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RMBS Fallout: Were Investors Duped?

One positive outcome from the Financial Crisis Inquiry Commission so far is the increased attention to the mortgage due diligence process for residential mortgage-backed securities.

Aided by commission testimony, journalists including Reuters’ Felix Salmon and The Times’ William Cohan are shedding light on how the due diligence process worked in the run-up to the credit crisis and expressing outrage at the lack of transparency that existed. Many are pinning the blame on issuers, who paid for due diligence results without sharing the results with investors who ultimately bought the RMBS.

Their outrage makes some sense—there wasn’t a lot of transparency. But it’s focused on too narrow of a group, and it doesn’t show a real understanding of the rules in play at that time.

In the run-up to the crisis, there was no rule that issuers had to perform due diligence at all. They obtained diligence for their own purposes, and when they did, no rule dictated that the results be disclosed to rating agencies and investors.

That was a major systemic problem. But why pin it on the issuers?

This was not news to the SEC, which regulates the industry, or to the rating agencies, which based ratings off of untested data provided directly from issuers. It wasn’t news to the due diligence firms operating at the time, which resisted calls for systematic reform. And it wasn’t news to investors, who willingly entered the pie-eating contest that RMBS trading became. By the time the meltdown was underway, investors had years of experience buying subprime loans and watching them default, and seeing the reasons for those defaults. It was no secret among investors that there were bad loans in these pools, or that issuers were paying for due diligence they had no right to see.

Cohan points to testimony by Chapman University School of Law professor Kurt Eggert:

“Investors were not given sufficient information to make the decisions that they needed to make to see if they were going to buy these securities. … They should have gotten the due diligence reports that we just heard described. Those reports existed. The exceptions were described and defined. Why weren’t investors given that information which was in the hands of the people that were selling the securities? Why weren’t they given the underwriting reports by the originators who knew what exceptions were given and why?”

The answer is simple: because it wasn’t required. And nobody – not investors, nor the SEC nor the rating agencies – were demanding that it be required.

The fact remains that investors still don’t have access to due diligence reports. But other important reforms, many of which I’ve advocated since before the credit crisis, are creating a system that better protects their interests.

Most notably, New York Attorney General Andrew Cuomo’s imposed rules on rating agencies operating in his state – these include major players S&P and Moody’s, as well as Fitch – require rating agencies to obtain due diligence results from an independent third-party review firm such as Allonhill. The rules require that reliable sampling methodology be used, and that errors and problem loans be disclosed, among other rules. There are still potential loopholes that should be filled – for example, rating agencies outside of New York are not bound by the rules, and there is no process for evaluating the quality of the due diligence firm in a uniform way – but this is a promising start.

Another positive step, which the SEC so far has resisted, would include allowing investors access to the same information that rating agencies must provide to all other rating agencies under the newly instituted, and controversial, SEC Rule 17g-5.

Industry participants on all sides share the blame for systemic problems that contributed to the collapse. By continuing to work together to implement these critical reforms, we can also share in the credit for a responsible return.