Far more than any trader's profane e-mails, due diligence reports from the securitization boom could worsen the financial industry's litigation headaches — and conceivably expose some firms and individuals to criminal charges.

Investment banks commissioned the reports from firms like Clayton Holdings and Hansen Quality to ensure that the mortgages the banks were buying met their underwriting standards. A substantial number of the loans did not, but the banks included them in the securities they sold to investors anyway, the reports indicate.

These previously confidential red-flag communications from the bubble years have been turning up as evidence in civil litigation against banks, and in public hearings like those held last year by the Financial Crisis Inquiry Commission. They've been largely drowned out by the torrent of news about servicing errors and other mortgage mishaps.

"We all know from the different testimony that there is a considerable amount of fraud or gross negligence in what was sold and it is now coming out and being verified through all of the plaintiff litigation," said Thomas R. Borgers, a former senior investigator at the commission. "If you are doing a 2 or 5% sample and you find that 20, 30, 40, 50% of all the sample had defects … what would you do? Would you stop there and buy all of the mortgages? Or would you continue on with a greater sample of the pool? I would, as prudent banker, go after more and more of the product if I saw more and more problems in what I am buying."

But the securitizers "were not doing that for the most part," said Borgers, now managing director at Mesirow Financial Consulting. "What they would do is accept a lot of these exceptions or override them and put them in the pool."

Evidence that the firms selling mortgage securities knew the collateral did not meet their guidelines would undermine the defense that these investments soured for reasons beyond the sellers' control.

"A lot of people bought into the global financial catastrophe argument — that these problems were caused by the collapse of the housing market and macroeconomic factors," said Isaac Gradman, a former plaintiff's attorney who now runs a consulting firm, IMG Enterprises. "I think that the due diligence reports that were run by the securitizers prior to purchasing the loan pools for the originators is the strongest evidence available that the banks knew that they were buying defective loans."

Due diligence reports have turned up as major exhibits in a variety of cases against investment banks. Some allege predatory lending and violations of state consumer deceptive trade practice laws. Others involve investors and insurers suing investment banks in civil fraud cases over loans that allegedly breached underwriting standards. These cases include a lawsuit by the bond insurer Ambac Assurance Corp. against JPMorgan Chase & Co.; the Federal Home Loan Bank of Pittsburgh's suit against JPMorgan Chase and Countrywide (which is now a part of Bank of America Corp.); and Massachusetts' $102 million settlement with Morgan Stanley.

The information due diligence firms provided to securitizers could be the basis for future criminal fraud cases, said Tamar Frankel, a professor at the Boston University School of Law. Under the Securities Act of 1933 it is a crime to sell securities accompanied by information that was intended to mislead. Underwriters have an obligation to vet the products they sell, Frankel said.

Even if the securitizer is a large corporation, "if they get from the inside, some suggestion that something is wrong, they have to pursue it," she said.

The recent revelations about due diligence reports from the FCIC should be a green light for law enforcement to take action, according to Christopher Peterson, a professor at the University of Utah's S.J. Quinney College of Law. However, Peterson said these reports do not necessarily provide slam-dunk evidence of fraud.

"One thing that could have been the case is that the [due diligence] company really was doing good due diligence, and the investment bank was ignoring it," Peterson said, "or it could be that the due diligence company wasn't really doing due diligence which would mean that the company didn't have to ignore it, because it was shoddy due diligence."

Third-party due diligence was supposed to help safeguard private label mortgage securitizations. The market was dominated by a half dozen companies including Clayton, Bohan Group, Wattersen Prime, and Hansen.

Working for securitizers, due diligence firms sought to determine whether the loans met underwriting guidelines; if they complied with state and federal laws; and most critically, did a loan that did not fit any guidelines have any "compensating factors," such as a higher borrower income, that would justify its being bundled into a mortgage-backed security. With a due diligence report in hand, the securitizer could negotiate a price for the mortgage or kick out loans that did not meet its standards.

One case that has dropped several bombshells is the Ambac suit. In that case, the insurer is alleging that from the evidence in reports provided by Clayton Holdings and other due diligence firms, Bear Stearns (which is now a part of JPMorgan Chase) knew that a significant percentage of the loans it was selling did not meet the brokerage's underwriting criteria. On one Ambac-insured deal, 56% of the insured loans were defective, according to a Clayton loan disposition summary cited in the lawsuit. According to Ambac, Bear Stearns concealed this knowledge.

Ambac also alleges Bear Stearns refused to repurchase defective loans from the investors that bought them, while at the same time secretly negotiated rep-and-warranty settlements worth $367 million on many of those same loans from the originators.

JPMorgan Chase is fighting Ambac's charges. "Ambac is a large sophisticated insurance company that is trying to blame others for risks it knowingly took and was paid for taking," said Jennifer Zuccarelli, a spokeswoman for JPMorgan Chase. "We do not believe Ambac's claims are meritorious and intend to defend Bear vigorously."

Some of the most dramatic findings in the FCIC report released in February concerned testimony from Keith Johnson, the former president of Clayton, a firm that did due diligence on an estimated $1 trillion worth of mortgages. Johnson told the commission that of approximately 900,000 loans that Clayton reviewed for 23 investment banks including Citigroup Inc., Goldman Sachs Group Inc., and Morgan Stanley, during an 18-month period that ended in June 2007, only 54% met the guidelines of the investment banks. According to Johnson, investment banks included in securities that they sold to investors a large percentage of the loans that did not meet their own underwriting guidelines on the basis of "compensating factors." They also included in the securities approximately 100,000 loans for which compensating factors could not be found — so-called Grade 3 Event loans.

Michael Duvally, a Goldman Sachs spokesman, declined comment. Calls to Morgan Stanley and Citigroup were not returned.

Apparently little effort was made to inform investors of this critical information about the securities they were buying. According to the FCIC, "many prospectuses indicated that the loans in the pool either met guidelines outright or had compensating factors, even though Clayton's records show that only a portion of the loans were sampled, and of those that were sampled, a substantial percentage of Grade 3 Event loans were waived in."

However, if regulators and investigators concluded that such reports were not read by the banks that commissioned them, that might make them less likely to pursue allegations of malfeasance. Johnson himself downplayed his former clients' culpability. After an FCIC investigator asked him whether his clients were put on notice that a significant percentage of loans in their pools did not meet their guidelines, he replied, "I think that our reports went to transaction managers who were pretty low level maybe in the eyes of the traders. I don't think that any of our clients would knowingly and willfully try to manufacture bad products."

Johnson, now the chief executive of Helios AMC, a servicer of defaulted commercial real estate loans and other troubled assets, did not return calls for this story. Nor did Clayton Holdings.

Due diligence reports performed by Clayton on loans that Lehman Brothers purchased from a subprime originator figured prominently in one of the first successful anti-predatory-lending lawsuits brought against an investment bank.

In 2006, after years of litigation, the United States Court of Appeals for the Ninth Circuit affirmed an earlier 2003 court decision that found Lehman guilty of aiding and abetting a fraud.

Sheila Canavan, a lawyer who represented a group of elderly plaintiffs and AARP in the case against Lehman and First Alliance Mortgage Co., said that it can be costly and time-consuming to get to the stage in a lawsuit called discovery where due diligence documents are produced. First Alliance filed for bankruptcy in 2000.

Due diligence reports have not yet been used as ammunition for criminal prosecutions over whether securities laws were violated. However, investigators have clearly been studying the issue. In 2008, then-New York Attorney General Andrew Cuomo went to the extent of offering Clayton executives criminal and civil immunity in exchange for their cooperation in an inquiry into whether or not banks had critical information about subprime loans that they intentionally concealed from investors in mortgage-backed securities.

More recently, the states of Nevada and Arizona are reportedly investigating the due diligence work that Clayton did for investment banks.

One new arena where due diligence reports are getting a lot of attention is at the New York State Assembly Standing Committee on Insurance, which is holding hearings into violations of representations on securitized debt transactions. (The committee oversees insurers regulated by the state, including bond guarantors.) Clayton declined an invitation to appear at a hearing in February, said the panel's chairman, Assemblyman Joe Morelle, who said he was interested in learning more about the role of due diligence firms in securitizations. "Clearly if you had a report from a due diligence firm that said if you are not in compliance with your own rules and you ignored that and continued to seek credit enhancements on deals, then that is problematic with us," Morelle said.

As embarrassing as the due diligence reports may be, they do not portray the true extent of the problems with some of the loans investment banks were trading, said Dru Jacobs, executive vice president of Adfitech, a firm that provides a variety of mortgage-related services including due diligence on private label securities. (It did work for Bear Stearns.) According to Jacobs, because of pressure from the investment banks to produce timely results, many due diligence providers generally just checked documents contained in a loan file and did little reverification of data. "Due diligence providers were pressured to provide reports in a very short time frame and in a short time frame they found multiple issues," Jacobs said. "Had they been given more time, they would have found even more discrepancies."