Internal Control Questionnaires and Verification Procedures

Verification Procedures

1. Evaluate the methodology used to set loan pricing relative to risk.

2. Test a sample of loans to ensure underwriting policies and guidelines are appropriately followed.

3. Determine the level of underwriting and policy exceptions. Evaluate the impact these exceptions have on credit quality and risk based pricing.

4. Ensure appropriate controls exist over the real estate appraisal process.

5. Review the contractual documents, including the loan purchase and sale agreements and offering circulars, to validate that the institution is legally entitled to receive the cash flows from the securitization that have been booked as a retained interest. These cash flows may include excess principal and interest payments from the collateral and release of reserve funds.

6. Verify that retained interests are accounted for in compliance with GAAP and the bank’s securitization policy.

   1. For each securitization transaction, verify that there is an appropriate legal opinion that meets FAS 125 sales criteria. Review legal opinion and assess reasonableness.

   2. Review accounting entries for securitization transactions. Assess reasonableness of “gain on sale”. Ensure that residual interests are initially recorded at their relative fair value.

   3. Ensure retained interests (excluding servicing assets) are accounted for at fair value. Ensure servicing assets are accounted for at the lower of cost or market value.

   4. Verify that servicing assets are amortized over their useful life and evaluated for impairment on a quarterly basis.

7. Perform an in-depth analysis of the valuation modeling process for retained interests.

   1. Evaluate the reasonableness of model validation procedures performed by bank management. Test model to ensure output is calculated correctly and provides meaningful results.

   2. Determine the model appropriately reflects the terms and conditions in securitization documentation.

   3. Evaluate the independence and competency of personnel responsible for valuation.

   4. Review the methodology and supporting documentation to assess the reasonableness of cash yield, prepayment, default, loss, and discount rate assumptions and verify their calculations.

   5. Compare the prepayment, default, and loss assumptions used in valuing the retained interests to actual performance of the underlying collateral. If the underlying collateral does not have sufficient performance history, compare assumptions to deals with substantially similar underlying assets. In addition, evaluate whether weaknesses or liberal collection practices identified in servicing reviews are fully considered in these assumptions.

   6. Calculate the cash yield of the portfolio based on actual cash received from customers. Compare the cash yield calculated to the cash yield assumption used in valuing the retained interests.

   7. Compare model estimates of monthly cash flow to actual cash flow received by the bank. Significant variances require explanation.

   8. Compare the discount rate used in valuing the retained interests to the discount rate that other market participants use to value retained interests with substantially similar underlying assets.

   9. Verify discounted cash flow methodology. Ensure that expected cash flows are discounted based on when received (cash out method) as opposed to when earned by the trust (cash in method).

   10. Determine that the valuation of residual interests properly reflects the following impacts on cash flows:

       • Fees (e.g., trustee, servicer, insurer).

       • Release of or additions to a reserve or overcollateralization account.

       • Payments from delinquent loans that are not in default.

       • Recoveries.

       • Insurance coverage of losses (e.g., FHA guaranteed).

       • Credit losses.

8. Review supporting cash flow documentation to determine the following:

   1. The amount of interest paid to the senior bond classes matches the stated coupon rate for each bond class.

   2. Cash flows are distributed to bond classes and the retained interest according to the terms of the prospectus, offering circular, or pooling and servicing agreement.

   3. The deal redemption or cleanup provision is accurately reflected in the cash flows to the retained interest holder.

9. Reconcile the dollar volume of loans serviced by a third party, including a subsidiary or an affiliate, that are either on-balance sheet or that have been sold in a securitization.

   1. Independently verify that the amount of loans being serviced ties to the institution’s records and the supporting cash flow documentation for valuing the retained interests.

   2. For on-balance sheet loans, verify that the dollar volume of loans on the servicing statements ties to the dollar volume of loans on the institution’s records.

   3. For securitized loans, verify that the dollar volume of loans on the servicing statements ties to the dollar volume of loans on the supporting cash flow documentation for valuing the retained interests.

10. Review held for sale loan accounting practices:

    1. Assess management’s methodology for assigning loans as “held for sale” versus its permanent portfolio.

    2. Verify that management applies LOCOM (Lower of Cost or Market) accounting to loans held for sale. Ensure pricing used is reasonable and well supported.

    3. Ensure loans that are transferred from “held for sale” to the permanent investment portfolio are transferred at LOCOM.

    4. Determine the timeliness and assess the accuracy of the “held for sale” and permanent portfolio account reconcilements.

11. Evaluate the effectiveness of the servicing function. This review should include:

    1. Evaluate whether MIS reports for servicing operation provide adequate information to monitor servicing activities.

    2. Assess the accuracy of cost of service information to ensure it includes all costs associated with direct and indirect overhead, capital, and collections. Compare cost of service with industry averages to judge the efficiency of the operation.

    3. Assess the effectiveness of loan collection practices.

    4. Evaluate the efficiency of the asset disposal unit.

    5. Test loss mitigation practices to ensure these activities are conducted in a safe and sound manner.

    6. Ensure the cash management function has established appropriate segregated custodial accounts. Determine if adequate controls exist over custodial accounts, including daily balancing, monthly reconcilements, assigned authority for disbursement, and appropriate segregation.

    7. Review servicing advancing practices to ensure the activity is conducted in a safe and sound manner. Verify that servicing advances are consistent with industry practices and conducted in accordance to the servicing agreement and securitization documentation.

    8. Verify that investor accounting and reporting is timely and accurate. Ensure servicing reports used for reporting conform to the requirements of securitization documents.

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