Auditor: Supervisors Covered Up Risky Loans

Now that millions of people are facing foreclosure because they got into loans that never should have been approved, everybody's looking for someone to blame. Borrowers, or their brokers, lied on loan applications. Others got high interest rates they couldn't afford.

A big unanswered question is whether the Wall Street investment banks that were packaging these mortgages knew they were selling garbage loans to investors. A wave of litigation is starting against these firms. One former worker whose job was to catch bad loans says her supervisors covered them up.

Mortgage Quality Control

Tracy Warren is not surprised by the foreclosure crisis. She saw the roots of it firsthand every day. She worked for a quality-control contractor that reviewed subprime loans for investment banks before they were sold off on Wall Street.

It was her job to dig into the loans and ferret out problems. By 2006, they were easy to find.

"I'd see people who were hotel workers saying that they made, in California, making $15,000 a month so that they could qualify for a $500,000 home," Warren says. "If a hotel worker is making $15,000 a month changing sheets at the Days Inn, everybody would want to do it. It just really made no sense."

Warren has worked in the mortgage business for 25 years, the past five in quality control. Most recently, she was a contract worker for a company called Watterson-Prime, which did loan audits for investment banks. She says their biggest client was Bear Stearns, which recently all but collapsed because of its exposure to bad loans.

Putting Bad Apples Back in the Barrel

Warren thinks her supervisors didn't want her to do her job. She says that when she would reject, or kick out, a loan, they usually would overrule her and approve it.

"The QC reviewer who reviewed our kicks would say, 'Well, I thought it had merit.' And it was like 'What?' Their credit score was below 580. And if it was an income verification, a lot of times they weren't making the income. And it was like, 'What kind of merit could you have determined?' And they were like, 'Oh, it's fine. Don't worry about it.' "

After a while, Warren says, her supervisors stopped telling her when she had been overruled. She figured it out by going back later and pulling the loans up on her computer.

"I would look every couple of days, and just see, if it was a loan that I thought was a bad loan, I'd go back and see if it was pulled."

About 75 percent of the time, loans that should have been rejected were still put into the pool and sold, she says.

'A Smoking Gun'

Some legal experts say it's a pretty big deal that people like Warren are willing to talk.

"This is a smoking gun," says Christopher Peterson, a law professor at the University of Utah who has been studying the subprime mess and meeting with regulators. "It suggests that auditors working for Wall Street investment bankers knew how preposterous these loans were, and that could mean Wall Street liability for aiding and abetting fraud."

Bear Stearns had no comment.

The loan-auditing firm Watterson-Prime's parent company, Fidelity National Information Services, provided a statement. It says the company has no incentive to give loans a passing review if they fail to meet underwriting criteria and that it uses additional quality-control measures to further check up on loan reviews.

But Peterson says such breakdowns in quality control must have happened at a lot of companies. How else did millions of people wind up in loans that they can't pay?

"People have a tendency to think about economic trends as though they're an uncontrollable force that no one understands. This isn't the weather. These are people who are individually making decisions to approve and pass on fraudulent loans," he says.

Accountability on Wall Street

Peterson said auditors like Warren basically were hired to find the bad apples in the barrel and pull them out: borrowers with payments they couldn't afford, houses with inflated appraisals, people lying about their income.

But Warren says her bosses were taking a lot of those bad apples and putting them back in. And Peterson says he thinks the investment banks had a strong financial incentive to do that.

"They put the bad apples back in the barrel because they knew that they could sell the bad apples along with the good apples and, at least in the short term, nobody would know the difference. That's why they put them back in — because they made more money that way," Peterson says.

"There's a name for this — it's called 'passing the trash,' " says David Grais, an attorney getting ready to sue Wall Street firms on behalf of investors — big pension funds and others — who bought the bad loans.

"These were immensely profitable deals. One study showed that the investment banks were making a 40 percent return on equity every two months on these securitizations, which is an eye-popping number," he says.

Grais says many people on Wall Street make huge bonuses when their business unit is making big money. So the faster they could package up loans — good, bad or ugly ones — and sell them to investors, the more money that they made, he says.

Warren thinks her managers got bonuses for how quickly they reviewed loans, not for how many bad loans they caught.

Watterson-Prime disputes that. It says its managers, staff and contractors are compensated on an hourly or salary basis and never by the number of loans reviewed.

Report: Banks Agreed to Limit Loan Rejections

Other evidence is emerging.

A bankruptcy examiner in the case of the collapsed subprime lender New Century recently released a 500-page report, and buried inside it is a pretty interesting detail. According to the report, some investment banks agreed to reject only 2.5 percent of the loans that New Century sent them to package up and sell to investors.

If that's true, it would be like saying no matter how many bad apples are in the barrel, only a tiny fraction of them will be rejected.

"It's amazing if any investment bank agreed to a maximum number of loans they would kick back for defects. That means that they were willing to accept junk. There's no other way to put it," says Kurt Eggert, a law professor at Chapman University.

Meanwhile, the attorney general in New York and other prosecutors are taking a look at all of this. They, too, want to know whether Wall Street firms were covering up bad loans and selling them to investors.

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