Did Wall Street firms comprehend the risks in mortgage market?

NY Times:

An investigation into the mortgage crisis by New York State prosecutors is now focusing on whether Wall Street banks withheld crucial information about the risks posed by investments linked to subprime loans.

Reports commissioned by the banks raised red flags about high-risk loans known as exceptions, which failed to meet even the lax credit standards of subprime mortgage companies and the Wall Street firms. But the banks did not disclose the details of these reports to credit-rating agencies or investors.

The inquiry, which was opened last summer by New York’s attorney general, Andrew M. Cuomo, centers on how the banks bundled billions of dollars of exception loans and other subprime debt into complex mortgage investments, according to people with knowledge of the matter. Charges could be filed in coming weeks.

In an interview Thursday, Connecticut’s attorney general, Richard Blumenthal, said his office was conducting a similar review and was cooperating with New York prosecutors. The Securities and Exchange Commission is also investigating.

The inquiries highlight Wall Street’s leading role in igniting the mortgage boom that has imploded with a burst of defaults and foreclosures. The crisis is sending shock waves through the financial world, and several big banks are expected to disclose additional losses on mortgage-related investments when they report earnings next week.

As plunging home prices prompt talk of a recession, state prosecutors have zeroed in on the way investment banks handled exception loans. In recent years, lenders, with Wall Street’s blessing, routinely waived their own credit guidelines, and the exceptions often became the rule.

It is unclear how much of the $1 trillion subprime mortgage market is composed of exception loans. Some industry officials say such loans made up a quarter to a half of the portfolios they saw. In some cases, the loans accounted for as much as 80 percent. While exception loans are more likely to default than ordinary subprime loans, it is difficult to know how many of these loans have soured because banks disclose little information about them, officials say.

Wall Street banks bought many of the exception loans from subprime lenders, mixed them with other mortgages and pooled the resulting debt into securities for sale to investors around the world.

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Judging by the losses the Wall Street firms have taken on these instruments, it is not clear that they even comprehended the risks. If they had, they would not have invested so heavily in the instruments that have cost them so much. Apparently there was a perception that by bundling these products the risks would be spread and therefore less. There was clearly a failure of risk analysis at the Wall Street firms. What those firms should be looking at is whether they were mislead about the risks by the banks who were bundling the exception loans. Usually those issuers have to sign indemnity agreements with the underwriters. That will be something to watch as these cases move forward. However, I question the premise of Cuomo's case. To withhold the risks you have to understand them to begin with. The investment bankers are already paying a heavy price for the failure to know the risks. Fining them at this point will only compound the problem.