More causes to the subprime crisis, but why do we always find out too late?

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Auditor: Supervisors Covered Up Risky Loans
by Chris Arnold

Morning Edition, May 27, 2008 · Now that millions of people are facing foreclosure because they got into loans that never should have been approved, everybody's looking for someone to blame. Borrowers, or their brokers, lied on loan applications. Others got high interest rates they couldn't afford.
A big unanswered question is whether the Wall Street investment banks that were packaging these mortgages knew they were selling garbage loans to investors. A wave of litigation is starting against these firms. One former worker whose job was to catch bad loans says her supervisors covered them up.
Mortgage Quality Control
Tracy Warren is not surprised by the foreclosure crisis. She saw the roots of it firsthand every day. She worked for a quality-control contractor that reviewed subprime loans for investment banks before they were sold off on Wall Street.
It was her job to dig into the loans and ferret out problems. By 2006, they were easy to find.
"I'd see people who were hotel workers saying that they made, in California, making $15,000 a month so that they could qualify for a $500,000 home," Warren says. "If a hotel worker is making $15,000 a month changing sheets at the Days Inn, everybody would want to do it. It just really made no sense."

Warren has worked in the mortgage business for 25 years, the past five in quality control. Most recently, she was a contract worker for a company called Watterson-Prime, which did loan audits for investment banks. She says their biggest client was Bear Stearns, which recently all but collapsed because of its exposure to bad loans.
Putting Bad Apples Back in the Barrel
Warren thinks her supervisors didn't want her to do her job. She says that when she would reject, or kick out, a loan, they usually would overrule her and approve it.
"The QC reviewer who reviewed our kicks would say, 'Well, I thought it had merit.' And it was like 'What?' Their credit score was below 580. And if it was an income verification, a lot of times they weren't making the income. And it was like, 'What kind of merit could you have determined?' And they were like, 'Oh, it's fine. Don't worry about it.' "
After a while, Warren says, her supervisors stopped telling her when she had been overruled. She figured it out by going back later and pulling the loans up on her computer.
"I would look every couple of days, and just see, if it was a loan that I thought was a bad loan, I'd go back and see if it was pulled."
About 75 percent of the time, loans that should have been rejected were still put into the pool and sold, she says.
'A Smoking Gun'
Some legal experts say it's a pretty big deal that people like Warren are willing to talk.
"This is a smoking gun," says Christopher Peterson, a law professor at the University of Utah who has been studying the subprime mess and meeting with regulators. "It suggests that auditors working for Wall Street investment bankers knew how preposterous these loans were, and that could mean Wall Street liability for aiding and abetting fraud."
Bear Stearns had no comment.
The loan-auditing firm Watterson-Prime's parent company, Fidelity National Information Services, provided a statement. It says the company has no incentive to give loans a passing review if they fail to meet underwriting criteria and that it uses additional quality-control measures to further check up on loan reviews.

But Peterson says such breakdowns in quality control must have happened at a lot of companies. How else did millions of people wind up in loans that they can't pay?
"People have a tendency to think about economic trends as though they're an uncontrollable force that no one understands. This isn't the weather. These are people who are individually making decisions to approve and pass on fraudulent loans," he says.
Accountability on Wall Street
Peterson said auditors like Warren basically were hired to find the bad apples in the barrel and pull them out: borrowers with payments they couldn't afford, houses with inflated appraisals, people lying about their income.
But Warren says her bosses were taking a lot of those bad apples and putting them back in. And Peterson says he thinks the investment banks had a strong financial incentive to do that.
"They put the bad apples back in the barrel because they knew that they could sell the bad apples along with the good apples and, at least in the short term, nobody would know the difference. That's why they put them back in — because they made more money that way," Peterson says.
"There's a name for this — it's called 'passing the trash,' " says David Grais, an attorney getting ready to sue Wall Street firms on behalf of investors — big pension funds and others — who bought the bad loans.
"These were immensely profitable deals. One study showed that the investment banks were making a 40 percent return on equity every two months on these securitizations, which is an eye-popping number," he says.
Grais says many people on Wall Street make huge bonuses when their business unit is making big money. So the faster they could package up loans — good, bad or ugly ones — and sell them to investors, the more money that they made, he says.
Warren thinks her managers got bonuses for how quickly they reviewed loans, not for how many bad loans they caught.

Watterson-Prime disputes that. It says its managers, staff and contractors are compensated on an hourly or salary basis and never by the number of loans reviewed.
Report: Banks Agreed to Limit Loan Rejections
Other evidence is emerging.
A bankruptcy examiner in the case of the collapsed subprime lender New Century recently released a 500-page report, and buried inside it is a pretty interesting detail. According to the report, some investment banks agreed to reject only 2.5 percent of the loans that New Century sent them to package up and sell to investors.
If that's true, it would be like saying no matter how many bad apples are in the barrel, only a tiny fraction of them will be rejected.
"It's amazing if any investment bank agreed to a maximum number of loans they would kick back for defects. That means that they were willing to accept junk. There's no other way to put it," says Kurt Eggert, a law professor at Chapman University.
Meanwhile, the attorney general in New York and other prosecutors are taking a look at all of this. They, too, want to know whether Wall Street firms were covering up bad loans and selling them to investors.
Analysis: Lenders, Investors, Buyers Fed Loan Crisis
by Robert Smith and Adam Davidson

Morning Edition, May 27, 2008 · Co-host Robert Smith talks to NPR's Adam Davidson about how lenders, investors and buyers all contributed to the subprime mortgage crisis.

Davidson says everyone at every step of the chain acted irresponsibly, "taking on way more risk than was appropriate." He says he has interviewed dozens of homeowners, subprime home buyers who bought way more house than they could afford, who said they knew they were taking on more risk than was reasonable. And the mortgage brokers and mortgage banks knew, too.
Brokers didn't mind the extreme risk because they were passing on loans quickly to the banks; banks didn't mind because they were passing on the loans to Wall Street. Wall Street knew about the extreme risk but was passing it on to global investors, many of whom said they weren't paying enough attention because they trusted the credit rating agencies — but now those agencies admit that their models were flawed and faulty, Davidson says.
Many thought the reward would outweigh the risk, he says. Everyone "was making massive amounts of money — you're talking about 25-year-old kids who don't have a college degree making over a million a year."
Shady Practices Led to New Century Financial's Fall
by Carrie Kahn

Morning Edition, March 27, 2008 · Two years ago, New Century Financial was the country's second largest subprime mortgage lender. Now, it's in bankruptcy, and a new report mandated by the bankruptcy court shines light on the company's shady practices.


Business
New Century's Risky Lending Practices Detailed
by Chris Arnold

All Things Considered, March 26, 2008 · Before the mortgage company New Century went bankrupt last year, it was the second-largest sub-prime lender in the country. A court-appointed examiner released a new report Wednesday that finds widespread wrongdoing at the company and also alleges negligence by the company's auditor KPMG.
The report says New Century had a brazen obsession with selling more loans without due regard to the risks.
Michael J. Missal, the examiner appointed to dig into New Century's collapse as part of the bankruptcy process, says, "What we found was it really shows the embryo of the credit crisis and how easy it was to originate very risky loans and put them into the financial system."
In its quest for new customers, New Century made increasingly unwise loans, according to the report. Borrowers incomes weren't documented. Loans were offered for the full value of a house. Missal adds, "They took risky products — made them that much riskier — and essentially created a ticking time bomb that exploded in 2007 as the market was changing."
Missal was also charged with finding causes for lawsuits that creditors might pursue. He named New Century's accounting firm, KPMG:
"Their independent auditors, KPMG, were supposed to be there to test and be skeptical of the way New Century was doing business. I found that KPMG failed to do so and a cause of action may exist."
A spokesman for KPMG says the report needs to be reviewed.

Missal says executives at New Century also failed in their oversight responsibilities and engaged in improper accounting. He says top executives were paid millions of dollars in bonuses that were calculated based on inaccurate financial statements.
The SEC and Department of Justice are both investigating New Century.
A Lot of Blame to Share in Subprime Sinkhole
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All Things Considered, August 16, 2007 · Robert Siegel talks with Financial Times reporter Saskia Scholtes about the article "As Subprime Bites, U.S. Investigators Look for Culprits."
Scholtes, and colleague Brooke Masters, found fraud at myriad levels of the market, from borrowers who overstate their incomes, to fraudulent companies that offer help to lie about income, to lenders who don't bother to check.
As subprime bites, US investigators look for culprits
By Brooke Masters and Saskia Scholtes
Wednesday Aug 8 2007 14:05

http://us.ft.com/ftgateway/superpage.ft?news_id=fto080820071539268198
At the height of the US subprime lending boom, taking out a mortgage   could not have been easier. Low credit score and history of bankruptcy? No problem. Income too low to qualify for a mortgage? Inflate what you earn on a "stated income" loan. Nervous that your lender might check up on your "stated income"? Visit www.verifyemployment.net.
For a $55 fee, the operators of this small California company will help you get a loan by employing you as an "independent contractor". They provide payslips as "proof" of income and, for an additional $25, they also man the telephones to give you a glowing reference should your lender need it.
But perhaps the most absurd aspect of the US subprime mortgage market in recent years is that lenders became so generous with credit provision for out-of-pocket borrowers that very few checks were ever made.
That left the system extraordinarily vulnerable to widespread fraud, a possibility that federal and state prosecutors across the US have begun to look into. With the subprime crisis expected to cost investors between $50bn (£24bn, €36bn) and $100bn, according to the US Federal Reserve, these investigations could transform it from a market correction to a full-blown national scandal.
At the root of the subprime problem was easy credit: lenders and their brokers were often rewarded for generating new mortgages on the basis of volume, without being directly exposed to the consequences of borrowers defaulting. During several years of strong capital markets and strong investor appetite for high-yielding securities, lenders became accustomed to easily selling the risky home loans they made to Wall Street banks. The banks in turn packaged them into securities and sold them to investors around the globe.
Such ease of mortgage funding allowed thousands of borrowers to get away with fraudulently mis-stating their incomes, often with the encouragement of their brokers. More ambitious fraudsters appear to have taken out multiple mortgages and walked away with the cash.
Karen Gelernt, a partner at law firm Cadwalader, Wickersham & Taft, says: "The difficulty is getting a handle on the size of the problem, because there is no real mechanism for reporting fraud for most originators in this market. In fact, they had every incentive not to report."
Fraud has been detected up and down the financing chain: just as borrowers have lied to get better rates and larger loans, mortgage brokers and loan officers have lied to borrowers about the terms of their loans and may also have lied to the banks about the qualifications of the borrowers. Appraisers, likewise, have lied about the value of the properties involved.
"The recent rapid expansion of the subprime market was clearly accompanied by deterioration in underwriting standards and, in some cases, by abusive lending practices and outright fraud," Ben Bernanke, Fed chairman, recently told lawmakers. With mortgage rates rising and house prices falling, subprime borrowers have been defaulting at record rates.
The fallout is working its way up from the retail level – forcing people out of their homes and lenders into bankruptcy. Investment banks have lost revenue as investors back away from mortgage securities and a handful of high-profile hedge funds have collapsed – most notably two highly leveraged funds managed by
Bear Stearns (NYSE:BSC) . The crisis has contributed to turmoil in financial markets in recent weeks and could threaten the health of the US economy as lenders tighten access to credit, putting a drag on consumer spending.
For some, this rapid and dramatic unravelling of the subprime lending industry has echoes of the costly savings and loans crisis of the early 1980s – a meltdown that also had its origins in financial market innovation and inadequate oversight, and which many cite as a contributing factor in the 1990-91 economic recession. That crisis ended with a federal bail-out of $150bn and a handful of high-profile convictions for fraud.
This time around, the major losers have been hedge funds, which in theory are limited to wealthy investors. But some analysts believe the pain could spread – many pension funds and college endowments have turned to hedge funds to heat up their returns and some, including Harvard University, are starting to get their fingers burned. Harvard is estimated to have lost $350m of the $550m it invested in a hedge fund run by Jeffrey Larson, a former Harvard money manager, that collapsed recently as a result of positions related to the subprime market.
If the losses trickle down and end up hurting small investors, pressure may grow for a public bail-out. Rumours swept the market earlier this week that Fannie Mae (NYSE:FNM) and Freddie Mac, the government-backed mortgage agencies, might get the authority to make sweeping purchases of underpriced mortgage securities.
"The US mortgage landscape has become a top-of-mind political talking point, and we would not be surprised to see the usual 'flow like mud' legislative process fast-tracked with respect to items offering relief to the ­troubled mortgage market," says Louise Purtle, strategist at ­CreditSights, a research firm.

Most fraud in subprime lending appears to have been so-called "fraud for purchase" – lying about income so as to win a mortgage approval. In reviewing a sample of "no doc" loans that relied on borrowers' statements, the Mortgage Asset Research Institute recently found that almost all would-be home owners had exaggerated their income, with almost 60 per cent inflating it by more than 50 per cent.
These fraudulent borrowers are often difficult to uncover, says Ms Gelernt, because they often stretch to meet their minimum payments for some time before they eventually default. The time lag between initial fraud and default also makes a conviction hard to obtain, she adds, while mortgage investors also have little chance of recovering their losses from individual borrowers in these circumstances.
Many of the originators to blame for poor quality control standards may not be held to account either – with several such lenders already in bankruptcy. "There's a real problem in finding fraud after the fact because the money is already out the door and you won't get the recovery," says Ms Gelernt.
Loose lending standards also facilitated fraud for profit. US prosecutors around the country have broken up at least a dozen mortgage fraud rings and more cases are expected.
In one New York case, the FBI charged 26 people who used stolen identities, invented purchasers and inflated appraisals to obtain subprime loans on more than $200m of property. In an Ohio case, 49 per cent of the mortgages processed by a ­single broker never made even a first payment.
The fate of a series of North Carolina neighbourhoods built by Beazer Homes (NYSE:BZH) may offer a foretaste of the looming problem. Low income home-buyers around Charlotte have sued the builder alleging that its lending arm steered them into mortgages they could not afford, leading to widespread foreclosures.

The homeowners allege that sales agents misrepresented their personal data, including assets and income, to help them qualify for government-insured mortgages starting in 2002. By the beginning of this year, 10 Beazer subdivisions in Charlotte had foreclosure rates of 20 per cent or higher, compared with 3 per cent state-wide, according to a local newspaper analysis.
The FBI is probing Beazer for possible fraud and the US Housing and Urban Development is examining whether its sales practices violated government-insured mortgage rules. Beazer has defended its sales practices and says it has a "commitment to managing and conducting business in an honest, ethical and lawful manner". In June it announced that it had fired its chief accounting officer for allegedly attempting to destroy documents. The company's shares have lost 75 per cent of their value since the probes began.
Several state attorneys-general are also on the trail. Andrew Cuomo of New York state made headlines this spring with a series of subpoenas to property appraisal companies and has said publicly that he is probing the entire industry. Sources familiar with the office's work say the investigation is still at a relatively early stage.
Marc Dann, the Ohio attorney- general, is looking further up the funding chain. He has been outspoken in his criticism of the role the financial services industry may have played in the large numbers of foreclosures in his state. "There's a whole series of people that knew or should have known that there was fraud in the acquisition of these mortgages," Mr Dann told the Financial Times. "We're looking at ways to hold everybody who aided and abetted that fraud."
Mr Dann's office is looking at brokers, appraisers, rating agencies and securitisers and plans to use several legal methods to hold bad actors accountable. The Ohio attorney-general not only has criminal enforcement powers, but also represents the third-largest set of public pensions in the country and can thus file civil lawsuits on behalf of investors.

"But for the mechanism of packaging these loans, the fraud never would have existed," Mr Dann says. "We're following this trail from homeowner to bondholder." He says his investigation could take six months to a year to bear fruit.
The Securities and , for its part, is investigating whether Bear Stearns and other hedge fund managers were forthright about disclosing the rapidly declining value of their holdings.
Many of the mortgage-related securities bought by the hedge funds are rarely traded and difficult to value accurately. They are often valued in portfolios according to complex mathematical models because real market prices are not available, making it possible to disguise underperformance if models are not updated.
The SEC has not brought a case in the area so far, but current and former regulators note that it has previously won settlements from several mutual funds and banks that failed to revise the prices of illiquid assets during a falling market.
Private securities lawyers are also starting to file securities fraud lawsuits on behalf of investors who have lost out because of the subprime meltdown.
Jake Zamansky, a lawyer who negotiated an early settlement from Merrill Lynch in the scandal over skewed investment bank research, has filed an arbitration claim against Bear Stearns alleging the firm misled investors about its exposure to the mortgage-backed securities market.
The class action law firm of Bernstein Litowitz is also preparing a claim against Bear Stearns, alleging the firm made material mis-statements in the offering documents for its now defunct hedge funds.
"This was simply about a hedge fund strategy that failed," said a Bear Stearns spokesman. "We plan on defending ourselves vigorously against the allegations in these complaints."
Other hedge funds may also come under political or legal pressure over their role in the loan crisis.
Richard Carnell, a professor at Fordham law school, says it may be possible to hold the investment banks that securitised the mortgages at least partially responsible in the case of a major collapse of the market. "There are two things you can object to in the securitisers' conduct: failing to disclose material facts about the credit quality of the mortgages; and you can also criticise them for acting as an enabler for someone they know is a bad actor," he says.

But putting together a case will not be easy because the hedge funds and other investors who bought such securities are presumed to be sophisticated about financial matters. This means it will be harder for them to prove they were not properly warned about the risks involved.
In the case of the Bear Stearns funds, investors may face new hurdles to recovering any money through US lawsuits. Though the funds operated mostly in New York, they were incorporated in the Cayman Islands and that is where they have filed for bankruptcy. In what could be a test case for international bankruptcy laws, the liquidators have applied to the US courts asking them to block US lawsuits during the liquidation process.
Bear Stearns said in a statement: "Because the two funds are incorporated in the Cayman Islands, the funds' boards filed for liquidation there . . . The return to creditors and investors will be based on the underlying assets and liabilities of the funds not on the location of the filing."
Even if the US lawsuits do go forward, a case pending before the Supreme Court could also prove crucial to investors who hope to make a case that hedge funds and rating agencies enabled widespread fraud.
In Stoneridge Investment Partners v Scientific Atlanta, the court is considering whether investors can recover from firms – including accountants, lawyers and bankers – that help a public company commit fraud by participating in a "scheme to defraud". If the high court rules against "scheme liability", investors who lost money in the subprime market will have very few places to turn to try to get some of it back.
William Poole of the Federal Reserve Bank of St. Louis thinks that this may be what investors who lose money on subprime mortgage-linked securities deserve for not looking at them closely enough.

Criticising Wall Street underwriting standards recently, he said: "The punishment has been meted out to those who have done misdeeds and made bad judgments. We are getting good evidence that the companies and hedge funds that are being hit are the ones who deserve it.''
RISING PRICES OFFSET A BRITISH SUBPRIME SNIFFLE
Last month some of the most senior figures in the UK mortgage industry gathered at London's Royal Albert Hall for a glittering awards dinner, writes Jane Croft.
Entertainment was provided by British comedian Al Murray and a colourful troupe of can-can dancers. But in spite of the celebratory mood, the chatter soon turned to recent findings by the UK's Financial Services Authority on problems with subprime mortgages. The regulator had said it was "very concerned" about "the high level of subprime arrears in a benign market" and had uncovered "weaknesses" in lending practices.
The level of defaults has been much lower than across the Atlantic – partly because the UK subprime market is much smaller, accounting for around 8 per cent of mortgages compared with 20 per cent in the US.
However, a recent report by Standard & Poor's showed overall arrears and repossession rates in the British subprime sector rising. The rating agency's non-conforming Residential Mortgage Backed Securities (RMBS) index tracks the performance of subprime mortgages securitised into capital markets. It found 10.5 per cent of loans in the first quarter of 2007 were more than 90 days in arrears – up from 7 per cent in 2004.
This is still far below the US, where research by the Centre for predicts that one in five subprime mortgages made in the past two years will end in foreclosure.
A big concern raised by the FSA is whether UK mortgage brokers and lenders are properly assessing how much borrowers can afford to pay back each month. While he acknowledges there are key differences between the US and UK, Clive Briault, managing director of retail markets at the FSA, admitted recently that "we cannot completely ignore the parallels with our own market".

The FSA is also concerned that rising house prices are encouraging some over-indebted borrowers to increase their levels of debt by borrowing against their property.
In its review, the FSA examined 11 lenders and 485 case files at 34 mortgage brokers. It found that in a third of the files, brokers had made an "inadequate assessment" of the customers' ability to afford the loan. It also found failings amongst lenders that resulted in "the approval of potentially unaffordable mortgages".
Figures from the Council of last week showed that home repossessions jumped 30 per cent year-on-year, rising to 14,000 in the first half of 2007. The industry body said some of the increase was due to rising defaults on subprime mortgages. Indeed, a third of the possession hearings in one local study by the Citizens Advice Bureau last year were brought by subprime mortgage lenders.
The buoyancy of the UK market, at least, means there is still an escape route. "House prices have not been impacted as they have in the US," says Andrew South, an analyst at S&P. "That gives borrowers more refinancing options if they get into difficulties."