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.