Friday, March 28, 2008

Operational Risk – JPMorgan Chase Teaches Mortgage Brokers To Cheat

The Oregonian reported Friday morning that it obtained a copy of an internal JPMorgan Chase (“JPMC”) memo titled “Zippy Cheats & Tricks” that provides step-by-step instructions on how to enter false data into a loan approval system called ‘Zippy.’ (Hat tip to Calculated Risk.) In essence, an in-house guide to committing mortgage fraud. Here are pertinent excerpts of the Oregonian report:

“It is a primer on how to get risky mortgage loans approved by Zippy, Chase's in-house automated loan underwriting system. The secret to approval? Inflate the borrowers' income or otherwise falsify their loan application.”

The "Cheats & Tricks" memo was instructing those [external mortgage] brokers how to get difficult loans approved by Zippy. "Never fear," the memo states. "Zippy can be adjusted (just ever so slightly.)" The Chase memo deals specifically with so-called stated-income asset loans, one of the most dangerous of the mortgage industry's innovations of recent years. Known as "liar loans"

The [Zippy Cheats & Tricks] document recommends three "handy steps" to loan approval:
Do not break out a borrower's compensation by income, commissions, bonus and tips, as is typically done in a loan application. Instead, lump all compensation as the applicant's base income.

If your borrower is getting some or all of a down payment from someone else, don't disclose anything about it. "Remove any mention of gift funds," the document states, even though most mortgage applications specifically require borrowers to disclose such gifts.

If all else fails, the document states, simply inflate the applicant's income. "Inch it up $500 to see if you can get the findings you want," the document says. "Do the same for assets."
This is going to be potentially very damaging to JPMC as the internal memo had been forwarded on to the OCC (Office of the Comptroller of the Currency), who has so far declined to comment on the matter.

Operational Risk Analysis
Fact 1: JPMC acknowledges the veracity of the document:
  • “Bank spokesman Tom Kelly confirmed that the "Cheats & Tricks" memo was e-mailed from Chase but added that it does not reflect Chase corporate policy.”
Fact 2: Falsification of information on a mortgage application is a crime (from a FNMA standard mortgage application):
  • “I/We fully understand that it is a Federal crime punishable by fine or imprisonment, or both, to knowingly make any false statements concerning any of the above facts as applicable under the provisions of Title 18, United States Code, Section 1001, et seq.”
Fact 3: The mortgage application fraud systemic and accepted practice within Chase Mortgage:
  • “The March e-mail was sent by Tammy Lish, a former Chase account representative in Portland.”
  • "I did not write it," Lish said. "It was sent to me by another (Chase) rep in another office along with some other documents that were more step-by-step customer training documents."
Fact 4: This fraud was encouraged, as evidenced from external mortgage brokers having copies of the memo:
  • “[Todd] Williams [a broker with Evergreen Ohana Group in Portland] and other mortgage brokers gave a copy of the memo to Oregon financial regulators.
Basel Level 1 Loss Event Categories And Violations Identified
Potential operational risks identified from above facts would be a violation of the following list of Basel loss events:

Level 1 - Internal Fraud
  • Level 2 - Unauthorized Activity – Chase loan officers engaged in systemic entry of false income & assets data
  • Level 2 - Theft and Fraud – Credit fraud perpetrated by several Chase loan officers in entering false income & assets data
Level 1 - Clients, Products & Business Practice
  • Level 2 - Suitability, Disclosure & Fiduciary – Chase Mortgage allowed these fraudulent mortgage to be approved; Chase loan officers willfully violated internal policies and the law; Chase loan officers misused client information to obtain mortgage loan approval; and JPMC now faces legal, monetary, and regulatory liabilities resulting from these violations.
  • Level 2 - Improper Business or Market Practices – Chase loan officers willfully engaged and encouraged improper business practice; Chase loan officers were a party to the illegal activities; Chase loan officers willful violated data integrity by ‘cheating’ the system; and Chase loan officers promoted systemic practice of fraud by disseminating the memo to external brokers.
Level 1 - Execution, Delivery & Process Management
  • Level 2 - Transaction Capture, Execution & Maintenance – Chase loan officers condoned falsifying borrower data; Chase’s operational risk management system did not pick up on this illegal practice; data integrity system did not identify the trends of loan officers and brokers making incremental adjustments to the data input to obtain approval.
  • Level 2 - Vendors & Suppliers – Chase Mortgage did not properly review and monitor mortgage brokers’ operating procedures, which would have identified the systemic fraud.
Loss From Identified Risk Events
This appears to be a systemic problem as many of these ‘liar loans’ have been made in the recent years and are now one of the reasons for the current credit crisis and bank write-downs -- JPMC alone had taken $1.3 billion write-down on sub-prime MBS positions. There will be other banks that will also be exposed for allowing similar activities to occur. As the OCC is now looking into the situation, I expect that we will hear more from them on this matter.

I hope astute readers are wondering the same thing as I am at this point. Which is: “Where were the risk managers and audit on this?” I find it implausible that a major bank such as JPMC that has multiple layers of monitoring and control (risk management, compliance officers, and independent audit reviews) did not pick this risk event up, given that the Chase loan officers were sending this memo to external brokers.

I hope Jamie is reading this and that he can put someone capable on this risk event ASAP to mitigate the damage.

Have a Great Weekend!
Ed Kim
DISCLOSURE: The author holds long positions in JPM at this time.

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1 comment:

ses said...

Good article...very informative for banking