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FINANCIAL CRISIS INQUIRY COMMISSION REPORT
Clayton Holdings, a Connecticut-based firm, was a major provider of third-party
due diligence services. As Clayton Vice President Vicki Beal explained to the FCIC,
firms like hers were “not retained by [their] clients to provide an opinion as to
whether a loan is a good loan or a bad loan.” Rather, they were hired to identify,
among other things, whether the loans met the originator’s stated underwriting
guidelines and, in some measure, to enable clients to negotiate better prices on pools
of loans.
The review fell into three general areas: credit, compliance, and valuation. Did the
loans meet the underwriting guidelines (generally the originator’s standards, some-
times with overlays or additional guidelines provided by the financial institutions
purchasing the loans)? Did the loans comply with federal and state laws, notably
predatory-lending laws and truth-in-lending requirements? Were the reported prop-
erty values accurate? And, critically: to the degree that a loan was deficient, did it
have any “compensating factors” that offset these deficiencies? For example, if a loan
had a higher loan-to-value ratio than guidelines called for, did another characteristic
such as the borrower’s higher income mitigate that weakness? The due diligence firm
would then grade the loan sample and forward the data to its client. Report in hand,
the securitizer would negotiate a price for the pool and could “kick out” loans that
did not meet the stated guidelines.
Because of the volume of loans examined by Clayton during the housing boom,
the firm had a unique inside view of the underwriting standards that originators were
actually applying—and that securitizers were willing to accept. Loans were classified
into three groups: loans that met guidelines (a Grade Event), those that failed to
meet guidelines but were approved because of compensating factors (a Grade
Event), and those that failed to meet guidelines and were not approved (a Grade
Event). Overall, for the months that ended June , , Clayton rated of the
, loans it analyzed as Grade , and another as Grade —for a total of
that met the guidelines outright or with compensating factors. The remaining of
the loans were Grade . In theory, the banks could have refused to buy a loan pool,
or, indeed, they could have used the findings of the due diligence firm to probe the
loans’ quality more deeply. Over the -month period, of the loans that Clayton
found to be deficient—Grade —were “waived in” by the banks. Thus of the
loans sampled by Clayton were accepted even though the company had found a basis
for rejecting them (see figure .).
Referring to the data, Keith Johnson, the president of Clayton from May to
May , told the Commission, “That to me says there [was] a quality control
issue in the factory” for mortgage-backed securities. Johnson concluded that his
clients often waived in loans to preserve their business relationship with the loan
originator—a high number of rejections might lead the originator to sell the loans to
a competitor. Simply put, it was a sellers’ market. “Probably the seller had more
power than the Wall Street issuer,” Johnson told the FCIC.
The high rate of waivers following rejections may not itself be evidence of some-
thing wrong in the process, Beal testified. She said that as originators’ lending guide-
lines were declining, she saw the securitizing firms introduce additional credit
