Tuesday, May 27, 2008

NPR on Mortgage Quality Control

by Tanta on 5/27/2008 04:49:00 PM

This is a sobering, if rather overstated, segment on mortgage loan sale due diligence and the pressures to accept even the most dubious of loans.

Tracy Warren is not surprised by the foreclosure crisis. She saw the roots of it firsthand every day. She worked for a quality control contractor that reviewed subprime loans for investment banks before they were sold off on Wall Street. . . .

Warren thinks her supervisors didn't want her to do her job. She says that when she would reject, or kick out, a loan, they usually would overrule her and approve it.

"The QC reviewer who reviewed our kicks would say, 'Well, I thought it had merit.' And it was like 'What?' Their credit score was below 580. And if it was an income verification, a lot of times they weren't making the income. And it was like, 'What kind of merit could you have determined?' And they were like, 'Oh, it's fine. Don't worry about it.' "

After a while, Warren says, her supervisors stopped telling her when she had been overruled.
I have no particular reason to question Ms. Warren's abilities or her take on the situation; I have no doubt that for any number of reasons marginal loans were pushed back into pools over the objections of perfectly competent auditors. I have also had experience with staff whose supervisors stopped telling them when they had been overruled, because . . . life is too short. I suspect I am not the only one who has had this experience. Whatever the merits of this story may be, this I think is an overstatement:
"This is a smoking gun," says Christopher Peterson, a law professor at the University of Utah who has been studying the subprime mess and meeting with regulators. "It suggests that auditors working for Wall Street investment bankers knew how preposterous these loans were, and that could mean Wall Street liability for aiding and abetting fraud."
Forgive me for being a shill for Wall Street, but this strikes me as silly. The investment banks, including Bear Stearns, published loan underwriting guidelines detailing what they would accept in mortgage pools, and everybody in the industry had a copy at the time. The things came right out and said that things like stated income for a wage earner were acceptable. Was Mr. Peterson calling that "preposterous" at the time? I was. And I never had to look at a single loan file.

What I suspect Ms. Warren is overlooking is, precisely, that the due diligence on those Bear Stearns pools--like every other pool for every other investor--was based on evaluating the individual loans' compliance with the specific guidelines agreed to for the pool. If the guidelines allowed utter stupidity, it isn't likely that the project supervisors would kick out a loan for displaying that particular kind of stupid. If there's something preposterous here, it was in plain sight in the prospectuses to every one of these loan deals. I am having a hard time with the idea that "the smoking gun" didn't show up until this week.

And then there is this part, which has made it all over the web today:
A bankruptcy examiner in the case of the collapsed subprime lender New Century recently released a 500-page report, and buried inside it is a pretty interesting detail. According to the report, some investment banks agreed to reject only 2.5 percent of the loans that New Century sent them to package up and sell to investors.

If that's true, it would be like saying no matter how many bad apples are in the barrel, only a tiny fraction of them will be rejected.

"It's amazing if any investment bank agreed to a maximum number of loans they would kick back for defects. That means that they were willing to accept junk. There's no other way to put it," says Kurt Eggert, a law professor at Chapman University.
Now, I actually plowed my way through that New Century report, and I have to say that there's a reason this claim was, um, "buried" therein. From page 135 of the report (Warning! Big Honkin' pdf that will take forever to download!):
[K]ickout data may not be a true indication of loan quality trends because New Century was able, particularly when the subprime market was strong and housing prices were rising, to negotiate understandings with certain loan purchasers to limit kickouts to a maximum rate, such as 2.5%. Flanagan [NEW's former head of loan sales] was explicit in stating to the Examiner that such understandings were reached. The Examiner was unable to establish corroboration for this statement. Nevertheless, such understandings may have limited kickouts, masking loan quality problems that existed but were not reported.
The report goes on to document that NEW's typical kickout rate was north of 5.00% and in many months much higher than that; except in securitization (not whole loan) deals where NEW retained residual credit risk, the kickout rate of 2.5% was, to quote the report, "probably more aspirational than real." The fact that no one could produce a contract or set of deal stips or e-mail or sticky note "corroborating" this claim suggests to me that it may have existed only in Mr. Flanagan's mind.

There are, of course, situations in the whole loan sale world in which people have perfectly respectable reasons to agree to limit "kickouts" up front. Occasionally pools are offered for bid with the stipulation of no kickouts: these are "as is" pools and it is expected that the price offered will reflect that. I have myself both offered and bid on no-exclusion loan pools. This is mostly an issue in the "scratch and dent" loan market, where one might have a mixed pool of pretty good and pretty botched up loans to sell. Allowing a buyer to "cherry pick" the deal just leaves you with all the botched up loans to sell separately, which is never anyone's preferred approach. Of course any buyer of loans can decline to bid on a no- or limited-kickout basis. Those who do bid on these deals tend to lower the bid price accordingly. The NEW report also documents the steady deterioration in NEW's profit margin on its whole-loan sales, and trying to get investors to take packages of loans with limited or no kickouts might explain some of that. My guess, from reading the report, is that while NEW might have thought it wanted a 2.5% kickout rate, it ended up accepting a much higher one because the price discount was more than it could face.

I am not trying to suggest that anyone is particularly innocent here. This all just has a sort of Captain Renault quality to it: we are shocked, shocked! that gambling went on in these casinos. The published underwriting guidelines that were available to everyone involved made explicit what was going on with these loans, and those guidelines were published with the deal prospectuses. Now we have a bunch of investors--including institutional ones with absolutely no excuse--wanting to grab hold of stories like Ms. Warren's about cruddy individual loans, as if the pool guidelines weren't themselves a big flaming hint that the loans were absurd.