More prosecutions of investment banks coming?

By Felix Salmon
September 27, 2010
Gretchen Morgenson buried something explosive in her story today about the FCIC testimony of a mortgage-analysis executive in Sacramento?

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Has Gretchen Morgenson buried something explosive in her story today about the FCIC testimony of a mortgage-analysis executive in Sacramento? Here’s her 28th and 29th paragraphs:

Because these loan samples were provided to the Wall Street investment banks that commissioned them, they could see throughout 2006 and into 2007 that the mortgages they were financing and selling to investors were becoming increasingly sketchy.

The results of the Clayton analyses were not disclosed to investors buying the loan pools. Instead, Wall Street firms used the information to pressure the lenders issuing the most troubled loans to accept a lower price for them, according to prosecutors who have investigated these cases.

If you remember, the SEC’s central accusation against Goldman Sachs was that it lied to its clients — it knew something important about the Abacus deal which the clients didn’t know, and Goldman didn’t see fit to enlighten them.

That case, centered on one deal at one bank, resulted in a $550 million fine, and billions of dollars of market capitalization wiped off Goldman’s share price.

Yet it seems here that something similar was going on very regularly, not only at Goldman but also at Citigroup, Deutsche Bank, UBS, Merrill Lynch, Bear Stearns and Morgan Stanley.

This time, the lie of omission was not that John Paulson was both choosing and shorting the CDS in a synthetic CDO. Rather, it was that Clayton Holdings had analyzed the mortgages going into subprime mortgage pools, and found that only 54% of the loans going in to subprime mortgage pools met the lenders’ underwriting standards, and that 28% of the loans sampled were outright failures. Many of those failures ended up being accepted into the pools, rather than rejected.

Obviously, the numbers varied from bank to bank. (Goldman’s almost endearing in its doomed attempted defense that “the percentage of deficient loans that went into its pools was smaller than Clayton’s average”.) But it seems here that the banks knew that their loan pools were dirty — they told as much to the originators, and tried to to get a discount on the loans as a result. But they didn’t bother to inform the investors in those pools.

In fact, the banks might even have had an incentive to put together dirty pools. After all, dirty loans come cheaper — and so you can make more money when you sell them off to bond investors at the same price as cleaner loans.

If prosecutors are chatting away to Morgenson about this, I suspect that indictments are coming down the pike. And given how important the SEC’s case against Goldman turned out to be, a series of big cases against a whole slew of investment banks could have enormous repercussions for their reputation and their share prices. So beware, anybody buying stock in Goldman, Citi, BofA or Morgan Stanley: there’s serious litigation risk here, I think.

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