Testifying before the Financial Crisis Inquiry Commission last week, Keith Johnson, the former president and chief operating officer of Clayton Holdings, said the big-three credit rating agencies rejected evidence of many mortgages being pooled into securities in 2006 and 2007 as being subpar in quality. Between the first quarter of 2006 and the second quarter of 2007, Clayton reviewed more than 911,000 mortgages for its clients, such as Deutsche Bank and Goldman Sachs, that sold them as security pools. Johnson told the FCIC only half of them, 54%, met the kinds of standards these Wall Street firms were advertising to investors. The other 46% were “bad loans” written on unchecked information such as borrower stated income. The FCIC also heard testimony from Benjamin Wagner, the attorney general for the eastern district of California. He told the commission, in a session before Johnson’s, the most prevalent mortgage fraud schemes during the housing build-up came from borrowers. “Although the mortgage fraud we have seen in this district takes a number of forms, the fraud schemes prevalent during the period from 2003 through 2008 were loan origination schemes, all of which essentially come down to one thing – material lies to the mortgage lender,” Wagner said. “Mortgage fraud perpetrators primarily lied about borrowers’ qualifications for obtaining a mortgage loan, about the true market price of the property securing the mortgage loan, and about what the money being borrowed was to be used for.” Clayton reviewed about 20% of mortgages issued by third parties, not from major lenders like Bank of America or JPMorgan Chase. Johnson said of that 20%, Clayton did due diligence to detect faults like mortgage fraud on about 50% to 70% of the market share. Of the pool, 46% did not meet the standards required for securitization. Of all 911,000 mortgages reviewed, Clayton detected some minor fault in about 18% of them that were still eligible for securitization, but rejected 28% for approval. However, securitizers, Johnson said, waived through 39% of those Clayton rejected. Clients went to Clayton with their own overlaying standards, above the regulatory requirements on the originators. “We thought that these exception-tracking mechanisms, we were the only ones that had it. I thought it was a management tool that they could get that 54% to 100%,” Johnson said. “We took this to the credit rating agencies and said, ‘Wouldn’t this information be great for you to have as you assign tranche levels of risk?'” Johnson said they shopped the data to Fitch Ratings and Standard & Poor’s in 2006, then took it to Moody’s Investors Service in 2007. “While most said they loved it, none of them would have adopted it at that time. If anyone at that time had adopted they would have probably lost market share,” Johnson said. “The issuers would have gone through the easier channel.” Credit rating agencies have taken their share of the blame for not properly rating the collateral underneath the mortgage-backed securities that went sour when the housing bubble burst. No one at that Fitch, S&P, or Moody’s could immediately confirm any meeting. “In the 1980s, due diligence was really simple. It was good loan, bad loan. When you bought the loan, I owned, it went in my portfolio. If it went delinquent and into default, I had to be personally liable and would have to answer to a guy named Lew Ranieri,” Johnson said. “In this case here, I think the liability got pushed out to the investor, and we got away from the practice of good loan bad loan.” A story in the New York Times on Johnson’s testimony can be found here. Write to Jon Prior.

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