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Rating Agencies, The Subprime Blame Game, and Fishy FCIC Testimony

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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.

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17 comments

  1. I know

    What is Dixie Lee doing these days with FCIC .. I assume she’s under table where she belongs — versus … oh never mind.

  2. anon

    I think the legal line of attack is that those who sold the MBS failed to comply with the underwriting and documentation standards described in their offerings. Plaintiffs might also go after other statements or omissions in the offering docs.

    http://www.scribd.com/doc/34161218/Mortgage-Investors-Suing-for-MBS-FRAUD-is-Your-Trust-Named

    From HuffPo story: “If issuers had been scrutinizing all the collateral in a security and only putting in loans that met actual underwriting and documentation requirements, a lot of these deals wouldn’t have gotten done,” said Cecala. But as a practical matter that didn’t happen. Most of the loans that were originated got thrown in securities one way or another. . . . Johnson told the crisis panel that he thought the firm’s findings should have been disclosed to investors during this period. . . . The firm’s findings could have been “material”

    If a statement or omission (aka lie) is not material, there is no cause of action for fraud or misrepresentation. If (1)it is material, (2) investors relied on that lie, and (3)investors lost money because of it, they get the court’s blessing to fight over the charred remains, their lawyers get to collect fees, and the banks get to rinse and repeat with new products and offerings.

    This current system encourages fragmentation. Whether you’re BP or the banksters (or one of the companies they hire), it’s better to be able to deny responsibility and point fingers when one’s shoddy practices blow up. It’s much harder to regulate such a system (even if the regulators had been doing their job). It’s also harder to recover damages via lawsuits (more parties mean more time and expense, increase uncertainties, etc.). Lawsuits are a bad method of recovering damages or regulating undesirable behavior, but they seem to be all we have now.

    Government is similarly fragmented; it won’t/can’t effectively monitor the industries it’s supposed to regulate, help the victims, or even work together to get the the bottom of the problems in the financial system (or, e.g, the health care system, the environment). This was FCIC’s last hearing. They won’t dig any deeper. How convenient since contributions to the pols depend on the profits of the new Robber Barons.

    Thanks for your many stories on this.

    1. Yves Smith Post author

      As indicated in the post, the statue of limitations has passed on reps (representations) and warranties in the offering docs. And reps and warranties claims are hard to prove and not worth much, legally. You’d have to go through the pool on a loan-level basis and prove the defaults resulted from bad underwriting as opposed to other factors (borrower divorce, losing his job, having a medical emergency, misrepresenting income).

      Even if you could pursue that sort of case now, they are costly and don’t yield much.

      1. anon

        I agree about the problems with litigation (and am not disagreeing about the problems re: the SoL). I said here and in an earlier comment about this yesterday that litigation is expensive, time-consuming, and uncertain (particularly in cases like these where there are multiple parties) and that it’s a bad method of compensating victims(e.g., protecting investors or consumers) or regulating behavior. I’m not sure where the point(s) of disagreement are on this issue.

        My reply was more in reference to “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”. It sounded as if you were looking for possible explanations as to why the findings of Clayton Holdings might be relevant to lawsuits (apart from the SoL problem).

        If investors are suing based on failure to comply with the underwriting or documentation standards described in the banks’ offerings, the information provided by Clayton Holdings potentially seems quite relevant (apart from the SoL problem). If that’s the theory the banks would not have needed to make warranties or reps about the results of the diligence or said that everything was fine with the loans (though plaintiffs’ cases would be strengthened if they made those reps).

      2. anon

        Just to clarify, I’m not a litigator and don’t know which SoL might apply to the actions investors might bring. An action under section 10(b) has a SoL that ends the earlier of five years after the fraud or two years after plaintiffs discover (or should have discovered) the fraud. (The Supreme Court ruled on this on April 27, 2010 in Merck & Co., Inc. v. Reynolds, 559 US ____).

        http://www.law.cornell.edu/supct/html/08-905.ZC1.html
        http://www.lexology.com/library/detail.aspx?g=28cea128-b6d5-4525-a32a-05ba8b04375d

        However, these actions must prove an intent to defraud or deceive.

        http://www.thecorporatecounsel.net/Blog/2010/04/the-secs-porn-story-my.html.

        http://www.lexology.com/library/detail.aspx?g=f6402566-4c62-48c0-99c0-24ce31df1fc1

        http://www.jdsupra.com/post/documentViewer.aspx?fid=81fde52c-033d-46c4-8080-0ca1dfb4251e

        The SoL for other actions (e.g., actions under the Blue Skies laws of various states as well as common law or equitable actions under state law) varies.

        http://www.dwyercollora.com/law-articles/securities/statute-of-limitations-2009.aspx

        Since this is not my area of expertise, I assume that you’re correct about which SoL applies to these actions, although the three year rule may have been the one under Lampf, Pleva, Lipkind, Prupis & Petigrow v. Gilbertson (US Supreme Court, 501 U.S. 350 (1991)) that was changed by Sarbox and Merck.

      3. anon

        I tried to post this before but it didn’t show up. Apologies if there’s a double post.

        Just to clarify, I’m not a litigator and don’t know which SoL might apply to the actions investors might bring. An action under section 10(b) has a SoL that ends the earlier of five years after the fraud or two years after plaintiffs discover (or should have discovered) the fraud. (The Supreme Court ruled on this on April 27, 2010 in Merck & Co., Inc. v. Reynolds, 559 US ____).

        http://www.law.cornell.edu/supct/html/08-905.ZC1.html
        http://www.lexology.com/library/detail.aspx?g=28cea128-b6d5-4525-a32a-05ba8b04375d

        However, these actions must prove an intent to defraud or deceive.

        http://www.thecorporatecounsel.net/Blog/2010/04/the-secs-porn-story-my.html.

        http://www.lexology.com/library/detail.aspx?g=f6402566-4c62-48c0-99c0-24ce31df1fc1

        http://www.jdsupra.com/post/documentViewer.aspx?fid=81fde52c-033d-46c4-8080-0ca1dfb4251e

        The SoL for other actions (e.g., actions under the Blue Skies laws of various states as well as common law or equitable actions under state law) varies.

        http://www.dwyercollora.com/law-articles/securities/statute-of-limitations-2009.aspx

        Since this is not my area of expertise, I assume that you’re correct about which SoL applies to these actions, although the three year rule you refer to may have been the one under Lampf, Pleva, Lipkind, Prupis & Petigrow v. Gilbertson (US Supreme Court, 501 U.S. 350 (1991)) that was changed by Sarbox and Merck.

  3. Diogenes

    While I don’t mean to suggest that Keith Johnson’s reticence is any way acceptable, I would like to share a couple of experiences that I had with Moody’s which convinced me that the rating agencies, to a large extent, function in a parallel universe divorced from reality.

    At the beginning of this past decade I structured several issues of municipal asset backed securities: these were tax exempt bonds secured by future payment streams due to the states under the Master Settlement Agreement with the major American tobacco producers (known colloquially as “tobacco bonds”). A large part of my analytical function involved simulating various stressed cash flows in a dynamic model that provided for the flexible (i.e., revenue constrained) repayment of the bonds. The purpose of this exercise was to demonstrate the resilience of the bond issue’s structure. Each of the three rating agencies– Moody’s, S&P and Fitch– provided very clear guidelines for how to stress the cash flows in order to prove that the bonds would still be able to paid off within their repayment parameters.

    Our goal was to achieve a single A rating from each of the three rating agencies. This was the highest they offered for this kind of security and we had to jump through various hoops to show that a proposed structure would meet each agency’s stress test requirements for this rating.

    Moody’s was typically the most complicated in requiring four Monte Carlo simulations of 2,000 iterations each using various random factors. Having never done this before I didn’t realize that “in the real world” folks use something called a “static seed” in order to insure that each time they run the model, the same random numbers get generated. The result of this oversight was that on the fourth set of 2,000 iterations on the day we actually priced an issue of bonds, one test out of 2,000 failed. Moody’s was adamant that the single A rating would not be provided based on this one single failure. My savvy colleague suggested we simply run the test again. We did and of course we passed and Moody’s agreed to accept these revised results. (I subsequently computed the probability of having one failure in the fourth set of iterations at about 1 in 20.) But what struck me was that nobody at Moody’s had any idea that in statistics you often throw out the high and the low values, particularly when you have a very large sample. Theirs was a rigid and absolute rule: pass or fail.

    Taking advantage of these rules allowed us to realize that we could produce substantially more bond proceeds for our clients by dropping Moody’s and using only S&P and Fitch. On a somewhat smaller issue, we decided to do exactly that. It ended up that this bond issue was about 8% larger than it would have been if we had gotten a single A rating from Moody’s as well. More importantly, there was no penalty in the bond pricing despite the lack of a Moody’s rating. What do you suppose Moody’s reaction to this was? Within days they had adjusted their criteria for an A rating downward sufficiently that there was no longer a compelling reason not to pay them a fee when it came time to structure our next issue of bonds.

    There’s one other point that always bothered me which bears mentioning: No one at any of the three rating agencies had any capacity that I was aware of either to verify or replicate these cash flows. At the time of structuring each of my bond deals I hired an independent accounting firm that was specialized in these arcane rules to verify that all of my numbers that were delivered to the rating agencies were correct. But I couldn’t escape the fact that the rating agencies lacked any means for a dynamic revaluation of the cash flows in the future after adjusting for historical cash receipts and bond payments. Given that not all single A tobacco bonds were alike– in fact there was quite a bit of diversity– this made it effectively impossible to adjust the ratings going forward other than in a very crude, back of the envelope fashion. (Of course, as near I could tell, the ratings fees were based solely on the upfront rating, not the ongoing rating maintenance.)

  4. martingaler

    The agencies would have passed on this because of reliance on reps and warrants from the underwriter. This was necessary to streamline the process when reviewing so many deals/loans. Why go through extra cost and work when you could just point the finger at somebody else and point out that they vouched for the validity of the data you were given?

    Kickouts were done for a variety of reasons and I without more detail it is hard to say how insidious bank’s inactions were. A loan with a suspicious appraisal could be dropped out of a deal, be reappraised and securitized without any adjustment to the loan other than of course LTV etc. Same with stale ficos that perhaps pushed the loan out of the required buckets. No loans that were categorized as predatory were allowed into private label deals and that was always included in the r&w.

  5. RK

    The most intelligent thing I have heard said about the NRSRA’s (Moodys, S&P,
    Fitch) which were granted monopoly status in 1975, came in a comment on
    Zero Hedge. The author stated, ” The NRSRA”s should be thought of as an arm
    of the national security apparatus. They exist to bestow undeserved credit on
    favored institutions, and conversely to punish companies or countries which need to be brought down. They can create instant profits or losses by influencing CDS prices,and corporate or sovereign debt rates. They are a financial weapon system of the highest magnitude, and like other weapon systems, the 2 dominant practitioners are monopolies owned/maintained by
    the U.S. Government

  6. john c. halasz

    The first signs of the crisis were in Dec. 2006, when the subprime lenders began dropping like flies. I’d assumed all along though, that the subprime lending platforms with “wholesale lines of credit” were just cut-outs with “plausible deniability” for the Wall. St. I-banks, at least until the started to swallow their own Kool-Aid and bought some of them up their own damn selves. Is my memory or analysis wrong?

  7. Glen

    Thanks for this post.

    why we have not forced all the ratings agencies into BK to force a change in leadership and perhaps a chance to regain some minor pretence at honesty is beyond me. One has to assume that the ratings agencies and all who interact with them are a bunch of lying cheaters with an axe to grind at this point.

  8. Alan Wynnewood

    The statement “Clayton Holdings, which did something colloquially called underwriting in the subprime space…” strikes as inaccurate. Clayton did contract due diligence, assessing the quality of loan files. The banks did the underwriting. It seemed clear in the testimony that Clayton did its job, did not lie about their findings, which makes them not at all culpable in the way the ratings agencies and banks are. I also read the early releases reporting testimony givin to AG Andrew Cuomo, and the current testimony accords with that. I see Clayton Holdings as the good guy among the three players.

    1. Yves Smith Post author

      Alan,

      The colloquial term in the space for what Clayton did WAS underwriting, you are being disingenuous to claim otherwise, and it was also understood to mean vetting of a sample of the deals, as opposed to securities underwriting. Rating agencies were understood to look more favorably upon underwritten deals.

  9. liberal

    But they didn’t take risk, as that term implies; instead, they sampled the mortgages in pools due to be securitized and provided reports…

    What I don’t get about the bubble is this: Why the f*** wasn’t the Fed doing this?

    Dean Baker et al. correctly saw the bubble simply based on the fact that prices couldn’t be supported by incomes. But in terms of all the fraudulent mortgages, did the Fed ever think of statistically sampling mortgages to keep track of what’s going on?

    What a bunch of incompetent morons.

  10. cheap cigarette cartons

    Why in the world do people want to smoke? I have never figured that one out. My dad always called it a a cancer stick instead of a cigarette ha. When I see somebody smoking it just makes me sick to think of what they’re doing to themselves. Oh well, you can’t win them all. That’s my rant for the day haha.

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