A report from the Office of Inspector General Federal Housing Finance Agency found that the housing finance agencies and regulators missed opportunities to avoid losses from the Taylor, Bean & Whitaker Mortgage Corp. debacle.
Counterparties of Taylor Bean should have been alerted by various red flags about the fraud scheme that brought down both Taylor Bean and Colonial Bank.
But it wasn’t just counterparties that missed the red flags; investors and regulators are also guilty of not spotting the signs.
That is according to a letter from FHFA OIG Acting Inspector General Michael P. Stephens to FHFA Director Melvin L. Watt.
The letter included a paper that focuses on the multi-year secondary marketing scheme carried on by officers and employees of the now defunct Taylor Bean and Colonial Bank, which failed at a cost of $3.8 billion to the Federal Deposit Insurance Corp.’s Deposit Insurance Fund.
At one point, Taylor Bean was the biggest privately held mortgage company in the country, employing more than 2,000 people. Its mortgage servicing portfolio was 512,000 loans for $80 billion as of Aug. 3, 2009.
The report outlined five phases of the Taylor Bean scheme that started with the “sweeping” phase where overdrafts were covered up. People inside the lender’s bank, Colonial Bank, conspired with Taylor Bean insiders to hide the overdrafts.
By the end of 2003, the rolling overdraft exceeded $120 million — an unmanageable level for the co-conspirators.
So the overdrafts were moved into another bank account that was used by Taylor Bean to acquire loans. In this second phase, fake loans were used to offset the deficits created by the overdrafts.
However, a negative cash flow at Taylor Bean left it sucking up its cash and pushing the deficit to $250 million by 2005.
At that point, the deficit was moved from the account used to purchase individual loans to an account where pools of loans were purchased. This third-phase account required pre-sold loans to be moved off the books within 30 days. But it didn’t receive the level of regulatory scrutiny as the individual loan account and had fewer Colonial employees with access.
By 2009, the deficit had ballooned to $500 million — prompting the creation of Ocala Funding, a supplemental warehouse line of credit that sold commercial paper to investor banks. BNP Paribas and Deutsche Bank purchased $1.7 billion of this commercial paper and ultimately suffered losses of $1.5 billion.
The fifth and final phase of the conspiracy was an attempt to utilize the Troubled Assets Relief Program to save Colonial from insolvency. Colonial’s application for $553 million in TARP funds was approved on the condition it obtain $300 million from outside investors. Funds from Ocala Funding were to be used to meet this requirement.
But, acting on a hunch, investigators looked into if the $300 million that Taylor Bean was supposed to be raising for the TARP financing was instead a “round trip transaction” — or even accounting fraud. Investigators suspected that the $300 million investment was a sham that didn’t increase capital at Colonial.
While the investigation didn’t turn up evidence of a round trip transaction, it did prompt co-conspirators to come clean and reveal details about the scheme.
The failure to adequately address the red flags resulted in billions of dollars in losses.
Freddie Mac, which lost more than a billion dollars because it failed to ensure Taylor Bean was inadequately capitalized, filed a $1.78 billion proof of claim in Taylor Bean’s bankruptcy.
Net funding practices on Ginnie Mae loans enabled Taylor Bean to withhold payoffs. When it collapsed in August 2009, there were 788 net-funded loans where the original mortgage hadn’t been paid off.
The report criticized Ginnie for not having more robustly monitored MBS pools and for waiving its own guidelines for continued commitment authority even though Taylor Bean had exceeded allowable delinquency rates.
Ginnie wound up buying back more than $4 billion in nonperforming Taylor Bean loans. That resulted in an increase of $720 million to its loss reserves.
One red flag missed by regulators was the changing of Colonial’s charter three times during a single decade.
Colonial changed from FDIC-regulated in 1997 to being regulated by the Federal Reserve. Then, in 2003, it changed from a state charter to a federal charter and became regulated by the Office of the Comptroller of the Currency.
But in June 2008 it reverted to a state-chartered bank and went back to being FDIC-regulated. This happened as an OCC management review was pending. The OCC was proposing a cease-and-desist order.
The FDIC was advised of the OCC’s tentative findings and the proposed order and began to follow up on the information. But it didn’t restrict Colonial’s activities.
The OIG said that the government-sponsored enterprises need to do a better job of monitoring counterparties. They also need to step up contract enforcement and improve communication between each other.
After discovering discrepancies in 2000 on pledged Taylor Bean loans, Fannie Mae studied the situation for two years and terminated the company as a seller. But it didn’t formally advise Freddie or the GSE regulator at the time about the termination.
Freddie viewed the severed ties between Fannie and Taylor Bean “as a business opportunity,” the report stated. Approving the company as a seller-servicer involved little due diligence.
Freddie expanded Taylor Bean’s volume limit to $34.5 billion by 2008.
But the report indicates that excessive growth in MBS — Taylor Bean’s remaining principal balance soared $60 billion between December 2003 and June 2008 — should have been a red flag for Freddie.
While staff at Freddie identified financial statement deterioration and discrepancies, Freddie didn’t increase its monitoring of Taylor Bean.
Freddie’s board of directors were not advised of Taylor Bean’s condition, an inability to meet repurchase demands and that it planned $300 public offering to buy Colonial even as it didn’t meet its repurchase obligations.
The OIG recommends that the GSEs coordinate with Ginnie Mae on best practices for the length of time an independent public accountant can audit a counterparty before being replaced.
Counterparties would be required in seller-servicer agreements to require chief risk officers and internal auditors to report illegal activities, compliance violations and unresolved suspicions to the chief financial officer and the board of directors.
The OIG also wants to see Fannie, Freddie and Ginnie share counterparty information about negative performance, compliance problems and evidence of illegal activities. It also wants to see adequate oversight by FHFA.
Stephens said that FHFA should issue guidance that limits the number of years that the same accountant can be used for a single counterparty.
The report also recommends supplemental compliance tests for the accountants and increased monitoring by Fannie and Freddie on counterparties with characteristics that are inconsistent with overall activity.
A more rigorous process is suggested for the GSEs when they waive contractual obligations of counterparties.
“Three evident areas for improvement that the TBW-Colonial fraud exemplifies are: counterparty monitoring, contract enforcement and communication,” the report concluded.
A response to the OIG’s letter from FHFA is sought by Oct. 31.
