The Finger Pointing Continues In The Subprime World

Implications: This article is illustrating finger pointing looking for a villain, instead of "post-mortem" to find a hero.  What the industry needs is a clear plan for rebuilding the subprime securitization market.  In my opinion, a great part of that will be tied to the outsourced due diligence function, and the value those in that area add to the process.  One of the leading players in the space is now looking to be at odds with their client base. 

Analysis: Disclosure:  I hold a long (albeit small) position in Clayton Holdings, one of the firms mentioned in the article.. 

And let's also get an assumption for this analysis out on the table.  Markets in the US and around the globe are all responsible for the subprime situation.  Most every investor wants more yield, and wants plenty of product and liquidity available with an ever increasing return.  No one player is more greedy than all the others, and all the hunt for wrongdoers will do is show how large a problem this is.  It is simple theory that if increasing yield needs to be delivered on debt instruments, with available product at higher rates than the general market, then credit standards have to drop.

This is a tough one to analyze, but the message is clear to me that there is an avenue of inquiry being looked at here that will not result in positive change for the industry.  The type of finger pointing going on is seeking to find a bad guy in one or more of the participants in the mortgage industry. 

You can be confident that the major "Wall Street" securitizers named in the article didn't start cutting back on outsourced due diligence review to hide problems with underlying credit quality.  They may have, however, done so, to keep the deal flow at unprecedented levels.  It is clear to me, that they chose to use other diligence alternatives to make sure the book of business was what they expected it to be.  More than one of the firms captioned in the article actually built or bought a mortgage banking firm so they could better manage risk.  All utilized automated systems to return information about the collateral underlying the loans.  No one turned a blind eye to quality, rather they were driven to produce "yield rated" originations in very high volumes to satisfy the market.

All the securitizers were buying their loans from the same conduits, and selling them to the same marketplace.  I doubt anyone of them spent less on due diligence in 2007 then previous years, as compared to their peers.

NY is putting CLAY in a bad position with its clients.  Timing couldn't be worse.  If Clayton reinvented their business they could achieve outstanding organic growth by providing more services instead of less.  If they and the small group of niche players (including First American's Bohan, and FIS' Watterson Prime) would actually serve a role where they sat between the originators and the securitizers on every deal, and if typification of sub prime risk could be standardized, this would be a far better market to invest in.  Beyond understanding the level of risk, outsourcing a good deal of the pre-funding decisioning to qualified third parties makes sense.  Given the elimination of no/alternative documentation loans, and with enforcing reasonable (market based) loan to value ratios, it is possible to get back on the right track.