[Senate Hearing 107-698]
[From the U.S. Government Publishing Office]
S. Hrg. 107-698
THE FAILURE OF SUPERIOR BANK, FSB
HINSDALE, ILLINOIS
=======================================================================
HEARING
before the
COMMITTEE ON
BANKING,HOUSING,AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDRED SEVENTH CONGRESS
FIRST SESSION
ON
THE FAILURE AND IMPLICATIONS OF SUPERIOR BANK, FSB, HINSDALE ILLINOIS,
FOCUSING ON THE NEED FOR CONTINUED REGULATORY VIGILANCE, MORE STRINGENT
ACCOUNTING, AND CAPITAL STANDARDS FOR RETAINED ASSETS
__________
SEPTEMBER 11 AND OCTOBER 16, 2001
__________
Printed for the use of the Committee on Banking, Housing, and Urban
Affairs
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81-942 WASHINGTON : 2002
___________________________________________________________________________
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COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
PAUL S. SARBANES, Maryland, Chairman
CHRISTOPHER J. DODD, Connecticut PHIL GRAMM, Texas
TIM JOHNSON, South Dakota RICHARD C. SHELBY, Alabama
JACK REED, Rhode Island ROBERT F. BENNETT, Utah
CHARLES E. SCHUMER, New York WAYNE ALLARD, Colorado
EVAN BAYH, Indiana MICHAEL B. ENZI, Wyoming
ZELL MILLER, Georgia CHUCK HAGEL, Nebraska
THOMAS R. CARPER, Delaware RICK SANTORUM, Pennsylvania
DEBBIE STABENOW, Michigan JIM BUNNING, Kentucky
JON S. CORZINE, New Jersey MIKE CRAPO, Idaho
DANIEL K. AKAKA, Hawaii JOHN ENSIGN, Nevada
Steven B. Harris, Staff Director and Chief Counsel
Wayne A. Abernathy, Republican Staff Director
Dean V. Shahinian, Counsel
Sarah Dumont, Republican Professional Staff Member
Geoffrey P. Gray, Republican Senior Professional Staff
Joseph R. Kolinski, Chief Clerk and Computer Systems Administrator
George E. Whittle, Editor
(ii)
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C O N T E N T S
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THURSDAY, SEPTEMBER 11, 2001
Page
Opening statement of Chairman Sarbanes........................... 1
Opening statement of Senator Johnson............................. 3
WITNESS
Ellen Seidman, Director, Office of Thrift Supervision,
Washington, DC................................................. 5
----------
TUESDAY, OCTOBER 16, 2001
Opening statement of Chairman Sarbanes........................... 7
Comments or prepared statements of:
Senator Carper............................................... 38
Senator Johnson.............................................. 42
WITNESSES
Ellen Seidman, Director, Office of Thrift Supervision,
Washington, DC................................................. 8
Prepared statement........................................... 43
Response to written question of Senator Sarbanes............. 117
John Reich, Director, Federal Deposit Insurance Corporation,
Washington, DC................................................. 15
Prepared statement........................................... 60
Response to written question of Senator Sarbanes............. 118
Bert Ely, President, Ely & Company, Inc., Alexandria, Virginia... 29
Prepared statement........................................... 67
George G. Kaufman, Ph.D, John F. Smith, Jr. Professor of Finance
and
Economics, Loyola University Chicago, Chicago, Illinois........ 32
Prepared statement........................................... 100
Karen Shaw Petrou, Managing Partner, Federal Financial Analytics,
Inc.,
Washington, DC................................................. 34
Prepared statement........................................... 107
(iii)
THE FAILURE OF SUPERIOR BANK, FSB HINSDALE, ILLINOIS
----------
TUESDAY, SEPTEMBER 11, 2001
U.S. Senate,
Committee on Banking, Housing, and Urban Affairs,
Washington, DC.
The Committee met at 10:06 a.m., in room SD-538 of the
Dirksen Senate Office Building, Senator Paul S. Sarbanes
(Chairman of the Committee) presiding.
OPENING STATEMENT OF CHAIRMAN PAUL S. SARBANES
Chairman Sarbanes. The hearing will come to order.
We obviously are confronted with an extremely serious
situation. My own view, very frankly, is that we should not to
let these people simply close down not only the Government of
the United States, but close down the United States, despite
some very harrowing things that are happening. So it is my
intention, unless I receive word to the contrary from higher
authorities, to proceed with this hearing this morning. We have
all the witnesses here, unless their panic quotient is very
high, I intend to go ahead.
This morning, the Committee will hear testimony on the
failure of Superior Bank of Illinois. Press reports estimate
that the loss to the Savings Association Insurance Fund will
approximate $500 million. It is the largest U.S.-insured
depository institution by asset size to fail since 1992.
On July 27, just a couple of months ago, the Office of
Thrift Supervision closed Superior Bank after finding that the
bank was critically undercapitalized. That is, tangible equity
capital was less than 2 percent of its total assets. The OTS
stated that Superior's problems arose from, ``. . . high-risk
business strategy which was focused on the generation of
significant volumes of subprime mortgage and automobile loans
for securitization and sale in the secondary market, while
keeping residual assets.''
The OTS found ``Superior became critically undercapitalized
largely due to incorrect accounting treatment and aggressive
assumptions for valuing residual assets.''
Shortly after this failure, I asked the General Accounting
Office and the Inspector Generals of the Federal Deposit
Insurance Corporation and the Department of the Treasury to
thoroughly review why the failure of Superior Bank resulted in
such a significant loss to the deposit insurance fund, and to
make recommendations for preventing any such loss in the
future. I look forward to their reports and as soon as they are
completed, which I anticipate would be relevant to the next
session of the Congress, we will hold further hearings to
review their findings.
I am very deeply concerned about the impacts of this
failure. For the SAIF, this failure will cause a material
financial loss estimated currently at $500 million, but with
the expectation that it may, in fact, be larger. Uninsured
depositors will suffer losses of their savings and the failure
raises concerns about the supervision of our Federally insured
depository institutions.
Obviously, the failure of a $2 billion thrift raises many
concerns relevant to the oversight responsibilities of this
Committee involving how the failure happened, its impact, and
how to prevent similar failures in the future. During today's
hearings, I hope we can focus on several important questions.
We appreciate that there are investigations going on that may
involve important questions of liability with respect to
superior and to its owners, and we do not want to intrude into
that investigative process, so we are focusing in a different
direction.
Are there characteristics of Superior Bank that it shared
with other institutions that have failed in the past few years,
such as First National Bank at Keystone, Pacific Trust & Loan,
BestBank, or OceanMark Bank? If so, were these, or should these
have been red flags to the regulators?
I am particularly concerned that there seems to be a
pattern of failed institutions that have held high
concentrations of risky residual assets with which the
regulators have not yet fully dealt.
Are there other thrifts or banks with heavy concentrations
of assets that the regulators would consider as extremely
risky? Did the primary regulator, OTS, effectively supervise
Superior? Did the OTS and the insurer, the FDIC, cooperate
effectively? Does the FDIC need more authority to effectively
exercise its back-up role? Why did Prompt Corrective Action
after it was applied fail to prevent this failure? Are
regulatory or legislative changes needed to reduce the
likelihood of future failures? In particular, after the failure
of Keystone 2 years ago, at a loss of just under $800 million,
why did the four Federal financial regulators not adopt
stronger rules governing the holdings of risky residual assets?
These and other issues we hope to address today. We have
two panels of witnesses. Our first panel includes the Director
of the OTS, Ellen Seidman. The OTS, of course, is the primary
regulator with respect to Superior Bank. And Former Acting
Chairman of the FDIC and current FDIC Director, John Reich.
Actually, we welcome John back to the Senate where he worked
for many years as Chief of Staff to Senator Connie Mack, a
distinguished former Member of this Committee.
Our second panel includes three distinguished experts in
the banking industry: Bert Ely, President of Ely & Company of
Alexandria, Virginia; Dr. George Kaufman, John F. Smith, Jr.
Professor of Finance and Economics at Loyola University
Chicago; and Karen Shaw Petrou, Managing Director of Federal
Financial Analytics here in Washington.
I will turn to my colleague, Senator Johnson, for any
statement he might have.
STATEMENT OF SENATOR TIM JOHNSON
Senator Johnson. Thank you, Mr. Chairman, for conducting
this timely and important hearing. I think all of us here in
this room today are having some difficulty focusing on the
important issues at hand relative to the Superior Bank failure,
given what has happened to our Nation this morning with now the
collapse of the World Trade Center building and the attacks in
Washington. My thoughts and prayers certainly go to the very
many families that must be suffering great anguish as we speak
here today. It is important for the principles of our democracy
and the strength of our Nation to remain intact, and that is
what we are about in this hearing.
Mr. Chairman, I thank you for holding this hearing on the
failure of the Superior Bank of Hinsdale, Illinois. I doubt
that I was the only one who was surprised to learn of the
thrift's failure on July 27 of this year.
Since that time, there has been a lot of finger-pointing
among the parties involved. I happen to believe that today is
not about assigning blame or passing the buck. We clearly have
a problem and today, our task is to get to the bottom of it so
that it simply does not happen and the likelihood of it
happening again is minimized. There are sure to be lessons
learned from the failure of Superior and I hope that we can get
beyond the finger-pointing today.
Of course, we will take a hard look at many different
issues, including Prompt Corrective Actions, methods
evaluation, the role of accounting auditors, and interagency
cooperation, to name a few.
While today's hearing is likely to focus on these more
technical issues, we should not lose sight of the fact that it
is exactly situations like the Superior failure that emphasize
the critical role that Federal deposit insurance plays in the
lives of ordinary Americans.
FDIC is one of the cornerstones of our financial system,
and it is worth pausing to note that the failure of Superior
Bank appears to have caused little, if any, public panic about
the health of our banking system. That is the goal of the
Federal deposit insurance. And it is no small feat. According
to FDIC policy for a conservatorship situation, they typically
close a failed institution on a Friday after the close of
business, with the goal of reopening on a Monday in a way where
the customers would be hard-pressed to identify any differences
in the bank's operations.
Indeed, our deposit insurance system is premised on the
assumption that banks and thrifts will, on occasion, fail,
despite the best efforts of regulators. On that point, we
should remember that the regulatory agencies deserve
significant credit for their hard work in keeping our banking
system healthy. Their task is especially challenging where
there is fraud by the institution, or serious error by a
national auditor.
However, I find this failure to be especially notable, as
were the failures of First National Bank of Keystone and
BestBank, because of the magnitude of the failure proportional
to the size of the institution. The loss estimates for Superior
range from $500 million to $1 billion, with a loss rate of
anywhere from 20 to 45 percent. Some experts estimate that the
failure could cost around a 7 basis point drop in the SAIF
ratio, which, as I have said in the past, should help to focus
Congress and industry alike on the need to consider reforms to
our Federal deposit insurance system.
Mr. Chairman, I am particularly troubled by the losses to
Superior's uninsured depositors. While the numbers have not
been confirmed, FDIC estimates that the uninsured depositors
held upward of $50 million in Superior on July 27. According to
one report, 816 depositors held $66.4 million in uninsured
deposits on the day Superior was shut down.
Even worse, to my mind, is the fact that Superior's
uninsured deposits increased by $9.6 million in the second
quarter of this year, when the regulators knew that the bank
was in trouble.
Who were these uninsured depositors? Clearly, some were
sophisticated investors who knew enough to pull their money out
of Superior when call report data indicated a precarious
situation for the bank, even though sophisticated investors
were challenged in evaluating the health of the thrift given
reports of Superior's egregious misrepresenting on its thrift
financial reports. As one of the witnesses included in his
written statement, call report data posted on the FDIC website
was inaccurate as late as June of this year.
And as for the rest of the uninsured depositors, press
reports are informative. For example, a former parcel carrier
who was injured on the job had deposited a hard-fought
settlement of $145,000 of his money in Superior on July 26, the
day before the Hinsdale thrift collapsed. Another woman
deposited $120,000 in proceeds from her recently deceased
mother's home just days before Superior was closed by the
regulators. In addition, it has been reported that many
individuals held uninsured retirement savings at Superior.
I hope either today or at some point in the near future, we
will receive more details on how many of the uninsured deposits
at Superior Bank were retirement funds and how they came to be
parked at Superior.
As I have indicated previously, Congress has a
responsibility to think about the appropriate level of Federal
deposit insurance for retirement funds. We provide tax
incentives for people to save for their retirement and in fact,
we recently increased those savings incentives. People who set
aside relatively modest amounts every year for retirement can
easily amass more than $100,000. It seems to me that the next
step for Congress is to make sure that our working families
have the option of a safe investment for those funds. To keep
us informed, I am calling on the FDIC to release additional
information, even in redacted form, to this Committee.
I thank the witnesses for their extensive and thoughtful
written testimony and I once again thank you, Mr. Chairman, for
calling this hearing in a timely manner, even during these
difficult times.
Chairman Sarbanes. Thank you very much, Senator Johnson.
I am happy now to turn to our witnesses. Ms. Seidman, we
will hear from you first, and then from Mr. Reich.
Ordinarily, we ask our witnesses to try to limit their oral
presentation to 10 minutes. I understand when the OTS people
were told that, they reacted quite strongly, saying that it was
not possible for Ms. Seidman to condense what she had down to
10 minutes.
Ms. Seidman. Actually, Senator, I have succeeded.
Chairman Sarbanes. Well, I was going to tell you that we
were going to give you the extra time. You are the regulator
that is on the spot and we want to hear from you. We want to
make sure that you do not walk away from the table saying the
Committee did not give me a chance to present. So if you need
to take some time over the 10 minutes, not unreasonably, I
invite you to do so.
We will now be happy to hear from you.
STATEMENT OF ELLEN SEIDMAN
DIRECTOR, OFFICE OF THRIFT SUPERVISION
Ms. Seidman. Thank you very much, Senator.
Mr. Chairman, Senator Johnson, I welcome this opportunity
to speak to you about the failure of Superior Bank and some of
the policy issues raised by that failure.
Before I start, I understand, and I believe from Senator
Johnson's own statement, that some Committee Members are
concerned that I did not mention Superior, whether by name or
otherwise, in my testimony on the state of the thrift industry
on June 20. So, today, I want to be very clear about the
troubled institution situation in the thrift industry.
As of yesterday, there were 17 thrifts out of a total of
1,045 rated CAMELS ``4'' or ``5''. Were you to ask me whether
one of these institutions might fail within the next 6 months,
I would have to say yes. Were you to ask me whether one of
these institutions will fail, I would have to answer that I do
not know and that we at OTS, as the other bank regulators with
respect to the troubled institutions they supervise, are
working hard to get those institutions returned to health,
merged or acquired, or voluntarily liquidated. And many of the
17 are well on their way.
During my tenure at OTS and for years before, there have
been far more successes than failures. In fact, this is the
third failure on my watch. A good result for the financial
system, but, unfortunately, for us, there are no headlines
about successes and no hearings about them.
Superior was, when it failed, a $1.8 billion privately
owned institution, held 50 percent by the Pritzker and 50
percent by the Dworman families. Under the FSLIC assistance
program, the two families had purchased Superior's $1.5 billion
troubled predecessor, Lyons Savings Bank, in 1988, and infused
$42 million into it. While Superior's new owners had difficulty
stabilizing the newly acquired institution, by 1993, both OTS
and the FDIC rated it CAMELS ``2''. OTS raised the
institution's rating to CAMELS ``1'' in October 1997, and the
FDIC did not raise any concern.
Starting in 1993, Superior built its mortgage banking
business. And, as with most mortgage bankers and an increasing
number of subprime lenders, Superior was not holding the loans
in its portfolio. Rather it was securitizing them, the process,
described more fully in my written statement, by which a pool
of loans is divided into securities of varying levels of credit
quality and sold to investors with varying appetites for risk.
Superior, like many issuers, held onto the residual, the
security with the greatest amount of risk or otherwise provided
significant credit enhancement.
In theory and in practice, this process has both expanded
and liquified the market for many credit products. However, as
described more fully in my written testimony, both the gap
accounting and regulatory capital treatment of these
instruments means that securitization can also be a way to
increase the scope of operations, leverage the balance sheet
with capital that consists of little other than assumptions
about future cashflows, create real uncertainty about the
quality of both regulatory reporting and audited financial
statements. When the gap in regulatory accounting is incorrect,
when the cashflows do not materialize as anticipated, and when
the institution goes faster than it seems able to control,
problems arise, as they did at the failed institutions that you
mentioned in your opening statement, Chairman Sarbanes.
During 1999, both the OTS and the FDIC started having
serious concerns about Superior. Early in the year, OTS focused
its attention on the inadequate asset classification system,
which led to inaccurate loss reserves and regulatory
accounting, as well as on the deteriorating auto portfolio. We
rated the institution a ``2'' in March 1999. The FDIC was more
focused on the increasing concentration of residuals and rated
it a ``3'' in May. By July, however, both agencies were
increasingly focused on the concentration and evaluation of
residuals. The institution's management resisted making changes
and, to some extent, you can understand why. In May 1999,
Fitch, which rated Superior's long-term debt an investment-
grade triple B, stated----I am sorry, sir?
Chairman Sarbanes. The Capitol police apparently are moving
people out of the building. And as I indicated at the outset,
if that sort of request or order came through, we obviously
would honor it. So, we will have to suspend the hearing, to be
resumed at some opportune time. We thank the witnesses for
coming. We apologize. But I am sure they understand our
situation.
This hearing is recessed until further call of the Chair,
which will not be today, I would also add. And we will hold Ms.
Seidman to her 10 minutes the next time we come together.
Thank you all very much.
[Whereupon, at 10:25 a.m., the hearing was recessed, to
reconvene at the call of the Chair.]
THE FAILURE OF SUPERIOR BANK, FSB HINSDALE, ILLINOIS
----------
TUESDAY, OCTOBER 16, 2001
U.S. Senate,
Committee on Banking, Housing, and Urban Affairs,
Washington, DC.
The Committee met at 10:30 a.m., in room SD-538 of the
Dirksen Senate Office Building, Senator Paul S. Sarbanes
(Chairman of the Committee) presiding.
OPENING STATEMENT OF CHAIRMAN PAUL S. SARBANES
Chairman Sarbanes. The hearing will come to order.
I expect that our other colleagues will be along shortly.
We have been receiving a briefing on yesterday's events and our
authorities seem to have it under control.
We are, of course, resuming the hearing on the failure of
the Superior Bank that began on September 11, and we are
pleased to have our witnesses back before us. I will be very
brief in my opening statement because I want to return to our
witnesses and give them a chance to get their statements in
this time, at least.
Press reports have estimated the losses to the SAIF, the
Savings Association Insurance Fund, will approximate $500
million in the Superior Bank. Others are estimating even
higher. I have seen some estimates higher. It is the largest
U.S.-insured depository institution by asset size to fail since
1992.
On July 27, OTS closed Superior Bank after finding that it
was critically undercapitalized; that is, tangible equity
capital was less than 2 percent of its total assets. OTS stated
that Superior's problems arose from a high-risk business
strategy which was focused on the generation of significant
volumes of subprime mortgage and automobile loans for
securitization and sale in the secondary market, while keeping
residual assets. OTS found, ``Superior became critically
undercapitalized largely due to incorrect accounting treating
and aggressive assumptions for valuing residual assets.''
Shortly after this failure, the Committee asked the General
Accounting Office and the Inspector Generals of the Federal
Deposit Insurance Corporation and the Department of the
Treasury to look into the matter, and we look forward to
receiving their reports.
For the SAIF, this failure will cause a large financial
loss. For people whose savings accounts had more than $100,000
and, thus, held uninsured deposits, it is estimated there is
about $60 million of that, so there will be a significant cost
there. And for the public, generally, the failure of a major
bank is unsettling and raises questions about the supervision
of U.S. depository institutions.
There are a number of questions that I hope we will touch
on today in the course of this hearing.
First, are there characteristics of Superior Bank that are
shared with other institutions that have failed in the past few
years, such as First National Bank of Keystone, Pacific Trust &
Loan, BestBank, or OceanMark Bank? If so, were these, or should
these have been red flags to the regulators?
I am particularly concerned that if there is a pattern of
failed institutions that held high concentrations of subprime
residual assets, which the regulators have not yet effectively
dealt with. Are there other thrifts or banks similar to
Superior in difficult situation? Did the primary regulator,
OTS, effectively supervise Superior? Did the OTS and the
insurer, the FDIC, cooperate effectively? Does the FDIC need
more authority to effectively exercise its back-up supervision?
Why did Prompt Corrective Action after it was
applied fail to prevent the failure of Superior? Are regulatory
or legislative changes needed to reduce the likelihood of
future failures? We are particularly interested in this issue.
And especially, why, after the failure of Keystone in September
1999, at a loss of $780 million, the Federal financial
regulators have not yet adopted a strong rule governing the
holding of subprime residual assets?
We look forward to examining these issues today. We have
two panels. The first panel, which is at the table, includes
the Director of the OTS, which had primary regulatory
responsibility for Superior Bank, Ellen Seidman, and the Former
Acting Chairman of the FDIC and current FDIC Director, John
Reich.
I welcome both witnesses before the Committee and, Mr.
Reich, I just want to comment that we are pleased to have you
back with the Senate because we know you worked here for many
years as Chief of Staff to Senator Connie Mack of Florida, who
of course was a very distinguished Member of this Committee.
We would be happy to hear from the witnesses. Ms. Seidman,
we will obviously start with you.
STATEMENT OF ELLEN SEIDMAN
DIRECTOR, OFFICE OF THRIFT SUPERVISION
Ms. Seidman. Thank you, Mr. Chairman.
Since the adjournment of this hearing on September 11, in
the wake of terrorist attacks on the World Trade Center and the
Pentagon, OTS, like the other Federal bank regulators, has been
heavily focused on maintaining both the strength of and
confidence in the banking system and ensuring that the banking
system is working with law enforcement to do its part to trace,
freeze, and stop flows of assets and funds to terrorists and
those related to them. I have not had an opportunity to report
to you on our actions, so I would just like to go over them
briefly.
First, of course, we made certain that all of our employees
were accounted for and safe and, fortunately, they were.
Starting on September 12 and continuing through the following
week, we had regular conference calls and video calls with our
regional directors, other bank supervisors, and members of the
financial markets working group. These were to gather and share
information and to ensure that our regional directors,
particularly those in New Jersey and in Atlanta, which serves
the D.C. area, were aware of and able to deal with any
operational or customer service issues. Fortunately, there were
few issues after the first day or so, and some institutions
concerned about the availability of cash who put temporary
limits on withdrawals, were lifted.
On September 12, and again on the September 14, we issued
press releases and letters to CEO's urging thrifts to
accommodate the needs of borrowers impacted by the events of
September 11, including those affected only by delays in mail
service. We noted that assistance to the community would be
taken into account in an institution's CRA evaluation.
On September 13, we joined other bank regulators in issuing
guidance concerning temporary impacts on capital, and during
the following weeks, we issued a release and CEO letter
informing thrifts of their obligations under the Soldiers and
Sailors Civil Relief Act and a series of releases and CEO
letters concerning responsibilities under the Foreign Assets
Control Act, the Executive Order issued on September 24, and
requests by the FBI and other law enforcement agencies to
assist in tracking terrorist funds. We have continued to keep
up with our institutions to make certain that any concerns or
difficulties are quickly resolved.
I can report that the Nation's thrifts have responded well
to the events of September 11 and are effectively serving their
customers, their communities, and the greater needs of the
Nation.
Now before I get really into Superior, I understand that
the Chairman perhaps and some other Committee Members are
concerned that I did not mention Superior, whether by name or
otherwise, in my testimony on the state of the thrift industry
on June 20. So, I want to be really clear today about the
current troubled institution situation.
As of yesterday, there were 16 thrifts out of a total of
1,037 OTS-supervised institutions that were rated CAMELS ``4''
or ``5''. That is 16 out of 1,037. Were you to task me whether
one of these institutions might fail within the next 6 months,
I would have to answer yes. That is what a CAMELS rating of
``4'' or ``5'' suggests as a possibility. Were you to ask me
whether one of these institutions will fail, I would have to
answer that I do not know and that the deteriorating economic
environment on which a number of you have been or are scheduled
to be briefed by the FDIC makes failures more likely.
However, I will also assure you that we at OTS, as the
other bank regulators with respect to the troubled institutions
they supervise, are working hard to get those institutions
returned to health, merged or acquired, or voluntarily
liquidated, and many are well on their way.
During my tenure at OTS and for years before, there have
been far more successes than failures. In fact, during my 4
years, 53 different institutions have at some point been rated
CAMELS ``4'' or ``5''. There were only 3 failures. This is a
good result for the financial system, but there are, of course,
no headlines about the successes and no hearings on them.
My written statement goes into substantial detail about the
regulatory history of Superior through its failure on July 27.
And in the interest of time, I will not repeat it here. But I
believe it is a history of, since 1999, constant and consistent
regulatory escalation, with some success, in the face of
complexity, substantial mistakes by professionals, and
management and board recalcitrance. Were there things that, in
retrospect, we might have done better? Yes. In particular, I
believe we should have pushed management, the thrift board, and
the holding company board harder to honor the commitments they,
in fact, made in a timely manner, from May 1999, right through
to July 23 of this year.
But responsibility for the success or failure of any
depository institution rests with its management directors and
owners. We have an investigation underway to determine the
causes of the failure and what enforcement action is
appropriate. And at this stage, we have issued 27 subpoenas to
corporations and individuals.
As you know, and as you have mentioned, others are also
pursuing the causes of the failure. Since late July, OTS staff
has spent approximately 100 staff-hours in direct discussions
with the Treasury IG, the FDIC IG, and the GAO, and many more
hours in preparation for those sessions. We have copied and
made available for review in excess of 130,000 pages of
documents. I would now like to turn to seven broad areas raised
by Superior, other recent failures and other high-risk or
troubled institutions, and I hope in this context I can answer
some of the issues that the Chairman has raised in his opening
statement. All of this is covered more extensively in my
written testimony. In some cases, however, this oral
presentation provides updated information on action we have
taken since this hearing recessed.
First, subprime lending. The consistently higher proportion
of subprime lenders found in the troubled institution category
both at OTS and overall confirms that there are special risks
in this business. They go beyond credit risk to operational
risk, prepayment risk, reputation and legal risk, and when done
in the volumes that are possible only through securitization or
constant loan sales, liquidity, and funding risk.
OTS first warned the thrift industry about the heightened
risks of subprime lending in June 1998. This was followed by
interagency subprime guidance in March 1999. By this January,
interagency guidance that included guidance on the appropriate
level of capital to hold against subprime loans, and on August
17, by a series of questions and answers concerning the
guidance. In this area, the major additional regulatory step
that needs to be taken relates to better gathering of
information.
OTS had notified the thrift industry that we would begin
collecting data on subprime lending with the September 2001
TFR. But we have delayed collection to coordinate with the bank
regulators. We need to move quickly, in a manner that enables
all the Federal bank regulators to collect qualitative data on
who is in this business, even if we cannot get highly accurate
quantitative information. With the support of Chairman Powell,
Comptroller Hawke, and Governor Meyer, in September, this
process recommenced through the FFIEC supervisory and reporting
task forces. Of course, regulations, guidance, and reporting
must be accompanied by enhanced supervisory action.
Second, securitization. Securitization provides an
opportunity to liquify a loan portfolio and can be used to
transfer some portion of interest and credit risk to other
parties. Current risk-based capital rules are structured to, in
general, allow issuers of securities to carry less capital
against securitized assets than against those same assets when
they are on the books. In effect, securitization increases an
institution's financial and operating leverage, creating a
situation where the institution's profitability is dependent on
a large and generally growing volume of business. The risks
inherent in such a structure are exacerbated when the
institution concentrates its securitization of subprime assets,
for which the secondary market is particularly subject to
disruption.
In December 1999, the Federal bank regulators issued
guidance on asset securitization. The guidance addressed many
of the concerns noted above and set forth fundamental risk
management practices that the agencies expected of institutions
that engage in securitization.
With respect to the relationship between securitization and
risk-based capital, since 1993, the Federal bank regulators
have recognized the potential for regulatory capital arbitrage
created by the current rules and have been trying to issue a
regulation on recourse and direct credit substitutes to respond
to this problem. As is evident by the fact that the regulation
is still not final 8 years later, the problem is not simple.
Spurred in part, however, by the failure of Superior, the
principals have instructed their staffs to move quickly to
closure and we expect that final interagency action on this
rule will happen this month.
As discussed more fully in my written statement, the
financial leverage inherent in securitization is multiplied
many times over when the issuer, in a quest to maintain a
market for its securities and get the highest price, retains an
ever-greater portion of the pool's unexpected risk. This is the
retention of a residual interest, which may take a number of
forms. Under GAAP, the present value of the entire future
stream of income represented by the residual must be booked at
the time the security is sold, so-called gain-on-sale
accounting. Yet this stream is dependent on a number of highly
subjective assumptions concerning the discount rate, default
rate, and prepayment speed. And not only are these assumptions
subjective, they change, sometimes dramatically, over time.
These factors make the value of the residual extremely volatile
and subprime residuals, with their lack of a secondary market,
are even harder to value. There is currently no limit on the
extent to which residuals can be counted as either leverage or
risk-based capital for regulatory purposes.
In September 2000, in part as a result of the Keystone
events, the regulators proposed to limit residuals to 25
percent of leveraged capital and to require that dollar-for-
dollar risk-based capital be held for residuals. We are working
quickly toward a final rule that will be part of the recourse
and direct credit substitutes rule that I mentioned earlier
that should be out by the end of this month. In addition, since
March of this year, we have been collecting information on
residuals on the thrift financial report, a process the other
regulators started this June, and we are working to enhance
that information.
The quarterly TFR data will be supplemented by more
detailed database and risk assessment report compiled from
information obtained through on-site exams and off-site
analysis, and by revised preexamination schedules on
securitization, residuals and valuation assumptions. The
combination of additional information, adoption of the proposed
regulation, and increased regulatory vigilance should go a long
way to reducing the risk represented by institutions whose
capital was wholly or even mostly represented by residuals. Now
while the residual rule, when adopted, should help resolve that
problem, it highlights a much bigger issue. What appears to
make sense for accountants may not coincide with the needs of
regulators, particularly when it involves creation of
speculative amounts of capital. In many ways, this is also what
is at the heart of the debate concerning loan loss allowances.
Current law permits regulators to deviate from GAAP as long
as our regulations are, ``no less strict.'' We have been
reluctant to do so, in large part, because the creation of two
sets of books is not only confusing, but also burdensome,
particularly for publicly held companies. We may, however, need
to bite this bullet. But it would be better in the long run if
the accounting profession were required, by statute if
necessary, to consult with bank regulators and to consider in
writing the impact of major accounting changes on depository
institutions before such changes are promulgated. Three other
important accounting issues are timely resolution of disputes,
accounting competence, and accounting independence.
Protracted accounting disputes played a role in the failure
of not only Superior, but also Keystone and PTL. This is
currently a relatively low-risk proposition for institution
management and its
accountants. The longer the dispute goes on, the longer the
institution can avoid booking the inevitably higher reserves or
lower asset values the regulator is demanding. In most cases,
these disagreements are resolved amicably and quickly. However,
when the consequence of the regulators' position are large, as
where it would cause the institution to drop a capital
category, and that was very much what was at issue here, delay
is often the winning strategy.
To get at this problem, we recommend that the Congress
enact legislation providing that when a Federal bank regulator
issues an accounting dispute letter concerning a dispute that
could cause an institution to drop a PCA capital category, a 60
day clock for resolution would start, at the close of which, if
there is no resolution, the regulator's position will be
adopted for regulatory reporting purposes and therefore for
PCA.
Accounting competence is also becoming a more serious issue
as financial institutions enter into ever more complex
transactions from an accounting perspective. It is essential
that at least two people on any engagement team, including the
engagement and review partners, understand the complexities of
the major or primary line of business of the institution. This
may not have been the case with the Superior accountants and is
part of the subject of our investigation. We recommend that the
AICPA and major accounting firms strengthen the requirements
for training and experience. Finally, there is the issue of
accounting independence.
First, many accountants assist clients with valuation of
complex financial instruments such as residuals and regard this
as part of their audit work. This means that the same
accounting team that develops the valuation then audits it. We
recommend that the AICPA and the SEC limit the provision of
valuation services in connection with an audit.
Second, we think it is time for Congress to encourage the
AICPA and the SEC to give full consideration to an external
auditor rotation requirement, at least for institutions of
significant size. While there are definite economies to be
gained from having the same auditor year after year, both
regulators and investors would benefit from a periodic fresh
look at large and complex institutions.
Now, I understand that there is concern over whether the
regulators are using Prompt Corrective Action effectively. But
I believe that the track record over the last several years,
particularly when combined with safety and soundness actions
under Section 39 of the FDIA has been good.
Since 1991, we have issued PCA directives to 47
institutions and directives under Section 39 to 30 different
institutions. There are also some overlaps, yet only 8 of these
institutions, including Superior, have failed.
Nevertheless, our recent experiences lead us to believe
there is one improvement that could make PCA a good deal more
effective. The section of PCA dealing with critically
undercapitalized institutions, those that will be shut down in
90 days if not recapitalized, is the only portion of the
statute that does not include a risk-based capital component.
Rather, it is based solely on Tier 1 equity capital, which is
essentially a GAAP definition.
In a world in which many of the riskiest institutions are
booking capital for GAAP purposes that has little economic
reality in a liquidation scenario, this is ineffective. We,
therefore, recommend that a risk-based capital trigger be added
to the definition of critically undercapitalized.
As Chairman Powell has noted, the FDIC as an insurer has an
important role to play in assessing the health of insured
institutions and also in attempting to limit claims on the
insurance funds. However, the FDIC is not the primary Federal
regulator of institutions holding the bulk of industry assets
and we all need to work together better.
First, we need better information-sharing, including not
only the sharing by the primary regulators of information we
develop about institutions that we supervise, but also sharing
by the FDIC of its analysis of institutions regulated by
others. The forward-looking risk assessment essential to an
analysis for insurance purposes can also be extremely helpful
both in improving current supervision and what is sometimes
more difficult--convincing banks' management and board of the
need for a strategic change. I have discussed this issue with
Chairman Powell and he has stated that he supports greater and
more effective two-way information sharing.
Second, there needs to be better communication of potential
problems relating to institution-specific issues at the
Washington level. Regional coordination and communication with
respect to individual institutions appears to be quite good and
the staffs in Washington work well together on policy issues.
But where there is a disagreement about an institution-specific
issue at the regional level, we need a better process for
bringing the issue to the attention of both staff of all
agencies in Washington and, if necessary, the FDIC board.
Finally, I agree with Director Reich that we need to review
and revise the 1995 procedural agreement concerning back-up
supervision. This process has started, including a joint
working group of very senior supervisory officials from all
four Federal banking agencies. I hope it can conclude
relatively quickly, and I have certainly encouraged my staff to
do that. The final topic I want to cover is the issue of
broader interagency coordination.
To the extent that regulations could have prevented the
Superior failure, our inability to move more quickly on
interagency recourse and residual rules has to be tagged as
part of the problem. This is largely an area where the
regulators have to have the will to improve, and that it can
only be accomplished through more frequent informal but agenda-
driven meetings directly among the principals. There have been
various attempts at this during my 4 years at OTS, but none
have been sustained or particularly successful.
I am pleased to say that we are trying again. We had our
first breakfast meeting on September 28, and Chairman Powell
assures me he has another one being scheduled.
We also need to do a better job of encouraging the staff to
bring disputes to the principals earlier in the process. Like
all staffs, ours have a tendency to want to try to resolve the
problems themselves, in part out of a respect for the
principals, but I suspect in part out of a concern that the
principals will not really understand what is at issue. The
principals themselves need to do a better job of forcing the
issue.
Finally, we need to do a better job of working together
across agencies. The unfortunate events of September 11 have
brought us closer again, reviving some of the spirit of working
together we felt in preparing for Y2K. We need more cross-
training, more work on each other's examinations, perhaps
details into other agencies, and interagency SWAT teams for
particularly tough or high-risk issues.
We have made very significant progress on this issue.
Within the past month, we have instituted a program of having
examiners from several agencies participate in exams of
institutions with securitization activity and the first such
exam is underway, and there is now a regular monthly
interagency meeting to discuss securitization issues. We are
laying a groundwork for a marked increase in multiagency
participation and exams in 2002.
I have obviously spent my time on suggestions about how to
improve the regulatory process, including the role of
accountants that relate to a series of issues that all seem to
have come together in the failure of Superior. And I do
certainly think that there is room for improvement and we
really have started to make improvement and, moreover, have
begun to complete actions that had started long before the
failure of Superior. However, it is useful to close with the
observation that regulatory action can only go so far. The
ultimate responsibility for the success or failure of any
depository institution rests with its owners and management.
Thank you very much.
Chairman Sarbanes. Well, thank you very much.
I just might note that President Bush has nominated James
Gilleran of California to become the Director of OTS. And his
confirmation hearing will be held on this Thursday, the day
after tomorrow. We wanted to get the hearing in with respect to
Superior obviously during your tenure, during your watch, since
you are familiar with the situation. But the Gilleran hearing
will be on this Thursday.
Mr. Reich, we would be happy to hear from you now.
STATEMENT OF JOHN REICH
DIRECTOR, FEDERAL DEPOSIT INSURANCE CORPORATION
Mr. Reich. Thank you, Mr. Chairman.
In my oral testimony, I will briefly summarize the issues
which I think make the Superior failure a matter of interest to
the Congress, the regulators, the industry, and interested
members of the public. And I will spend a few moments
discussing the lessons I think we have learned from the
institution's demise. At the outset, Mr. Chairman, I want to
make clear two very important points.
First, America's banking industry is safe and sound. While
we have some concerns--regulators, by definition, almost always
have some concerns--we are very comfortable with the stability
of our financial system and the failure of Superior Bank should
be viewed in that context, as an anomaly.
Second, I would like to stress that Superior failed because
of its own actions. Its board, its management decided to pursue
a risky lending and securitization strategy. By securitizing
loans on the riskier end of the spectrum and retaining large
portions of that risk in the bank, they pursued a business plan
that ultimately led to the thrift's demise.
While much has been made about the supervisory history of
Superior and the regulators' handling of this thrift, I want to
stress that the bank's owners and managers bear the
responsibility for the failure of Superior. That is not to say,
Mr. Chairman, that we regulators cannot learn valuable lessons
from the events which led to the failure, which should help us
in the future.
At the FDIC, we first noticed significant problems at
Superior Bank in late 1998. While the thrift was still highly
rated, our off-site reviews noticed the bank was taking on more
high-risk, subprime assets. We also noted the thrift
experienced significant growth in retained interest, often
called residuals, and mortgage-servicing assets. It was this
volatile combination which ultimately led to Superior's failure
in late July.
On the basis of this information, the FDIC did ask to join
the Office of Thrift Supervision January 1999 examination. That
request was denied.
The FDIC continued to monitor the thrift through off-site
reviews and following the January 1999 denial, the FDIC and the
OTS, in my view, subsequently worked well together to
understand and address the problems presented by Superior.
While the news in 1999 was troubling to the FDIC in our
capacity as the deposit insurer, the conditions in 2000 and
2001 did not improve. The risk in the bank continued to grow
and the regulators became increasingly worried about how the
volatile residual assets were being valued by the thrift.
Serious disagreements about the accounting methodology
prevented a timely resolution to this dispute. While the
regulators' view ultimately prevailed, the write-down in the
value of Superior's residual portfolio did not occur until
March of this year. This $270 million write-down crippled the
thrift's capital position.
The OTS, as the primary regulator, requested a
recapitalization plan that would have saved the thrift from
insolvency. In late May, this plan was finalized and was
scheduled to be implemented within 60 days, by late July 2001.
Ultimately, the owners failed to implement the plan.
While clearly financially capable of rescuing this thrift,
they chose not to do so. The FDIC was appointed conservator on
July 27, 2001. Our first priority as the conservator for
Superior was to ensure uninterrupted service for the customer
base in the Chicago area. The point of the conservatorship, as
opposed to an outright liquidation, was to preserve franchise
value. Any banker knows the franchise is only as good as its
satisfied customer base and we have made that our priority in
managing New Superior.
Since July, we have processed more than 60,000 customer
inquiries through our call centers and in-person consultations
to ensure as little disruption to the community as possible.
Taking care of insured depositors is our job and we take it
seriously.
We are making progress toward returning Superior to the
private sector by the end of the year. Bids for deposits are
due October 25. We have finished the initial marketing of the
residuals, the loan serving, and loan production platform and
final bids are expected in November. What lessons can we learn
from Superior's demise? I will mention three.
First, we must do a better job dealing with institutions
fitting Superior's relatively new and volatile risk profile.
Since 1998, several institutions looking like Superior have
failed, with the FDIC incurring more than a billion dollars in
losses. We must see to it that institutions engaging in risky
lending, securitization, and high retention of residual assets
hold sufficient capital to protect against sudden insolvency.
The regulators have offered an interagency proposal
requiring dollar-for-dollar reserves against residuals retained
within institutions and a limit on the overall amount of
residuals any one institution may hold. We expect a final rule
will be published in the Federal Register in late November. As
the protector of the insurance funds, the FDIC believes it is
important that we find a way to ensure that banks hold
additional reserves against such volatile assets.
Second, Superior taught us a lesson about the effectiveness
of the prompt, corrective action guidelines currently in the
law. PCA appears to be sufficient for handling all but a few
troubled bank cases. It is less effective in the handling of
instances where institutions suffer sudden shocks, like cases
of fraud or large write-downs of asset values.
Under the current PCA statute, the FDIC cannot take
separate action against non-FDIC-insured institutions until the
institution becomes critically undercapitalized. In cases like
Superior, when the institution becomes impaired very quickly,
this constraint prevents us from having time to take
meaningful, independent action to minimize the risk to the
funds. The FDIC believes that deposit insurers should have
additional authority under PCA rules to intervene before a non-
FDIC-supervised institution becomes critically
undercapitalized.
The last lesson to be learned and perhaps the easiest one
to resolve is the need to improve FDIC access. While some of
the post-Superior discussion focused on the relationship
between the OTS and the FDIC, the plain truth of the matter is
that both agencies worked well together for more than 18 months
dealing with a very troubled institution.
It is also fair, however, to point out that two sets of
eyes earlier in the process might have mitigated a portion of
the loss to the insurance funds. In part, this is a shortcoming
of the FDIC board's own internal procedures.
We intend to review--in fact, we are reviewing--whether our
own board's special insurance examination policy is inhibiting
our ability to determine the risk which non-FDIC-supervised
institutions pose to our funds.
All of these lessons are important.
In conclusion, I appreciate the opportunity to represent
the FDIC here today. I look forward to working with you and our
fellow financial regulators to implement these necessary
improvements.
I will be happy to answer questions.
Chairman Sarbanes. Thank you very much, sir. We appreciate
your testimony. I first want to focus on this regulation that
we are now assured is about to happen.
After Keystone Bank failed in September 1999, 2 years ago,
and that resulted in losses of close to $800 million, the
Federal banking regulators in September 2000, promulgated a
proposed rule to impose stricter capital rules and limit the
concentration of residuals, is that correct?
Ms. Seidman. [Nods in the affirmative.]
Chairman Sarbanes. That was a little over a year ago. The
comment period for the proposed rule closed on December 26,
2000, about 10 months ago. And as yet, there is no final rule.
Now in a letter to the regulators, they indicated to us,
``. . . for the last 8 months, the agencies have been working
to balance the industry's comments with supervisory concerns.''
I know you are now assuring us you are going to get this
rule in the near future. But I am interested to find out why it
took so long to get to the rule, accepting the assurance for
the moment that the rule is about to come.
Let me say that I obviously have some quizzical response to
that given the past record. As you prepare to answer that
question, I want to read from a comment letter in which a
thrift president complained that the proposed capital
requirements in the new rule--this is a comment during that
comment period after you put out the proposed rule--``. . .
would impose stringent capital limits and penalty capital
requirements on institutions whose practices do not warrant any
such treatment.''
That letter adds that the thrift has a proven track record
and, ``. . . depth of expertise in securitization activities. .
. .'' We have done so without taking on undue liquidity,
credit, or interest-rate risk. Now that was a letter submitted
during the comment period on December 22 of last year and the
letter obviously came from Superior Bank. Now why has it taken
so long to move on this rule?
Ms. Seidman. Let me answer that question in a couple of
ways.
First of all, the comment letter from the Halloran was by
no means the only comment letter that read like that. And as to
the representations Mr. Halloran made in that letter, those
were representations that were already under serious question
by both the OTS and the FDIC at the time he wrote the letter.
In terms of the interagency process, the interagency
process is a difficult process. While the residual rule has
taken 8 months, the recourse and direct credit substitutes rule
has taken 8 years. It is a difficult process in part because
each regulator looks at things slightly differently. We need to
work together. We need to work hard to ensure fairness across a
wide range of institutions and, in the case of the residual
rule, we had to make sure that its very technical requirements
did not conflict with the even more technical requirements of
the recourse and direct credit substitutes rule which deals
with a greater part of the same issue.
My staff in 1998, when bank regulators adopted limitations
on purchase credit card relationships, nonmortgage servicing
rights, and mortgage servicing rights, was pressing very hard
for limitation also on residuals. It is part of the interagency
process that it did not happen then. I am sorry it took the
failure of Superior to move it along now, but it has moved
along and it will be final.
Chairman Sarbanes. When was the proposed rule put out on
the recourse rule?
Ms. Seidman. There have been several proposed rules. There
was one in 1993. The most recent proposed rule was, I believe,
in 2000, but I am not sure. Can I just ask my staff ?
[Pause.]
Sometime in 2000.
Chairman Sarbanes. Well, on the residuals the agencies were
able to get together within a year 's time and propose the
rule. Is that correct?
Ms. Seidman. Senator, it is much easier to get together on
a proposal than it is on a final rule, frankly. On a proposal,
while you do a lot of work to reconcile different perspectives
and different ways of looking at things and making sure you
have it right, you know that the comments coming back will help
you sharpen your pencil and help you sharpen the rule when it
finally becomes final. Moreover, a proposal is not binding on
the industry. So there is a lot more flexibility to get to yes
on a proposal. The final rule is really what counts and what is
so difficult.
Chairman Sarbanes. Now when you got this comment letter,
you had already focused on Superior as a real problem case?
Ms. Seidman. Oh, certainly, sir. As you know, the focus on
Superior started in early 1999. By late 1999, both the FDIC and
the OTS were very seriously concerned with the institution
and----
Chairman Sarbanes. When you got this letter, did it
heighten your concern about Superior?
Ms. Seidman. It did not particularly heighten our concern.
We knew that--first of all, it was a comment letter on a
regulation. The issues that Mr. Halloran raised in those
letters were issues we were already aware of and concerned
about. By not very many months after that letter was written,
Superior's CAMELS rating was dropped to a ``4'' by both
institutions.
Chairman Sarbanes. And the fact that you had the president
and managing officer telling you in December everything is just
terrific here in the course of arguing against your proposed
rule, did not move you to quicker action?
Ms. Seidman. I think we acted quite quickly. The next
examination started in January and at the time it ended----
Chairman Sarbanes. Now is that the examination that the
FDIC participated in?
Ms. Seidman. Yes, that was the January 2000 examination
that the FDIC participated in.
Chairman Sarbanes. The one where you were turned back.
Ms. Seidman. 1999.
Mr. Reich. 1999.
Chairman Sarbanes. 1999.
Ms. Seidman. January 1999. And by May 2000, when that exam
closed, both the FDIC and the OTS had rated Superior a ``4''.
Chairman Sarbanes. Now am I correct that a failure of
another institution somewhat with the amount of loss, somewhat
larger than is now being estimated for Superior, would bring
the fund ratio below 1.25 percent and trigger the fees?
Mr. Reich. No, sir, that is not correct. Of course, at this
moment, we do not ultimately know what the final cost of the
Superior resolution is going to be. We have reserved currently
approximately $300 million for Superior. The asset sales that
are scheduled to take place later this month and in November
will diminish the loss. But the BIF is currently at a ratio of
1.32, 1.33. The SAIF is at 1.40. And we do not believe that the
loss will bring the ratios down below 1.25.
Chairman Sarbanes. How much more of a loss would the SAIF
have to experience to go to 1.25 and trigger the fees?
Ms. Seidman. The number has to be more than double, well
more than double the amount.
Mr. Reich. It would be a very large number and we do not
anticipate being at that level any time in the near future.
Chairman Sarbanes. What would the number be? We must know
what the number is.
Mr. Reich. I believe each basis point would represent about
a $17 billion charge to the fund. So to lower the fund from its
present level, the BIF from 1.32 to 1.25, 7 basis points----
Chairman Sarbanes. Would be about $800 million, would it
not?
Ms. Seidman. I think you have the BIF and the SAIF
confused.
Chairman Sarbanes. No, I am doing the SAIF.
Ms. Seidman. Yes. The BIF has a lower capitalization right
now than the SAIF.
Chairman Sarbanes. Right.
Ms. Seidman. The SAIF is at 1.40. So it is 15 basis points
above 1.25. A portion of the Superior loss is already in the
reserves that are counted into the 1.40. To get to 1.25, you
are probably going to need an additional $1.5 billion loss,
give or take, and none of these numbers, mind you, include any
recover from parties who we believe should be the subject of
enforcement action.
Chairman Sarbanes. Well, we will check these figures out. I
have a different set of figures that I am looking at, and we
need to ascertain those. And we will probably give you some
follow-up questions in that regard.
Mr. Reich, in an article you wrote in The American Banker
in August, you said about 1\1/2\ percent of insured
institutions have significant subprime portfolios. Yet, these
lenders represent about 20 percent of the banks on the FDIC's
problem bank list. We regulators must make sure these lenders
hold enough capital to cover the risks they face.
In The Washington Post, in an article entitled, ``A
Practice That Lends Itself To Trouble,'' it said, of the
hundred banks on the problem bank list, 15 are subprime
lenders. Seven of the 21 bank failures since January 1998, were
institutions, including Superior, that were involved in
subprime lending. What can the panel tell us about the risks
associated with subprime lending?
Mr. Reich. Well, first of all, I would say that subprime
lending in and of itself is not a bad activity for banks to be
engaged in. That is how many banks satisfy their Community
Reinvestment Act requirements. Most banks have lending officers
well qualified to make loans that would be categorized as
subprime loans and in and of itself, it is not an activity that
should raise concern.
But when there are targeted programs that require special
expertise, the regulators have a responsibility to make certain
that the people in those institutions are managing those
activities appropriately and that the banks have capital
requirements that take the additional risks that are attached
to subprime lending into consideration.
As those articles indicated that you quoted, we have about
100 banks on our problem loan list at the present time, and of
those 100 banks, about 20 are institutions that are engaged in
subprime lending. And the most recent statistics regarding the
number of institutions which have been failed, you mentioned 7
in 21, it is now 8 of 22 institutions that have failed, have
been significant subprime lenders.
Ms. Seidman. I agree with what Director Reich has said,
although I would point out that one can meet one's CRA
obligations with prime lending also. But it is important that
we recognize a couple of things here.
One is that it is not just subprime lending that is at
issue here, although subprime lending, particularly when done
in a program form, which is what our guidance in March 1999,
January 2001, and then the Q and A's in August this year, are
all about, does require substantially better expertise, risk
management, reserving, and capitalization, than a similar
business done on a prime basis.
What you had here and what a number of other subprime
failures have involved is a combination of subprime lending,
then securitization, and then residuals. That is why it is so
critically important for us to get at this residual issue,
because it will really help us make sure that the capital that
is held against subprime loans is real capital.
Mr. Reich. If I could, Mr. Chairman, I would like to add,
one of my concerns that I expressed in the op-ed, or that
resulted in the op-ed, was that when the interagency guidance
was issued on subprime lending, we distributed it to 9,700
insured institutions, at a time when there were approximately
150 insured institutions engaged in subprime lending,
subsequently, arousing the concerns of several thousand bankers
concerned about whether the types of loans that they make in
the normal course of business, many character loans that every
bank makes every day of the week, would be categorized as a
subprime loan and would jeopardize or make the bank exposed to
having to maintain a capital level of perhaps up to 3 times
their normal capital.
At the FDIC, at our outreach efforts, and at our meetings
with delegations of bankers who come for briefings at the FDIC,
we have tried to assuage their concerns that the interagency
guidance was intended for a narrow group of banks which have
targeted lending programs specializing in subprime lending.
Chairman Sarbanes. Professor Kaufman, who is going to be on
the next panel, in his statement submitted to the Committee,
says that in the case of Superior, a number of red flags were
flying high that should have triggered either a rapid response
by regulators or continuing careful scrutiny.
And he then mentions Superior's rapid asset growth from
1996 to 2000, a large percentage of risky, nontraditional
assets, such as residuals. Superior held more than 7 times the
residual assets of any other savings institution, as this chart
shows.
This is Superior and these are the other--well, I have a
big one here. It is a pretty dramatic contrast.
Ms. Seidman. When is this? I am sorry.
Chairman Sarbanes. That is Superior over there on the left,
and these are----
Ms. Seidman. Excuse me? What period is this?
Chairman Sarbanes. This is in March 2001. A year earlier,
they held residuals in excess of 300 percent of Tier 1, and 2
years earlier, they held 200 percent.
He also mentions well above market rates Superior offered
on deposits, including broker deposits, and the high percentage
of off balance sheet recourse obligations held by Superior.
Now, at what point did these red flags attract your attention?
Ms. Seidman. I would say they attracted the FDIC's
attention at the end of December 1998, and attracted our
attention soon after. We actually were first--we were initially
concerned about the automobile program, which is another
subprime program, which we eventually got them to shut down in
December 2000.
Professor Kaufman is absolutely right. But what is also
clear is that the enhanced scrutiny and action that he was
talking about was happening. There was definitely enhanced
scrutiny in this institution from at least mid-1999 on. This is
easily lost because as the institution had to take greater
capital hits because of revaluation or increased loan loss
reserves, the percentage of residuals kept going up. But by
June 2000, we had gotten the institution to cease securitizing.
And it therefore was creating no additional residuals. The
percentage kept going up because the capital kept going down.
But the institution was creating no new residuals.
We had worked with them to put a number of limitations on
their activities. The auto activity in particular was stopped,
to improve their underwriting, to stop some of what they were
doing.
In July 2000--this is a year before the institution
failed--we told them to stop taking brokered deposits, which
they did. They were able to hold onto the ones they had, but
they could not renew brokered deposits and they could not take
new ones. This, by the way, is part of the reason for--this
plus the way Superior reported its uninsured deposits--the
precipitous drop-off in uninsured deposits that I know Mr. Ely
has talked about.
By late 2000, both the FDIC and the OTS not only were
working with Superior under Section 39 of the FDIA, which is a
much more flexible section than PCA in a situation where
reported capital is higher than it should be, but there are
problems. And that is what we were working under, when we got
in, the 2000 audit report.
Superior's financial year ran from June to June. The June
2000 audit report was delivered in October, at which point both
the FDIC and the OTS started pouring over not only the audit
report, but also all the work papers. It was at that point that
we realized notwithstanding the representation that the
overcollateralization accounts were being accounted for
properly, they were not. It was not until January 2001,
however, that we could get a national partner at Ernst & Young
to agree with that conclusion. At that point, the write-downs
were very large and as Director Reich pointed out, what had
been a problem that could have been solved suddenly became a
very precipitous problem.
Now this problem still could have been solved. The people
who own this institution not only have the resources to solve
the problem, but also had promised to solve it, and then walked
away a mere week before the deadline, making it impossible for
us to find an alternative solution.
Chairman Sarbanes. Well, an article in--and I want to give
you a chance to respond to all of this because there is a lot
out there in the press--The National Mortgage News, in August
of this year, entitled, ``Residual Mess Kills Superior,''
quotes an investigator who said, ``The OTS knew about the poor
assets on Superior's books since last July. Why did they sit on
their haunches and diddle with Ernst & Young for 6 months
arguing about what they, the residuals, were worth, and then
diddle another 6 months negotiating with the Pritzkers?'' How
do you respond to that?
Ms. Seidman. Whoever wrote that had what in August was a
perfectly understandable distorted view of the facts. It was
less than a month since the failure and the facts have really
only begun to come out, in part, as a result of this hearing
and many, many, many more facts will come out as part of our
enforcement investigation and the other actions, the other
investigations that are going on.
It is clear from my testimony that we did not sit on our
haunches and diddle. We took a whole series of regulatory
actions and any number of them were indeed successful. As I
have said in my oral statement today, if I had to do it over
again, the one thing I would have done is not get more promises
from the management and board of this institution, but work
more diligently at making sure they actually implemented what
they had agreed to implement.
As to the capital plan, the plan would have infused a
very--hundreds of millions of dollars--significant amount of
money, into this institution. It was a capital plan that was
backed by people who were perfectly capable of proceeding with
it. The fact that they chose to walk away a week before the
date they had promised to implement it--mind you, this was a
sudden move on their part.
Until July 16, the capital plan had a number of other
things that were required. Shedding employees, closing
unprofitable business lines, negotiating with Greenwich Capital
for some financing. All of that was happening. The capital plan
was being implemented. And then the owners walked away.
I do not regard that as diddling. I regard that as
unfortunate and I regard that as something that will be
discussed in a number of investigations and enforcement
actions.
Chairman Sarbanes. Well, now, Mr. Ely, in his statement,
which comes later, states that the OTS failed to recognize a
fundamentally flawed business model Superior adopted when it
acquired Alliance Funding at the end of 1992. Instead, the OTS
appears to have permitted Superior to pursue that model for
over 8 years until its closure on July 27.
The linchpin of Superior's flawed model was retaining the
worst portion of its asset securitizations. Hence, we see the
steady build-up of dubious, nonmainstream thrift types of
assets on Superior's balance sheet. Worse, it appears that
these assets were consistently overvalued for many years.
Had the OTS taken a greater initiative to independently
establish conservative valuations of Superior's securitization-
related assets, Superior would have been forced to adopt a more
profitable business model or sell itself to a stronger
financial institution. And he makes the point that the failure
of the First National Bank of Keystone should certainly have
set off alarm bells and that there was a failure to appreciate
the extent to which Superior was an outlier among thrifts. It
was far from being the typical post-FIRREA thrift. What is your
response to that?
Ms. Seidman. My response is that this is a case of rather
gross overstatement.
First of all, mortgage banking, which was Superior's
baseline business plan, is a common business plan not only in
the thrift industry, but also in the banking industry, and it
is becoming more so, and in fact, has kept the thrift industry
healthy during the period of low flight yield curve that we had
several years ago. So the basic model of mortgage banking is
not flawed.
Chairman Sarbanes. Let me continue on that point. Mr. Ely
says, for example, at the end of 1997, almost 4 years before
Superior failed, it had almost 7 times--seven times--as much
invested in the asset categories containing securitization-
related assets per dollar of total assets as did the rest of
the thrift industry.
Ms. Seidman. Senator, I am not going to argue with Mr.
Ely's point that this was an outlier. It was.
Chairman Sarbanes. Well, why wasn't it----
Ms. Seidman. I am going to argue that at least beginning in
1999, we were very much on top of it. We were moving it to
shrinkage. We had stopped by the middle of 2000, the creation
of new residuals. And we had some extraordinarily wealthy
people agreeing that they would put this institution whole.
Chairman Sarbanes. Let us take 1997. This is the figures I
am giving you now.
Ms. Seidman. No, I hear you.
Chairman Sarbanes. And the assertion behind this statement
is that, as he says here, even a rudimentary comparative
analysis of Superior's TFR data with thrift industry data
should have flagged it as an outlier worthy of special
attention years before it failed.
Ms. Seidman. Senator, whether it should have flagged it in
1997 is something I guess we can argue about now.
What I know is that a full 2\1/2\ years before this
institution failed, at a time when the problems were a good
deal smaller, we were aware of it. And I would like to read
you, one of the other things that Mr. Ely does in his testimony
is talk about how the private sector was on top of this and
really was far ahead of the regulator.
In May 1999, at a time when the OTS and the FDIC were
downgrading this institution to a ``4'', here is what Fitch,
which rates the institution's long-term debt a triple B, which
is investment-grade, had to say about how Superior accounted
for residuals.
Important to evaluating the company's performance is our
assessment that Superior uses appropriate assumptions in
recognizing FAS 125 income. That is scale on sale income.
Furthermore, the company's process for valuing related
financial receivables, recognizing adjustments on a quarterly
basis when applicable, is viewed positively.
This was May 1999. We did not downgrade it until May 2000.
But by May 1999, both we and the FDIC knew there was an issue
here, and it was an issue, at the very least, of concentration
and perhaps of valuation. It is always easier to see these
things in hindsight.
Chairman Sarbanes. That is quite true, but the question
then becomes, as we are trying to think ahead for the future,
if you are sitting there telling us, we did everything right,
and even here a couple of years just before the thing fell flat
on its face, we started to move, what does that say about our
process? Are we going to have another Superior that comes down
the road the same way?
It seems to me you had all kinds of signals that this
outfit was outside anything approximating a normal parameter
for activity in the industry. That seems to me very apparent.
And yet, it went along until it got to desperate straits.
Ms. Seidman. Senator, I do not disagree with you. And in
fact, as Mr. Ely also mentions in his testimony, there was
another institution, another thrift that was in similar straits
at approximately the same time. We were able to successfully
work with the owner of that institution to have a voluntary
liquidation, a liquidation which occurred with no loss to the
insurance fund, no loss to uninsured depositors. Mr. Ely
mentions it, never mentions why that institution had a
voluntary liquidation.
Senator, our track record is not perfect. The people who
owned this institution, much to our surprise, walked away from
it after having promised to put it back together again. But it
is a track record I am proud of and that I am pleased to leave
my successor.
Chairman Sarbanes. It is not an adequate response to a
particular problem situation to say to me, we have done well in
all these other instances, if, in fact, you were deficient in
handling this instance.
Ms. Seidman. Senator, I have agreed with you.
Chairman Sarbanes. It is relevant to saying, this agency is
not a complete flop. But I am not asserting that and that is
not what we are trying to get at. But for you to sit there at
the table and then say, we did the other things right, but we
did not do this thing right, what can we do about this thing
that was not done right to make sure that it does not happen
again?
Ms. Seidman. Senator, I have a couple of responses to that
and I am pleased to hear you say that it is not the agency's
overall record that you are going after.
Chairman Sarbanes. I am not going after anything. I am just
trying to find out what we can do to improve this situation.
You do not have to be overly defensive. Just try to address
that aspect.
Ms. Seidman. The first thing is, as I have mentioned in my
testimony, there are a number of things that we are doing.
Given that the problem is this combination of heavy investment
in subprime, securitization, and residuals, the new regulation
should make a major difference and, moreover, the programmatic
subprime guidance that we issued should also prove extremely
helpful. So there is activity that is going on, and it is all
described in both my written statement and my oral statement.
Chairman Sarbanes. Why did the OTS deny the FDIC's written
request to join the OTS in the examination of Superior in
January 1999?
Ms. Seidman. Senator, the reason that the OTS regional
office, and this was an action that was carried out entirely
between the FDIC and the OTS regional offices in Chicago. No
one at either institution in Washington knew what was going on.
The reason related to Superior's concerns that they had ongoing
litigation with the FDIC.
Would I have made the same decision at that point? I hope
not. And when it came to my attention in September 1999, after
the Keystone failure that we had in fact once denied a
request--and mind you, even the FDIC IG has not found any other
instance in which we did that--my immediate reaction was to say
to all of my regional directors, you do not do that. And if you
have any reason why you think it might be a good idea to do
that, you have to get that up to Washington so we can talk at a
Washington level about whether this makes any sense at all.
It has never happened since. The work that we are doing in
this task force, which includes my senior supervisory people,
as well as the senior supervisory people from the FDIC, the
OCC, and the Fed, will ensure that a new protocol is in place
so this issue will not arise again.
Chairman Sarbanes. Mr. Reich, what authority do you think
the FDIC should have to go in and join in an examination?
Mr. Reich. Well, frankly, Mr. Chairman, under ideal
conditions, I would like for the FDIC to have the authority to
go into any institution regardless of its CAMEL rating,
whenever we believe that there are reasons that may develop
that could subject the FDIC fund to exposure.
Chairman Sarbanes. Do you have a problem with that, Ms.
Seidman?
Ms. Seidman. That is a standard that is--as stated, and I
suspect that Director Reich does not really mean to put quite
so many qualifiers on it--it is a standard that would lead to
the possibility of the FDIC being in thousands of institutions
in this country.
The CAMELS ratings are not necessarily dispositive of the
issue of whether there is risk to the insurance fund. And that
is what we are working on in the renegotiation of this
protocol, which, as I said, includes all four agencies, not
just the two of us.
Chairman Sarbanes. So, you would not allow them to go in if
they judged----
Ms. Seidman. No, it is not that I----
Chairman Sarbanes. --that there was a reason to go in.
Ms. Seidman. If they judged that there was a reason to go
in, yes, we would say, yes.
Chairman Sarbanes. Then what was wrong with his statement?
Ms. Seidman. I believe Director Reich's qualification was,
if we thought there might be a possibility of a risk. That is
further away than we think there may be a problem here. Let us
go in and take a look. But, you know, Senator, I believe that
when this protocol is finished, all four agencies will feel
very comfortable with it, including the FDIC, and it will not
get finished if the FDIC does not feel comfortable with it.
Chairman Sarbanes. When is that protocol going to be
finished?
Ms. Seidman. Well, we were hoping to get it done by the end
of the month. There is a little bit of hold-up now. I just
heard about that this morning. Since I firmly believe that this
is one of those situations where if you tell the senior people
who have to live with this year after year, and get it done in
a way that the kind of problems that arose in this case will
not arise again, they will, I have left it to them and am
awaiting their response.
Chairman Sarbanes. We are very interested in that protocol.
Ms. Seidman. And it will be arriving.
Chairman Sarbanes. We are interested in, partly, why it has
taken so long, and of course, we are interested in the
substance of what the rule will embrace.
Ms. Seidman. One important element of it is that the last
one did not include the Fed. The same issue arises with respect
to State member banks as does with OTS or OCC regulated
institutions. So that by adding the Fed to the discussion this
time, we will end up with something much stronger.
Chairman Sarbanes. Is there anything else you want to add?
Mr. Reich.
Mr. Reich. Yes. I would like to review a little history
with respect to the current rules under which the FDIC board
operates.
It was, in 1995, during a time when the FDIC board was
composed of just three members--the FDIC Chairman, the OCC
Comptroller of the Currency, and the Director of the OTS--there
was a board resolution passed by a vote of 2 to 1, which
prohibited the FDIC from exercising back-up examination
authority unless it was brought to the attention of the board
of directors of the FDIC.
This had an inhibiting impact on our ability to engage in
back-up examination authority. And it is always a risk that
will exist as long as the board is composed of members, of the
current membership of the board and jeopardizes the FDIC when
we do not have a full board and places the Chairman of the FDIC
potentially at a disadvantage, unfortunately, in instances that
could only be described as turf wars, with the other
regulators.
Chairman Sarbanes. Yes, what is the problem with the FDIC
coming in and engaging in an examination if they think there is
a problem? I am asking Ms. Seidman. What is the problem with
that?
Ms. Seidman. If they think there is a problem, there is no
problem with them coming in. The issues that we are dealing
with are issues that are fairly important. How many examiners?
When? Do we go in together? Do we issue a joint examination
report? What is the role of the primary regulator in dealing
with the board of directors? Because in the old days, in the
pre-1995 days--and I was not here--there was difficulty in that
respect.
Chairman Sarbanes. What was the difficulty?
Ms. Seidman. The difficulty arose when the FDIC, in a
training mission, sent 27 examiners into a small institution,
or when the FDIC met with the board after the OTS met with the
board. There are things that can be solved by people of
goodwill. And the reason why going back to this 1995 protocol
is so troubling to me, is I have sat on the board of the FDIC
now for 4 years. I have been an extremely active member of that
board. I have sat on the FDIC audit committee for 4 years, a
rather thankless job.
I believe in the FDIC every bit as much as I believe in my
own organization. I have sat on the FDIC board with a full 5
member complement. I am sorry the staff feels intimidated
because I really do not believe that they should or need to.
Frankly, it is the nonindependent board members who would never
in a board case brought by the FDIC staff to take independent
regulatory action, say no at the board level.
I wish there had been a full FDIC board all the time that I
was there. It was good while it was there. And the 5 member
board is terrific. But, unfortunately, that tends to be
dependent on a lot of other things, including the whole
Presidential nomination process.
Chairman Sarbanes. Do your regional people have the
authority to keep the FDIC out?
Ms. Seidman. No, absolutely not. That is what I said
earlier, that as soon as I found out----
Chairman Sarbanes. Well, they must have had the authority
because they did it. You had your regional people in Chicago.
The FDIC people wanted to go in and participate in the
inspection, as I understand it. Is that correct?
Ms. Seidman. That is correct.
Chairman Sarbanes. The OTS regional people said, no, we are
not going to let you come in. Is that right?
Ms. Seidman. That is correct. But I think it is important
to recognize what happened next is they reached an agreement
that the OTS would pass on all of its exam work papers and make
available to the FDIC all of its examiners before the exam
ended and act as a conduit to bring anything back that the FDIC
wanted to have brought back.
Now, do I think that that was a great solution? Certainly
not in hindsight, and I hope I would not have then.
Chairman Sarbanes. Do you think your regional OTS people in
Chicago should have had the authority to deny the FDIC request?
Ms. Seidman. They did not in fact have the final authority.
If the FDIC regional office in Chicago had brought that to
Washington's attention, there would have been conversations and
something else would have happened.
What we are saying now is we are not leaving it to the
regional offices who have to work together day after day on
issue after issue, to have to take an appeal. We are saying,
no, you cannot deny it at the regional level, period, end of
issue. If you are even thinking about it, it needs to go to
Washington. We do not want to force the FDIC regional offices,
who have to have a good working relationship with the regional
offices of the other regulators, into an appeal position.
Chairman Sarbanes. What is the OTS position today--let me
quote a statement of yours in a hearing before the House
Banking Committee in February 2000. ``We have one policy . . .
the door is always open. We have told our regional directors
that whenever the FDIC asks to go into a thrift, that request
must be honored. A second set of eyes is a benefit when an
institution is showing signs of stress. And in numerous
instances, we have sought out FDIC participation in examining a
problem institution.''
But the first sentence here is, ``. . . we have told our
regional directors that whenever the FDIC asks to go into a
thrift, that request must be honored.'' Is that your position?
Ms. Seidman. That is exactly our position. That is our
position, that statement was dated February 2000.
Chairman Sarbanes. February 8, 2000.
Ms. Seidman. Right. It came after Keystone. It came after I
found out for the first time in September or October 1999, that
there had been a denial in January 1999.
Chairman Sarbanes. Then how do you differ with Mr. Reich a
little earlier in this conversation we were having when in fact
you now say, ``We have told our regional directors that
whenever the FDIC asks to go into a thrift, that request must
be honored?''
Ms. Seidman. The only way I am really differing with Mr.
Reich is that Mr. Reich's initial standard that he set forth
was a standard that I suspect the FDIC would not, in fact, use
in deciding whether to go into an institution. The FDIC's
standard is, in fact, are we concerned that there may be a
problem here? And when they use that standard, the answer is
yes.
Chairman Sarbanes. Well, we have the other panel. We have
to move along. We are interested in finalization of this
regulation.
Ms. Seidman. It will happen.
Chairman Sarbanes. We intend to follow that very closely.
And we may well hold further hearings on this issue. But we
have to tighten up this protocol. My reaction to all of this,
both the written testimony and the factual examination and this
examination today, is that the protocol is lacking.
Ms. Seidman. It is. That is why we are working on it. It
will be tightened up and it will include the Fed this time.
Chairman Sarbanes. Mr. Reich, anything else you want to
add?
Mr. Reich. Well, I would echo your comments about the
importance of updating the capital rules with respect to
residual assets. There are today about 10 institutions which
have 25 percent or more of their capital in subprime residuals.
We are closely monitoring those institutions and do hope that
by the end of November this rule is, in fact, published in the
Federal Register.
I would want to emphasize that the FDIC in no way wants to
examine all the banks in the country all the time. We do not
have the staff, the resources, or the capability to do that.
What we do want to do is to examine those banks that we think
bring potential risk to the insurance fund. There may have been
instances in the past--I am not aware of them, but I would not
dispute that they occurred--where we have put too many
examiners in a bank in a given situation. And my experience
with the FDIC in the past 9 months, what I have seen on the
part of our supervisory people is a desire to have a small
number of people, and in some cases, one or two, in given
situations to explore particular problems.
That was our original intention with Superior in December
1998, when our capital market specialist identified the
increasing problem with residual asset growth on the balance
sheet of Superior Bank, and our intent would have been to send
one or two people--this is hindsight testimony at this point--
had we joined the January 1999 examination.
Chairman Sarbanes. Thank you all very much.
If the other panel would come and take their places at the
table, we will proceed in just a couple of moments.
[Pause.]
First of all, I want to thank the witnesses for their
patience and for their coming back to be with us again. We have
three experts on the banking industry with us: Mr. Bert Ely,
the President of Ely & Company of Alexandria, Virginia; Dr.
George Kaufman, who is the John F. Smith, Jr. Professor of
Finance and Economics at Loyola University Chicago; and Karen
Shaw Petrou, the Managing Partner of Federal Financial
Analytics here in Washington, DC.
We very much appreciate your being with us. We have your
full statements, and, of course, those will be included in the
record.
If you could summarize, I will go across the panel, take
each of your statements. We ran a little long with the other
panel, for obvious reasons. So, if you could compress it, we
would appreciate that.
Mr. Ely, why don't we just start with you and we will move
across the panel to Dr. Kaufman and Ms. Petrou, you will be
last but not least, I assure you.
STATEMENT OF BERT ELY
PRESIDENT, ELY & COMPANY, INC.
Mr. Ely. Mr. Chairman, thank you very much for the
opportunity to testify today. I have prepared an oral
statement, but in the interest of time, I will condense that
down by skipping over the first portion of it and touching on
what I see as the failures of the regulators and, specifically
the OTS in the Superior situation, as well as my
recommendations for future legislative action.
Some of this you picked up on yourself in your questioning
of the previous panel. But what is important to emphasize is
that the OTS did fail to recognize the fundamentally flawed
business model that Superior adopted back in 1992, when it
acquired Alliance. Key to Superior's flawed model was retaining
the worst portion of its asset securitizations. But also,
again, as you mentioned, the OTS apparently failed for years to
appreciate the extent to which Superior was an outlier among
thrifts.
It was far from typical, almost from the very beginning.
But also, Superior did not reserve adequately for future loan
charge-offs and asset write-downs, constantly causing its
capital to be overstated. It also relied heavily on nonretail
deposits, including brokered deposits, to fuel the growth and
funding of its securitization-related assets.
Especially troubling was its gathering of uninsured
deposits and what I found particularly troubling is the fact
that even after it was well known that Superior was on the edge
of failure, that uninsured deposits were allowed to grow by
$9.6 million in the second quarter of this year.
Another problem that Ms. Seidman does address in her
written testimony, but I still find astounding, is the extent
to which Superior was filing flawed and clearly erroneous
thrift financial reports to the OTS. This constituted the only
publicly available information on the institution which would
impair the ability of uninsured depositors and other creditors
to properly assess in a timely way the financial condition of
Superior.
Also, I do not think the FDIC is blameless, either.
Although it raised concerns about Superior in late 1998, the
question I would pose is, did the FDIC pound the table hard
enough about Superior's declining condition? Frankly, I doubt
it. Also, the FDIC appears not to have developed a ``Plan B''
to execute if the Pritzker/Dworman recapitalization plan for
Superior fell through. This unpreparedness is evidenced by the
fact that the FDIC had to place Superior in a conservatorship,
in my opinion, will add to its insolvency loss.
Turning to some broader regulatory issues, there have been
35 FDIC-insured bank and thrift failures since the beginning of
1995. Three of them--Superior, Keystone, and BestBank--account
for $1.8 billion, or about 87 percent of the FDIC's losses,
since 1995.
The loss amount in these three failures is so high because
the insolvency loss percentage in these failures is high,
ranging up to 78 percent in the Keystone caper. Despite the
regulators' best efforts, though, there will be the occasional
failure of small institutions, the ``fender-benders'' of
deposit insurance. Of the 35 failures since 1995, 23 were
fender-benders. In my opinion, they do not represent a major
public policy concern.
Whenever we see a high-loss percentage, that strongly
suggests the regulators moved far slowly in resolving a failing
institution. Rather than trying to save a bank to keep it
independent, regulators should become much more aggressive in
forcing weak institutions to merge into stronger institutions
or to liquidate prior to insolvency. In light of the recession
triggered by the September 11 terrorist attacks, it has become
even more imperative than ever that regulators move quickly to
resolve troubled banks and thrifts. Let me just close by moving
on to some specific legislative recommendations.
First, there has to be more frequent and conservative
valuation of risky assets by the regulators.
Second, the bank regulatory agencies need to develop their
own capabilities to detect fraud and to value all types of bank
assets. It is inexcusable for the regulators to constantly try
to lean on and, frankly, pass the blame to the outside
accountants. The outside accountants do not work for the
Government. They do not work for these agencies. The agencies
need to be able to act independently on their own.
Third, it is not necessary to raise the capital standards
for intervention under Prompt Correction Action, as raising
those trigger points by a few percentage points will do nothing
to prevent bank failures with high-percentage losses.
Fourth, the FDIC should levy losses above a certain
percentage of a failed institution's assets on the State or
Federal chartering agency for that institution, since it is a
chartering agency that, in the final analysis, makes the
closure decision.
Fifth, there need to be tough sanctions and even job
terminations for high-level personnel in the agencies
responsible for supervising a failed institution with a high-
loss percentage.
Sixth, I agree with Director Reich that the FDIC's
intervention powers should be strengthened, particularly when
off-site monitoring suggests a lower CAMELS rating than the
chartering agency has established.
Seventh, it is also important to give the FDIC greater
power to force the closure of State-chartered institutions.
That is an issue that was not present here, but it did come up
with regard to the BestBank situation.
Eighth, it is also important to recognize that sufficiently
high, risk-sensitive premiums would provide weak banks with a
powerful financial incentive to recapitalize or to sell before
insolvency is reached.
Ninth, I am troubled that the FDIC seems to back away from
the notion of charging weak institutions the premiums that they
should be charged. The FDIC has been exploring the idea of
relying upon reinsurance premiums to establish risk-sensitive
premium rates for large banks. I do not think that that is
feasible since a reinsurer must not only take into account a
bank's insolvency risk, but also the greater risk that the
chartering agency will move too slowly to close a failing bank.
Finally, it is important that there be public notification
that amended thrift financial reports and bank call reports
have been filed with the regulators to alert depositors and
outside analysts to a possible decline in a bank's financial
condition because of the amended return.
In closing, the Superior Bank failure is quite troubling,
coming on the heels of the unnecessarily expensive Keystone and
BestBank failures. Congress needs to probe deeply, as you have
been doing today, into the regulatory failings underlying these
failures and to respond to their causes and not their symptoms.
Mr. Chairman, I thank you and I welcome your questions.
Chairman Sarbanes. Thank you very much. That was a very
helpful statement and we very much appreciate the care and the
thought that went into it.
Dr. Kaufman.
STATEMENT OF GEORGE G. KAUFMAN, Ph.D
JOHN F. SMITH, JR. PROFESSOR
OF FINANCE AND ECONOMICS
LOYOLA UNIVERSITY CHICAGO
Mr. Kaufman. Thank you, Mr. Chairman. I will summarize my
long written statement which I submitted for the record.
Chairman Sarbanes. Yes, the full statement will be included
in the record.
Mr. Kaufman. What is important is not so much that Superior
failed--bank failures have been infrequent in recent years and
inefficient or unlucky banks should be permitted to exit the
industry in order to maximize the industry's contribution to
the economy--but the exceedingly large magnitude of its loss to
the FDIC. As you have noted, this loss has been estimated in
the press to be somewhere between $500 million and $1 billion,
or 20 to 40 percent of the bank's assets at the date of its
resolution. Recent changes in the Federal deposit insurance
system have greatly reduced the Government and taxpayers'
liability for losses to the FDIC from bank failures by
requiring near-automatic and near-immediate increases in
insurance premiums to replenish the fund whenever the FDIC's
reserves fall below 1.25 percent of insured deposits. In this
way, the system is effectively privately funded. Nonetheless,
because bank failures are widely perceived to be more
disruptive than the failure of most other firms, and the larger
the loss, the greater the potential for disruption, bank
failures are still a public policy concern and an important
public policy issue.
Congress enacted the FDIC Improvement Act, or FDICIA, in
1991 to reduce both the number and, in particular, the cost of
bank failures through Prompt Corrective Action, PCA, and Least
Cost Resolution, LCR.
PCA specifies sanctions that first may and then must be
imposed by the regulators as a bank's financial condition
deteriorates in order to turn the bank around before it becomes
insolvent with possible losses to the FDIC. The sanctions are
triggered primarily by declines in bank capital ratio. But PCA
is intended to compliment, not to replace, the regulators'
other supervisory techniques that rely on other signals of a
bank's financial condition. FDICIA has an explicit section
entitled, ``more stringent treatment based on other supervisory
criteria.'' Indeed, PCA was introduced not because regulators
tended to react too quickly to developing bank problems, but
too slowly. Thus, regulators are not required or even
encouraged to delay corrective action until the capital
tripwires are breached.
Because of confidentiality, I do not know with certainty
many of the details of Superior's failure and, in particular,
the roles of the OTS and the FDIC. However, the public
information casts suspicion on both the promptness of the OTS's
action and the strength of the corrective actions when taken.
Nor is a 20 to 45 percent loss rate what I suspect Congress had
in mind when it enacted Least Cost Resolution. Indeed, this
loss rate promises to be greater than the average loss rate on
banks of comparable size in the bad pre-FDICIA days.
It appears that in Superior, as in the earlier costly
failures of the First National Bank of Keystone in 1999, and
again, the ironically named BestBank in 1998, a number of red
flags were flying high that should have triggered either rapid
regulatory response or continuing careful regulatory scrutiny.
Although each flag was not flying for each bank, these red
flags would include, but not be limited to: Very rapid asset
growth. Superior doubled in size in the 3 years between year-
end 1996 and 1999, and Keystone grew even more rapidly. Well
above market rates offered on insured and/or uninsured counter
or brokered deposits. Had the regulators sent their examiners
to the dozen banks and thrifts that offered the highest deposit
rates in the late 1980's, they would have zeroed in on the
worst failures of that period. Rapid withdrawal of uninsured
deposits. High ratio of bank repurchase agreements to total
funding. This indicates that other banks, which may reasonably
be expected to be well informed, are lending only on a
collateralized basis; High percentage of brokered deposits; A
larger percentage of activities in risky lending. Although
legitimate and, at times, highly profitable, subprime lending
is generally riskier than prime lending and requires more
careful supervision by both the bank's own management and
regulators. Very large percentage of assets in not only very
risky but also complex derivatives and other nontraditional
assets, given the bank size and management capabilities.
None of these flags either by itself or even in combination
with others guarantees trouble. But because the cost of
spotting them is low, they are worth following up on to see
whether the fish really smells.
Based on the public information on recent costly bank
failures, I recommend the following proposals for serious
consideration: Increased regulatory emphasis on red flags and
quicker responses. Establish an interagency SWAT team for
valuing complex assets. This would likely be of particular
benefits to the OTS and FDIC, who deal primarily with smaller
and less complex institutions. Making it an interagency team
would reduce turf considerations in calling on it for help.
Increase the values of the capital ratios for the tripwires in
PCA. This is something that the regulatory agencies can do now
and something I have argued for for many years, and that is
long overdue. Put the examination fee structures of the OCC and
the OTS on the same basis as those of the FDIC and the Federal
Reserve. By needing to charge fees for examinations to obtain
the operating revenue, there is a tendency for the OCC and the
OTS to view their member institutions as clientele, and to be
reluctant to take actions that may encourage them to change
their charter and primary regulator. Shorten the period for
beginning the resolution process after a bank is classified
critically undercapitalized to 90 days, with no extension. The
evidence is strong that losses to the FDIC increase on average
the longer an insolvent or near-insolvent bank is permitted to
continue to operate. Increase the ability of the FDIC to
participate in on-site examinations by other agencies. And I
mention in my longer statement how this may be done. Increase
emphasis on market valuations, especially for equity of large
banks.
But none of these suggestions would be effective unless the
supervisors have not only the ability, but also the will, to
comply with the underlying objectives and spirit of Prompt
Corrective Action and Least Cost Resolution.
At times, the actions of all four Federal bank regulatory
agencies suggest a lack of commitment. It may be desirable,
therefore, to encourage additional sensitivity training for
regulators, to increase their commitment to these important
objectives. Regulators should be judged adversely not by the
number of bank failures, but by the cost of the failures.
Thank you.
Chairman Sarbanes. Thank you very much, sir.
Ms. Petrou.
STATEMENT OF KAREN SHAW PETROU
MANAGING PARTNER, FEDERAL FINANCIAL ANALYTICS, INC.
Ms. Petrou. Thank you very much, Mr. Chairman.
I would like, since there has been such a well-informed
discussion of the specific aspects of the Superior failure and
appropriate relation of that to the Keystone, BestBank, Pacific
Thrift & Loan, and other recent costly failures, to focus on
some specific public policy issues that all of these failures
point to.
In the wake of the September 11 attack, we have become all
too aware that even hypothetical risks can become suddenly and
sadly real. In the same way these bank failures remind us of
the importance of vigilant bank supervision.
Many of the actions that Dr. Kaufman and Mr. Ely have
suggested were those recommended in a Congressional commission
chartered after the wake of the 1980's S&L crisis and, indeed,
some of the actions that have been recommended are
reinstatements of regulations issued by the bank and thrift
regulators in the wake of FIRREA and FDICIA.
For example, there had been a rule triggering regulatory
scrutiny for high-growth institutions. That was one of the
findings in the 1980's and 1990's, and has been set.
Institutions which grow incredibly fast are either run by
geniuses or something is up, and the regulators should take
extreme care to be sure that it is the former, and not the
latter.
Rules to that effect had been promulgated, but in a burst
of deregulatory enthusiasm in the 1990's, when we all thought
everything would only go up, those rules were repealed. They
should be reinstated.
The capital rules are the cornerstone of Prompt Corrective
Action. At this times, I would like to shift my focus to them
because, as you have said, Mr. Chairman, the role of residuals
and the role of recourse in these institutions was critical,
not only to their high-risk strategies, but also to their high-
cost failures.
It is essential that capital incentives be compatible with
risk incentives. The bank regulators talk a lot about
incentive-compatible regulation. However, the current risk-
based and leverage capital rules run, in my opinion, counter to
correct public policy incentives.
Looking ahead at some of the changes being proposed in the
new rewrite of the international risk-based capital rules,
often called the Basel Accord, the disconnect between
regulatory incentive and economic reality for insured
depositories will only grow wider. This was clearly the case
with the residual rule. It is quite possible under current
capital rules that an institution that invests only in zero-
risk Treasury securities has to hold higher capital than an
institution like Superior, which holds on its books as capital
these very high-risk, complex securitization residuals. That
should be fixed. It may well be fixed in the pending rule. It
never should have been allowed to last this long.
Congress called on the regulators to act on the recourse
issue in 1994, with a specific provision in the Reigle-Neal Act
requiring action on recourse. Eight years later, that rule
remains a work in progress, hopefully one soon to be completed.
I would like to point out that the cost of poor regulatory
capital incentives are not only that risk increases sometimes
exponentially with these poor and miscalibrated incentives, but
also that the banking system does not work as efficiently as
Congress intended.
One of the tragic consequences of the September 11 attack
was the destruction of much of the infrastructure that creates
asset-backed securities, particularly mortgage-backed
securities, private-label ones issued by guarantors other than
Government-sponsored enterprises.
Current capital rules place private-label asset-backed
securities at a significant capital disincentive to the
Government-sponsored ones, even though it has been recognized
since the first proposed rewrite of the recourse rules in the
early 1990's that there was no rational reason for
differentiating high-quality, private-label securities. In the
wake of the September 11 attack, with the disruptions to the
secondary market, it is much more difficult for the private-
label institutions to function. And these capital impediments
that they labor under, which are an anachronism, only
complicate and prolong the process of economic recovery.
Miscalibrated capital rules make economic incentives far less
powerful than they otherwise would be.
Another concern about the capital rules is pending
proposals to impose a specific capital charge for operational
risk. We learned after the September 11 attacks that systems
redundancy, contingency planning and insurance are critical to
the speedy and, indeed, often remarkable, recovery that
occurred after the World Trade Center was destroyed.
A specific capital charge under consideration would, in
fact,
penalize institutions through their capital requirements for
investment in these risk-reducing measures. That again seems
counter-intuitive, and it could have the kind of destructive
implications that one sees in the Superior, BestBank, and
Keystone cases, when the capital incentives are miscalibrated.
I do think it is vital for Congress to take an active
interest in the risk-based capital rules. They are adimittedly
very technical. But if you will recall, in the late 1980's,
when the first round of the Basel Accord was introduced, many
analysts, myself and Dr. Kaufman included, argued that those
rules, contributed to the credit crunch of the late 1980's and
the early 1990's, and slowed economic recovery down. They are
technical rules with strong public policy implications.
Thank you very much.
Chairman Sarbanes. Well, thank you very much. This panel
has been enormously helpful as we try to work through this.
We have been joined by Senator Carper. I am just going to
ask a couple of questions and then yield to him. We are very
pleased that he is here with us.
First of all, Dr. Kaufman, let me ask you, on these red
flags that you indicated, at the moment, are they written
anywhere as standards or parameters to guide the actions of the
regulators?
Mr. Kaufman. On the whole, not. But as Ms. Petrou said,
there was in the past a growth flag that was there.
Chairman Sarbanes. Is there general agreement amongst the
experts that the red flags you set out, is there a consensus
that those are appropriate red flags? How do Mr. Ely and Ms.
Petrou feel about that?
Mr. Ely. With regard to the red flags, in my testimony, I
identified a number. There is a judgment element that comes
into play here. And the thing that I have wondered about as I
look at these expensive failures, where is the 50 plus senior
supervisor with 30 plus years of experience, been in the
trenches for years, seen lots of failures, where is that
person, man or woman, stepping up to the situation of taking a
look at this, looking at the institution, looking at the
numbers, and saying, this place stinks. We need to do something
about it.
There seems to be a lack of that kind of human factor at
work here, where some grey-haired, bald-headed person says,
there is something wrong here. All I have to do is take a few
minutes looking at it and I know there is something wrong. That
is what we mean by the red flags. In a way, it is a matter of
taking lots of different factors into consideration and looking
at the institution and saying, things just do not look right
here. They do not add up. Something is wrong. Go find the
problem.
Chairman Sarbanes. Well, now, the grey-haired, bald-headed
person, may work for you and Dr. Kaufman. But we ought to add
into that some woman, striking woman with dark hair as well in
this evaluation.
Mr. Ely. My point is that this is what comes from years of
experience, of living with these things, these issues, for 20
or 30 years, having been through lots of problems. Again, it is
like a doctor who has seen 10,000 patients. When the next one
walks in, they can very quickly size up what the situation is.
Chairman Sarbanes. Ms. Petrou.
Ms. Petrou. Thank you, Mr. Chairman. My hairdresser
appreciates your comment.
[Laughter.]
In fact, FDICIA, which was a product of compromises and
contention that you, I know, remember very well, is a
remarkably
robust statute. And, in addition to the Prompt Corrective
Action provisions in Section 131, it also has an array of
operational and managerial safeguards that Dr. Kaufman
referenced, which you can find in Section 132. Those are the
red flags.
I agree in general with the regulators' determination not
to issue those as binding rules because, as Mr. Ely says,
judgment is an important factor. It is also true that some
institutions manage risk better than others. In fact, some
institutions are quite successful, profitable, well-
capitalized, subprime securitizers. But the agencies need to
look at those red flags.
They are specific in the statute that tell the industry
what the agencies will be looking form and they are issued in a
way that permits them to take rapid and binding supervisory
action.
Chairman Sarbanes. Dr. Kaufman, do you want to add
anything?
Mr. Kaufman. I do not think so. I agree with what was just
said.
Chairman Sarbanes. Ms. Petrou, in your testimony, you
recommended--I think I am quoting you correctly here, ``The
FDIC should have expedited authority to review troubled
institutions, but no greater authority should be granted to
review healthy banks.''
Ms. Petrou. That is correct.
Chairman Sarbanes. And of course, regulators currently
identify the healthiest banks by giving them the top
supervisory CAMEL rating of ``1''. Now in December 1998,
Superior was a CAMEL ``1'' rated institution. If the FDIC had
no greater authority to examine a ``1'' rated institution, it
might well not have been able to move in on Superior. I mean,
we had the other problems. But that standard may not work,
might it not, at least in this instance? Of course, we had
these gross over-statements of value and so forth, which
collapsed finally when they dealt with the accountants. But
what is your response to that concern?
Ms. Petrou. I do not think that the FDIC should have
unilateral authority, to be seeking, to enter and examine
healthy, CAMELS ``1'' institutions; which is what I had
understood the FDIC to be seeking, at least in some earlier
statements.
The reason for that is because I believe there is a
tremendous potential for misallocation of supervisory
resources. As Mr. Ely has said, for example, the FDIC has a
major responsibility to be the deposit insurer and to ensure
that the incentives of deposit insurance work to support
supervisory ones. The current, and I would say significant
problems in the risk-based premium matrix require urgent FDIC
attention.
Should the FDIC seek the authority, of a back-up enforcer,
and request such from the primary supervisor, I absolutely
agree as Director Seidman has said, that should be granted.
However, I do not think that the FDIC should have unilateral
authority on its own to supervise healthy institutions.
Mr. Ely. Mr. Chairman, if I could add to that.
There is not really a lot of concern when institutions are
``1'' and ``2'' rated. Where the concern really starts to grow
is when you drop down to a ``3'' rated situation and
specifically, where the chartering agency may rate the
institution as a ``2'', but the FDIC, just looking at call
report data and reviewing the exam reports that is off the
site, comes up with a CAMEL rating of ``3'' or lower. Then that
might be a situation specifically where the FDIC should be able
to go to the chartering agency and say, listen, there is a
difference here in CAMEL rating that is significant enough that
we are going to go in, we need to go in with you on the next
exam, unless you have a real powerful reason as to why we
should not. In other words, drawing again the distinction
between the ``2'' and ``3'', that is perhaps the most important
distinction that needs to be drawn.
Chairman Sarbanes. How do we square that comment with the
fact that Superior, in December 1998, had a ``1'' rating? And
in fact, in 1999, had a ``2'' rating.
Ms. Petrou. Mr. Chairman, if the capital incentives were
better drawn, they never would have had a CAMELS ``1'' rating
because they would not have been able to count residuals as
capital.
Chairman Sarbanes. That is a good answer.
Ms. Petrou. The CAMEL system is very heavily dependent on
the first C--it is supposed to stand for Capital Assets
Management Earnings Liquidity and Sensitivity. Each one of
those letters has a meaning as to what the supervisors are to
look for. But in fact, it is very heavily capitaldependent and
the capital incentives are misplaced.
Mr. Ely. I would agree with Ms. Petrou. The other problem
with capital is that it is a lagging measure of a bank's risk
because, in effect, it does not reflect asset write-downs that
have not yet been taken. Also, if I remember correctly, in
1999, the OTS dropped it from a ``1'' to a ``2'', but the FDIC
dropped it to a ``3''. And there was a point in time there
where you again had that ``2''/``3'' split. And that is the
kind of situation I have in mind where the FDIC should
basically be able to, if not go in on its own motion, at least
be able to insist on accompanying the examiners from the other
agency in the next exam.
Chairman Sarbanes. Dr. Kaufman, if you don't want to add
anything, then I am going to yield to Senator Carper.
Mr. Kaufman. No, that is fine.
Chairman Sarbanes. Okay. Senator Carper.
COMMENTS OF SENATOR THOMAS R. CARPER
Senator Carper. Thanks, Mr. Chairman.
I remember when Bert Ely had a full head of black hair.
Mr. Ely. That was a long time ago.
Senator Carper. And Karen Petrou was Karen Shaw. It is just
great to see each of you again. I had the pleasure when I was
on the House Banking Committee to sit in a hearing like this,
to be educated, and to walk out of there feeling a whole lot
better about what we were going to do as a Committee because we
heard from each of them. Thank you for being with us today.
Thank you for excellent, excellent testimony.
I want to just ask a couple of questions. Let me just start
off by saying, there must be some angst in this country, some
banks that are in the same kind of business as Superior, making
their money pretty much in the same way, that are not on the
same road to ruin. I would just ask you, what might distinguish
the way those banks are being operated and the way that
Superior was run into the ground?
Mr. Ely. If I could address that because I have spent some
time looking at Superior. Superior was really almost unique in
terms of its particular business plan. It really was an outlier
in terms of residuals on the balance sheet. There are, however,
some other institutions out there that are outliers in
different ways that I also have concerns about.
But I am not aware of another institution operating today
that closely resembles Superior. Keystone was another one that
had a lot of the characteristics of Superior, but, of course,
that failed a couple of years ago.
Ms. Petrou. Senator Carper.
Senator Carper. Karen.
Ms. Petrou. I would say that thing that distinguishes
Superior is it was closely held amongst two principal owners in
a highly complex structure that integrated the institution with
the real estate development businesses of the two principal
owners. That significantly distinguishes Superior from
institutions that are broadly traded in the public market,
covered by many investment analysts and subject to market
discipline.
In my written testimony, I strongly recommend that
management and corporate structure be among the red flags that
the
supervisors rely upon. And it may well be that such closely
held institutions not be given CAMEL ``1'' ratings strictly
because they do run a much higher degree of supervisory risk.
Senator Carper. Dr. Kaufman.
Mr. Kaufman. Something that I have emphasized in my
testimony, that we really should not be that worried about the
bank failures, per se. Poorly managed banks should be permitted
to fail. What is important is that they fail with no cost to
the FDIC, that we should not try to keep all banks alive, that
banks should be given the opportunity, so to speak, to fail.
That is important to drive the inefficient and the unlucky
banks out.
What is important and where the FDIC, particularly the OTS,
failed in this case, the Keystone case, and the BestBank case,
was that the banks did not only fail, but also they failed with
very large losses. And that should not happen.
Mr. Ely. Senator Carper, if I could just endorse something
that Karen said. Not only was Superior closely held, but also
the same was true of Keystone and BestBank, all closely held
institutions.
And while we had a number of publicly owned, broadly owned
banks and thrifts that failed in the 1980's, including some
very large institutions, I do think that market discipline that
comes from broad common stock ownership, has improved in the
1990's.
Again, Karen makes a very good point that kind of a
negative for a bank is if there is a lack of public ownership
and the following by bank stock analysts, and also the need for
the company to file with the SEC. The SEC filings and the SEC
review of those filings also introduces an important element of
oversight that is lacking in these closely held institutions.
And again, it also addresses George's point. If you have market
discipline, the stock price will be dropping sooner, and that
is going to force action--it will be a market-driven action--
long before they reach the depth of insolvency that we have
seen in these very expensive failures.
Senator Carper. Each of you were good to give us a laundry
list of recommendations that we might pursue. What I want to
ask you to do is to establish some sense of priority in terms
of the importance of those recommendations. I would just ask
you to reflect back on those recommendations and to say, Mr.
Ely, if we were only to, as a Committee, as the legislative
branch, do two of them, which two should we do first?
Mr. Ely. I think the most important one is to hold senior
regulators personally responsible for the expensive failures.
Frankly, if there were a few people fired over these failures,
that that might have a tremendous disciplining effect on the
agencies. And that is perhaps the single most important one
that immediately comes to mind. I think the others are
important. But there still has to be this sense of personal
accountability.
The banking regulators have a fiduciary obligation to the
banking industry. Why is that? It is for the point that George
made, that Congress very properly has made deposit insurance
and privately financed system because the banks were on the
hook for the losses. And my sense is that within the regulatory
establishment, there is not that sense of fiduciary
responsibility to the banks because, in a sense, we have a
moral hazard situation. If the regulators err, it is going to
be the banks who are going to pay through higher premiums. And
this goes to the point that the Chairman made in the first
panel. What is going to be the impact of additional losses on
the reinstitution of premiums? So, I would say that is, the
single most important recommendation.
Senator Carper. Thank you.
Dr. Kaufman.
Mr. Kaufman. I guess I would say to move sooner rather than
later. But I do not think that we could rank, or that we should
rank, these red flags or these recommendations because every
bank is different. And you do not want to lock the regulators
into a structure which may work for Bank A and we miss in Bank
B. If we have a large number of flags, we have the Prompt
Corrective Action which we could strengthen, particularly in
the way that we measure capital.
Congress, indeed, in FDICIA urged the regulators to move
more toward market value accounting. The regulators have not
done so. But I would not lock in the regulators and just a
limited number of signals because we have 10,000 banks and
thrift institutions and they vary all over the ballpark.
Senator Carper. Ms. Petrou.
Ms. Petrou. I would emphasize the important role of
capital. The Chairman has pointed to the delay in issuing the
residual rule and the recourse rule as significant factors, not
only in Superior, but also in Keystone, BestBank, and Pacific
Thrift & Loan.
This problem could get worse, not better, because of some
proposed changes to the capital rules. And I urge Congress to
take an active role in reviewing these changes so that they do
not have an adverse macroeconomic or systemic risk impact. The
rules do look awful, and they are 700 pages. They are highly
technical and I would not wish them on you. But I do think that
they are the major drivers of bank decisionmaking because,
ultimately, profitability is determined by return on equity.
Therefore, how much and what type of equity the regulators
demand determine the economic incentives under which bank
managers operate.
Mr. Ely. Senator Carper, I wonder if I could add to that on
capital and on the Basel capital rules. The Basel 1, the ones
adopted in the late 1980's, as well as Basel 2, the rules that
are under consideration now and may be under consideration for
many years to come, both have a very serious failing. And that
is that there is no guidance in there with regard to loss
provisioning, the reserving for losses, reserving for the
decline in asset value.
A measure of capital is only as good as the values that are
associated with assets. And if assets are not written down
properly to their value, then you are going to have overstated
capital. And that is what happened in Superior in spades. Not
only were its assets overvalued, but also they were overvalued
for many years.
What we see in the Basel rules is, while we talk about
capital, there is no explicit addressing of the issue of loss
reserving and if you do not have that, you do not have good
capital rules.
Senator Carper. Mr. Chairman, this is an excellent panel,
and I just want to thank you for bringing them together.
Again, to each of you, thank you for joining us today and
sharing your counsel with us.
Chairman Sarbanes. Yes, we are deeply appreciative for your
contribution. And if it is not too much of an imposition, I
expect we will call on you again because we really need the
benefit of this outside perspective that you bring.
We are now following closely these regulations which will
be an important step forward, assuming they do the right thing.
And then we will have to move from there in other ways to
tighten and strengthen the system. Thank you very much for your
contribution.
The hearing stands adjourned.
Senator Carper. Thank you.
Mr. Ely. Thank you.
Mr. Kaufman. Thank you.
[Whereupon, at 12:40 p.m., the hearing was adjourned.]
[Prepared statements, response to written questions, and
additional material submitted for the record follow:]
PREPARED STATEMENT OF SENATOR TIM JOHNSON
Chairman Sarbanes, thank you for holding today's hearing into the
failure of
Superior Bank of Hinsdale, Illinois. Preparing for today's hearing was
especially poignant. As you no doubt remember, Mr. Chairman, you and I
sat together on this dais the morning of September 11, before the
magnitude of the day's events had become clear. While the terrorists
distracted us temporarily from the business at hand, we gather today
with renewed determination to keep America's economy strong.
When Superior Bank failed on July 27 of this year, there was a lot
of finger-pointing among the parties involved. In the past month, we
have learned an important lesson about how much we can achieve when we
pull together toward a common goal. Today, it is my hope that we can
examine the problems that caused the failure of Superior Bank, identify
what systemic weaknesses we need to address, and work together to
reassure the American people that we have the strongest banking system
in the world.
In the last month, we have gained a renewed appreciation for the
strength of America's financial institutions, which have withstood the
futile attempts against them. At the same time, we in Congress, on a
bipartisan basis, have identified some areas that could be strengthened
still further. Recently, by a 21-0 vote, the Senate Banking Committee
passed a significant antimoney laundering package, which provides our
law enforcement personnel essential weapons in the war on terrorism.
I congratulate you, Mr. Chairman, for pulling our diverse Committee
together behind a package that helps our country wage war on terrorism.
I urge my colleagues in the House of Representatives to pass this
critical legislation so President Bush can sign it into law. The Senate
acted swiftly to arm our law enforcement personnel against terrorists,
and it is now the House's turn to act.
Today, we must take a hard look at many different issues that keep
our financial institutions strong, including Prompt Corrective Action,
methods of valuation, the role of accounting auditors, and interagency
cooperation, to name a few. These measures, which help to comprise our
rigorous regulation of financial institutions, are absolutely critical
in keeping Americans confident about our financial marketplace. But
while today's hearing is likely to focus on these more technical issues
that may be able to prevent bank failures, we must not forget that when
banks do fail, Federal deposit insurance plays an absolutely critical
role in maintaining consumer confidence in the banking system.
Federal deposit insurance is one of the cornerstones of our
financial system, and it is worth pausing to note that the failure of
Superior Bank appears to have caused little, if any, public panic about
the health of our banking system. This is the goal of Federal deposit
insurance. And it is no small feat. According to FDIC policy for a
conservatorship situation, the agency typically closes a failed
institution on a Friday after the close of business, with the goal of
reopening on Monday in a way where the customers would be hard-pressed
to identify any differences in the bank's operations.
Indeed, our deposit insurance system is premised on the assumption
that banks and thrifts will, on occasion, fail, despite the best
efforts of regulators. We should remember that the regulatory agencies
deserve significant credit for their hard work in keeping our banking
system healthy. Their task is especially challenging where there is
fraud by the institution, or serious error by a national auditor.
This failure is especially notable, as were the failures of First
National Bank of Keystone, West Virginia, and BestBank of Boulder,
Colorado, because of the magnitude of the failure proportional to the
size of the institution. Preliminary loss estimates for Superior Bank
range from $500 million to $1 billion, with a loss rate of anywhere
from 20 to 45 percent. The data is not yet final, but early estimates
show that the failure could cause a significant drop in the SAIF ratio,
which, as I have said in the past, should help to focus Congress and
industry alike on reforms to our deposit insurance system. The current
deposit insurance system is dangerously procyclical, and the time to
make changes is now.
Mr. Chairman, I am particularly troubled by the losses of
Superior's uninsured depositors. While the numbers have not been
confirmed, the FDIC estimates that uninsured depositors held upward of
$64 million in Superior on July 27. According to one report, 816
depositors held $66.4 million in uninsured deposits on the day Superior
was shut down.
Even worse, to my mind, is the fact that Superior's uninsured
deposits increased by $9.6 million in the second quarter of this year,
when the regulators knew that the bank was in trouble.
Who were these uninsured depositors? Clearly, some were
sophisticated investors who followed call report data and pulled out of
Superior when the situation looked precarious for the thrift. Although
in this case, we have reports that Superior misreported its Thrift
Financial Reports, which reduces the possibility of even sophisticated
depositor discipline.
As to the rest of the uninsured depositors, press reports are
informative. It was reported that a former parcel carrier who was
injured on the job had deposited a hard-fought settlement of $145,000
in Superior on July 26--the day before the Hinsdale thrift collapsed.
Another woman deposited $120,000 in proceeds from her recently deceased
mother's home just days before Superior was closed by the regulators.
And it is hard to believe that Superior is unique in serving uninsured
depositors, many of whom rely on their bank's safety to protect their
retirement savings.
As I have said before, Congress has a particular responsibility to
think about the appropriate level of Federal insurance of retirement
funds. We provide tax incentives for people to save for their
retirement, and in fact we recently increased those savings incentives.
People who set aside relatively modest amounts every year for
retirement can easily amass more than $100,000, and many of these
savers are working families who scrimp and save to make sure that they
are self-sufficient in their old age, and that they do not become a
drain on the next generation. It seems to me the next step for Congress
is to make sure that our working families have the option of a safe
investment for those funds.
According to the FDIC, approximately $60 billion of retirement
funds are sitting uninsured in depository institutions, and that a
higher deposit insurance limit would dramatically reduce the risk to
these prudent savers. I plan to hold a hearing later this month in the
Financial Institutions Subcommittee to consult with experts in the
field of retirement savings about how we in Congress can act to protect
the hard-earned savings of responsible, working Americans. While we on
this Committee must do everything we can to prevent banks from failing,
we must also take steps to protect investors should an institution
fail, despite our best efforts.
I thank the witnesses for their extensive and thoughtful written
testimony, and I once again thank you, Mr. Chairman, for rescheduling
this hearing.
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PREPARED STATEMENT OF ELLEN SEIDMAN
Director, Office of Thrift Supervision, U.S. Department of the Treasury
October 16, 2001
I. Introduction
Good morning, Chairman Sarbanes, Ranking Member Gramm, and Members
of the Committee. On July 27, 2001, the Office of Thrift Supervision
(OTS) closed, and appointed the Federal Deposit Insurance Corporation
(FDIC) as conservator and receiver of, Superior Bank, FSB, Hinsdale,
Illinois (Superior). In the 46 days since the Government assumed
control of Superior, there have been a multitude of news stories, a
number of separate Federal investigations commenced, and extensive
briefings with Congressional staff about Superior. Although the focus
of these investigations varies, all parties involved are trying to get
to the bottom of what went wrong at Superior Bank, how it happened, and
what steps can be taken to reduce the likelihood of a similar failure.
That is also, of course, why we are here today. Ultimately, it may
take years to complete the full record of Superior's downfall. We are
still at a preliminary stage of the investigation of the details of
Superior's failure. For this reason, great care is required to avoid
mistakes in how we characterize the actions of those we believe are
responsible. We have to be equally cautious about tipping off the
responsible parties about the course of our investigation.
I have already stressed to you, Mr. Chairman, my strong desire to
provide you with as much information and details regarding the failure
of Superior as you deem necessary. I have also indicated my concern not
to compromise any potential actions that the OTS, the FDIC, or any
other agency may pursue in connection with this matter. I understand
from staff that you share this concern. We have done our best to honor
these competing interests.
Before getting into Superior, I think it important to clarify a few
misperceptions regarding the impact of the failure on the thrift
industry and on the Savings Association Insurance Fund (SAIF). First,
the effect on the thrift industry from the failure is minimal. Although
Superior did not close until after the end of the second quarter, at
our quarterly press conference last week, I noted that if the failure
of Superior were included in second quarter numbers, it would have
resulted in a $1.76 billion reduction, down to $964.68 billion, in
total industry assets at June 30, 2001. Record quarterly earnings of
$2.51 billion would have increased to $2.54 billion without Superior's
loss.
The bigger story, of course, is the impact of the failure on the
SAIF. The FDIC projections of a $500 million loss to the SAIF equate to
more than a quarter of the institution's assets at the time of
failure.\1\ If this projection holds, it represents a significant hit
to the SAIF, but by no means a deadly blow. Based on unofficial
estimates, about a $500 million loss to the SAIF will reduce its
reserve level from 1.43 basis points to approximately 1.37 basis points
of SAIF-assessable deposits, still exceeding the current 1.32 basis
point capitalization of the Bank Insurance Fund (BIF) and, more
importantly, exceeding the 1.25 designated reserve ratio. While the
size of the drop in the SAIF is significant in relative terms, the fund
remains strong, as I reported to you in June of this year.
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\1\ While this is high, it is not the highest percentage for recent
failures. Two non-OTS institutions had higher percentage loss
estimates. Pacific Thrift & Loan failed in November 1999 and the
initial estimated loss was $49.9 million on assets of $117.6 million;
in the case of Keystone National Bank, estimated losses were in excess
of $300 million on assets of $1.0 billion.
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The losses at Superior were so high largely because of that
institution's concentration in residuals. The concentration in
residuals at Superior was exacerbated by a faulty accounting opinion by
the institution's external auditors that caused capital to be
significantly overstated, and by management and board recalcitrance in
acting on regulatory recommendations, directives, and orders.
Competition and innovation in our financial services system have
provided tremendous benefits to consumers and have made financial
institutions stronger. These same factors, however, pose unique risks
and challenges to depository institutions. The challenge is in managing
the level of risk taking. While competition encourages institutions to
take risks, too much risk taking will undermine an institution's core
business strategy. Innovation, a tool institutions use to compete more
effectively, can also be overused. An institution that adopts every new
financial, operational, and technological innovation runs the risk of
losing its strategic focus, and its customer base.
As Federal Reserve Board (FRB) Chairman Alan Greenspan observed
before the Conference of State Banking Supervisors in May of this year:
Banking in this country is, in most areas, highly
competitive, and the industry has proven itself to be highly
resilient. To survive and be effective, banks must be willing
and able to take risk. Revenue, shareholder equity, and if
necessary the [Federal deposit insurance funds] are there to
deal with mistakes. Put differently, while public policy needs
to limit the financial and social costs of bank failures, we
should not view every bank failure as a supervisory or
regulatory failure. It is not our role to prevent all failures,
let alone to guard against every earnings decline. Indeed, to
do our jobs well, we should understand that the essential
economic function of banks is to take risk, and that means
mistakes will sometimes be made. A perfectly safe bank, holding
a portfolio of Treasury bills, is not doing the economy or its
shareholders any good.\2\
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\2\ Remarks by FRB Chairman Alan Greenspan at the Conference of
Bank Supervisors, Traverse City, Michigan (via satellite), May 18,
2001.
The key, of course, is for officers and directors to know and
understand the risks an institution is taking. This is part of their
fiduciary duty to the institution and its shareholders. Increasing
involvement in novel and complex financial transactions requires
officers and directors to turn to experts to understand the risks
inherent in a new activity. Consulting with experts does not, however,
absolve management and directors of their fiduciary obligations; it
remains their responsibility to know and understand.
Our system includes other checks to prevent potential problems.
Foremost among these is sound supervision and oversight by the Federal
banking agencies. This brings us to the question whether the OTS made
the right calls with respect to Superior Bank.
Clearly, decisions were made that we must answer for. Were we too
slow to recognize the problems at Superior? As some of the major issues
that ultimately brought Superior down began to unfold in mid-1999, were
we too slow to act to address problems after they were discovered? We
took an increasingly escalating series of formal actions, including,
starting in May 2000, a ratings downgrade to CAMELS ``4'', a directive
not to grow, and a notice of deficiency under 12 U.S.C. Sec. 1831, 12
CFR Part 570. We issued a Prompt Corrective Action (PCA) directive in
February 2001 that required significant operating changes, as well as a
major capital infusion, and did so before the institution reported
itself to be significantly undercapitalized. If there is something we
could have done better, it would have been--in late 1999 and early
2000--to put stronger, and more consistent, pressure on Superior's
management and board of directors, and the board of its holding
company, to take the actions they said they would, and to do it in a
timely manner.
The issue of interagency coordination between the OTS and the FDIC
is popular with some in the press, a dangerous trap for both agencies
in litigation, and of little substantive value in reviewing what really
went wrong at Superior Bank. Were there occasional disagreements in
judgment between the OTS and the FDIC about the handling of Superior?
Yes. Did this cause Superior to fail? No. Did they increase potential
losses to the SAIF? I do not believe so. While individuals from our
respective agencies may disagree with each other at times, there is
every incentive for the OTS, the OCC and the FRB to work with the FDIC
to address problem institutions. More significantly, there is
definitely value added by having two regulators instead of one working
on the same problem. I make that observation from two perspectives--OTS
Director and FDIC Board Member.
The OTS has extensive experience in resolving the issues and
problems confronted by troubled institutions. We are intimately
familiar with the tools provided by PCA, as well as the other
supervisory and enforcement tools afforded by the Financial
Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA) and
the Federal Deposit Insurance Corporation Improvement Act of 1991
(FDICIA). And we have a good track record in preventing failures, as
well as in reducing resolution costs charged to the SAIF. Since 1996,
there have been only three thrift failures other than Superior,
resulting in total combined losses to the SAIF of less than $24
million. At the same time, we have successfully dealt with any number
of institutions in potential trouble, by recapitalizations, management
and board changes, mergers and acquisitions, and voluntary
liquidations. Fortunately for the financial system but unfortunately
for us in the context of today's hearing, those successes never make
news and no one holds hearings about them.
My testimony today will address the chronology of events leading up
to Superior's failure; discuss the causes of the institution's failure;
and provide some suggestions about what we at the OTS, the Federal
banking agencies working together, other organizations such as the
accounting profession, and Congress can do to mitigate the risk of a
similar failure.
II. Chronological History of Superior
In December 1988, the Pritzker and Dworman interests acquired Lyons
Savings Bank, a Federal Savings Bank, Countryside, Illinois (Lyons), a
failing institution with $1.5 billion in assets and $1.7 billion in
liabilities, for a combined contribution of $42.5 million. The
acquisition was made with assistance from the former Federal Savings
and Loan Insurance Corporation (FSLIC). Pursuant to the acquisition,
the Pritzkers and Dwormans each owned 50 percent of Coast-to-Coast
Financial Corporation (CCFC), which wholly owned the institution. Lyons
was renamed Superior Bank FSB (Superior), with its home office in
Hinsdale, Illinois, in April 1989.
In connection with the acquisition of Lyons, the Pritzker and
Dworman entities asked for and received a waiver from the Federal Home
Loan Bank Board of various filing and reporting requirements for all
but three holding companies of the acquired institution. The only
companies required to file periodic reports and/or financial
information were CCFC, UBH, Inc. (UBH), and Coast Partners (CP), which
were all formed for the purpose of acquiring and operating Superior.
UBH, controlled by the Dwormans, and CP, controlled by the Pritzkers,
remained predominantly shell companies each with their primary activity
the ownership of 50 percent of CCFC. CCFC owned Superior and several
other small financial services affiliates with operations that
complemented Superior.
Throughout the history of Superior, OTS examinations indicated that
Superior's only dealings with holding company affiliates involved
either CCFC or its wholly owned subsidiaries. As a result, CCFC and its
subsidiaries remained the focus of OTS holding company examinations of
Superior.
Superior's activities were severely limited during the first few
years of its operation. During its first 5 years, the institution
operated under a FSLIC Assistance Agreement that concentrated
management's efforts on resolving problem assets and supporting claims
for yield maintenance from FSLIC under the agreement. By December 1992,
most of the institution's problem assets were resolved and the effects
of the FSLIC Assistance Agreement had diminished.
While Superior's owners had some difficulty stabilizing their
institution, by 1993 both OTS and FDIC had rated it a CAMELS ``2''. At
this point, Superior's management began to focus on expanding the
institution's mortgage lending business. The acquisition of a mortgage-
banking subsidiary, Alliance Funding Company, Inc. (Alliance), from an
affiliate at the end of 1992 provided Superior with the ability to
expand its mortgage lending business. Alliance is a nationwide consumer
finance company that operates as a full service mortgage banker
originating or purchasing, on a wholesale basis, mortgage loans secured
by first and second liens on 1 to 4 family homes.
As Superior expanded its mortgage banking activities during the
mid-1990's it consistently received a composite ``2'' rating during
safety and soundness examinations from 1993 through 1996. In 1997, OTS
gave it a ``1'' rating. The FDIC was on-site for the July 1993 exam and
reviewed OTS's exam report off-site for the August 1994, September
1995, October 1996, and December 1997 examinations. During this period,
FDIC did not dispute OTS's overall composite rating of Superior.
Starting in 1993, Superior built its mortgage banking business. And
as with most mortgage bankers and an increasing number of subprime
lenders at the time, Superior was, in general, not holding the loans in
portfolio. Rather it was securitizing the loans--the process by which a
pool of loans is divided into securities of varying levels of credit
quality and sold to investors with varying appetites for risk. And
Superior, like many issuers, held on to the security with the greatest
amount of risk or otherwise provided significant credit enhancement for
the less risky securities. These include interest-only or I/O strips,
spread accounts, and cash collateral or overcollateralization accounts,
and are collectively known as ``residuals'' because they receive the
last cash flows from the loans.
In December 1998, OTS scheduled an examination of Superior
commencing in January 1999. At this time, Superior Bank was rated ``1''
by OTS and well capitalized. Although the FDIC Regional Director
requested to have one examiner join OTS at this examination, he agreed
to alternate arrangements with the OTS Regional Director. Under the
arrangement, the FDIC reviewed OTS's work papers off-site during the
latter part of OTS's exam. If the FDIC had questions based on the OTS
work, OTS agreed to present those issues on behalf of the FDIC to
Superior's management. This arrangement was made because the
institution was concerned about giving an FDIC examiner full access to
its books and records while in the midst of litigation with the FDIC
over a tax sharing agreement arising out of the original acquisition of
the institution from the FSLIC.
During 1999, both OTS and the FDIC started having serious concerns
about the institution. Early in the year, OTS focused its attention on
the inadequate asset classification system, which led to inaccurate
loss reserves and regulatory accounting, as well as on the
deteriorating auto portfolio. OTS rated the institution a ``2'' in
March. The FDIC was more focused on the increasing concentration of
residuals and rated it a ``3'' in May. But by July 1999, both agencies
were increasingly focused on both the concentration and the valuation
of residuals. The institution's management and the rating agencies did
not see a problem. In May 1999, Fitch, which rated Superior's long-term
debt an investment-grade BBB, stated:
Superior, with assistance from CCFC and its financial
management affiliate, has developed and executed business
strategies related to the origination, securitization, and
servicing of nonprime consumer assets that have led to strong
operating results in recent years. . . . Important to
evaluating the company's performance is our assessment that
Superior uses appropriate assumptions in recognizing FAS 125
income. Furthermore, the company's process for valuing related
financial receivables, recognizing adjustments on a quarterly
basis when applicable, is viewed positively. Extensive analysis
of historic prepayment and credit performance of existing loan
pools provides a basis for
rational accounting. Superior's strict adherence to its
internally generated risk-based pricing parameters has also
contributed to slower, but generally more profitable, loan
origination growth than its competitors.
In May 1999, through discussions between FDIC and OTS regional
staff, it was agreed that the FDIC would participate with OTS on the
next regular safety and soundness examination at Superior. This
agreement was formalized in writing by the FDIC in September 1999. OTS
provided written concurrence.
With more institutions getting involved in securitizations, and
with the OCC's and FDIC's experience with the Keystone and Pacific
Thrift and Loan failures in late 1999, the Federal banking agencies
(FBA's'') issued interagency guidance on asset securitizations in
December 1999. In January 2000, concurrent OTS-FDIC examinations of
Superior commenced. OTS raised significant supervisory concerns
regarding Superior's securitizations and exposure to residuals in the
report of examination. Based on that report, OTS downgraded Superior's
composite rating to a ``4'' from the ``2'' rating assigned to the
institution in 1999. The downgrade was primarily attributed to the
significant concentration of residual assets on the books of Superior.
The FDIC also assigned Superior a ``4'' overall composite rating.
In the May 2000 transmittal of Superior's January 2000 examination
report, OTS advised Superior's management to take the necessary steps
to increase capital or reduce the risk inherent in the institution's
operations. OTS also required, among other things, that Superior make
all necessary adjustments to capital as of March 31, 2000, ensure that
the Allowance for Loan and Lease Losses (ALLL) was sufficient to cover
risks, and appropriately classify assets. OTS also notified Superior
that because its capital level had fallen to ``adequately capitalized''
\3\ it could no longer accept new, or renew maturing, brokered
deposits.
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\3\ Superior was adequately capitalized on a risk basis. Tier 1
equity capital exceeded 12 percent, in the well-capitalized range.
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As a result of OTS's examination report, OTS sent to Superior's
board of directors on July 5, 2000 a notice of deficiency and
requirement for submission of a 12 CFR Part 570 safety and soundness
compliance plan pursuant to Section 39 of the Federal Deposit Insurance
Act. The notice of deficiency required Superior's board to take action,
including the following:
Develop procedures for analyzing the ongoing fair market value
of the institution's residual assets;
Obtain periodic independent valuation of a sample of
receivables;
Develop a plan to reduce the level of residual assets to no
greater than 100 percent of Tier 1 (core) leverage capital within a
1 year time period;
Revise the institution's automobile lending policy and
establish performance targets for its automobile lending operation;
and
Develop a revised ALLL policy and maintain adequate loan loss
reserves.
Because of OTS's concern regarding the concentration in residuals,
Superior's board ceased securitizing loans at the thrift and, instead,
sold newly originated loans to its holding company. This stopped the
growth of residuals at the institution. The OTS also forwarded a
supervisory letter to Superior on July 7, 2000 officially notifying the
institution of its designation as a problem institution, as defined in
Regulatory Bulletin 27a, and in troubled condition pursuant to 12 CFR
Sec. 563.555. The notice prohibited asset growth, except in the amount
of interest on deposits, and placed restrictions on new employment
contracts and hiring of senior officers, required regulatory approval
of third party contracts outside the normal course of business and
disallowed ``golden parachute'' payments. The FDIC's Chicago office
indicated its concurrence with this supervisory strategy.
Superior's board submitted a compliance plan to OTS on August 4,
2000. The board's response indicated that procedures were being
developed and implemented, with the assistance of Ernst & Young (E&Y),
to value the institution's residual assets. The board had developed a
plan to transfer the residual assets from the books of Superior to
CCFC, and its affiliates, within the requested timeframe. In addition,
the institution's subprime automobile lending operation had been
terminated and adequate loan loss reserves were established. The
institution ceased its securitization activities as of June 30, 2000,
but continued to originate loans for sale to its holding company and
its affiliates, with the servicing retained by Superior.
OTS made additional information requests on September 1 and October
27, 2000, with regard to the institution's compliance plan, and the
board's responses were received on September 29 and November 13, 2000,
respectively.
During review of the institution's compliance plan, OTS and FDIC
commenced a field visit examination on October 16, 2000. Due to
significant problems that were identified, the field visit continued
into early 2001. The field visit was conducted to review Superior's
progress in calculating the fair market value of its residual assets;
to determine management's compliance with the corrective action
required by the January 24, 2000, examination; and to review and
determine the board's compliance with OTS's July 7, 2000, supervisory
letter. The field visit exam report disclosed that Superior's financial
statements for June 30, September 30, and December 31, 2000 contained
significant errors. The fair market value analysis of the residual
assets had not been completed. Management also failed to implement
several of OTS's January 24, 2000, examination instructions and
continued to delay required adjustments to the financial statements
during the course of the field visit.
In October 2000, E&Y issued their audit of Superior's fiscal year
ending June 30, 2000. OTS and FDIC undertook a review not only of the
audited financials but also the underlying workpapers. Additionally,
during this time, OTS and FDIC accountants had meetings and discussions
with E&Y and Superior regarding whether GAAP had been appropriately
applied to the overcollateralization accounts.
Pursuant to the field visit, OTS communicated to Superior's
management on November 15, 2000, that Superior's residual assets were
significantly overstated on June 30, due to the absence of acceptable
valuation procedures and the use of incorrect accounting treatment. The
examiners, with the assistance of the OTS and FDIC accountants,
determined that Superior, notwithstanding representations to the
contrary, was not accounting for the residual assets in compliance with
Statement of Financial Accounting Standards (SFAS) No. 125. Superior
overstated the value of its residual assets when it failed to properly
recognize the impact of timing delays in the receipt of cash flows on
the overcollateralization (O/C) assets within residuals retained on its
books. E&Y failed to take exception to this improper reporting.
The O/C assets are a credit enhancement on the securitizations
pledged for the benefit of the REMIC bond insurer and trustee. E&Y
provided an unqualified audit opinion even though management
erroneously accelerated the receipt of the estimated cash flows from
the underlying loans related to the O/C assets. These cash flows would
not be released by the trustee and received and retained by Superior
until much later in the life of the REMIC trusts. This error caused
Superior to report inflated assets, earnings and capital. Combined with
other valuation adjustments, the examiners estimated an appropriate
write-down of the residual assets might exceed $200 million.
In addition, OTS's and FDIC's October 2000 field visit disclosed
that Superior's management and board of directors failed to take
certain actions to ensure that the books and records accurately
reflected the true financial condition of the institution. These
actions primarily involved the failure to recognize various write-downs
applicable to the institution's automobile loan operations. The
examiners determined that, although portions of the required write-
downs were implemented, three material adjustments totaling
approximately $13 million were not recorded. Therefore, OTS directed
Superior's board to make these adjustments.
In light of the major adjustments that appeared likely in
Superior's financial statement, OTS's focus shifted from completing the
Part 570 plan process to consideration of a PCA Directive pursuant to
Section 38 of the FDIA.
On December 19, 2000, OTS and FDIC again met with Superior and E&Y
to discuss the accounting treatment applied to the residual assets. The
OTS advised the institution that the accounting treatment was incorrect
and a significant adverse valuation adjustment to these assets was
necessary. Management and E&Y continued to disagree. OTS insisted that
the issue be raised with E&Y's national office.
On January 11, 2001 in a meeting with Superior, E&Y, and the
regulators a national review official for E&Y acknowledged that the
accounting treatment applied by E&Y to the residual assets was
incorrect, although E&Y did not agree as to the amount of the
adjustment. E&Y proposed a Reevaluation of Retained Interest Accounting
Work Plan for the reevaluation of the residual assets, with updates to
the OTS every 2 weeks. The Work Plan proposed to revalue the respective
assets using the correct accounting methodology from the date of
inception for each of the securitization pools. The revaluation later
resulted in a write-down of the residual assets in the amount of $270
million.
Two key management officials at Superior were replaced in early
2001, after the January 11, 2001 meeting. Nelson L. Stephenson resigned
from Superior's board on January 22, 2001. Mr. Stephenson had been a
Director since 1990 and Chairman since 1997. Mr. Stephenson was
instrumental in developing and coordinating loan securitization and
sales activity at the institution. Mr. Stephenson was replaced as
Chairman by Stephen Mann. Mr. Mann was originally hired by Superior as
a consultant to analyze and negotiate acquisitions and strategic
alliances. After the January 11, 2001 meeting, William C. Bracken was
replaced as Chief Financial Officer (CFO) and Secretary of Superior.
Mr. Bracken was a key management official of the institution and had
the responsibility for classified asset reporting and verification of
the major assets of Superior. Walter F. Rusnak replaced Mr. Bracken as
CFO and Corporate Secretary.
On February 12, 2001, OTS notified the board of directors of
Superior that the capital ratios of the institution were in the
``significantly undercapitalized'' PCA category. This condition was the
result of various adjustments made by Superior in conjunction with the
January 24, 2000, examination report, as well as those made by Superior
to the risk weighting of certain assets. This conclusion was also based
upon OTS examiners' findings communicated to the institution during the
October field visit. Superior's board was directed to submit a PCA
Capital Restoration Plan (Capital Plan) by mid-March. Superior also
became subject to requirements and/or restrictions pursuant to Section
38 of the FDIA.
On February 14, 2001, OTS issued a PCA directive to Superior based
upon OTS's determination that the institution was ``significantly
undercapitalized.'' The PCA directive required that Superior originate
only loans that it had forward commitments to sell, and to sell all
loans originated by the institution on a weekly basis. In conjunction
with the PCA directive, the institution's holding companies, SHI and
CCFC, consented to the issuance of a cease and desist order to fund an
escrow account at Superior, to be at least $5 million at all times,
that would cover any losses from Superior's weekly sales of mortgage
loans. The order also prohibited the holding companies from incurring
any new debt or making capital distributions.
On March 2, 2001, Superior amended its December 31, 2000, TFR to
reflect the adjusted valuation of its residual assets under SFAS No.
140, as well as required write-downs. On March 14, 2001, an off-site
examination was conducted at Superior to review recent changes in the
institution's capital, earnings, liquidity, and sensitivity positions.
Based upon the analyses performed during this exam, on March 16
Superior was assigned a composite exam rating of ``5'', a downgrade
from the composite ``4'' rating in the January 2000 exam. The FDIC also
downgraded Superior to a ``5''.
On March 14, 2001 Superior submitted the first version of a Capital
Plan, as conceived by its shareholders and approved by the board. That
same day, OTS and FDIC commenced regular safety and soundness
examinations at Superior. Although not finalized, OTS's exam report
again proposed a composite rating of ``5'' for the institution. The
examiners determined that the institution's low capital level,
concentration of high-risk assets, and large operating losses required
an immediate capital infusion for Superior to become a viable
institution. The findings disclosed that an additional reduction of the
fair market value of the residual assets was warranted, potentially
causing the institution to become ``critically undercapitalized'' and
insolvent.
Because of the problems with erroneous accounting interpretations,
accurate audited financial information on Superior has not been
available for at least the past 3 fiscal years (since June 30, 1998).
The institution's most recent independent audit was completed as of
June 30, 2000 by E&Y. The accompanying financial statements do not
accurately reflect the fair market value of Superior's residual assets
under Generally Accepted Accounting Principles (GAAP). E&Y was not
retained to perform the institution's audit work for the year ended
June 30, 2001.
On March 30, 2001, CCFC made a temporary capital infusion into
Superior in order to keep the institution above the ``critically
undercapitalized'' PCA category pending completion of its Capital Plan.
CCFC transferred to Superior its beneficial interest in residual assets
in seven securitization pools with an estimated value of $81.0 million.
Without the infusion, Superior's PCA designation would have been
downgraded to ``critically undercapitalized'' as of March 31, 2000.
In April, FDIC's Division of Resolutions and Receiverships began to
send staff into Superior in anticipation of a possible closure of the
institution, should a capital plan not be adopted and implemented.
On May 7, 2001, OTS demanded that CCFC repay a $36.7 million
receivable owed to Superior. CCFC responded that it would repay the
receivable when the Capital Plan was implemented. In the interim,
Superior's management indicated it would collect monthly interest from
CCFC. The receivable was classified as a loss after Superior failed to
implement the Capital Plan.
On May 24, 2001, OTS, with non-objection from the FDIC, approved
the Capital Plan submitted by Superior on March 14, 2001, as amended on
April 30, May 15, and May 18, 2001, including revisions received by OTS
on May 19 and May 21, 2001. The Capital Plan included the following
strategies:
Reduce the level of risk currently present in Superior's
operations by removing the residual assets from the institution's
balance sheet and replacing them with cash and low-risk mortgage
backed securities;
Recapitalize the institution to a position of regulatory
capital compliance; and
Restructure operations to return the institution to a
financially healthy and profitable entity on a going forward basis.
The Capital Plan included an aggregate cash infusion of $270
million by the Pritzker and Dworman interests, with the Pritzkers
contributing $210 million, the Dwormans contributing $50 million, and
CCFC contributing the remaining $10 million. A portion of the Pritzker
contribution would be leveraged, resulting in a net benefit to the
thrift of at least $450 million, net of associated pledged assets. As
provided in the Capital Plan, these strategies were to be implemented
between 30 and 60 days from the approval date of the plan, but no later
than July 23, 2001. OTS also received joint and several guarantees of
up to $100 million of performance of the Capital Plan by eight of the
holding companies, including several family trusts.
The Capital Plan required a number of cost-cutting actions at the
bank in addition to the capital infusion. These included reducing
staff, cutting out unprofitable lines of business, closing various loan
production offices, hiring new management, and acquiring new board
members. From May 24, when the plan was accepted, to July 16, although
there were a few disagreements about reporting, Superior was diligently
working toward implementation. For example, from March 31 to closure,
the number of employees declined by approximately 500. Greenwich
Capital, the entity that was to finance the transaction, confirmed that
things were moving toward successful implementation.
On July 16, 2001, the Pritzker interests forwarded a letter to OTS
indicating that they no longer had confidence in some of the
projections they used in developing their Capital Plan. They indicated
that, despite their original projections, it was now their view that
the future cash flows from the institution's residual assets would not
be sufficient to support their strategy in the Capital Plan to remove
the residuals from Superior's books. The correspondence concluded that
it was now their opinion that their Capital Plan would not work and,
therefore, they were not prepared to support it.
By letter dated July 21, 2001, the OTS responded to the Pritzker's
July 16 correspondence. OTS indicated that, even under the most extreme
case set forth in the Pritzker's modified projections, it appeared that
the concerns expressed by the Pritzker interests would not be an issue
until many years later. OTS's correspondence also noted that under the
base case cash flow numbers set forth in the Capital Plan, the pledged
assets supporting the residuals would be unaffected. More importantly,
under either set of assumptions, the projections for the first several
years would have kept the institution in capital compliance upon
implementation of the Capital Plan. OTS's correspondence concluded with
the demand that the Pritzkers fulfill their obligations under the
Capital Plan.
Subsequent to receipt of the July 16, 2001 letter, OTS and the FDIC
together held a number of meetings with the Pritzker and Dworman
interests, separately, without success. On July 25, 2001, Superior's
board of directors executed an Agreement and Consent to the Appointment
of a Conservator or Receiver and on July 27, 2001, OTS appointed the
FDIC as conservator and receiver of Superior.
III. Subprime Lending, Securitization, and Residual Valuation
The following discussion is intended to highlight the risks
associated with subprime lending, how the process of securitization,
particularly combined with the retention of receivables, can
dramatically increase such risks, and what can be done to control these
risks.
A. Subprime Lending
The growth in subprime lending over the last decade means that more
credit has been made available to families that had previously faced
very limited credit opportunities. Technological advances in financial
markets have enabled lenders to gather, analyze, and process more
information more quickly. Lenders have developed management systems
that effectively increase the likelihood of repayment of these higher
risk loans. Financial market developments in securitizing subprime loan
pools have made more funding available for subprime lending at
attractive rates.
Yet, subprime lending is not simply prime lending with a little
more risk. The difference is not just the degree of risk but also the
kinds of risk and their complexity. Subprime loans not only default
more frequently than prime loans, they also prepay both when interest
rates decline and when creditworthiness improves. Prepayment risk is,
therefore, greater for subprime loans. Unlike prime mortgages, older
subprime mortgages can be riskier because in general, even with
prepayment penalties, loans often will prepay if the borrower's credit
improves. Sudden changes in economic conditions or in interest rates
can cause losses to mount quickly and high market valuations to
disappear.
Increased competition in the subprime market has significantly
narrowed lending margins, encouraging institutions to specialize in
what they believe to be their strengths. For many subprime lenders,
profit centers in the origination and servicing of subprime loans, not
in holding them in portfolio. To finance greater levels of originations
and servicing, institutions engaged in subprime lending have often
turned to securitization, rather than deposits, as a major funding
source.
Access to capital markets through securitization allows loan
originators to enhance their liquidity, diversify and lower their
funding costs, manage interest rate risk, build operational economies
of scale, and help manage credit risk. Risks from securitization arise
from problems funding aggressive growth, overdependence on a highly
credit-sensitive funding source, creation of accelerated and unrealized
earnings, and less sound, more volatile balance sheets from leverage
and concentrated residual risk, all of which are compounded in the case
of subprime lending. Each of these issues will now be discussed in more
detail.
B. Securitization
Securitization provides a mechanism by which an institution can
convert a pool of loans into a mix of top investment grade, highly
marketable securities (typically sold for cash), and lower grade,
subordinate credit-risk-concentrated securities. This financial alchemy
is achieved by reapportioning the cash flows (interest and principal
payments) from the loan pool to the security holders in the order of
their
seniority. In essence, the cash flows from the entire pool of loans
create a waterfall. Obligations to senior security holders are met
first, with remaining cash, if any, cascading down to more junior
securities in order of their priority. Any remainder after all other
obligations are met is apportioned to the residual security holder.
Any shortfall in cash flows due to losses in the loan pool affects
the residual security holders first, because they are the last to be
paid. The residual security holder is in a ``first dollar loss''
position and thus is exposed to the risk of the entire loan pool.
Should the shortfall from the loan pool be sufficiently large, the
security holders in the ``second-dollar loss'' position will be
affected next. In essence, each subordinate position provides a credit
enhancement to the more senior securities because it stands below it in
terms of access to the cash flows of the entire loan pool. The lower
yield on high-quality, low-risk senior securities may offset the higher
yields required on more junior positions. This is especially true if
the issuer, who is in the best position to evaluate the credit quality
of the loan pool, keeps the most risk-exposed subordinate positions. In
essence, the issuer is certifying the quality of the pool by a
willingness to be exposed to the most risk.
C. Risks of Securitization
Securitization provides a means to fund substantial origination
growth by reducing the link between the financial performance of the
issuer and the risk of the
securities. This ability to leverage origination capacity and
supplement revenues through servicing fee income has been an important
benefit for financial institutions. Accompanying this relaxation of
funding constraints, however, is increased exposures in areas such as
operational capabilities. This is especially evident when originators
attempt to increase volume by migrating to lower quality borrower
classes where servicing costs and techniques can vary widely and
increase dramatically. A number of monoline and specialty finance
institutions, particularly subprime lenders, fund a substantial portion
of their activities through securitization.
The extensive reliance on securitization as a funding source
creates incentives for institutions to engage in questionable market
practices to ensure continued availability of funding. Most, if not
all, of the ``pressures'' associated with institutions surreptitiously
retaining risk and implicitly supporting previous securitizations have
their roots in the desire to maintain ongoing market access at cost
effective pricing. This pressure grows exponentially when
securitization becomes the only viable method of funding ongoing
operations and meeting business objectives. The substantial fixed costs
associated with establishing and maintaining origination and servicing
facilities and staff require a continual high volume of loan
originations and securitizations. Competitive pressures from firms
entering this business have also exacerbated these problems by
narrowing margins and increasing prepayments as borrowers refinance,
leaving one lender for another.
As the securitization market has matured, issuers have offered
incremental changes in their obligations and structural credit
enhancements to increase the value of their investment-grade
securities. Examples include revolving-asset structures, typical in
credit card securitizations, and seller-provided credit enhancements
such as cash collateral or spread accounts. The extent to which an
institution had transferred risks of the loan pool to outside investors
became much more difficult to ascertain with the advent of these new
credit enhancements. Liberal assumptions made by institutions
regarding, for example, seller-servicing actions and residual asset
valuations, and the complexity of accounting rules made the
determination of the extent of retained risk and the valuation of the
retained interests difficult. One of the most contentious issues
arising out of subprime securitizations is the valuation of retained
subordinate positions--residuals and seller-provided servicing.
D. Seller-Provided Servicing
Seller-servicing is quite common in some product types, such as in
the subprime market, as seller-servicers are often specialists in a
product or transaction type and can provide the most efficient
execution. The primary duty of a servicer is the collection and pass
through of funds from the underlying borrowers to the trustee and/or
investors. Other duties include loss mitigation and workout, investor
accounting, custodial account management, collateral protection through
foreclosure, and escrow management.
Servicer-related issues have become a growing concern. One factor
fueling this has been the aggressive migration of originators into
subprime and/or lower quality asset types, and the growing number of
instances where originators are providing both servicing and credit
enhancement to the same transaction. This combination has raised new
issues regarding the assumption of risk for seller-servicers that may
be able to mask losses by artificially keeping loans current through
servicer advances. The concern is that investors receive principal and
interest payments from loans that are not paying as agreed without
exhausting existing credit enhancement for the privilege, a problem
similar to that which surfaced in the BestBank failure. The issuer
benefits by continuing to recognize inflated overcollateralization
assets on its balance sheet.
E. Residual Interests
Structural enhancements that involve a seller's retention of risk
typically take two forms. First loss positions, where an originator
offers its right to excess interest income (after servicing, coupon
payments, and normal loss expectations) and/or a cash collateral
account, are designed to cover some small multiple of expected losses
on the underlying asset pool. Second loss positions, where an
originator may retain a subordinated interest in the securitized asset
pool or pledge additional assets as an overcollateralization cushion,
are designed to cover more severe or ``catastrophic'' levels of loss.
Collectively, these exposures are referred to as ``residual interests''
for accounting and risk-based capital purposes.
Because residual interests are often carried on the balance sheet
and have no current regulatory limitations on amounts booked, several
regulatory concerns have arisen. First, examinations have repeatedly
encountered inconsistency and over-optimism in initial and ongoing
valuation of residual interests. Questionable valuation methods have
included incorrect cash flow modeling, unsupported loss assumptions,
inaccurate prepayment estimates, and inappropriate discount rates. As
residuals generally have no liquid secondary market, their estimated
market values are difficult to verify. This lack of verifiability has
sometimes led to extended disagreements with institutions and their
accounting firms about proper valuation.
Second, residual interests are exposed to a significant level of
credit and interest rate risk that make their values extremely
sensitive to changes in the underlying assumptions. This sensitivity is
magnified in the case of subprime residuals. As a result, these
volatile residual interest assets provide little real capital support,
particularly in times of stress.
F. Subprime Securitizations and Valuation Issues
Securitized subprime loan pools present an even greater challenge
to the proper valuation of residuals and servicing rights for several
reasons. First, by definition, subprime loans are extensions of credit
to borrowers with weak credit histories. The ability of these borrowers
to make loan payments is very sensitive to changes in overall economic
conditions. For example, the recent slowdown in the economy has led to
a substantial increase in subprime mortgage delinquencies, while, so
far, having little impact on the performance of prime mortgages.
Second, insured institutions' involvement in the subprime market
has not been tested during a period of prolonged economic downturn.
Higher than expected default rates reduce the value, sometimes
dramatically, of both residual assets (since these are in the most
junior position) and the servicing rights, as future payments cease and
collection costs increase when loans default. As this occurs, book
values of residual assets and the servicing rights should be written
down. This will swiftly lower the level of regulatory capital for
institutions with high levels of residual assets and servicing rights.
Third, subprime borrowers will refinance their loans to reduce
interest costs if overall interest rates drop enough to overcome
disincentives to prepayment, as they have recently, or as borrowers'
credit ratings improve. This second factor (credit-
induced prepayment) is absent in prime mortgages and further
complicates the valuation of servicing rights, as prepayments for
either reason stops servicing income.
Fourth, some institutions have been able to use residual interests
and gain-on-sale accounting (for example, immediate recognition of the
present value of expected future cash flows) to improve their capital
positions by securitizing assets. This happens most often when an
originator securitizes higher-risk assets such as subprime loans. As an
example, the overcollateralization requirements for an investment-grade
security rating for a pool supported by subprime loans is typically
higher than the 8 percent capital charge assigned when such loans are
on an institution's balance sheet. In this instance, the institution
can use gain-on-sale accounting provisions to improve its capital
position even though its risk exposure has not changed.
Finally, the gain-on-sale accounting for residuals provides a
strong incentive for companies to grow origination volume, sometimes to
unsustainable levels. Since securitization gains are directly
proportional to the volume of loans securitized, in some cases the
primary source of ongoing earnings growth is increased loan origination
and securitization volume. This may eventually lead to the dilemma
where market conditions warrant a reduction in loan origination volume,
however, the result would be to reduce both reported earnings and the
institution's stock price.
G. Regulatory Responses
With respect to subprime lending, OTS first raised concerns in June
1998. This was followed by interagency guidance on subprime lending in
March 1999. That guidance stressed the management and operational
challenges in subprime lending, and cautioned of the need for increased
capital and reserves. In January 2001, the FBA's issued expanded and
supplemental guidance intended to strengthen the examination and
supervision of institutions with significant subprime lending programs.
The January 2001 guidance principally applies to institutions with
substantial subprime lending programs that equal or exceed 25 percent
of an institution's Tier 1 regulatory capital. The guidance instructs
examiners to consider, based on the size, concentration level, and
relative risk of an institution's subprime lending
activities, the following elements:
Portfolio growth rates;
Trends in the level and volatility of expected losses;
The level of subprime loan losses incurred over one or more
economic downturns, if such data/analyses are available;
The impact of planned underwriting or marketing changes on the
credit characteristics of the portfolio, including the relative
levels of risk of default, loss in the event of default, and the
level of classified assets;
Any deterioration in the average credit quality over time due
to adverse selection or retention;
The amount, quality, and liquidity of collateral securing the
individual loans;
Any asset, income, or funding source concentrations;
The degree of concentration of subprime credits;
The extent to which current capitalization consists of
residual assets or other potentially volatile components;
The degree of legal and/or reputation risk associated with
subprime business line(s); and
The amount of capital necessary to support an institution's
other risks and activities.
Because of the elevated risk levels, examiners were also warned
that the quality of subprime loan pools may be prone to rapid
deterioration, especially in the early stages of an economic downturn.
The guidance indicated that sound underwriting practices and effective
control systems can help provide the lead time necessary to react to
deteriorating conditions, while sufficient allowance and capital levels
can reduce their impact.
In December 1999, responding to increased use of securitizations by
institutions, the Federal banking agencies (FBA's) published Guidance
on Asset Securitization (Securitization Guidance). The interagency
guidance addressed supervisory concerns with risk management and
oversight of these securitization programs. The Securitization Guidance
highlighted the most significant risks associated with asset
securitization, and emphasized agency concerns with certain residual
interests generated from the securitization and sale of assets. The
guidance also set forth fundamental risk management practices that the
agencies expected of institutions that engage in securitization
activities.
The Securitization Guidance stressed the need for institution
management to implement policies and procedures that include limits on
the amount of residual interests that may be carried as a percentage of
capital. The guidance stated that, given the risks presented by
securitization activities, the FBA's would be considering regulatory
restrictions that limit or eliminate the amount of certain residual
interests that could be recognized in determining the adequacy of
regulatory capital.
In September 2000, the FBA's published a notice of proposed
rulemaking on residual interests in asset securitizations or other
transfers of financial assets (Residuals Proposal).\4\ The proposal was
intended to address the agencies' concerns with residual interests
highlighted in the Securitization Guidance. The Residuals Proposal
defined residual interests and required a dollar-for-dollar capital
charge against risk-based capital, that is, residuals would be counted
neither as assets nor capital for risk-based capital purposes. The
FBA's further proposed a deduction from Tier 1 capital of the total
amount of residual interests held by an institution in excess of 25
percent of Tier 1 capital. This, in effect, creates a concentration
limit because of the severity of the capital requirement.
---------------------------------------------------------------------------
\4\ See 65 Fed. Reg. 57993.
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The FBA's received many comments on the Residual Proposal from
banks and thrifts, law and accounting firms, trade associations, and
Government-sponsored enterprises. Several commenters opposed the
proposed capital treatment, believing that concerns associated with
residual interests should be handled on a case-by-case basis under the
existing supervisory authority. Many of these comments referenced the
Securitization Guidance, which highlighted the supervisory concerns
associated with residual interests.
Even before the events that unfolded with Superior Bank, the OTS
had significant concerns with the credit risk exposure associated with
deeply subordinated assets, particularly below-investment grade and
unrated residual interests. While the dollar-for-dollar capital
requirement could result in an institution holding more capital on
residual interests than on the underlying assets had they not been
sold, in many cases the relative size of the retained exposure by an
originating institution provides insight into the quality of the
securitized asset pool. In other words, large residual positions often
serve as a signal of the lower credit quality of the sold assets. The
dollar-for-dollar and concentration requirements would also reduce an
institution's ability to leverage its balance sheet based on the gain
on sale accounting for residual interests.
To most effectively implement our guidance on subprime lending and
securiti-
zation, as well as any new capital regulation, it is critical that the
agencies receive more and better quality information, on a regular
basis, preferably through the TFR and Call Reports, on both subprime
lending and residual holdings. OTS in March of this year and the other
FBA's in June began to collect data on residuals, but the quality needs
to be improved. All agencies are working toward a proposal to begin
collecting data on subprime lending.
IV. Accounting and Financial Reporting Issues
OTS's experience with Superior highlights a number of accounting
and financial reporting issues, and other problems confronting all of
the FBA's. These include problems with GAAP as it is applied to the
regulatory reporting requirements of the FBA's, and problems with SFAS
No. 140 (which replaces SFAS No. 125) and gain-on-sale accounting. In
addition, the independent role of external auditors and their training
and experience with complex financial instruments and transactions are
issues raised by our experience with Superior. Finally, perhaps the
most vexing issue confronting the FBA's in this area is how to resolve
disputes and disagreements between FBA examiners, and outside
accountants, especially when such disputes implicate regulatory capital
levels.
A. Regulatory Reporting Consistent with GAAP
Since 1997, regulatory reporting by banks and thrifts on both the
bank Call Report and the TFR has been in accordance with GAAP. Although
this approach has several benefits, including uniformity, it
incorporates into regulatory accounting practices (RAP) certain
generally accepted accounting practices that have been troublesome for
effective bank supervision. One such practice is ``gain-on-sale''
accounting.
The accounting and reporting for securitizations and residual
interests is dictated by SFAS No. 140,\5\ which was issued in September
2000. Under SFAS No. 140, a transfer of loans in a securitization
transaction where control of the loans is deemed to have been
surrendered must be accounted for as a sale. The various criteria for
transfer or surrender of control under this standard were established
from a legal point of view. Therefore, sale recognition is not
dependent on a transfer of risks and rewards. Where the transfer has
been accounted for as a sale, and where the proceeds exceed the cost,
the seller must report a gain on the sale. This is so even if the
seller has (1) significant continuing involvement with the assets sold,
including recourse, and (2) retained substantial non-cash assets, such
as residual interests.
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\5\ SFAS No. 140, ``Accounting for Transfers and Servicing of
Financial Assets and Extinguish-
ments of Liabilities,'' replaced SFAS No. 125, issued in 1996 and
effective in 1997.
---------------------------------------------------------------------------
A gain typically results where the seller retains a residual
interest in the loans. An example is illustrative of the problem. In a
securitization transaction in which loans with a face amount of $1,000
are sold for cash proceeds of $980, and a residual interest with a fair
value of $50 is retained,\6\ the transaction will produce the following
results:
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\6\ The total value exceeds the face amount of the loans because it
includes the discounted
expected future cash flows (that is, interest payments and late fees).
---------------------------------------------------------------------------
The transaction produces a ``cash loss'' of $20, computed as
follows:
Cash proceeds $980
Cost of loans (1,000)
------------
Cash gain (loss) on sale of loans (20)
============
Under SFAS No. 140, however, a ``gain-on-sale'' of $30 is
reported,\7\ computed as follows (using a simplified method):
---------------------------------------------------------------------------
\7\ Under the ``allocated cost based on relative fair value
method,'' as required by SFAS No. 140, would actually result in a
retained residual interest of $49 and a ``gain-on-sale'' of $29. For
purposes of this example, the $1 difference is not significant.
Cash proceeds ............. $980
Cost of loans $1,000 .............
Retained residual interest (50) .............
--------------
Net cost 950 ............. (950)
============== ------------
Gain-on-sale ............. 30
============
The ``gain-on-sale'' of $30 can be reconciled as follows:
Cash gain (loss) on sale of loans $(20)
Retained residual interest 50
------------
Gain-on-sale 30
============
Under SFAS No. 140, fair value is the amount at which an asset
could be bought or sold in a current transaction between willing
parties, other than in a forced or liquidation sale. This implicitly
permits the use of more favorable valuation assumptions as to
prepayments, credit losses, and discount rates than are used by buyers
when such interests must be sold in a forced sale. However, we
understand that most sales of residual interests are in a forced or
liquidation sale. Under such circumstances, the price paid is usually
substantially lower than the fair value, which is the amount at which
the asset is carried on an institution's books. As a result,
substantial losses are reported on these sales.
While SFAS No. 125 established the original gain-on-sale
requirements, SFAS No. 140 added additional disclosure requirements
with respect to residual interests, which became effective in late
2000.\8\ Companies must now disclose their critical assumptions as to
prepayments, credit losses, and discount rates on an aggregate basis.
Although this may subject the valuation of these assets to greater
market discipline, because the disclosures may be made on an aggregate
basis, they may not be sufficiently detailed for bank supervisory
purposes.
---------------------------------------------------------------------------
\8\ Emerging Issues Task Force (EITF) issue No. 99-20,
``Recognition of Interest Income and Impairment on Purchased and
Retained Beneficial Interests in Securitized Financial Assets,'' which
became effective in June 2001, established additional requirements for
the recognition of income and impairment in the accounting of residual
interests.
---------------------------------------------------------------------------
OTS and the other FBA's already have statutory authority to remove
from regulatory reporting the undesirable accounting practice of gain-
on-sale. However, this authority has seldom, if ever, been used to
address undesirable accounting practices that are required under GAAP.
Doing so could create RAP/GAAP differences and add to the regulatory
burden. Most RAP/GAAP differences that existed in the 1980's and the
early 1990's were eliminated for this very reason. Nevertheless, in
light of the very substantial concerns we have had with the valuation
of residuals and their volatility, as discussed above, the FBA's have
proposed removing from regulatory capital most of the GAAP capital
inflation caused by gain-on-sale accounting by deducting the residual
interests in computing regulatory capital.
While this may, at least temporarily, mitigate the residuals
problem as it relates to capital, this situation illustrates the
broader issue that accounting changes can sometimes have far-reaching,
and troublesome implications for bank regulation. We therefore
recommend that prior to the issuance of a SFAS that has a potential
major impact on banks and thrifts, the FASB should conduct a formal
impact study, and consult with the FBA's regarding the potential impact
of the change or revision.
B. External Auditor Issues
1. Auditor Independence
Under relevant professional standards, an external auditor must be
independent, both in fact and in appearance. Some believe that this
independence becomes impaired where an auditor provides certain
``nonaudit'' services (such as consulting) to an audit client. In
recognition of this, last year the SEC revised its independence rules
to limit an auditor's ability to provide ``nonaudit'' services to an
audit client.
The SEC's revision did not, however, delineate what appropriately
falls within the purview of ``audit'' services. Thus, independence
issues remain with respect to services that are labeled as ``audit''
services by an auditor. In the context of securiti-
zations, auditors typically provide valuation services. Such services
may include advising on the methodologies and assumptions for
estimating the fair value of residual interests. Quite often, such
services are provided by members of the audit team, and are considered
``audit'' services; nevertheless, the audit team will then audit the
valuation, for example, the results of their own work. It is not
farfetched to question whether the auditor's independence becomes
impaired where the auditor provides valuation services in connection
with an audit, regardless of how the services are characterized.
In 1999, the audit profession's Independence Standards Board (ISB)
recognized this threat to independence, and issued an interpretation
that limited the provision of valuation services, but only as it
relates to derivative instruments. The AICPA and SEC should be
encouraged to further strengthen auditor independence rules to prevent
auditors from providing valuation services to audit clients, even if
those services are considered ``audit.''
Congress or the FBA's could also encourage the AICPA and SEC to
establish an ``external auditor rotation'' requirement, or at least as
to institutions of significant size. This would require that an
external audit firm and/or engagement partner limit their relationship
with an audit client to a specified number of years (for example, 3 to
4 years). While we understand the economic arguments in opposition to
this requirement, its adoption would result in a periodic ``fresh
look'' at the institution from an audit perspective, to the benefit of
investors and regulators.
2. External Auditor Training and Experience
The accounting, reporting, and regulatory capital treatment for
securitizations and residual interests is highly complex, both because
of the complexity of the instruments themselves and because of the
accounting and reporting requirements. It is imperative that key
members of the external audit team, including the engagement partner,
have sufficient training and experience in this area. In addition, it
is important that a second partner with sufficient training and
experience in the area perform a review. Unfortunately, over the last
several years, we have seen situations where this level of training and
experience was lacking. For those institutions, this has resulted in
significant unfavorable adjustments to reported income, GAAP capital,
and regulatory capital.
The most obvious way to address this problem is to encourage the
AICPA and major external audit firms to strengthen their requirements
for training and experience. The key members of an audit team,
including the engagement partner and the review partner, should be
trained in and experienced with all of the financial complexities
anticipated in an engagement. Where unanticipated issues arise, an
audit firm should make arrangements to bring in the necessary experts
to complete a review or indicate to the institution that it is unable
to do so.
3. Resolution of Accounting Disputes
The objectives of an external audit and an examination are very
different. The objective of an audit is for the auditor to issue an
opinion that the financial statements of the audit client are prepared
in accordance with GAAP. That is, the sole purpose of the audit is to
opine on the institution's financial statements.
By contrast, an examination is much more comprehensive. The
objective of an examination is for the examiner to form conclusions and
recommendations regarding the safety and soundness of the institution.
The examiner evaluates the institution's capital, asset quality,
management, earnings, liquidity, and sensitivity to market risk. But in
doing so, the examiner, who is usually not an accountant, relies, in
many aspects of the exam, on the auditor's certification of the
financial statements. This includes items such as the valuation of
assets, which may involve, for example, loan loss allowances or
residual interests.
An institution that receives a ``clean'' opinion from its external
auditor could receive an examination report in which the examiner
concludes that the institution is operating in an unsafe and unsound
manner, for example because of operational or systems problems, poor
underwriting, or capital not commensurate with the institution's risk
profile. The examiner could recommend major changes at the institution
or prospective enforcement actions.
Management has primary responsibility for an institution's
financial statements, including external financial statements
(including Call Reports and TFR's) and financial statements included in
audit reports. When there is disagreement between institution
management and an examiner on an accounting issue with a significant
potential adverse impact on the institution, most often the external
auditor, as an expert, is asked to support management's position. When
this happens at an OTS-regulated institution, the OTS Regional
Accountant, and sometimes the OTS Chief Accountant, works with the
examiner to resolve the dispute. Unfortunately, this process sometimes
takes several months or longer. During this time, the institution's
regulatory reports may not reflect the adjustment that could result
from a resolution unfavorable to the institution. As a result, there
may be a delay in certain supervisory actions, pending resolution of
the issue.
To get at this problem, we recommend that Congress enact
legislation providing that a Federal bank regulator may issue an
``accounting dispute letter,'' starting a 60 day clock for resolution
of the dispute, if the dispute could result in a lower PCA capital
category for the institution. If there is no resolution at the close of
this 60 day time period, the regulator's position will be adopted for
regulatory accounting purposes including, in particular, the Prompt
Corrective Action provisions of Section 38 of the FDIA. The provision
could be either an amendment to PCA or could stand alone. While this
may seem extreme, we believe it will be used judiciously to force
resolution only in those cases in which delay and intransigence, rather
than legitimate policy disputes, are at issue.
V. Prompt Corrective Action \9\
Ten years ago, Congress enacted Section 38 of the Federal Deposit
Insurance Act (FDIA)--better known as Prompt Corrective Action (PCA).
PCA was intended to give the FBA's the tools to minimize the potential
cost to the deposit insurance funds of troubled institutions and ensure
that the regulators not only could, but also would, act quickly. Under
PCA, capital is the key factor in determining an institution's
condition. As an institution's capital condition deteriorates,
regulators can use increasingly restrictive tools, including closing
the institution, to avert or stem potential losses to the deposit
insurance fund.
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\9\ See also the discussion of resolution of accounting disputes,
above.
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At the same time PCA was enacted, Congress added a new Section 39
to the FDIA to address the full panoply of noncapital related safety
and soundness related management and operational standards. That new
authority authorized the FBA's to establish those standards, require
institutions not in compliance with those standards to submit a plan
showing how they would attain compliance, and take actions against and
impose restrictions on institutions failing to submit or implement an
acceptable plan.
PCA never contemplated that every institution subject to a PCA
directive would be closed or that there would never be any loss to the
insurance fund. The intent was to ensure early regulatory action and
impose escalating restrictions upon institutions as their capital
levels declined so that any eventual closure would result in smaller
losses to the deposit insurance fund. The operational and managerial
standards implemented under Section 39 were intended to serve similar
goals for safety and soundness issues not necessarily involving
capital.
In many ways, PCA has served its intended purposes well. OTS has
issued 50 PCA Directives to 47 different institutions since 1992; only
8 of the 47 institutions involved failed. We have one PCA Directive
outstanding. The remaining 38 institutions were restored to health,
voluntarily liquidated, or eventually merged or sold to another
institution--in all cases with no loss to the deposit insurance fund.
With respect to the three institutions other than Superior that were
placed into receivership after the Resolution Trust Corporation (RTC)
ceased its operations, PCA helped OTS impose appropriate limits on the
troubled institution and substantially shrink its eventual cost to the
deposit insurance fund. None resulted in a material loss to the fund.
OTS used PCA in attempting to resolve the problems at Superior, and the
institution shrank by about 15 percent in its final 6 months, including
the roll-off of more than $120 million in insured brokered deposits.
Nevertheless, there will likely be material loss to the deposit
insurance fund.
We have used our authority under Section 39 and our implementing
regulations at 12 CFR Part 570 more frequently than PCA in recent
years, especially since directives under that authority worked
effectively in the context of Y2K. OTS has issued 32 notices under Part
570, half of them related to Y2K. Other than Superior and
Oceanmark,\10\ none of the institutions has failed.
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\10\ Oceanmark FSB, failed in 1999, with a current estimated loss
to the SAIF of $620,000. The Part 570 notice in that case related to
Y2K, and had no bearing on the failure. A PCA directive was also issued
to Oceanmark.
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A. Timing Issues With the PCA Process
PCA was not intended to deal with catastrophic events--such as a
liquidity crisis or a loss of market confidence--but with stemming the
deterioration of an institution's capital position over time. PCA
contains provisions allowing for downgrades in PCA categories based
upon noncapital related safety and soundness concerns. However, the
required hearing process involved with a downgrade and the availability
of non-PCA enforcement tools, including the safety and soundness tools
of Section 39, have meant that the downgrade provision for noncapital
factors has been used only once by a FBA.
Congress may wish to reexamine how the safety and soundness
measures of Section 39 of the Federal Deposit Insurance Act interact
with the PCA provisions under Section 38. Both sections anticipate the
passage of a certain amount of time as the regulators require a plan
and the institution prepares and presents a satisfactory plan
addressing the regulators' concerns. In the case of Superior, OTS used
both tools because at the outset the institution's reported capital
levels did not trigger the PCA process. However, the negotiations over
the institution's condition and what then would be an acceptable
capital or safety and soundness plan caused considerable delays under
both provisions.
B. Including a Risk-Based Capital Measure in the PCA Critically
Undercapitalized Category
Including a risk-based capital measure in the PCA critically
undercapitalized level would allow regulators to address serious off
balance sheet risks. Certain risks embedded in an institution's
portfolio, such as those presented by securitizations, may not be
adequately reflected in GAAP total assets and resulting tangible equity
levels. In the event an institution becomes undercapitalized on a risk
basis, the institution would not fall into the critically
undercapitalized PCA category absent the availability of a risk-based
capital measure. All of the other PCA categories have a risk-based
capital component to address these risks. We believe such a measure is
increasingly important as more and more institutions engage in higher
levels of securitizations and other off balance sheet activities.
The FBA's can address some of these concerns through rulemaking,
but statutory authority that recognizes that off balance sheet type
risks may be serious enough to warrant steps that includes potentially
closing an institution would be helpful.
VI. Interagency Coordination Issues
An issue that has spawned significant interest in the context of
Superior is the extent of coordination between OTS and the FDIC in
addressing problems at the institution during the last several years.
As I noted at the outset of my statement, there were occasional
disagreements in judgment between OTS and the FDIC about the handling
of Superior. But these had little, if any, bearing on Superior's
failure.
In particular, I believe it is unlikely that the addition of one
FDIC examiner to OTS's January 1999 examination team would have
prevented Superior's failure or materially reduced SAIF losses from the
failure. Unfortunately, this is impossible to prove. OTS had a fully
staffed, on-site examination in January 1999, and we shared all of our
work papers and examination materials with the FDIC during this
process. Based on our work papers, the FDIC issued Superior a composite
CAMELS rating of ``3,'' which was lower than our ``2'' composite
rating.
While individuals from our respective agencies may disagree with
each other at times, there is every incentive for the FBA's to work
together and, particularly, to coordinate and cooperate with the FDIC
to address problem institutions. There is definitely benefit in having
two regulators instead of one working on the same problem. In fact,
this was very much the experience between OTS and the FDIC in the
handling of Superior. In numerous instances, issues arose in which a
joint OTS-FDIC response provided not only the best answer, but also the
strength of a joint determination. Moreover, the healthy tension
between the primary regulator and the FDIC aids in accomplishing the
best result for the financial services system and the deposit insurance
funds: a private sector solution where feasible and a least-cost
liquidation, with prefailure shrinkage, where not.
A. Coordination With the FDIC:
The Role of the Deposit Insurer as Back-up Regulator
The FDIC has served as back-up regulator to OTS for the oversight
of thrift institutions since the enactment of FIRREA in 1989. The
relationship between the agencies and their respective industry
oversight roles have evolved during the last 12 years. While the FDIC
initially conducted separate exams for a large portion of OTS-regulated
thrifts, by 1995 this duplication of regulatory oversight was viewed as
counter-productive. As a result, both agencies agreed upon a protocol
that guaranteed FDIC an on-site exam presence for troubled institutions
but required some level of justification to go on-site for nontroubled
institutions. The same protocol applies to the FDIC's back-up role for
national banks regulated by OCC and State member banks regulated by the
FRB.
Since March 1995, FDIC has participated on-site in 74 OTS exams.
Under the interagency protocol, disputes between the FDIC and another
FBA regarding FDIC exam participation are to be resolved by the FDIC
Board. Since I joined the FDIC Board in October 1997, no cases have
been submitted to the FDIC Board for consideration. All requests for
exam participation have been worked out on an informal basis, mostly
through the respective agency's regional offices. Moreover, I have
informed OTS's Regional Directors that they are not to deny any
requests by the FDIC for on-site access; such a denial can only be made
by me or my Deputy. Despite a general sense the current arrangement has
handled most circumstances, we believe it would be appropriate for all
the banking agencies, including the Federal Reserve Board, to revisit
the general approach and mechanics of FDIC on-site participation in
exams of institutions for which it is not the primary Federal
regulator.
Without waiting for the broader review, we are looking internally
at how to make FDIC participation more productive. The operational
details of coordinating FDIC exam participation are determined at the
regional level and can take different forms. For example, we may divide
the work, or the FDIC may simply review and assess work performed by
OTS examiners. However, in all cases, the exam report is prepared by
OTS, sent to the FDIC for review, and then issued by OTS.
The FDIC will usually prepare an internal report and provide it to
OTS. The FDIC does not provide any direct written communication to the
thrift as a result of the exam participation. And they do not jointly
sign the OTS exam report. This can result in some counter-productive
differences in the timing of each agency's report. OTS adheres to a
very strict timeframe on transmission of the report to the institution
in order to promote timely resolution of any deficiencies detailed in
the report. Since the FDIC report is not transmitted to the thrift, the
same type of time pressures are not present.
Differences in the timing of exam report completion can create
difficulties for both the institution and the regulators when there are
divergent conclusions. Once the on-site review has been completed, it
is more difficult to resolve these interagency differences. In order to
remedy this shortcoming we are committed to developing a procedure that
will result in the resolution of any differences in a timely manner so
that the agencies can present a unified and complete regulatory
position in the report of exam and, where appropriate, quickly move to
implementation of any
enforcement action.
On-site FDIC exam participation tends to receive the bulk of the
attention when addressing the FDIC's role as back-up regulator.
However, for the vast majority of thrifts the FDIC fulfills their back-
up role through off-site analysis.
This process tends to operate very successfully without much
fanfare. Throughout the year FDIC case managers review and analyze a
myriad of both public and private information on OTS-regulated thrifts.
We are continually working to provide the FDIC easy access to
institution-specific information. The FDIC has direct access to
institution-specific financial data through our internal reporting
systems, and we provide the FDIC with monitoring information on a
quarterly basis. Unless the OTS is otherwise directed by the FDIC, the
FDIC regional office receives the draft exam report on every one of our
institutions 10 days before it is finalized, so any concerns the FDIC
might have can be resolved or added before the report is transmitted to
the institution. The number of interagency disputes that arise from
this process is small and we are jointly working toward more timely
recognition and resolution of differences, particularly rating
differences.
B. Streamlining Interagency Coordination Processes
The final topic I want to cover is the issue of broader interagency
coordination. To the extent regulations could have prevented the
Superior failure, our inability to move more quickly on both the
recourse and the residual rules has to be tagged as part of the
problem. Like more effective boards and management, this one is hard to
legislate. This is largely an area where the regulators have to have
the will to improve. And I firmly believe that it can only be done by
more frequent informal, but agenda-driven, meetings directly among the
principals. There have been various attempts at this during my 4 years
as OTS Director--the regulators' breakfasts, lunches after FDIC board
meetings, regular and not-so-regular bilateral meetings between various
combinations of principals--but none have been sustained or
particularly successful. I discussed this issue with Chairman Powell
over breakfast 2 weeks ago, and he was very eager to try again.
We also need to do a better job of encouraging the staff to bring
disputes to the principals earlier in the process. Like all staffs,
ours have a tendency to want to try to solve problems themselves, in
part out of respect for the principals, but I suspect in part out of a
concern that the principals will not really understand what is at
issue. At OTS, our small size and flat structure helps me break this
down, but we are certainly far from perfect. The principals themselves
need to do a better job of forcing the issue.
Finally, we need to do a better job of working together across
agencies. We already have a series of interagency groups or committees
that regularly exchange information on problem institutions or
specialty areas such as securitization or capital market activities. We
need to add more cross-training, more work on each other's
examinations, perhaps details into other agencies (although, of course,
each agency is concerned that the other will poach its best people). If
we understood each others' perspectives better at all levels, we would
not only do a better job, we would also probably do it more
efficiently.
VII. Conclusion
I have spent the bulk of this testimony on suggestions about how to
improve the regulatory process, including the role of accountants, that
relate to a series of issues that all seem to have come together in the
failure of Superior Bank. And I do think there is room for improvement.
However, I think it is useful to close with the observation that
regulatory action can only go so far: the ultimate responsibility for
the success or failure of any institution rests on those who own,
operate, and run the institution.
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PREPARED STATEMENT OF JOHN REICH
Director, Federal Deposit Insurance Corporation
October 16, 2001
Mr. Chairman, Senator Gramm, and Members of the Committee, I
appreciate the opportunity to testify on behalf of the Federal Deposit
Insurance Corporation regarding the failure of Superior Bank FSB,
Hinsdale, Illinois (Superior). In my testimony today, I will briefly
summarize the crucial issues, which make the failure of Superior of
special interest to the regulators, the Congress and the public. I will
provide a brief chronology of the FDIC's role in the events leading up
to the failure of Superior followed by a description of our actions in
resolving this troubled thrift. Finally, I will turn to a discussion of
the lessons learned.
Introduction
The primary reason for Superior's failure was the decision of its
board and management to book high levels of retained interests related
to the securitization of subprime assets. The retained interests were
deeply subordinated, at a first loss position, to more senior claims on
the more than $4 billion in subprime loans that Superior Bank sold to
investors. Over the course of several years, Superior's retained
interests represented an increasing multiple of its Tier 1 capital.
Volatility of Retained Interests
Since 1998, failures of institutions with risk characteristics
similar to those of Superior have cost the FDIC insurance funds more
than $1 billion. The failure of Superior Bank again highlights the
inherent volatility of retained interests.\1\ Retained interests,
sometimes referred to as ``residuals,'' represent an accounting
recognition of immediate gains on the sale of assets in the course of
securitization activities. These interests pose significant valuation
and liquidity concerns, particularly when related to higher-risk
subprime or high loan-to-value loans. A complex, assumption-driven
valuation process makes the value of the retained interest very
volatile and subject to much interpretation.
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\1\ Retained interests are balance sheet assets representing the
right to a specified portion of the remaining cash flows from a
securitization after paying bondholder obligations, covering credit
losses, and paying servicing and trust-related fees.
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Limits of Prompt Corrective Action
The failure of Superior also illustrates the limits of Prompt
Corrective Action (PCA)--tools given to the regulators in 1991 to
assist in the supervision of insured institutions and to assist in
avoiding high costs to the insurance funds when institutions do fail.
Although it has yet to be tested during a prolonged economic downturn,
so far PCA has been successful and has worked in a high percentage of
cases involving problem institutions. In fact, most troubled
institutions turn around during the PCA supervisory process. However,
the corrective actions under PCA will not necessarily stem the losses
in situations where unrecognized losses are already embedded in the
assets. This is especially true in situations such as the failure of
Keystone National Bank, which involved fraud, and Superior Bank, which
involved a dramatic restatement of the complex, assumption-driven
values related to retained interests.
Failures caused by fraudulent activity by bank managers or
directors also pose a challenge to regulators and the implementation of
PCA. From a supervisory standpoint, fraudulent activity is by its
nature harder to detect than is unsafe or unwise conduct. Because fraud
is both purposeful and harder to detect, it can--and frequently does--
significantly raise the cost of a bank failure. The same internal
weaknesses that lead to credit and other operating losses have provided
opportunities for dishonest and illegal activities.
Finally, the failure of Superior highlights the role of the
institution's accountants when their opinions are at odds with the
regulators. Going forward, this is a serious public policy issue that
must be addressed.
As discussed in detail later in this testimony, the FDIC believes
the banking agencies need to continue work toward ensuring that
adequate risk-based capital is held against retained interest assets,
as well as implementing limits on the degree to which retained
interests can be recognized for regulatory capital purposes.
FDIC's Role in the Events Leading to the Failure of Superior Bank
The Pritzker and Dworman families purchased Superior Bank in 1988
in a Federal Savings & Loan Insurance Corporation (FSLIC) assisted
transaction. At the time, the thrift was troubled and the investors
injected $42.5 million into Superior through a holding company, Coast-
to-Coast Financial Corporation (CCFC). CCFC, in turn, owned Superior
FSB through a shell holding company, Superior Holdings, Inc. (SHI),
which was formed in 1998 and became a thrift holding company in 1999.
CCFC itself was owned by a multitiered and complex set of companies/
trusts that is controlled by the Pritzkers and Dwormans.
During the late 1980's and early 1990's, the thrift operated under
an assistance agreement with the FSLIC.\2\ The FDIC examined the
troubled thrift several times during this period, usually concurrently
with the Office of Thrift Supervision (OTS)--Superior's primary Federal
regulator. Superior's supervisory rating was eventually upgraded to a
CAMEL rating of composite ``2'' in 1993 when the institution's
condition stabilized.\3\ From 1993 to 1996, the thrift was rated a
composite ``2'' by the OTS. In October 1997, the OTS assigned a
composite ``1'' rating. During this period of time, based on the
apparently satisfactory condition of the thrift, the FDIC's review of
the thrift's financial condition was primarily limited to off-site
monitoring of publicly available quarterly statements of income and
condition filed with Federal regulators, OTS examination reports, and
other available information.
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\2\ This agreement included capital protection provisions and
called for reimbursement of expenses for collecting certain problem
assets, payment of 22.5 percent of pretax net income to the FSLIC, and
payment of a portion of certain recoveries to the FSLIC. (In later
years, there was a disagreement over certain provisions to the
assistance agreement and lawsuits are currently pending.)
\3\ CAMEL is an acronym for component ratings assigned in a bank
examination: Capital, Asset Quality, Management, Earnings, and
Liquidity. In 1997, an additional component, ``S'' for Sensitivity to
market risk, was added. A composite CAMELS rating combines these
component ratings, again with 1 being the best rating.
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The FDIC's interest as insurer was heightened in December 1998 when
we conducted an off-site review of Superior, based on September 30,
1998 financial information. The FDIC's off-site review noted
significant reporting differences between the bank's audit report and
its quarterly financial statement to regulators, increasing levels of
high-risk, subprime assets, and growth in retained interests and
mortgage servicing assets. Based on these concerns, the FDIC sent a
written request that an FDIC examiner participate in the January 1999
OTS examination. OTS orally denied this request but did share work
papers and met with the FDIC at the end of the 1999 examination to
discuss the bank's condition.
The FDIC's review of the OTS's January 1999 examination and
additional off-site monitoring generated significant concerns about the
institution's risk profile, particularly with regard to unusual
regulatory reporting, and the high, and growing, concentration in
retained interests and other high-risk assets. As a result of our
concerns, the FDIC officially downgraded the thrift to a composite
``3'' in May 1999, triggering deposit insurance payments under the risk
related premium system. (OTS had downgraded the institution to a
composite ``2'' after the 1999 exam.)
In September 1999, the OTS concurred with a formal FDIC request to
participate in the January 2000 examination. Findings from this
examination revealed many weaknesses, including extremely high
concentrations of high-risk assets, inadequate management and controls,
inaccurate reporting, and lack of documentation/support for retained
interest valuations. The OTS and FDIC both assigned composite ``4''
ratings for the thrift in May 2000.
As the primary Federal regulator for this institution, the OTS
issued a safety and soundness plan as a corrective action that, among
other things, required the thrift to get an independent valuation of
the retained interests, which was ultimately performed by Ernst & Young
(E&Y). FDIC and OTS examiners extensively reviewed the valuation and
discussed it with thrift management and E&Y. In early August 2000, the
FDIC noted that estimated future cash flows were not discounted to
present value for some retained interests, which had the potential of
significantly overstating the value of the retained interests. In late
August 2000, the FDIC and OTS raised the issue with E&Y, who agreed to
revisit the issue as part of their upcoming audit of Superior's June
2000 fiscal year-end financial statements.
FDIC then participated in an OTS visit to Superior in October 2000
to review this issue, among other things. From this point until mid-
December, in various correspondence, the local E&Y office attempted to
support its position that the future estimated cash flows should not be
discounted. OTS and FDIC objected, and in late December, the OTS
directed the thrift to raise the issue to E&Y's national office.
In mid-January 2001, E&Y's national partner agreed with the
regulators, and the thrift began the process of revaluing the assets.
Examiner estimates showed that the revaluation would result in
significant writedowns and, in mid-February the OTS issued a Prompt
Corrective Action (PCA) Significantly Undercapitalized notice to the
thrift and Cease and Desist Orders to several of the holding companies.
On March 2, 2001, the thrift amended its financial statements,
taking a $270 million (gross) writedown on its books, reducing the
capital ratio to 2.08 percent and book capital from approximately $250
million to $43 million. At this point, the FDIC downgraded the thrift
to a composite ``5''. An OTS examination, with FDIC participation,
began on March 19, 2001.
The thrift submitted its first PCA capital plan in mid-March, and a
number of discussions were held between the regulators and with the
thrift's owners and management to address inadequacies in the plan.
Various revisions were made to the plan over the next 2 months, with a
modified plan received on May 18, 2001. During this time period FDIC
raised a number of concerns about the plan with OTS both orally and in
writing.
The proposals were very complex, but essentially provided for the
sale of the thrift's retained interest portfolio to an entity to be
owned, but not controlled by the Pritzkers (known as ``Newco''). On May
24, the OTS approved the final capitalization plan. The FDIC had made a
number of comments about the plan but ultimately did not object. At the
time of OTS's approval, we believed that the plan, which called for a
$270 million cash infusion, increased the chances for the thrift to
become viable. It appeared that the bank would have an opportunity to
begin to stabilize if the capital plan was implemented as presented.
Also, all parties understood that cost cutting and shrinkage, and
perhaps additional capital and strategic alliances would be necessary
in the long run to ensure the thrift's viability.
During the next 2 months, the FDIC and the OTS remained on site at
Superior while the thrift's owners and management began implementing
the plan. Among other things, the owners began to negotiate the loan
agreement called for by the plan, develop required accounting and legal
opinions, shed businesses, and cut costs. However, in mid- to late-
July, the Pritzker family began indicating its reluctance to implement
the plan as their and Dworman's proposed capital contributions
appeared to be at greater risk. At that time, there had been marked
deterioration in the loans underlying the retained interests, according
to thrift representation. Also, the proposed lender had prepared a
projection that showed cash flows could be less than those projected by
the thrift's management. Numerous meetings were held with the OTS,
thrift management, and the Pritzkers and Dwormans to discuss the issue.
Ultimately, the Pritzkers and Dwormans failed to implement the
capital plan. On July 25, 2001, the FDIC Board met to consider Superior
and met again on July 27, 2001, when the OTS closed the thrift and
appointed the FDIC as receiver.
Resolution of the Superior Bank Failure
When the FDIC took responsibility for Superior, the first priority
was to provide virtually uninterrupted service for insured depositors.
The FDIC transferred all the assets and insured deposits to New
Superior, a newly chartered, full-service mutual savings bank under
FDIC conservatorship. All insured depositors and customers
automatically became customers of New Superior and depositors continued
to have access to their funds by writing checks, using debit cards,
going to New Superior's Internet site, and using automated teller
machines.
Deposits--Insured and Uninsured
At the time of closing, Superior had approximately $1.7 billion in
over 91,000 deposit accounts. Of this, approximately 94 percent of the
accounts totaling $1.4 billion were initially determined to be fully
insured and transferred to New Superior. Depositors had full access to
these funds when the branches reopened Monday morning. The remaining 6
percent of the accounts, totaling approximately $280 million, were
considered potentially uninsured funds that required further FDIC
review. To address the concerns of potential uninsured depositors and
other customers, the FDIC immediately set up toll-free call centers,
which handled over 8,700 customer inquiries during the closing weekend
and over 48,000 customer inquiries through August 31. For those callers
who had questions about deposit insurance coverage, appointments were
scheduled with FDIC staff members. Through August 31, the FDIC has
determined that an additional $165 million of the $280 million in
deposits is insured and these funds have been released to depositors.
Three percent of the $1.7 billion in total deposits have been
determined to be uninsured--a total of $49 million. The FDIC is still
gathering information from depositors to review insurance coverage for
an additional $68 million in deposits to determine if those deposits
may be insured. The FDIC continues to work with depositors to resolve
the remaining claims and ensure that insured depositors are protected.
Resolution Strategy and Management
The FDIC's strong preference in resolving a bank failure is to
market the bank prior to the FDIC's appointment as receiver. This type
of transaction allows us to minimize disruption to the failed bank's
insured depositors and customers, while minimizing the cost of failure
to the deposit insurance funds. When Superior failed, however, the FDIC
had not had an opportunity to effectively market the bank or its
assets. After reviewing the alternatives, the FDIC Board of Directors
determined that a conservatorship would be the least-cost alternative
to the Savings Association Insurance Fund (SAIF), while maintaining
banking services in the communities served by Superior. Unlike
liquidation or other alternatives, the conservatorship allows the FDIC
to market New Superior as a going concern and to attempt to sustain the
ongoing value of the thrift's business. The FDIC Board believed this
was crucial to maximizing the sale price for the deposit franchise, the
loan origination network, the loan servicing operation, and the
residual interests and related servicing.
An important component of this strategy is effective management of
New Superior. The FDIC has been able to obtain the services of an
experienced banker, John D. Broderick, to serve as New Superior's Chief
Executive Officer and President. The FDIC also created a five-person
Board of Directors to oversee New Superior's operations during the
conservatorship. The primary goal of Mr. Broderick and New Superior's
Board is to prepare the institution for a return to the private sector
in the near future.
The effectiveness of the conservatorship strategy requires that New
Superior continue to be a full service bank. Accordingly, New Superior
is continuing to accept deposits and make loans. To support operations,
the FDIC has made available a $1.5 billion line of credit. Through
August 31, New Superior had drawn down $644 million to maintain an
appropriate liquidity cushion and finance operations. We anticipate
substantial repayments to the line of credit as operations continue.
Alliance Funding, a division of Superior headquartered in
Orangeburg, New York, continues to direct New Superior's consumer
finance and mortgage banking operations. The FDIC has retained
HanoverTrade.com, a subsidiary of Hanover Capital Mortgage Holdings, as
a financial advisor to assist in the valuation and marketing of
Alliance-related assets.
The FDIC is working with the staff of New Superior to return the
institution to private ownership as soon as possible. The FDIC plans to
start contacting potential bidders this month and expects to begin
returning the deposits and assets to the private sector in October with
completion by year-end. We will have a better estimate of the cost to
the SAIF upon the final resolution of the conservatorship.
Lessons for Bank Management and Bank Regulators
The Offices of the Inspector General of the Department of Treasury
and the FDIC and the General Accounting Office are all conducting
reviews, and may have recommendations for the FDIC and the OTS.
However, certain lessons can already be drawn from the Superior failure
and the failure of several other institutions in the past few years.
Subprime Lending and Securitization Remain a Concern
Concentrations in retained interests related to subprime assets
figured prominently in at least two bank failures prior to the Superior
failure, Keystone National Bank and Pacific Thrift and Loan (PTL). The
FDIC has addressed these activities in various forms.
We have developed risk-focused examination procedures for
evaluating subprime lending programs and securitization activities. The
FDIC also closely monitors, on a quarterly basis, all insured
institutions having 25 percent or more of Tier 1 Capital invested in
subprime loans, high loan-to-value mortgages, and/or retained interests
in securitizations. Effective on June 30, 2001, the FDIC, OCC, and
Federal
Reserve implemented a new Call Report schedule that significantly
increases our ability to monitor retained interests on an off-site
basis.
Subprime Lending
Since 1997, the FDIC and the other Federal banking regulators have
been warning the industry about the increased risks in subprime lending
through various formal communications and during on-site examinations.
Subprime lending can meet the credit needs of a broad spectrum of
borrowers in a safe and sound manner if: (1) risks are effectively
managed through proper underwriting standards and attention to
servicing; (2) loans are priced on the basis of risk; (3) allowances
for loan losses cover the potential credit losses in the portfolios;
and (4) capital levels reflect the additional risks inherent in this
activity.
However, in some cases, these safeguards are not always maintained.
The FDIC estimates that approximately 140 insured institutions have
significant exposures in the subprime lending business. These subprime
lenders represent just over 1 percent of all insured institutions, yet
they account for nearly 20 percent of all problem institutions--those
with CAMELS ratings of ``4'' or ``5''. Ninety-five percent of all
insured institutions are rated CAMELS ``1'' or ``2,'' while only 70
percent of the identified subprime lenders are so rated.
While not necessarily the proximate cause of the failure, 8 of the
22 banks that have failed since 1997 have had significant subprime
lending portfolios. Further, since most subprime lenders in the bank
and thrift industry have not been tested in a prolonged economic
downturn, it is realistic to expect additional problems for
institutions with concentrations of subprime loans should the economic
conditions deteriorate further.
Securitization of Subprime Loans
A common theme emerging from our supervision of subprime lending is
the uncertainty regarding the valuation and accounting for retained
interests. In a securiti-
zation, the subprime lender sells packages of loans to another party or
institution, but often retains as an asset the right to receive a
portion of the cash flows expected from the loans. The expected value
of these cash flows is generally referred to as the retained interest.
A number of assumptions are involved in estimating the value of these
retained interests, including default rates, loss severity factors,
prepayment rates, and discount rates. Varying legal structures of
securitizations and the number of factors that underlie the various
assumptions further complicates the process.\4\
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\4\ For example, interest rates, economic conditions, loan terms,
and loan underwriting, among other things, drive prepayment rates.
---------------------------------------------------------------------------
Under Generally Accepted Accounting Principles (GAAP), the fair
value of these expected future cash flows are recorded on balance
sheets as assets in the form of interest-only strips receivable, spread
accounts, or other rights, sometimes referred to as retained interests.
The best evidence of fair value is a quoted market price in an active
market. But in the case of retained interests where there is no market
price, value must be estimated based on the assumptions mentioned
above. These assumptions need to be regularly analyzed and adjusted for
current conditions.
Even when initial internal valuations are reasonable, unforeseen
market events that affect default, payment, and discount rates can
dramatically change the fair value of the asset. These complications
sometimes lead to differences of opinion between examiners and banks
and their accountants regarding the accounting and valuation of these
assets. In the Keystone, Pacific Thrift & Loan, and Superior cases, the
accountants, all nationally recognized firms, did not initially agree
with examiners, resulting in protracted valuation and examination
processes.
The banking agencies issued supervisory guidance concerning
retained interests to banks on December 13, 1999. That guidance
requires bank management, under the direction of its board of
directors, to develop and implement policies that limit the type and
amount of retained interests that may be booked as an asset and count
toward equity capital. This interagency guidance also states that any
securitization-related retained interest must be supported by
objectively verifiable documentation of the interest's fair market
value, utilizing reasonable, conservative valuation
assumptions.
More Stringent Capital Standards Are Warranted
The banking regulators recognize the need to strengthen the capital
requirement for retained interests. Retained interests serve as credit
enhancements for the securitized assets. As such, these assets are
considered to be recourse exposures that subject the institution to
risk of loss on the transferred assets. As a result, under the current
rules, risk-based capital is required for securitized assets that are
deemed to be transferred with recourse due to retention of these
retained interests.
The banking agencies' capital rules limit the amount of risk-based
capital that a bank or thrift must hold against retained interests, as
well as other recourse exposures, to no more than the amount the
institution would have been required to hold against the assets sold,
had those assets remained on the bank's books--typically 8 percent of
the amount of the assets sold for 100 percent risk-weighted assets.
This amount is known as the ``full capital charge.'' The following
illustration will clarify this concept:
An institution has $100 in loans or other assets on its books
that require a minimum of $8 in total risk-based capital. The
institution sells $100 in assets, but retains a $15 recourse
exposure in the form of a retained interest. Under the current
capital rules, the amount of risk-based capital required would
be $8, even though the bank's exposure to loss is $15. In the
event the retained interest needed to be written down, the
capital held against this asset may prove to be inadequate,
which could pose undue risk to the bank.
On September 27, 2000, the agencies published a notice of proposed
rulemaking entitled, Capital Maintenance: Residual Interests in Asset
Securitization or Other Transfers of Financial Assets. This proposal is
intended to address concerns associated with retained interests.
Retained interests have exposed some institutions to high levels of
credit and liquidity risk, and their values have proven quite volatile.
The proposed capital treatment for residual interests would, on a net-
of-tax basis:
Require that the amount of residual interests (aggregated with
certain other types of assets) in excess of 25 percent of Tier 1
capital be deducted for regulatory capital purposes, and
Require an institution to hold a dollar in risk-based capital
for every dollar in residual interests (on a net of tax basis) up
to the 25 percent limit.
The ``dollar for dollar'' capital requirement, in tandem with the
concentration limit, would ensure that adequate risk-based capital is
held against retained interests and would limit the amount of retained
interests that can be recognized for regulatory capital purposes.
Comments from interested parties generally considered the treatment to
be very conservative and recommended that the agencies restructure the
proposal to target those institutions whose retained interests posed
undue risk to their banking operations. Since the comment period closed
on December 26, 2000, the agencies have been working to ensure that we
address our supervisory concerns while being mindful of the issues
raised by commenters. The agencies expect to promulgate a final rule
next month.
Additional Authority for the Insurer Under PCA May Be Warranted
Prompt Corrective Action standards were intended to limit losses to
the insurance funds. In some cases, the remaining capital cushion in
troubled institutions will be sufficient to absorb as yet unrecognized
losses. In other cases, losses embedded in troubled institutions, for
example, losses which will be incurred as time passes due to poor
quality of some assets already on the books, may exceed the capital
cushion.
Congress and the regulators face a difficult question in
determining where the capital cut-off for various types of regulatory
intervention should be. The trade-off is between being careful not to
seize an institution that truly possesses positive economic capital
that might enable it to survive temporary financial problems, and
waiting too long to act where an institution's actions may result in
additional losses to the insurance funds. This trade-off is not always
simple. For example, while the FDIC's study of the last banking crisis
found that there were 343 banks that failed between 1980 and 1992 that
might have been closed earlier under PCA, it also found that over the
same time period there were 143 banks that did not fail that might have
been closed under the PCA closure rule.\5\
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\5\ FDIC, History of the Eighties--Lessons for the Future, Vol. 1.,
p. 52.
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Under PCA, the FDIC, as deposit insurer, only has authority to take
separate action against non-FDIC supervised institutions that fall into
Critically Undercapitalized category. Among other things, such separate
action could include restricting the institution's activities,
reviewing material transactions, and approving capital plans.
Institutions reach the Critically Undercapitalized level very soon
before failure. Especially for institutions such as Superior, with
highly volatile assets, limiting FDIC intervention to the Critically
Undercapitalized level significantly inhibits our ability to direct
remedial action that could minimize exposure to the funds. The FDIC
believes that the deposit insurer should have additional authority
under PCA rules before a non-FDIC-supervised institution becomes
Critically Undercapitalized.
Regulatory Coordination Exists But Can Be Improved
The final lesson to be learned and perhaps the easiest one to
resolve, is the need to improve regulatory coordination. While much
discussion has focused on the supposed bureaucratic infighting between
the OTS and the FDIC regarding Superior, the plain truth of the matter
is that both agencies worked together for a period of well over 18
months in dealing with this troubled institution. However, in this
particular case, it may be valid to argue that having two sets of eyes
earlier in the process may have mitigated the loss.
Section 10(b) of the Federal Deposit Insurance Act authorizes the
FDIC to conduct an examination of any insured depository institution
that is not directly supervised by the FDIC if the FDIC Board of
Directors finds that an examination is necessary to determine the
condition of the institution for insurance purposes. Over the years,
the FDIC has adopted various policies to govern special insurance
examinations. The current policy, adopted on March 5, 1995, delegates
authority to the Director of the Division of Supervision or his written
designee to approve special insurance examinations for banks where the
FDIC has been invited to participate, and, in cases where the primary
Federal regulator does not object, for poorly rated (CAMELS ``4'' and
``5'') banks or banks likely to fail and for banks where material
deteriorating conditions are not reflected in the current CAMELS
rating. The Board must approve all other special insurance examination
requests. As a result of bank and thrift failures over the past 2
years, the FDIC will review whether our own special insurance
examination policy is inhibiting FDIC access to assess the risk that
non-FDIC supervised institutions present to the insurance funds.
Conclusion
I appreciate the opportunity to appear before this Committee today
to discuss the failure of Superior Bank and to again highlight the need
for continued regulatory vigilance and more stringent accounting and
capital standards for retained interest assets, particularly those
related to subprime lending. I look forward to working with the
Committee to see that these improvements are implemented.
Addendum to the FDIC Statement, Submitted September 11, 2001,
On the Failure of Superior Bank, FSB
The FDIC previously submitted written testimony, which briefly
summarized the crucial issues that make the failure of Superior of
special interest to the regulators, the Congress, and the public. This
addendum provides an update on some of the data reported in our
previous statement, a progress report on our resolution process and the
status of our rulemaking process regarding capital requirements related
to securizations.
Deposits--Insured and Uninsured
At the time of closing, Superior had approximately $1.7 billion in
over 91,000 deposit accounts. Of this total, approximately 94 percent
of the accounts totaling $1.4 billion were initially determined to be
fully insured and transferred to New Superior. The remaining 6 percent
of the accounts, totaling $281 million, were considered potentially
uninsured funds that required further FDIC review. The FDIC's toll-free
call centers have handled over 60,000 customer inquiries through
September 28. Currently, the FDIC has determined that an additional
$200 million of the $281 million in deposits is insured and these funds
have been released to depositors. Four percent of the $1.7 billion in
total deposits have been determined to be uninsured--a total of $64
million. The FDIC is still gathering information from depositors to
review insurance coverage for the remaining $17 million in deposits to
determine if those deposits may be insured. The FDIC continues to work
with depositors to resolve the remaining claims and make certain
insured depositors are protected.
Resolution Strategy and Management
The FDIC continues to work with the staff of New Superior to return
the institution to private ownership as soon as possible. The FDIC
began to contact potential bidders for the deposit franchise in mid-
September. The local core deposits have stabilized at approximately
$1.1 billion and we expect competitive bidding for the franchise. In
early October, we completed the initial marketing and investor
clearance for the sale of residuals, loan servicing, and the loan
production platform. Preliminary proposals are due before the end of
October with final bids due by the end of November. In addition, the
FDIC has been selling loans from New Superior's portfolio--$170 million
in loans sold through October 10, with an additional $310 million in
additional loans on the market with their sale likely by the end of
November. We are scheduled to receive bids for the Superior deposits on
October 25 and expect to start returning the deposits and assets to the
private sector in November with completion by year-end. We will have a
better estimate of the cost to the SAIF upon the final resolution of
the conservatorship.
To support New Superior's ongoing operations, the FDIC made
available a $1.5 billion line of credit. Through October 5, the FDIC
had advanced $829 million to New Superior to maintain an appropriate
liquidity cushion and finance operations. To date, New Superior has
repaid $89 million of that total, leaving $740 million in outstanding
advances. We anticipate substantial repayments to the line of credit as
operations continue.
Capital Standards for Securitization of Loans
As noted in our earlier submission to the Committee, the banking
regulators recognize the need to strengthen the capital requirement for
retained interests. The ``dollar for dollar'' capital requirement, in
tandem with the concentration limit, would ensure that adequate risk-
based capital is held against retained interests and would limit the
amount of retained interests that can be recognized for regulatory
capital purposes. The FDIC and other banking regulators now anticipate
that the final rule on the capital treatment of recourse, direct credit
substitutes, and residual interests in asset securitizations will be
published in the Federal Register in late November. The FDIC Board is
scheduled to consider the final rule at our Board Meeting on October
23. The final rule contains an effective date of January 1, 2002, and
provides for a one year transition period for transactions prior to
that date.
----------
PRPEPARED STATEMENT OF BERT ELY
President, Ely & Company, Inc.
October 16, 2001
Mr. Chairman and Members of the Committee, I want to thank you for
the opportunity to testify today regarding the July 27, 2001, failure
of the Superior Bank, FSB, which was headquartered in Oakbrook Terrace,
Illinois. My testimony will address several issues regarding the
Superior failure: My theory as to why Superior failed, a review of the
regulatory shortcomings that led to this very expensive failure,
broader regulatory problems that have been quite evident in some very
expensive bank and thrift failures in recent years, and legislative
recommendations to at least lessen these problems, if not eliminate
them.
Before continuing, Mr. Chairman, I want to commend you for starting
this hearing on September 11 even though news had reached us of the
terrorist attacks that had already struck New York and the Pentagon
that morning. Although those attacks shut down Washington that day and
forced the postponement of this hearing, they did not shut down America
nor our Government, as our attendance here this morning attests. My
testimony this morning benefits from the opportunity to have reviewed
the written statements Ellen Seidman, Director of the Office of Thrift
Supervision (OTS), and John Reich, Director of the Federal Deposit
Insurance Corporation (FDIC), submitted for the September 11 hearing.
Why Superior Failed
Superior, under the Pritzker/Dworman ownership, was created at the
end of 1988 as the successor to the failed Lyons Federal Bank, FSB, one
of the infamous S&L resolutions that year. Like many other 1988 S&L
resolutions, Superior started life with enormous tax benefits and a
substantial amount of FSLIC-guaranteed assets under a FSLIC Assistance
Agreement. However, Superior could not profit indefinitely from its
FSLIC launch. As Mr. Reich noted in his September 11 statement,
Superior was a ``troubled thrift'' in the late 1980's and early 1990's.
In order to survive, Superior had to develop a long-term business
strategy. Enter Alliance Funding, Superior's wholesale mortgage
origination division, which Superior acquired at the end of 1992 ``from
an affiliate,'' as Ms. Seidman noted in her September 11 statement.
With Alliance on board, Superior became a one-trick pony that was
doomed to stumble, fatally, one day, or in this case 8\1/2\ years
later.
Superior's trick, or business plan, was to concentrate on subprime
lending, principally on home mortgages, but for a while in subprime
auto lending, too. Subprime loans generally are those made to borrowers
evaluated as B, C, and D credit risks while prime loans are made to A-
quality credit risks. While Superior originated loans as a retail
lender in the Chicago area, that is, making loans directly to consumers
through its own offices, my sense is that it originated or purchased
most of its loans through Alliance, which is headquartered in
Orangeburg, New York, outside of New York City, in Rockland County.
Working from its home office and 10 branches around the country,
Alliance either purchased loans originated and funded by independent
mortgage bankers or it funded in its own name mortgages originated by
mortgage bankers and brokers. In effect, Alliance vacuumed up subprime
loans across the country for later securitization. It appears that
Superior became a dumping ground for low-quality, and possibly
predacious, mortgages that brokers could not sell elsewhere. There also
are reports that Superior loosened its loan underwriting standards in
1999 to attract additional mortgage business.
I encourage Committee Members and their staff to visit the Alliance
website, www.allfun.com, to get a full flavor of the types of mortgages
in which Alliance specializes. The following list highlights some of
Alliance's lending programs as they existed on July 31, 2001, just
after the FDIC took over Superior: ``limited and no credit borrowers,''
``mortgage down 3 months or foreclosures,'' ``80 percent LTV for recent
discharge from Bankruptcy,'' ``borrowers cannot source down payment,''
``fixed income is grossed up 135 percent,'' ``full array of options for
stated income and limited documentation borrowers,'' ``highest LTV's in
the industry for rural properties,'' ``open Chapter 13 Bankruptcies at
75 percent LTVV'' ``second homes are considered owner-occupied,''
``second mortgage behind private allowed,'' and so forth. Some of
Superior's riskiest products have been dropped from the Alliance
website since the FDIC took over Superior, a strong indication of
Superior's highly risky lending. In addition to mortgages, Superior
also engaged in subprime auto lending, most heavily in 1998 and 1999,
with a substantial phase-down of that business in 2000. I do not wish
to condemn subprime lending in general, but clearly Superior engaged in
especially high-risk subprime lending that ultimately was its downfall.
Briefly, Superior appears to have adopted this business model:
Vacuum up subprime mortgages, and originate a few, too;
Warehouse the mortgages on the Superior balance sheet, using
insured deposits to fund that warehouse;
Service the mortgages;
Periodically securitize some of the mortgages, usually on a
quarterly basis, while retaining the servicing rights to them;
Sell the mortgages, for securitization purposes, for more than
they really are worth, but hide that fact by taking back interest-
only strip receivables and other securitization residuals that can
be treated on Superior's balance sheet as an asset. As Ms. Seidman
noted in her September 11 statement, ``Superior, like many issuers,
hold on to the security with the greatest amount of risk or
otherwise provided significant credit enhancement for the less
risky securities.'' In effect, the retained interests in the
securitized mortgages represented a hidden price discount to
facilitate their sale;
By selling mortgages for more than they really are worth,
report excessive profits or gains on the sale of those mortgages
for securitization purposes; and
Report artificially high net income, because of excessive
gain-on-sale income, which enables substantial dividend payouts, as
well as the appearance of high capital levels.
Evidence from Superior's Thrift Financial Reports (TFR), which
Superior filed quarterly with the OTS, supports this theory:
Superior first reported gain-on-sale income in 1993, the first
full year after Superior's December 31, 1992, acquisition of
Alliance Funding.
From 1994 to 1999, Superior's gain-on-sale income increased
each year. For the 5 years from 1995 to 1999, Superior's gain-on-
sale income totaled $487 million, $72 million more than Superior's
pretax income. In effect, Superior consistently lost money before
taking into account its gain-on-sale income. For the thrift
industry as a whole, less Superior, gain-on-sale income usually
equals about 10 percent of pretax income.
Starting in 1993, Superior began accumulating the types of
assets associated with retained interests in mortgage
securitizations. While the precise amount of these assets cannot be
determined from Superior's TFR's, the balance sheet categories in
which these assets are placed accounted for an increasing
proportion of Superior's assets.\1\ Assets in these categories rose
from 20 percent of Superior's total assets at the end of 1992 to 34
percent the following year-end, to 56 percent in 1996, 60 percent
the following year, and to a peak of 65 percent at the end of 2000.
While this percentage has been rising for the thrift industry as a
whole, the industry percentage has been much lower; for example, it
rose from 9 percent at the end of 1997 to 13 percent at the end of
2000.
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\1\ The balance sheet categories are: mortgage derivative
securities, other mortgage pool securities, interest-only strip
receivables and other instruments, and all other assets.
---------------------------------------------------------------------------
As Ms. Seidman noted in her September 11 statement, ``large
residual positions often serve as a signal of the lower credit
quality of the sold assets.'' As she also noted, ``residuals
generally have no liquid secondary market, [so] their estimated
market values are difficult to verify. This lack of verifiability
has sometimes led to extended disagreements with institutions and
their accounting firms about proper valuation.'' She further
observed that ``we understand that most sales of residual interests
are in a forced or liquidation sale. Under such circumstances, the
price paid is usually substantially lower than the fair value,
which is the amount at which the asset is carried on an
institution's books. As a result, substantial losses are reported
on these sales.''
Superior paid $188 million in dividends in the 1989-1999
period, which gave
Superior's stockholders an 18.1 percent pretax cash return on their
initial investment of $42.5 million in Superior. These stockholders
also may have reaped additional profits from the substantial tax
benefits the Federal Government gifted to them when they acquired
Lyons.
Despite its substantial dividend payments, Superior
accumulated an impressive amount of capital on its balance sheet
through the retention of reported earnings. From $59.4 million at
the end of 1992, equal to 6.1 percent of its assets, Superior's
book capital rose to $297.6 million at the end of 1999, equal to
13.8 percent of its assets. As Ms. Seidman noted in her September
11 statement, ``some institutions have been able to use residual
interests and gain-on-sale accounting (for example, the immediate
recognition of the present value of expected future cash flows) to
improve their capital positions.''
Superior's tax benefits as successor to the defunct Lyons
Savings Bank helped this capital accumulation. From 1992 to 1998,
Superior reported pretax income of $289.7 million on which it
claimed a Federal tax credit of $10.6 million. Only in 1999, did
Superior begin to pay a meaningful amount of Federal income tax,
However, Superior's capital was a mirage, for in 2000, Superior's
reported equity capital shrank $260 million, to $38 million (1.8
percent of assets), largely due to ``other adjustments'' in its
capital accounts in the fourth quarter of 2000. This reduced
capital percentage made Superior ``critically undercapitalized''
under the Prompt Corrective Action standards for regulatory
intervention established in the FDIC Improvement Act of 1991.
Regulatory Shortcomings That Led to a Very Expensive Failure
Superior's regulators, and specifically the OTS, failed miserably
in their supervision of Superior. Hopefully, the forthcoming inspector
general and General Accounting Office reports on the Superior failure
will provide a detailed insight into and documentation of these
failings. However, even now important conclusions can be drawn from the
public record, specifically from Superior's TFR's. My key conclusions
are as follows:
The OTS failed to recognize the fundamentally flawed business
model Superior adopted when it acquired Alliance Funding at the end
of 1992. Instead, OTS appears to have permitted Superior to pursue
that model for over 8 years, until its closure on July 27. The
preceding section of this testimony summarizes that flawed business
model.
The linchpin of Superior's flawed model, as Ms. Seidman noted,
was retaining the riskiest or worst portion of its asset
securitizations. Hence, we see the steady buildup of dubious,
nonmainstream-thrift types of assets on Superior's balance sheet.
Worse, it appears that these assets were consistently overvalued
for many years. Had the OTS taken the initiative to independently
establish conservative valuations of Superior's securitization-
related assets, Superior would have been forced to adopt a more
profitable business model or sell itself to a stronger financial
institution. The First National Bank of Keystone failure on
September 1, 1999, should have immediately set the OTS alarm bells
ringing about Superior since it owned a far larger amount of
residual interests than did Keystone.
The OTS apparently failed to appreciate the extent to which
Superior was an outlier among thrifts--it was far from being the
typical post-FIRREA thrift. For example, at the end of 1997, almost
4 years before Superior failed, it had almost seven times as much
invested in the asset categories containing securitization-related
assets, per dollar of total assets, as did the rest of the thrift
industry. For 1997, Superior's gain-on-sale income, per dollar of
pretax income, was twelve times the industry average that year.
Most startling, at the end of 1997, Superior's recourse exposure
related to assets sold, per dollar of capital, was 31 times the
industry average. Even a rudimentary comparative analysis of
Superior's TFR data with thrift industry data should have flagged
it as an outlier worthy of special attention years before it
failed. For these reasons, it is absolutely astounding and quite
troubling that the OTS in October 1997 raised Superior to a CAMELS
``1'' composite rating from a CAMELS ``2'' rating and stayed at
that level until March 1999.
It is not at all clear if Superior was reserving adequately
for future loan charge-offs and asset writedowns on a timely basis,
particularly toward the end. Any underre-serving for future charge-
offs and writedowns, of course, would be another factor causing
Superior's capital to be overstated.
In a throw-back to the S&L crisis, Superior appears to have
relied to a great extent on nonretail deposits to fund the growth
of its securitization-related assets. My rough estimate is that
less than half of Superior's deposits were genuine retail deposits
held by individuals and businesses located within a reasonable
proximity of Superior's 17 branches. At June 30, 2000 (the last
date for which branch deposit data is available), Superior's La
Grange Branch reported $827 million in deposits while its Berwyn
and Downers Grove branches reported deposits of $143 million and
$123 million, respectively.\2\ They are hardly your typical retail
branch. Also, Superior started attracting brokered deposits in 1998
but brokered deposits declined significantly during 2000 from $403
million at the end of 1999; they had dropped to $81 million by June
30, 2001. According to Ms. Seidman, OTS told Superior in the spring
of 2000 to stop accepting or rolling over brokered deposits.
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\2\ FDIC's annual Summary of Deposit data by bank and thrift branch
can be found at www.fdic.gov.
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Especially troubling was Superior's gathering of uninsured
deposits. Superior significantly increased its uninsured deposits
in 1998, the year it began taking brokered deposits as it grew its
assets from $1.3 billion to $1.8 billion. Uninsured deposits jumped
in 1998 from $93 million to $316 million and then rose to $569
million by the end of 1999 before hitting a quarterly peak of $572
million on March 31, 2000. After dropping $80 million over the next
6 months, uninsured deposits went into a free-fall, plunging $440
million, or 89 percent, from last September 30 to March 31 of this
year. This drop may reflect a correction of past accounting
errors,\3\ apparently a frequent problem at Superior, or a genuine
run by larger depositors. I trust the Inspectors General and the
GAO will investigate what sparked that drop. I am even more
troubled by the almost obscene increase in Superior's uninsured
deposits during the second quarter of this year, when they rose
$9.6 million. Had the OTS moved more quickly to close Superior,
those new uninsured depositors would not have suffered any loss. As
it is, they will suffer a significant loss.
---------------------------------------------------------------------------
\3\ Ms. Seidman makes numerous references in her September 11
statement to Superior's erroneous financial statements, including
references on pages 16, 17, 19, and 22.
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A major problem any outsider experienced in trying to assess
Superior's true condition were the often erroneous TFR's Superior
filed with the OTS. In reviewing Superior's TFR data, as made
available on CD's sold by Sheshunoff & Company, I have found
numerous inconsistencies and unreconciled differences in Superior's
financial data that stem from the quiet filing of amended TFR's.
For example, until the March 31, 2000, TFR Superior had reported no
interest-only strip receivables. Suddenly, on that date, Superior
report $644 million of interest-only strips, which accounted for 28
percent of its total assets. Previously, those interest-only strips
appear to have been classified on Superior's TFR's as ``mortgage
derivative securities.''
A far more egregious reporting incident occurred for the fourth
quarter of 2000. Superior's initial TFR for December 31, 2000,
reported that it had $255.7 million in capital on the date, for an
11.2 percent leverage capital ratio, which is quite strong.
However, on March 2 of this year, Superior filed an amended TFR \4\
showing $37.9 million of capital, for a capital ratio of just 1.8
percent, which means that Superior was ``critically
undercapitalized'' at the end of last year. This data may not have
been published on the FDIC website until as late as June of this
year. Quite possibly, uninsured depositors in Superior were misled
by that initial TFR. Over the years, OTS failed badly in ensuring
that Superior filed accurate TFR's the first time.
---------------------------------------------------------------------------
\4\ Ms. Seidman's September 11 statement.
---------------------------------------------------------------------------
Despite TFR inaccuracies and overvalued assets, it was
possible to determine that Superior was deeply insolvent as early
as last September 30. Based on Superior's TFR data as of that date,
I sent a letter to Ms. Seidman on February 9 of this year warning
her about Superior's looming insolvency; a copy of that letter is
attached to this testimony. OTS never replied to my letter. The
rest is history. What is particularly troubling about that history
is Superior's rapid deterioration after September 30 and even more
so after the first of this year. Superior's reported capital ratio
declined sharply, from 13.5 percent on September 30 to 3.1 percent
on March 31, 2001.
Even that capital percentage was overstated, for as Ms. Seidman
notes, on March 30, 2001, one day before the end of the quarter,
Superior's parent holding company made a ``temporary capital
infusion into Superior in order to keep the institution above the
`critically undercapitalized' PCA category pending completion of
its Capital Plan.'' In fact, without this capital infusion of
residual interests with an ``estimated value of $81 million,''
Superior would have reported a negative net worth of $20 million on
March 31, 2001. Of course, Superior's reported negative capital of
$197 million on June 30 of this year strongly suggests that
Superior's capital was grossly overstated on March 31, and much
earlier.
Other measures suggest declining asset quality. For example,
unpaid interest on mortgages Superior owned rose from 1.1 percent
last September 30 to 4.7 percent on March 31 of this year; the
thrift industry average on March 31 was .58 percent. This disparity
suggests that Superior was experiencing a substantial
increase in delinquencies in its mortgage portfolio. A similar
deterioration was observed for loans Superior was servicing for
others, which largely consisted of loans it had securitized.
Advances by Superior on these loans to pay principal, interest,
taxes, and insurance rose steadily, from 1.5 percent at the end of
1999 to 1.9 percent on September 30, 2000, to 2.1 percent at the
end of 2000, to 3.0 percent on March 31, 2001, and to 3.2 percent
on June 30, 2001. This rising percentage strongly indicates a
deterioration in the loans Superior has securitized, which suggests
a further impairment in the value of Superior's securitization-
related assets. As Ms. Seidman noted, seller-servicers of subprime
loans, such as Superior, ``may be able to mask losses by
artificially keeping loans current through servicer
advances.''
OTS added to Superior's insolvency loss by moving far too
slowly to close the institution. The slow, drawn out closure
process is summarized in Ms. Seidman's September 11 statement. What
is particularly troubling is the extent to which the OTS was
willing, during extended discussions with the Pritzker interests,
to engage in a window-dressing exercise to punt Superior's eventual
insolvency far into the future. Two sentences in Ms. Seidman's
statement are especially telling in this regard: ``OTS indicated
that, even under the most extreme case set forth in the Pritzker's
[sic] modified projections, it appeared that the concerns expressed
by the Pritzker interests would not be an issue until many years
later . . . More importantly, under either set of assumptions, the
projections for the first several years would have kept the
institution in capital compliance upon implementation of the
Capital Plan'' proposed by the Pritzkers. Shades of the S&L crisis!
The FDIC is not fault-free in this situation, Although the
FDIC reportedly raised concerns about Superior in December 1998,
when it sought to examine Superior, and was denied by the OTS, one
must still wonder if the FDIC pounded the table hard enough in
closed-door meetings of the FDIC Board (on which Ms. Seidman sits)
about Superior's declining condition. Given the depth of Superior's
insolvency, one can reasonably wonder if the FDIC pushed hard
enough for an earlier closure of Superior, particularly since (1)
the FDIC ``did not like the [Superior]
recapitalization plans \5\'' and (2) FDIC personal were at Superior
continually, starting 96 days before Superior was closed.\6\ Also,
given the FDIC's long-standing concerns about Superior and its
eventual access to the institution, the FDIC seems not to have been
prepared for OTS's decision to close Superior. In effect, the FDIC
appears to have not developed a ``Plan B'' to execute immediately
if the OTS's ``Plan A,'' the Pritzker/Dworman recapitalization of
Superior proposed on May 24, 2001, fell through.
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\5\ American Banker, August 9, 2001.
\6\ American Banker, August 21, 2001.
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This unpreparedness is evidenced by the FDIC's decision to continue
operating Superior in a conservatorship rather than to immediately
sell its branches, its
retail deposit franchise, and what few good assets Superior has.
However, it is highly unlikely that a single buyer will purchase
all of Superior's good assets. Most likely, a Chicago-area
depository institution will purchase the Superior branches while a
subprime mortgage specialist will purchase Alliance Funding and
Superior Servicing, Superior's servicing arm. Although it can never
be calculated, the FDIC probably has increased the eventual
Superior insolvency loss through its bungling of the Superior
closure.
The OTS summed up quite well Superior's numerous shortcomings in a
news release it issued on July 27, 2001, the day it closed Superior:
``Superior Bank suffered as a result of its former high-risk
business strategy, which was focused on the generation of
significant volumes of subprime mortgage and automobile loans
for securitization and sale in the secondary market. OTS found
that the bank also suffered from poor lending practices,
improper recordkeeping and accounting, and ineffective board
and management supervision. Superior became critically
undercapitalized largely due to incorrect
accounting treatment and aggressive assumptions for valuing
residual assets.''
Ms. Seidman, in testimony delivered to the Financial Institutions
and Consumer Credit Subcommittee of the House Financial Services
Committee just 31 hours before she closed Superior suggested that
``certain types of nontraditional smaller institutions'' could fail
suddenly. Although she may have had Superior in mind that day, that
statement certainly is not applicable to Superior. Superior did not
fail suddenly nor was its failure a surprise, for it planted the seeds
of its self-destruction 8\1/2\ years earlier. The fundamental question
which must be asked, and answered: Why did the OTS tolerate that self-
destructive business strategy?
Broader Bank Regulatory Problems That Have Become Quite Noticeable
In Recent Years
From the beginning of 1995 to last Friday, there have been 35 bank
and thrift failures, 33 of which caused a loss to the BIF and/or the
SAIF. Attached to this testimony is a table listing these 35 failures.
Losses range in size from an estimated $80,000 to $813 million, the
latest loss estimate for the Keystone fiasco.\7\ Although the FDIC has
not yet announced a loss estimate for the Superior failure, I plugged a
$750 million figure in the table, which reflects my gross loss estimate
of approximately $1 billion less that portion of the loss that will be
borne by uninsured depositors and general creditors as well as
litigation recoveries, net of litigation expenses. As the table shows,
three failures--Superior, Keystone, and BestBank--account for $1.79
billion, or 87 percent, of estimated BIF/SAIF losses over the last 6\3/
4\ years.
---------------------------------------------------------------------------
\7\ The amount of the FDIC's subrogated claim in the Keystone
receivership, as shown in the FDIC Statement of Assets and Liabilities
in Liquidation (Unaudited) for Keystone for the period ending August
31, 2001.
---------------------------------------------------------------------------
The loss amount in these three failures, which also happen to be
the three largest institutions to fail, is so high largely because the
insolvency loss percentage in these failures is so high, ranging up to
78 percent in the Keystone caper. BestBank had the fourth-highest loss
percentage, 61 percent, while Pacific Thrift and Loan Company, with the
fourth-highest loss amount, experienced the second-highest loss
percentage of 67 percent. Superior appears to come in sixth, at 42
percent, although that percentage will change as the FDIC gets a better
fix on Superior's ultimate loss amount. Two small institutions, Union
Federal Savings Bank and Commonwealth Thrift and Loan, also had high
loss percentages--62 percent and 44 percent, respectively. Had the loss
percentage in the four most costly failures been held to 30 percent--
still a high percentage, especially for larger institutions--the
insolvency loss in these four cases would have been trimmed by $860
million, or 42 percent of the FDIC's insurance losses since 1995.
Four charts appended to this testimony graphically place these
expensive failures in perspective with other bank and thrift failures.
Figure 1 contrasts the handful of extremely expensive failures since
1995 with the multitude of relatively inexpensive failures. Figure 2
presents this contrast in another manner, as a stacked bar. Figure 3
shows a distribution of FDIC insolvency losses as a percentage of
assets in the failed institutions. Figure 4 ranks the 10 most expensive
FDIC-insured failures since 1986 based on their insolvency loss as a
percentage of total assets. Although Superior and Keystone were the
smallest two of these 10 institutions, in terms of assets at the time
of failure, they made the ``top ten'' list because of their high-loss
percentages.
It is clear from the table and the charts that there have been
numerous instances, even among small institutions where high loss
percentages can reasonably be expected, where the loss percentage has
been fairly low--under 10 percent or 20 percent. It is not unreasonable
to classify low-cost failures of smaller banks and thrifts as the
occasional ``fender-benders'' of the deposit insurance business. Of the
35 FDIC-insured failures since the beginning of 1995, I have
characterized 23 of them as fender-benders.\8\
---------------------------------------------------------------------------
\8\ A deposit insurance fender-bender is rather arbitrarily and
liberally defined as (1) a failed institution with less than $50
million in assets and an insolvency loss percentage below 30 percent,
(2) an institution with assets between $50 million and $100 million and
a loss percentage below 20 percent, or (3) an institution with more
than $100 million of assets and an insolvency loss below $5 million.
---------------------------------------------------------------------------
Failures with high loss percentages, including the cases I just
cited, strongly suggest that at least some of the time the regulators
have moved far too slowly in getting a bank or thrift turned around,
recapitalized, sold, or closed. This is a troubling situation that
could worsen as the economy slides into a recession. Therefore, the
four Federal bank regulatory agencies \9\ should get much more
aggressive and move much more quickly to resolve problem situations
before they create an insolvency loss. Given the insolvency risk of
trying to save a weak bank or thrift so that it can remain independent,
regulators should become much more aggressive in forcing weak
institutions to merge into stronger institutions or to liquidate prior
to insolvency, as Pacific Southwest Bank, FSB, did earlier this year.
---------------------------------------------------------------------------
\9\ Federal Reserve Board, Comptroller of the Currency, FDIC, and
OTS.
---------------------------------------------------------------------------
One troubling thread running through some of the most expensive
failures was a bank management team that vigorously fought efforts by
examiners trying to gain a good understanding of the bank's financial
condition and operating practices. That clearly was the case in the
BestBank and Keystone failures. Apparently that happened to some extent
at Superior. According to an article in the September 7, 2001, American
Banker, Ms. Seidman stated at a news conference the previous day that
OTS examiners ``were confronted with a management that was `fighting
back hard' against the [OTS's] criticisms.'' It amazes me that
examiners were cowed in these situations given that that type of
resistance often signals severe problems in the institution. Instead of
being cowed, examiners who face a management ``fighting back hard''
should dig even harder and deeper to uncover the problems the
management obviously is hiding.
What is especially troubling in the most costly failures has been
the amount of buck-passing and finger-pointing by the regulators,
specifically in asserting that it is up to a bank's or thrift's outside
auditors to detect fraud and properly value assets. In the Superior
case, the OTS has been especially vociferous in asserting that Ernst &
Young, Superior's auditors, was slow to properly value the
securitization residuals on Superior's balance sheet.\10\ See, for
example, Ms. Seidman's unsubstantiated assertion in her statement that
``the concentration of residuals at Superior was exacerbated by a
faulty accounting opinion by the institution's external auditors that
caused [Superior's] capital to be significantly overstated.''
---------------------------------------------------------------------------
\10\ From 1964 to 1966, I was on the audit staff of Ernst & Ernst,
a predecessor firm to Ernst & Young. I have no ties to Ernst & Young at
this time.
---------------------------------------------------------------------------
In fact, fraud detection and asset valuation are absolutely central
to the effective examination and supervision of depository
institutions. Given the importance of these activities, bank regulators
must make reasonable efforts to detect fraud and to properly value
assets, with their own staffs or outside contractors, rather than
relying on independent parties, such as an institution's accounting
firm. I estimate that Superior paid the OTS $760,000 in 2000 in
examination fees, as well as substantial fees in earlier years. Those
sums certainly were sufficient to permit the OTS to obtain the
assistance of outside experts in periodically estimating the value of
Superior's securitization-related assets. Any plea by the OTS that it
was hamstrung by Ernst & Young in valuing Superior's residual interests
is patently absurd.
Most disturbing is the sense that the Federal bank regulators
neither embrace nor even understand their fiduciary obligation to the
banking industry to minimize insolvency losses without being unduly
restrictive of banking activities. Regulators owe this fiduciary
obligation because it is the banking industry, through past and future
deposit insurance assessments, and not taxpayers, who stand first in
line to pay for regulatory failure. Good banks and thrifts do not let
bad institutions fail, regulators do. If the regulators do a good job
of protecting bankers' pocketbooks, the taxpayer will automatically be
protected.
This absence of a sense of fiduciary obligation raises this
question--why are regulators not concerned about the impact of their
failures on deposit insurance assessments? Partly it may be regulatory
tradition and a lack of personal accountability on the part of senior
regulatory management. After all, how many senior regulators have been
fired over the last 20 years because of the almost 2,800 bank and
thrift failures that have occurred? But there may be another reason,
particularly at the OTS, for this lack of fiduciary obligation, and
that is survival of the OTS, which is dependent upon its ability to
generate examination fees. According to OTS financial statements posted
on www.ots.treas.gov, the OTS slid from an $18 million profit in 1996
to a $13 million loss in 2000. According to an August 28, 2001,
American Banker article, the OTS projects that it will return to
profitability in 2003. Perhaps it will, but maybe it will not as the
number of thrifts continues to decline. One can reasonably wonder if
the prospective loss of $760,000 annually in exam fees deterred senior
OTS management from moving more quickly to close Superior.
One additional point merits a mention in this discussion of broader
regulatory problems that Congress should ponder, and that is the
concept of depositor discipline. The notion of depositor discipline is
the rationale for a deposit insurance limit, on the theory that large,
uninsured depositors, armed with accurate, timely information about a
bank's condition, will run from a weak institution, thereby ringing an
alarm bell to wake up sleepy regulators. As I noted above, there
appears to have been a substantial run by uninsured depositors from
Superior last winter. What triggered this apparent run is a mystery, as
is its effect on the OTS. Assuming a 40 percent loss rate, those
uninsured depositors who fled Superior from last October to March of
this year escaped a $175 million loss. As it is, the 816 depositors
holding $66.4 million of uninsured deposits when Superior was closed
\11\ (an average of $81,400 per depositor) face a loss in the $25
million range. How could large depositors, such as a former parcel
deliverywoman who deposited a $145,000 disability payment in Superior
the day before it closed,\12\ determine the true state of Superior's
financial condition based on then publicly available TFR's?
---------------------------------------------------------------------------
\11\ American Banker, August 14, 2001.
\12\ Ibid.
---------------------------------------------------------------------------
Many believe that deposit insurance creates a moral hazard, in that
insured depositors care not a whit about a bank's or thrift's financial
condition. But regulatory moral hazard trumps depositor moral hazard if
regulators publish erroneous information on which to judge an
institution's condition, as OTS did in the Superior situation, or if
regulators inexplicably drag their feet in closing an insolvent
institution, as the OTS did in the Superior situation. Although seldom
discussed, regulatory moral hazard is the real issue Congress must now
address, not depositor moral
hazard. Attached is an article of mine, ``Regulatory Moral Hazard: The
Real Moral Hazard in Federal Deposit Insurance,'' which provides
insights into this problem.
Legislative Recommendations
Superior's failure teaches many lessons, and will teach more as its
causes become better understood. However, from both a legislative as
well as a regulatory perspective, it is important not to draw the wrong
conclusions from these lessons and accordingly enact new laws and adopt
new regulations that will worsen matters. The following are my
legislative recommendations stemming from the Superior failure:
Require regulators to more frequently and conservatively value
risky assets. While Generally Accepted Accounting Principles, or
GAAP, represent a good starting point in establishing asset values,
GAAP should not straitjacket regulators if they conclude, after
conducting the appropriate analyses, that GAAP overstates the value
of an asset. In such cases, the regulators should require that an
asset's value be reduced, at least for regulatory accounting
purposes. This approach would be much better than higher capital
requirements on risky types of assets. While it is much easier to
set higher uniform capital standards, those standards will (1)
drive less risky assets off bank balance sheets (this is called
``regulatory arbitrage''), and (2) postpone the day when asset
values, and therefore capital levels, are realistically recognized
on an institution's balance sheet. Also consider barring a
financial institution from retaining any portion of its asset
securitizations so a true market value is established for assets
when they are sold.
Do not raise capital standards for intervention under Prompt
Corrective Action as that will not make a meaningful difference in
preventing bank and thrift failures with high-loss percentages.
However, higher intervention standards could cause sound, well-run
banks and thrifts to overcapitalize themselves, which would drive
lower-risk assets off of bank balance sheets (another form of
regulatory arbitrage).
Empower the FDIC to levy losses above a certain percentage of
a failed institution's assets--say above 20 percent or 30 percent--
on the chartering agency of the bank. The agency would then have to
pass that levy back to the institutions it has chartered through
higher exam fees. The institutions chartered by that agency would
then have a powerful incentive to pressure the agency's top
management to prevent future high-loss-percentage failures.
Provide for tough personal sanctions and job terminations for
high level personnel in the agency or agencies responsible for the
supervision of a failed institution with a high-loss percentage.
While a failed institution's management is directly responsible for
its failure, the institution's regulators must be held personally
accountable if the subsequent insolvency loss is too high. With the
onset of a recession in the aftermath of the September 11 terrorist
attacks, it has become more imperative than ever that the
regulators move quickly to resolve troubled institutions through a
merger, sale, recapitalization, or all else failing, closure. Under
no circumstance should a banking regulator delay resolving an
institution while trying to ``save'' it.
Require the bank regulatory agencies to develop the
capabilities--either internally or under contract--to detect fraud
and to value all types of bank and thrift assets. While regulators
should review reports from a bank's or thrift's outside auditors to
gain an additional perspective on the institution, regulators
should not place any reliance on audit reports for either
examination or supervisory purposes. I was greatly troubled to read
in Ms. Seidman's statement that an OTS examiner is ``usually not an
accountant.'' In fact, accounting skills are an essential
requirement for conducting good safety-and-soundness examinations.
Strengthen the FDIC's intervention powers, particularly when
off-site monitoring suggests a lower CAMELS rating than the
chartering agency has established. At a minimum, FDIC personnel
should be able to accompanying another agency's examiners on an
already-scheduled examination without the consent of the other
agency. However, because examinations are disruptive to banks and
thrifts, the FDIC should not be given the authority to conduct
backup exams on its own initiative. If a chartering agency refuses
to let the FDIC do a back-up examination, the agency should be
required to give the FDIC a confidential memorandum
explaining the reasoning behind its denial. If the institution
later fails with a high-loss percentage, then that memorandum
should be taken into consideration in determining how best to
discipline senior management of the chartering agency (see above).
Give the FDIC greater power to force the closure of State-
chartered institutions. Under no circumstances should a State
banking department have final authority over the closure of a bank
or thrift whose insolvency would cost the participants in a
Federally administered deposit insurance program. If a State
government wishes to retain the ultimate closure decision, then it
should reimburse the FDIC for any insolvency loss the FDIC might
otherwise incur.
Acknowledge that sufficiently high-risk-sensitive premiums,
levied on the basis of leading indicators of banking risk, would
provide weak banks with a powerful financial incentive to
recapitalize or sell before insolvency is reached. An injection of
capital should lead to a sufficient lowering of premiums to pay for
that additional capital. That incentive might be more successful in
avoiding insolvency losses than relying upon banking supervisors to
turn around 4- and 5-rated banks. In this regard, I was quite
troubled to read in the FDIC's recommendations for deposit
insurance reform,\13\ on pages 8, 11, and 13, that the FDIC rejects
the idea of charging the riskiest banks and thrifts the full amount
of the premium they should pay, based on the FDIC's loss
experience. The statement on page 13 of the FDIC report, ``there is
a concern that premiums could get so high that they could push
institutions that might otherwise have survived into failure,''
reflects a
fundamental misunderstanding of the role that risk-sensitive
deposit insurance premiums should play, which is to force the
resolution of a problem.
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\13\ ``Keeping the Promise: Recommendations for Deposit Insurance
Reform,'' Federal Deposit Insurance Corporation, April 2001.
---------------------------------------------------------------------------
Do not permit the FDIC to rely upon reinsurance premium rates
to establish risk-sensitive premium rates for large banks as those
rates will be too high given that a reinsurer must not only take
into account the risk that a bank will become insolvent, but also
the possibly greater risk the chartering agency will be slow to
close a failing bank. Superior amply demonstrates the closure risk
any reinsurer faces.
There should be public notification of the filing of amended
TFR's and bank call reports to alert depositors and outside
analysts to a possible decline in a bank's or thrift's financial
condition. If depositor discipline is ever to be meaningful,
particularly for banks and thrifts which do not file financial
statements with the
Securities and Exchange Commission, then it is absolutely vital
that depositors have access to timely, accurate information with
which to assess a bank's or thrift's financial condition and
probability of failure.
These recommended reforms ultimately may not be sufficient to
overcome regulatory moral hazard, in which case the Congress should
pursue more fundamental reforms. Former Treasury Department General
Counsel Peter J. Wallison proposed in an attached April 27, 2001,
op-ed in the American Banker, headlined ``Industry, Not Government
Is the Real Deposit Insurer,'' that the banking industry
``establish the loss reduction policies that the FDIC enforces--
especially those concerning bank examinations and insurance
premiums.'' I go one step further in
advocating the cross-guarantee concept to delegate to the private
sector the full responsibility for ensuring the safe-and-sound
operation of banks and thrifts. This concept is summarized on pages
251 and 252 in my ``Regulatory Moral Hazard'' article cited above.
Conclusion
The Superior Bank failure is quite troubling, coming on the heels
of the unnecessarily expensive Keystone and BestBank failures. I urge
Congress to probe deeply into the regulatory failings leading up to
these failures and to respond to their causes and not their symptoms.
Mr. Chairman, I thank you again for the opportunity to testify
today in this most important matter. I welcome your questions and
questions from your colleagues.
PREPARED STATEMENT OF GEORGE G. KAUFMAN, Ph.D.
John F. Smith, Jr. Professor of Finance and Economics
Loyola University Chicago, Chicago, Illinois
October 16, 2001
Mr. Chairman, it is a pleasure to testify before this Committee on
the public policy implications and lessons from the recent failure of
the ironically named Superior Bank, located in the suburbs of my home
city of Chicago. What is important is not so much that Superior
failed--bank failures have been infrequent in recent years and
inefficient or unlucky banks should be permitted to exit the industry
in order to maximize the industry's contribution to the economy--but
the exceedingly large magnitude of its loss to the FDIC. This loss has
been estimated in the press to be somewhere between $500 million and $1
billion, or 20 to 45 percent of the bank's assets at the date of its
resolution. Recent changes in the Federal deposit insurance system have
greatly reduced the Government and taxpayer's liability for losses to
the FDIC from bank failures by requiring near automatic and near
immediate increases in insurance premiums to replenish the fund
whenever the FDIC's reserves fall below 1.25 percent of insured
deposits. In this way, the system is effectively privately funded.\1\
Nonetheless, because bank failures are widely perceived to be more
disruptive than the failure of most other firms, and the larger the
loss (negative net worth), the greater the potential for disruption,
bank failures are still a public concern and an important public policy
issue.
---------------------------------------------------------------------------
\1\ George G. Kaufman, ``The Current Status of Deposit Insurance in
the United States and Proposals for Reform,'' Working Paper, Loyola
University Chicago, August 2001; George G. Kaufman, ``Congress Should
Not Monkey With Deposit Insurance System,'' American Banker, August 10,
2001, p. 6; and George G. Kaufman and Peter J. Wallison, ``The New
Safety Net,'' Regulation, Summer 2001, pp. 28-35.
---------------------------------------------------------------------------
In response to the large number of bank and S&L failures in the
1980's and early 1990's at a high cost not only to the surviving
institutions but, at the time, also to taxpayers, Congress enacted the
FDIC Improvement Act (FDICIA) in 1991 to reduce both the number and, in
particular, the cost of bank failures through Prompt Corrective Action
(PCA) and Least Cost Resolution (LCR) by the regulators.
PCA specifies sanctions that first may and then must be imposed by
the regulators as a bank's financial condition deteriorates in order to
turn the bank around before it becomes insolvent with possible losses
to the FDIC. The sanctions are triggered primarily by declines in bank
capital ratios. But PCA is intended to compliment, not to replace, the
regulators' other supervisory techniques that rely on other signals of
a bank's financial condition. Indeed, PCA was introduced not because
regulators tended to react too quickly to developing bank problems, but
too slowly (to forbear).\2\ Thus, regulators are not required or even
encouraged to delay corrective action until the capital tripwires are
breached.
---------------------------------------------------------------------------
\2\ George J. Benston and George G. Kaufman, ``The Intellectual
History of the Federal Deposit Insurance Corporation Improvement Act of
1991'' in George G. Kaufman, ed., Reforming Financial Institutions and
Markets in the United States, Boston: Kluwer Publishers, 1994, pp. 1-
17.
---------------------------------------------------------------------------
Because of confidentiality, I do not know with certainty many of
the details of the Superior failure and, in particular, the roles of
the OTS and FDIC. However, the public information available casts
suspicion on both the promptness of the OTS's actions and the strength
of the corrective actions when taken. Nor is a 20 to 45 percent loss
rate what the drafters of FDICIA or, I suspect, Congress had in mind
when they designed LCR. Indeed, this loss rate promises to be greater
than the average loss rate on banks of comparable size in the bad pre-
FDICIA days. \3\ \4\
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\3\ George G. Kaufman, ``The U.S. Banking Debacle of the 1980's:
Overview and Lessons,'' The Financier, May 1995, pp. 9-26.
\4\ The high resolution costs should also serve as a wake-up call
for all insured banks that, because they will pick up the cost in the
form of higher premiums when the FDIC's reserve ratio dips below 1.25
percent, they need to monitor more carefully and continuously both
their fellow banks to discourage excessive risk-taking and the
regulatory agencies to encourage more timely resolutions.
---------------------------------------------------------------------------
To put the Superior failure in perspective, while it is the largest
FDIC insured institution to fail since mid-1993, it is a relatively
small bank. Its losses, large as they may be, are no threat to either
the FDIC or the local or national economies. Moreover, the loss rate
for the next two largest institutions that failed in this period were
even greater. The estimated loss rate on the 1999 failure of the $1.1
billion First National Bank of Keystone (West Virginia) is near 75
percent and that on the 1998 failure of the $320 million, again
ironically named, BestBank (Boulder, Colorado) is near 55 percent (see
attached tables). This suggests that something is not working the way
it was intended. Although all three of these banks may be viewed as
outliers and not representative in their operations of the large
majority of banks--BestBank was primarily an Internet bank, Keystone
relied to a unduly large extent on insured brokered deposits to fund
very risky mortgage residuals, and Superior focused on transforming its
high credit risk subprime mortgage loans into even higher credit and
interest risk interest only residuals--one has to wonder, if the
supervisors cannot do better when times are good and failures few, how
would they do, if things are not changed, when times are bad and bank
failures more frequent. On the other hand, it may be argued that, at
such times, bank problems are likely to be more generic and supervisors
more able to deal with them. Nevertheless, an important contribution of
these hearings is to identify lessons from the recent costly failures
that may reduce the probabilities of a repeat performance.
It appears that in Superior, and possibly even more so in the other
two failures, a number of red flags were flying high that should have
triggered either a rapid response by regulators or continuing careful
scrutiny. Although each flag was not flying for each bank, these red
flags would include, but not be limited to:
Very rapid asset growth. Superior doubled in size in the 3
years between year-end 1996 and 1999 and Keystone grew even more
rapidly.
Well above market rates offered on insured and/or uninsured
counter or brokered deposits. Had the regulators sent their
examiners to the dozen banks and thrifts that offered the highest
deposit rates (which are readily available from private vendors) in
the late 1980's, they would have zeroed in on the worst failures of
that period.
Rapid withdrawal (run) of uninsured deposits. This suggests
that the market is indicating concern that the bank is in financial
difficulties and finds it cheaper to fund itself with other sources
of funds, such as insured deposits.
High ratio of bank repurchase agreements to total funding.
This indicates that other banks, which may reasonably be expected
to be well informed, are lending only on a collateralized basis.
High percentage of brokered deposits.
A large percentage of activity in risky lending. Although
legitimate and, at times, highly profitable, subprime lending is
generally riskier than prime lending and
requires more careful supervision by both the bank's own management
and the regulators. As the FDIC has noted, while largely subprime
lending institutions
account for less than 2 percent of the nearly 10,000 insured
institutions, they account for some 20 percent of all problem
institutions.
Very large percentage of assets in not only very risky but
also complex derivatives and other nontraditional assets, given the
bank size and management capabilities. Derivatives, per se, are not
risky if used appropriately by knowledgeable management. Many banks
use derivatives successfully to reduce portfolio risk exposure.\5\
But heavy use of the most risky and complex derivatives by smaller
banks bodes ill and deserves greater regulatory oversight.
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\5\ Elijah Brewer, William Jackson, and James Moser, ``The Value of
Using Interest Rate Derivatives to Manage Risk at U.S. Banking
Organizations,'' Economic Perspectives (Federal Reserve Bank of
Chicago), Third Quarter 2001, pp. 49-66.
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High percentage of off balance sheet recourse obligations
relative to on balance sheet assets.
None of these flags, either by itself or even in combination with
others, guarantees trouble. But because the cost of spotting them is
low, they are worth following up on to see whether the fish really
smells.
We would know a great deal more about what the regulators did or
did not do and who knew what when with respect to these flags in
Superior, if we knew:
The dates of the recent on-site examinations by the OTS.
What was discovered in these exams.
What corrective actions were taken and when.
What actions were taken by Superior in response to these
suggestions and recommendations.
What did the FDIC believe it knew in 1999 that the OTS may not
have known.
As noted earlier, the available public evidence suggests either
very late realization of the seriousness of the situation by the OTS,
not very forceful corrective actions by the OTS, and/or not very rapid
nor strong response by Superior. Moreover, the speed of regulatory
action was particularly slow after Superior's reported equity capital
ratio on call reports at year-end 2000 declined below the 2 percent
threshold for critically undercapitalized status that triggers
receivership, conservatorship, or a recapitalization plan within 90
days.
A number of additional questions arise. In retrospect it is clear
that Superior's reported capital was overstated by, among other things,
underreserving for loan losses well before year-end 2000 and even
before the reevaluation of the ``toxic waste'' residuals. Why were
adjustments not made earlier? Why did the FDIC sign off on the proposed
recapitalization plan at the end of the 90 day period, when the
negative net worth at that time was likely to be much larger than the
reported proposed recapitalization amount? Hopefully, we will know more
about these events after these hearings than we knew before them and we
can develop more refined and accurate prescriptions for future
regulatory action. But based on the public information to date, I
recommend the following proposals for serious consideration:
Increase regulatory emphasis on red flags and quicker
responses.
Establish an interagency SWAT team for valuing complex
assets.\6\ This would likely be of particular benefit to the OTS
and FDIC, who deal primarily with smaller and less complex
institutions. Making it an interagency team would reduce turf
considerations in calling on it for help.
---------------------------------------------------------------------------
\6\ Superior's interest only residuals and some other assets appear
to have been so difficult to value that the FDIC did not advance a
dividend to the uninsured depositors of the present value of the
estimated recovery amount of the assets as it does in most failures.
This increased the hardship to these depositors by having their
accounts in excess of $100,000 frozen until recovery is actually
achieved.
---------------------------------------------------------------------------
Increase the values of the capital ratios for the tripwires in
PCA. As I have argued for many years now, the current values were
determined by the regulators when banks were in weak financial
condition in 1992 and are less appropriate today when the capital
ratios of almost all banks exceed the regulatory guidelines in each
category and are low relative to those of bank competitors not
covered by the Federal safety net. For example, the FDIC notes that
the average equity ratio for banks concentrating in subprime
lending was about 10 percent, less than one-half that of their
nonbank competitors.
Put the examination fee structures of the OCC and OTS on the
same basis as those of the FDIC and the Federal Reserve. By needing
to charge fees for examinations to obtain their operating revenue,
there is a tendency for the OCC and OTS to view their member
institutions as ``clientele'' and to be reluctant to take actions
that may encourage them to change their charter and primary
regulator. While supervisors and banks should not be in an
adversarial position, neither should regulators view banks as their
clientele. A possible solution is to have all examinations financed
by the FDIC through insurance premiums.
Shorten the period for beginning the resolution process after
a bank is classified critically undercapitalized to 90 days, with
no extensions. The evidence is strong that losses to the FDIC
increase on average the longer an insolvent or near insolvent bank
is permitted to continue to operate.\7\
---------------------------------------------------------------------------
\7\ Some regulators were recently quoted in the American Banker
that they had nursed a number of ``4'' and ``5''--CAMELS rated banks
back to health at a cost saving to the FDIC. If, as appears likely,
some of these banks had also been classified critically--
undercapitalized, history clearly documents that greater cost savings
are achieved, on average, through quicker resolution. Rob Blackwell,
``Debate on Exam Power is Headed for Congress,'' American Banker,
September 4, 2001, pp. 1, 6.
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Increase the ability of the FDIC to participate in on-site
examinations by other agencies. However, this may not be easy to
achieve in practice. On the one hand, too many FDIC examinations
would involve duplication and inefficiency. On the other hand,
because FDIC participation examinations cannot be hidden from view,
sporadic FDIC participation with other primary Federal regulators
may send a signal that could start or reinforce an unwarranted run.
One way may be to have the FDIC participate in the examination of
all ``3'', ``4'', and ``5''--CAMELS rated banks and of ``1'' and
``2''--rated banks on a random basis.
Increase emphasis on market valuations, particularly for
equity of large banks. Although FDICIA encouraged this, it has
received a cold shoulder from regulators.
Require a minimum of credibly, uninsured, subordinated debt,
particularly for large banks, that can count fully as regulatory
capital to provide supplementary market signals of the bank's
financial strength from either primary or secondary markets and to
trigger regulatory response as part of or in addition to PCA.\8\
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\8\ U.S. Shadow Financial Regulatory Committee, Reforming Bank
Capital Regulation, Washington, DC, American Enterprise Institute,
2000.
But none of these suggestions will be effective unless the
supervisors have not only the ability but also the will to comply fully
with the underlying objectives and spirit of PCA and LCR. At times, the
actions of all four Federal bank regulatory agencies suggest a lack of
commitment. It may be desirable, therefore, to encourage additional
sensitivity training for regulators to increase their commitment to
these important objectives. Regulators should be judged adversely not
by the number of bank failures, but by the cost of the failures.
PREPARED STATEMENT OF KAREN SHAW PETROU
Managing Partner, Federal Financial Analytics, Inc., Washington, DC
October 16, 2001
Mr. Chairman, I appreciate the opportunity to appear this morning
to discuss the lessons for policymakers suggested not only by the
Superior Federal Bank failure, but also by other recent closings of
insured depositories and the new, post-attack risk context in which
these specific cases must be considered. I am the Managing Partner of
Federal Financial Analytics, a firm that has advised financial services
companies in the United States and abroad for the last 16 years.
Federal Financial Analytics has no clients that are parties in the
Superior or other recent bank failures before you today.
This hearing was just being convened on September 11 when the
planes struck. It is now the first piece of regular business taken up
by the Committee since the attack. It is a relief for all of us to
discuss Superior FSB, a relatively ordinary failure in the ordinary
times that are sadly now behind us. The lessons from the failure--and
several prior ones similar to it--are, however, even more pertinent
today, when hypothetical risks have now become alarmingly real.
In 1993, I was an adviser to a commission chartered by Congress to
examine the causes of the S&L crisis and to make recommendations about
ways to prevent another one. One major commission finding that has been
cited in many other books on the 1980's crisis: Congress throughout the
period was not given reliable information on which to act and, in some
cases, it ignored the signs of brewing trouble. As the Commission
concluded, ``Congress appears to have been largely unaware of the
severe problems developing in the S&L industry. . . By the time the
extent of the problem was recognized, much of the damage was done.''
The prompt attention the Superior Federal Bank case is receiving in
this hearing and your interest in any action that the case may warrant
indicates that one of the more important lessons of the 1980's will
guide Congress in 2001.
In this statement, I would like to offer the following
recommendations and conclusions, based on the Superior FSB failure,
those that preceded it and the new risk profile for the financial
services industry:
The ``Prompt Corrective Action'' capital standards are not a
reliable guide for regulatory intervention because the capital
standards on which they rest are flawed and about to become more
so. Distortions in capital standards actually create incentives for
banks to take risks. This was the case with Superior, because
capital incentives encouraged a concentration in high-risk residual
assets. It could be the case for the financial system more broadly
due to proposed capital rules that will discourage banks from
obtaining insurance or otherwise reducing operational risk.
Congress should push for rapid action on the recourse/residual
rules, and take a close, hard look at pending changes to the
international risk-based capital rules.
No bank regulator has a perfect record in recent bank
failures. The FDIC should have expedited authority to review
troubled institutions, but no greater authority should be granted
to review healthy banks. Doing so would add regulatory burden
without any offsetting improvement. Indeed, duplicative regulation
could distract resources from emerging risks. Numerous improvements
to supervisory practices by all of the regulators should be made.
The pace of bank and thrift consolidation may make the OCC and
OTS over-
dependent on revenue from a few very large institutions. There is
no evidence that this has to date resulted in forbearance, but this
could occur with further consolidation. Restructuring of the
assessment scheme, including consideration of use of FDIC premiums,
should be considered.
Finally, in the context of a hearing examining regulatory failure,
it is important also to recognize success. After the September 11
attack, the resources of our Nation's financial system were strained to
breaking. Treasury, the Federal Reserve, and the other supervisory
agencies all played an important role in acting quickly to quell any
panic, right the banking ship, and protect the system from further
harm.
I. The Critical Importance of Correct Capital Incentives
In the wake of the banking and thrift crises of the late 1980's,
Congress decided to use capital as the criterion for regulatory
intervention. This made sense, since one of the other key findings of
the 1993 Congressional Commission cited above--along with most other
analyses of the time--was that capital forbearance not only
precipitated the crisis, but also significantly increased its cost.
The capital-related sanctions can be found in Section 131 of the
FDIC Improvement Act of 1991. They are often called the ``Prompt
Corrective Action'' or PCA section, based on the Congress' intent that
regulators would initiate Prompt Corrective Action when bank or thrift
capital fell below designated thresholds. However, the statute does
give regulators numerous options to refrain, including flexibility to
delay closing a critically undercapitalized institution.
Some have argued that the PCA framework should be more prescriptive
so that a primary regulator must close a bank when it fails the
critical capital test. However, I am very concerned that an automatic
trigger based on a single indicator of bank condition could result in
the closing of some healthy banks and the ongoing operation of other,
truly insolvent ones. This is because the current measures of capital
adequacy on which the PCA tests are based are flawed. Indeed, under
current capital standards, a bank with its entire portfolio in risk-
free Treasury securities could be subject to higher regulatory capital
standards than one like Superior with a portfolio of risky subprime
assets.
Further, pending changes to the Basel risk-based capital standards
suggest that this problem could become even worse, increasing the
already wide variance between the amount of capital a bank needs as
determined by the market (economic capital) and that demanded by bank
regulators. As discussed in more detail below, the new financial risk
environment makes it even more urgent that flaws in both the current
and prospective capital standards be quickly remedied. Congress should
oversee the capital regulatory process because failures in it could
have grave macroeconomic consequences, as well as increase systemic
risk.
A. The Role of Residuals and Other Structured Assets
As noted, the PCA framework is only as strong as the capital rules
on which it rests. In 1991, financial markets were far simpler than at
present, when financial ``engineering'' techniques have multiplied the
ways risk can be sliced and diced among originators, issuers, and
investors. Failures in the capital rules accurately to reflect risk are
quickly identified and exploited as banks seek to maximize their return
on equity by holding assets that provide the greatest relative return
(adjusted for risk) in relation to regulatory capital.
Bank regulators disagreed over the capital condition of Superior
Federal Bank as it slid toward regulatory insolvency, and this is one
of the disputes now before the Committee. However, the Superior case is
not an isolated one. In three other recent bank failures--Keystone,
BestBank, and Pacific Thrift & Loan--questions about capital adequacy
comparable to those at Superior are also relevant. All four banks
engaged in complex securitization transactions that put structured
assets, often called residuals, on their books. The appropriate capital
treatment for residuals and for other structures in which a bank
retains risk, ``recourse'' in regulatory parlance, remains very crude
in relation to the real risks posed by these complex instruments.
Further, the accounting valuation of residuals remains at best an art,
putting bank regulators at the mercy of accountants whose judgment
proved unreliable in each of these recent bank failures.
Unsettled economic circumstances make residual valuation still more
problematic. In early September, a major nonbank mortgage servicer took
a $2.1 billion write-off of servicing value because of model failures,
and market indications are that several other large lenders may be
forced to do the same in coming weeks because of the Fed's sharp
reductions in interest rates after the terrorist attacks.
Under current capital standards, the real risk of residuals and
recourse positions is not captured. In some cases, risk is underpriced
in capital terms, creating incentives such as those which drove
Superior FSB to amass millions in complex residual interests. In other
areas, risk is overpriced. For example, the current rules treat high-
quality, asset-backed securities the same as very risky instruments.
This significantly reduces the profitability associated with lower-risk
assets, creating a perverse incentive for banks to take on more--not
less--risk.
Revisions to the recourse and residual capital standards have been
pending for almost a decade. Regulators have been slow to act because
these instruments are complex and because some institutions profit
handsomely from the ``risk arbitrage'' opportunities created by the
holes in the current capital rules. However, this failure to act has
had several serious consequences. First, it created the conditions that
led not only to the Superior FSB failure, but also to the others cited
above. Other institutions may be suffering major revaluations in their
residual books, and rapid action on the new capital rule is essential
to identify these institutions and bring them into an appropriate PCA
framework.
Second, the failure of the capital standards to capture accurately
certain risks could now be contributing to ongoing instability in the
financial markets. The September 11 attacks struck at the heart of the
system for bundling loans into asset-backed securities. The bulk of
this market is based on mortgage loans, but many other types of assets
that is, credit card receivables--are similarly securitized. Private-
label asset-backed securities have long labored under a capital
disadvantage to those issued by Government-sponsored enterprises
because even the highest-rated private securities bear a far higher
capital charge than securities backed by the GSE's. Rapid recovery of
the securitization market would be enhanced by quick action on the
recourse rules, which would remedy this capital handicap and create a
quick stimulus to this troubled market. Doing so could help to reduce
long-term mortgage rates because lenders would have more ready access
to the secondary market, reducing their costs of doing business.
B. Additional Capital-Related Risks
Despite awesome stress, the Nation's financial system recovered
remarkably quickly from the destruction of the September 11 attack.
This was in part the result of heroic work by the Nation's financial
regulators. However, it also resulted from the less noticeable years of
investment by financial services firms in back-up computer centers,
redundant transaction centers, contingency planning, and costly
insurance. None of these was cheap, and all reduced return to
shareholders, but each proved essential in bringing the financial
system back online in remarkably good order in an amazingly short time.
One would assume that bank regulators would seek to build in as
many incentives as possible for banks to prepare for reasonable and
unreasonable disaster scenarios. However, one proposed change to the
international risk-based capital rules would, in fact, create a
perverse incentive against disaster preparedness and operational risk
mitigation. This is because the proposed rules would impose a specific
capital charge against ``operational risk,'' without any discount for
banks that have made the extensive investment in disaster recovery
cited above.
As with the residual and recourse rules, misplaced capital
incentives with regard to operational risk will encourage risk-taking,
not reduce it. Rules which are very detailed and highly technical can
appear to be ``state of the art,'' but small mistakes or misplaced
incentives can have significant, adverse policy consequences.
Another major problem with the rewrite of the international capital
standards is its failure to deal well either with portfolio or line-of-
business diversification. As a result, institutions with big portfolios
of risky loans might not be penalized, nor would those which fail to
engage in a prudent mix of businesses where risks tend naturally to
hedge each other. This failure could, in fact, create a regulatory
incentive for banks to become monoline institutions focusing on the
high-risk end of the market. This could lead to more, not fewer,
Superior-style failures.
C. Special U.S. Risks
The link between PCA and capital under U.S. law makes it especially
urgent that the capital rules be properly calibrated to risk. In other
countries, banks that fail the Basel or their own domestic capital
rules may get a slap on the wrist, if their regulators even do that.
However, FDICIA obligates U.S. regulators to take the steps outlined
above if the capital slips below stated thresholds. Thus, banks will
maintain regulatory capital even if their true risk profile argues for
far more--and sometimes far less--regulatory capital. In addition, the
link between being ``well-capitalized'' and being allowed under the
Gramm-Leach-Bliley Act to form a financial holding company ties U.S.
banks far more closely to the capital standards than is the case in
other countries.
The PCA framework and GLBA requirements mean that many bank
examiners focus on the letter of the capital requirements, not their
spirit. They impose capital sanctions in a mechanical fashion or deem
banks to be well-capitalized regardless of their real risk potential.
The fact that many Texas banks (such as, First National City) were
well-capitalized under the PCA framework on the day they were closed
makes it clear that regulatory capital cannot be the sole criterion on
which regulators base their supervisory decisions. Superior FSB's
precipitous decline from the top of the capital heap to the bottom
reinforces this decade-old lesson.
Policy Recommendations
In my view, the PCA framework is a valuable one, as it prevents the
endless forbearance that characterized both bank and thrift regulation
during the 1980's. However, the serious flaws in the current and
prospective capital rules argue strongly against too tight or too
mechanical a link between capital and supervisory intervention. Under
PCA, there has yet to be a bank liquidation that did not cost the FDIC
money, demonstrating that reliance solely on capital as the PCA trigger
provide no guarantee against losses to the deposit insurance fund, as
Congress intended.
Specifically, I would suggest the following:
Rapid action by bank regulators to finalize the recourse and
residual rules. Congress required the bank regulators to issue the
recourse rules in the Riegle-Neal Act of 1994. The Superior failure
and the problems it and others expose with regard to the capital
treatment of securitization-related assets makes action on these
rules essential;
Congressional review of the bank capital framework, with
particular regard to the emerging Basel rules. In addition to the
PCA-related problems outlined above, the rules could have a
dramatic and unintended effect on economic growth and on lending to
low- and moderate-income borrowers. Congress should ensure that the
bank regulators are informed by broad, public policy interests as
the capital rules are finalized; and
The PCA framework should be modified to reduce its reliance on
capital. Banks should be upgraded in the PCA framework, as well as
downgraded, when non-capital factors affect their risk profile.
Further, regulators should make greater use of their power under
current law to evaluate noncapital factors (that is, management
expertise) and downgrade institutions and impose sanctions
accordingly.
II. FDIC Enforcement Power
The Committee is rightly concerned that bank regulators work well
together, and that the FDIC be informed early about any emerging
problems that might result in a cost to the deposit insurance fund.
However, the FDIC already has broad authority to intervene in troubled
institutions that are not dependent on cooperation from its sister
agencies. For example, the FDIC can terminate deposit insurance at its
sole discretion, without regard to whether a primary regulator has
decided to close a bank or savings association. Further, the FDIC can
under current law notify a primary regulator that it believes that PCA
sanctions should be invoked. Should the primary regulator fail to do
so, the FDIC can intervene. In the 10 plus years since the FDIC got
these powers, they have never been used. This suggests to us that
differences of opinion among the regulators are isolated and that these
should be resolved through greater Congressional oversight and improved
regulatory communication, not through any statutory change.
Indeed, giving the FDIC broader authority could well be
problematic. There appears to be little reason to give the agency
automatic authority to examine healthy banks, especially the large ones
that are already subject to double and in some cases triple or more
supervision from a variety of bank and nonbank regulatory bodies.
Further, the FDIC has little experience with specialized, sophisticated
institutions. While it might like to learn on-the-job to anticipate
potential problems, its entry into such institutions would add
considerable regulatory burden without any discernible benefit.
Indeed, supervision of all insured depositories might be improved
if the FDIC worked with other bank regulators to take advantage of
their expertise. While Superior and Keystone are the largest and most
costly recent bank failures, the FDIC has had two smaller ones of its
own. BestBank of Colorado failed in 1999 due to very dubious management
practices and questionable lending, while Pacific Thrift & Loan failed
largely because of the same problems with residuals that toppled
Superior. In both cases, the FDIC let as many as 5 years lag between
the time at which it first spotted trouble and the time the banks were
closed. Through these years, the FDIC appeared as reluctant to second-
guess management and accountants as its sister agencies in the Keystone
and Superior cases. In the era of emerging risk in which we find
ourselves, it is essential that bank regulatory resources be deployed
as effectively as possible, and this would argue for an FDIC focus on
its own supervisory concerns, not on those under the purview of other
financial supervisors. The FDIC can also make a contribution toward
improving the safety of the financial system as a whole by moving
rapidly on fundamental reform to the deposit insurance system to
eliminate the incentives to risk-taking endemic within the premium
structure of the deposit insurance funds.
Policy Recommendations
Supervising banks engaged in complex activities during trying
economic times is hard work for each agency charged with doing so. When
bank management is engaged in systematic fraud or desperate practice,
all of the regulators face a still more daunting task. None has a
recipe for total success, and each would benefit from improving
communications with the others and from more general reforms to bank
examination. These could include:
Tighter scrutiny of and, in some cases, sanctions against bank
management. When management and/or major shareholders are big
borrowers from their own institutions or have a record of
association with other troubled institutions, supervision should be
far more stringent. Bank examiners should consider making use of
their PCA powers to impose a higher capital burden on closely held
institutions, especially those engaged in high-risk or insider-
related lines of business.
Requiring that only the head of another regulatory agency may
decline a request from the FDIC for joint examinations.
Reviewing depository institution accounting standards,
especially with regard to complex securitization-related assets and
derivatives exposures. Bank regulators have long resisted market-
value accounting because this could expose institutions to earnings
volatility. However, historical cost accounting protects
institutions from quick recognition of losses, which increases the
likelihood of deeper losses down the road. Current accounting
practices also reduce market discipline and encourage regulatory
forbearance, since banks may look far healthier than they actually
are.
Reinstating the report process related to high-growth
institutions mandated in FIRREA. In 1995, the FDIC decided to
terminate its guidance in this area, despite substantial evidence
that banks that grow very fast for reasons not associated with
mergers or acquisitions pose a disproportionate risk to the deposit
insurance funds.
Reconsideration of the current policy against disclosure of
CAMELS ratings. Bank regulators have long opposed public
disclosures, fearing this would exacerbate liquidity problems at
troubled banks. However, they are proposing both within the United
States and in the Basel process to institute a series of highly
complex and, in some cases, very burdensome new disclosure
requirements. A simpler disclosure with regard to a bank's
condition would significantly improve market discipline, especially
in the absence of a proper relationship between deposit insurance
premiums and bank risk.
Creating teams of specialized examiners on call to any Federal
financial supervisor. This would encourage the cost-effective
development of experts in highly complex areas such as asset
securitization and the proper valuation of residuals, while
minimizing the number of duplicative exams to which the
institutions are subject. Regulators might also be required to have
their own or to share teams of specially trained anti-fraud
examiners, whose law enforcement orientation might improve
supervision in cases like Keystone.
III. Examination Fees
It is also possible that the dependence of certain regulators on
assessment fees could create problematic supervisory incentives. At
present, we do not see any evidence that fees have played any role in
recent supervisory decisions by the OCC and OTS. Indeed, as these
agencies note, problem institutions generally cost the agencies far
more in supervisory resources and, in some cases, court costs than they
provide in fees. Further, both agencies experience what they call
reputation risk when an institution fails on their watch, as is evident
not only from today's hearing, but also from earlier ones in the House
after Keystone's collapse.
However, the fact that fees are not now problematic does not mean
that they will not become so in time. The consolidation in the banking
industry means that the OCC and OTS are increasingly dependent on a few
very large institutions for the bulk of their revenue. This is
particularly true at the OTS, where one very large savings association
dwarfs the rest of the industry in terms of market size and, therefore,
assessment fees. Loss of such an institution to another regulator could
be costly, and it is therefore possible that an agency head might be
more inclined to work with such a bank than with a smaller one with
less impact on the agency's bottom line.
But while the shape of the looming problem with assessments is
clear, the cure is less so. Bringing the OTS and OCC under the
appropriations process is, in my view, highly ill advised. The problem
with appropriating supervisory resources is evident at OFHEO, the
safety-and-soundness regulator for Fannie Mae and Freddie Mac. Due to
budget and other pressures, Congress consistently appropriates less for
OFHEO than the agency requests, giving it fewer resources with which to
supervise its charges than is the case at the OCC and OTS for very
large institutions.
The OCC has suggested that the premiums paid by national banks and
Federal savings associations to the FDIC be used also to pay for bank
supervision, as is the case for State nonmember banks. Doing so would
ensure that the FDIC uses its resources wisely, while eliminating an
obvious inequity between the Federal and State charters. However, it is
very difficult to identify precisely which portion of the FDIC's
premiums should be subtracted to compensate Federally chartered
institutions. Further, doing so could reduce the resources available to
absorb losses to the deposit insurance funds, increasing the prospect
of rapid increases in industry-wide premiums or even, under extreme
circumstances, taxpayer assistance. Finally, calibrating the amount
repatriated to Federal supervisors would become far more difficult when
truly risk-based premiums are instituted.
In light of these concerns, I recommend that:
Congress consider the issue of Federal examination fees in the
context of pending proposals to reform deposit insurance.
Specifically, Congress might consider allocating a portion of the
premiums paid by each Federally chartered bank and savings
association as a supervisory charge, rebating these fees back to
the primary regulator for as long as the deposit insurance funds
stay above their designated reserve ratios.
RESPONSE TO WRITTEN QUESTION OF SENATOR SARBANES FROM ELLEN
SEIDMAN
Q.1. I understand that there is still some uncertainty
regarding what will be the net loss to the Savings Association
Insurance Fund (SAIF) from the failure of Superior Bank. I am
concerned that another failure of similar cost could cause the
SAIF ratio to fall below 1.25. Using the latest FDIC
information from June 2001, the SAIF had a balance of $10.79
billion covering insured deposits that were worth $772.9
billion. This places the current SAIF ratio at approximately
1.40 percent. I understand that in these figures some money has
already been taken to deal with the Superior failure, on the
order of $300 million. Ms. Seidman, if the net cost to the SAIF
from the Superior failure is $750 million, and holding the
deposit base constant, what would be the size of another
failure or set of bank failures that would cause the SAIF ratio
to fall below 1.25?
A.1. The failure of Superior Bank will reduce the SAIF's excess
reserves, but the fund can absorb these losses and maintain a
cushion above its 1.25 percent designated reserve ratio. As of
September 30, 2001, the SAIF held reserves of $10.8 billion
against $779.2 billion in insured deposits, a reserve ratio of
1.39 percent. The SAIF's excess over its designated reserve
ratio was $1.1 billion.
When the FDIC approved the sale of Superior Bank on October
31, 2001, they estimated that the loss to the SAIF would be
between $450 million and $550 million. At that time, the fund
held specific reserves of $450 million for Superior (for
example, apart from the $10.8 billion), so this would imply
additional potential losses of up to $100 million. Subtracting
$100 million from the SAIF would leave its reserve ratio at
1.38 percent, with $975 million in excess reserves. In your
question, you cite an early, unofficial estimate that the
failure could cost the SAIF $750 million, in which case the
SAIF's reserve ratio would fall to 1.35 percent, with remaining
excess reserves of $775 million.
The SAIF's losses from Superior Bank are mitigated by the
agreement made in December 2001 between the OTS and the FDIC
and the holding companies of Superior Bank. Under this
agreement, the holding companies have agreed to pay the FDIC
$460 million, of which $100 million has already been paid out
and the remainder will be paid out over a 15 year period. In
addition, Superior's deposit base was sold at a substantial
premium. It is our understanding the FDIC expects to have an
adjusted loss estimate for Superior in the near future.
The failure of Superior Bank was quite costly to the SAIF,
but the fund was able to absorb these losses without severely
depleting its reserve cushion. While future failures are always
a possibility, the fund is not currently facing problems that
might imperil its ability to remain fully capitalized. As of
September 30, 2001, there were 17 OTS-supervised institutions
with $3.6 billion of assets on the problem list, only three of
which, with aggregate assets of $400 million, were less than
adequately capitalized. Of course, these numbers can fluctuate
significantly over time.
RESPONSE TO WRITTEN QUESTION OF SENATOR SARBANES FROM JOHN
REICH
Q.1. As of June 2001, the Savings Association Insurance Fund
(SAIF) had a balance of $10.79 billion covering insured
deposits that were worth $772.9 billion. This places the
current SAIF ratio at approximately 1.40 percent. Holding
constant the deposit base, what amount of additional losses to
the SAIF would cause the fund ratio to fall below 1.25?
A.1. Losses exceeding approximately $1.1 billion would lower
the SAIF reserve ratio below 1.25 percent if SAIF-insured
deposits are held constant at the June 30, 2001 estimated
amount of $772.9 billion. This calculation does not include
interest income on the SAIF balance.
This calculation would not significantly change using the
September 30, 2001 data. As of that date, the SAIF balance was
$10.8 billion. Estimated insured deposits were $779.2 billion,
resulting in a SAIF reserve ratio of 1.39 percent. Holding
SAIF-insured deposits constant at this level, it would again
require losses exceeding approximately $1.1 billion to lower
the SAIF reserve ratio below 1.25 percent (ignoring, as before,
interest income).