CSI: Subprime

NEW YORK (Fortune) -- When a mortgage goes bad, Wall Street firms turn to firms like Clayton Holdings.

Clayton's forensic analysts get to work, looking for fraud and other slip-ups that can get its clients off the hook for big investment losses.

Recently, Clayton analyst Amber Woolverton came across a $300,000 foreclosure that smelled fishy.

First, the borrower claimed the house was owner-occupied even though she owned another home jointly with her husband. Second, Woolverton discovered that the borrower had bought another home on the very same day - also passed off as owner-occupied.

"These were obviously investment properties," says Woolverton. "And she couldn't keep up [with the payments]."

A lot of the recent problems have come from subprime mortgages - home loans made to borrowers with less than desirable credit, in exchange for higher interest rates. Thanks to increasingly unaffordable homes and a voracious investor appetite for bonds made up of these loans, subprime mortgages mushroomed during the housing boom.

In 2006, these loans accounted for 20 percent of all mortgages, up from 5 percent in 2001, according to trade publication Inside Mortgage Finance.

The trend has been a boon to Clayton (Charts), a tiny $240 million Shelton, Conn., company that performs an important service: reducing subprime risk for such clients as Bear Sterns, Goldman Sachs, and Morgan Stanley.

Now, it's the subprime delinquencies that are on the rise after years of lenders throwing money at anybody with a pulse. Smaller lenders like New Century (Charts) Financial have been thrown into death spirals. Big lenders including HSBC have also been punished for their overexposure to these risky loans.

What exactly does Clayton do? Think of the company as a quality control manager in a mortgage securitization factory. At the front end of the process, Wall Street firms use Clayton to visit lenders and pore through a sampling of the loans they're buying before pooling them into mortgage-backed securities and selling them off to investors.

"The Clayton seal of approval means something," says William Blair analyst John Neff.

Generally, Clayton tests between 15 percent and 25 percent of the mortgages for sale. (Considering the industry's current mess, Wall Street firms will probably be asking for bigger samples in future securitizations.)

"They're our eyes and ears in the field," says Joseph Swartz, who manages due diligence for Deutsche Bank's U.S. residential mortgage pools. "We depend on them to help us identify loans that are high risk."

Of course, not every client acts on Clayton's advice. One, whom the company declines to name, has been scarfing up about 60 percent of the loans that Clayton said weren't up to snuff. "Everyone reached for volume," says Frank Filipps, Clayton's CEO. "In the last 18 months, a lot of the loans that were purchased didn't meet the buyer's own standards."

After securitization, Clayton monitors the performance of the loans - some $419 billion all told - and conducts autopsies on every mortgage that dies (internally, that business is nicknamed CSI Subprime).

If the investigator finds any problems that violate guarantees made by the originator of the loan, the client can put it back to the lender. In fact, one big reason why subprime lender New Century Financial is failing is the number of poorly originated loans it has had to eat.

Lately, Clayton is finding more and more delinquencies as a result of fraud, rather than the usual death and divorce hardships of life.

An investigation last fall, for instance, unearthed a New Jersey scheme that had the buyer and seller colluding to inflate the value of a house.

Around the same time, an examination of a $500,000 California delinquency revealed a daycare worker falsely claiming to make $13,000 a month - out of her home!

The con that will no doubt go down in company history involved a delinquent borrower who signed his loan paperwork as - you're gonna love this - M. Mouse. Yes, that's M as in Mickey.

"The originator bought it back," says Kevin Kanouff, who heads up the surveillance part of Clayton's business. "That would have been a tough one to refute."

Also, there are certain zip codes that are infested with fraud. Detroit lays claim to two zip codes in Clayton's top 10. Indianapolis has three.

Wall Street's recent pullback from buying pools of subprime loans may affect the front end of Clayton's business. "But we're using them more on the back end," says Deutsche Bank's Swartz. Which means Amber Woolverton should have plenty more subprime mortgage cases to crack in the months ahead.

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