Will Investigations of "Exception" Mortgages Go Anywhere?

In a front page story, the New York Times reports that state attorney general Andrew Cuomo has launched an investigation of whether “exception” mortgages, meaning ones that fell outside the lender’s guidelines but were nevertheless approved, were adequately disclosed when bundled into mortgage backed securities. Connecticut’s attorney general is working on a similar, cooperative review, and the SEC, doubtless not wanting to be outflanked, is also taking a look.

As the Times tells us:

An investigation into the mortgage crisis by New York State prosecutors is now focusing on whether Wall Street banks withheld crucial information about the risks posed by investments linked to subprime loans.

Reports commissioned by the banks raised red flags about high-risk loans known as exceptions, which failed to meet even the lax credit standards of subprime mortgage companies and the Wall Street firms. But the banks did not disclose the details of these reports to credit-rating agencies or investors.

The inquiry, which was opened last summer by New York’s attorney general, Andrew M. Cuomo, centers on how the banks bundled billions of dollars of exception loans and other subprime debt into complex mortgage investments, according to people with knowledge of the matter. Charges could be filed in coming weeks…..

As plunging home prices prompt talk of a recession, state prosecutors have zeroed in on the way investment banks handled exception loans. In recent years, lenders, with Wall Street’s blessing, routinely waived their own credit guidelines, and the exceptions often became the rule.

From everything the article says, the level of exception loans as a proportion of subprime lending overall is not yet known. However, based reports of mortgage fraud and the earlier writings of Tanta at Calculated Risk, I suspect this problem is not going to be the big smoking gun that the state AG’s hoped to find. The reason? Exception loans were supplanted to a considerable degree by a much better innovation, from the banks’ standpoint: the no-doc. Tanta in “What’s Really Wrong With Stated Income,” pointed out how the use of no/low doc loans shifted liability from the bank to the borrower, an outcome highly attractive to the lender. She contrasted the process for lending to a self-employed person who has trouble verifying income. Number 1 is via a stated income loan; Number 2 is the traditional “full doc” approach, in which the bank notes that the debt-to-income (DTI) is considerably above the bank’s guidelines but is warranted for various good reasons.

…..what happens if it actually goes bad?

Well, with Number 1, it’s “clearly” the borrower’s fault. He or she lied, and we can pursue a deficiency judgment or other measures with a clear conscience, because we were defrauded here. We can show the examiners and auditors how it’s just not our fault….

With Number 2? There is no way the lender can say it did not know the loan carried higher risk. Of course, higher-risk loans do fail from time to time, and no one has to engage in excessive brow-beating over it, if you believed that what you did when you originally made the loan was legit. If you’re thinking better of it now, at least with Number 2 you have an opportunity to see where your underwriting practice or assumptions about small business analysis went wrong….

What the stated income lenders are doing is getting themselves off the hook by encouraging borrowers to make misrepresentations. That is, they’re taking risky loans, but instead of doing so with eyes open and docs on the table, they’re putting their customers at risk of prosecution while producing aggregate data that appears to show that there is minimal risk in what they’re doing. This practice is not only unsafe and unsound, it’s contemptible.

The FBI has said that based on a study of 3 million loans, 30% to 70% of the early payment defaults in 2006 were “directly linked to mortgage application misrepresentation.” That to me is a very strong indication that a very high proportion of the loans that would have otherwise been exception loans were instead low or no doc.

In other words, it may be hard to make a case that investors were given a mistaken impression about the level of exception loans, i.e., if it was disclosed that the securities did include exception loans and the level was, say, under 10%, was the failure to be more specific a breach of securities laws? I’m no expert, but I’d hazard a guess not (note if they failed completely to mention that exception loans were in the deal, that’s a different kettle of fish).

The no/low-docs seem the more obvious target, given that they almost certainly accounted for a larger proportion of these instruments, but the fact that the AG’s aren’t going after them says disclosure may have been more complete.

What is sad about this whole effort to find perps is that there were bona fide cases of lender fraud, specifically when the lender or broker gave the borrower one set of terms verbally and had quite another in the documents at the closing, and those are just about certain never to be prosecuted successfully.

Although it is anecdotal, I have read and heard enough stories of the few borrowers who took courses and knew what to look for in the agreements finding discrepancies and having to insist they be corrected. What convinces me that these situations weren’t mere errors but were in fact institutional practice was the borrower was given incorrect (and of course more favorable to the bank) contracts not once. but three and as many as five times. It doesn’t take that many tries to correct an error if your intent is to fix it, and not hope to trip up a borrower who might be gullible enough to trust you on a later go-round.

But this type of fraud, no matter how pervasive, is just about impossible to prove. Unless the poor victim was lucky enough to have a witness or an odd bit of confirming documentation, it’s ‘he said versus she said.” And so a whole class of bad guys will get off scot-free.

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  1. newsman

    In the Household International case from several years ago, borrowers were told they would get an “equivalent rate” of six to seven percent. That’s because these were 18-year mortgages, as I recall, and the monthly payment on the principal was “equivalent” to the payment of a six to seven percent loan SPREAD OVER 30 YEARS. That meant their actual apr was more like 12 percent. This was not explained. Some people only figured this out when they had their taxes done–their tax preparer pointed it out to them.

    Fortunately for the borrowers, some of them did have “odd bits of confirming information” that the Household “loan officers” had given them in an unguarded moment. (btw–many or most of these people were not “subprime;” only their loans were.)

    Some borrowers got partial redress in the litigation that followed. One hfc local office manager who was fired for doing this sued the company and alleged she had been following orders. The company produced all kinds of documentation to show that this kind of behavior was frowned upon by headquarters.

    It appeared as though the company did, in fact, formally forbid its sales force to mislead borrowers. It also appeared that the sales force was goaded to make loans at an ever-accelerating pace, and if they did they were handsomely rewarded. Local and regional managers developed too-clever sales pitches involving things like “equivalent interest rates” to close more deals (which were also loaded down with hidden fees, insurance premiums etc.)

    I suspect one would find the same things in many of these suspect mortgage companies: a fine code of ethics on the wall, and ample financial incentives to break that code.

    The sales manager’s lawsuit was settled out of court.

  2. High Yield Harv

    Of they were not disclosed. None of the buyers of these securities knew nor cared what was in them. They were buying the highest AAA yields they could find and did no due diligence.

  3. newsman

    One thing is murky to me: how were these securities ultimately sold, and to whom? As I understand it, nobody was buying these things retail, from their local Edward Jones financial advisor. The customers were big shots, am I correct?

    Giving some of my own mutual funds more than my usual limited DD, I noticed one (Westcore Flexible Income) reporting some relatively small holdings in CDOs with very long names and VERY high interest rates(18 percent in some cases; I’m guessing junior tranches or something)–with footnotes revealing that in some cases these cdos were no longer performing as advertised.

    So when I discovered this fund a couple of years ago and bought it based on an online fund-screening tool for income funds, I was buying a little taste of these CDOs. No real harm done to me–the fund was not terribly vulnerable to these dodgy investments–its share price has declined, but not below the level of my original purchase, and i got the yields I was expecting.

  4. Anonymous

    These investigations continue to badger the lenders and banking community, while nothing may be proved in this case it may uncover other problems or point out new direction the AG might consider in the future. Jimmy Hoffa if alive today would tell you that having the gov’t constantly looking for wrong doing in your backyard is a bad sign.

  5. steve

    I’m sure the banks will point to their own losses as a defense (though in reality their losses stem from warehousing and inventory risk from when the music suddenly stopped).

    The CDO prospectuses I’ve read have disclaimers about collateral quality out the wazoo. Odd stuff for AAA paper…The banks will point to the rating agencies (which I believe crossed the line with their modeling input on many deals and became underwriters).

    Still, there may be liability to the banks if representations about due dilligence on the collateral were wrong or misleading…this would differ from broad generalizations about the high credit risk on the collateral. Did the percentage of loans tested per pool decline (I’ve heard it did), and were the testing criteria modified (I’ve heard they were).

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