The Wall Street Journal-20080131-State Subprime Probe Takes a New Tack

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State Subprime Probe Takes a New Tack

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The New York attorney general's office, pursuing an investigation into whether Wall Street firms improperly packaged and sold mortgage securities, is latching onto a powerful regulatory tool: the 1921 Martin Act.

The state law, considered one of the most potent legal tools in the nation, spells out a broad definition of securities fraud without requiring that prosecutors prove intent to defraud. As a result, the act has become an influential hammer in recent years for New York state prosecutors in cracking down on securities manipulation, improper allocation of initial public offerings of stock and misleading stock research on Wall Street.

Now the staff of New York Attorney General Andrew Cuomo is looking to use this legal lever as it examines whether firms might have committed securities fraud by glossing over warning signs of bad mortgage loans they packaged into securities, people familiar with the matter said.

Some officials on Wall Street hadn't expected Mr. Cuomo to employ the aggressive prosecutorial tactics against the financial industry used frequently by his predecessor, Eliot Spitzer. Using the Martin Act will provide an easier road to prosecute mortgage abuses than other investigators examining this area. The act also will allow the New York attorney general to pursue both criminal and civil penalties.

The development comes as the attorney general's office has gained the cooperation of Clayton Holdings Inc., a company that provides due diligence on pools of mortgages for Wall Street firms. At issue is whether the Wall Street firms failed to disclose adequately the warnings they received from Clayton and other due-diligence providers about "exceptions," or mortgages that didn't meet minimum lending standards.

Such disclosures could have prompted credit-ratings firms to judge certain mortgage-backed securities as riskier investments, making them more difficult to sell, these people said. The attorney general is examining, among other things, whether some Wall Street firms concealed information about the exceptions from the credit-rating concerns, these people said, in a bid to bolster ratings of mortgage securities and make them more attractive to buyers, such as pension funds, which often required AAA, or investment grade, ratings on potential investments in securities containing risky mortgages.

The attorney general's office has issued Martin Act subpoenas, which don't spell out whether matters are civil or criminal in nature, according to people familiar with the matter. So far, the recipients include financial firms Bear Stearns Cos., Deutsche Bank AG, Morgan Stanley, Merrill Lynch & Co., and Lehman Brothers Holdings Inc., possibly among others. Representatives of Bear, Deutsche, Morgan, and Lehman declined to comment on the investigation. A Merrill spokesman said, "We cooperate with regulators when they ask us to," but declined to elaborate.

Meantime, some industry specialists are calling for reforms in the way securities firms package mortgage securities. Among them is making public the due-diligence reports provided by Clayton and its rivals to both ratings firms and the public. "We need to . . . improve the due- diligence process by standardizing it and by disclosing" the results to ratings agencies and investors, said Rod Dubitsky, head of asset- backed securities research at Credit Suisse Group. Another improvement, he said, would be hiring an independent party to "police" or monitor the loan pool, ensuring that mortgages being packaged into new securities for sale had the loan attributes that had been described.

With data provided by Clayton, Mr. Cuomo's office is seeking to gather more information on how Wall Street firms purchased home loans that had been singled out as "exception loans" -- that is, loans that didn't meet the originator's lending standards. Data from Clayton, for instance, indicates that in 2005 and 2006, years in which the mortgage-securitization business was going full throttle, some investment banks acting as underwriters were purchasing large numbers of loans that had been flagged as having exceptions, these people said.

In 2006, according to the data, as much as 30% of the pool of exception loans was purchased by some securities firms, these people said. One likely reason: Flawed loans could be purchased more cheaply than standard loans could be, lowering a firm's costs as it sought to compile enough mortgages for a new security.