit-Suisse has filed a motion to dismiss the case said a spokesman, Bruce Corwin.

Several due diligence firm executives said that they reported a slide in loan quality to their investment bank clients but that those mortgages were still bought up and passed on to investors.

"In some cases we felt that we were potted plants," said Keith Johnson, president of Clayton Holdings, Inc. CLAY.O, a large due-diligence firm based in Connecticut.

During the housing frenzy, many Wall Street firms appear to have overlooked due diligence warnings about problem mortgages in order to keep up with the market, due diligence executives said.

"Twelve months ago there was a lot of competition for newly originated loans and the buyer who would purchase more of the (loan) pool was more likely to win that bid. The choices sometimes were business choices," said Bruce Watterson, the president of Watterson Prime LLC of Bellevue, Washington. Watterson Prime is owned by Fidelity National Information Service Inc. FIS.N, Watterson said.


As lenders relaxed their underwriting standards during the recent housing boom, Wall Street firms followed suit by easing the guidelines that due diligence companies followed, several executives said.

“We got away from where we were in the late 90s,” Clayton’s Johnson said, referring to a time that due diligence firms were expected to give full-throated opinions on the safety of mortgage loans.

In the last two weeks, major ratings agencies have downgraded subprime mortgage investments and said they expect more such loans to borrowers with shaky credit will fail.

Moody’s customarily receives summaries of due-diligence studies but not the full reports which might have helped the ratings agency evaluate now-troubled mortgage securities, said Nicolas Weill, chief credit officer for Moody’s asset finance team.

“It’s difficult to know what would have happened if we had gotten that information,” he said.

Weill said Moody’s would have welcomed due diligence reports if they had helped them learn something new about the mortgages.

Standard & Poor’s relies on lenders and mortgage securitizers to conduct their own due-diligence and does not have access to such reports “generally speaking,” said spokesman Christopher Atkins.

Lehman Brothers Holdings LEH.N and Bear Stearns Cos BSC.N, two major underwriters of mortgage bonds, declined to comment on how they handle due diligence reports.

However, while due-diligence reports may contain facts that ratings agencies seek, they might not be interested in seeing the reports, said Josh Rosner, a housing analyst with independent research firm Graham Fisher & Co. in New York.

“The International Organization of Securities Commissions code of conduct requires that they use all available information in their ratings process,” he said. “To require them to look at due diligence would move them to another level of responsibility.”

Mortgage securitizers relaxed their due-diligence tests during the housing boom just as lenders loosened their loan standards in that time but all sectors of the market are retrenching now, Clayton’s Johnson said.

“We are in a correction process right now,” he said.

Deutsche Bank DBKGn.DE and Morgan Stanley MS.N accounted for nearly a quarter of Clayton revenue in 2006, according to the company annual report. Both firms declined to comment on what they do with due-diligence reports.