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FHFA watchdog: GSEs still at risk of TBW-style scams

Counterparty risk still real threat

Fraud definition

It's been more than three years since Lee Farkas went to jail for mortgage fraud. Even today, not enough is being done to prevent a similiar scheme from happening in the mortgage market again, a new report warns.

Fannie Mae, Freddie Mac, and Ginnie Mae are all still at risk of billion-dollar loses via fraudulent schemes like the one perpetrated by Farkas' Taylor, Bean & Whitaker and Colonial Bank throughout the 2000s, according to a new report from the Federal Housing Finance Agency’s Office of the Inspector General.

In the new report, the FHFA’s watchdog warns that the government-sponsored enterprises and their government counterpart, Ginnie Mae, must make improvements in several areas to avoid a recurrence of the multi-billon dollar losses that were suffered at the hands of TBW chairman Lee Farkas and his co-conspirators.

The TBW story is the stuff of legend in the annals of housing finance and Farkas’ name is one of the most notorious from the fallout of the financial crisis.

TBW was, at one time, the largest privately held mortgage company in the U.S., employing over 2,000 people. TBW originated, serviced and sold mortgages in pools to Freddie Mac. Its funding was provided by Colonial Bank and later, by a TBW subsidiary, Ocala Funding.

Beginning in 2002 and stretching to 2009, Farkas and his fellow conspirators swept funds between accounts at Colonial and Ocala to cover constant overdrafts. By December 2003, the rolling overdraft had grown to more than $120 million and sweeping the funds back and forth became too complex, so Farkas and others began selling mortgages that didn’t exist to cover the shortages.

By 2009, Colonial Bank had more than $500 million in nonexistent loans on its books.

At the same time, Farkas had also set up Ocala Funding to provide commercial paper to investor banks. According to the FHFA-OIG report, BNP Paribas and Deutsche Bank purchased $1.7 billion in commercial paper from Ocala. The commercial paper was supposedly backed by mortgages originated or purchased by TBW.

But that was not the case.

Farkas and his fellow conspirators diverted nearly all of the funds and when TBW went belly up in 2009, BNP Paribas and Deutsche Bank lost nearly $1.5 billion.

Freddie Mac also filed a $1.78 billion proof of claim in TBW’s subsequent bankruptcy.

At one point, TBW also sold loans to Fannie Mae. In 2002, loans sold to Fannie represented 85% of TBW’s business. Fannie Mae canceled its seller/servicer agreement with TBW when it learned that Farkas had personally taken out eight loans, totaling $2 million and not actually backed by homes or any other eligible collateral, to pay for the repurchase of non-compliant loans that TBW had sold to Fannie.

Farkas intended to sell the eight fraudulent loans to Fannie to obtain the funds he needed to pay Fannie for the other non-compliant loans. Fannie discovered this fraud when Farkas was unable to make payments on the eight loans. Fannie did not communicate its findings to Freddie, its regulator or other interested parties.

Subsequently, Freddie considerably increased the volume of its business with TBW.

Farkas’ schemes were finally discovered when Colonial, which was on the verge of insolvency, applied for $553 million in funding from the Troubled Asset Relief Program. Colonial’s application was tentatively approved on the condition that it raise $300 million from outside investors.

According to the FHFA-OIG report, Farkas agreed to invest $150 million in the failing bank through TBW and help raise the additional $150 million because he knew that without the investment, TBW’s fraud would be discovered.

The additional $150 million would end up being diverted from Ocala’s books to Colonial’s, but the entire nature of Colonial’s fundraising raised a red flag with the Special Inspector General for TARP. Investigators questioned whether the injection of funding from Farkas was a “round trip” transaction, where the $300 million from TBW would be paid back from the TARP funds.

In the process of the investigation, several of Farkas’ co-conspirators eventually revealed the details of the multi-year, multi-billion dollar fraud.

Farkas was sentenced to 30 years in prison in 2011 and ordered to forfeit $38.5 million in ill-gotten gains for the $2.9 billion scheme after he was found guilty on 14 counts of bank, wire and securities fraud. Six of his co-conspirators also served (or are serving) significant jail time.

In the new report from the FHFA-OIG, the watchdog advises the FHFA that Fannie and Freddie need to improve in the areas of counterparty monitoring, contract enforcement and communication to prevent a similar situation from reoccurring.

“The failure to adequately address the red flags cost various parties losses of billions of dollars,” the FHFA-OIG said in a letter addressed to FHFA Director Mel Watt.

The FHFA-OIG suggests that Fannie and Freddie need to begin by placing stipulations on how long an independent public accountant is permitted to audit a counterparty. The report states that the length of time that an independent public accountant serves with a company can be “indicative” of a problem.

“If a counterparty changes IPAs routinely, then it could be trying to prevent IPAs from becoming too familiar with its operations,” the report states. “Alternatively, if a counterparty uses the same IPA year after year, then questions of collusion or competence may arise.”

The OIG suggests that Fannie, Freddie and Ginnie Mae coordinate on the best practices for IPAs and that the GSEs should require IPAs to perform supplemental compliance tests.

The OIG also suggests that the GSEs should increase their oversight of counterparties that “exhibit abnormal or unusual characteristics,” such as frequent charter changes or sudden “extraordinary” growth. Colonial changed its charter several times and TBW experienced massive growth over a very short period of time.

The OIG also advises the FHFA to implement guidance to the GSEs that will “govern their discretion to waive contractual obligations of counterparties.”

The OIG report states that the guidance should include requirements for: detailed written analysis of justifications for waivers, written descriptions of required corrective action plans, short timeframes for all waivers and monitoring steps to assure that corrective action plans have been satisfied.

Finally, the OIG advises that the GSEs need to improve their communication both internally and externally.

“The TBW-Colonial fraud reveals that various actors were victimized because they didn’t learn of or from the experiences of others,” the report states. “In retrospect, it appears obvious that Fannie Mae, Freddie Mac, Ginnie Mae and the Federal Deposit Insurance Corp. should have shared their experiences with counterparties among themselves and then should have learned from each others’ experiences.”

The OIG suggests that the FHFA should require the GSEs to share information between themselves and other interested parties, specifically about the negative performance and potentially illegal activity of its counterparties.

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