One big issue in the foreclosure mess is whether owners of certain RMBSs will be able to put them back to the banks that issued them, claiming that they were issued under false pretenses. The bond issuers are making this case, and their stocks have soared. Reuters has taken the lead in highlighting the role of third-party due diligence firms in this mess.

The big cheese in the industry is Clayton Holdings, which was hired by big banks to vet the loan it intended to buy and package; it accounts for perhaps two-thirds of the industry. These tests often discovered problems with loans, and the bank would reject them, putting them back with the originator. But these firms only test a sample of the mortgages, so it's clear that some bad mortgages ended up in the securitized bond.

The issue is whether this information should have been disclosed to the buyer. The banking industry is downplaying its legal liability here. But plaintiffs' lawyers are onto it. You can bet the SEC is taking a look at it as well. If courts and state regulators side with plaintiffs, the losses could be huge. But that remains a big if at this point.

For more:
- here's a Reuters article

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