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ALL IN 

DISCLOSURE AND DUE DILIGENCE:
“A QUALITY CONTROL ISSUE IN THE FACTORY”
In addition to the rising fraud and egregious lending practices, lending standards de-
teriorated in the final years of the bubble. After growing for years, Alt-A lending in-
creased another  from  to . In particular, option ARMs grew  during
that period, interest-only mortgages grew , and no-documentation or low-docu-
mentation loans (measured for borrowers with fixed-rate mortgages) grew .
Overall, by  no-doc or low-doc loans made up  of all mortgages originated.
Many of these products would perform only if prices continued to rise and the bor-
rower could refinance at a low rate. 
In theory, every participant along the securitization pipeline should have had an
interest in the quality of every underlying mortgage. In practice, their interests were
often not aligned. Two New York Fed economists have pointed out the “seven deadly
frictions” in mortgage securitization—places along the pipeline where one party

knew more than the other, creating opportunities to take advantage. For example,
the lender who originated the mortgage for sale, earning a commission, knew a great
deal about the loan and the borrower but had no long-term stake in whether the
mortgage was paid, beyond the lender’s own business reputation. The securitizer
who packaged mortgages into mortgage-backed securities, similarly, was less likely to
retain a stake in those securities.
In theory, the rating agencies were important watchdogs over the securitization

process. They described their role as being “an umpire in the market.” But they did
not review the quality of individual mortgages in a mortgage-backed security, nor
did they check to see that the mortgages were what the securitizers said they were.
So the integrity of the market depended on two critical checks. First, firms pur-
chasing and securitizing the mortgages would conduct due diligence reviews of the
mortgage pools, either using third-party firms or doing the reviews in-house. Sec-
ond, following Securities and Exchange Commission rules, parties in the securitiza-
tion process were expected to disclose what they were selling to investors. Neither of
these checks performed as they should have.

Due diligence firms: “Waived in”
As subprime mortgage securitization took off, securitizers undertook due diligence
on their own or through third parties on the mortgage pools that originators were
selling them. The originator and the securitizer negotiated the extent of the due dili-
gence investigation. While the percentage of the pool examined could be as high as
, it was often much lower; according to some observers, as the market grew and
originators became more concentrated, they had more bargaining power over the
mortgage purchasers, and samples were sometimes as low as  to . Some secu-

ritizers requested that the due diligence firm analyze a random sample of mortgages
from the pool; others asked for a sampling of those most likely to be deficient in some
way, in an effort to efficiently detect more of the problem loans.