The most shocking discovery yet about how the banks hid their toxic mortgages.

Making government work better.
Oct. 19 2010 6:42 PM

What Clayton Knew

The most shocking discovery yet about how the banks hid their toxic mortgages.

Bank paperwork. Click image to expand.
Banks had—and hid—critical information about the poor quality of the bonds they were selling

Since the early days of the current economic cataclysm, I have believed that we would, with some investigation, find the Rosetta stone that would demonstrate that the banks knew that the toxic mortgages they were packaging were, in fact, not viable financial instruments.

This belief stemmed from my experience as New York state's attorney general. The AG's office had investigated enough subprime lenders to recognize the magnitude of fraud and the ubiquity of bogus credit analysis. Our efforts to expand our inquiry were stymied by the banks—and the Bush administration—which claimed we didn't have jurisdiction to pursue the inquiry into many of the major national banks. (We finally won, in June 2009, in a 5-4 ruling from the U.S. Supreme Court. The ruling was a bit late.)

I saw enough to know that any investigator doing even a minimal amount of work would reach the same conclusion we had. And I knew that the credit departments of the major banks would have documented this shoddy analysis. This is why I encouraged all the investigators with whom I spoke to begin by demanding access to the documents that the credit departments of the banks examined.

Some of these documents have emerged, and they tell quite a fascinating and appalling tale: These documents, from Clayton Holdings, a due diligence company retained by the banks, reveal that Clayton, after analyzing more than 900,000 mortgages, told the banks that about 30 percent of the loans being packaged into securitized products did not satisfy the banks' own underwriting standards. This meant that the securitized products were almost bound to blow up.

So what did the banks do? They essentially ignored this information. We all know why: The process of securitization shifted the risk to others, and the banks were making too much money by continuing to push the deals through the pipeline. But the critical aspect to this information is that it puts to rest the banks' argument that they merely fell into the same econometric mistake that others had made in believing that the housing market was bound to keep rising. It wasn't just that the banks were wrong about their forecast of the housing market; it is that they intentionally ignored critical information given to them by the very people who were supposed to perform due diligence. And then they apparently withheld from investors that critical information about the quality of the bonds they were selling.

What is to be done? As those who watched a segment I did with Josh Rosner on Parker Spitzer last week know, I believe that massive investigative resources should be put behind simple questions relating to the Clayton documents:

Who saw these documents, and when?

What was said about these documents to those up the chain of command at the banks?

What efforts were made to verify the conclusions Clayton reached, to evaluate what the consequences would be if their conclusions were correct, and to notify federal authorities of the risk posed by securitizing so many substandard loans?

What lawyers and investment bankers were told of this information, and what rating agencies had access to this information?

And were major banks shorting their own securitized products after seeing negative due diligence information that they had not shared with the market? This would be dangerous territory for the banks. As William D. Cohan wrote in the New York Times last week, many seem to have preferred ignorance to knowledge in this arena.

There is one other critical area of inquiry. A fair number of people have been troubled by the fact that certain law enforcement agencies saw these documents but did nothing with the critical information they revealed. So the question must be asked: What agencies had these documents, and what, if anything, did they do?

It is not too late to use the Clayton information to claw back bonuses and hold the banks, rating agencies, and government enforcement agencies accountable.

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