Following up on the last posting here, it seems that rigorous due diligence and accurate reporting of risk actually may not have been a high enough priority in the mortgage-backed securities business, not when there was so much to be made off unsuspecting investors induced to buy into this hyped market. Thus, the New York state attorney general’s probe into the mortgage-backed securities industry is reported to be heating up after Clayton Holdings, Inc., a full service management firm catering to players in the MBS business, struck a deal with the AG.

You be the judge, from the front page New York Times January 27, 2008 report on this development:

“There is no evidence that Clayton did anything wrong, but securing immunity provides legal certainty for the company and its officers. The company is in a difficult position, because its cooperation might hurt its clients, the investment banks.

Clayton, a publicly held company and the nation’s largest provider of mortgage due diligence services to investment banks, communicated daily with bankers putting together mortgage securities.

As part of the deal, Clayton has told the prosecutors that starting in 2005, it saw a significant deterioration of lending standards and a parallel jump in lending exceptions. In an another sign that the industry was becoming less careful, some investment banks directed Clayton to halve the sample of loans it evaluated in each portfolio, a person familiar with the investigation said.

The mortgage business boomed from 2002 to 2006, generating lucrative fees for mortgage brokers, lenders, credit rating firms, investment banks and many investors. Investment banks began buying billions of dollars of more risky loans made to borrowers with blemished, or subprime, credit histories and packaging them into securities that paid high interest.

Among the biggest investment banks in the mortgage business are Lehman Brothers, the Royal Bank of Scotland, Bear Stearns, Morgan Stanley and Merrill Lynch. None of them have been accused of wrongdoing in Mr. Cuomo’s investigation [New York state Attorney General Andrew Cuomo].

It is unclear how many lending exceptions are contained in the $1 trillion subprime mortgage market, but industry participants cite figures ranging from about 50 percent to 80 percent for some loan portfolios they examined.

The investigation is likely to hinge on whether the reports produced by Clayton included material information, which the issuers of securities must provide to investors under law. Securities fraud cases often turn on courts’ interpretation of materiality.

Investment banks hired companies like Clayton to evaluate a sample, say 20 percent, of the loans. The review was supposed to determine whether the loans complied with the law and met the lending standards that the mortgage companies said they were using. Loans that did not were classified as exceptions.

As demand for the loans surged, mortgage companies were in a strong enough position to stipulate that investment banks have Clayton and other consultants look at fewer loans. The lenders wanted the due diligence to find fewer exceptions, which were sold at a discount, the person familiar with the investigation said.

The investment banks then pooled the mortgages into securities, often by blending loans from different lenders. Information on those mixed pools was then delivered to the rating agencies, which assigned the securities a score. Pension funds and other big investors bought them because they had triple-A ratings.

But investment banks did not give the rating agencies their due diligence reports, and it appears that the agencies did not demand them, people familiar with Mr. Cuomo’s investigation said.”

Jenny Anderson, Vikas Bajaj, Loan Reviewer Aiding Inquiry into Big Banks,  N. Y. TIMES, January 27, 2008, at A1.