The Wall Street Journal-20080128-Due-Diligence Firm to Aid New York Subprime Probe

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Due-Diligence Firm to Aid New York Subprime Probe

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New York state prosecutors have secured cooperation from a company that analyzes mortgages for banks, aiding an investigation into the role of Wall Street banks in the subprime-mortgage-market turmoil.

Clayton Holdings Inc., which reviews loans for investment banks before they are turned into securities and sold to investors, reached an agreement last week to provide information and testimony to the office of New York Attorney General Andrew Cuomo. His office had subpoenaed several such businesses, known as due-diligence firms, last year.

The agreement, reported by the New York Times and confirmed by Clayton, provides immunity from prosecution.

The investigation's focus is whether investment banks disclosed enough to investors and to credit-rating firms about the securities after receiving reports by due-diligence firms that showed an increasing number of loans in recent years didn't conform to minimum lending standards, according to a person familiar with the matter. It also aims to determine whether the credit-rating firms asked enough questions about the quality of the loans that backed the securities they rated, this person said.

Benjamin Lawsky, Mr. Cuomo's deputy counselor and special assistant, and Eric Corngold, executive deputy attorney general for economic justice, are leading the probe.

Investment banks that underwrite securities have an obligation to make sure that statements included in offering documents to investors are accurate and that "material" risks are disclosed. Clayton, of Shelton, Conn., began providing documents to New York prosecutors last year, but its promise of further cooperation and testimony will help prosecutors determine what facts were material, according to the person familiar with the investigation.

Among the issues are loans known as exception loans, or potentially questionable loans not meeting all of the originator's lending standards. The investigation is looking at whether the broad language written in prospectuses about the risky nature of these securities changed little in recent years, even as due-diligence reports noted that the number of exception loans backing the securities was rising.

Mr. Cuomo's office has subpoenaed several investment banks; none has been charged. Clayton also hasn't been charged.

It is unclear what banks might be involved in the probe. In a filing with the Securities and Exchange Commission, Clayton said "many" banks and lending firms have been among its clients. Deutsche Bank AG and Morgan Stanley accounted for about 24% of the company's revenue in 2006, while Lehman Brothers Holdings Inc. had been a large client in the past. Deutsche Bank and Morgan Stanley declined to comment; Lehman Brothers couldn't be reached.

The SEC is also investigating the role of due-diligence firms, investment banks, and credit-rating firms in the packaging and sale of residential mortgage-backed securities. Clayton has previously provided the SEC with the same information as state prosecutors, according to people familiar with the matter.

The company says it has "no reason to believe that it is a target of an SEC investigation."

Frank P. Filipps, Clayton's chairman and chief executive, said in an interview yesterday that the company had given the New York attorney general's office copies both of the due-diligence reports it gave to its clients from 2005 through 2007 and of email correspondence.

In 2006, about 30% of loans examined by Clayton had some kind of exception, company executives say. Mr. Filipps said some were simple errors that were unlikely to affect the performance of a pool of loans, such as the transposition of the numbers in an address. Other problems were more meaningful, such as loans that fell outside minimum financial guidelines set by lenders. Some investment banks, he said, would reject loans identified as exceptions, but others "purchased many of the loans regardless of our findings."

The company receives a flat fee, typically around $150, from the investment bank issuing the securities for each loan file it reviews.

The probe may lead to civil or criminal cases against investment banks or their employees for securities fraud under New York's Martin Act, or a broad civil settlement between the firms and Mr. Cuomo.

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Peter Lattman contributed to this article.