Clayton was the dominant (roughly 70% of the market) "due diligence" firm hired by secondary market purchasers to review a sample of the loans offered for sale by the loan originators to determine whether the sample actually met the loan guidelines. Clayton was not a paragon of virtue, but its managers had the good sense to cut an immunity deal. Clayton was a deliberately weak grader (which produced a passel of whistleblowers), so the reality is much worse than the results I am about to report. (See the FCIC testimony of the Citigroup whistleblower, Richard Bowen, to see the fraud incidence found in more competent and vigorous due diligence.)
The national average for the 18 month period January 2006-June 2007, was that Clayton found that 46% of the reps & warranties were false. Note that this demonstrates that it was normal for both that the loan quality of the lenders was pathetic and that they lied endemically when they claimed that the loans were made in accordance with their loan guidelines. That means that as weak as those guidelines were they were shams intended to hide an even more pathetic reality.
I do not know anyone that would continue to buy from Amazon if they cheated him 46% of the time, but trillions of dollars of toxic mortgages were sold through pervasively fraudulent reps and warranties for years. This only makes sense if the officers running the purchasers are also following the accounting control fraud recipe. This huge incidence of fraud grew: the share of false reps & warranties found by Clayton in their loan reviews grew every quarter from 4th Quarter 2006 on: rising from 43% to 47% to 53% as of June 30, 2007. Yes, you read that correctly, a majority of the reps and warranties reviewed by Clayton were false by the second quarter of 2007. Note that the secondary market purchasers did not, and could not (without moving to 100% sampling), use the Clayton sampling to exclude more than 10% of the fraudulent loans. Again, DOJ prosecutors have to understand percentages, not "rocket science."
What is going on, of course, is the financial variant of "don't ask; don't tell." The fraud recipe works simultaneously for the senior officers of the loan originators and the senior officers of the banks that acquire the loans. This makes it much more difficult to establish reliance in a civil suit because the purchasers knew that the loans they were buying were toxic and that the originators' reps and warranties were false. This fact produces a very unusual result. Normally, it is harder to prosecute a defendant than to bring a civil case against them, but because reliance is not an element of a criminal fraud case it is actually easier to prosecute loan originators for their fraudulent sales to the secondary market than to bring a successful civil case against the lenders' senior officers.
DOJ uses the Clayton reports, which exist for every loan package that Clayton reviewed (and recall that it had 70% of the due diligence market), in its major cases and key offices have hundreds of thousands of pages of Clayton documentation.
The other particularly useful source of information on the sham underwriting by loan originators is lawsuits filed by agencies of the United States, including NCUA, the FHFA, the FDIC, and the SEC as well as actions filed by DOJ. In many of these lawsuits agencies of the United States cite the fact that the loan standards of the lenders that they are suing are shams and that the lenders are on the OCC's list of the "worst of the worst" lenders.
Consider these brief excerpts from a NCUA action against Credit Suisse, et al. Note the tenor of NCUA's descriptions of what investigations of the fraudulent lenders have disclosed. The numbers in brackets are the paragraphs of the complaint that I excerpted.
"[7] [T]he Originators had systematically abandoned the stated underwriting guidelines in the Offering Documents. Because the mortgages in the pools collateralizing the RMBS were largely underwritten without adherence to the underwriting standards in the Offering Documents, the RMBS were significantly riskier than represented in the Offering Documents. The property values supporting the average LTV, CLTV and mixed LTV ratios were routinely overvalued at the time of origination, rendering the average LTV, CLTV and mixed LTV ratios inaccurate. Further, the rates of owner occupancy were far lower than represented in the Offering Documents. Indeed, a material percentage of the borrowers whose mortgages comprised the RMBS were all but certain to become delinquent or default shortly after origination. As a result, the RMBS were destined from inception to perform poorly.
[57] A. The Surge in Mortgage Delinquency and Defaults Shortly After the Offerings and the High OTD Practices of the Originators Demonstrate Systematic Disregard of Underwriting Standards
96. During the housing boom, mortgage lenders focused on quantity rather than quality, originating loans for borrowers who had no realistic capacity to repay the loan. The FCIC Report found "that the percentage of borrowers who defaulted on their mortgages within just a matter of months after taking a loan nearly doubled from the summer of 2006 to late 2007." Id. at xxii. Early Payment Default is a significant indicator of pervasive disregard for underwriting standards. The FCIC Report noted that mortgage fraud "flourished in an environment of collapsing lending standards-- Id.
97. In this lax lending environment, mortgage lenders went unchecked, originating mortgages for borrowers in spite of underwriting standards:
Lenders made loans that they knew borrowers could not afford and that could cause massive losses to investors in mortgage securities. As early as September 2004, Countrywide executives recognized that many of the loans they were originating could result in "catastrophic consequences." Less than a year later, they noted that certain high-risk loans they were making could result not only in foreclosures but also in "financial and reputational catastrophe" for the firm. But they did not stop [FCIC 2011: xxii].
105. In sum, the disregard of underwriting standards was pervasive across originators."
There are even more detailed complaints about WaMu's systematic disregard of its purported loan underwriting standards.
DOJ's Shameful Pursuit of the Fraud "Mice"
While Wagner provides only four attorneys to fail to prosecute JPM he devotes the great bulk of his grossly inadequate resources to prosecuting the fraud "mice." In those cases DOJ turns around and claims that these same lenders that agencies of the U.S., including DOJ, have found to have engaged in the "systematic disregard of underwriting standards" supposedly consistently comply with their loan standards and would reject any loan that failed to comply with those standards.
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