The mortgage bond scandal FAQ

By Felix Salmon
October 18, 2010
mortgage bond scandal to keep you tided over, since there seems to be a lot of confusion out there.

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I’m going to be spending the next couple of weeks in South Africa, which means I’ll be off the grid (on a plane) for all of Monday, and less-than-fully online thereafter. I’ve invited the old team from the Curious Capitalist—Justin Fox and Barbara Kiviat—to help out with some guest-blogging, which I’m very excited about. But in the meantime, here’s a FAQ on the mortgage bond scandal to keep you tided over, since there seems to be a lot of confusion out there.

I’m hearing a lot about foreclosuregate, MERS, moratoriums, bad title, etc. What does this have to do with that?

Nothing. This is an entirely separate, parallel, scandal. The main area overlap is that it gives investors in mortgage bonds one more colorable reason why they should be able to put back their bonds to the banks who issued them—over and above the fact that they have the right to do that if the mortgages weren’t properly transferred.

So this isn’t about legal title to mortgages. What is it about?

Just like the Goldman Abacus case, it’s fundamentally about investment banks’ lies of omission when it came to the investors who were buying bonds from them.

In that case, Goldman neglected to tell investors that John Paulson, who had helped select the bonds in a CDO, was also short the CDO. In this case, what’s the information that the investment banks neglected to tell investors?

The results of the due diligence tests that companies like Clayton and Allonhill performed on the loan pools the investment banks were buying.

Hang on, back up a minute here. Without waving your arms around like a demented spider monkey, can you explain what you’re talking about?

I can try. A key part of the mortgage securitization process was the way in which mortgage originators like Countrywide—lenders which lent you the money to buy your house—would then get their money back by taking those loans and selling them, in bulk, to investment banks like Lehman Brothers or Merrill Lynch. They’d put a large number of loans into a pool, circulate a document detailing the characteristics of each of the loans in the pool, and then sell the pool to the highest bidder.

But banks didn’t simply pay whatever they bid. Instead, after they won the auction to buy the loan pool, they would hire someone like Clayton to do due diligence on the loan pool, to make sure that what they were buying was what they had been told they were buying. “At the core of our service,” says Clayton, “is the capability to compare electronic file data against data retrieved from source documentation made available to Clayton (i.e. loan files).”

Now, it’s easy to be shocked by what Clayton found when it did its due diligence: it turns out that in many of these loan pools, the loans simply didn’t conform to the lenders’ own underwriting guidelines. But whether you or I find such things shocking is actually pretty much beside the point. The point is that the banks found the findings shocking—or at least they pretended to when they then turned around to the originator and demanded a discount on the price they were paying for the loan pool.

So that’s why the Clayton findings count as material information, right? They were directly responsible for lowering the price of the loan pool.

Right. The banks were willing to pay X for the loan pool based on the electronic file data supplied by the originators, but after having Clayton go in and test that electronic data against the original loan files, the banks were only willing to pay some sum less than X.

But isn’t Clayton’s research just like anybody else’s research—just an opinion about publicly-available information? Investment banks doing a secondary offering of shares don’t need to tell investors about other banks’ buy or sell ratings on those shares, even if those ratings affect the share price.

No, this is different. Because the loan files that Clayton had access to were not publicly available. And in any case, Clayton wasn’t being paid for its opinion. It was being paid to diligently go through a subset of the loan pool, one loan at a time, and check each loan against various underwriting standards. Clayton’s opinion didn’t matter to anyone. What mattered was the new information that Clayton dug up.

What do you expect, that the banks would put all the loan-level information into the bond prospectus? That would make it thousands of pages long! Didn’t John Hintze report back in May that, in the words of his headline, “The Loan Data Was There for All to See”? Anybody could have done the Clayton analysis, and in fact people like John Paulson and Michael Burry did do the Clayton analysis of loan-level data. They didn’t like what they saw, they shorted the bonds, and they made lots of money. So long as the information was public, there can’t be anything wrong here.

Yes, the investment banks, as well as companies like CoreLogic, did make some loan-level data available to investors. But that data, presented in easily-digestible spreadsheet form, was essentially the same as the electronic data that the banks were using to price the loan pool before they sent in Clayton. That data alone, it turns out, if looked at in the right way by someone like Paulson or Burry, was all you needed to short the bonds and make lots of money. But the original loan files which Clayton checked that data against? They were not publicly available, and for good reason: they included things like the borrowers’ names, salaries, social security numbers, and other private information.

Clayton’s report, then, was non-public information: it was the product of looking at private loan files, not semi-public spreadsheets. No one else—not Paulson, not Burry—could do what Clayton was doing, and so Clayton was adding a valuable layer of information to what was publicly known.

Now, it’s true that even when investors knew that Clayton had done these tests, they evinced precious little interest in seeing the results. All they really cared about was the credit rating. And even the ratings agencies weren’t interested in seeing Clayton’s results, which is scandalous in and of itself. But the securities laws don’t say that banks can withhold material non-public information if the investors don’t seem to care about it.

But even if the banks didn’t pass on Clayton’s reports to investors, couldn’t investors have got those reports from Clayton directly? If Clayton was running these tests for the banks, and if it was offering the same information to the ratings agencies, couldn’t anybody have simply bought the reports from Clayton? And if so, that hardly makes the information nonpublic, does it?

That’s a stretch. Investors weren’t even told that Clayton had done due diligence on the loan pool; they were barely informed that any kind of due diligence had been done at all. And even if they did somehow find out about the existence of the Clayton report, it’s not obvious that Clayton would or could have sold it to them. After all, it had been commissioned by the bank, which presumably therefore had control over who could see it and who could not.

And in any case, the investors in the Abacus deal ended up winning a lot of money from Goldman Sachs, even though they had exactly the same information about the contents of Abacus as John Paulson and Goldman Sachs did. What I’m talking about here looks as though it’s clearly worse than Abacus: the investors didn’t have the same information as Clayton and the investment banks had. The banks could have passed that information on, but they chose instead to keep it to themselves. Why? The obvious reason is that they feared that if they made the Clayton reports public, the investors might not pay as much for their bonds, or the ratings agencies might not give them the all-important triple-A rating.

Still, it seems that you’re seeking to punish banks for doing more work on these bonds than they needed to do. The banks were not required to do due diligence on these loan pools. If they didn’t want investors to know the results of the due diligence, they could have simply not done any due diligence at all, and then, according to you, there would have been no scandal. Instead, they spent their own money on hiring the likes of Clayton to double-check everything — and for that you want to punish them?

Yes. It’s great that the banks did the double-checking. But the whole point of double-checking is to make sure that nothing unexpected is lurking in the loan pool. When something unexpected did turn out to be lurking in the loan pool, the banks had an obligation to pass that information on to their buy-side customers. The banks put themselves in a situation where they found themselves in possession of material non-public information. That they did so voluntarily is beside the point; they still had an obligation to disclose it.

Material non-public information, eh? So you’re saying that banks violated Rule 10b5-1 of the Exchange Act?

Yes, but that’s not all. There’s also Section 17 of the Securities Act, which says that banks can’t withhold material facts when they offer securities to the public. And of course Section 15E(s)(4)(A) of the Exchange Act was specifically written to close any possible loophole and ensure that banks will never attempt such behavior again.

So we can expect a bunch of lawsuits around this issue?

From investors, certainly. And possibly from regulators and/or prosecutors too. They’ve been looking at the issue for a long time and so far haven’t taken any action, but times change. The public—left and right—is furious at the banks for seemingly being the sole sector of the economy to emerged unscathed from the crisis they caused. Regulators and prosecutors ultimately represent the public. And a lot of the detail surrounding Clayton’s reports only emerged quite recently, with the FCIC hearings in Sacramento on September 23. It’s possible there won’t be any prosecutions. But it’s equally possible that there will be.


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There is nobody who wants the banks prosecuted (and convicted) more than me. But this has been going on a while now, and I see no evidence that anyone in the gubermint wants to do anything about it. When the Fed and Treasury are making money at a furious pace to GIVE to banks, its hard to see who in the gubermint is going to suceed in getting it back.

Posted by fresnodan | Report as abusive

Since the banks can’t legally prove they own these mortgages doesn’t that mean that can take these bad loans off their balance sheets?

Posted by levinsontodd | Report as abusive

Mr. Salmon is correct. The repurchase debacle is a separate gotcha on the bond side. The consumer issue deals with legal title, alleged fraud, and a legal system that appears to have ignored due process in favor of priority for anything that a bank or its agent wanted to say or sign on a piece of paper. It appears that a deaf, dumb and blind monkey could have walked into a court and started a foreclosure proceeding if it wanted. And walked away with a house. The true owner of the mortgage notes should have been the Real-Estate Mortgage Investment Conduits. MERS own web site sais that it is simply a nominee. The Real-Estate Mortgage Investment Conduits had to be bankruptcy-removed to get their ratings so they likely do not own the notes either. I’m not sure where in law either or these entities has standing or possibly even the right to have taken payments or levied fees that created deficiencies. It seems they took the money anyway. Chain of title is evidently broken on hundreds of thousands if not millions of parcels of residential real estate. Title insurance companies refuse to insure title because none of the above is “of record”. They will be unable to reserve against the size of these losses unless everybody simply agrees to say that none of this ever happened. This seems to be where it is heading. Voice vote anyone? The anticipated legal fees alone per unit would be enough to wash them out. Of course, many recall that former Treas. Secretary Paulson mentioned in ’08 that it wasn’t even possible to ascertain the real “owners” of notes/mortgages tied to complex MBS tranches and this is why TARP was needed. So I guess everyone can defend themselves with whatever is already on the record.

You really think this is a “processing error”?

Posted by residentialrisk | Report as abusive 10/11/
or zw

Josh Rosner, who heads the research firm Graham Fisher, presents new proof to “Parker Spitzer” that banks knew they were selling bad loans before the mortgage crisis. Parker Spitzer CNN – October 11th, 2010

Re: Clayton Due Diligence Reports

Rosner: “The investment banks had every reason to know that these loans didn’t even meet their own standards. . . The trading desks really took over the business and actually Eliot raised an interesting question. What if the trading desks saw these due diligence documents, knew that 28%, 29% didn’t meet the underwritings standards, knew that those were sold as securities to investors and then with that knowledge traded against that by going short these securities?”

Spitzer: “Well, let me explain. What you’re saying because this is such a huge point. At the hearings and in the movie (Inside Job) there is an out take of Lloyd Blankfein saying we traded against the very documents and mortgages we sold to the entire investment community, meaning we shorted them. We were betting on them going down, not up. If they did that when they had knowledge from these documents that we’re now talking about, that in fact 29% or more were non-compliant, it could create criminal liability. So again, the critical issue is who saw these documents? When? What did they do with this information? This is a swamp, a cesspool and somebody should be dropping a thousand subpoenas right now on them.”

Rosner: “And by the way, this information has sort of been floating around on the ether, in the public ether, in the law enforcement ether for the past three years and there has been nothing done about it.”

Spitzer: “Why has the SEC not jumped all over this to see if the mortgages were safe and sound?”

Rosner: “It’s a very good question.”

Spitzer: ” . . . This is, it seems to me the Holy Grail that explains and is the blueprint for unmasking how absolutely venal the behavior was inside the investment banks.”

BTW – Commonly used CDO Prospectus language that would cover such things as Clayton due dilligence reports and insider servicer information.

“The Protection Buyer or its affiliates and/or the Portfolio Selection Agent or its affiliates may have information, including material, non-public information, regarding the Reference Obligations and the Reference Entities. Neither the Protection Buyer nor the Portfolio Selection Agent will provide the Issuer, the Trustee, the Issuing and Paying Agent, any Noteholder or any other Person with any such non-public information.”

Posted by MichelDelving | Report as abusive

“Since the banks can’t legally prove they own these mortgages doesn’t that mean that can take these bad loans off their balance sheets?”

Good point. But if a Bank/seller cannot prove to an institutional buyer of an MBS that they actually owned the mortgage/note/anything of value at the time of the sale, I’m pretty sure that is fraud.

Posted by danmordo | Report as abusive

“former Treas. Secretary Paulson mentioned in ‘08 that it wasn’t even possible to ascertain the real “owners” of notes/mortgages tied to complex MBS tranches and this is why TARP was needed.”

Anybody have a link or source for this above info stated by residentialrisk in the comments above ? This is for litigation support, foreclosure defense vs. Bank of America ; please email me at . Thanks. Urgent ! BAC cranked the machine back up (they found “not one error” – imagine that.) Thanks.

Posted by cfmalloy | Report as abusive

Very good work Felix.

Isn’t this finally too big to ignore? Or is it now too big to fix? Where is the SEC? RICO act anyone? I am but a lay person from Canada looking down and shaking my head and tch-tching, but not only is the whole world watching, we are anticipating you are going to screw us again as well… and the taxpayers it seems.

So I am sprinkling down some fairy dust over your country… which is about as helpful as anything done so far. The blanket solution of denial and coverup (the 3 monkeys sating) has failed, so time for action? Oh and do not give anyone shouting “off with their heads” and axe…

Scandalous lies about the value of houses by appraisers, raters, investment bankers, abuse of loans, disregard for the law and ethics and massive over-leveraging by homeowners and investment banks alike caused the bubble and subsequent bust.

Is this very all encompassing ‘culture or corruption’ the reason no one wishes to start laying down those thousand subpoenas? If it is, they it will only get worse. And the new regulations will be even more of a joke

Ratings companies using speed of servicer to complete foreclosure to determine rating? Wow nice… much better then actually checking loan quality to rate … wow what a sad situation that is. No wonder they were

The investment firms created the s**tty instruments with s**tty servicer loans from their subsidiaries, paid to have the s**tty instruments he called s**t by Clayton, Paid to have Ratings agencies call their s**t AAA (knowing they had done it many, many times prior) and then sold known s**t to Investors and called it really good compost, then shorted the s**t! Goldman (and the other Investement Banks) is the self professed market maker … but of what? Bad mortgages? (yes, yes , yes)

I hope I am not repeating a URL. This one is such a good read , as are the comment. A few lawyers have chimed in as well.

So it was a scam, but everyone was doing it? o-the-subprime-debacle-part-2-2010-10

This is very politically incorrect… but funny as hell way to keep your sanity as you read
(if you are easily offended, disclaimer, do not look at the other visuals) 09/foreclosureland-usa.html

Goldman’s code of ethics vestors/corporate-governance/corporate-g overnance-documents/bus-cond-ethics.pdf

Posted by hsvkitty | Report as abusive

With columns like this – please, don’t hurry back from South Africa. If I want misinformation I can make it up myself.

Posted by cranston | Report as abusive

Cranston, my 15 year old would be able to formulate an argument rather then simply write PHAIL! (as you have done albeit an iota more maturely) and run. Please tell us what misinforms and your sources.

Posted by hsvkitty | Report as abusive

hsvkitty, let me try and summarize the argument as I see it. We have some info, that

a) the investors could get relatively easily if they wanted
b) that the investors at the time showed no interest in.
c) that certain investors – we NOW know – COULD have used that information to [MAYBE] successfully short those bonds.
d) this information wasn’t just passed onto the investors or maybe it was. We don’t know because we haven’t seen the prospectuses for the bonds the loans ended up in.

I would love to see which MBS bonds those rejected loans went into. I would love to see the prospectus for those bonds. I would love to see the performance of those bonds vs the bonds who were not rejected. I would love to see the reject rates on 2004-2005 vintage loans whose MBSes Paulson and co LOST money betting against. That would make a truly fascinating story to read.

‘Til then yet another storm in a teacup.

Posted by Danny_Black | Report as abusive

Good work Felix. This can truly turn into real nastiness if investors try to put the MBS bonds back to the banks. And they have every reason to do so. First of all they don’t know which MBS bonds are good and which are bad. Second, the market value of many of the MBS bonds is or could become impaired. Putting them back at 100 cents on the dollar is therefore an attractive option. Lastly, every holder has an incentive to be first to put the bonds back to the banks. Why? If many investors return their MBS bonds the banks may well run into liquidity problems. It is better to be first than to take the risk the bank cannot return the purchase price because others were ahead of you. I have written more about this on my blog

Robijn Hornstra

Posted by RobijnHornstra | Report as abusive

^Not so much. MBS investors know full well the extent of damaged / impaired MBS holdings currently, or previously, in their portfolio holdings. These problems began emanating over 3 years ago. Feel free to visit a clearinghouse for market prices; I’d suggest MarkIT, and search for residential MBS / ABX index levels.

Many of the private label bonds are impaired. Largely, due to underperforming loans + bad economy + widespread unemployment + lack of growth in wages. (I recognize that certain ZIP codes in the DC area failed to receive that message). Throw in widespread & multiple notch downgrades from the when-issued level of individual credit rating on many of these private label deals.

Some, some of the bonds may get put back but only after/if a successful + protracted arrangement working through the courts. I’ll step on a limb, that anything rated A or less when issued is not getting a nickel.

Posted by McGriffen | Report as abusive

@ Danny Black What I got from the article that said all the info that was available to anyone came in a series of data streams, each needing a particular reader to get the actual data, and then another program to amalgamate the data and make sense of it to get what you needed from the data. An investor would be looking at the loan status as much s possible.

If you read back to that discussion, you will find a person who replied saying that he worked for an investment firm and that is what they did all day, go through such data to make sense of it, so that means you might be wrong that they showed no interest. It seems people were looking at the dat in a different way.

In other words, the ratings company had a program that showed which servicers were acting quickly on foreclosure and rated them high and that was their primary reasonin gfor stamping AAA, so anyone who knew this and did the same now had inside info.

Did those who were going short also have that data because then they truly did have insider information, being the rating agencies provided info on how they rated so the bonds could be rated AAA when included the portfolios.

Did those who made the portfolios and shorted use the rating agents false rating system, their inside information on loan status at the source (being their subsidiaries were lenders) and possibly enhanced computers programs to garner that data from MERS as well, that made them go short on their own product they were selling?

It now seems the data in Mers was deeply flawed, being no one checked/cared to ensure the data going into it was correct or procedures followed. Who knew that? If the MERS data had no county name or mortgage number on it, who securitized it? Who was supposed to check to ensure that the data was entered, being the dispensation for electronic data had that stipulation?

There are so many loopholes that bank deregulation allowed to be opened again, this has been going on for 10 years. The Government, the courts, Wallstreet, the banks, the rating agencies and servicers all knew this was going on and used and abused it and perpetuated the problem in the name of greed until they were caught. Isn’t it time they paid the piper and that it stopped? Once it fizzles in the press, people go on with their business, as do banks. But that is the LAST thing you want to happen!

If the courts do revisit foreclosures I would think that 10 years of litigation might be a fair estimate. More then procedural fluff and document glitches will be holding up the court system if property laws are maintained.

Because the banks are bleeding and there is no way a second stimulus will be in the offing, it would seem the banks and the Government and perhaps even the courts will be happy to consider it a tempest in a teapot and will be looking for ways to make it fizzle.
BUT fraudulent documents are a valid reason to revisit a foreclosure and no court should turn them down, as there has been proven fraud at the origination, securitization and foreclosure levels.

It seems few Americans (unless they are being foreclosed upon) and few banks are that interested in the law or justice. I see a huge increase in Credit Union start ups in the future. Again I will praise our regulations on the banking system here in Canada in keeping the banks (fairly) honest.

Back to the topic at hand (I am sorry Felix, for interrupting your topic, but there is some melding in the issues involved) The SEC is reviewing the same data that was used by Clayton and hopefully we will know soon if Felix and others here are correct and what happened here was fraud. (unless it will again be swept under the carpet with fines and a few hands slapped)

Posted by hsvkitty | Report as abusive