During a little-noticed hearing this week in Sacramento, Calif., a firm hired by Wall Street to analyze mortgages given to borrowers with poor credit, which were then packaged and sold to investors during the boom years, revealed that as much as 28 percent of those loans failed to meet basic underwriting standards -- and Wall Street knew all along.

Worse, when the firm flagged those loans for potential issues, Wall Street banks ignored its recommendation nearly half the time and likely purchased those loans anyway -- selling them to unwitting investors who were never told that the biggest home loan due diligence firm in the country had found potential defects in these mortgages.

The revelations give a better picture of what many have likely known for years: Wall Street firms knew they were buying lead yet passed it off as gold to investors who had no knowledge of the alchemy behind the scenes. But it also has real-world implications: the data released Thursday could bolster pension funds and other investors in their pursuit to force Wall Street banks to take back the bogus mortgages they peddled. An untold number of lawsuits have been filed in the wake of the subprime mortgage crisis and subsequent housing market collapse. Thus far, Wall Street has been winning that battle.

Clayton Holdings, a Connecticut-based firm that analyzes home mortgages for banks, hedge funds, insurance companies and government agencies, provided its data Thursday to the Financial Crisis Inquiry Commission, a bipartisan panel created by Congress to investigate the roots of the worst financial crisis since the Great Depression. The FCIC held its last public hearing in Sacramento, the home of the panel's chairman, where two current and former top Clayton executives testified under oath about the firm's role in the mortgage securitization chain.

During the height of the boom in 2006 and the period prior to its immediate end during the first six months of 2007, Clayton inspected home loans for Wall Street firms and government-backed mortgage giant Freddie Mac. Clayton looked at loans that the companies wanted to purchase from mortgage originators like New Century Financial, Countrywide Financial, and Fremont Investment & Loan. The company examined 911,039 mortgages, documents show.

Clients included Bank of America and JPMorgan Chase, the nation's two biggest banks by assets which together have about $4.4 trillion; Citigroup, Deutsche Bank, Goldman Sachs, Morgan Stanley, Bear Stearns and Lehman Brothers. Clayton controlled about 50 to 70 percent of the market, Keith Johnson, the firm's former president, told the crisis panel.

Clayton, though, typically looked at roughly 10 percent of the pool of mortgages available for purchase, Vicki Beal, a senior vice president at the firm, said in response to a question by panel chairman Phil Angelides. But during the frenzied last months of the boom, when lenders and securitizers were trying to sell off as much as they could before the market collapsed, that figure reached as low as 5 percent.

Of the 911,000 loans that Clayton scrutinized, 72 percent either met the mortgage seller's standards and other guidelines set by the buyer of the mortgages, typically Wall Street firms, or they had off-setting factors that allowed Clayton to give them a passing grade, like if the borrower who took out the mortgage put a lot of money down or had a very high income.

But 28 percent failed to meet those standards. Of those 255,802 mortgages that Clayton flagged for what were a variety of reasons, Wall Street ended up waiving 100,653 of them, or 39 percent of those loans that did not meet basic standards. And Wall Street firms didn't share this with investors.

"This should have raised red flags," said Guy Cecala, publisher of Inside Mortgage Finance, a leading trade publication and data provider.

"To our knowledge, prospectuses do not refer to Clayton and its due diligence work," Beal told the FCIC in prepared remarks. "Moreover, Clayton does not participate in the securities sales process, nor does it have knowledge of our loan exception reports being provided to investors or the rating agencies as part of the securitization process."

Johnson said that Clayton "looked at a lot of prospectuses" -- documents given to potential investors outlining what comprises the deal -- and that the firm wasn't aware of any disclosure to investors of Clayton's "alarming" findings, Johnson said.

The reports Clayton generates are "the property of our clients and provided exclusively to our clients. When Clayton provides its reports to its clients, its work on those loans is generally completed -- Clayton is not involved in the further processes of securitizing the loans and does not review nor opine on the securitization prospectus," Beal said.

During questioning by Angelides, Beal acknowledged that, because the firm was checking roughly 10 percent of the mortgages Clayton's clients were looking to purchase, one could say that Wall Street firms waived in as many as 1 million loans that Clayton had initially rejected.

Angelides told the current and former Clayton executives that it appeared that securities issuers -- Wall Street firms -- didn't examine the other 90 to 95 percent of loans that comprised a pool waiting to be securitized and sold to investors. Johnson agreed with him.

Furthermore, Johnson said that he heard that some market participants operated under a "three strikes, you're out rule" -- if bad loans were flagged by Clayton, sellers and issuers would have Clayton take out another 5 to 10 percent sample to check the pool again. Angelides hinted that when done three times, it would be incredibly unlikely that Clayton would again discover those individual questionable loans, and that they'd find their way into securitization deals. Johnson agreed.

"What the standard practice, supposedly, and best practices call for is if you do a sampling and you show problems, you go back and take a bigger slice and keep going until you find out the true extent of the issue and the problem," Cecala said.

That didn't happen.

"If issuers had been scrutinizing all the collateral in a security and only putting in loans that met actual underwriting and documentation requirements, a lot of these deals wouldn't have gotten done," said Cecala. "But as a practical matter that didn't happen. Most of the loans that were originated got thrown in securities one way or another."

Johnson told the crisis panel that he thought the firm's findings should have been disclosed to investors during this period. He added that he saw one European deal mention it, but nothing else.

The firm's findings could have been "material," Johnson said, using a legal adjective that could determine cause or affect a judgment.

It's unclear whether the firms ended up buying all of those loans, or whether Wall Street securitized them all and sold them off to investors.

"Clayton generally does not know which or how many loans the client ultimately purchases," Beal said. That likely will be the subject of litigation and investigations going forward.

"This should have a phenomenal effect legally, both in terms of the ability of investors to force put-backs and to sue for fraud," said Joshua Rosner, managing director at independent research consultancy Graham Fisher & Co.

Original buyers of these securities could sue for fraud; distressed investors, who buy assets on the cheap, could force issuers to take back the mortgages and swallow the losses.

"I don't think people are really thinking about this," Rosner said. "This is not just errors and omissions -- this appears to be fraud, especially if there is evidence to demonstrate that they went back and used the due diligence reports to justify paying lower prices for the loans, and did not inform the investors of that."

Beal testified that Clayton's clients use the firm's reports to "negotiate better prices on pools of loans they are considering for purchase," among other uses.

Nearly $1.7 trillion in securities backed by mortgages not guaranteed by the government were sold to investors during those 18 months, according to Inside Mortgage Finance. Wall Street banks sold much of that. At its peak, the amount of outstanding so-called non-agency mortgage securities reached $2.3 trillion in June 2007, according to data compiled by Bloomberg. Less than $1.4 trillion remain as investors refused to buy new issuance and the mortgages underpinning existing securities were either paid off or written off as losses, Bloomberg data show.

The potential for liability on the part of the issuer "probably does give an investor more grounds for a lawsuit than they would ordinarily have", Cecala said. "Generally, to go after an issuer you really have to prove that they knowlingly did something wrong. This certainly seems to lend credibility to that argument."

"This appears to be a massive fraud perpetrated on the investing public on a scale never before seen," Rosner added.

New York Attorney General Andrew Cuomo, who's running for governor, reportedly launched an investigation and granted Clayton immunity in exchange for information on what Wall Street knew and when, according to press reports in January 2008. A spokesman for the state prosecutor didn't return a Friday call seeking comment.

Clayton, for example, analyzed about 10,200 loans for Bank of America. It found problems in 30 percent of them. Of those, the bank waived about a quarter.

For Credit Suisse, Clayton found that 37 percent of the 56,300 loans it reviewed failed to conform to standards. It waived a third of those.

Clayton discovered that 42 percent of the pool of loans Citigroup wanted to buy didn't meet standards, and that nearly a third of those were waived anyway. Citi is the nation's third largest bank by assets and is still owned by taxpayers.

JPMorgan Chase and Goldman Sachs had rejection rates of 27 and 23 percent, respectively. JPMorgan's waiver rate was 51 percent. Goldman Sachs, often derided for its practices during the boom and bust, had a waiver rate of 29 percent, far below the 39 percent average Clayton experienced.

Among the firms with the worst records are Morgan Stanley, Deutsche Bank and Freddie Mac.

About 35 percent of the 66,400 loans Deutsche wanted to buy were marked for having some kind of deficiency; the bank waived half of them. Morgan's 63,000 loans had a rejection rate of 37 percent; 56 percent of them were waived in. Clayton rejected 35 percent of the loans government-owned Freddie Mac wanted to buy. The firm, one half of the mortgage duo now owned by taxpayers and costing the Treasury hundreds of billions of dollars, waived 60 percent of those loans.

Neal, though, testified that Deutsche was one of its tougher clients when it came to checking mortgages. Because of its rigorous guidelines, that's likely why the German lender had such a high rejection rate, she said.

These firms were among the biggest issuers of so-called non-agency mortgage-backed securities in 2006 and the first half of 2007. Goldman issued about $65 billion in these securities, Inside Mortgage Finance data show. JPMorgan issued about $61 billion. Morgan Stanley sold about $49 billion, followed closely by Deutsche which sold $46 billion and Credit Suisse which issued $40 billion. Bank of America and Citigroup were next, selling $37 billion and $35 billion, respectively, data show.

Spokesman for Citi, Morgan, Deutsche, and Goldman declined to comment. Representatives for Freddie Mac and JPMorgan didn't respond to requests for comment.

But none of this should be new to savvy market players. Clayton had been warning about these issues for years, Cecala said.

"We have regular conversations with Clayton and Clayton would make the claim that they were seeing a lot of bad loans in their examinations and not many people were acting on it," Cecala said. "And clearly, the only way we could have the problems that we experienced is if people actually ignored problems. It's not like these were bad loans that suddenly turned bad. There were problems from day one and someone should have known it.

"Clayton was very frustrated that a lot of people never really acted on [their findings]," said Cecala. "Clayton would report that a lot of times they found problems in loan samples and not only did the issuer not want them to sample any more, which would have cost more money, but they didn't act on the information they uncovered."

Issuers, which hired Clayton to perform due diligence, didn't want to pay for more sampling. They also wanted to pump out as many deals as quickly as possible, Cecala added.

But, he cautioned, investors weren't necessarily paying attention to these kinds of details.

"Keep in mind that investors ultimately bought a deal almost exclusively based on the rating, and not the issuer's decision [regarding] what loans to put in or what loans not to put in," Cecala said. "Historically there's been very little recourse back to the issuer for problems with securities down the road and the bottom line is if you can get it past the ratings services you're more or less home free."

The three big credit rating agencies that dominate the market -- Standard and Poor's, Moody's Investors Service and Fitch Ratings -- had a chance to use Clayton's information during this time, but declined, Johnson testified.

He told the crisis commission that Clayton had meetings with S&P in 2006 and with Fitch and Moody's in 2007. "All of them thought this was great," Johnson testified.

But the rating agencies declined. The reason why, Johnson said, was because if a rating agency bought Clayton's services it would have likely been more stringent. That, in turn, would cause it to lose market share because Wall Street issuers would have just gone to an easier rating agency.

The rating agencies began requiring such third-party due diligence in 2007 after a state attorney general stepped in, Johnson said. By then, though, it was too late.

"Keep in mind that the rating services basically based a lot of their rating decisions not on an examination of every loan or the collateral, but basically on representations from the issuer," Cecala said. "That was the system we had in place."

Cecala said it was "highly unlikely" that Wall Street firms shared Clayton's findings with the rating agencies.

"We could have... stopped the factory from producing," Johnson lamented.

*************************