The Cat's Outta the bag

Subprime lending problems ensnaring big Wall Street firms
By Michael Hudson
THE WALL STREET JOURNAL
Sunday, Jul. 01 2007

Twelve years ago, Lehman Brothers Holdings Inc. sent a vice president to
California to check out First Alliance Mortgage Co. Lehman was thinking about
tapping into First Alliance's lucrative business of making "subprime" house
loans to consumers with sketchy credit.

The vice president, Eric Hibbert, wrote a memo describing First Alliance as a
financial "sweat shop" specializing in "high-pressure sales for people who are
in a weak state." At First Alliance, he said, employees leave their "ethics at
the door."

The big Wall Street investment bank decided First Alliance wasn't breaking any
laws. Lehman went on to lend the mortgage company roughly $500 million and
helped sell more than $700 million in bonds backed by First Alliance customers'
loans. But First Alliance later collapsed. Lehman landed in court, where a
federal jury found the firm helped First Alliance defraud customers.

Today, Lehman is a prime example of how Wall Street's money and expertise have
helped transform subprime lending into a major force in the U.S. financial
markets. Lehman says it is proud of its role in helping provide credit to
consumers who might otherwise have been unable to buy a house, and proud of the
controls it has brought to a sometimes-unruly business.

Now, however, that business is in deep trouble, and some consumer advocates and
policymakers are pointing the finger at Wall Street. Roughly 13 percent of
subprime loans stand in or near foreclosure, bringing turmoil and sometimes
eviction to tens of thousands of homeowners. Dozens of lenders have gone out of
business. Bear Stearns Cos. is trying to bail out a hedge fund it manages that
was hurt by subprime mortgage losses.

Critics say Wall Street firms helped create the mess by throwing so much money
at the market that lenders had a growing incentive to push through shaky loans
and mislead borrowers.

At a hearing in April, Sen. Robert Menendez, D-N.J., said Wall Street firms
"looked the other way" as they profited from questionable loans, "fueling a
market that has very little discipline over itself."

Federal Reserve chief Ben Bernanke said in a May speech that some lenders
focused more on feeding the marketplace than on the quality of loans, in part
because most of the risks that loans would go bad were passed on to investors.
As a result, "mortgage applications with little documentation were vulnerable
to misrepresentation or

overestimation of repayment capacity by both lenders and borrowers," he said.

A generation ago, housing finance was different. Bankers took in deposits, lent
that money to house buyers and collected interest and principal until the
mortgages were paid. Wall Street wasn't much involved.

Now it plays a central role. Wall Street firms provide working capital that
allows thousands of mortgage firms to make loans. After lenders sign up
consumers for home loans, investment banks pool the income streams from these
loans into bonds known as mortgage-backed securities. The banks sell them to
yield-hungry investors around the world.

Before the mid-1990s, mortgage-backed securities consisted mostly of loans to
borrowers with good credit and cash to make ample down payments. Then
investment banks found they could do the same with riskier loans to borrowers
with modest incomes and flawed credit. Pooling the loans created a cushion
against defaults by diversifying the risk. The high interest rates on the loans
made for bonds with high yields that investors savored. New technology helped
make it easier for lenders to collect and collate mounds of information on
borrowers.

Lehman, one of Wall Street's biggest players in the subprime boom, says it has
gone to great lengths to screen loans for fraud and vet the lenders it works
with.

At the sector's peak in 2005, with the housing market booming, loan defaults
remained low. Wall Street pooled a record $508 billion in subprime mortgages in
bonds, up from $56 billion in 2000, according to trade publication Inside
Mortgage Finance. The figure slid to $483 billion last year as the housing
market slumped and subprime defaults picked up.

Lehman topped other Wall Street firms over the last two years, packaging more
than $50 billion in subprime-mortgage-backed securities in both 2005 and 2006.
Overall, Lehman officials say, the subprime business has accounted for 3
percent of the firm's overall revenue in recent quarters, or roughly $500
million in 2006.

Lehman has also been a leader in investment banks' push to buy their own
lenders. Through its subprime unit BNC Mortgage Inc., it lends directly to
consumers, bringing in more fees and giving it more control over the quality of
the loans.

Lehman's deep involvement in the business also has made the firm a target of
criticism. In more than 15 lawsuits and in interviews, borrowers and former
employees have claimed that the investment bank's in-house lending outlets used
improper tactics during the recent mortgage boom to put borrowers into loans
they couldn't afford.

Twenty-five former employees said in interviews that front-line workers and
managers exaggerated borrowers' creditworthiness by falsifying tax forms, pay
stubs and other information, or by ignoring inaccurate data submitted by
independent mortgage brokers. In some instances, several ex-employees said,
brokers or in-house employees altered documents with the help of scissors, tape
and Wite-Out.

"Anything to make the deal work," said Coleen Columbo, a former mortgage
underwriter in California for Lehman's BNC unit. She and five other
ex-employees are pursuing a lawsuit in state court in Sacramento that claims
BNC's management retaliated against workers who complained about fraud.

Lehman officials say there's no evidence to support such claims. They say the
firm has tough antifraud controls and goes to great lengths to ensure that it
works with mortgage brokers and lenders who meet high standards and that loans
are based on accurate information.

Lehman said company records clearly refute specific details of the accounts
given by these former employees. It said most of them never raised concerns
during their tenures at Lehman lending units, even though that was a
requirement of their jobs. Some employees contacted by The Wall Street Journal
said they weren't aware of improper practices.

"We think it is misleading to extrapolate from a handful of cases, in each of
which we have a strong defense, and make a judgment about the way we conduct
our business," Lehman said.