Knowledge of debt risk key to loan probe

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"Do not sign anything you do not understand."
-- FBI, Mortgage Fraud, 2007

Knowledge of debt risk key to loan probe

February 1, 2008


A federal investigation of potential mortgage-market fraud is likely to examine whether banks duped investors into buying securities marketed as stable that were really backed by risky home loans.

Officials did not give many details at a Tuesday briefing on the criminal probe of 14 companies being conducted by the FBI and Securities and Exchange Commission. But accounting experts and lawyers who have studied the mortgage crisis say investigators are probably sifting through reams of records to figure out how much investment banks knew -- and disclosed -- about the risks of mortgage securities backed by subprime loans.

The key issue for investigators is whether they can prove banks knowingly deceived investors.

"The question is: Did they have enough knowledge to cause the marketing of the bonds themselves to be a fraudulent act?" said Ohio Attorney General Marc Dann, who has been investigating the industry. "What we're finding ...the deeper we dig into this, is that they knew a lot."

Before last year's collapse of lending to borrowers with weak credit, the field boomed from $160 billion in new mortgages in 2001 to a peak of $625 billion in 2005, according to trade publication Inside Mortgage Finance. Money flowed from around the world, as bonds backed by high-priced U.S. mortgages paid healthy yields. The makers and packagers of those loans reaped hefty fees.

Kathleen Engel, a professor at Cleveland-Marshall College of Law who has written about predatory practices, said investigators probably will examine financial firms that profited by betting against the subprime mortgage market. That would suggest they "knew something that other people didn't know and they weren't sharing it," she said.

Morgan Stanley, Goldman Sachs Group Inc. and Bear Stearns Cos. all disclosed in regulatory filings Tuesday that they are cooperating with requests for information from unspecified regulatory and government agencies. Representatives of Deutsche Bank, Bear Stearns, Citigroup Inc. and Morgan Stanley declined to comment. Representatives of Lehman Brothers Holdings Inc. and Goldman Sachs did not immediately respond to requests for comment.

It's going to be difficult to prove that Wall Street firms or subprime lenders intended to commit fraud, Guy Cecala, publisher of Inside Mortgage Finance, said in an e-mail message. But, he said, "it shouldn't be too difficult to get these companies to pay some hefty amounts to settle the charges in order to avoid the stigma associated with a federal prosecution."

Some say the subprime mortgage industry long showed signs of questionable accounting practices, both in how loans were made to borrowers, and in how the value of mortgage investments were calculated. While lenders typically sold mortgage-backed securities to investors, they often retained an interest in those investments.

"In many cases there was a very very high risk that (home loans) wouldn't pay off, but yet it wasn't reflected in their accounting," said Donn Vickrey, co-founder of Scottsdale, Ariz., research firm Gradient Analytics.

Several state officials including those in New York, Connecticut and Illinois are pursuing their own investigations. Massachusetts Secretary of State William Galvin on Friday filed civil charges against Merrill Lynch & Co., alleging that the investment bank sold shaky mortgage securities to the city of Springfield, Mass. even though it knew the investments were risky.

"We are puzzled by this suit," Merrill Lynch spokesman Mark Herr said in an e-mail. "We have been cooperating with (Galvin's office) in its inquiry."

Florida Attorney General Bill McCollum said Thursday that he is investigating the nation's No. 1 mortgage lender, Countrywide Financial Corp., for possible unfair and deceptive business practices. Countrywide said it will cooperate with the Florida investigation.

Sorting through the mess is bound to be an extraordinary task for investigators. "It certainly has the potential to become a massive investigation that could involve many high-profile institutions," said Robert Mintz, a former federal prosecutor in New Jersey and head of law firm McCarter & English LLP's white collar defense practice.