Friday, March 28, 2008

Operational Risk – Improper Disclosure By Citigroup Mortgage

Mike "Mish" Shedlock in his blog, Global Economic Analysis, wrote about a potentially serious breach of fiduciary responsibility by Citibank. The issue is a clear example of operational risk that will most likely result in reputational harm and financial losses from improper and inadequate disclosure of the interest rate reset on a mortgage loan.

In essence, the issue revolves around 3/1 ARM I/O (3-year fixed rate, then 1-year adjustable rate interest only mortgage). In layman’s terms, this means that the mortgage payment is adjusted annually after the first three years of fixed rate payment. By law, the reset notice must contain the Regulation Z (b)(226.5)(a)(2), which requires:

"The terms "finance charge" and "annual percentage rate," when required to be disclosed with a corresponding amount or percentage rate, shall be more conspicuous than any other required disclosure.”
Now, since the reset will occur in June, what Citibank sent out in March was only a promotional letter, which does not require a Reg. Z disclosure, and not a notice of mortgage rate reset. However, the operational risk of reputational harm has already occurred as this is now being discussed negatively in a public forum.

Making the problem even worse, is exhibit E of Mish’s blog:
“Question 2. If we refinance should we stick with an arm or go to a fixed mortgage?
Answer: You do not want an arm you want a fixed. We used a 15 yr. fixed as a example;
We were quoted: 15 yr fixed-5.5 with an Apr of 5.65 and a $4400.00 fee.
We asked for a good faith FAX and she said they do not give those.”
If a Citibank loan officer indeed said they do not give those [good faith], then this is a clear violation of the Real Estate Settlement Procedures Act (RESPA). Per RESPA, a potential borrower has the right to a good faith disclosure of all the fees pertaining to a refinance.

Finally, pretending to be a supervisor and then hanging up on the telephone conversation is never an acceptable conduct. This would be a clear violation of internal policies and procedures for customer service.

So, we have here three errors:
  1. Solicitation letter that appears to be a mortgage interest reset letter – potential violation of Reg. Z
  2. Not providing a Good Faith Estimate when a customer requests one – potential violation of RESPA
  3. Pretending to be a supervisor and then hanging up on the telephone conversation – violation of internal policies and procedure.
So using Basel loss event categories, these are potential operational risks under two level-1 categories: (1) Clients, Products & Business Practice and (2) Execution, Delivery & Process Management and, specifically, potential operational risk under five Level-3 categories:
  1. Fiduciary breaches / guideline violations
  2. Suitability / disclosure issues
  3. Retail consumer disclosure violations
  4. Improper trade / market practice
  5. Client permissions / disclaimers missed
It will be interesting to see how many other Citibank customers start complaining of the same issue. Once the total population of the complaints is known, the operational risk loss amount can be quantified.

Ed Kim

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