Subprime Mortgage Watchdogs Kept on Leash
By E. Scott Reckard
Loan checkers say their warnings of risk were met with indifference.
They could see the meltdown coming.
Freelance financial watchdogs who examined the paperwork on sub-prime home loans being sold to Wall Street had an inside view of the boom in easy-money lending this decade. The reviewers say they raised plenty of red flags about flaws so serious that mortgages should have been rejected outright - such as borrowers' incomes that seemed inflated or documents that looked fake - but the problems were glossed over, ignored or stricken from reports.
The loan reviewers' role was just one of several safeguards - including home appraisals, lending standards and ratings on mortgage-backed bonds - that were built into the country's complex mortgage-financing system. But in the chain of brokers, lenders and investment banks that transformed mortgages into securities sold worldwide, no one seemed to care about loans that looked bad from the start. Yet profit abounded - until defaults spawned hundreds of billions of dollars in losses on mortgage-backed securities.
"The investors were paying us big money to filter this business," said Cesar P. Valenz, one of the loan checkers. "It's like with water. If you don't filter it, it's dangerous. And it didn't get filtered."
As foreclosures mount and home prices skid, the loan review function, known as due diligence, is gaining attention. The FBI is conducting more than a dozen probes into whether companies along the financing chain concealed problems with mortgages. And a presidential working group has blamed the sub-prime debacle in part on a lack of diligence by investment banks, rating firms and mortgage-bond buyers.
"Although market participants had economic incentives to conduct due diligence," the group said in a policy statement, "the steps they took were insufficient." To prevent mortgage crises, the group recommended increased disclosure of "the level and scope of due diligence performed" on home loans underlying the securities.
At the height of the sub-prime era, such disclosure wouldn't have been pretty, the freelance loan checkers say.
In interviews with The Times, eight experienced loan reviewers said that as marginal lending increased, quantity took precedence over quality. Squads of 10 to 15 veteran loan checkers gave way, they said, to packs of 40 to 50 mostly novice reviewers posted at or near sub-prime factories such as now-defunct Orange County lenders New Century Financial Corp. and Ameriquest Mortgage Co.
Executives at the two main firms that hired the freelancers - Shelton, Conn.-based Clayton Holdings Inc. and San Francisco-based Bohan Group - say the reviewers weren't there to find every potential problem with a sub-prime loan. Rather, the executives say, the job was to perform specific tests to help buyers determine how much to pay for a pool of loans. In some cases, the investors wanted only minimal testing, said Frank P. Filipps, Clayton's chairman and CEO.
"The client really drives the process," Filipps said.
Sub-prime mortgages skyrocketed in popularity - with the volume of sub-prime-backed securities soaring from $13 billion in 1995 to $594 billion in 2005 and $521 billion in 2006 - and business exploded for Clayton and Bohan. At the peak, Clayton had about 900 loan-review contractors working for it at any given time, and privately held Bohan had about 350. At publicly held Clayton, revenue rose from $19 million in 2000 to $239.2 million in 2006.
As time passed, Clayton and Bohan executives said, Wall Street firms and their investor customers accepted increasing levels of default and fraud in sub-prime loans as they grew to trust software designed to offset those risks by charging higher interest rates, extra fees and penalties for paying off mortgages early.
As Wall Street grew more comfortable, it demanded less of the review process. Early in the decade, a securities firm might have asked Clayton to review 25% to 40% of the sub-prime loans in a pool, compared with typically 10% in 2006, although the requirements varied, Filipps said.
By contrast, loan buyers who kept the mortgages as an investment instead of packaging them into securities would have 50% to 100% of the loans examined, Bohan President Mark Hughes said.
But the freelancers interviewed by The Times never got the memo that their reviews were supposed to be nice and easy. Flying from city to city and typically paid $30 to $40 an hour, with expenses covered, the reviewers say they worked conscientiously to assure the investment banks and mortgage-bond investors that no surprises lay in the files.
Loan reviewer Jana Lujan recalled showing a file to a supervisor in 2004, during a check of sub-prime mortgages made by a Brea bank that regulators later cited for unsound lending. A title report showed a tax lien on the property.
"I said we needed evidence it had been paid off and released," to ensure against foreclosure, Lujan said. "And he said: 'Just go ahead. Assume it's being taken care of.'"
Loan-buyer representatives who were on site during the reviews also showed little interest in the details, Lujan said.
Lujan said one Clayton supervisor would throw away documents that appeared to have been altered fraudulently. The lack of a document in the file meant the loan had to be sold at a slight discount, she said, but it still could be sold.
Lujan, Valenz and one other loan checker said supervisors at Clayton and Bohan also would change the way fees were described so that mortgages would not be red-flagged as potentially predatory under U.S. law, which would render them unsalable and force the sellers to take them back.
Filipps said he wasn't aware that anyone at Clayton had changed fee categories to bring loans into compliance. He said discarding of documents had never been brought to his attention.
At Bohan, Hughes said he had heard of lenders, but not employees of loan-review firms, throwing documents away. He described attempts to change fee classifications as not unheard of in the industry, but he added that Bohan didn't tolerate such misrepresentations.
New York Atty. Gen. Andrew Cuomo, who is investigating some aspects of the mortgage debacle, has given Clayton immunity from prosecution in return for help in learning whether debt-rating firms and investors got enough information about the loans being sold.
Calling the immunity deal misguided, former Clayton contractors say Clayton and Bohan knowingly understated problems in loan pools.
"There's no way you should give immunity to these guys. They are part of the problem," Valenz said.
Valenz, a veteran employee of mortgage firms, said he complained to bosses about flawed reviews while working directly for Clayton and also for other companies that hired him through a temporary staffing firm on Clayton's referral. He said that after he clashed with supervisors on one such referral job at a bank in Puerto Rico, he was sent home and Clayton never again offered him work.
An attorney for Clayton said Valenz was let go because the Puerto Rico bank fired him for insubordination. Valenz now works as an out-of-state lender's representative to mortgage brokers in Southern California.
The reviewers said the less-thorough approach made their expertise irrelevant and led to pressure to work faster. Valenz and Lujan said they were told to check two or three files an hour when it took an hour or more to do one properly.
One Clayton project supervisor "told us if we spent more than 20 minutes on a file, we were spending 20 minutes too long," Lujan said.
Though quick checks called "data scrubs" could take 20 minutes per loan, Filipps said, complex reviews could take three hours, with the average review taking 80 minutes in 2006.
The biggest problems, the reviewers said, were appraisals that looked inflated and "liar's loans," so nicknamed because borrowers weren't required to prove they earned enough to make their payments.
"You can't tell me a Kmart or a Wal-Mart or a Target floor worker is making $5,000 a month, or a house cleaner is making $10,000," said former loan reviewer Irma Aninger of Palm Desert, a 40-year financial services industry veteran.
Aninger, who did work for Clayton and Bohan, said she tried repeatedly to have such loans marked as unacceptable but was overruled by supervisors, who were known as project leads. "The lead would say, 'You can't do that. You can't call these people liars,'" Aninger said.
Aninger said one such supervisor was Clayton's Ed Peek. He denied discouraging the rejection of "stated income" loans. "Many, many, many stated income loans were rejected," he said, but the loan buyers often bought the rejected mortgages anyway.
From his perch, Peek said, he could see the deterioration of overall standards.
"I had been looking at sub-prime mortgages since the beginning," he said. "When it started, you couldn't get a sub-prime loan for over 80%" of a property's value.
"But the guidelines loosen, and the investors would still buy," Peek said. "They loosen up some more, and investors still buy," until highly risky loans for 100% of a home's value were pushed through.
"Everyone knew this was a bubble that couldn't last," he said. "We all could see this coming."