National Board Releases HomeSide Review Outcomes - Wachtell, Lipton, Rosen & Katz Report - 21 January 2002

We are pleased to present to the Committee our report on the events surrounding last year's writedowns at HomeSide Lending. In light of ongoing legal proceedings with former HomeSide executives in the United States, the report is privileged and confidential.

As you know, this report was an extensive undertaking. Since October, we interviewed more than fifty people in the United States and Australia. These people include both former and current employees of HomeSide and the National Australia Bank Group, as well as outside and internal auditors and experts. We collected and reviewed roughly half a million pages of printed documents, as well as a very large volume of electronic records. In conducting our review and writing our report, we were fortunate to have had the help of Promontory Financial Group LLC, a Washington, DC-based financial and regulatory consulting firm we retained, whose prior experiences as financial institution safety and soundness supervisors, advisors and bankers were of invaluable assistance to us.

As our report makes clear, the events leading to the HomeSide writedown were complex and multifaceted. Nevertheless, you will see that the more important conclusions may be simply stated. In particular:

• Last September's writedown of HomeSide's mortgage servicing rights (MSR) asset had three main causes. The ultimate underlying cause was an unprecedented US interest rate environment and a corresponding collapse in the market for bulk sales of mortgage servicing rights (MSRs). This environment probably made a substantial writedown inevitable, and, in fact, a number of prominent US companies, including Washington Mutual, took substantial MSR writedowns last year.

• Another cause was the Group's strategic decision to adopt a near-term sale valuation instead of a going-concern valuation of HomeSide's mortgage servicing rights (MSR) asset. This part of the writedown could only have been avoided had the Group not made the strategic decision last September to exit the MSR business.

• Nevertheless, a third cause of the September writedown was the fact that, even apart from the negative economic environment, HomeSide's MSR valuation was simply too high. This overvaluation of the MSR asset led HomeSide to hedge the interest rate risk of its MSR portfolio incorrectly, which in the end increased the size of the MSR writedown it had to take. (Other mistakes in hedging strategy led to the loss recognized in July 2001.)

• The overvaluation had two principal elements. First, HomeSide personnel made a mistake in their use of software used in the MSR valuation process. Having looked into the origin of this mistake, we are convinced it was just that a mistake, and not an intentional attempt to inflate the value of the MSR asset. Once made, the error was not an easy one to detect. The error's impact on MSR valuation was in fact relatively small until the end of 2000, and only began to grow significantly when US interest rates dropped precipitously thereafter.

• The second element of the overvaluation stemmed from use of discretionary aspects of MSR valuation software by HomeSide personnel. Despite the use of sophisticated computer models in MSR valuation, there is inherent uncertainty in MSR valuation because the valuations produced by the models depend heavily upon the assumptions put into the models. Reasonable people can disagree on these assumptions, and, as a result, they can disagree on MSR valuations by as much as 20 to 25 percent. This uncertainty of value was exacerbated by the absence in 2001 of bulk MSR sales large, open-market transactions that could have provided useful valuation guideposts. HomeSide's valuation assumptions contributed to overvaluation of its MSR asset in the extremely difficult market environment that existed last year.

• Both elements of the overvaluation resulted from deficiencies in the staffing and structure of the risk management area within HomeSide. As we explain at length in our report, HomeSide's senior management failed to ensure that sufficient expertise and resources were devoted to risk management at HomeSide  and in particular to the MSR valuation process. Among other failings, HomeSide lacked an adequate "middle office"  an additional, supervisory level of management that could have served to review the implementation of valuation software as well as discretionary valuation assumptions.

• The Group performed extensive and thorough due diligence before its acquisition of HomeSide. It appears, however, that no one was specifically tasked with following up on some recommendations made by the Group's due diligence team.

• Group management had effective internal audit and reporting mechanisms, but was not in the executive suite at HomeSide. As a result, the Group did not have day-to-day involvement in the management of HomeSide, and areas of risk-management weakness that the Group identified both during due diligence and during subsequent periodic visits were not corrected as immediately or rigorously as the Group directed. For example, certain recommendations of the Group's internal auditors in late 2000 were not implemented by HomeSide's management as they should have been, and it took several months for the Group to realize this fact from overseas. Nevertheless, we were greatly impressed with the promptness and vigor with which the Group took corrective action when it learned in May 2001 that HomeSide had suffered hedging losses. The increased Group oversight and on-site Group executive presence at HomeSide that followed ultimately led in early September 2001 to detection of the input error and a significantly improved MSR valuation process which spared the Group from what would have been further, greater losses in September and October 2001, when US interest rates declined even further.

• In hindsight, it would have been preferable for the Group to have had an on-site senior executive in the management suite at HomeSide from the outset. The culture at HomeSide could have benefited from the type of controls and practices that on-site Group executives would have brought to a business like HomeSide's. Although the Group, when it acquired HomeSide, justifiably believed that HomeSide's management team had a strong, proven track record in the mortgage servicing industry, that team was not focused upon risk management to the extent that Group executives, coming from a traditional commercial banking culture, would have been.

In short, our review uncovered no evidence of unlawful or improper conduct by Group personnel. Nor, given the high-level attention and prompt corrective action taken by the Group, can a case be made that Group executives or directors were negligent in their oversight of HomeSide. Accordingly, there is no basis, in our judgment, for any disciplinary action against any of the Group's executives, directors, or auditors.

On behalf of ourselves and Promontory, we wish to thank the Committee, the Board, and Group personnel for their cooperation with our review. We were very much impressed with the Group's willingness to engage in the searching self-examination that this review necessarily entailed, and we hope that our report will help the Board in carrying out its responsibilities.