The Back Alley Archives

The first document everyone should read is by S&P, the largest of the rating agencies. The context of the document is that a professional credit rater has told his superiors that he needs to examine the mortgage loan files to evaluate the risk of a complex financial derivative whose risk and market value depend on the credit quality of the nonprime mortgages "underlying" the derivative. A senior manager sends a blistering reply with this forceful punctuation:

"Any request for loan level tapes is TOTALLY UNREASONABLE!!! Most investors don't have it and can't provide it. [W]e MUST produce a credit estimate. It is your responsibility to provide those credit estimates and your responsibility to devise some method for doing so."

A rating agency (Fitch) first reviewed a small sample of nonprime loan files after the secondary market in nonprime loan paper collapsed and nonprime lending virtually ceased. The second document everyone should read is Fitch's report on what they found.

Fitch's analysts conducted an independent analysis of these files with the benefit of the full origination and servicing files. The result of the analysis was disconcerting at best, as there was the appearance of fraud or misrepresentation in almost every file.


[F]raud was not only present, but, in most cases, could have been identified with adequate underwriting, quality control and fraud prevention tools prior to the loan funding. Fitch believes that this targeted sampling of files was sufficient to determine that inadequate underwriting controls and, therefore, fraud is a factor in the defaults and losses on recent vintage pools.

These two documents are enough to begin to understand:

* the FBI accurately described mortgage fraud as "epidemic"

* nonprime lenders are overwhelmingly responsible for the epidemic

* the fraud was so endemic that it would have been easy to spot if anyone looked

* the lenders, the banks that created nonprime derivatives, the rating agencies, and the buyers all operated on a "don't ask; don't tell" policy

* willful blindness was essential to originate, sell, pool and resell the loans

* willful blindness was the pretext for not posting loss reserves

* both forms of blindness made high (fictional) profits certain when the bubble was expanding rapidly and massive (real) losses certain when it collapsed

* the worse the nonprime loan quality the higher the fees and interest rates, and the faster the growth in nonprime lending and pooling the greater the immediate fictional profits and (eventual) real losses

* the greater the destruction of wealth, the greater the (fictional) profits, bonuses, and stock appreciation

* many of the big banks are deeply insolvent due to severe credit losses

* those big banks and Treasury don't know how insolvent they are because they didn't even have the loan files

* a "stress test" can't remedy the banks' problem -- they do not have the loan files