[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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?

            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)




?

                            C O N T E N T S

                              ----------                              

                      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.
                               ----------
                  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.
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    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\
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    \3\ Superior was adequately capitalized on a risk basis. Tier 1 
equity capital exceeded 12 percent, in the well-capitalized range.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    \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:
---------------------------------------------------------------------------
    \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.
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    \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.
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    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.
                               ----------
                    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\
---------------------------------------------------------------------------
    \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\
---------------------------------------------------------------------------
    \5\ FDIC, History of the Eighties--Lessons for the Future, Vol. 1., 
p. 52.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    \2\ FDIC's annual Summary of Deposit data by bank and thrift branch 
can be found at www.fdic.gov.
---------------------------------------------------------------------------
 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.
---------------------------------------------------------------------------
 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.
---------------------------------------------------------------------------
    \5\ American Banker, August 9, 2001.
    \6\ American Banker, August 21, 2001.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    \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\
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
 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.
---------------------------------------------------------------------------
 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\
---------------------------------------------------------------------------
    \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).
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