Clayton Holdings, the mortgage banking industry’s largest due diligence provider, struck an agreement to help an investigation by New York Attorney General Andrew Cuomo’s office into MBS underwriting and disclosure practices, the New York Times reported Sunday. The deal provides Clayton with immunity from civil and criminal prosecution in exchange for its cooperation with the ongoing inquiry. At issue here is whether vital information was either held back from investors or prevented from disclosure altogether by shoddy risk management practices during the underwriting and issuance of various subprime mortgage-backed securities. From the story:
… underwriters typically said that loans that did not meet even lowered lending standards, called exceptions, accounted for a â€œsignificantâ€? or â€œsubstantialâ€? 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 … In a statement on Saturday, Clayton’s chairman and chief executive, Frank P. Filipps, acknowledged the agreement and said, â€œWe 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 purchasedâ€? by securities issuers. â€œThis information that we provided to the attorney general is the same information that we provided to our clients.â€? … 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 NY Times goes on to suggest that Clayton “is in a difficult position, because its cooperation might hurt its clients, the investment banks.” That’s the sort of line that moves papers off the rack, I suppose, but I’ll bet that this was one of the easiest decisions the company’s board has ever had to make. Clayton’s entire reputation is built on the company’s ability to accurately perform due diligence, and much of the securitization industry — including the ratings assigned any MBS issue — rests on the market’s ability to trust that reputation. Choosing not to cooperate here would have introduced a reputational risk far greater than any other long-term risk Clayton could face otherwise. After all, it’s not as if the company is providing top-secret information here. It’s merely providing the same information it provided to its clients — what the firm’s clients chose to do with that information is beyond Clayton’s control. And frankly, I’d guess it’s beyond the company’s care, too. As the secondary market has shifted dramatically in favor of greater market transparency, a firm like Clayton stands to gain significantly. Due diligence matters far more now than it ever has, and market participants are willing to pay more now for that function than they ever have before; the company’s core business has never been more central to the long-term health of mortgage banking. Refusing to aid the investigation would have put all of that at risk — a much more difficult position to be in, IMHO, versus where Clayton now finds itself. Disclosure: The author held no positions in CLAY at the time this post was originally published.