Far more than any trader's profane e-mails, due diligence reports from the securitization boom could worsen the financial industry's litigation headaches — and conceivably expose some firms and individuals to criminal charges.
Investment banks commissioned the reports from firms like Clayton Holdings and Hansen Quality to ensure that the mortgages the banks were buying met their underwriting standards. A substantial number of the loans did not, but the banks included them in the securities they sold to investors anyway, the reports indicate.
These previously confidential red-flag communications from the bubble years have been turning up as evidence in civil litigation against banks, and in public hearings like those held last year by the Financial Crisis Inquiry Commission. They've been largely drowned out by the torrent of news about servicing errors and other mortgage mishaps.
"We all know from the different testimony that there is a considerable amount of fraud or gross negligence in what was sold and it is now coming out and being verified through all of the plaintiff litigation," said Thomas R. Borgers, a former senior investigator at the commission. "If you are doing a 2 or 5% sample and you find that 20, 30, 40, 50% of all the sample had defects … what would you do? Would you stop there and buy all of the mortgages? Or would you continue on with a greater sample of the pool? I would, as prudent banker, go after more and more of the product if I saw more and more problems in what I am buying."
But the securitizers "were not doing that for the most part," said Borgers, now managing director at Mesirow Financial Consulting. "What they would do is accept a lot of these exceptions or override them and put them in the pool."
Evidence that the firms selling mortgage securities knew the collateral did not meet their guidelines would undermine the defense that these investments soured for reasons beyond the sellers' control.
"A lot of people bought into the global financial catastrophe argument — that these problems were caused by the collapse of the housing market and macroeconomic factors," said Isaac Gradman, a former plaintiff's attorney who now runs a consulting firm, IMG Enterprises. "I think that the due diligence reports that were run by the securitizers prior to purchasing the loan pools for the originators is the strongest evidence available that the banks knew that they were buying defective loans."
Due diligence reports have turned up as major exhibits in a variety of cases against investment banks. Some allege predatory lending and violations of state consumer deceptive trade practice laws. Others involve investors and insurers suing investment banks in civil fraud cases over loans that allegedly breached underwriting standards. These cases include a lawsuit by the bond insurer Ambac Assurance Corp. against JPMorgan Chase & Co.; the Federal Home Loan Bank of Pittsburgh's suit against JPMorgan Chase and Countrywide (which is now a part of Bank of America Corp.); and Massachusetts' $102 million settlement with Morgan Stanley.
The information due diligence firms provided to securitizers could be the basis for future criminal fraud cases, said Tamar Frankel, a professor at the Boston University School of Law. Under the Securities Act of 1933 it is a crime to sell securities accompanied by information that was intended to mislead. Underwriters have an obligation to vet the products they sell, Frankel said.
Even if the securitizer is a large corporation, "if they get from the inside, some suggestion that something is wrong, they have to pursue it," she said.
The recent revelations about due diligence reports from the FCIC should be a green light for law enforcement to take action, according to Christopher Peterson, a professor at the University of Utah's S.J. Quinney College of Law. However, Peterson said these reports do not necessarily provide slam-dunk evidence of fraud.
"One thing that could have been the case is that the [due diligence] company really was doing good due diligence, and the investment bank was ignoring it," Peterson said, "or it could be that the due diligence company wasn't really doing due diligence which would mean that the company didn't have to ignore it, because it was shoddy due diligence."
