[A-List] Reuters: Wall Street often shelved damaging subprime reports

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Reuters
Wall Street often shelved damaging subprime reports
Friday July 27, 12:10 pm ET 
By Patrick Rucker 

WASHINGTON (Reuters) - 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 much of the information to credit
rating agencies or investors, Wall Street sources said.
The mortgage consultants, known as "due-diligence firms," were hired by
investment banks to make sure blocks of mortgages conform to the mortgage
seller's own standards. The studies provided a first glimpse of loan quality
for ratings agencies and investors who do not normally see the full reports.

As the U.S. housing boom reached its crescendo in 2006 and investors showed a
strong appetite for mortgages, lenders relaxed their underwriting standards,
and millions of borrowers with poor credit records were able to obtain subprime
mortgages as a result.

Default rates on many of those subprime mortgages are now rising, some
borrowers face foreclosure on their homes, and investors in the mortgages face
losses.

"If all the information about these investments was properly disclosed, our
client would have made different decisions...and, specifically, not bought
these investments," said Dale Ledbetter, a Florida attorney suing Credit Suisse
Group (VTX:CSGN.VX - News) on behalf of an insurer that lost money on mortgage
bond investments.

Now some of the firms that prepared those damaging due-diligence reports say
their work should be turned over to investors so they understand the underlying
assets better.

"I am sure there is a value in those reports," said Joe Andrea, a partner with
Opus Capital Markets Consultants of Chicago but due diligence firms like his
are not empowered to release the reports, he added.

While subprime mortgage security prospectuses warned about the perils of such
loans in recent years, they did not enumerate the findings of due diligence
reports.

Ledbetter's suit, filed on behalf of Bankers Life Insurance Co., claims that
the investment bank failed to perform or disclose proper due diligence on the
mortgages it sold to investors. One of those investments was downgraded five
times from early 2005 to late 2006.

Credit-Suisse has filed a motion to dismiss the case said a spokesman, Bruce
Corwin.

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

"In some cases we felt that we were potted plants," said Keith Johnson,
president of Clayton Holdings, Inc. (NasdaqGM:CLAY - News), a large
due-diligence firm based in Connecticut.

During the housing frenzy, many Wall Street firms appear to have overlooked due
diligence warnings about problem mortgages in order to keep up with the market,
due diligence executives said.

"Twelve months ago there was a lot of competition for newly originated loans
and the buyer who would purchase more of the (loan) pool was more likely to win
that bid. The choices sometimes were business choices," said Bruce Watterson,
the president of Watterson Prime LLC of Bellevue, Washington. Watterson Prime
is owned by Fidelity National Information Service Inc. (NYSE:FIS - News),
Watterson said. 

LOAN STANDARDS EASE

As lenders relaxed their underwriting standards during the recent housing boom,
Wall Street firms followed suit by easing the guidelines that due diligence
companies followed, several executives said.

"We got away from where we were in the late 90s," Clayton's Johnson said,
referring to a time that due diligence firms were expected to give
full-throated opinions on the safety of mortgage loans.

In the last two weeks, major ratings agencies have downgraded subprime mortgage
investments and said they expect more such loans to borrowers with shaky credit
will fail.

Moody's customarily receives summaries of due-diligence studies but not the
full reports which might have helped the ratings agency evaluate now-troubled
mortgage securities, said Nicolas Weill, chief credit officer for Moody's asset
finance team.

"It's difficult to know what would have happened if we had gotten that
information," he said.

Weill said Moody's would have welcomed due diligence reports if they had helped
them learn something new about the mortgages.

Standard & Poor's relies on lenders and mortgage securitizers to conduct their
own due-diligence and does not have access to such reports "generally
speaking," said spokesman Christopher Atkins.

Lehman Brothers Holdings (NYSE:LEH - News) and Bear Stearns Cos (NYSE:BSC -
News), two major underwriters of mortgage bonds, declined to comment on how
they handle due diligence reports.

However, while due-diligence reports may contain facts that ratings agencies
seek, they might not be interested in seeing the reports, said Josh Rosner, a
housing analyst with independent research firm Graham Fisher & Co. in New York.

"The International Organization of Securities Commissions code of conduct
requires that they use all available information in their ratings process," he
said. "To require them to look at due diligence would move them to another
level of responsibility."

Mortgage securitizers relaxed their due-diligence tests during the housing boom
just as lenders loosened their loan standards in that time but all sectors of
the market are retrenching now, Clayton's Johnson said.

"We are in a correction process right now," he said.

Deutsche Bank (XETRA:DBKGN.DE - News) and Morgan Stanley (NYSE:MS - News)
accounted for nearly a quarter of Clayton revenue in 2006, according to the
company annual report. Both firms declined to comment on what they do with
due-diligence reports.



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