Did bankers ignore warnings about faulty loans?

“You can’t get losses of this magnitude without massive fraud,” said Bill Black, a professor at the University of Missouri in Kansas City and an expert on bank fraud. Black should know, he played a key role in uncovering S&L fraud 20 years ago.

If Black is right, an American Banker story March 14 gives new detail on how some of that fraud might be surfacing.

Investment banks and trusts that bought loans to securitize and sell to investors often hired companies to examine the loan files first. The idea was to make sure the loans were good quality, before they were turned into securities and sold to investors.

Through lawsuits, often filed by investors against securitizers, and through the Financial Crisis Inquiry Report, details of these reports, called due diligence reports, are leaking out. It appears they sometimes found seriously defective loans but investment banks and trusts bought the loans anyway, either because the decision to buy was made by someone who didn’t read the due diligence report or because securitizing was so profitable they didn’t care.

RepoWatch tracks securitization because repurchase agreements made it all possible. For example, when investment banks and trusts bought loans from mortgage originators, the purchase was often structured as a repo loan. When investment banks and trusts sold the securities, the sale was often structured as a repo loan. Often banks themselves bought the securities, to use as collateral for repo loans. Top U.S. regulators have said the interconnectedness of the repo market was the systemic risk most responsible for forcing the taxpayer bailout of the mega-banks in 2008.

From the American Banker story, which has much detail:

“We all know from the different testimony that there is a considerable amount of fraud or gross negligence in what was sold and it is now coming out and being verified through all of the plaintiff litigation,” said Thomas R. Borgers, a former senior investigator at the (financial crisis inquiry) commission. “If you are doing a 2 or 5% sample and you find that 20, 30, 40, 50% of all the sample had defects … what would you do? Would you stop there and buy all of the mortgages?” …

“A lot of people bought into the global financial catastrophe argument — that these problems were caused by the collapse of the housing market and macroeconomic factors,” said Isaac Gradman, a former plaintiff’s attorney who now runs a consulting firm, IMG Enterprises. “I think that the due diligence reports that were run by the securitizers prior to purchasing the loan pools from the originators is the strongest evidence available that the banks knew that they were buying defective loans.”