(RRR RRERRERERERRERERSRRARRRSA SSA

BRERERRRRRRERRERRRRRERRRRARARRRASRSRASRSA 2.

CHAPTER 3 _

Table 2
OCC Examinations and Supervisory Response
(1992 to 1999)

Date
Exam CAMELS® Supervisory Response/
Started® Rating Safety and Soundness Issues Date of Action __ Enforcement Actions Taken

116/92 2121312 ‘System and intemal control deficiencies 3/19/82 ‘Commitment Letter
+ Inadequate policies, systems and controls
+ Call Report violations
Tass 221312 |» Lack of comprehensive intemaVextemal audit functions 0728/93 + Revised Commitment
* No policies and procedures for FHA Title | loan program Letter
* No policy guidelines developed for Interest Rate Risk
management
+ Concems over certificates of deposit investments
* Inadequate documentation of intemal loan reviews
+ Truth in Lending Act (Reg. Z) violations
a1194 222322 | Repeat Call Report violations S894 * Supervisory Letter
+ Concems with treatment of gain on loan sales and loan issued for Call Report
administration violations
*  Falsification of bank records regarding Truth in Lending 5/5/95, * Criminal referral for
Act reimbursements falsification of bank
. records relating to Reg.
Z violation
5/5/95 .
BSIS5 222322 | + Accounting and control issues identified, especially the 724786 > Commitment Letter
FHA Title | program terminated
S195 37 Operational deficiencies surrounding the FHA Title loan B/30/96 * Ombudsman upheld
securitization program rating
* 11/3/95 - FDIC downgrades Keystone’s CAMEL rating
based on the 5/8/95 examination
*___ 1/22/96 - bank appealed exam rating of 3 to Ombudsman
STIS6 222212 | Bank's financial condition was sound None
+ FDIC participated in the exam
7728/97 | 31844433 [+ Concerns with controls over FHA Title | loan program 3/28/98 > Formal Agreement
securitizations 8/6/98 + CMPs issued for Call
* Loans not being charged-off Report violations
* Unacceptable intemal audit
* Call Report violations
+ __ Inadequate provision for loan loss
9/3198 | 4/445444 [+ Insufficient progress with Formal Agreement TISID *  CMPs initiated but not
* Unsafe concentration of mortgage products issued for Call Report
* Bank illegally accepted brokered deposits and brokered deposit
* Inaccurate Call Reports violations
*__ FDIC participated in the exam
721198 | No Rating | + illegally accepted brokered deposits S799 * Bank closed
Assigned | + — Backdated brokered deposit records
* Loans reported on bank's books not owned by Keystone
*___FDIC participated in the exam _

‘Source: OCC’s Supervisory Monitoring System, Reports of Examination and Examination Workpapers

5 Exam start date per Report of Examination (ROE).

° The first number is the composite rating. A rating of 1 through S is given, with 1 having the least
regulatory concern and 5 having the greatest concern. Individual components of the CAMEL rating
system are Capital adequacy, Asset quality, Management administration, Earnings and Liquidity.
Effective 1/1/97, an additional component addressing Sensitivity to market risk was added to the
examination ratings under OCC-B-97-1, Uniform Financial Institutions Rating System and Disclosure of
Component Ratings.

7 OCC conducted a special examination, concentrating on the FHA Title I loans and securitization
program. The 3 rating was the bank’s composite CAMEL rating.

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CHAPTER 4

Oversight of Asset Securitization Activities

OCC issued OCC Bulletin (OCC 99-46), Interagency Guidance on Asset
Securitization Activities, dated December 14, 1999, to bank officers and
examining personnel. The Bulletin reminds bank managers and
examiners of the importance of fundamental risk management practices
governing asset securitization activities. It discusses the expectation for
critical components of an effective oversight program for asset
securitization activities. These activities include:

¢ independent risk management commensurate with the complexity of
securitization activities,

* comprehensive audit coverage,

© appropriate residual interest valuation and modeling methodologies,

¢ accurate and timely risk-based capital calculations, and

¢ prudent internal limits to control the amount of equity capital at risk
that is used to support securitization retained interests.

Additionally, OCC in November 1999 asked its examiners to complete
an asset securitization survey. The purpose of the survey was to
determine the number of national banks involved in securitization
activity and to assess the volume of risk from the booking of a residual
asset.

Moreover, in December 1999, the OCC began setting up a special
oversight committee, comprised of securitization experts who would help
deal with banks that have gotten into or may get into trouble because of
securitization activities.

This guidance was based on asset securitization activities found at
Keystone and other banks.

Asset Verification Procedures Database

In November 1999, OCC established a project to develop a
comprehensive database of verification procedures. The database is
designed to provide examiners guidance on appropriate procedures to
validate and test the bank’s internal controls, and to verify the existence
of assets and the reliability of financial records. The verification
procedures should be issued in a new separate booklet of the
Comptroller’s Handbook or incorporated into individual booklets by
subject area. OCC plans to complete this project in May 2000.

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CHAPTER 4

RECOMMENDATIONS AND LESSONS LEARNED

The specific underlying causes of Keystone’s failure remain unknown
until Federal law enforcement officials complete their investigations. As
a result, the OIG was unable to fully assess the adequacy of OCC’s
supervision of Keystone. Nevertheless, the OIG believes that Keystone
offers several valuable lessons and opportunities to improve the
supervisory process. To its credit, OCC has already undertaken several
initiatives to improve examination polices and procedures. Based on
facts known to date, the OIG also has seven recommendations that focus
on examination and enforcement procedures.

Recommendations
Recommendations 1 - 3

In Chapter 3, we noted that Keystone’s financial accounting, reporting
and underlying control problems had repeatedly surfaced in OCC
examinations at least since 1992. However, verification of Keystone’s
reported loans was not conducted until 1999. The loan verifications
revealed that total assets were overstated by nearly 50 percent, and
Keystone was unable to account for over $500 million in unsubstantiated
loans. Aside from the potential underlying fraud aspects of this
discovery, we believe that OCC’s risk-based examinations may place
undue reliance on external auditors to ensure the accuracy of financial
information that is vital to detecting unsafe and unsound banking
practices.

Accordingly, the OIG recommends that the Comptroller of the Currency:

1. Issue either new or supplemental examination guidelines
requiring a risk assessment of a bank’s financial accounting,
reporting, and controls as an integral part of assessing the bank’s
overall risk.

2. Develop detailed examination guidelines and/or indicators as to
when full reliance may not be placed on a bank’s external audited
financial statements and related accompanying statements.

3. Establish guidelines and supplemental examiner training, on
testing procedures when full reliance may not be placed on
audited financial statements. This recommendation is not

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Appendix 2
Page 1 of 5

GLOSSARY OF TERMS

Allowance for
Loan and Lease
Losses

Asset Quality

Brokered
Deposits

Call Report

CAMEL/
CAMELS

Capital Markets

A valuation reserve established and maintained by charges
against a bank’s operating income. As a valuation reserve,
it is an estimate of uncollectable amounts that is used to
reduce the book value of loans and leases to the amount that
is expected to be collected.

The quantity of existing and potential credit risk associated
with the loan and investment portfolio, other real estate
owned, and other assets, as well as off-balance sheet
transactions.

Funds which a bank obtains, either directly or indirectly, by
or through any broker, for deposit into a deposit account.
Brokered deposits include both those in which the entire
beneficial interest is held by a single depositor and those in
which the deposit broker sells participations to one or more
investors. Under 12 Code of Federal Regulations §337.6,
only “well capitalized” banks may accept brokered deposits
without FDIC approval.

A bank’s quarterly Consolidated Report of Condition and
Income. It includes a balance sheet and income statement,
and other information about the bank.

The OCC and other bank regulators use the Uniform
Financial Institution Rating System to evaluate a bank’s
performance. CAMEL is an acronym for the performance
rating components: Capital adequacy, Asset quality,
Management administration, Earnings and Liquidity. An
additional component addressing Sensitivity to market risk
was added effective 1/1/97. CAMELS

Includes investments such as mortgage-backed securities,
dealer activities, foreign exchange, off-balance sheet items
and other related activities.

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CHAPTER 1

Our review covered the period from 1992 to the bank’s failure in 1999.
In performing our review, we analyzed supervisory and enforcement
files and records maintained by the OCC Headquarters, district, and field
offices. We also reviewed records maintained by the FDIC and the

FRB. In addition, we discussed various aspects of the supervision of
Keystone with OCC officials, including examiners and attorneys. We
also interviewed FDIC officials and examiners who had participated with
OCC in three examinations at Keystone, or who were responsible for
monitoring Keystone for federal deposit insurance purposes.

The audit was conducted in accordance with the Government Auditing
Standards issued by the Comptroller General of the United States, and
included such audit tests as were deemed necessary. At the time of this
report, Federal law enforcement officials were still investigating the
alleged fraud surrounding the $515 million in unsubstantiated loans, as
well as related matters. Therefore, we could not fully assess the cause
of the bank’s failure.

For a more detailed discussion of our objectives, scope and
methodology, refer to Appendix 4.

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Appendix 3
Page 6 of 7

CHRONOLOGY OF SIGNIFICANT EVENTS

3/29/99 OCC & FDIC conduct one week on-site review of residual valuation,
risk-based capital calculations, liquidity, and compliance with the
brokered deposit regulations. OCC and FDIC also meet with external
auditors to discuss the methodology for valuing the residual assets.

4/19/99 Keystone hires new President.

5/5/99 FFIEC issues interagency agreement on proration of assets, upholding
OCC’s 11/9/98 opinion.

6/15/99 OCC and FDIC examiners visit Certified Public Accountant’s office to
review audit workpapers for the 12/31/98 financial statement audit of the
bank.

6/21/99 OCC starts safety and soundness examination with FDIC participation.

6/23/99 FDIC notifies OCC of composite rating downgrade from 4 to 5 based on

OCC’s 8/31/98 examination with FDIC participation. The FDIC noted
the bank’s viability could be in jeopardy unless record-keeping matters
were resolved, a supported value of the residual was determined,
concentration in HLTV loans was reduced, and management took
proactive corrective action. FDIC’s CAMELS rating: 5/455454.

715/99 OCC issues notice of CMP assessments.
7/19/99 6/21/99 examination is halted because the bank alleges a former OCC

examiner made disparaging remarks against bank management.
Consequently, Keystone obtains court order to hold OCC documents and

workpapers.

7/23/99 OCC sends letter to Keystone requiring the bank to stop taping and
monitoring OCC employees.

7126/99 FDIC examiners find Keystone obtained $24 million of brokered
deposits in violation of PCA brokered deposit restriction.

7127199 OCC examiners return to Keystone to resume 6/21/99 examination.

7129/99 OCC asks permission from Keystone to contact the loan servicers to

obtain direct verification of loan information.

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Appendix 3
Page 4 of 7

CHRONOLOGY OF SIGNIFICANT EVENTS

9/18/97 OCC internal document indicating that Keystone’s application with the
FRB of Richmond, Virginia to establish a holding company was going to
be turned down.

10/26/97 Keystone’s President dies.

2/13/98 FDIC requests to participate in next OCC examination tentatively
scheduled for 11/2/98. FDIC notifies OCC of the composite rating
downgrade from 3 to 4 based on serious weaknesses in asset quality,
earnings and management depicted in OCC’s 7/28/97 examination.

2/26/98 OCC sends letter to FDIC indicating participation in the next
examination tentatively scheduled for 11/2/98 would be unnecessarily
burdensome to the bank.

5/7/98 FDIC notifies Keystone of the composite rating downgrade from 3 to 4

based on serious weaknesses in asset quality, earnings, and management
depicted in OCC’s 7/28/97 examination.

5/28/98 Keystone signs Formal Agreement regarding the accuracy of the bank’s
accounting records and management information systems, the need to
obtain a nationally recognized auditing firm, and 12 other articles
requiring the bank to improve the safety and soundness of the bank.

6/26/98 Keystone hires a former OCC capital markets specialist as a bank
consultant.
6/29/98 OCC notifies Keystone of their PCA “undercapitalized” category based

on 3/31/98 Call Report.

7127/98 OCC approves Keystone’s selection of a nationally recognized Certified
Public Accountant firm per the 5/28/98 Formal Agreement.

7/29/98 OCC authorizes FDIC to participate in the 8/31/98 examination
originally scheduled for 11/2/98.

8/6/98 OCC notifies Keystone’s legal counsel of intention to issue CMPs against
the Senior Vice President and bank’s Board of Directors for Call Report
violations.

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Appendix 4
Page 3 of 3

DETAILED OBJECTIVES, SCOPE AND
METHODOLOGY

e Interviewed OCC officials from the Special Supervision and Fraud
Division and Enforcement and Compliance Division in OCC’s
Headquarters, and officials from the Southeastern District.

e Interviewed the OCC EICs for all examinations since 1992 to obtain
their perspective on the bank’s condition and the scope of the
examinations. We also interviewed at least one other examiner from
each examination, including capital markets and securitization
specialists who participated in the Keystone examinations.

e Reviewed selected FDIC supervisory files including correspondence
with OCC and Keystone, and interviewed at least one FDIC
examiner from each of the examinations in 1996, 1998 and 1999.

To prevent the inappropriate disclosure of sensitive information, we
provided the FDIC a copy of the draft report. Their comments have
been incorporated into this report, where appropriate.

We conducted this audit in accordance with Government Auditing
Standards issued by the Comptroller General of the United States and
included such tests as were deemed necessary. At the time of review,
Federal law enforcement officials were still investigating alleged fraud at
Keystone. FDIC’s investigative activities had also not been completed in
sufficient time for us to take into account in our review. Consequently,
we did not attempt to fully determine the cause of the bank’s failure
beyond readily available records at the time.

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wwwewewwvwwewe

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CHRONOLOGY OF SIGNIFICANT EVENTS

Appendix 3
Page 2 of 7

718/94

9/8/94

5/5/95

5/8/95

6/5/95

TIN4/95

8/15/95

11/3/95

12/13/95

FRB of Richmond, Virginia requests additional information from
Keystone in order to process their initial draft application for the
Employee Stock Ownership Plan as a bank holding company originally
submitted 1/90.

OCC issues Supervisory Letter for Call Report violations identified in
the 12/93 and 3/94 Call Reports.

OCC makes 2 criminal referrals to United States Attorney, Federal
Bureau of Investigation, and United States Secret Service. One relates to
falsification of bank records for Truth in Lending violations (Regulation
Z). The other relates to the misapplication of bank funds for services
that appear to have been performed as part of the President’s official
duties.

OCC conducts safety and soundness examination. Examiners find
reported earnings and capital satisfactory and compliance with the
Commitment Letter is substantially complete; and accounting and control
issues with the FHA Title I program are identified. CAMEL rating:
2/22322. Exam completed 8/3/95.

OCC conducts FHA Title I mortgage examination. Examiners identify
several significant weaknesses in the administration of the FHA Title I
mortgage banking operation. Composite rating downgraded from 2 to 3.
Exam completed 12/1/95.

Keystone files application to establish operating subsidiary with OCC.

OCC approves application to establish an operating subsidiary to engage
in mortgage banking service (Keystone Mortgage Corporation).

FDIC notifies OCC of composite rating downgrade from 2 to 3 based on
numerous deficiencies noted in OCC’s 5/8/95 examination. FDIC’s
CAMEL rating: 3/33433.

Keystone’s President writes to OCC Ombudsman requesting an OCC
examiner be fired for alleged disrespect to the President and the bank.

OIG -00-067 MATERIAL LOSS REVIEW OF THE FIRST NATIONAL Page 41

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CHAPTER 3

According to OCC officials and documents, direct verifications were not
performed for two reasons:

e OCC relied on bank management and external auditors to confirm the
existence of bank assets held by third parties pursuant to generally
accepted auditing standards, which was in line with OCC’s risk-
focused examination approach.

e bank management expressed concern that OCC’s direct contact with
the loan servicers to verify loan balance reports would harm the
bank’s reputation and likely impair its ability to sell loans in the
market. And OCC did not want to cause harm to the institution.

Conclusions on OCC’s Bank Examination Results

OCC actively supervised Keystone as reflected by annual on-site
examinations. OCC examiners appeared to focus mostly on the highly
technical and risky area of securitizing subprime mortgages. In
hindsight, however, it was the unsubstantiated loans that had been
masked by inaccurate books and records and not credit risk that led to
Keystone’s insolvency. The insolvency occurred in 1999 when loan
balances were verified.

Earlier verification appeared warranted, possibly as early as 1997, given
the recurring financial control weaknesses, the presence of uncooperative
bank management, the possible management integrity issues, and the
repeated regulatory violations.

It is unclear whether earlier verification by OCC would have detected
unsubstantiated loans sooner, minimized eventual losses to the BIF, or
detected fraud. Nevertheless, the supervisory history of Keystone points
to a potential fundamental weakness in OCC’s examination process.
Under OCC’s risk-based approach, examiners may have placed too much
reliance on audited financial statements especially when conditions would
suggest otherwise. Furthermore, to the extent that Keystone’s overstated
loan balance is due to fraud, OCC’s examination procedures might not
have been sufficient to detect fraud.

Enforcement Actions

From 1992 through Keystone’s closing in 1999, OCC had issued several
enforcement actions and CMPs for bank regulatory violations. These
-enforcement actions were largely ineffective in getting Keystone to fully

OIG -00-067 MATERIAL LOSS REVIEW OF THE FIRST NATIONAL Page 13
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CHAPTER 4

According to OCC, it is developing this database based on lessons
learned from the Keystone review where direct verification was a means
of identifying the bank’s financial condition.

OCC and FDIC Coordination

OCC issued a draft memorandum dated January 5, 2000 that establishes
guidelines to be followed in involving FDIC in OCC’s examinations.
Before Keystone’s closure, the authority to deny an FDIC examination
participation request was delegated to a division director. Now, only the
Comptroller can deny an FDIC request to participate in an examination.

This memo was drafted in response to the situation in 1998 where the
FDIC was initially denied participation in the on-site examination at
Keystone. Although the FDIC was eventually allowed to participate in
the Keystone examination, the OCC and FDIC felt that better
communication was needed between the two agencies. Furthermore,
senior OCC and FDIC officials have established monthly meetings to
better communicate the status of problem banks.

Special Supervision Quality Assurance Proposal

In a draft memorandum, dated December 16, 1999, the OCC proposed
to establish a Quality Assurance initiative for the Special Supervision and
Fraud Division. The initiative will provide a written product addressing
the effective and appropriate supervision of the banks and provide OCC
management with a lessons learned study. A special review team will be
appointed to assess a sample of Special Supervision banks. The team’s
primary objectives are to assess compliance with OCC’s prompt
corrective action policy and determine the effectiveness and
appropriateness of supervision. The same team will assess those banks
not covered by the OIG’s material loss review. This program will help
strengthen OCC’s supervisory review of problem banks similar to
Keystone.

Management Response and OIG Comments

In its March 8, 2000 written response to the OIG’s draft report, OCC
concurred with the reported findings, conclusions and recommendations.
As noted above, OCC had already undertaken several initiatives based
on lessons learned from Keystone. In response to our recommendations,
OCC recently established a high level committee of senior deputy

: comptrollers to review, develop and implement corrective actions.

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EXECUTIVE DIGEST

law enforcement officials were investigating potential fraud that may have
led to Keystone’s failure. As a result, we could not fully assess the cause of
Keystone’s failure. (See page 2)

Audit Results

Why Keystone Caused a Loss to the Fund

Keystone was a relatively small community bank situated in an economically
depressed county in West Virginia. In 1977, with assets of $17 million,
Keystone came under new management. Keystone’s new management
undertook an operating strategy that entailed growth into the high-risk areas
of subprime mortgages, and selling loans for securitization. By 1999, assets
had grown to $1.1 billion.

The majority of Keystone’s loans were purchased or underwritten outside its
local operating area, and included subprime Federal Housing Authority
(FHA) Title I home improvement loans and similar high loan-to-value
(HLTV) loans. The bank eventually pooled these loans for sale

(i.e., securitization) by external underwriters. Rather than service the
pooled loans themselves, Keystone used several commercial service
providers throughout the country. Although viewed as risky, Keystone’s
strategy was reportedly profitable. Profitability aside, Keystone’s growth in
these high-risk areas occurred without adequate fundamental management
systems and controls. (See page 1)

Keystone’s insolvency was established during the 1999 examination when
examiners were unable to verify the existence of $515 million of the $553
million in reported loans that were held by two of the commercial loan
service providers. This discrepancy represented nearly 50 percent of the
bank’s reported assets in 1999. Inaccurate financial records masked
Keystone’s true financial condition. Furthermore, problems of weak
financial accounting, reporting, and controls were repeatedly cited in prior
OCC examinations. Allegations of fraud are presently under investigation.
(See page 4)

OCC’s Supervision of Keystone
Bank Examination Results

Beginning in early 1992, OCC conducted annual on-site examinations up to
the time of Keystone’s failure. These examinations were conducted under a

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BANK OF KEYSTONE


CHAPTER 3

not determine the true brokered deposit amount because the bank did not
correctly identify its brokered deposit base.

On June 29, 1998, PCA growth restrictions were triggered after
Keystone’s capital was adjusted as required by OCC. The adjustments
resulted in lowering the capital category from “well capitalized” to
“undercapitalized.” However, there may have been a basis for curbing
growth sooner by invoking PCA’s reclassification provision based on the
July 1997 examination, when the report was completed on

December 19, 1997. The examination, which resulted in a composite
rating of 3, cited numerous unsatisfactory conditions and uncorrected
deficiencies. For example:

The bank’s condition was less than satisfactory.

Management and Board supervision were unsatisfactory, a condition
based in part on deficiencies identified in previous examinations.
One repeat deficiency was the absence of a comprehensive internal
audit program.

e Earnings, as reported, were inaccurate and overstated.

e The bank’s funding structure subjected it to higher liquidity risks
because Keystone was heavily dependent on savings and certificate of
deposit accounts well above market rates.

e Accounting systems and controls were seriously deficient.

In addition, an OCC capital markets specialist who assisted in the 1997
examination cited additional unsafe and unsound practices in an internal
memorandum to a senior OCC official. In a November 1997
memorandum, the specialist recommended that OCC should consider
requiring Keystone to cease its FHA Title I lending program until the
bank could provide an accurate management information system, as well
as accurate books and records. The specialist further stated that
additional lending activity will only compound an already problem
situation.

Even though reclassification may have been a means to curb growth
sooner, it is unclear whether that would have been any more effective
than the other enforcement actions used since 1992. For example, after
the June 1998 brokered deposit restrictions were triggered, OCC found
during the August 1998 examination that “the bank continued to accept,
renew or roll over brokered deposits, or solicit other deposits by offering
an effective yield that exceed the limits set by the regulation during the
period of time the bank was undercapitalized.” Moreover in the 1999

-examination, FDIC and OCC examiners found that Keystone violated the

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CHAPTER 3

Keystone’s accounting system problems included inadequate loan
inventory controls, poor reconciliation processes, and weak loan
administration. Furthermore, the OCC examiners repeatedly cited
Keystone for Call Report violations (12 U.S.C. §161). Between 1992
and 1998, OCC cited Call Report violations in 4 of the 7 examinations
and at various times between examinations.

OCC examiners said they were never completely “comfortable” with the
bank’s mortgage securitization operation. According to OCC
documents, Keystone management’s emphasis was on earnings and
growth although they did not have the expertise, proper controls and
systems to manage the associated risks. Indeed, OCC typically rated
Keystone’s management 3 or worse under the uniform financial
institutions rating system. The 1996 examination was the one exception
in which OCC rated bank management 2. In 1996, OCC conducted the
examination at Keystone with FDIC participation. OCC examiners
found bank management had taken positive steps to improve core bank
activities and the FHA loan program. Given the problems found in prior
examinations, the significantly lower rating given just one year later, and
the eventual closing of the bank, the 1996 examination results seemed
inconsistent. However, based on our review of OCC examination
records and discussions with OCC officials, we determined that the basis
for their 1996 examination conclusion was that bank management was
making progress on several fronts including inventory controls,
reconciliations, and other quality controls measures.

Keystone’s Accounting Records

OCC’s examination reports were replete with indications that Keystone’s
accounting systems and financial reports were unreliable, and the
associated controls were deficient. It should be noted that examination
procedures did not require an independent verification of loan balances.
Instead, examiners typically relied upon the work of external auditors
and the bank’s internal audit function as a fundamental management
control. OCC did not verify Keystone’s loan balances until 1999.

Our review of OCC documents and interviews with OCC examiners
revealed that OCC identified weaknesses in the internal and external
audit functions, and other “red flags” that indicated Keystone’s financial
records were unreliable. Although we could not conclude that earlier
verifications by OCC would have detected Keystone’s apparent

® FDIC’s participation focused on Keystone’s FHA Title I Loan program and its risks.

OIG -00-067 MATERIAL LOSS REVIEW OF THE FIRST NATIONAL Page 10
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CHAPTER 3

January 1996, OCC terminated the action, maintaining that Keystone had
achieved substantial compliance. Keystone’s management provided
assurances to OCC that safety and soundness concerns would be met.

OCC officials told us that a Commitment Letter should not continue for
more than one or two years, when more severe enforcement action may
be needed to compel bank management to address problems. Keystone
was given more time because, according to the examiners-in-charge
(EIC), progress was being made on corrective actions.

Problems Addressed in Commitment Letter Resurfaced in Later Years

The problems identified in the 1992/1993 Commitment Letter were not
fully corrected when OCC terminated the Letter. At that time, a
progressively forceful action addressing unresolved problems seemed
more appropriate because control and system problems resurfaced. For
instance, in the June 1996 examination, OCC again identified problems
in Keystone’s internal audit and loan review functions. These issues had
been previously included in the original 1992 Commitment Letter.
Without an enforcement action in effect, Keystone’s control and system
problems continued for two more years until they were again included in
the 1998 Formal Agreement. Table 4 shows similar corrective actions
cited in the 1992/1993 Commitment Letter and the 1998 Formal
Agreement.

Table 4
Corrective Actions Cited in Both
Commitment Letter and Formal Agreement

Establish internal audit program

Engage external audit firm

Correct loan administration program

Establish independent loan review

Enhance allowances for loan and lease losses (ALLL) program
Implement interest rate risk and funds management improvements
Implement management and personnel improvements

Implement management information systems improvements
Correct violations of law and regulation

Source: 1992/1993 Commitment Letter and 1998 Formal Agreement

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CHAPTER 3

OCC examiners suggested that Keystone may have been
“sanitizing” information before providing it to OCC. Examiners
were concerned that false management information system
information was an issue and commented that OCC would
“...have to be able to get info (sic) direct from the servicers in
order to know.”

The 1998 examination records show that OCC again encountered
numerous problems. OCC:

continued to receive inaccurate reports, including Call
Reports and supporting worksheets. OCC noted problems
with bank management’s unwillingness or inability to follow
accounting guidelines and comply with laws and regulations.
This was demonstrated in the September 30, 1998 Call Report
where bank management appeared to estimate data to achieve
the desired Prompt Corrective Action (PCA) category of
“well capitalized.”

found significant weaknesses in accounting practices and risk
management systems. Books and records continued to be
inaccurate. Likewise, during this joint examination, FDIC
examiners found errors in virtually everything they reviewed.

telephoned one of the bank’s loan servicers to confirm loan
balances on servicing reports. The examiner found out that
the information provided to them by Keystone was not
coming directly from the servicer. The servicer told the
examiner that the reports were produced by Keystone
internally and not by the servicing company. Despite this
information, OCC officials said they accepted the bank’s
explanation and did not pursue the matter further.

Even though examiners routinely identified these accounting, reporting,

and control problems, OCC did not directly verify the existence of bank
assets and reliability of financial records until the 1999 examination. By
then, bank assets had grown from $850 million in 1997 to over

$1.1 billion in 1999.°

° Part of the growth. was attributed to the booking of residual assets according to Financial Accounting

Standards Board No.125.

OIG -00-067 MATERIAL LOSS REVIEW OF THE FIRST NATIONAL Page 12
BANK OF KEYSTONE


CHAPTER 3

PCA restrictions intentionally to obtain $280 million of brokered
deposits.

Conclusions on OCC’s Enforcement Actions

OCC routinely identified unsafe and unsound banking practices, found
regulatory violations, and responded with a series of enforcement
actions. None of the actions were substantively effective, particularly in
addressing the accounting, reporting and control problems that may have
masked Keystone’s overstated loan balances. Keystone repeatedly
violated banking regulations, continually engaged in unsafe and unsound
practices, and did not demonstrate the capacity to adequately manage
high-risk activities, such as subprime lending and asset securitization.
Given the possibility of fraud, it is difficult to say if any enforcement
actions would have been effective.

Even though OCC issued several enforcement actions, one aspect of
Keystone’s activity that was not addressed was growth. Assets grew
ten-fold during a period when OCC routinely found that Keystone

(1) lacked fundamental risk controls and systems, such as accurate books
and records, (2) was uncooperative with examiners, (3) engaged in
activities that raised questions about management’s integrity, and (4) did
not adequately manage high-risk activities. Without some provision to
curb growth, Keystone exposed the BIF to increasingly higher levels of
risk.

Given the sudden discovery of unsubstantiated loans, PCA, as an
enforcement tool, was limited in mitigating Keystone’s loss to the
insurance fund. However, OCC also did not use PCA’s reclassification
provision. The OIG believes reclassification may have been a way to
curb growth during the first half of 1998.

OIG -00-067 MATERIAL LOSS REVIEW OF THE FIRST NATIONAL Page 25
BANK OF KEYSTONE


CHAPTER 3

banking operation beginning in 1995. Furthermore, in late 1997, OCC
transferred the bank’s supervision from the Southeastern District to the
Special Supervision and Fraud Division in Washington, DC.

During the 1990s, OCC’s supervision of Keystone was complicated by a
strained relationship with bank management. OCC officials described
bank management as uncooperative, combative, secretive and
manipulative. Bank management boasted of its incredibly high eamings
and strong capital and continued to expand its mortgage loan securitization
operations. Keystone management also routinely contested examination
findings and made various charges against the examiners to discredit the
examinations. This included attempts to get third parties to intercede by
complaining to U.S. Senators and directly to senior OCC officials. Bank
management also hired consultants, including a former Comptroller of
the Currency, to assist in addressing OCC’s concerns. According to
OCC senior officials, these attempts did not affect OCC’s supervision of
the bank.

According to OCC and FDIC officials, Keystone management also
impeded on-site examinations by restricting access to bank employees and
records. Basic documents, such as trial balances and general ledgers,
were not made readily available, and some documents had to be
repeatedly requested. According to OCC officials, bank management
responses were so untimely that examiners did not have time to review
them before having to move onto the next scheduled bank examination.
OCC officials said Keystone management seemed well aware that
examiners had set timeframes for completing an on-site examination and
that by stalling the examination process long enough, examiners would
eventually leave the bank with issues unresolved.

OCC’s relationship with Keystone management was particularly strained
when OCC issued two criminal referrals in 1995 against two senior bank
officers for falsifying bank records relating to Regulation Z, Truth in
Lending Act, and misapplying bank funds.

. In 1999, the relationship became even
more contentious when OCC discovered that bank officers secretly taped
phone calls with OCC employees and objected to its examiners working
in an'area viewed by a security camera. The strained relationship
peaked when the U.S. Marshals Service was asked to provide security
for the examiners at Keystone.

OIG -00-067 MATERIAL LOSS REVIEW OF THE FIRST NATIONAL Page 7
BANK OF KEYSTONE


Appendix 6
Page 1 of 1

FINAL REPORT DISTRIBUTION

U.S. Department of the Treasury

Office of the Under Secretary for Domestic Finance

Office of the Assistant Secretary for Public Affairs

Office of the Assistant Secretary for Financial Institutions Policy

Office of Strategic Planning and Evaluations, Departmental Offices
Office of Accounting and Internal Control, Departmental Offices

Office of Budget, Financial Management Division, Departmental Offices

Office of the Comptroller of the Currency
Senior Deputy Comptroller, Bank Supervision Operations
Ombudsman
Deputy Chief Counsel

Deputy Comptroller, Southeastern District
Assistant Deputy Comptroller, Charleston Field Office

Office of Management and Budget
OIG Budget Examiner
U.S. General Accounting Office
Comptroller General of the United States
Federal Deposit Insurance Corporation

Chairman
Regional Director, Atlanta District Office

OIG -00-067 MATERIAL LOSS REVIEW OF THE FIRST NATIONAL Page 51
BANK OF KEYSTONE


TABLE OF CONTENTS

APPENDICES

Appendix 1 Management Response ................:ceeeeeeeeeeeeeeeeees
Appendix 2 Glossary of Terms ..............cccccssececeeeeseeeeeceeeaes

Appendix 3 Chronology of Significant Events ...........
Appendix 4 Detailed Objectives, Scope and Methodology..
Appendix 5 Major Contributors to This Report..........

Appendix 6 Final Report Distribution .........00........ceeeeeeeeeeeees

OIG-00-067 MATERIAL LOSS REVIEW OF FIRST NATIONAL
BANK OF KEYSTONE

Page vii


CHAPTER 3

initially assessed a $25,000 CMP against one officer and $10,000 CMP
against each of five directors. OCC negotiated a settlement for $13,000
against the officer and $2,000 against each of the five directors. The
dollar amounts assessed did not deter Keystone management from
continuing to violate banking laws and regulations.

In June 1999, OCC again approved CMPs for Call Report and brokered
deposit violations found in the second and third quarters of 1998. OCC
initially assessed a $100,000 CMP against one officer and $25,000 CMP
against each of six directors. However, OCC asked for a stay in
imposing the CMPs when Keystone claimed that they discovered OCC
documents disparaging bank management and obtained a temporary
restraining order against OCC. CMPs may still be imposed once the
Federal law enforcement investigation is completed.

Prompt Corrective Action

PCA’s mandatory actions and restrictions had limited effect in mitigating
Keystone’s loss because of the bank’s reported profitability and high
capitalization levels. These PCA actions and restrictions are dependent
on accurate books and records, and are triggered based on bank capital,
a lagging indicator of unsafe and unsound practices. Although PCA’s
restrictions were eventually triggered in June 1998, conditions appeared
to have existed earlier to warrant the use of PCA’s reclassification
provision as a means to curb growth.

PCA Intended to Provide Prompt Resolution of Bank Problems

The intent of PCA is to promptly resolve a bank’s problems at the least
possible long-term loss to the deposit insurance fund. This is to be
accomplished through a system of progressively severe regulatory
intervention as bank capital levels fall below prescribed categories. PCA
classifies banks into five capital categories: “well capitalized,”
“adequately capitalized,” “undercapitalized,” “significantly
undercapitalized,” and “critically undercapitalized.” A bank with capital
in the three lower capital categories is considered “undercapitalized” and
is automatically subject to certain mandatory restrictions and supervisory
actions. These actions include, but are not limited to, submitting a
capital restoration plan to OCC and restricting its asset growth. PCA
does not replace but supplements enforcement actions available to
regulators to address unsafe and unsound banking practices.

OIG -00-067

MATERIAL LOSS REVIEW OF THE FIRST NATIONAL Page 22
BANK OF KEYSTONE



CHAPTER 3

accounting, reporting, and control problems, also raises the issue as to
whether the Formal Agreement was timely.

OCC issued a Formal Agreement on May 28, 1998 to address the
problems identified in the examination started in July 1997. Those
examination findings elevated OCC’s concerns about the bank’s
condition. Specifically identified were poor supervision and
administration of the bank’s loan program, and the bank’s asset quality
deterioration.

As with the Commitment Letter, Keystone was unable or unwilling to
fully address the Formal Agreement within the agreed timeframes. The
Formal Agreement had generally set a 60 day timeframe for full
compliance, which would have been in July 1998. As Table 5 shows,
OCC concluded in the August 31, 1998 examination that the bank was
non-compliant with four provisions, partially compliant with six
provisions, and fully compliant with three provisions. The remaining
two provisions did not require action.

Table 5
Keystone Generally Did Not Comply
with the Formal Agreement

| Level of Established

| Formal Agreement Provisions Compliance Timeframes

i May 28, 1998 August 31, 1998 (approximate)

| Submit monthly progress reports Partial 30 days

| Retain external audit firm Partial 30 days

| Select Chief Financial Officer Compliance 60 days

| Ensure accuracy of books, records, and

| Call Reports Non-Compliance 30 days
Develop loan administration
program/managing risk Partial 60 days
Establish Internal Loan Review System Partial 60 days
Establish ALLL Program | Non-Compliance 30 days

Prior to

Analyze new products and services Compliance involvement
Implement internal audit program Partial 30 days
Correct violations of law or regulation Non-Compliance 60 days
Implement strategic plan Non-Compliance 60 days
Monitor liquidity/interest rate risk Partial 90 days
Implement Bank Information System Compliance 45 days

Source: 1998 Formal Agreement and August 31, 1998 ROE

OIG -00-067 MATERIAL LOSS REVIEW OF THE FIRST NATIONAL Page 19

BANK OF KEYSTONE



EXECUTIVE DIGEST

used. For example, OCC revised and extended a 1992 Commitment Letter
giving Keystone nearly four years to comply. (See page 15)

Prior to terminating the Commitment Letter, examiners continued to find
Call Report violations, and OCC responded with a Supervisory Letter
warning Keystone that continued violations could lead to CMPs. The OIG
believes the continued violations warranted progressively severe enforcement
action, such as the issuance of CMPs rather than another informal action.
(See page 17)

Subsequent examinations identified continued unsafe and unsound practices.
OCC responded with a Formal Agreement, which Keystone signed in

May 1998. The Formal Agreement also proved largely ineffective in getting
Keystone to achieve full compliance or meet the initial agreed-to time frames
for full compliance. Moreover, despite deficient management controls and
systems, the Formal Agreement did not provide for any growth restrictions.
(See page 18)

In 1998, Keystone continued to violate Call Report regulations, and OCC
responded with CMPs totaling $23,000. Later that year, it was apparent that
the CMPs were also ineffective because bank management continued to
submit inaccurate Call Reports. (See page 21)

Prompt Corrective Action’s (PCA) mandatory actions and restrictions had
limited effect in mitigating Keystone’s loss because of the bank’s reported
profitability and high capitalization levels. Although PCA restrictions were
eventually triggered in June 1998, conditions appeared to have existed
earlier to warrant the use of PCA’s reclassification provision as a means to
curb growth. (See page 22)

Recommendations and Lessons Learned

Until Federal law enforcement agencies complete their investigations, it is
difficult to fully assess OCC’s supervision of Keystone and the underlying
causes that led to its failure. Nevertheless, the OIG believes Keystone offers
several valuable lessons and opportunities to improve supervisory processes.
To its credit, OCC has started a series of initiatives to improve examination
procedures. (See page 29)

The OIG makes seven recommendations. Three recommendations focus on
different aspects of assessing the level of reliance that should be placed on
audited financial statements when the accuracy of the information is in

OIG-00-067 MATERIAL LOSS REVIEW OF FIRST NATIONAL Page iv
BANK OF KEYSTONE


EXECUTIVE DIGEST

strained relationship with bank management marked by mutual distrust and
an uncooperative bank management. Keystone management routinely
contested examination findings. Also, examiners allegedly experienced
delay tactics and were subjected to unusual working conditions such as being
viewed by surveillance cameras and having phone conversations taped.

OCC examiners routinely identified unsafe and unsound practices,
regulatory violations, and management activities that were questionable.
OCC examination reports and supporting records were replete with
indications that Keystone’s financial accounting systems and reports were
unreliable and the underlying controls were deficient. For example, OCC
found ineffective internal and external audit functions in 1992 and 1993,
apparent incidences of falsified bank documents in 1994 that resulted in
criminal referrals, out-of-balance loan accounts between $8 and $12 million
in 1995, and numerous other accounting and internal control problems.

Despite finding these significant problems over several years, OCC
examiners generally did not perform more extensive examination procedures
that might have revealed the true condition of the bank. For example, OCC
examination procedures did not normally require loan verifications. OCC
continued to rely on the results of the financial statement audits by external
auditors that normally include tests to verify the existence of the loan
portfolio. It was not until 1999 that OCC independently verified the
reported loan balances at the commercial servicers. The OIG cannot
conclude that earlier loan verifications would have surfaced the
unsubstantiated loans sooner or minimized the loss to the Bank Insurance
Fund (BIF). However, given the many problems identified year after year,
earlier verification appeared warranted. (See page 6)

Enforcement Actions

In response to the numerous problems identified during examinations, OCC
used both informal and formal enforcement actions, including the issuance of
Civil Monetary Penalties (CMP). These actions proved largely ineffective
in getting Keystone to fully address its operating problems, comply with
provisions of the enforcement actions, or to cease violating banking
regulations. Yet, correcting many of these problems would have been
critical in addressing the bank’s inaccurate financial records. The examiners
ultimately found that these inaccurate records masked the bank’s assets.

Aside from the possibility of fraud, it is unclear why OCC’s enforcement
actions were largely ineffective. However, the OIG believes some
contributing factors were the timeliness and type of enforcement actions

OIG-00-067

MATERIAL LOSS REVIEW OF FIRST NATIONAL Page iii
BANK OF KEYSTONE


CHAPTER 3

Beginning in 1992, OCC routinely identified problems with Keystone’s
internal controls and accounting systems, including internal and external
auditing deficiencies, as shown in Table 2 on the next page. (Also, see
Appendix 3 for a detailed chronology of significant events regarding
Keystone.)

OIG -00-067 MATERIAL LOSS REVIEW OF THE FIRST NATIONAL Page 8
BANK OF KEYSTONE


TABLE OF CONTENTS

EXECUTIVE DIGEST ........... 2... occccccccceeeeeeeccecceeeeeceeceseeeeeeeeteeeeenens i
ABBREVIATIONS

Background ....
Objectives, Scope and Methodology...

Chapter 2: Why Keystone Caused a Loss to the Fund...................00c.c000e00e 4

Chapter 3: OCC’s Supervision of Keystone ................. 6
Bank Examination Results...............
Keystone’s Accounting Records....
Conclusions on OCC’s Bank Examination Results .
Enforcement Actions .....
Commitment Letter...
Supervisory Letter
Formal Agreement
Civil Money Penalties
Prompt Corrective Action... .
Conclusions on OCC’s Enforcement Actions .............000cccccceeeeeeeeeeeee 25

Chapter 4: Recommendations and Lessons Learned ..
Recommendations.................
Recommendations 1 - 3
Recommendations 4 - 6...
Recommendation 7 .
Lessons Learned
Guidance on Access to Bank Books and Records .
Oversight of Asset Securitization Activities...
Asset Verification Procedures Database
OCC and FDIC Coordination
Special Supervision Quality Assurance Proposal..
Management Response and OIG Comment ............0.....ccccseeeeeeeeeeeeeeees

OIG-00-067 MATERIAL LOSS REVIEW OF FIRST NATIONAL Page vi
BANK OF KEYSTONE


CHAPTER 3

address its operating deficiencies, some of which were critical to the
accounting, financial reporting, and control problems.

As previously noted in Table 2, OCC issued both informal

(i.e., Commitment Letter and Supervisory Letter) and formal

(i.e., CMPs and Formal Agreement) enforcement actions between 1992
and 1999. Chart 1 shows that these actions had little effect in curbing
Keystone’s growth, which ultimately will impact the size of the loss to

the BIF.
Chart 1
Keystone’s Asset Growth and
OCC’s Enforcement Actions
(1992 to 1999)
cD
$1,200 ;
$1,000-|
z |
S — $800~
=
2 4
g $800.
2 |
B  $400-
g 1
2

$200-
|

so+ - T

1992 1993 1994 1995 1996 1997 1998 Aug-
99
Year

Chart 1 Shows the Years OCC Enforcement Actions Were in Effect
A = 1992/1993 Commitment Letter Issued/Revised
= September 1994 Supervisory Letter Issued
C = May 1998 Formal Agreement Issued
D = August 1998 CMPs Issued
E = July 1999 CMPs (put on hold)

Source: Keystone’s Call Report data and OCC documents

OIG -00-067 MATERIAL LOSS REVIEW OF THE FIRST NATIONAL Page 14
BANK OF KEYSTONE


Material Loss Review
of
The First National Bank of Keystone

OIG-00-067 March 10, 2000

This report has been reviewed for public dissemination by the Office of Counsel to
the Inspector General. Information requiring protection from public dissemination
has been redacted from this report in accordance with the Freedom of Information
Act, 5 U.S.C. section 552.

Office of Inspector General

Porrrrry

. United States Department of the Treasury

a 23


Appendix 2

Page 3 of 5
GLOSSARY OF TERMS
High Loan-to- A loan secured by a lien on residential real estate where the
Value lien may have less financial value than the amount of the

loan. OCC considers a loan to be HLTV if the loan amount
exceeds 90 percent of the appraised value of the real estate
subject to the lien.

Informal and Informal enforcement actions are documents that provide a
Formal bank with guidance and direction in addition to that
Enforcement provided by the ROE. Informal actions are those instances
Actions where it is desirable to have written commitments from a

bank’s management and board of directors. Formal
enforcement actions are reserved for significant safety and
soundness or compliance problems that, unless corrected,
constitute a present or future threat to the survival of the
bank or otherwise pose a serious threat to the bank’s safety
and soundness.

Leveraged A borrower whose debt to equity ratio is significantly above
Borrower normal.

Loan A way for banks to sell assets. In practice, banks securitize
Securitization loans by pooling assets with similar characteristics and

selling interests in these pools to investors. National banks
currently are permitted to securitize residential, consumer
and commercial loans.

Occ Responsible for ensuring that the OCC appeals process

Ombudsman provides a fair and timely review of disagreements on
agency findings and decisions. With the consent of the
Comptroller of the Currency, the Ombudsman has the
discretion to supersede any agency decision or action during
the resolution of an appealable matter.

Prompt A framework of supervisory actions for insured banks
Corrective which are not adequately capitalized. These actions become
Action increasingly severe as a bank falls into lower capital

categories. The capital categories are: Well Capitalized,
Adequately Capitalized, Undercapitalized, Significantly
Undercapitalized, and Critically Undercapitalized

(12 U.S.C. §1811).

OIG -00-067 MATERIAL LOSS REVIEW OF THE FIRST NATIONAL Page 37
BANK OF KEYSTONE


CHAPTER 1

INTRODUCTION

This report summarizes the Office of Inspector General’s (OIG) review
of the failure of The First National Bank of Keystone (Keystone) in
Keystone, West Virginia. We conducted this review in response to our
mandate under Section 38(k) of the Federal Deposit Insurance Act
(FDIA). On September 1, 1999, the Office of the Comptroller of the
Currency (OCC) declared Keystone insolvent after examiners were
unable to verify $515 million in loans, nearly half of Keystone’s reported
assets. At the time of this report, the bank’s failure had been attributed
to alleged fraud, and law enforcement officials were still investigating
the circumstances surrounding the unsubstantiated loans.'

Background

Keystone was incorporated in 1904 under the National Banking Act.
The bank was situated in a depressed coal county in rural West Virginia.
In 1977, Keystone was a small community bank with about $17 million
in assets. That year, new management took over and essentially stayed
in place until 1999.

According to OCC officials, in 1992 Keystone began an investment
strategy that quickly transformed Keystone into a niche lender focusing
on subprime mortgage loans’ and total assets grew to approximately
$107 million. Keystone reportedly provided the economic base for the
community and was its major employer. In late 1993, Keystone began
purchasing and securitizing Federal Housing Authority (FHA) Title I
home improvement loans that were originated from around the country.
Keystone’s securitization program entailed purchasing FHA Title I loans,
pooling the loans, then selling interests in the pooled loans through a
securities underwriter. Keystone used commercial loan servicers
throughout the country that collected the loan payments, maintained the
individual loan account balances, and corresponded with the loan
customers. Keystone sold the pooled loans, but retained a residual asset?
portion of the securitized loans. By 1995, Keystone was reported to be
one of the most profitable community banks in the country.

! Unsubstantiated loans are defined as assets that were included in Keystone’s books but the bank was not
able to verify the existence of the loans.

? Subprime mortgages are extended to borrowers exhibiting higher delinquency or default risks than
traditional borrowers.

> Residual assets represent the cash flows, if any, that will be received in excess of the contractual
servicing fee and ‘other costs associated with securitized assets.

OIG -00-067 MATERIAL LOSS REVIEW OF THE FIRST NATIONAL Page 1
BANK OF KEYSTONE


ABBREVIATIONS

ALLL
BIF
CAMEL

CAMELS

CMP
EIC
FDIA
FDIC
FFIEC
FHA
FRB
HLTV
IRS
Occ
OIG
PCA
ROE
TC&D
U.S.C.

Allowance for Loan and Lease Losses
Bank Insurance Fund

Capital adequacy, Asset quality, Management administration,
Earnings, Liquidity

Capital adequacy, Asset quality, Management administration,
Earnings, Liquidity, Sensitivity to market risk

Civil Money Penalty
Examiner-In-Charge

Federal Deposit Insurance Act

Federal Deposit Insurance Corporation
Federal Financial Institutions Examination Council
Federal Housing Authority

Federal Reserve Bank

High Loan-to-Value

Internal Revenue Service

Office of the Comptroller of the Currency
Office of Inspector General

Prompt Corrective Action

Report of Examination

Temporary Cease and Desist Order

United States Code

OIG -00-067 MATERIAL LOSS REVIEW OF THE FIRST NATIONAL Page viii

BANK OF KEYSTONE


Appendix 5
Page 1 of 1

MAJOR CONTRIBUTORS TO THIS REPORT

OFFICE OF INSPECTOR GENERAL

Donald R. Kassel, Director, Banking and Fiscal Service
Benny W. Lee, Director, Program Audits

Ric Doery, Deputy Counsel to the Inspector General
Linda G. Darby, Audit Manager

Garrett W.J. Gee, Auditor-in-Charge

Patricia C. Shimizu, Auditor

John B. Mansfield, Auditor

Joseph K. Eom, Auditor

OIG -00-067 MATERIAL LOSS REVIEW OF THE FIRST NATIONAL Page 50
BANK OF KEYSTONE


Appendix 1
Page 1 of 2

MANAGEMENT RESPONSE

9) MEMORANDUM

Comptroller of the Currency
Administrator of National Banks

Washington, DC 20219

To: Dennis S. Schindel, Assistant Inspector General for Audit
From: John D. Hawke, Jr., Comptroller of the Currency
Date: March 8, 2000

Subject: Draft Audit Report on the Material Loss Review

We have received your draft audit report titled Material Loss Review of The First National Bank of
Keystone and we believe it is a thoughtful and thorough analysis of the OCC’s supervision of
Keystone. We fully concur with the report’s conclusions that the OCC has important lessons to lea
from this matter. The supervisory issues you identified as being in need of particular attention
include how we assess certain operational functions and safety and soundness issues, and how we
use and obtain compliance with enforcement actions.

The report makes recommendations designed to improve the OCC’s assessment of national banks’
accounting, reporting and contro! functions and the related audits conducted by third parties. With
respect to enforcement, you recommend that the OCC better define or clarify what constitutes
compliance and that we reassess some of our current practices. Finally, you recommend that the
OCC assess whether Keystone’s failure points to the need for a different supervisory response so as
to mitigate the ultimate risk exposure to the BIF.

These recommendations are constructive and we welcome them. As the report notes, the OCC has
already undertaken a series of initiatives addressed to these concerns. I have recently formed a high
level committee of senior deputy comptroliers to review your recommendations as well as our
present management of problem banks, who will make recommendations to me as to how we can
implement improvements in this area.

Our examiners were confronted with extraordinarily difficult circumstances in Keystone. While
their perseverance ultimately led to the discoveries that resulted in the bank’s closure, we should
always review our performance in situations such as this to see how we can perform more
effectively. We appreciate your awareness that the spectre of apparent fraud made it difficult to draw
conclusions as to when the magnitude of the bank’s losses could have been discovered, had different
procedures been used. We will all benefit from the careful and thorough analysis that you have
provided.

OIG -00-067 MATERIAL LOSS REVIEW OF THE FIRST NATIONAL Page 33
BANK OF KEYSTONE



CHAPTER 3

the TC&D was a better enforcement action than the Formal Agreement,
but that the TC&D may have been a means to curb growth. Curbing
growth was not covered by the Formal Agreement.

Timeliness of Formal Agreement

In our opinion, the Formal Agreement could have been issued as early as
January 1998 rather than in May 1998. OCC issued the Formal
Agreement nearly six months after reporting the results of the July 1997
examination. OCC delayed issuing the Formal Agreement for several
reasons:

e Keystone management was given additional time to respond to the
December 1997 Report of Examination because OCC transferred
supervision of the bank from the Southeastern District to
Headquarters’ Special Supervision and Fraud Division in
September 1997.

e Keystone’s Chairman passed away in October 1997, and OCC did
not want to issue an enforcement action during bank management’s
transition period.

¢ OCC relied on Keystone’s commitment to spin-off its existing FHA
mortgage loan activity into a non-bank affiliate. OCC believed the
spin-off would remove the higher risk assets from the bank’s balance
sheet, improve the quality of the loans, and improve the bank’s risk
profile. The spin-off that was to have occurred on
December 15, 1997 was extended to March 31, 1998. However, the
proposal never materialized because of bank management’s inability
to secure financing for the proposed affiliate.

OCC officials opined that the Agreement was issued timely given the
circumstances. However, in our opinion, existing conditions may have
called for a more urgent response. From January 1996 to May 1998,
Keystone was not under an enforcement action, although OCC had
identified continuing problems with Keystone’s accounting, reporting
and internal controls. Therefore, a more timely implementation of the
Formal Agreement may have been warranted.

Civil Money Penalties

In August 1998, OCC issued CMPs against Keystone management for

_ Submitting inaccurate Call Reports in each quarter of 1997. OCC

OIG -00-067

MATERIAL LOSS REVIEW OF THE FIRST NATIONAL Page 21
BANK OF KEYSTONE


Appendix 2

Page 4 of 5
GLOSSARY OF TERMS
Regulation Z, The Truth in Lending Act (15 U.S.C. §1601) was enacted
Truth in in May 1968, and implemented as Regulation Z effective
Lending July 1969. The Act is intended to ensure that credit terms

are disclosed in a meaningful way so consumers can
compare credit terms more readily and knowledgeably.

Risk-Based A bank examination strategy that focuses examiners on the
Examinations identification, measurement, monitoring and control of risk.
Special Responsible for managing the closing of all national banks
Supervision and and for reviewing and coordinating the supervisory

Fraud Division strategies of all banks which OCC believes to exhibit a high

potential to fail within the next 12 months.

Subprime A mortgage loan to a borrower whose credit is below good
Mortgage credit standards. Such borrowers pose a greater risk and are

characterized by paying debts late, filing for personnel
bankruptcy and/or an insufficient credit history. A
subprime loan is usually referred to as marginal, nonprime
or below “A” quality.

Supervisory An informal enforcement action comprised of a document to

Letter be used in cases where a CMP is not warranted but the
office nonetheless wishes to call attention to a supervisory
problem pursuant to its authority under 12 U.S.C. §1818.

Temporary An interim order issued by the OCC pursuant to its
Cease and authority under 12 U.S.C. §1818 and is used to impose
Desist Order measures that are needed immediately pending resolution of

final Cease & Desist Order. Such orders are typically used
only when immediately necessary to protect the bank against
ongoing or expected harm. A TC&D may be challenged in
U.S. District Court within 10 days of issuance, but is
effective on issuance and remains effective unless
overturned by the court or until a final order is in place.

OIG -00-067 MATERIAL LOSS REVIEW OF THE FIRST NATIONAL Page 38
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CHAPTER 3

Formal Agreement and Growth

The Formal Agreement addressed all the problems found in the
examination, but did not include a provision to curb growth. A growth
provision could have been adopted until the bank achieved compliance
with the other provisions of the Formal Agreement. In fact, OCC
records indicated that the bank increased its HLTV loans another

$100 million during the fourth quarter of 1998. Furthermore, these
loans increased the bank’s total concentration of HLTV loans from

510 percent to 525 percent of capital.

OCC indicated that curbing growth would have effectively shut down the
bank, and could not be justified, given the bank’s profitability. While
the OIG understands the dilemma OCC was facing at the time, the
situation raises the question as to when should growth and/or profitable
activities be curbed if fundamental controls to ensure reliable books and
records have been historically deficient. Furthermore, by 1998 the bank
had demonstrated a pattern and practice of noncompliance with other
enforcement actions, repeated regulatory violations, potential
management integrity issues, and less than satisfactory management, as
reflected in its CAMELS ratings.

Given Keystone’s historical lack of cooperation with OCC, the OIG
believes that it is unlikely OCC would have gotten Keystone to agree to a
Formal Agreement provision curbing growth, or to consent to an
equivalent article in a Cease & Desist Order. Therefore, using a
Temporary Cease and Desist (TC&D) would have been a means to
restrict growth as an interim measure. A TC&D takes immediate effect
when management will not agree or consent to a Formal Agreement or
Cease & Desist Order. The TC&D remains in effect unless overturned
by the court or until a final Cease & Desist Order is in place.

The bank’s condition at the time appeared to meet the requirement for a
TC&D. Specifically, the bank’s books and records were so inaccurate
that the OCC was unable to determine the financial condition of the
bank. At the time, several OCC officials opined that conditions existed
to use a TC&D as an appropriate action. However, OCC senior officials
told us that, at the time, the Formal Agreement was more appropriate
because OCC could achieve everything they wanted through this action.
Specifically, they said that the Formal Agreement (1) was more
comprehensive, (2) had the same legal ramifications as a TC&D, (3) the
bank was willing to agree to the Formal Agreement, and (4) the bank

was not in imminent danger of failing. The OIG does not believe that

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BANK OF KEYSTONE


EXECUTIVE DIGEST

question. Three other recommendations are aimed at reassessing the
enforcement response when bank management is either not timely or not
compliant in addressing problems covered in an enforcement action.
Finally, the OIG recommends that OCC evaluate whether a different
supervisory approach is needed to address growth in high-risk activities,
accompanied by high profitability and adequate capitalization, without
sufficient management systems and controls. (See page 26)

OCC Response and OIG Comments

OCC concurred with the OIG’s findings and recommendations in its
March 8, 2000 written response to the draft report. The Comptroller has
formed a committee of senior deputy comptrollers to implement the
recommendations. Planned corrective action, as well as the various
initiatives already undertaken, is responsive to the intent of our
recommendations. (See page 31)

OIG-00-067 MATERIAL LOSS REVIEW OF FIRST NATIONAL Page v

BANK OF KEYSTONE



(RRR RRRRRRRRARARRRZBRESRRESRSRRAZASZAZASZSASAAAAAA BAAD Aaa aad ddd ddd

CHAPTER 3

$515 million loan balance discrepancy, OCC’s delayed verification under
the circumstances point to a potential weakness in OCC’s examination
procedures. These procedures placed heavy emphasis on assessing
controls rather than performing transaction testing and account
verification.

A chronology of the red flags and early warning indicators follows:
The 1992 and 1993 examinations reported that the bank did not

have effective internal and external audit functions to verify
account balances.

In 1994, OCC found that two senior bank officers violated
“Truth in Lending” regulations, for apparently falsifying bank
documents and misapplying bank funds. OCC filed criminal
referrals with the United States Attorney.

In 1995, OCC examiners found that the bank’s FHA total loan
portfolio of $130 million was out-of-balance by $8 to

$12 million. This discrepancy was attributed to the absence of
basic accounting controls, such as account reconciliation and poor
management information systems.

In 1997, OCC examiners found recurring and far more significant
problems. Specifically, the bank’s:

© poor accounting systems and controls resulted in record
keeping errors, inaccurate reporting, misstatements of balance
sheet and income statement accounts, and questionable
account integrity.

e loan database contained inaccuracies especially pertaining to
loan balance and delinquency status. Inaccuracies in the
database reports prevented the OCC from placing reliance on
the report.

e procedures for reconciling general ledger accounts did not
appear acceptable, and bank management could not provide
general ledger details to support account balances.

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Appendix 4
Page 2 of 3

DETAILED OBJECTIVES, SCOPE AND
METHODOLOGY

To assess the adequacy of OCC’s supervision of the bank, we attempted
to determine (1) when OCC first identified Keystone’s safety and
soundness problems, (2) the gravity of the problems, and (3) the action
OCC took to get the bank to correct the problems. Additionally, we
attempted to determine whether (1) the problems could have been
discovered earlier, (2) all the problems were identified and reported, and
(3) enforcement actions were comprehensive, timely, and effective in
dealing with the unsafe or unsound activity. Specifically, we:

Assessed OCC actions based on its own internal guidance and
legislative guidance provided by Financial Institutions Reform,
Recovery, and Enforcement Act of 1989 and FDIA.

Discussed various aspects of the supervision of Keystone with
knowledgeable senior OCC officials.

Reviewed 1992 through 1999 examination reports and related
available examination documents and workpapers relative to
Keystone. We began our review of examination reports with the
1992 examination because OCC issued a Commitment Letter in
1992. In reviewing examination reports, we sought to obtain
information on the condition of the bank at the time of each
examination and the significance of the bank’s problems identified by
the OCC. However, we were unable to fully assess OCC’s basis for
the revised 1995 examination rating. This audit limitation occurred
because OCC’s workpapers for the June 5, 1995 examination were
lost in 1995.

Reviewed 1992 through 1999 correspondence and enforcement files
to gain an understanding of the problems identified, the approach and
methodology used by OCC to assess the bank’s condition, and the
regulatory action used by OCC to compel the bank management to
address the deficient conditions found.

Reviewed and analyzed OCC’s Supervisory Monitoring System data,
and reports including: Supervisory Events, Other Significant Events,
Overall Summary Comments, and Risk Assessments.

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CHAPTER 4

Recommendation 7

The OIG acknowledges that timely enforcement action largely depends
on the early detection of either unsafe/unsound financial condition and/or
banking practices. Given the nature of periodic examinations as opposed
to a continuous on-site presence, examiner detection of problems can
occur after a bank has already established a high-risk position or
accumulated a high level of risky assets.

Since 1992, OCC examiners found that Keystone was engaging in a
strategy of high-risk growth without adequate fundamental management
systems and controls. However, high profitability and capitalization
appeared to mitigate OCC’s supervisory response. This occurred even
when Keystone was operating under an enforcement action up through
1996. During this four year period, Keystone’s assets grew from $107
million period to $381 million, in effect a 300 percent increase.

Given the existence of the 1992 Commitment Letter, the OIG raises the
issue as to whether a different supervisory response is needed when:

e high-risk growth is accompanied by high profitably and
capitalization,

¢ fundamental management systems and controls are deficient, and

* management lacks expertise and its integrity is questionable.

Accordingly, the OIG recommends that the Comptroller of the Currency:

7. Further assess whether Keystone’s failure necessitates a different
supervisory response to mitigate the ultimate risk exposure to the
BIF. The OIG believes this assessment needs to focus on high-
risk growth while addressing known unsafe and unsound banking
practices. This assessment should not be limited to regulatory
restrictions on growth and incremental increases to regulatory
capital. Other possible considerations might include the adequacy
of existing regulations over the use of brokered deposits and
certain interest rate restrictions, and possible restrictions on the
use of insured deposits to fund uncontrolled high-risk growth.
Furthermore, this assessment would likely necessitate consulting
with other banking regulators through the Federal Financial
Institutions Examination Council (FFIEC).

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BANK OF KEYSTONE


CHAPTER 4

Lessons Learned

As mentioned above, OCC has already started to implement a number of
changes to improve its supervisory policies and procedures based on
lessons learned through its experience with Keystone. Such changes
include:

e providing guidance to examiners in securing access to bank books
and records,

¢ increasing or improving oversight of asset securitization activities,

¢ starting an asset verification procedures database project,

e changing OCC guidance and practice for coordinating supervisory
activities with FDIC, and

e establishing a quality assurance program for problem banks in OCC’s
Special Supervision and Fraud Division.

We believe that these changes will further enhance OCC’s ability to
effectively regulate the national banking system.

Guidance on Access to Bank Books and Records

OCC issued guidance to address situations when examiners encounter
resistance by bank management to provide them with access to bank
books and records. The Policies and Procedures Manual (PPM 5310-
10), Guidance to Examiners in Securing Access to Bank Books and
Records, dated January 7, 2000, discusses:

e OCC’s statutory authority for access to bank information and
records,

e bank management tactics sometimes used to resist examinations
(referred to as “red flags”), and

e remedies that examiners have when they encounter resistance to
requests to interview bank staff or review the bank’s books and
records.

OCC issued this guidance as a result of examiners at Keystone not
having direct access to the bank’s books and records.

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CHRONOLOGY OF SIGNIFICANT EVENTS

8/31/98

9/23/98

11/9/98

12/4/98

12/98

12/21/98

12/22/98

12/23/98

2/1/99

2/1/99

3/24/99

Appendix 3
Page 5 of 7

OCC conducts safety and soundness examination with FDIC
participation. Examiners find a deficient residual valuation model,
unsafe concentration of mortgage products, and violations of law
(brokered deposits and Call Reports). ROE directs Board of Directors to
replace current President, as duties and responsibilities were not
commensurate with the position. CAMELS rating: 4/445444. Exam
completed 1/12/99.

FDIC internal memorandum concludes that Keystone is subject to
brokered deposit and interest rate restrictions.

OCC sends letter to Keystone providing initial opinion on proration of
assets and risk-based capital.

Keystone appeals the proration of assets opinion to OCC’s Ombudsman.
Keystone hires a former Comptroller of the Currency as a consultant.

OCC Comptroller receives letter from Senator John D. Rockefeller IV,
West Virginia, expressing Keystone’s concern with OCC’s inconsistent
application, interpretation, and clarification of policies and procedures.

OCC Comptroller receives letter from Senator Robert C. Byrd,
West Virginia, requesting clarification from OCC with regard to certain
policies, procedures, and regulations.

OCC Headquarters official has a phone conversation with the former
Comptroller and current Keystone consultant discussing OCC’s intent to
write down residual value. The former Comptroller of the Currency
requests that OCC hold off on making any adjustments to the residual
value, but the OCC official does not agree.

OCC’s Ombudsman allows Keystone to continue current practices on
asset proration until FFIEC interagency agreement is finalized.

Former OCC capital markets specialist replaces interim Keystone
President.

Former OCC capital markets specialist resigns as Keystone’s President.

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CHAPTER 3

OCC Downgraded Keystone’s Composite Rating but Terminated the

Commitment Letter

In December 1995, OCC downgraded the bank’s composite CAMEL
rating from 2 to 3. OCC decided to take a formal administrative action
against the bank unless the bank corrected the problems by

January 31, 1996. Immediately afterwards in January 1996, OCC
terminated Keystone’s Commitment Letter, maintaining that Keystone
had substantially complied with the intent of the Letter. These two
actions appear to be contradictory. An EIC said that although the bank’s
condition had deteriorated, the Letter was no longer relevant because it
did not address the bank’s current problems. OCC, however, did not
take any action based on the bank’s composite 3 rating because the bank
appealed the rating. Instead, OCC decided to review the bank’s
corrective actions during the 1996 examination. Thus, OCC did not take
further action until the Formal Agreement was issued on May 28, 1998.
OCC officials indicated, in hindsight, that either a revised or a new
enforcement action may have been more appropriate to compel bank
management to resolve the problems. Without an effective enforcement
action or the necessary cooperation of bank management, Keystone’s
control and system problems persisted.

Supervisory Letter

OCC issued a Supervisory Letter on September 8, 1994 for Call Report
violations identified in the April 1994 examination. The Call Report
violations were for the quarters ended December 31, 1993 and

March 31, 1994, and entailed inaccuracies related to past due and non-
accrual loans, misclassification of investment securities and borrowing
transactions.

The Supervisory Letter served as a formal notification to bank
management of its obligation to develop and implement Call Report
procedures to prevent future violations, and warned that Call Report
violations in the future may result in CMPs. OCC issued the
Supervisory Letter while the Commitment Letter was still in effect.

The use of a Supervisory Letter while another informal action was
already in effect for Call Report violations proved to be ineffective and
redundant. The Call Report problem had already been identified in
OCC’s 1992/1993 Commitment Letter. When Keystone did not comply
with the Call Report provision of the Letter, a progressively severe

.enforcement action seemed warranted. Despite these two enforcement

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Appendix 4
Page 1 of 3

DETAILED OBJECTIVES, SCOPE AND

METHODOLOGY

We conducted this review of Keystone in response to our mandate under
Section 38(k) of FDIA, 12 U.S.C. §1811. This section provides that if a
deposit insurance fund incurs a material loss with respect to an insured
depository institution on or after July 1, 1993, the inspector general for
the appropriate Federal banking agency shall prepare a report to the
banking agency, which shall:

¢ ascertain why the institution’s problems resulted in a material loss to
the insurance fund;

© review the agency’s supervision of the institution; and
¢ make recommendations for preventing any such loss in the future.

As defined by Section 38(k) of FDIA, a loss occurring after

June 30, 1997, is considered material if it exceed $25,000,000 or

2 percent of the institution’s total assets. The Act also requires us to
complete the report within six months after it becomes apparent a
material loss has been incurred.

We initiated a material loss review based on the loss estimate prepared
by the FDIC. As of December 31, 1999, the FDIC estimated that the
Keystone failure will cost the BIF between $750 and $850 million.

Our review covered events spanning the last seven years of the bank’s
life from 1992 to 1999. We conducted fieldwork from September 1999
to January 2000.

We reviewed supervisory and enforcement files and records maintained
by OCC’s Headquarters in Washington, DC; District Office in Atlanta,
GA; Field Office in Charleston, WV; and Ombudsman Office in
Houston, TX.

We reviewed the quarterly Call Report data, Board of Directors’
Minutes, and external audit reports for Keystone.

We interviewed FDIC Investigators to obtain their overall conclusions on
why the bank’s failure resulted in a material loss to the BIF.

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EXECUTIVE DIGEST

Overview

Objectives,

As mandated under section 38(k) of the Federal Deposit Insurance Act
(FDIA), the Office of Inspector General (OIG) reviewed the failure of The
First National Bank of Keystone (Keystone) in Keystone, West Virginia. On
September 1, 1999, the Office of the Comptroller of the Currency (OCC)
declared Keystone insolvent after examiners could not verify $515 million in
recorded loans. Although alleged fraud is believed to be a factor in
Keystone’s failure, Federal law enforcement agencies were still investigating
the underlying circumstances at the time of this report.

OCC examined Keystone yearly from 1992 until its failure in 1999. The
examinations repeatedly uncovered unsafe and unsound banking practices
and regulatory violations. However, OCC enforcement actions proved
largely ineffective in getting Keystone to fully address its operating
problems. Alleged fraudulent accounting practices, uncooperative bank
management and reported high profitability may have all served to mask the
bank’s true financial condition from OCC examiners. Despite this,
indicators existed throughout the period that may have dictated a more
aggressive supervisory response from OCC. The OIG believes that
Keystone offers valuable lessons learned and opportunities for OCC to
improve examinations and enforcement procedures.

As of December 31, 1999, the FDIC estimated that the Keystone failure will
cost the Bank Insurance Fund (BIF) between $750 and $850 million, making
it one of the largest dollar losses in Federal Deposit Insurance Corporation
(FDIC) history.

Scope and Methodology

FDIA mandated review objectives include: (1) ascertaining why the bank’s
problems resulted in a material loss to the insurance fund, (2) reviewing
OCC’s supervision of the bank, and (3) as applicable, recommending
measures to prevent future losses.

The OIG’s review focused on OCC’s supervision of Keystone from 1992
until the bank failed in 1999. We conducted fieldwork between
September 1999 and January 2000.

The audit was performed in accordance with the Government Auditing
Standards issued by the Comptroller General of the United States, and
included such tests as were deemed necessary. During our review, Federal

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Appendix 2
Page 2 of 5

GLOSSARY OF TERMS

Cease & Desist
Order

Civil Money
Penalty

Commitment
Letter

Federal
Financial
Institutions
Examination
Council

FHA Title 1
Loan

Formal
Agreement

A formal enforcement action issued by the OCC to a bank
or affiliated party to stop an unsafe and unsound practice or
violation of a law or regulation pursuant to authority under
12 U.S.C. §1818. A Cease & Desist Order is terminated
when the bank’s condition has significantly improved and
the bank has substantially complied with its terms.

A fine assessed against individuals or banks under

12 U.S.C. §1818 for violation of any law or regulation; any
final or temporary order, including Cease & Desist Order,
suspension, removal, or prohibition order; any condition
imposed in writing in conjunction with the grant of any
application or other request; any written agreement, and
regulatory reporting requirements. Under certain
circumstances, the OCC may also assess fines for unsafe or
unsound practices and breaches of fiduciary duty.

An informal enforcement action comprised of a document
signed by representatives of the OCC and the bank
reflecting specific written commitments to take corrective
action in response to problems or concerns identified by the
OCC in its supervision of the bank.

A formal interagency body empowered to prescribe uniform
principles, standards, and report forms for the Federal
examination of banks by Federal regulators established
under Title X of the Financial Institutions Regulatory and
Interest Rate Control Act of 1978.

Loans generally consisting of junior lien home improvement
loans (a junior lien is one that is subordinate to a first lien).

A formal enforcement bilateral document signed by the
board of directors and the responsible OCC official. Its
provisions are set out in article-by-article form and
prescribe those corrective and remedial measures necessary
to correct deficiencies or violations in the bank and return it
to a safe and sound condition. It is a legally recognized
document issued pursuant to the OCC’s enforcement
authority under 12 U.S.C. §1818.

OIG -00-067 MATERIAL LOSS REVIEW OF THE FIRST NATIONAL Page 36
BANK OF KEYSTONE


Appendix 1
Page 2 of 2

MANAGEMENT RESPONSE

Thank you for the opportunity to review and comment on the draft report. Our staff has provided
technical comments directly to the 1.G. Staff.

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BANK OF KEYSTONE


CHAPTER 2

WHY KEYSTONE CAUSED A LOSS TO THE FUND

Keystone’s insolvency was established when the bank was unable to
account for $515 million of loans, nearly half of the $1.1 billion in
reported assets. According to OCC’s Bank Closing Report, examiners
found that the Bank engaged in an unsafe or unsound banking practice of
including on its balance sheet loans that it did not own. The overstated
assets were attributed to alleged fraud. Keystone’s inadequate
accounting systems and controls helped mask this alleged fraud.

On June 21, 1999, OCC and FDIC began a joint on-site examination of
Keystone. A primary focus of the review was to determine the asset
quality of the loan portfolio. In reviewing the loan balances between the
bank and servicer reports, the examiners found inconsistencies in the
loans listed, the principal balances, and due dates. Because Keystone
management did not adequately explain the items in question, the
examiners initiated their own independent verification of assets and
contacted loan servicers directly to confirm loan balances. This led to
the discovery on August 23, 1999 of the $515 million discrepancy in
loans reported by Keystone and confirmed by the servicers, as outlined
in Table 1.

Table 1
Discrepancy in Loans Owned and Serviced
as of June 30, 1999
($ in millions)

Loans Owned
Rane Keystone | Servicer | Adjustment
Reported | Confirmed | (Reduction)
A $320 $32 ($288)
B 233 6 (227)
Total | $553 $38 ($515) |

Source: OCC Bank Closing Report

The portfolio of loans reported by Keystone was 14 times more than the
amount confirmed by the loan servicers. Bank management contended
that the discrepancy was due to reporting errors by loan servicers and
that the disputed loans would be found. Up to the day of its closure,
bank officials could not verify the existence of the reported loans, or
explain the accounting discrepancy.

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Appendix 3
Page 7 of 7

CHRONOLOGY OF SIGNIFICANT EVENTS

8/18/99 Keystone brings in security guards reportedly to protect bank employees
and examiners.

8/23/99 OCC examiners secure information from servicers indicating loan totals
reported by Keystone are overstated by $515 million according to
servicer provided reports.

8/23/99 OCC asks U.S. Marshals Service to provide security for OCC examiners
during the 6/21/99 examination.

8/26/99 OCC’s Washington Supervision Review Committee approves an Order
of Investigation for apparent backdating of brokered deposit records.
The Order also covered the misstatements of the bank’s books and
records, especially in connection with the bank’s sale and booking of
securitized loans.

8/27/99 OCC and FDIC examiners visit two servicers to confirm balances of
loans held after finding a $515 million loan balance discrepancy on
8/23/99.

9/1/99 OCC declares Keystone insolvent and appoints FDIC as receiver.

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CHAPTER 3
OCC’S SUPERVISION OF KEYSTONE

From 1992, OCC examined Keystone each year up through the bank’s
closing in 1999. These examinations were conducted under a strained
relationship with bank management marked by mutual distrust, resistance
to examiner findings, and ended in perceived threats against OCC
examiners and the intervention of law enforcement officials.

OCC’s examinations generally focused on the credit risk associated with
subprime mortgage loan securitizations. Rather than credit risk,
however, Keystone’s insolvency resulted from the unsubstantiated loans,
which had been masked by inaccurate financial reports. It was not until
August 1999 that OCC independently verified reported loan balances and
surfaced the unsubstantiated loans. However, the pattern of reoccurring
accounting and internal control problems by 1997, and Call Report
violations coupled with Keystone’s inability or unwillingness to take
corrective action would suggest that verifications were warranted before
1999.

In response to finding unsafe and unsound banking practices, OCC
issued several enforcement actions and Civil Money Penalties (CMP) for
bank regulatory violations. These enforcement actions were largely
ineffective in getting Keystone to fully address its operating deficiencies,
some of which were critical to the accounting, financial reporting, and
control problems. In addition, OCC’s enforcement actions did little to
curb Keystone’s high-risk growth. Based on our review of OCC’s
enforcement files and related documents, we do raise several
observations relative to the timeliness of enforcement actions, the type of
enforcement actions used and the applicability and effectiveness of PCA.

Given the alleged fraud, it would be speculative to suggest that earlier
loan verifications would have surfaced the unsubstantiated loans sooner
and thus minimized or prevented BIF losses. Furthermore, it is difficult
to fully gauge the adequacy of OCC’s enforcement response to problems
identified in examinations and in minimizing the loss to BIF.

Bank Examination Results

Each year from 1992 to 1999, OCC conducted an on-site examination at
Keystone. Because of heightened concerns about Keystone’s loan
securitization activities, OCC brought in some of its capital markets and
_Securitization specialists to assist in evaluating Keystone’s mortgage

OIG -00-067 MATERIAL LOSS REVIEW OF THE FIRST NATIONAL Page 6
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Page 2

lessons learned and opportunities for OCC to improve
examinations and enforcement procedures.

The OIG makes seven recommendations. Three recommendations
focus on different aspects of assessing the level of reliance
that should be placed on audited financial statements when the
accuracy of the information is in question. Three other
recommendations are aimed at reassessing the enforcement
response when bank management is either not timely or not
compliant in addressing problems covered in an enforcement
action. Finally, the OIG recommends that OCC evaluate whether
a different supervisory approach is needed to address growth
in high-risk activities, accompanied by high profitability and
adequate capitalization, without sufficient management systems
and controls.

In your March 8, 2000 written response to our draft report,
you concurred with the reported findings and conclusions. In
response to our recommendations, you indicated that you had
recently formed a high level committee of senior deputy
comptrollers to review how OCC can implement corrective
action. A copy of your response has been incorporated in its
entirety as an appendix to the report.

We appreciate the courtesies and cooperation provided to our
staff during the review. Should you have any questions or
require any further assistance, please call me at

(202) 927-5400, or a member of your staff may contact

Benny W. Lee, Director, Program Audits, in San Francisco,
California at (415) 977-8810.

Attachment

cc: Laura L. McAuliffe, Director, Management Improvement


CHAPTER 4

intended to replicate the external auditor’s financial statement
work but rather to obtain an incremental assurance for specific
accounts as warranted.

Recommendations 4 - 6

OCC undertook several enforcement actions from 1992 up to Keystone’s
failure in 1999. These actions were largely ineffective in obtaining
substantively full compliance with the articles of the enforcement
actions. Reoccurring problems that were never fully addressed by
Keystone included weaknesses in financial accounting, reporting and
controls. In hindsight, these uncorrected problems proved key in
masking the bank’s true financial condition and, ultimately, the
unsubstantiated loans.

In Chapter 3, the OIG also made several observations relative to OCC’s
enforcement response as to timeliness, the type of enforcement action
used, and PCA’s reclassification provision. Accordingly, the OIG
recommends that the Comptroller of the Currency:

4. Enhance existing monitoring and review procedures of
outstanding enforcement actions by establishing clearer guidelines
on:

¢ what constitutes full compliance versus progress towards full
compliance before an action is either terminated, extended, or
replaced with a more severe enforcement action.

e the maximum time banks are allowed to achieve full
compliance so as to avoid seemingly protracted periods when
an enforcement action is extended as was done with the
1992/1993 Commitment Letter.

5. Reassess current enforcement practice that affords the use of
concurrent informal enforcement actions for repeat violations as
with the 1994 Supervisory Letter for the Call Report violations.

6. Reassess the use of PCA reclassification as a means of curbing
uncontrolled growth without adequate controls versus
incorporating this limitation in other enforcement actions.

OIG -00-067 MATERIAL LOSS REVIEW OF THE FIRST NATIONAL Page 27
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CHAPTER 3

Commitment Letter

Although the 1992 Commitment Letter adequately addressed the
problems found in the January 1992 examination, the Letter was not
effective in compelling Keystone to correct the problems. By extending
the enforcement action for nearly four years, OCC allowed Keystone a
protracted time period to address the problems. When OCC eventually
terminated the letter, the underlying problems were not fully resolved,
the promised corrective actions were not fully implemented, and similar
problems resurfaced in subsequent examinations. Rather than
terminating the Commitment Letter, perhaps progressively severe action
would have been warranted. Furthermore, OCC terminated the
Commitment Letter immediately after downgrading Keystone’s
composite CAMEL rating from 2 to 3.

Unusually Long Period Afforded Bank to Comply

OCC issued a Commitment Letter in March 1992. The Letter addressed
many unsafe and unsound banking practices, including inadequate audit
functions, incorrect Call Reports, and weak internal controls and
systems. According to OCC records, Keystone made some progress in
correcting the problems. But in October 1993, OCC revised the
Commitment Letter upon identifying additional problems and areas
requiring further work. Table 3 shows OCC’s major concerns in the
revised Commitment Letter.

Table 3
Revised Commitment Letter
of October 28, 1993

Established

Major Corrective Actions Needed Timeframes
Develop a comprehensive policy to guide the FHA Title I loan
securitization program 60 days
Develop comprehensive internal and external audit functions 60 days
Implement an effective interest rate risk management program 90 days
Obtain confirmations of certificates of deposit By year end
Improve internal loan review documentation 45 days
Correct violations of law cited in the ROE Immediate

Source: OCC Revised Commitment Letter

Based on the original established timeframes, Keystone should have fully
complied with the revised Commitment Letter by February 1994.
Keystone did not comply with the established timeframes. OCC

Subsequently extended the Letter for an additional two years. In

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DEPARTMENT OF THE TREASURY

WASHINGTON, D.c. 20220
March 10, 2000

OFFICE OF
INSPECTOR GENERAL

MEMORANDUM FOR JOHN D. HAWKE JR., COMPTROLLER

OFFICE OF THE COMPTROLLER OF THE CURRENCY
FROM: Dennis S. Schindel
Assistant Inspector General’ for Audit

SUBJECT: Material Loss Review of The First National Bank
of Keystone

This memorandum transmits the final report on our material
loss review of The First National Bank of Keystone (Keystone) .
Our mandate under section 38(k) of the Federal Deposit
Insurance Act (FDIA) required us to (1) ascertain why
Keystone’s problems resulted in a material loss to the
insurance fund; (2) review the Office of the Comptroller of
the Currency’s supervision of the bank; and (3) make
recommendations for preventing any such loss in the future.

This report covers the Office of the Comptroller of the
Currency’s (OCC) supervision of Keystone from 1992 until the
bank’s closing in 1999. OCC declared Keystone insolvent on
September 1, 1999 after examiners could not verify $515
million in recorded loans. Alleged fraud is believed to be a
factor in Keystone’s failure, and Federal law enforcement
agencies were still investigating the underlying circumstances
at the time of this report. As of December 31, 1999, the FDIC
estimated Keystone’s failure will cost the insurance fund
between $750 and $850 million.

From 1992 through 1999, OCC examinations repeatedly uncovered
unsafe and unsound banking practices and regulatory
violations. However, OCC enforcement actions proved largely
ineffective in getting Keystone to fully address its operating
problems. Alleged fraudulent accounting practices,
uncooperative bank management and reported high profitability
may have all served to mask the bank’s true financial
condition from OCC examiners. Despite this, indicators
existed throughout the period that may have dictated a more
aggressive supervisory response from OCC. The Office of
Inspector General (OIG) believes that Keystone offers valuable


Appendix 2

Page 5 of 5
GLOSSARY OF TERMS
ES
Unsafe and A practice in which (1) there has been some conduct,
Unsound whether act or omission, (2) which is contrary to accepted
Practice standards of prudent banking operations, and (3) which

might result in exposure of the bank to abnormal risk or
loss. An unsafe and unsound practice may be considered
reckless if it evidences disregard of, or indifference to, the
consequences of the practice, even though no harm may be
intended.

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BANK OF KEYSTONE


CHAPTER 3

Potential Limitation of PCA

PCA’s effectiveness is largely triggered by bank capital levels, and is
dependent on the accuracy and reliability of the financial records.
Because capital is the primary underpinning of PCA, OCC needed to
determine Keystone’s true financial condition before taking progressively
severe regulatory actions and restrictions to address bank problems.

However, with assets overstated by nearly 50 percent, as identified in
August 1999, OCC did not have an accurate picture of Keystone’s capital
level. In fact, the 1998 examination report noted that bank management
appeared to estimate data to achieve the desired PCA category of “well
capitalized.”

PCA is most effective when there is a gradual decline in a bank’s capital
category because more severe restrictions are triggered as capital
declines. In Keystone’s case, its capital category went immediately from
“adequately capitalized” to “critically undercapitalized” when

$515 million in unsubstantiated loans were identified in August 1999.

Reclassification Provisions

PCA is not solely tied to capital levels in order to use certain
discretionary actions and restrictions. These actions are available
through a PCA provision referred to as reclassification. This essentially
entails reclassifying a bank’s capital level to the next lower category if a
bank is in an unsafe or unsound condition, or engages in an unsafe or
unsound practice.’ In so doing, the actions and restrictions provided
under the next lower capital category can then be used.

In Keystone’s case, there may have been an advantage to using the
reclassification provision. By reclassifying the bank after the 1997
examination in January 1998 from “well capitalized” to “adequately
capitalized,” OCC could have restricted the bank’s use of brokered
deposits and certain interest-rate restrictions. Thus, OCC could have
curbed the bank’s growth six months before the bank’s capital levels
actually fell and triggered these restrictions automatically in June 1998.
This action may have curtailed the bank’s deposit growth from

$545 million in December 1997 to over $638 million by June 1998. Of
the $90 million in deposit growth during this 6 month period, we could

© 12 U.S.C. §18310(g). Section 8(b)(8) of the FDIA defines an unsafe or unsound practice to be (1) the
institution has received a less than satisfactory rating in its most recent examination report for assets,
management, earings, or liquidity, and (2) the institution has not corrected the deficiency.

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BANK OF KEYSTONE


CHAPTER 4

We believe OCC’s planned actions are collectively responsive to the
intent of the OIG’s recommendations. The OJG will also continue to
monitor OCC’s progress in addressing the reported findings and
recommendations. The full text of OCC’s response is included in
Appendix 1.

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BANK OF KEYSTONE


CHAPTER 3

actions, Keystone continued to submit inaccurate reports until its closure
in 1999.

CMPs May Have Been Warranted Instead of a Supervisory Letter

Keystone demonstrated a pattern and practice of violating Call Report
regulations. Between 1992 and 1998, Keystone was cited for Call
Report violations in 4 of the 7 examinations conducted by OCC.

Violations of law and regulation were cited in the 1992/1993
Commitment Letter. By 1994, OCC indicated that Call Report
violations were significant, appeared more willful than the 1992
violations, and that sufficient basis existed for an enforcement action.
Call Report errors found in the 1994 examination were more obvious
because the errors involved traditional banking activities.

In the 1995 and 1996 examinations, OCC did not cite Call Report
violations, but OCC maintained that Keystone did not ensure the
accuracy of Call Reports and identified improper accounting procedures
that would have likely affected the bank’s ability to file accurate Call
Reports. Call Report violations were again found in 1997 and 1998.

In August 1998, OCC eventually issued CMPs for the Call Report
violations. But the CMPs were ineffective deterrents or punishments
because Keystone continued to submit inaccurate Call Reports until the
bank’s closure in 1999.

Formal Agreement

After the Commitment Letter was terminated in 1996, problems
resurfaced at Keystone. OCC’s enforcement response was to have
Keystone sign a Formal Agreement in 1998. According to OCC
officials, a Formal Agreement was the appropriate enforcement action to
take. As with the prior enforcement actions, this also proved ineffective,
particularly with respect to the accounting, reporting, and controls
problems. Keystone management did not fully implement the terms of
the Formal Agreement and had not been fully cooperative with OCC
examiners, according to OCC officials. In hindsight, OCC officials
opined that most enforcement actions would not have been effective
because of bank management’s contentious and uncooperative tactics.
Nevertheless, the Formal Agreement lacked a growth restriction
provision that may have curbed Keystone’s growth and ultimately the
Size.of the loss. The conditions at the time, such as the bank’s

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CHAPTER 1

Objectives,

In 1997, Keystone began to develop and securitize its own high loan-to-
value (HLTV) loans that were also targeted at highly leveraged
borrowers with little or no collateral. The securitization of subprime
loans became Keystone’s main line of business and contributed greatly to
its profitability and growth. From 1992, Keystone grew from $107
million to over $1.1 billion by 1999. This rapid growth was partly
funded with above market rate deposits and brokered deposits.*
Although the bank appeared highly profitable, Keystone’s ten-fold
growth in this high-risk area occurred without adequate accounting
systems and controls, and despite regulators’ concerns over bank
management’s lack of expertise in the area. Furthermore, the bank did
not fully address OCC’s concerns or fully comply with enforcement
actions taken during the period and exhibited a pattern of repeatedly
violating banking regulations.

Keystone’s failure after such rapid growth under the aforementioned
conditions may ultimately prove costly. The Federal Deposit Insurance
Corporation (FDIC) has yet to finalize the cost of the bank’s failure to
the Bank Insurance Fund (BIF). FDIC estimated the loss, as of
December 31, 1999, to be between $750 and $850 million. This loss
will make Keystone’s failure one of the largest losses in FDIC history.

Scope and Methodology

FDIA’s mandated objectives are to (1) ascertain why the bank’s
problems resulted in a loss to the insurance fund, (2) review OCC’s
supervision of Keystone, and (3) make recommendations for preventing
any such loss in the future.

To accomplish our objectives, we conducted fieldwork at OCC
Headquarters in Washington, DC; OCC’s Atlanta District Office in
Atlanta, Georgia; Charleston Field Office in Charleston, West Virginia;
and the Ombudsman Office in Houston, Texas. Additionally, we visited
the FDIC’s Office of Inspector General in Washington, DC; Division of
Supervision in Washington, DC and Atlanta, Georgia; Division of
Resolutions and Receiverships in Dallas, Texas; and the Federal Reserve
Bank (FRB) in Richmond, Virginia. We performed our fieldwork
between September 1999 and January 2000.

* Brokered deposits.are funds which a bank obtains, either directly or indirectly, by or through a broker,
for deposit. A brokered deposit can be held by one or more investors.

OIG -00-067

MATERIAL LOSS REVIEW OF THE FIRST NATIONAL Page 2
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Appendix 3
Page 1 of 7

CHRONOLOGY OF SIGNIFICANT EVENTS

The following chronology describes significant events in Keystone’s history including:
examinations conducted, major problems identified, and enforcement actions taken by

occ.

Date

Event

1904

1977

1992

1/6/92

3/19/92

712/93

10/28/93

4/11/94

4/28/94

Keystone is incorporated under the National Banking Act.
Bank management changes hands.
Keystone begins to purchase FHA Title I home improvement loans.

OCC conducts safety and soundness examination. Examiners identify
system and internal control problems, weaknesses in the internal audit
function, and Call Report violations; however, the overall condition of
the bank remains satisfactory. CAMEL rating: 2/21312. Exam
completed 2/14/92."

Keystone signs Commitment Letter issued 3/7/92 to correct accounting
system and internal control weaknesses.

OCC conducts safety and soundness examination. Examiners find that
although the overall financial condition remains satisfactory, continued
effort is needed to address internal control and audit problems identified
in 1/6/92 exam. CAMEL rating: 2/21312. Exam completed 8/27/93.

Keystone signs revised Commitment Letter addressing FHA Title I loan
securitizations.

OCC conducts safety and soundness examination. Examiners identify
issues concerning gain on sale accounting, loan administration, and Call
Report violations; compliance with Commitment Letter is in progress,
but not complete. CAMEL rating: 2/22322. Exam completed 6/30/94.

Keystone’s President writes to Senior Deputy Comptroller complaining
of excessive OCC examinations.

Exam completion date is the exit conference date with bank management.

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BANK OF KEYSTONE


Appendix 3
Page 3 of 7

CHRONOLOGY OF SIGNIFICANT EVENTS

1/22/96 Keystone appeals to OCC Ombudsman contesting the composite rating
downgrade. The downgrade from 2 to 3 is based on the 6/5/95
examination completed 12/1/95.

1/24/96 OCC terminates Commitment Letter based on 5/8/95 and 11/27/95 OCC
examinations because Keystone was in substantial compliance with terms
of the Commitment Letter.

2/15/96 FDIC asks to participate in next OCC examination to review
FHA Title I program and related issues.

5/30/96 OCC’s Ombudsman upholds OCC’s composite rating downgrade from 2
to 3 based on the 6/5/95 examination.

6/5/96 OCC authorizes FDIC participation in 6/17/96 examination.

6/17/96 OCC conducts safety and soundness examination with FDIC

participation. Examiners find Keystone management responsive to
previous years deficiencies, but bank management still needs to establish
sound controls over the bank information system. CAMEL rating:
2/22212. Exam completed 8/27/96.

1/1/97 Financial Accounting Standards Board No. 125 takes effect. It requires
residual assets to be recorded in accordance with generally accepted
accounting principles. Keystone did not book the residuals until
September 1997.

6/10/97 Keystone files notice of intention to form a bank holding company with
the FRB of Richmond, Virginia.

7/28/97 OCC conducts safety and soundness examination. Examiners identify
concerns with controls over the loan portfolio of subprime home
improvement loans, loans not being charged off, inaccurate bank reports,
repeatedly unacceptable internal audit coverage, and Call Report
violations. CAMELS rating: 3/344433. Exam completed 12/19/97.

9/4/97 Keystone’s President requests a meeting with the OCC Comptroller.

9/9/97 Keystone’s supervision is transferred from OCC Southeastern District to
Special Supervision and Fraud Division in OCC Headquarters.

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BANK OF KEYSTONE


CHAPTER 2

Adequate accounting and financial controls are the fundamental basis for
OCC’s risk-based examination approach. OCC examiners typically did
not independently verify the bank’s reported loan balances. Examiners
relied on the bank’s external auditors to ensure the accuracy of reported
assets. A national public accounting firm issued an unqualified opinion
on Keystone’s December 31, 1998 financial statements. However, when
informed in August 1999 by examiners about certain reporting
discrepancies, the accounting firm did not adequately explain its
assertion that the loan portfolio had been properly confirmed. This
situation further influenced regulators’ decision to visit the loan servicers
and conduct an independent verification of the booked loans.

The OCC used its receivership authority under FDIA after finding
evidence of apparent fraud that resulted in the depletion of the bank’s
capital. Allegations of fraud are presently under investigation by Federal
law enforcement officials.

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BANK OF KEYSTONE