Important Doc From JPMC Settlement - - Statement of Facts - EVENT 3 "REJECT" & "WAIVED" SECURITIZED LOANS


Important Doc From JPMC Settlement – – Statement of Facts – EVENT 3 “REJECT” & “WAIVED” SECURITIZED LOANS

Important Doc From JPMC Settlement – – Statement of Facts – EVENT 3 “REJECT” & “WAIVED” SECURITIZED LOANS

Statement of Facts

Between 2005 and 2007, affiliates of each of JPMorgan Chase & Co. (“JPMorgan”)1, The Bear Stearns Companies, Inc. (“Bear Stearns”), and Washington Mutual Bank  (“WaMu”) securitized large amounts of subprime and Alt-A mortgage loans and sold the resulting residential mortgage-backed securities (“RMBS”) to investors, including federally insured financial institutions. Each of JPMorgan, Bear Stearns, and WaMu developed and maintained mortgage origination and securitization processes and controls, including processes for conducting credit, compliance, and property valuation due diligence on loans prior to acquisition and/or securitization as well as processes for the monitoring of loan originators and sellers based, in part, on the subsequent performance of loans acquired from those parties.

JPMorgan, Bear Stearns, and WaMu described these processes to investors in marketing materials, and represented to investors in offering documents that loans generally complied with underwriting guidelines. As discussed below, employees of JPMorgan, Bear Stearns, and WaMu received information that, in certain instances, loans that did not comply with underwriting guidelines were included in the RMBS sold and marketed to investors; however, JPMorgan, Bear Stearns, and WaMu did not disclose this to securitization investors.


Between 2005 and 2007, JPMorgan purchased loans for the purpose of packaging
and selling residential mortgage-backed securities. Before purchasing loans from third parties,
employees at JPMorgan conducted “due diligence” to (1) confirm that the mortgage loans were
originated consistent with specific origination guidelines provided by the seller, (2) confirm the
mortgage loans were originated in compliance with Federal, State, and local laws, rules, and
regulations, and (3) confirm that the property collateral had the value represented in the appraisal
at the time of origination. Through that due diligence process, JPMorgan employees were
informed by due diligence vendors that a number of the loans included in at least some of the
loan pools that it purchased and subsequently securitized2 did not comply with the originators’
underwriting guidelines, and, in the vendors’ judgment, did not have sufficient compensating
factors, and that a number of the properties securing the loans had appraised values that were
higher than the values derived in due diligence testing from automated valuation models, broker
price opinions or other valuation due diligence methods. In addition, JPMorgan represented to
investors in various offering documents that loans in the securitized pools were originated
“generally” in conformity with the loan originator’s underwriting guidelines; and that exceptions
were made based on “compensating factors,” determined after “careful consideration” on a
“case-by-case basis.” The offering documents further represented, with respect to
representations and warranties made to JPMorgan by sellers and originators of the loans, that
JPMorgan would not include any loan in a pool being securitized “if anything has come to
[JPMorgan’s] attention that would cause it to believe that the representations and warranties of a
seller or originator will not be accurate and complete in all material respects in respect of the
loan as of the date of initial issuance of the related series of securities.” Notwithstanding these
representations, in certain instances, at the time these representations were made to investors, the
loan pools being securitized contained loans that did not comply with the originators’
underwriting guidelines.

JPMorgan began the process of creating RMBS by purchasing pools of loans from
lending institutions, such as Countrywide Home Loans, Inc., or WMC Mortgage Corporation,
that originated residential mortgages by making mortgage loans to individual borrowers. After
entering into a contract to purchase loans, but prior to purchase, JPMorgan performed “due
diligence” on samples of loans from the pool being acquired to ensure that the loans were
originated in compliance with the originator’s underwriting guidelines.

JPMorgan salespeople marketed its due diligence process to investors through
oral communications that were often scripted by internal sales memoranda, through presentations
given at industry conferences, and to certain individual investors. In marketing materials,
JPMorgan represented that the originators had a “solid underwriting platform,” and that
JPMorgan was familiar with and approved the originators’ underwriting guidelines; that before
purchasing a pool, a “thorough due diligence is undertaken to ensure compliance with
[underwriting] guidelines”; and that such due diligence was “performed by industry leading 3rd
parties (Clayton and Bohan).”

JPMorgan contracted with industry leading third party due diligence vendors to
re-underwrite the loans it was purchasing from loan originators. The vendors assigned one of
three grades to each of the loans they reviewed. An Event 1 grade meant that the loan complied
with underwriting guidelines. An Event 2 meant that the loans did not comply with underwriting
guidelines, but had sufficient compensating factors to justify the extension of credit. An Event 3
meant that the vendor concluded that the loan did not comply with underwriting guidelines and
was without sufficient compensating factors to justify the loan, including in certain instances
because material documents were missing from the loan file being reviewed. JPMorgan
reviewed loans scored Event 3 by the vendors and made the final determination regarding each
loan’s score. Event 3 loans that could not be cured were at times referred to by due diligence
personnel at JPMorgan as “rejects.” JPMorgan personnel then made the final purchase

From January 2006 through September 2007, in the course of JPMorgan’s
acquisition of certain pools of mortgage loans for subsequent securitization, JPMorgan’s due
diligence vendors graded numerous loans in the samples as Event 3’s, meaning that, in the
vendors’ judgment, they neither complied with the originators’ underwriting guidelines nor had
sufficient compensating factors, including in many instances because of missing documentation
such as appraisals, or proof of income, employment or assets. The exceptions identified by the
third-party diligence vendors included, among other things, loans with high loan-to-value ratios
(some over 100 percent); high debt-to-income ratios; inadequate or missing documentation of
income, assets, and rental/mortgage history; stated incomes that the vendors concluded were
unreasonable; and missing appraisals or appraisals that varied from the estimates obtained in the
diligence process by an amount greater than JPMorgan’s fifteen percent established tolerance.
The vendors communicated this information to certain JPMorgan employees.

JPMorgan directed that a number of the uncured Event 3 loans be “waived” into
the pools facilitating the purchase of loan pools, which then went into JPMorgan inventory for
securitization. In addition to waiving in some of the Event 3 loans on a case-by-case basis, some
JPMorgan due diligence managers also ordered “bulk” waivers by directing vendors to override
certain exceptions the JPMorgan due diligence managers deemed acceptable across all Event 3
loans with the same exceptions in a pool, without analyzing these loans on a case-by-case basis.
JPMorgan due diligence managers sometimes directed these bulk waivers shortly before closing
the purchase of a pool. Further, even though the Event 3 rate in the random samples indicated
that the un-sampled portion of a pool likely contained additional loans with exceptions,
JPMorgan purchased and securitized the loan pools without reviewing and eliminating those
loans from the un-sampled portions of the pools.

According to a “trending report” prepared for client marketing purposes by one of
JPMorgan’s due diligence vendors (later described by the vendor to be a “beta” or test report),
from the first quarter of 2006 through the second quarter of 2007, of the 23,668 loans the vendor
reviewed for JPMorgan, 6,238 of them, or 27 percent, were initially graded Event 3 loans and,
according to the report, JPMorgan ultimately accepted or waived 3,238 of these Event 3 loans –
50 percent – to Event 2.

During the course of its due diligence process, JPMorgan also performed a
valuation review. JPMorgan hired third-party valuation firms to test the appraisal’s estimate of
the value of the mortgaged properties through a variety of data points, including (1) automated
valuation models, (2) desk reviews of the appraisals by licensed appraisers, and (3) broker price
opinions. After reviewing the relevant data, the valuation firm would provide a “final
recommendation of value.” JPMorgan had a “tolerance” of 15 percent in the valuation review,
meaning that JPMorgan would routinely accept loans for securitization, including those with
loan-to-value ratios as high as 100 percent, when the valuation firm’s “final recommendation of
value” was up to 15 percent under the appraised value. In the same marketing communications
described above, JPMorgan salespeople disclosed that its property valuation review involved an
“Automated review of appraisals, with secondary reviews undertaken for any loans outside of
tolerance.” JPMorgan did not disclose that its “tolerance” was 15 percent.

In one instance, JPMorgan’s due diligence revealed that several pools from a
single third-party originator contained numerous stated income loans (i.e., loans originated
without written proof of the borrower’s income) where the vendor had concluded that borrowers
had overstated their incomes. Initially, due diligence employees and at least two JPMorgan
managers decided that these pools should be reviewed in their entirety, and all unreasonable
stated income loans eliminated before the pools were purchased. After the originator of the loan
pools objected, JPMorgan Managing Directors in due diligence, trading, and sales met with
representatives of the originator to discuss the loans, then agreed to purchase two loan pools
without reviewing those loan pools in their entirety as JPMorgan due diligence employees and
managers had previously decided; waived a number of the stated income loans into the pools;
purchased the pools; and subsequently securitized hundreds of millions of dollars of loans from
those pools into one security. In addition, JPMorgan obtained an agreement from the originator
to extend contractual repurchase rights for early payment defaults for an additional three months.

Prior to JPMorgan purchasing the loans, a JPMorgan employee who was involved
in this particular loan pool acquisition told an Executive Director in charge of due diligence and
a Managing Director in trading that due to their poor quality, the loans should not be purchased
and should not be securitized. After the purchase of the loan pools, she submitted a letter
memorializing her concerns to another Managing Director, which was distributed to other
Managing Directors. JPMorgan nonetheless securitized many of the loans. None of this was
disclosed to investors.

On some occasions, prospective investors in mortgage-backed securities marketed
by JPMorgan requested specific data on the underlying loan pools, including information on due
diligence results and loan characteristics, such as combined-loan-to-value ratios. JPMorgan
employees sometimes declined to provide information to such investors concerning such loan
data, including combined loan-to-value ratio data. In some instances, JPMorgan employees also
provided data on the percentage of defective loans identified in its own due diligence process as
a percentage of the pool that was acquired rather than as a percentage of the diligence sample,
without disclosing the basis of their calculation.

Bear Stearns

Throughout the relevant time periods described below, Bear Stearns made various
statements concerning the processes by which Bear Stearns monitored third party loan sellers
and aspects of the performance of the loans Bear Stearns purchased from those sellers.
Between 2006 and 2007, Bear Stearns purchased, securitized and sold to investors
billions of dollars of Alt-A mortgage loans. Some of these loans were acquired by Bear Stearns
through what was known as its “flow-conduit.” Flow-conduit loans were acquired by EMC
Mortgage – a wholly owned Bear Stearns subsidiary – from a wide variety of sellers and
mortgage originators (“Flow-Conduit Sellers”). After acquiring these loans, Bear Stearns would
generally bundle them, securitize that bundled pool of loans, and sell the securities (“Flow-
Conduit Securities”) to investors. Investors included federally-insured financial institutions and
other institutional investors nationwide.

Between 2006 and 2007, Bear Stearns implemented a program for monitoring
Flow- Conduit Sellers. Among other things, Bear Stearns monitored the financial well-being of
the Flow-Conduit Sellers, tracked aspects of the performance of loans being originated by
individual Flow-Conduit Sellers, and reviewed a sample of the loans post-acquisition to
determine whether they complied with certain underwriting and/or origination standards.

Beginning in approximately June 2006 and continuing through 2007, as part of its
monitoring program, Bear Stearns assigned “grades” to individual sellers. Bear Stearns
employed different grading systems over different time periods. But, at relevant times, the Bear
Stearns grading system included a grade of “F” for sellers whose financial condition or credit
profile, loan performance, and claims history warranted significant scrutiny and potentially a
discontinuation of the business relationship, and also allowed for sellers to be “suspended” or

Flow-Conduit Securities typically included loans from many, and in some cases,
as many as hundreds, of Flow-Conduit Sellers. Prospectus supplements for Flow-Conduit
Securities were required by regulation to identify the Flow-Conduit Sellers only if those sellers
exceeded a specified concentration of loans in the security pool. In only one security during the
relevant period, a Flow-Conduit Seller exceeded that concentration; in that instance, the
prospectus supplement identified the relevant Flow-Conduit Seller. Consistent with the
applicable regulatory disclosure requirements, Bear Stearns did not otherwise identify the Flow-
Conduit Sellers in any given security.

Bear Stearns discussed its seller monitoring process with certain investors. In
some communications with investors, Bear Stearns described its seller approval and seller
monitoring processes as a way to filter out poor-performing sellers. Bear Stearns informed
certain investors in Flow-Conduit Securities that, as a result of Bear Stearns’ seller monitoring,
certain Flow-Conduit Sellers had been terminated or suspended. Bear Stearns further
communicated that it would not continue to purchase loans originated by terminated or
suspended sellers. Certain of this same information was also communicated to rating agencies in
January 2007. Between 2006 and 2007, certain Flow-Conduit Securities included a number of
loans originated by sellers that, at the time of securitization, had received “F” grades, or had been
designated as “suspended” or “terminated.” Purchasers of Flow-Conduit Securities were not
informed as to the presence of loans from those sellers in Flow-Conduit Securities.

In certain instances, Bear Stearns employed a quality control process to review
the loans after they had been purchased, which meant in certain circumstances that the loans
were already included in Flow-Conduit Securities (among other securities) when the review took
place. In certain investor presentations and communications, Bear Stearns stated that its loan
acquisition processes included post-purchase quality control reviews, but, by the end of the
relevant time period, once Bear Stearns made a decision to suspend or terminate and discontinue
loan purchases from sellers, it did not undertake this post-purchase review for loans that had
been originated by those Flow-Conduit Sellers. The absence of a quality control process for such
loans meant that Bear Stearns did not take certain steps that might have been undertaken to cure
potential exceptions in the underlying loans, or to determine if Bear Stearns had to repurchase
them out of the trusts holding them for investors.

Bear Stearns personnel, including certain managers, were aware that Flow-
Conduit Securities included a number of loans from poorly graded Flow-Conduit Sellers, and
were likewise aware that the loans originated by these poorly graded sellers sometimes
experienced high rates of default. At least one Bear Stearns employee questioned the continued
inclusion of loans from those sellers in Flow-Conduit Securities.

Certain of the Flow-Conduit Securities also included loans acquired through bulk
purchases of pools of loans from larger originators (“bulk purchases”) rather than from Flow-
Conduit Sellers. For bulk purchases of Alt-A, as well as subprime, loans, Bear Stearns often
conducted credit-related due diligence on the loan pool (or, in the case of Alt-A loans, on a
sample of the loan pool) to be acquired. Bear Stearns typically hired a third-party due diligence
vendor to review the loans selected for diligence and to provide a score reflecting the vendor’s
judgment as to whether the loan was originated in accordance with applicable underwriting
guidelines or had adequate compensating factors.

Bear Stearns’ due diligence managers reviewed the vendor’s determinations and
made the final decision as to whether Bear Stearns would purchase the loan or not. In certain
circumstances, Bear Stearns due diligence managers or other employees determined after their
review of the loans that, notwithstanding a vendor’s identification of exceptions to specified
underwriting guidelines, Bear Stearns would purchase loans where there was a variance from the
guidelines that the managers or other employees deemed acceptable. In addition, Bear Stearns
completed bulk purchases of Alt-A loan pools even though the rate of loans with exceptions in
the due diligence samples indicated that the un-sampled portion of a pool likely contained
additional loans with exceptions.

The last securitization by Bear Stearns was in 2007. The conduct described above
with respect to Bear Stearns all occurred prior to JPMorgan’s acquisition of Bear Stearns in
March 2008.


Prior to WaMu’s failure and closure by the Office of Thrift Supervision (“OTS”)
in 2008, internal WaMu reviews indicated specific instances of weaknesses in WaMu’s loan
origination and underwriting practices, including, at times, non-compliance with underwriting
standards; the reviews also revealed instances of borrower fraud and misrepresentations by
others involved in the loan origination process with respect to the information provided for loan
qualification purposes. WaMu did not disclose to securitization investors in written offering
materials the information from its internal reviews concerning instances of borrower fraud and
misrepresentations regarding borrower credit, compliance, and property valuation, in the
origination of loans, including as to loans that were sold into securitizations. WaMu also did not
disclose to investors information regarding instances of fraudulent and/or poor underwriting by
certain non-WaMu loan originators who sold loans to WaMu, the fact that certain internal
processes and controls were determined by internal reviews to have been ineffective in certain
circumstances in preventing weak loan origination practices, or that the systems and data issues
led to certain instances of delinquent loans being included in pools that were securitized in
RMBS offerings. The last securitization by Washington Mutual was in 2007.

On September 25, 2008, the OTS seized Washington Mutual Bank and placed it
into receivership with the Federal Deposit Insurance Corporation (“FDIC”). After the bank’s
failure, JPMorgan acquired WaMu’s assets and certain specified liabilities from the FDIC. The
actions and omissions described above with respect to WaMu occurred prior to OTS’s closure of
WaMu and JPMorgan’s acquisition of the identified WaMu assets and liabilities.

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