Let’s be clear: there are plenty of bad guys, chumps, and people who should have known better in the subprime mess. High on the list for well deserved scorn are the ratings agencies, who still retain a central role in structured credit. Well, now, come to think of it, the mortgage securities business is now pretty much a subsidiary of the US government. Think the failure to reform ratings agencies and the failure of the private label mortgage securitization market to revive are unrelated events?
We’ve long critics of ratings agencies. But given what easy and obvious targets they are, one ought to be mindful of whether people who join in on the attacks on them might be engaging in more than a bit of artful misdirection.
There has been a fair bit of excited press coverage (see here and here) about a FCIC session last week. On deck was Keith Johnson, head of a firm called Clayton Holdings, which did something colloquially called underwriting in the subprime space. But they didn’t take risk, as that term implies; instead, they sampled the mortgages in pools due to be securitized and provided reports to their clients on what they found. In the case of subprime deals, the clients were investment banks putting the transactions together.
The juicy disclosure is that Johnson claims that half the mortgages his firm sampled in 2006 and 2007 didn’t meet the standards the banks had set. But revealingly, he shifts the focus away from his clients, the investment banks, and his relationship with them, to suggest the ratings agencies were at fault. Per the New York Times:
“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.
“If any one of them would have adopted it,” he testified, “they would have lost market share.”
Earth to base. Clayton already HAS a business relationship with the investment banks at this point. He implies now, in 2010, that he saw something amiss. So where does he go? Not to his clients, heavens no, if he clears his throat and asks why they are still buying crappy loans in the face of his reports, or maybe they ought to disclose them more clearly, he might jeopardize his meal ticket. Does he go to the SEC or the media to blow the whistle on subprime? Apparently not.
Instead, he cooked up an idea of how this little disparity might represent a new business opportunity and calls the ratings agencies. And one has to wonder how late in the game he made this move. Note he does not mention 2005, and by all accounts, the sharp fall in origination quality started in 2005. He didn’t call on Moodys till 2007 (suprime pretty much stopped cold in May 2007) and one wonders how late in 2006 he decided to cast about.
One also has to wonder why he hasn’t come forward on behalf of investors. The statute of limitations on securities underwritings is effectively three years. As noted, subprime was over as of May 2007. So Johnson testified after any investors might make use of this information (admittedly, as we discuss below, there are reasons why claiming the disclosure were inadequate probably isn’t a great line of attack).
Clayton was the largest provider of mortgage loan diligence in the market. The banks hired Clayton before they purchased or securitized subprime mortgage loans to confirm the quality and credit of the mortgage loans under consideration. In many ways, Clayton performed a role similar to that of a rating agency. Just about every subprime mortgage deal that was issued during the big bubble years had 10-20% of the loans reviewed for credit quality by an independent outside firm, and Clayton was the biggest player. Despite all of this diligence and review, just about every subprime mortgage deal issued during this period blew up. Seems like the diligence didn’t help all that much. This could due to a number of things, including the possibility that the underwriting was just fine and the loans blew up for other reasons – though that sure seems unlikely.
From what I can tell, no one heard about Clayton’s role in the crisis until January 2008, when the New York Attorney General’s office announced that Clayton had been granted immunity and would be providing information to the prosecutors on Wall Street’s bad practices in subprime land. Why on earth did Clayton need immunity? And from what?
Here we are in 2010 and still no news on how Andrew Cuomo has been using all of this valuable information from Clayton. Not to worry, however, because Clayton has still managed to make themselves useful: the Massachusetts AG recently announced a settlement with Morgan Stanley about its bad practices with former subprime lender New Century.
Clayton provided information about their former client, Morgan Stanley, which showed that Morgan Stanley knew, as a result of Clayton’s diligence, that New Century’s loans had all sorts of problems, including bad appraisals, predatory loans and a high concentration of stated income loans. But Morgan decided to buy the loans anyway and securitze them and sell them to Massachusetts pension funds.
Except that’s not the whole story. At first Morgan used this information to kick out the bad loans New Century tried to sell them, which would appear to be a sign that the process was working just fine. However, New Century was experiencing a similar loan rejection problem across Wall Street and was soon teetering on the brink of bankruptcy. Morgan, having extended New Century a hefty line of credit, agreed to buy more loans from New Century, at distressed prices, in an attempt to keep the lender afloat (For those who were watching, New Century’s bankruptcy in March 2007 marked the real trigger point for the financial crisis). Those desperation loans of New Century ended up in several Morgan Stanley MBS, which ended up in the Mass. pension funds. Since the whole New Century relationship looked quite ugly, it is no wonder that Morgan Stanley settled with the Attorney General.
Johnson has generously offered, presumably thanks to his grant of immunity, that both the rating agencies and the banks were on notice of the bad results of his former company’s diligence results. But it isn’t clear what this really means. The banks hired Clayton and others for their own diligence but they didn’t make any representations or warranties about the results of the diligence and that everything was fine with the loans, nor does Mr. Johnson appear to believe such a charge. The Times suggests that the banks did use the diligence results to kick back some loans and reduce the sales price for other loans, a savings the Times believes should have been passed along to the investors in the MBS backed by the weak loans. However, the value of MBS collateral was not set by the banks or based on the market price of the loans, but rather was determined by the rating agencies, the credit enhancement levels and the price investors were willing to pay for the bonds. The rating agency models all assumed that newly originated subprime loans would have a value equal to the loan balance, not some market value calculation.
The flood of articles about the Clayton results certainly must, we are told, have broad implications, about the failure of the rating agencies, the poor warehouse and mortgage lending practices of banks like Morgan Stanley, and the potential for future litigation against lenders and banks. It is of some historical interest to know that someone like Johnson was aware that thousands of mortgage loans were being originated without any regard to lending guidelines, though it certainly would have been nice if investors had been clued in back in 2005 and 2006 when they were considering buying the MBS, rather than in 2010, when their attorneys are trying to figure out what to do with the investor’s charred remnants. However, since the banks made no representations about the Clayton results, the rating agencies didn’t understand the significance of Clayton’s results (or didn’t want to pay as much as Clayton was charging), and most of the lenders who made the bad loans have long since left the planet, it is hard to know exactly what to do with these revelations.