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Saturday, January 12, 2008

Cuomo: Due Diligence and Disclosure

by Tanta on 1/12/2008 09:33:00 AM

Here's an update from Vikas Bajaj and Jenny Anderson of the NYT on Cuomo's "due diligence" investigation, "Inquiry Focuses on Withholding of Data on Loans."

But as home prices surged, subprime lenders, which market to people with weak credit, relaxed their guidelines. They began lending to people who did not provide documents verifying their income — so-called no-doc loans — and made exceptions for borrowers who fell short of even those standards.

The New Century Financial Corporation, for instance, waived its normal credit rules if home buyers put down large down payments, had substantial savings or demonstrated “pride of ownership.” The once-highflying lender, based in Irvine, Calif., filed for bankruptcy last year.

William J. McKay, who was the chief credit officer at New Century, said the company usually made exceptions so homeowners could borrow more money than they qualified for under its rules. In most cases, the decisions raised borrowers’ credit limits by 15 percent, he said.

New Century measured pride of ownership in part by how well buyers maintained their homes relative to their neighbors, Mr. McKay said, adding that this usually was not enough on its own to qualify a borrower for an exception.

Investment banks often bought the exception loans, sometimes at a discount, and packaged them into securities. Deutsche Bank, for example, underwrote securities backed by $1.5 billion of New Century loans in 2006 that included a “substantial” portion of exceptions, according to the prospectus, which lists “pride of ownership” among the reasons the loans were made.

Nearly 26 percent of the loans backing the pool are now delinquent, in foreclosure or have resulted in a repossessed home; some of the securities backed by the loans have been downgraded.

Mr. McKay defends the lending and diligence practices used in the industry. He said Wall Street banks examined exception loans carefully and sometimes declined to buy them. But they often bought them later among mortgages that New Century sold at a discount, he said.

Some industry officials said weak lending standards, not exceptions, were largely to blame for surging defaults. “The problem is not that those exceptions are going bad — you don’t have a lot of exceptions in the pools,” said Ronald F. Greenspan, a senior managing director at FTI Consulting, which has worked on the bankruptcies of many mortgage lenders. “To me it’s a more fundamental underwriting issue.”

To vet mortgages, Wall Street underwriters hired outside due diligence firms to scrutinize loan documents for exceptions, errors and violations of lending laws. But Jay H. Meadows, the chief executive of Rapid Reporting, a firm based in Fort Worth that verifies borrowers’ incomes for mortgage companies, said lenders and investment banks routinely ignored concerns raised by these consultants.

“Common sense was sacrificed on the altar of materialism,” Mr. Meadows said. “We stopped checking.”

And as mortgage lending boomed, many due diligence firms scaled back their checks at Wall Street’s behest. By 2005 , the firms were evaluating as few as 5 percent of loans in mortgage pools they were buying, down from as much as 30 percent at the start of the decade, according to Kathleen Tillwitz, a senior vice president at DBRS, a credit-rating firm that has not been subpoenaed. These firms charged Wall Street banks about $350 to evaluate a loan, so sampling fewer loans cost less.

Furthermore, it was hard for due diligence firms to investigate no-doc loans and other types of mortgages that lacked standard documentation.

“Years ago, it used to be, ‘Did the due diligence firm think it was a good loan?’ ” Ms. Tillwitz said. “We evolved into the current form, which is, ‘Did I underwrite these loans to my guidelines, which can sometimes be vague and allow exceptions?’”
"Pride of ownership" isn't actually the dumbest "compensating factor" I've ever run across, but it's up there. (The ultimate is always the old depository's standby, "existing bank relationship," which generally means we need to make sure this borrower has some more cash so he can make installment payments on all the other dumb loans we made to him last year. In comparison to that, making a dumb loan because the borrower appears to spend it all at HomeDepot seems almost sensible.)

While I have to agree with Ronald Greenspan that it's the rules, not the exceptions, that are the biggest problem, I do appreciate someone pointing out that some pools apparently got issued with 5% due diligence review. I used to buy whole loan pools for a federally-chartered depository and I can remember buying a prime-quality pool from another well-capitalized depository "preferred counterparty" from whom I had bought loans for years with "only" 10% pre-purchase credit due diligence (100% pre-purchase "collateral" or closing document review). Five percent for subprime loans from New Century? That boggles the mind.

But that's the thing; I can also remember losing deals because I wanted 20% or 30% due diligence and some other bidder would allow 10%. All over the mortgage world in 2003-2006 there were credit analysts being backed into corners by furious salespeople and traders and everyone else whose visions of the deep end of the bonus pool were evaporating when the credit people wouldn't race to the bottom on due diligence levels. You can try telling these people that you don't want to own loans that someone else doesn't want you to look at closely beforehand, but that won't work. It certainly didn't work well back in 2005 when nobody was taking any credit losses and the RE party was still white-hot. There was always someone saying, "Look, those geniuses on Wall Street will take it with 5%. What exactly is it you think you know that they don't?"

Wall Street basically set a standard--a terrible one--that everyone else had to compete with. I calculated a while ago, using numbers provided by the MBA, that fraud costs in 2006 were around 18 bps on gross 2006 mortgage production. A $350 due diligence charge on a $200,000 loan is, um, 17.5 bps. Of course the real fraud costs don't show up until much later, and looking at it now that 17.5 bps on due dilly looks like quite the bargain. But it didn't look like it then to too many people.

And, of course, the whole point of AUS/low-doc/brokered transactions was to shave the $350 or thereabouts off the transaction; this is the much-vaunted "cost savings" of "innovations." Once you close a loan, no further costs can be charged to that borrower (unless, um, you get "creative" with your servicing practices). The overall logic of the situation dictated that spending that $350 out of the lender's pocket was a "waste of money."

In the case of New Century, I'd probably have been willing to believe that it was. Why pay $350 to verify that this stuff is toxic waste when a casual perusal of the data tape makes that pretty damned obvious? But that wasn't quite the reasoning the Street was using. It is, however, why I am skeptical about how far Cuomo's investigation is going to go on this "failure to disclose" grounds. The prospectus did in fact say that the pools were full of third-party originated subprime loans with no docs, absurd LTVs, and toxic product terms. If you can swallow all that, why would you have been kept up at night by the thought that a few of them exceeded even these rules?

The reality of the situation is that "pride of ownership" was a concept that made sense to buyers of securities. And a whole bunch of other rubes, dupes, scoundrels, and pigs. New Century might as well have called them "Ownership Society™ Loans" and made it a product rather than an exception. Probably they were working on that very thing (with a lot of $350 flip charts) when BK interrupted the meetings.