Clayton Holdings Story in NYT Today

This is the biggest story of the year to date. Investment banks which used Clayton Holdings are going to go out of business, as their liabilities are astronomical.





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January 27, 2008
Reviewer of Subprime Loans Agrees to Aid Inquiry
By JENNY ANDERSON and VIKAS BAJAJ
A company that analyzed the quality of thousands of home loans for investment banks has agreed to provide evidence to New York state prosecutors that the banks had detailed information about the risks posed by ill-fated subprime mortgages.

Investigators are looking at whether that information, which could have prevented the collapse of securities backed by those loans, was deliberately withheld from investors.

Clayton Holdings, a company based in Connecticut that vetted home loans for many investment banks, has agreed to provide important documents and the testimony of its officials to the New York attorney general, Andrew M. Cuomo, in exchange for immunity from civil and criminal prosecution in the state.

The agreement, which was confirmed by Mr. Cuomo’s office and Clayton, forwards an investigation by the attorney general into the question of whether the investment banks held back information they should have provided in the disclosures that accompanied the huge packages of loans they offered as securities.

In these disclosures, underwriters typically said that loans that did not meet even lowered lending standards, called exceptions, accounted for a “significant” or “substantial” portion of the loans contained in the securities, but they offered little hard, statistical information that Clayton promised prosecutors it would provide as evidence.

Investment rating firms like Moody’s and Fitch have said that they were deprived of this information before they gave the securities the top rating, triple-A.

Mr. Cuomo has not accused any investment house of a transgression, but he has identified the disclosures of exceptions to the lending standards as the main line of his investigation.

“At the heart of the subprime meltdown is the inability to get information,” said Howard Glaser, a mortgage industry consultant who used to work for Mr. Cuomo when he was secretary of housing and urban development.

About a quarter of all subprime mortgages are in default, which has resulted in billions of dollars in losses for buyers of securities backed by these mortgages. Many of these loans were made with low teaser rates that would later increase.

Critics of these practices say many of these mortgages should never have been made because borrowers could not repay them.

Investment banks, for their part, have said they provided adequate disclosures, and they even kept some of the securities on their books. They have taken more than $100 billion in write-downs as a result.

Mr. Cuomo has already obtained some evidence through subpoenas. But Clayton, which in industry terminology conducts due diligence for the investment banks, could help him identify salient details in its reports.

“The cooperation of compliance officers or due diligence firms is the best cooperation you can get,” said Tamar Frankel, a professor of securities law at Boston University.

In a statement on Saturday, Clayton’s chairman and chief executive, Frank P. Filipps, acknowledged the agreement and said, “We have complied with a subpoena to produce due diligence reports on various pools of loans that we had reviewed for clients and on loans that had exceptions to lenders/seller guidelines and were eventually purchased” by securities issuers. “This information that we provided to the attorney general is the same information that we provided to our clients.”

Without an immunity deal, officials at Clayton could have refused to testify under their right to protect themselves against self-incrimination.

There is no evidence that Clayton did anything wrong, but securing immunity provides legal certainty for the company and its officers. The company is in a difficult position, because its cooperation might hurt its clients, the investment banks.

Clayton, a publicly held company and the nation’s largest provider of mortgage due diligence services to investment banks, communicated daily with bankers putting together mortgage securities.

As part of the deal, Clayton has told the prosecutors that starting in 2005, it saw a significant deterioration of lending standards and a parallel jump in lending exceptions. In an another sign that the industry was becoming less careful, some investment banks directed Clayton to halve the sample of loans it evaluated in each portfolio, a person familiar with the investigation said.

The mortgage business boomed from 2002 to 2006, generating lucrative fees for mortgage brokers, lenders, credit rating firms, investment banks and many investors. Investment banks began buying billions of dollars of more risky loans made to borrowers with blemished, or subprime, credit histories and packaging them into securities that paid high interest.

Among the biggest investment banks in the mortgage business are Lehman Brothers, the Royal Bank of Scotland, Bear Stearns, Morgan Stanley and Merrill Lynch. None of them have been accused of wrongdoing in Mr. Cuomo’s investigation.

It is unclear how many lending exceptions are contained in the $1 trillion subprime mortgage market, but industry participants cite figures ranging from about 50 percent to 80 percent for some loan portfolios they examined.

The investigation is likely to hinge on whether the reports produced by Clayton included material information, which the issuers of securities must provide to investors under law. Securities fraud cases often turn on courts’ interpretation of materiality.

Investment banks hired companies like Clayton to evaluate a sample, say 20 percent, of the loans. The review was supposed to determine whether the loans complied with the law and met the lending standards that the mortgage companies said they were using. Loans that did not were classified as exceptions.

As demand for the loans surged, mortgage companies were in a strong enough position to stipulate that investment banks have Clayton and other consultants look at fewer loans. The lenders wanted the due diligence to find fewer exceptions, which were sold at a discount, the person familiar with the investigation said.

The investment banks then pooled the mortgages into securities, often by blending loans from different lenders. Information on those mixed pools was then delivered to the rating agencies, which assigned the securities a score. Pension funds and other big investors bought them because they had triple-A ratings.

But investment banks did not give the rating agencies their due diligence reports, and it appears that the agencies did not demand them, people familiar with Mr. Cuomo’s investigation said.

In January 2007, Clayton briefed at least one credit rating agency about the exception reports it was producing, the person involved in the agreement said, but the credit firm did not ask to see the reports.

Last week, the chief executive of Moody’s Investors Service pointed the finger at investment banks. The executive, Raymond W. McDaniel Jr., said in reference to the information the company received, “Both the completeness and veracity was deteriorating.”

Chris Atkins, a spokesman for Standard & Poor’s, said the firm was not responsible for verifying information provided to it by the issuers of securities. It is customary for rating agencies to accept the information they are provided by issuers of securities.

In November, Fitch Ratings published a detailed review of 45 loans in an effort to identify what went wrong as mortgages were turned into securities. It found extensive inaccuracies and fraud. The firm noted that many of the problems would have been easy to identify by looking at loan applications, appraisals and credit reports — but it appears that such review was either never done or ignored. Fitch now says that it will no longer rate subprime mortgage securities unless it is provided access to loan files.

The Clayton agreement is the latest development in Mr. Cuomo’s efforts to uncover abuses in the mortgage business. In November, he sued a subsidiary of First American, a real estate services company, accusing it of inflating appraisals in an effort to secure business from Washington Mutual, the nation’s largest thrift.