Repurchases of Superior Federal, FSB, Loan Assets Sold to Beal Bank
September 13, 2004
Audit Report No. 04-035
Federal Deposit Insurance Corporation
Division of Resolution and Receiverships
Washington, D.C. 20429
DATE: September 7, 2004
MEMORANDUM TO: Stephen M. Beard, Deputy Assistant Inspector General for Audits
FROM: Mitchell L. Glassman [Electronically produced version; original signed by
Mitchell L. Glassman], Director, Division of Resolutions and Receiverships
SUBJECT: Draft Report Entitled, Repurchases of Superior Federal, FSB Loan Assets (Assignment Number 2003-046)
This memorandum is in response to the subject draft report dated August 25, 2004. In summary, we disagree with the audit's findings and recommendations regarding the sale of loans from the Superior Federal, FSB, conservatorship (New Superior), and the development and utilization of related Representations and Warranties (R&Ws) and Loan Sale Agreements (LSAs). The draft report and its recommendations do not consider, particularly for a bridge bank or conservatorship, that the facts and circumstances of an institution should be a primary driver in making business decisions and establishing documentation requirements. We believe that a bridge bank's or conservatorship's existing policies, procedures, and practices should serve as the foundation for its operations and that those be modified as needed and as practicable to reflect its changed status.
Adequate Due Diligence
DRR disagrees with the finding that there was inadequate due diligence to offer the R&Ws. DRR used a multifaceted approach to due diligence based on the facts and circumstances of the Superior conservatorship. DRR staff conducted Asset Valuation Reviews (AVRs), the standard due diligence process for DRR's loan sales, for the Scratch and Dent (S&D) loan sales, sampling a statistically significant number of loans from each pool offered in the sales, resulting in a review of 327 loans out of 1749 loans offered in these sales. Although the draft report characterizes this sampling approach as "limited due diligence," each pool's sample was constructed with a 95% confidence level.
Additionally, because of the unique nature of New Superior being a conservatorship and its business model of originating and selling loans, DRR factored New Superior's loan origination and servicing operations as well as actual R&W put-back experience from Old Superior's prior sales and put-back experience from RTC sales that offered market-typical R&Ws into its decision to continue Superior's practice of offering market-typical R&Ws. New Superior had a comprehensive subprime mortgage loan pipeline origination and sales operation based in Orangeburg, NY. Generally, loan brokers/direct lenders would submit loan applications underwritten for a New Superior loan program to one of its branches where New Superior employed a staff of approximately 270 New Superior underwriters. The underwriters in turn would ensure that an application was underwritten according to New Superior's guidelines, or that variances were justified based on compensating factors, before the application was accepted and funded. As an additional check on quality control and compliance for funded loans, New Superior employed 21 auditors in its Quality Control and Compliance Departments who, through a 200 question questionnaire, reviewed credit documentation, legal documents, and appraisals, and evaluated compliance with consumer regulations. DRR asset marketing staff also coordinated the sales with New Superior's servicing department, by identifying loans that were to be included in the sales, the R&Ws to be offered, and requesting that loans not meeting the R&Ws be identified so they could be offered in a sale with limited R&Ws. In its report, the OIG failed to recognize that as conservator, FDIC employed this staff, which effectively conducted on-going due diligence of the loan portfolio, both in the origination process and its servicing department, under the supervision of FDIC's appointed CEO, with oversight by DRR staff.
It also should be noted that neither the Treasury Department OIG Material Loss Review, the GAO Report, nor the FDIC OIG cited Superior's underwriting or servicing operations as a contributing cause of its failure.
Use of R&Ws Adequately Supported by Case and Other Documentation
The OIG report states that there was insufficient case documentation supporting the offering of the R&Ws in these sales. We disagree with this finding. The New Superior Board of Directors (the Board) approved the use of R&Ws at its August 16, 2001 Board meeting. A case, written by DRR-Asset Marketing Dallas staff, requesting the use of market-typical R&Ws (Modifications to Current and Future Loan Sale Agreements – Company and Individual Loan Representations and Warranties) was presented to the Board (Attachment 1). The case and its attachments included documentation associated with the types of R&Ws Superior offered prior to conservatorship, reviews by DRR and Legal Division staff, similarity of Superior's R&Ws to those RTC offered in its sales and their repurchase history, the added value of offering market-standard R&Ws, and current subprime market standards for typical R&Ws.
For example, Old Superior's R&Ws in its Merrill Lynch forward sale agreement included 15 R&Ws about the company and 77 R&Ws about the individual loans. The R&Ws recommended to the Board were to modify existing and future agreements to reflect New Superior's changed status. The Board and other attendees engaged in extensive discussions and deliberations about the risks and benefits offered by R&Ws, including Superior's repurchase history, as reflected in the minutes from that meeting (Attachment 2). Additional documentation in the form of e-mails, reports, and memoranda that were not included as case attachments, served as "work papers". The R&Ws for the S&D sales were modified to remove the R&Ws dealing with performance of the loans after origination. The final sales had 25 R&Ws about the loans and 7 company R&Ws. The IG report states on page 8: "We reviewed the well documented R&Ws development effort for the Forward Sales LSAs, but had difficulty establishing a direct link to the S&D sales because the supporting documentation did not clearly tie together the two sales initiatives". DRR believes there was adequate linkage established in the minutes of the meeting and the New Superior Board resolution that approved the use of market standard R&Ws that stated: "...with respect to the Equity One, First Boston and Countrywide transactions [i.e., the Forward Sales] and all future sales with similar reps and warranties". DRR agrees that the audit trail would have been clearer if the individual sales cases that followed had referred to this blanket case approval, however; it was clear to the Board (as evidenced by Board minutes of subsequent meetings and staff e-mails) that this approval covered all future loan sales.
Also on page 8, the OIG Report attempts to question the applicability of the R&W case to all loan sales by stating: "...the S&D sales to Beal vastly differed from DRR's Forward Sales effort..." To justify its assertion, the Report then makes statements that are neither correct nor relevant to the issue of using market R&Ws in New Superior's loan sales. For example, the Dallas Asset Marketing staff that was directly overseeing the S&D I sale authored the R&W case approved by New Superior's Board - not the conservatorship staff directly conducting the Forward Sales. And, although 23% of the loans sold to Beal were from S&D sales which contained loans not sold through securitization or earlier forward sale agreements generally due to delinquency (see Attachment 3, excerpt from DRR's financial advisor's Asset Valuation and Disposition Report, dated September 6, 2001), the Report does not explain the relevance to the specific R&Ws provided in the S&D sales. The relevant facts are that the loans sold in all of New Superior's loan sales came from the same loan origination platform and were serviced by Superior, and the S&D sales did not provide R&Ws for performance, only for their origination documentation and servicing.
Beal Bank Claims Not Viewed in Context of Total New Superior Repurchase Claims
By only focusing on the Beal Bank (Beal) sales the OIG fails to put these three sales in the context of the total loan pipeline sale operation at the New Superior conservatorship. The report ignores the majority of loans New Superior sold and is solely focused on the sale of 5,315 loans to Beal. All other sales of subprime mortgages, which included 7,362 loans and provided similar R&Ws, were not included in the OIG review. From the other sales, only a total of 968 claims were filed, of which 405 were approved (Attachment 4). This is an approved claim rate of 5.5%, which is in line with Superior's 5.0% put back history on sales prior to failure (Attachment 5). It should also be noted that, as stated earlier, DRR gave significant consideration to the historical repurchase data that Superior kept with respect to repurchase activity concerning different sale transactions. Specifically, in the (Old) Superior Bank, FSB/EMC Scratch and Dent Sale (BV $41.2MM – closed 6/26/01) only $211,256 in repurchases (.51%) was approved. The Superior/EMC sale agreement was used as the base document to formulate the LSA. It must be noted that EMC has submitted only 2 additional claims on this pool over the last three years. In addition, the 273 loans totaling $19.4 million that were sold in S&D I to Truman Capital have experienced a similar low put back rate. There are only 8 (2.9%) approved claims from this pool (Attachment 6).
Beal Bank Results Not Differentiated or Correlated to R&Ws
The OIG provides no evidence to support any cause and effect between the New Superior LSA and Beal's claims. The original case approving the use of R&Ws showed that Superior had experienced a 5% approved claim rate prior to failure, and the Beal experience is not out of line with this. There is no analysis of the type of claims submitted, the types approved or the type rejected. The report implies that additional due diligence would have changed the R&Ws offered or reduced the number of put backs. In Finding B of the report, the OIG indicates that the FDIC's decisions to accept or deny Beal claims were adequately supported. Of the 1,098 Beal claims processed, only 246 have been approved. Thus, it is apparent, and supported by the OIG's own finding, that Beal has submitted a substantial number of invalid claims. No amount of due diligence would predict or prevent this. Additionally, the OIG provided no analysis of either the cost or benefit of conducting additional due diligence. For instance, fraudulent loans would not be detected in a loan file review, and it would be extremely difficult to detect all the Home Owners Equity Protection Act (HOEPA) violations in a due diligence review (discussed later in this document).
A section of the sales case specifically addresses the R&Ws as follows: "...the reps and warrants offered in this sale are typical of those previously used by Superior Bank, FSB, in the sub-prime scratch and dent market and are contained in the mortgage loan purchase agreement attached as Exhibit A. The FDIC will provide a Corporate Guaranty of Superior Federal Bank FSB's R&Ws up to an amount equal to 10% of the principal balance of the pools sold as of the loan sale cut-off date for a period not to exceed three years from the sale closing date. The Agreement has been prepared by DFOB Legal and approved by FDIC DC Legal." The language in the R&W case and S&D sales cases, collectively, justify and substantiate that the R&Ws offered were very similar to those used by the former bank and the industry.
Home Owners Equity Protection Act (HOEPA)
The OIG failed to distinguish between the HOEPA representations and the other representations. For public policy purposes, DRR did not want to sell loans with HOEPA violations to any buyer and attempted to discover these loans during the due diligence and packaging phase. We knew that it would be expensive, difficult and time consuming to attempt to find all of these loans, so the HOEPA provision was included in all the sales agreements to allow FDIC to repurchase these loans. This was not done to enhance the value of the pools, but to allow FDIC to correct these violations rather than leave loans with HOEPA violations in the private sector. The vast majority of the approved Beal claims (187 out of 246 loans) were due to HOEPA violations. These violations generally involved under-disclosure of between $100 and $400 in loan fees.
The rules for determining HOEPA loans are not always clear. In fact, a contractor hired by DRR to review the HOEPA loans that were repurchased found that 65 of the 159 loans they reviewed were not HOEPA violations (Attachment 7). In reality only a very small percentage (1.5%) of the Beal loans have been repurchased for non-HOEPA reasons.
The report characterizes these loans as "predatory loans" and "violating predatory lending practices" without any supporting documentation. Although these loans potentially violated the HOEPA disclosure rules and, when combined with other facts, may be indicative of predatory lending practices, there has never been a finding that Superior engaged in predatory lending. Neither OTS nor DSC ever had an examination finding that Superior's lending practices were predatory.
DRR staff disagrees with Finding A of the Report and its two recommendations. However, recognizing the importance of documenting business decisions, by September 30, 2004, DRR will amend Section 2A of the Bridge Bank Manual to read: "The Bridge Bank Board of Directors should adopt policies for documenting business decisions and will distribute the policy to Bridge Bank management and to FDIC personnel working with the Bridge Bank."
James H. Angel, Jr.