Regulators have known about the mortgage bond scandal for three years

By Felix Salmon
October 15, 2010

Clayton isn’t the only company doing due diligence on mortgages: another company doing the same thing is Allonhill. Whose CEO, Sue Allon, has a blog post up today explaining that there’s nothing to get excited about here:

In the run-up to the crisis, there was no rule that issuers had to perform due diligence at all. They obtained diligence for their own purposes, and when they did, no rule dictated that the results be disclosed to rating agencies and investors.

Allon goes on to say that “nobody – not investors, nor the SEC nor the rating agencies” was demanding that the due diligence reports be made public.

But this doesn’t make sense to me: why wouldn’t investors want to see the reports, if they knew they were being conducted?

And then there’s this:

The fact remains that investors still don’t have access to due diligence reports.

Still? How is that even possible? Isn’t the whole point of Section 15E(s)(4)(A) of the Exchange Act — introduced recently as part of Dodd-Frank — to force underwriters to give investors access to due diligence reports?

And as for the SEC not caring about this, I’d point you to to a letter that Clayton sent to the Financial Crisis Inquiry Commission. The idea was to distance itself from its former employees’ testimony, but check out this admission, towards the end:

Clayton began to review prospectuses in the summer and fall of 2007 in response to specific questions from regulators about whether Clayton’s due diligence results were set forth in MBS prospectuses.

Clearly, regulators have known about this issue for three years now; they’ve certainly known about it for long enough to insert Section 15E(s)(4)(A) of the Exchange Act into the Dodd-Frank bill.

So while Allon is right that there might not have been a specific rule requiring disclosure of the diligence results, there were still general rules requiring that underwriters disclose all relevant information when they sold mortgage bonds — or any other kind of security — to investors. That’s where the huge potential liability lies.

Update: Patrick Rucker of Reuters was all over this back in July 2007:

Investment banks that bundle and sell home mortgages often commissioned reports showing growing risks in subprime loans to less creditworthy borrowers but did not pass much of the information to credit rating agencies or investors, Wall Street sources said…

“If all the information about these investments was properly disclosed, our client would have made different decisions…and, specifically, not bought these investments,” said Dale Ledbetter, a Florida attorney suing Credit Suisse.

31 comments

Comments are closed.