They could see the meltdown coming. Freelance financial watchdogs who examined the paperwork on subprime home loans being sold to Wall Street...

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They could see the meltdown coming.

Freelance financial watchdogs who examined the paperwork on subprime home loans being sold to Wall Street had an inside view of the boom in easy-money lending this decade.

The reviewers say they raised plenty of red flags about flaws so serious that mortgages should have been rejected outright — such as borrowers’ incomes that seemed inflated or documents that looked fake — but the problems were glossed over, ignored or stricken from reports.

The reviewers’ role was just one of several safeguards — including home appraisals, lending standards and ratings on mortgage-backed bonds — that were built into the country’s mortgage-financing system.

But in the chain of brokers, lenders and investment banks that transformed mortgages into securities sold worldwide, no one seemed to care about loans that looked bad from the start. Yet profit abounded until defaults spawned hundreds of billions of dollars in losses on mortgage-backed securities.

“The investors were paying us big money to filter this business,” said loan checker Cesar Valenz. “It’s like with water. If you don’t filter it, it’s dangerous. And it didn’t get filtered.”

As foreclosures mount and home prices skid, the loan-review function, known as “due diligence,” is gaining attention.

The FBI is conducting more than a dozen investigations into whether companies along the financing chain concealed problems with mortgages. And a presidential working group has blamed the subprime debacle in part on a lack of due diligence by investment banks, rating outfits and mortgage-bond buyers.

In interviews, eight experienced loan reviewers said quantity surpassed quality as marginal lending increased.

Squads of 10 to 15 veteran loan checkers gave way, they said, to packs of 40 to 50 mostly novice reviewers posted at or near subprime factories such as now-defunct Orange County, Calif., lenders New Century Financial and Ameriquest Mortgage.

Executives at the two main companies that hired the freelancers — Shelton, Conn.-based Clayton Holdings and San Francisco-based Bohan Group — say the reviewers weren’t there to find every potential problem with a subprime loan.

Rather, the executives say, the job was to perform specific tests to help buyers determine how much to pay for a pool of loans. In some cases, the investors wanted only minimal testing, said Frank Filipps, Clayton’s chairman and CEO.

“The client really drives the process,” Filipps said.

Hugely popular

Subprime mortgages skyrocketed in popularity — with the volume of subprime-backed securities soaring from $13 billion in 1995 to $594 billion in 2005 and $521 billion in 2006 — and business exploded for Clayton and Bohan.

As time passed, Clayton and Bohan executives said, Wall Street companies and their investor customers accepted increasing levels of default and fraud in subprime loans as they grew to trust software designed to offset those risks by charging higher interest rates, extra fees and penalties for paying off mortgages early.

As Wall Street grew more comfortable, it demanded less of the review process. Early in the decade, a securities company might have asked Clayton to review 25 to 40 percent of the subprime loans in a pool, compared with 10 percent in 2006, although the requirements varied, Filipps said.

By contrast, loan buyers who kept the mortgages as an investment instead of packaging them into securities would have 50 to 100 percent of the loans examined, Bohan President Mark Hughes said.

But the freelancers interviewed never got the memo that their reviews were supposed to be nice and easy.

Flying from city to city and typically paid $30 to $40 an hour, with expenses covered, the reviewers say they worked conscientiously to assure the investment banks and mortgage-bond investors that no surprises lay in the files.

Loan reviewer Jana Lujan recalled showing a file to a supervisor in 2004, during a check of subprime mortgages made by a Brea, Calif., bank that regulators later cited for unsound lending. A title report showed a tax lien on the property.

“I said we needed evidence it had been paid off and released,” Lujan said. “And he said: ‘Just go ahead. Assume it’s being taken care of.’ “

Loan-buyer representatives who were on site during the reviews also showed little interest in the details, Lujan said.

Lujan said one Clayton supervisor would throw away documents that appeared to have been altered fraudulently. The lack of a document in the file meant the loan had to be sold at a slight discount, she said, but it still could be sold.

Lujan, Valenz and one other loan checker said supervisors at Clayton and Bohan also would change the way fees were described so that mortgages would not be red-flagged as potentially predatory under law, which would render them unsalable and force the sellers to take them back.

Filipps said he wasn’t aware anyone at Clayton had changed fee categories to bring loans into compliance, and that discarding of documents had never been brought to his attention.

At Bohan, Hughes said he had heard of lenders, but not employees of loan-review companies, tossing documents. He described attempts to change fee classifications as not unheard of in the industry, but he added that Bohan didn’t tolerate such misrepresentations.

New York Attorney General Andrew Cuomo, who is investigating some aspects of the mortgage debacle, has given Clayton immunity from prosecution in return for help in learning whether debt-rating outfits and investors obtained enough information about the loans being sold.

Calling the immunity deal misguided, former Clayton contractors say Clayton and Bohan knowingly understated problems in loan pools.

“There’s no way you should give immunity to these guys. They are part of the problem,” Valenz said.

The reviewers said the less-thorough approach made their expertise irrelevant and led to pressure to work faster. Valenz and Lujan said they were told to check two or three files an hour when it took an hour or more to do one properly.

One Clayton project supervisor “told us if we spent more than 20 minutes on a file, we were spending 20 minutes too long,” Lujan said.

“Liar’s loans”

The biggest problems, the reviewers said, were appraisals that looked inflated and “liar’s loans,” so nicknamed because borrowers weren’t required to prove they earned enough to make their payments.

“You can’t tell me a Kmart or a Wal-Mart or a Target floor worker is making $5,000 a month, or a house cleaner is making $10,000,” said former loan reviewer Irma Aninger, a 40-year financial-services-industry veteran.

Aninger, who did work for Clayton and Bohan, said she tried repeatedly to have such loans marked as unacceptable but was overruled by supervisors, known as project leads. “The lead would say, ‘You can’t do that. You can’t call these people liars,’ ” Aninger said.

Aninger said one such supervisor was Clayton’s Ed Peek. He denied discouraging the rejection of “stated income” loans. “Many, many, many stated-income loans were rejected,” he said, but loan buyers still often bought the rejected mortgages.

From his perch, Peek said, he could see the deterioration of overall standards.

“Everyone knew this was a bubble that couldn’t last,” he said. “We all could see this coming.”