Made up FICO scores? Twenty-minute speed ratings to AAA? If government prosecutors like New York Attorney General Andrew Cuomo want answers to why the mortgage-backed securities market was so screwed up, they should talk to Matt Van Leeuwen from Bear Stearn's servicing arm EMC.
Reports indicated on Thursday that Cuomo is pursuing a criminal investigation surrounding banks supplying bad information to rating agencies about the quality of the mortgages they signed off on. But so far he hasn't been able to prove where in the chain of blame the due diligence for the ratings broke down.
What Cuomo needs to establish is: whose shoulders does it fall on to verify the information lenders were selling to investment banks about the quality of their loans? And who was ultimately responsible for the due diligence on the loans that created toxic mortgage securities that were at the heart of our financial crisis?
False Information and the Grey Area
Employed during the go-go years of 2004-2006, and speaking in an interview taped by BlueChip Films for a documentary in final production called Confidence Game, Van Leeuwen sheds some light onto the shenanigans going on during the mortgage boom that might surprise even Cuomo. As a former mortgage analyst at Dallas-based EMC mortgage, which was wholly owned by Bear Stearns, he had first-hand experience working with Bear's mortgage-backed securitization factory. EMC was the "third-party" firm Bear was using to vet the quality of loans that would purchase from banks like Countrywide and Wells Fargo.
Van Leeuwen says Bear traders pushed EMC analysts to get loan analysis done in only one to three days. That way, Bear could sell them off fast to eager investors and didn't have to carry the cost of holding these loans on their books.
According to two EMC analysts, they were encouraged to just make up data like FICO scores if the lenders they purchased loans in bulk from wouldn't get back to them promptly. Every mortgage security Bear Stearns sold emanated out of EMC. The EMC analysts had the nitty-gritty loan-level data and knew better than anyone that the quality of loans began falling off a cliff in 2006. But as the cracks in lending standards were coming more evident the Bear traders in New York were pushing them to just get the data ready for the raters by any means necessary.
In another case, as more exotic loans were being created by lenders, the EMC analyst didn't even know how to classify the documentation associated with the loan. This was a data point really important to the bonds ratings. When Bear would buy individual loans from lenders the EMC analyst said they couldn't tell if it should be labeled a no-doc or full doc loan. Van Leeuwen explains, "I wasn't allowed to make the decision for how to classify the documentation level of the loans. We'd call analysts in Bear's New York office to get guidance." Time was of the essence here. "So, a snap decision would be made up there (in NY) to code a documentation type without in-depth research of the lender's documentation standards," says Van Leeuwen.
Two EMC analysts said instead of spending time to go back to the lender and demand clarification, like if verification of income actually backed these loans, the executives at Bear would just make the loan type fit. Why? One EMC analyst explains, "from Bear's perspective, we didn't want to overpay for the loans, but we don't want to waste the resources on deep investigation: that's not how the company makes money. That's not our competitive advantage -- it eats into profits."
Twenty Minutes for AAA
It's easy to paint Bear as the only villain here -- but what were the rating agencies thinking?
Susan Barnes of Standards and Poor's testified before Congress last month saying banks like Bear were responsible for due diligence in the transactions described above: "For the system to function properly, the market must rely on participants to fulfill their roles and obligations to verify and validate information before they pass it on to others, including S&P."
Yet, was it reasonable for agencies to stand behind ratings when due diligence was done by an affiliate of Bear? That's like buying a car from a guy whose mechanic brother said it was great, and then finding out it was a lemon.
Equally amazing was how responsive the raters were even on the big deals. Van Leeuwen says, "The raters would provide a rating on a $1 billion security in 20-30 minutes." Describing it as "a rubber stamp," Van Leeuwen said that the ratings agencies slavish devotion to their computer models "was vital" because it allowed Bear to "cram mortgages through the process."
The greatest asset Bear had in its quest to squeeze every ounce of profit from the mortgage-backed securities market was the methodology of the big ratings agencies. The bankers knew what kind of loan detail was needed to get that coveted AAA rating. After they prepped the rating agencies for what they 'thought' the loans would look like, they would buy loans in bulk, and then spend a day scrubbing them.
Bear's decision to cut corners and to fail to take the time to make sure the raters got correct information about the quality of loans was a big no-no. But rating bonds based on fast reactions, instead of thoughtful analysis and reliable due diligence, also might place some responsibility on the agencies' shoulders.