This week's record $7 billion settlement between the Department of Justice and Citigroup stemming from the bank's flawed mortgage-backed securities closes yet another chapter on the financial crisis of 2008.
Although the particular type of subprime mortgage securities involved in the case are no longer being issued by any bank, and overall private mortgage bond issuance is just a fraction compared to pre-crisis levels, the settlement has lessons for structured bond investors anytime valuing collateral poses real challenges.
According to the facts underlying the settlement, Citigroup misrepresented the quality of the mortgage bonds it sold investors and manipulated the process for determining their quality.
In accordance with usual market practice, Citigroup:
- represented that the loans backing the securities complied with lender guidelines and applicable regulations, and had certain loan-to-value ratios and other indications of quality;
- promised that it would not include any loans if it learned they failed to meet the standards set out in its representations and warranties.
However, Citgroup did not tell investors that during its own review of the loans it found a significant portion not to be originated in compliance with underwriting guidelines or regulations, missing essential documentation, and were so poor that they should have been kicked out of the mortgage pool. Instead, Citigroup directed their due diligence vendor to re-categorize such loans as conforming with their promised guidelines.
Citigroup also included loans that violated its own tolerance thresholds regarding a home's value. Citigroup was supposed to reject loans larger than their due diligence firm's estimate of the home or if there was more than a 15 percent difference between the firm's valuation of the property and the appaiser's valuation. Yet despite the due diligence firm finding loans that deserved to be rejected, Citigroup ended up securitizing loans that failed to live up to the valuation guidelines.
The broad lesson for securitization investors is clear: the integrity of the due diligence process matters. Investors should determine whether the seller (bank) relies on the firm or whether it second guesses or even overrides the firm's findings.
The potential for mischief at the due diligence stage suggests that investors should not blindly rely on the representations and warranties made about the assets in a securitization pool or the process for screening them. Investors should have some access to the findings made by due diligence firms and attempt to verify whether the due diligence firm is aware of the bank second guessing the firm's decisions.
Indeed, investors should require disclosure of disputes between the bank and its due diligence firm to obtain some indication that the value of the assets underlying their securities may be shaky. Likewise, as a summary of post-crisis due diligence requirements and suggested practices notes, investors should "verify and prove the independence of the valuer" when the valuation process itself may be questionable.
In an article about the structures and practices of securitization (and other credit risk transfer) markets, I noted that investors' failure to properly assess the credit risk of mortgage securities and assets was a contributor to the financial crisis. But the past isn't just behind us. If the record Citigroup settlement serves as any reminder, it is that investor due diligence still has room to improve.