They could see the meltdown coming. (LA Times)
Freelance financial watchdogs who examined the paperwork on sub-prime home loans being sold to Wall Street had an inside view of the boom in easy-money lending this decade. The reviewers say they raised plenty of red flags about flaws so serious that mortgages should have been rejected outright — such as borrowers’ incomes that seemed inflated or documents that looked fake — but the problems were glossed over, ignored or stricken from reports.
As time passed, Clayton and Bohan executives said, Wall Street firms and their investor customers accepted increasing levels of default and fraud in sub-prime loans as they grew to trust software designed to offset those risks by charging higher interest rates, extra fees and penalties for paying off mortgages early.
As Wall Street grew more comfortable, it demanded less of the review process. Early in the decade, a securities firm might have asked Clayton to review 25% to 40% of the sub-prime loans in a pool, compared with typically 10% in 2006, although the requirements varied, Filipps said.
By contrast, loan buyers who kept the mortgages as an investment instead of packaging them into securities would have 50% to 100% of the loans examined, Bohan President Mark Hughes said.
The loan reviewers’ role was just one of several safeguards — including home appraisals, lending standards and ratings on mortgage-backed bonds — that were built into the country’s complex mortgage-financing system. But in the chain of brokers, lenders and investment banks that transformed mortgages into securities sold worldwide, no one seemed to care about loans that looked bad from the start. Yet profit abounded — until defaults spawned hundreds of billions of dollars in losses on mortgage-backed securities.
“The investors were paying us big money to filter this business,” said Cesar P. Valenz, one of the loan checkers. “It’s like with water. If you don’t filter it, it’s dangerous. And it didn’t get filtered.”
As foreclosures mount and home prices skid, the loan review function, known as due diligence, is gaining attention. The FBI is conducting more than a dozen probes into whether companies along the financing chain concealed problems with mortgages. And a presidential working group has blamed the sub-prime debacle in part on a lack of diligence by investment banks, rating firms and mortgage-bond buyers.
“Although market participants had economic incentives to conduct due diligence,” the group said in a policy statement, “the steps they took were insufficient.” To prevent mortgage crises, the group recommended increased disclosure of “the level and scope of due diligence performed” on home loans underlying the securities.