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As the subprime mortgage meltdown spreads and infects other related markets, two questions stand out: Why did the securitization process fail so badly? And what would it take to make securitized financings viable again? In short, can mortgage-backed structured finance be saved? Clearly, the default rates on mortgage-backed securities spiked in 2007. But what caused this unprecedented increase? Was fraud � whether in the form of inflated appraisals, predatory lending or manipulated credit scores � a central factor? Although misconduct probably occurred, growing evidence strongly suggests that fraud in the loan origination process was only a peripheral factor. Instead, more basic economic forces were responsible. New empirical studies appear to indicate that the best causal explanation for the housing bubble is that securitization undercuts the incentives of the originating banks to screen or monitor their borrowers. Of course, this is consistent with the popular understanding that securitized mortgages were “ninja loans” � i.e., the borrowers had “no income, no job and no assets.” But the truth is more complex and stranger. Higher-scoring, securitized loans defaulted more often Using a sample of more than 2 million home-purchase loans made between 2001 and 2006, researchers at the business schools of the universities of Michigan, Chicago and London have found that mortgage loans that were securitized during this period generally needed to have a credit score on the Fair Isaac & Co. (FICO) credit index above 620; loans with scores below that level were still made, but were retained by the originating banks. Yet, paradoxically, the higher-scoring securitized loans subsequently had a 20% higher default rate than the nonsecuritized loans with an otherwise similar risk profile but a FICO score below 620. The researchers’ explanation is that the banks screened more carefully the lower-scoring loans, knowing that they could not pass on the credit risk to others. In short, nonquantifiable subjective factors led the banks to make the lower-scoring loans, but such “softer” data neither needed to be considered in, nor could be easily incorporated into, the analysis of loans that were securitized. See Benjamin Keys, Tanmoy Mukherjee, Amit Seru and Vikrant Vig, “Securitization and Screening: Evidence from Subprime Mortgage Backed Securities” (2008). Securitization relies on objective, easily measured data, but such data may not be the best measure of credit risk. Free from the risk of default once they sold the loan, the banks had no incentive to screen based on the data that they themselves actually used. Ultimately, this pattern is a classic “moral hazard” problem. But, in theory, it should have been counterbalanced by increased vigilance on the part of the investment banks purchasing these loan portfolios. In the past, it probably was. The common practice among underwriters was to outsource their due diligence work to “contract underwriters,” which analyzed each loan portfolio to see if the mortgage loans in the pool complied with the underwriters’ lending criteria. One of the best known of these firms � Clayton Holdings Inc. � entered last month into a de facto plea bargain agreement with New York Attorney General Andrew Cuomo under which, in return for immunity under New York law, it will turn over the reports that it provided to its underwriting clients. Clayton’s general counsel has been quoted estimating that in 2006, around 30% of the loans included in securitized portfolios were “exception” loans � i.e., loans outside the underwriters’ normal criteria. Press reports have also attributed to Clayton the estimate that in some securitizations this percentage was well above 50% and the claim that its clients were warned of these problems. If so, it appears that neither the loan originator nor its purchaser, the investment bank, had much incentive to monitor loan quality. This is “moral hazard” with a vengeance. In litigation, these underwriters will have to rely on the defense that their generic disclosures that “exception” loans constituted a “substantial” or “significant” proportion of the securitization pool was sufficient to provide full disclosure. That could prove to be a tough sell to a jury. Still, the subprime litigation wars will be complex. Debt markets are seldom efficient in the way that equity securities markets are, and the “fraud on the market” doctrine will likely be inapplicable. But the largest institutions are likely to opt out of the various class actions and sue individually in state court, where they can escape much of the Private Securities Litigation Reform Act and assert individual reliance on the defendant’s statements. Uniquely, � 22(a) of the Securities Act of 1933 gives state courts concurrent jurisdiction and bars removal of state court cases to federal court. Thus, underwriters face a costly war on two or more fronts. High liability may teach underwriters to pay more attention to due diligence. But why did they apparently ignore their own agents, such as Clayton? Probably, underwriters believed that they had little need to focus on borrower creditworthiness so long as real estate values would continue to rise. Just as did the Japanese banks in the 1980s, they assumed that the collateral would always exceed the value of the outstanding loan. A recent study by two University of Chicago business school professors shows how quickly the expansion of securitization frustrated this expectation. Focusing on variations in housing appreciation and default rates across zip codes within the same county, they find that, between 2001 to 2005, those zip codes in which a high proportion of mortgage applicants had previously been denied loans experienced a sharp turnaround. In that period, these “underfunded” zip codes saw the denial rates on mortgage applications decline rapidly, meaning that riskier loans were being made. The number of mortgages originated and housing prices climbed hand in hand. Driving this rapid housing price appreciation was an equally sharp increase in the percentage of loans sold by originators shortly after origination. Not surprisingly, the sudden rise in the mortgage supply in these zip codes from 2001 to 2005 was followed by correspondingly sharp increases in the mortgage default rates from 2005 to 2007, with the default rates in these same zip codes vastly exceeding the rates elsewhere. In short, the impact of securitization was uneven and intensely focused. Although securitization made credit available in areas where it had been scarce, it also caused default rates to skyrocket in these same areas when the market cooled after 2005. See Atif Mian and Amir Sufi, “The Consequences of Mortgage Credit Expansion: Evidence from the 2007 Mortgage Default Crisis” (2008). The conclusion then seems inescapable: The rapid growth in the securitization of mortgages from 2001 on, coupled with weak screening, fueled the bubble. When eventually the spike in housing prices subsided and interest rates rose, marginally creditworthy borrowers with little, if any, equity at stake had no reason or ability to pay off mortgages that exceeded the market value of their homes. If the securitization process is as flawed as these studies suggest, can it be reformed? This question is central because real estate prices are likely to remain depressed so long as the securitization market remains frozen. Freddie Mac and Fannie Mae cannot begin to pick up most of the slack. Even if underwriters in the future invest more time and effort in due diligence and reduce the percentage of “exception” loans included in securitized portfolios, this still does not imply that investors will trust them. Similarly, investors have learned that they cannot rely on the credit rating agencies. Although the ratings agencies have introduced some modest reforms, it is probably beyond their capacity to conduct more than perfunctory due diligence on all the securitized offerings that they rate. What steps then can restore investor confidence? Ultimately, investors need a new gatekeeper upon whom they can rely to verify loan quality. Conceivably, the existing due diligence firms, such as Clayton Holdings, could partly fill this role by providing a certification that they had checked the loans within any given portfolio and found no more than a specified percentage to be “exception” loans, as defined. Such an expert certification would be included in the registration statement and would carry high liability under � 11 of the Securities Act of 1933. Yet, even if these small “due diligence” firms could be induced to provide such a certification and to accept the potential liability, they have neither the reputational capital nor the financial resources standing behind them to make their representations adequately credible to investors. Big Four firms could fill the role of new gatekeeper Who could fill the reputational void? The most likely candidate would be the Big Four auditing firms, which could expand into this field, in effect testing whether the loans in any portfolio met specified and clearly disclosed criteria. Indeed, over time, the accounting firms might even enter the credit rating business, thereby at last creating real competition in the ratings field. Not only do they have the necessary reputational capital, but a natural synergy exists here. Ratings based on an audit-like inquiry by the rater make much more sense than our current system under which the rating agency’s letter grade is wholly based on information provided by the issuer that it assumes to be true. Sarbanes-Oxley also presents no problem because the auditor performing this consulting role would not also be serving as auditor to the issuer. Whatever the reforms adopted, private action by the investment community is essential. The “good old days” of easy, low-effort securitizations are gone with the wind. Until informational asymmetry can be reduced, the subprime mortgage market will remain paralyzed and the economy correspondingly depressed. Private action could work better than mandatory governmental reforms in filling this void by introducing a new gatekeeper. John C. Coffee Jr. is the Adolf A. Berle Professor at Columbia Law School and director of its Center on Corporate Governance.

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