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Case Study Overview

Forensics

Post financial crisis, the banking industry faced a number of challenges. Consolidation

among surviving entities in the industry created complications amongst IT, financial, and

data systems. Surviving management teams inherited unresolved and complex financial,

legal and regulatory issues.

By 2011 the industry faced litigation on a number of fronts related to perceived inappropriate practices during the

credit bubble and subsequent crisis. This litigation took several shapes.

Fannie Mae and Freddie Mac alleged that they had been misled when they purchased what were presented as high

quality mortgage backed securities, which subsequently lost significant value. They alleged that the banks had painted

a false picture of the characteristics and risks of the underlying mortgage backed securities. A mortgage backed

security’s risk profile is dependent on the creditworthiness of the ultimate borrower, the origination and underwriting

policies that were used when making the loan, and the loan characteristics. For example, it has been alleged that banks

utilized certain vetting procedures before loans were purchased for securitization, when in fact they were not, that the

percentage of homes that were owner occupied was lower than advertised, and that Loan to Value (LTV) ratios were

higher than stated. (Refer appendix 1 for definitions).

It has also been alleged that banks generated profits at each step of the loan generation and securitization process and

were thus incentivized to simply generate as much volume as possible, without regard to loan quality. Many banks

responded by arguing that they also suffered large losses and thus had “skin in the game” as well.

Attorney Generals of various states filed cases alleging, among other things, that banks had engaged in “Robo-signing”,

whereby bank representatives signed home foreclosure documents without actually reviewing the accompanying

paperwork to verify that it was in order and the borrower was in fact in default.

Similar foreclosure practice class action lawsuits were brought by private homeowners.

Other lawsuits were brought concerning loan modification practices. The Home Affordable Modification Program

(HAMP) was a federal program that required certain banks to perform loan modifications and other foreclosure

prevention services. Many banks signed up for the program as a condition of receiving TARP (see appendix) funding,

but were subsequently investigated for not implementing its mandates.

ABC Financial

In this environment, Jamie Smith, CEO, was brought in to take control of ABC Financial. ABC Financial is a mid-size

bank with $800B in assets. ABC was formed through the combination of a legacy financial institution with several

banks that it acquired and consolidated under the ABC name. While the ABC’s Board is hopeful that the combinations

will eventually lead to greater profitability, in the medium term, ABC has inherited potential litigation which it needs

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to address. The challenges faced are complicated by the number of financial and IT systems being combined under one

roof. An organizational chart indicating how ABC was formed is shown below:

ABC Financial—Newly Formed

Financial Holding Company

XYZ Financial— Legacy Bank M&M Financial— Newly

Acquired Financial Institution

Various Smaller Banks—

Recently Acquired

The largest consolidation occurred with M&M Financial, which individually comprised a 25% increase in loans. XYZ

and M&M accepted TARP funds and are subject to the requirements of HAMP.

XYZ and M&M Loan Business

M&M had a different loan origination practice, served a different customer base and region, and used a different IT and

servicing system (in which consumer, loan, and payment data was entered, updated, and processed) than XYZ. XYZ and

M&M systems had not been integrated since the merger, making it difficult to run analytics on the entire population of

loans originated and serviced. In addition, there were different official written polices as to originating and servicing

loans for the legacy branches and departments.

These policies included: dealing with issues such as which applicants were extended loans and at what terms;

procedures when customers fell behind on payments; providing potential mortgage relief or forgiveness; and

foreclosure and default practices. It was unclear to what extent these policies may have been deviated from. A table

with estimated Loan Book Value (LBV), foreclosure rate, and modification rates is shown below:

Table 1

Values in Thousands (000’s) USD

Legacy XYZ

Legacy M&M

Other

ABC Financial

Loan Book Value 100,000,000 25,000,000 15,000,000 140,000,000

Foreclosure Rate 1.80% 2.50% NA

Mortgage Modification Rate 2.00% 7.00% NA

Customers of both legacy branches have filed complaints with state Attorney Generals alleging that they were

improperly foreclosed upon. The other banking institutions acquired did not have residential loans and are not relevant

to the current issues faced by the business.

M&M’s mortgage origination and servicing practice was formerly headed by Sarah Banks, who was known to be a

very active manager who communicated frequently with subordinates about the goals, benchmarks, and practices

of the group. An email from Sarah Banks has been included for PwC review. The equivalent group within XYZ was

headed by Lou McGee, known for his insistence on meeting deadlines, completing work, and not revisiting items after

a decision has been made. ABC management has been made aware that Lou was proud that his group had a lower loan

modification rate than any comparable group in the industry.

M&M Investment Banking Division

Prior to the credit crisis, M&M operated an investment banking group that was active in the securitization of mortgage

loans underwritten and serviced by M&M financial. After pooling and securitizing loans, they generated prospectuses

for the resulting bonds and sold them to investors. They also had a proprietary trading desk, which could purchase

and sell these bonds on the open market. Poor performance in the investment banking group partially lead to M&M’s

takeover by ABC Financial. An email from Pat Diamond, ABC Director of Finance, reviewing the performance of one

M&M securitization deal has been included for PwC review.

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Before being acquired, M&M was served with lawsuits from private investors alleging that the quality of loans backing

the issued bonds did not meet the terms of the prospectus. Many of the former employees of the investment banking

division had not been retained through the merger. According to past records, the terms in the prospectus for the

underlying loans were based on the written policies of M&M’s loan origination group.

IT and Data Issues Since the formation of ABC, the two legacy IT staffs have not integrated data. In the absence of an integrated IT

platform, the legacy IT staffs continue to exchange information, via ad hoc means such as email. The data they

worked with was typically stored on their workstations and on network shares to which the individual teams had

access.

Much of the mortgage transactional data was stored natively in different servers and was never combined once the

merger occurred because the data was dissimilar and the organization was not confident they could successfully

merge the databases without losing significant data. M&M operates a legacy mainframe system while XYZ

operates a homegrown system with an Oracle back end database. Two attempts were made to build a unified

system but both efforts were abandoned due to complexity and issues with verifying the completeness of data

during the prototyping phase.

It was common for mortgage account managers to request data to be extracted from the servers and commingled

with other servers to produce sales results. The commingling of data typically occurred on the mortgage account

mangers’ workstations and data was exchanged via email.

Summary

Clearly, the organization had legal risks that threatened to weaken the financial position of the bank, hurt its

reputation, and distract management and employees from day to day execution. After discussions with the Chief Legal

Officer and outside counsel, Jamie Smith made the decision to retain PwC to assist with the situation. A few issues were

foremost in Jamie’s mind:

- The number of legacy data, IT, and servicing systems presented a challenge to ABC, both in quantifying the

population of data relevant and estimating the financial risks, and in accurately responding to financial and loan data

discovery orders.

- Concern over meeting requirements to provide internal emails, memos, financial documents, and other information

that was relevant to the proceedings, and to perform analytics on outstanding data in different locations and formats

in response to litigation.

- The risk that official policies concerning loan origination and treatment were directly circumvented or erroneously

not followed.

- Concern that certain customers may have been improperly foreclosed upon and/or not made aware of applicable

mortgage loan modification programs as required.

- The aggregate actual characteristics of the loans which backed mortgage securities compared to the characteristics

advertised in the prospectus.

- The overall profitability (or losses) that typically occurred on a mortgage backed bonds issued by M&M during the

relevant period.

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APPENDIX 1

Definitions

- Securitization: The financial practice of pooling various types of contractual debt such as residential mortgages,

commercial mortgages, auto loans or credit card debt obligations and selling said consolidated debt as, for

example, bonds.

- Loan Pools: A group of mortgages, potentially with similar characteristics such as location, loan value, etc.

- Loan to Value: The ratio of the first mortgage loan as a percentage of the total appraised value of real property.

- TARP: A government program created for the establishment and management of a Treasury fund in an attempt to curb

the ongoing financial crisis of 2007-2008. The TARP gives the U.S. Treasury purchasing power of $700 billion to buy

up mortgage backed securities (MBS) from institutions across the country, in an attempt to create liquidity and un-

seize the money markets.

- HAMP: A loan modification program introduced in 2009 to promote stability in the housing market. The Home

Affordable Modification Program was aimed at helping homeowners who were devoting more than 31% of their gross

income toward mortgage payments. Eligible homeowners can receive adjustments to the mortgage principal, interest

rate or payments in order to get the percentage of income going to payments below 31%.

Sources: Investopedia and Wikipedia

*Note—Both Core and Forensic Technology Service Professionals will meet with Jamie Smith. Core professionals are not

expected to address deep technological issues.

APPENDIX 2 2

Email Recovered from Legacy M&M Email System

To: Managers, M&M Residential Loans Group

From: Sarah Banks

Date: October 11, 2006, 2:05pm Eastern Standard Time

Subject: Goals and objectives, no excuses

Team, I am disappointed we did not meet our goal of originating $2B in loans in the 3rd quarter. I have heard the comments that many

applicants would go over our written loan to property value maximum of 85%. To me that sounds like an excuse. Property values have

been on an upward trajectory and I think we are missing out on opportunities. Whatever needs to be done to meet your individual goals

should get done. Some of you are not being “creative” or aggressive enough.

I don’t need to tell you the pressure we are under to generate enough loans for the folks over in the investment banking division. They

package our product and no one was happy when they had to buy loans from 3rd party originators last quarter to meet their targets.

Everyone knows how profitable that group is. You need to do whatever is necessary to ensure that that profitability is maintained and

that we are all in a position to meet our targets so we get paid bonuses.

NO MORE EXCUSES!

Email from Pat Diamond, Director of Finance

To: Jamie Smith, CEO, ABC

From: Pat Diamond, Director of Finance, ABC

Date: March 15, 2012, 3:05pm Eastern Standard Time

Subject: Our initial review of the M&M Mortgage Securitization Trust 1 Deal

Jamie, as we discussed, I had our Finance team try to value M&M Trust 1 Deal as of April 1, 2011. This trust was formed

to take in loans, securitize them (combine pools of loans to form bonds), and then sell the bonds on the open market or

retain them. The trust was owned by M&M.

There were significant issues with gathering data and we are still not confident in all our inputs. That being said, here

are our initial results:

Value in thousands (000’s) USD - The Trust 1 Deal

Category Value

Loans on date originated/purchased (Q3, 2004): 1,000,000

Loans on date transferred to trust (March 1, 2005): 1,020,000

Proceeds, Bonds formed from loans and sold to 3rd parties (April 1, 2005):* 1,010,000

Bonds formed from loans and retained by Trust (As of April 1, 2005):* 40,000

Bonds Retained by Trust (As of April 1, 2011): 1,000

*The value of the bonds sold and retained exceeds the loans transferred to the trust because the securitized bonds are

valued higher than individual loan pools.

APPENDIX 2 3

Interestingly, we had discussions with Jim Jackson, one of the few legacy M&M investment employees left, and he told

us to look in to the group’s hedging practice. We found evidence of the following on the books:

Value in thousands (000’s) USD

Category Value

Holdings Designed to Hedge Loans (Q3, 2004) 1,000,000

Holdings Designed to Hedge Loans (Sold March 1, 2005) 977,000

For internal PwC use only, not for further distribution outside of PwC. ABC Financial is a fictitious company created for the purpose of administering a

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