Thursday, August 02, 2007

In Which Due Diligence Is Discovered

by Tanta on 8/02/2007 09:06:00 AM

From Reuters, via IHT, "Wall Street often shelved damaging subprime reports":

WASHINGTON: 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 on much of the information to credit rating agencies or investors, according to some of those who prepared the reports. . . .

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

"In some cases we felt that we were potted plants," said Keith Johnson, president of Clayton Holdings, a large due-diligence firm based in Connecticut.
Yeah, well, Keith, I gave up potted-plantdom and took to blogging. It doesn't pay as well, but it's less frustrating.

Having been both in the third-party due diligence business as well as employed by mortgage originators on the sell side and mortgage conduits on the buy side, I'll confirm that yes, there's tons of information that falls under the general heading of "due diligence" that nobody paid any attention to. It isn't just the reports of outside firms like Clayton. Everybody in the chain has loan reviewers, Quality Control analysts, compliance officers, document custodians, and "new loan boarding" specialists at the servicing level whose job it is, day in and day out, to look at this stuff and report on problems in a very "granular" way. Quite often, when I was doing loan-level due diligence, I would have to use my sophisticated Sherlock Holmes-level razor-sharp mind to spot subtle, well-hidden clues of fraud, misrepresentation, or violation of underwriting guidelines.

At other times, I'd flip open the file to see, right on top, page after page of worksheets, printouts, and memos from everyone else who had handled the thing so far indicating some serious problems with it. Discovering what's wrong with these loans involved using the reading skills Miss Buttkicker taught me in the third grade. But the loans were still in the deal, even though three or four people before me had noticed something wrong.

This is the "repurchase" meltdown, folks. Having ignored their own people, the originators sold these things to Wall Street. Wall Street, having ignored the due diligence firms they hired to look at the stuff, went ahead and securitized it. When it started performing just like all the little potted plants said it would, more due diligence firms were hired--or rehired--to go through and find enough "misrepresentations" so that the loans could be shoved back to the originators. I'm guessing that the originators who are being punished the hardest with repurchase requests are the ones who were too stupid to pull all of those worksheets and printouts and memos from the files before passing them on.

As for all those sophisticated institutional investors who read those prospectuses and failed to notice that none of them includes a section on "Due Diligence Findings" for the pool? This little former aspidistra says "Hi!"