[Senate Hearing 107-702]
[From the U.S. Government Publishing Office]



 
                                                        S. Hrg. 107-702


                       ANALYSIS OF 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

                             SECOND SESSION

                                   ON

  THE ANALYSIS OF 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

                               __________

                            FEBRUARY 7, 2002

                               __________

  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

                  Martin J. Gruenberg, Senior Counsel

                       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, FEBRUARY 7, 2002

                                                                   Page

Opening statement of Chairman Sarbanes...........................     1
    Prepared statement...........................................    28

                               WITNESSES

Jeffrey Rush, Jr., Inspector General, U.S. Department of the 
  Treasury.......................................................     3
    Prepared statement...........................................    28
Gaston L. Gianni, Jr., Inspector General, Federal Deposit 
  Insurance
  Corporation, Washington, DC....................................     6
    Prepared statement...........................................    35
Thomas J. McCool, Managing Director for Financing Markets and 
  Community
  Investment, U.S. General Accounting Office, Washington, DC.....    11
    Prepared statement...........................................    41

              Additional Material Supplied for the Record

Material Loss Review submitted by Jeffrey Rush, Jr, February 6, 
  2002...........................................................    57
Audit report submitted by Gaston L. Gianni, Jr., February 6, 2002   118

                                 (iii)


                      ANALYSIS OF THE FAILURE OF 
                 SUPERIOR BANK, FSB, HINSDALE, ILLINOIS

                              ----------                              


                       THURSDAY, FEBRUARY 7, 2002

                                       U.S. Senate,
          Committee on Banking, Housing, and Urban Affairs,
                                                    Washington, DC.

    The Committee met at 10:40 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. Let me call this hearing to order.
    First of all, I want to thank our witnesses for their 
patience. We obviously have no control over this situation.
    The vote was supposed to be at 5 minutes after 10 a.m. So, 
I thought we will begin the hearing after the vote, which 
seemed to make the most sense. The vote then got delayed 
somewhat, so it is a little later than would otherwise have 
been the case. But I do think we now have an uninterrupted 
period ahead of us. So, I think we will be able to carry this 
hearing through to completion. I certainly hope so.
    This morning, the Committee holds another hearing on the 
failure of Superior Bank, an insured depository institution. We 
are very pleased to have as our witnesses this morning: Jeffrey 
Rush, Jr., the Inspector General of the U.S. Department of the 
Treasury; Gaston Gianni, Jr., Inspector General of the Federal 
Deposit Insurance Corporation; and Thomas McCool, the Managing 
Director for Financial Markets and Community Investments of the 
General Accounting Office, GAO.
    Our witnesses will present their respective analyses of the 
causes of Superior's failure and offer their recommendations 
for preventing similar occurrences in the future.
    The Committee completed its first hearing on the failure of 
Superior on October 16. Actually, it was scheduled for the 
morning of September 11 and, in fact, began that morning, I, 
operating on the premise that we were not going to let the 
terrorists close down the Government of the United States. 
Twenty minutes later, the Capitol police showed up and threw us 
out of the hearing room and said, you would better get out of 
the Capitol complex.
    At the resumed hearing on October 16, we received testimony 
from the regulators, Ellen Seidman, Director of the Office of 
Thrift Supervision, and John Reich, Board Member of the FDIC, 
and also from three private-sector financial experts: Bert Ely, 
Professor George Kaufman, and Karen Shaw Petrou.
    On July 27, last summer, the OTS closed Superior Bank after 
finding that the bank was critically undercapitalized. The OTS 
concluded that Superior's problems arose from, ``a high-risk 
business strategy, and that Superior became critically 
undercapitalized largely due to incorrect accounting treatment 
and aggressive assumptions for valuing residual assets.''
    Superior is the largest U.S.-insured depository institution 
by asset size to fail in more than 9 years. The FDIC estimates 
that Superior's failure will result in a loss to the Savings 
Association Insurance Fund of approximately $300 to $350 
million. That is, as I understand it, their latest estimate.
    Since our last hearing, there have been a number of 
significant developments and I want to take a moment to touch 
on those.
    First, regulatory developments have addressed two issues 
that were raised at that hearing. On November 29 of last year, 
the Federal bank regulators jointly announced the publication 
of a final rule that changes the regulatory capital standards 
to address the treatment of recourse obligations, residual 
interests, and direct credit substitutes that expose banks, 
bank-holding companies, and thrifts to credit risks. This new 
rule addresses the question of large holdings of risky residual 
assets as arose in Superior's case. On January 29 of this year, 
the FDIC announced an agreement among the Federal bank 
regulators that expands the FDIC's examination authority. It 
makes it easier for the FDIC to examine insured banks and 
thrifts about which it has concerns. This addresses situations 
in which the FDIC wants to come in and participate in an 
examination, but the primary regulator refuses.
    Second, on December 10, the FDIC and OTS reached a $460 
million settlement agreement with Superior's holding companies 
and their owners.
    Third, with respect to the resolution, the FDIC as 
conservator has operated the bank. On November 19, Charter One 
Bank bought Superior's deposit franchise and other assets for a 
premium of about $52. The FDIC is currently in the process of 
selling the bank's remaining assets.
    The focus of today's hearings will be the findings and 
recommendations of the Treasury, the FDIC, and the GAO. In 
requesting these three agencies in the wake of Superior's 
failure to assess the reasons why the failure of Superior 
resulted in such a significant loss to the deposit insurance 
fund, I specified a number of areas of analysis, including the 
timeliness of regulatory response, the role of the outside 
independent auditor, and the issue of coordination among the 
regulators.
    We also requested in our letters to the three witnesses 
before us, or their agencies, recommendations for preventing 
future bank failures with their attendant losses. Their 
recommendations take on a new urgency as depository 
institutions continue to fail, not only at a cost to the 
insurance fund, but also to public confidence in our banking 
system, which, of course, is an intensifying problem nowadays, 
given all of what has transpired.
    Since the failure of Superior Bank just 7 months ago, four 
other insured banks have failed, with a potential cost to the 
BIF of somewhere, it is estimated, between $250 and $450 
million. So this hearing comes at a timely moment. These 
reports have just been completed and are ready now for, as it 
were, public attention, and that is why we moved quickly to try 
to hold this hearing at this opportune time.
    We look forward to hearing from our witnesses. Mr. Rush, we 
will start with you and just move right across the panel.

                 STATEMENT OF JEFFREY RUSH, JR.

       INSPECTOR GENERAL, U.S. DEPARTMENT OF THE TREASURY

    Mr. Rush. Thank you, Mr. Chairman. I am delighted to appear 
before the Committee to discuss our review of Superior.
    I would like to take one brief moment to introduce Marla 
Freedman, Don Kassel, and Benny Lee, the three audit 
professionals who not only run my entire audit program, but 
were responsible for all the banking work that we do at 
Treasury. They are seated behind me.
    Chairman Sarbanes. Why don't they stand up, so that we can 
acknowledge them.
    Good. Thank you all very much.
    Mr. Rush. We appreciate that. As you know, Superior was 
supervised by the Office of Thrift Supervision, an agency of 
the Department of Treasury. Under the provisions of the Home 
Owners' Loan Act, OTS is responsible for chartering, examining, 
supervising, and regulating Federal savings associations and 
Federal savings banks.
    The Federal Deposit Insurance Corporation Improvement Act 
of 1991 mandates that the inspector general of the appropriate 
Federal banking agency shall make a written report to that 
agency whenever the deposit insurance fund incurs a material 
loss. A loss is deemed material if it exceeds the greater of 
$25 million or 2 percent of the institution's total assets at 
the time that the FDIC initiates assistance or is appointed as 
a receiver. We have completed that review and on February 6, 
just yesterday, as mandated by FDICIA, my office issued a 
report on the material loss to the Director of the OTS and to 
the Chairman of the FDIC and the Comptroller General of the 
United States.
    I have prepared a statement and I will highlight some of 
the causes of Superior's failure, our concerns about the 
supervision of OTS, including the use of Prompt Corrective 
Action, and a status report on both ongoing audit and 
investigative work that our office is engaged in, all related 
to Superior's failure.
    As you have already stated, Superior's failure is the 
largest and most costly thrift failure since 1992. The FDIC has 
estimated the failure to exceed $300 million. At the time of 
its closing in July 2001, Superior had just over $1.9 billion 
in booked assets, which were largely funded with FDIC-insured 
deposits, totalling almost $1.5 billion.
    Superior was formerly known as Lyon Savings Bank of 
Countryside, Illinois and was acquired for $42\1/2\ million. 
Beginning in 1993, Superior embarked on a business strategy of 
significant growth into subprime home mortgages and auto loans. 
Superior transferred the loans to a third party, who then sold 
asset-backed securities to investors. The repayment of these 
securities was supported by the expected proceeds of the 
underlying loans.
    The large, noncash earnings generated from the subprime 
loan securitizations masked actual losses from flawed residual 
asset valuation assumptions and calculations. Superior's true 
operating results did not become evident to OTS or FDIC until 
October 2000, when they discovered that inaccurate accounting 
practices and faulty valuation practices had been going on.
    The root causes of Superior's failure go back to 1993. 
Indeed, we believe Superior exhibited many of the same red 
flags and indicators reminiscent of problem thrifts of the 
1980's and 1990's. These include: one, rapid growth into a new, 
high-risk activity, resulting in an extreme asset 
concentration; two, deficient risk-management systems related 
to valuation issues; three, liberal underwriting of subprime 
loans; four, unreliable loan loss provisioning; fifth, economic 
factors that affect asset value; and six, nonresponsive 
management to supervisory concerns.
    In the early years, the OTS's examination and supervision 
of Superior appeared inconsistent with the institution's 
increased risk profile. It was not until 2000 that the OTS 
expanded examination coverage to residual assets and started 
meaningful enforcement actions. By then, it was, arguably, too 
late, given Superior's high level and concentration of residual 
assets.
    We believe that OTS's supervisory weaknesses were rooted in 
a set of tenuous assumptions regarding Superior. Despite OTS's 
own increasing supervisory concerns, OTS: one, assumed the 
owners would never allow the bank to fail; two, assumed that 
Superior's management was qualified to safely manage a complex 
and high-risk program of asset securitization; and three, that 
the external auditors could be relied upon to attest to 
Superior's residual asset valuations. All of these assumptions 
proved to be false.
    OTS did not actively pursue an enforcement action to limit 
Superior's residual asset growth with a Part 570 safety and 
soundness compliance plan until July 2000. One of the Part 570 
provisions required Superior to reduce residual assets to no 
greater than 100 percent of core capital within a year.
    I should note that at this time, the residual assets were 
then about 350 percent of tangible capital. Although grounds 
existed for more forceful enforcement actions.
    Chairman Sarbanes. When you say, at this time, when was 
that?
    Mr. Rush. In late 2000. This is the summer of 2000.
    Although grounds existed for a more forceful enforcement 
action, such as a temporary cease-and-desist order, two OTS 
supervisory officials chose the Part 570 notice because it was 
not subject to public disclosure, whereas, other actions were 
subject to public disclosure. The OTS felt that public 
disclosure of an enforcement action might impair Superior's 
ability to obtain needed financing through loan sales.
    Throughout our report and in my statement, I will give you 
specific examples of weaknesses associated to OTS's examination 
of Superior. But given the amount of time, I would like to just 
go to our nine recommendations and then conclude by giving you 
a status report on the ongoing work.
    Chairman Sarbanes. Fine. The whole report will be included 
in the record and we are going to work through it very 
carefully as we develop an action program. But please go ahead.
    Mr. Rush. Our first recommendation is that OTS issue 
additional guidance with respect to third-party service 
providers. As you know in this case, Superior relied upon a 
third-party firm called Fintek to do those valuations for them.
    Our second recommendation is that OTS should assess the 
adequacy of guidance with respect to the examination of thrifts 
whose critical functions are geographically dispersed. This, 
again, was a problem with Superior in that it had offices not 
only in Illinois, but relied upon a New York firm to provide 
valuations.
    Recommendation three--we are asking OTS to require quality 
assurance reviews to cover examinations where an expanded 
review of the external auditor's workpapers would have been 
warranted. You will note that we found that only after 2000 and 
2001, did OTS look beyond the valuations that were attested to 
by the outside auditor.
    Recommendation four--we are asking OTS to assess the 
adequacy of guidance with respect to the application of new and 
changing accounting standards. It is clear that during this 
period of time in the middle 1990's, there was some confusion 
as to how the accounting standards applied to valuing 
securitized assets.
    Recommendation five--we are asking OTS to establish minimum 
testing procedures and assess the adequacy of guidance with 
respect to valuation policies and practices relating to 
residual assets.
    Recommendation six--we are asking OTS to ensure that 
quality assurance reviews cover adequacy of examiner follow-up 
on previously reported problems. We found substantial evidence 
that examiners failed to take action a second and third time 
when they returned to Superior and not found corrective action 
being taken.
    Recommendation seven--we are asking OTS to determine 
whether Superior violated Prompt Corrective Action restrictions 
when senior executives were paid bonuses in 2001.
    Recommendation eight--we are asking OTS to assess the 
adequacy of existing supervisory controls used to ensure thrift 
compliance with PCA restrictions as a general proposition.
    And finally, we are asking OTS to assess whether 
legislative or regulatory changes to PCA are warranted.
    As you will note in both my statement and the report, the 
concern about PCA is as follows. PCA activities tend to follow 
examination and discovery of capital problems. Thus, by looking 
at a lagging indicator, it is often too late for PCA to 
accomplish precisely what we think the legislation intended.
    Let me close by giving you a brief summary of our current 
activities. First, with respect to our audit. As you will note 
in our audit report, we do identify a scope limitation. We were 
unable to fully assess the aspects of OTS's supervision of 
Superior. This was due to the delays in getting access to a 
substantial number of records that were received in late 2001.
    As you may know, OTS issued 24 subpoenas in July and we did 
not get access to that material until almost November. We are 
going to continue our audit work to review all of that material 
and we will issue a separate report on all the material that we 
find. And we will also develop any leads necessary based upon 
that examination of records.
    In addition to our audit work, we are working closely with 
my colleagues in FDIC and with the Department of Justice 
through the Northern District of Illinois, where the U.S. 
Attorney in Chicago has asked us to look into a series of 
issues related to the bank failure to determine if there were 
any violations of law. We will issue a report on that 
investigation, as will our colleagues, at an appropriate time.
    That concludes my oral statement.
    Chairman Sarbanes. Well, we look forward to receiving that 
report. Do you have any idea of the timeframe for that?
    Mr. Rush. We are in the initial stages of interviewing 
employees of Superior. FDIC and Treasury investigators were in 
New York 
2 weeks ago. We have a lot of work to do jointly with the FDIC 
down in Texas and we will probably be spending the next few 
months sorting through the documents received through 
subpoenas.
    These subpoenas reach not only into the holding company, 
the firm, and its affiliates, but to some 15 individuals and to 
the external auditor.
    From my own standpoint, my office is particularly concerned 
that we have not looked at the external auditor's work papers. 
We have only looked at the work done by the external auditor to 
the extent that their work was included in the examination 
files that we looked at.
    So, we are talking conservatively a period of months.
    Chairman Sarbanes. All right.
    Mr. Gianni.

     STATEMENT OF GASTON L. GIANNI, JR., INSPECTOR GENERAL

             FEDERAL DEPOSIT INSURANCE CORPORATION

    Mr. Gianni. Thank you, Mr. Chairman.
    May I take the liberty to introduce my audit team also that 
have been poring over this?
    Chairman Sarbanes. Well, you better. Otherwise, you are 
going to have a morale problem.
    [Laughter.]
    Mr. Gianni. Mr. Chairman. To my left is Rus Rau, who is 
head of my audit organization. To my right is Patricia Black, 
my counsel. In back of Patricia is Steve Beard, who is one of 
my executives working on this job, and Mike Lombardi and David 
Loewenstein, who is my Congressional person.
    Chairman Sarbanes. Why not ask them to stand? We very much 
appreciate their efforts in this regard.
    Mr. Gianni. I will be able to go back to work now.
    [Laughter.]
    Thank you, sir. For purposes of our testimony, our 
responses to the nine topics you raised are summarized in four 
questions: Why did this bank fail? What was the role of the 
principal auditor? What did the regulators do? And why has this 
failure resulted in such a large loss of deposit insurance? We 
will also provide you and the Committee with the status of 
FDIC's resolution activities on the failed bank.
    I am going to try to, because we were covering some of the 
same ground that my colleague, the Inspector General from 
Treasury, I am going to try not to repeat some of the common 
themes. But what I would like to do is focus on why the bank 
failed and just give you an overview, without going into the 
specific details, since you have said that the report and 
testimony will be put in its entirety in the record.
    The failure of Superior was directly attributable to the 
bank's board of directors and executives ignoring sound risk 
management principles. They permitted excessive concentrations 
in residuals resulting from subprime lending rather than 
diversifying risk, and did so without adequate financial 
resources to absorb potential losses. They supported flawed 
valuations and accounting for residual assets that resulted in 
recognition of unsubstantiated and unreasonable gains from 
securitizations. They paid dividends and other financial 
benefits without regard to the deteriorating financial and 
operating conditions of Superior. And they overlooked a wide 
range of accounting and management deficiencies.
    These risks went effectively unchallenged by the principal 
auditor. The firm issued unqualified audit opinions each year, 
starting in 1990 through June 30, 2000, despite mounting 
concerns expressed by the Federal regulator. As a result, the 
true financial position and results of operations of Superior 
were overstated for many years.
    Once the residual assets were appropriately valued and 
generally accepted accounting principles were correctly 
applied, Superior was deemed to be insolvent by the OTS and OTS 
appointed the FDIC as receiver. At that time, the estimate of 
the loss was between $426 and $526 million.
    At Superior, the board of directors did not adequately 
monitor on-site management and overall bank operations. 
Numerous recommendations contained in various OTS examination 
reports beginning in 1993 were not addressed by the board of 
directors or the executive management. These recommendations 
included: placing limits on residual assets; establishing a 
dividend policy that 
reflects the possibility that estimated gains may not 
materialize; correcting capital calculations; writing down the 
value of various assets; and, correcting erroneous data 
contained in the thrift financial reports to OTS.
    I would like to turn to the role of the principal auditor. 
Ernst & Young, the bank's external auditor from 1990 to 2000, 
gave Superior, as I said, unqualified opinions. In 1999, Ernst 
& Young did not question the actions of Superior when it 
relaxed underwriting standards for making mortgage loans and 
also used more optimistic assumptions in valuing the residual 
assets. In 2000, when the examiners from both the OTS and FDIC 
started questioning the valuation of these assets, Ernst & 
Young steadfastly maintained that residual assets were being 
properly valued at the bank.
    Our work indicated that Ernst & Young also did not expand 
sufficiently its 2000 audit after the OTS and FDIC questioned 
the valuations of Superior's residual assets in January 2000. 
They did not ensure that Superior made adjustments to the 
capital required by OTS as part of the 2000 audit. They did not 
disclose, as a qualification to what was instead an unqualified 
opinion in 2000, that Superior may not have been able to 
continue as an ongoing concern because of its weak capital 
position as reflected in poor composite ratings by the Federal 
regulators. And last, they did not perform a documented 
independent valuation of Superior's residual assets as part of 
its annual audit, but instead, only reviewed Superior's 
valuation methodology and did not perform sufficient testing on 
securitization transactions.
    The OTS concluded the June 2000 financial statements were 
not fairly stated, contrary to the auditor's opinion. OTS 
recommended to the board of directors that the opinion should 
be rejected and the financial statements restated.
    Now, I wish to turn to the regulators. Banking and thrift 
regulators must also ensure that accounting principles used by 
financial institutions adequately reflect prudent and realistic 
measurements of assets. The FDIC, as insurer, must coordinate 
with the primary Federal regulators who conduct examinations of 
the institutions. In addition, the Congress has enacted 
legislation addressing Prompt Corrective Action standards when 
financial institutions fail to maintain adequate capital. These 
processes were not fully effective with respect to Superior.
    While OTS examination reports identified many of the bank's 
problems early on, they did not adequately follow-up and 
investigate the problems, particularly residual assets, as Mr. 
Rush has identified. These issues include placing limits on 
residual assets, establishing a dividend policy with 
consideration given to the imputed but unrealized gains from 
residual assets, errors in the calculation of allowance and 
loan lease losses, and the thrift financial reporting errors.
    Coordination between the regulators could have been better. 
The OTS did deny FDIC's request to participate in the regularly 
scheduled safety and soundness exam in January 1999, delaying 
any FDIC examiner on-site presence for approximately one year. 
FDIC has special exam authority under 10(b) of the Federal 
Deposit Insurance Act to make special examination of any 
insured deposit institution. An earlier FDIC presence at the 
bank may have helped to reduce losses that will ultimately be 
incurred by the SAIF. FDIC examiners were concerned over the 
residual asset valuations in 
December 1998. However, when the OTS refused an FDIC request 
for special examination, FDIC did not pursue the matter with 
its board. Working hand-in-hand in the 2000 examination, 
regulators were able to uncover numerous problems.
    As I said, Prompt Corrective Action did not work in this 
case. Under PCA, regulators may take increasingly severe 
supervisory actions when an institution's financial conditions 
deteriorate. The overall purpose of PCA is to resolve the 
problem of insured depository institutions before capital is 
fully depleted and thus limit the losses to the fund. For those 
institutions that do not meet minimum capital standards, 
regulators may impose restrictions on dividend payments, limit 
management fees, curb asset growth, and 
restrict activities that pose excessive risk to the 
institution. None of this occurred at Superior until it was too 
late to be effective.
    The failure of Superior underscores one of the most 
difficult challenges facing bank regulators today--how to limit 
risk assumed 
by banks when their profits and capital ratios make them appear 
financially strong. Risk-focused examinations adopted by all 
the agencies have attempted to solve this challenge. However, 
the recent failures of Superior Bank, First National Bank of 
Keystone, and BestBank demonstrate the need for further 
actions.
    In addition, beginning with the January 2000 exam, we 
believe that the OTS used a methodology to compute Superior's 
capital that artificially increased capital ratios, thus 
avoiding imposition of PCA. OTS used a post-tax capital ratio 
to classify Superior as ``adequately capitalized.'' Thus, 
Prompt Corrective Action did not kick in. If a pretax 
calculation had been used, Superior would have been 
undercapitalized and more immediately subjected to various 
operating constraints under PCA. These constraints may have 
precluded Superior management from taking actions in late 2000 
that were detrimental to the financial institution.
    Let us look at the loss to the fund. As of January 2001, as 
you stated, FDIC estimates the loss will range between $300 and 
$350 million. This loss includes the present value of the 
settlement in the amount of $460 million with the principal 
owners of the bank that was entered into by FDIC. Under the 
agreement, an affiliate of the bank's former holding company 
paid $100 million up front and plans to make an additional $360 
million over a 15 year 
period. If these payments are not made, the losses will be 
substantially increased.
    The FDIC board of directors determined that a 
conservatorship would be the least cost alternative for the 
Savings Association Insurance Fund. This decision was made, in 
part, because FDIC did not have sufficient information to 
develop other possible resolution alternatives. FDIC's access 
to Superior was limited, partly based on the fact that 
Superior's owners were in the process of implementing OTS's 
approved capital plan. When it did not materialize, FDIC had 
one day to close the bank and move into a conservatorship. 
Consequently, complete information on the range of resolution 
alternatives was not available to the FDIC to make the least 
cost decision for Superior's resolution. Since the bank has 
failed, FDIC has made progress, as you stated in your opening 
statement, in disposing of assets and certainly selling the 
deposits of the bank to another institution at a premium.
    There is now a new rule to amend the regulatory capital 
treatment of residual assets. In November, the Federal bank and 
thrift regulatory agencies issued the rule. We believe that if 
Superior had operated in accordance with these rules, if they 
were in effect at the time--they were not, but if they were--it 
would not have incurred the losses that it did and may have 
avoided a failure. I just cannot predict that, but it is 
possible.
    Our recommendations are broad, but we have identified a 
number for regulatory oversight agencies to consider. First, 
reviewing the external auditor's working papers of institutions 
that operate high-risk programs such as subprime lending and 
securitiza-
tion. Second, following up on red flags that indicate possible 
errors or irregularities.
    I might just as an aside, based on the work that we did in 
the failed bank and the work that my colleague did on the 
failed Keystone Bank and the investigation, we have developed a 
number of red flags and have put together a training program 
that we are 
offering to the FDIC bank examiners. We have also offered this 
training to the OTS and to the Office of the Comptroller of the 
Currency, making it available to their examiners. We are trying 
to share this knowledge that we have gained about what types of 
red flags are occurring in these institutions and how the 
examiners might be alert when these red flags crop up in their 
exams.
    Third, consult with other regulatory agencies when they 
encounter complex assets, such as those in Superior. I think it 
is good that they work in collaboration and that there is a 
joint governmental expertise brought to the situation. Last, 
follow up on previous examination findings and recommendations 
to ensure bank management has addressed examiners' concerns.
    In a related audit report that we will be releasing in the 
near future, we are recommending that FDIC take actions to 
further strengthen its special exam authority. As you indicated 
last week, the board did grant additional authority to FDIC to 
access banks with CAMELS composite ratings of ``3'', ``4'', 
``5'' as well as any that are undercapitalized. In addition, 
they have created an opportunity for FDIC to have access to the 
eight largest institutions, so that the examiners from FDIC can 
begin to build up additional expertise and real time 
understanding of any issues that these larger institutions may 
face. This expanded delegation implements the interagency 
agreement outlining the circumstances under which FDIC will 
conduct the examinations of institutions not directly 
supervised by the FDIC.
    While the agreement represents great progress for 
interagency examination coordination, it still places limits on 
FDIC's access as insurer. Had the provisions of this agreement 
been in effect in the 1990's, it would not have ensured that 
the FDIC could have gained access to Superior without going to 
its board when it requested access in December 1998. At that 
time, the bank was 1-rated from its previous OTS examination 
and there were disagreements as to whether there was sufficient 
evidence of material deteriorating conditions. To guarantee the 
FDIC independence as the insurer, we believe that the statutory 
authority for the FDIC's special exam authority should be 
vested in the FDIC Chairman. And if he would use that type of 
statutory authority, he would do so consulting with the other 
regulatory agencies. But it vests authority with the person who 
is responsible for overseeing the insurance fund.
    Last, we will be recommending that FDIC take the initiative 
in working with other regulators to develop a uniform method of 
calculating the relevant capital ratios used to determine an 
insured depository institution's Prompt Corrective Action 
category.
    In summary, the ability of any bank to operate in the 
United States is a privilege. This privilege carries with it 
certain fundamental requirements--accurate records and 
financial reporting on an institution's operations, activities, 
and transactions, adequate internal controls for assessing 
risks and compliance with laws and regulations, as well as 
utmost credibility of the institution's management and its 
external auditors. Most of these requirements were missing in 
Superior Bank. A failure to comply with the reporting 
requirements, poor internal controls, a continuing pattern of 
disregard for regulatory authorities, flawed and nonconforming 
accounting methodology, and the potential for the continuation 
of unsafe and unsound practices left regulators with nothing 
else to do but close Superior.
    Superior and the resulting scrutiny it has received will 
hopefully provide lessons learned on the roles played by bank 
management, external auditors, and the regulators, so that we 
may better avoid problems through improved communication, 
methodologies, and policies, the events that led to the 
institution's failure.
    Thank you, Mr. Chairman. I would be happy to answer your 
questions.
    Chairman Sarbanes. Thank you very much.
    Mr. McCool.

        STATEMENT OF THOMAS J. McCOOL, MANAGING DIRECTOR

           FINANCIAL MARKETS AND COMMUNITY INVESTMENT

                 U.S. GENERAL ACCOUNTING OFFICE

    Mr. McCool. Mr. Chairman, I guess the trend has been set, 
so I also probably feel obliged to recognize the audit team 
that actually did all the work. I am just a figurehead here.
    Chairman Sarbanes. It is not obliged. I understood you 
insisted upon that opportunity before we ever began here today.
    [Laughter.]
    Mr. McCool. We have Jeanette Frenzel and Darryl Chang, who 
are from our accounting group, Harry Medina, Karen Tremba, 
Kristi Peterson, who are from our financial markets group, and 
Paul Thompson from our Office of General Counsel.
    Chairman Sarbanes. Good. Why not ask them to stand and we 
express our appreciation to them for the hard work that we know 
has been done.
    Good. We would be happy to hear from you, Mr. McCool.
    Mr. McCool. Mr. Chairman, we are pleased to be here today 
to discuss our analysis of the failure of Superior Federal 
Savings Bank. Clearly, the size as well as the suddenness of 
its failure raised questions about what went wrong and what 
steps can be taken to reduce the likelihood of such costly 
failures in the future.
    My testimony today will briefly discuss the causes of 
Superior's failure and will evaluate the effectiveness of 
Federal supervision. We will also discuss some of the broader 
supervisory issues that were raised by the Superior failure and 
other recent failures.
    The primary responsibility for the failure of Superior has 
to reside with the owners and managers. Superior's business 
strategy of originating and securitizing subprime loans 
appeared to lead to high earnings, but, more importantly, 
resulted in a high concentration of extremely risky assets. 
This concentration and the improper valuation of these assets 
ultimately lead to Superior's failure.
    Originating and securitizing subprime home mortgages and 
auto loans are not inherently unsafe and unsound practices, but 
both require accurate measurement of the risks and vigorous 
management oversight. This is especially true when trying to 
make securiti-
zation attractive to the market, the originating bank retains 
the riskiest parts. The valuation of these residual interests 
is a very complex process and is highly dependent upon 
assumptions about future defaults, interest rates, and 
prepayment rates. Superior's residual interests were improperly 
valued and when these valuations were adjusted, the bank was 
recognized as significantly undercapitalized and eventually 
failed.
    Moving on to the quality of oversight provided by the 
regulators. Although we focus on three major areas of concern 
with OTS's supervision of Superior, the bottom line is that we 
do not believe that OTS exercised sufficient professional 
skepticism.
    First, its supervision appeared to be heavily influenced by 
the apparent high earnings and capital levels. Throughout the 
middle to late 1990's, OTS noted that Superior's activities 
were riskier than most other thrifts and merited close 
monitoring, but these reports also balanced those concerns with 
discussions of higher than peer earnings and leverage capital 
ratios. This was true even though the earnings represented 
estimated and uncertain payments in the future and the 
magnitude was based on the riskiness of the underlying business 
strategy.
    Second, OTS consistently assumed that Superior's management 
had the necessary expertise to safely manage the risky 
activities and relied on Superior's management to take 
necessary corrective actions to address deficiencies noted in 
examinations. Moreover, OTS counted on the owners coming to the 
financial rescue of Superior, if necessary. As my colleagues 
have already stated, all of these assumptions proved unfounded.
    Third, OTS also placed undue reliance on the external 
auditor. The GAO has always supported having examiners use the 
work of external auditors to enhance supervision and minimize 
burden. However, this reliance needs to be predicated on the 
examiners obtaining reasonable assurance that audits have been 
performed in a quality manner.
    In the case of Superior, Ernst & Young provided unqualified 
opinions on the bank's financial statements for years. Only at 
the insistence of the regulators did Ernst & Young's regional 
office seek a review by the national office on the valuation 
question and the national office decided that the regulators 
were correct. But the problems were so severe, that failure was 
inevitable.
    FDIC, on the other hand, raised questions, serious 
questions about Superior's operations at the end of 1998, based 
on its off-site monitoring and asked that an FDIC examiner 
participate in the January 1999 exam, although earlier FDIC 
off-site reviews had not raised any concerns. FDIC's 1998 off-
site review noted with alarm the high-risk asset structure and 
the residuals were 150 percent of capital. It also noted 
significant reporting differences between the bank's audit 
report and its regulatory financial report.
    As again was stated earlier, the OTS and the FDIC 
coordination was hindered by poor communication regarding 
supervisory concerns and strategies. The policy existing at the 
time stated that the FDIC participation was based on 
anticipated benefit to the FDIC as the deposit insurer and risk 
of failure that the institution poses to the fund.
    Again, part of our concern in this case was that it is not 
clear that the FDIC nor OTS actually followed the procedure and 
policy that was in place. We do know that OTS eventually did 
not allow FDIC to join in the examination in 1999, but it did 
allow a review of work papers.
    On this basis, OTS lowered the rating of Superior from a 
``2'' to a ``3''. We do know the new policy is in place and 
again, one of our concerns was that the old policy was not 
implemented, so the new policy, to be effective, at least has 
to be implemented. If not, as 
Mr. Gianni has already said, more presumption needs to be 
placed on FDIC's ability to get into an institution, no matter 
what its rating might be.
    As a consequence of the delayed recognition of problems at 
Superior Bank, enforcement actions were not successful in 
containing the loss to the insurance fund. Once the problems 
were identified, OTS took a number of formal enforcement 
actions, including a PCA directive.
    Although it is impossible to know if early detection would 
have prevented the failure of Superior, it is likely that 
earlier detection could have triggered enforcement actions to 
limit Superior's growth and asset concentration and, as a 
result, the size of the loss to the insurance fund.
    Now, I would just like to conclude with a few observations.
    I guess the issue of Prompt Corrective Action is always an 
interesting one. Obviously, the current Prompt Corrective 
Action trip-
wires are based on measures in capital. One of the issues I 
think that has already been suggested is that the new 
regulation on residuals and capital treatment for residuals 
would have potentially at least mitigated, if not resolved, the 
problem at Superior. And so the fact is that the regulators 
have taken action to improve their risk-based capital treatment 
for residual assets.
    I guess it is also true that the regulators are involved in 
a much higher level and broader attempt to try to improve the 
risk-based capital measurement, and again, that should also go 
some way toward improving the usefulness of Prompt Corrective 
Action if it is based on risk-based capital measures that more 
properly measure risk than the current risk-based capital 
measures.
    Another observation is that, currently, the final tripwire 
that pushes banks and thrifts into the critically 
undercapitalized category is based on a leverage ratio. So all 
the tripwires before that are based on measures of risk-based 
capital. But the final tripwire is currently a leverage ratio.
    We think that is something that the regulators ought to 
revisit, that if risk-based capital is well founded, that you 
would also want to potentially move a firm or a bank into 
critically undercapitalized category based on a risk-based 
capital measure as well.
    And then the last observation, which is an observation that 
we have been making for a long time, is that, again, as has 
been mentioned numerous times so far, capital is a lagging 
indicator and any tripwires based on capital are always going 
to be probably too slow to keep the Bank Insurance Fund from 
taking some kind of a hit. It could be less in various 
circumstances, but it is still going to be difficult to keep 
the insurance fund from taking some losses.
    But we do think that noncapital tripwires, tripwires that 
are based on either management or operationally based safety 
and soundness measures, again, some of the red flags that have 
also been discussed earlier, would be and could be used more 
effectively by the regulators than they currently are, that 
these red flags should trigger at least much more intensive 
oversight by the regulators and potentially could even lead to 
a presumption that enforcement actions would result if certain 
tripwires, certain red flags were set off.
    Mr. Chairman, that concludes my statement. I would be happy 
to answer any questions.
    Chairman Sarbanes. Well, thank you very much. We appreciate 
the testimony of the the members of the panel.
    I just want to show a chart to start here. These are the 
amount of residuals held by the 10 largest holders of residual 
interest. Now this was as of March 2001, so it is pretty late 
in the process, and I am going to deal with that in a minute. 
That is Superior over at the left.
    [Laughter.]
    You might tend to miss it because you tend to see everyone 
down here, and there, it looms over there.
    [Laughter.]
    Now, a year earlier, the residuals as a percent of their 
Tier 1 capital went up by about 25 percent between January 2000 
and January 2001. So even if I start adjusting that column and 
take it down a little bit, the gap is still enormous.
    How can anyone looking at something like that fail to say, 
well, there is really something strange going on here? Either 
Superior are geniuses that no one else in the whole industry 
has perceived, or there is something amiss here. And it seems 
to me, given those two choices, you would tend to conclude that 
something is amiss because there are a lot of smart people in 
these businesses.
    And that leads me to this question about where you all said 
that the OTS examiners expressed concern about the residual 
assets going back some number of years. But they continued to 
grow.
    Why was nothing done? They were recommending corrections, 
but they did not require corrections and they just let it go 
from year to year and that column continued to run up. This gap 
or this contrast just grew and grew and we had this very 
serious problem.
    In the meantime, of course, they were over-valuing these 
residuals. They were paying out very significant dividends over 
that period of time, in the hundreds of millions, if I am not 
mistaken. Now how did it just drift like that? Why didn't the 
OTS examiners move from just noting it and recommending to 
requiring? Do we have any perceptions on that point?
    Mr. Rush. I will speak first. We have all mentioned the set 
of assumptions that we found when we went into examination 
records and talked with regulatory officials. And two of those 
assumptions I think bear upon the question you are raising.
    It would appear that OTS examiners thought that management 
at Superior knew what it was doing during these periods of 
rapid growth. And it is clear now that they did not.
    Chairman Sarbanes. It is a little bit like Enron, isn't it?
    Mr. Rush. Yes.
    [Laughter.]
    It is also clear that because the owners are known for 
their personal wealth, the two principal investors, there 
seemed to be a sense within OTS that because this was one of 
those rescued institutions of the late 1980's, that the 
investors would be willing to bring additional capital to the 
table.
    Let me be sure, though, that your point is not lost on that 
chart. Your chart only shows probably a half dozen institutions 
and it starkly contrasts the residual assets at Superior Bank 
from other institutions.
    I indicated in my statement and in greater detail in our 
audit report, the value of residual assets on the books at 
Superior Bank exceeded that of the next 29 thrifts in the 
United States. It is clearly something that was known and 
apparent to the regulators.
    Chairman Sarbanes. Yes, it just loomed out of the 
landscape.
    Mr. Rush. But we really cannot account for this failure to 
act when you see such incredible growth over a short period of 
time.
    Chairman Sarbanes. Does anyone else want to add anything?
    Mr. Gianni. What you are talking about is a system where 
recommendations are made and in subsequent recommendations or 
subsequent years, you have a follow-up system to ensure that 
those recommendations were addressed. What OTS advised us was 
that it fell through the cracks. From 1993 to 2000, where you 
have management not paying attention, and the board not paying 
attention to what the regulators are saying. In my opinion, 
that is a strong indictment of that management and the board.
    Why OTS did not push harder? I cannot answer that question, 
sir. I can speculate. It is a matter of whether it is being 
brought up the chain of command. It is how far the examiners 
are bringing it up the chain of command, what degree of support 
they feel they are going to get from the chain of command.
    This is a difficult situation where you have regulators 
trying to regulate, and at the same time they are dependent on 
those institutions for their livelihood. It is a fine line that 
has to be walked. And I do not know that that would be the case 
here, but it is a difficult environment that the examiners are 
operating in.
    Chairman Sarbanes. Mr. McCool in his testimony says, ``The 
failure of Superior Bank illustrates the possible consequences 
when banking supervisors do not recognize that a bank has a 
particularly complex and risky portfolio.''
    Now at our first hearing here, Professor Kaufman made a 
recommendation, ``Establish an interagency SWAT team for 
valuing complex assets. This would likely be of particular 
benefit to the OTS and FDIC who deal primarily with smaller and 
less complex institutions.''
    What is your view of a SWAT team or a group with 
specialized expertise available to all bank regulators? Is that 
feasible? Would that be useful? What is your reaction to that?
    Mr. Gianni. My reaction is very positive. In fact, I think 
that my new chairman would be receptive to that type of 
engagement, where the regulators come together and work. We 
certainly would be pushing for it as the insurer. We would like 
to see more opportunities where our examiners are working side 
by side with the principal examiners. I think it makes for good 
Government.
    Mr. McCool. If I might add.
    Chairman Sarbanes. Yes.
    Mr. McCool. I think that there is a number of different 
areas in which the regulators can internally or externally 
provide expertise. I think some of the agencies have a fair 
amount of expertise already. For others, a SWAT team might be a 
very useful device.
    I guess the one thing that I would also suggest, though, is 
that there is a dynamic within not just OTS, but to some 
extent, all the regulators, of not necessarily wanting to go 
out to someone else and ask for help. And so, I think part of 
it is that--I know that this happens in my work at GAO. It is 
an idea that you think you can bring to bear the right 
resources and it is somehow, to some extent, admitting that you 
do not know how to do your job if you have to go out and ask 
for help.
    This is something that would have to be worked from an 
internal dynamic, internal cultural perspective, that it is not 
only all right, but it is expected that examiners or the 
relevant parties know what they do not know and know where to 
go to get help. That would be an important part of making 
something like this work.
    Chairman Sarbanes. Mr. Rush, did you want to add to that?
    Mr. Rush. I come at it a little differently without being 
troubled by the approach.
    There is a tendency to invest expertise in people who can 
provide it too late. And my best example would be arson 
investigators, the people who know the most about fires, only 
come on the scene when the building's been destroyed.
    Chairman Sarbanes. Right.
    Mr. Rush. I think the concern I would have about a SWAT 
team approach is being certain you integrate it into the 
routine processes of examinations, rather than assume that 
people who do not know what they do not know, are going to ask 
for help.
    I will again go back to your chart. None of us are paid as 
examiners. All of us can see the stark difference in the 
valuation of residual capital held by Superior and other 
institutions. Yet, no one took action even under the best of 
circumstances until late 1998, early 1999. From the standpoint 
of effective action, it was too late. If we have a SWAT team 
that comes in after we have a failed bank, we have just added 
one more layer of ineffective regulation.
    So, I would certainly hope that any consideration for a 
SWAT team approach that does ensure expertise assumes that you 
have to integrate it in the regulatory process on the front end 
and not on the tail end.
    Chairman Sarbanes. Well, maybe you could require the 
particular regulators to certify a certain number of cases for 
the SWAT team each year.
    Mr. Rush. This is the position that I assume we could all 
agree.
    Chairman Sarbanes. Which would get at your point. So, then, 
part of the job of the ordinary inspectors is to locate at 
least whatever number of cases you are talking about that have 
to go over for further examination by the SWAT team, which 
could be a composite from the various agencies and would be a 
highly trained, highly skilled group. Of course, its arrival on 
the scene would, in and of itself, send an important message.
    Mr. Rush. Signal. Oh, yes.
    Chairman Sarbanes. Presumably. The American Banker on 
February 5, wrote an article entitled, ``OMB--More Failures, 
New FDIC Premiums.'' And it reported: ``The Office of 
Management and Budget is predicting a sharp and sustained 
increase in spending on bank failures over the next 6 years.''
    And then they made reference to these other failures that I 
talked about. What are your views as to whether the regulators 
have adequate staff and experience to meet the coming 
challenges? And I do not want to set you up, Mr. Gianni. I 
understand the FDIC is planning to RIF a sizable number of 
attorneys. I do not know how I square that with this OMB 
prediction of additional failures and where we are going to be 
if we lose this? What is your perception of the adequacy of the 
resources that are available to the regulators to monitor these 
situations?
    Mr. Gianni. With regard to the lawyers, you are right that 
the Corporation is in the process of downsizing the amount of 
lawyers that they do have. Many of those lawyers were the 
residual from the 1990's, when we were cleaning up the failed 
bank institutions.
    Chairman Sarbanes. You use the word residual advisedly, I 
assume.
    [Laughter.]
    Mr. Gianni. It seemed appropriate. I must have it on my 
mind. But, anyway, they are trying to get to a level that will 
allow them to effectively carry out their responsibilities. At 
the same point in time, the projections that OMB are putting 
forth would indicate that there may be a rise in failures. That 
would be certainly a large workload for resolution-type 
activities and not necessarily exam-type activities.
    For the resolution activities, FDIC has moved to a 
different strategy. They have moved to a strategy to adopt a 
RTC approach, a Resolution Trust Corporation approach. FDIC 
calls it the firehouse approach, which basically says this is 
the level of resources we need for policy and oversight. But we 
are going to depend on the private sector to help us resolve 
the institutions by managing the assets, quantifying the 
assets, and then ultimately selling those assets. That was an 
RTC model, and in hindsight, it was a model that worked, 
although there were some blemishes. But RTC worked very 
effectively. So, we have adopted that.
    As it relates to the examiners, FDIC has not undergone a 
reduction in its examination force. My biggest concern about 
our examination force is that the FDIC is the principal 
regulator for only one of the top 20 largest institiutions. 
There is a lot going on in these institutions with new 
instruments trying to advance the financial markets. If we, as 
insurers, do not have the expertise to deal with those issues, 
it presents a problem for us not only in the supervisory area, 
but also in the area of resolving those assets, should those 
institutions fail. So, I think the agreement reached by the 
board to allow FDIC to begin to participate in the exams of 
large institutions will help strengthen that expertise within 
the Corporation.
    Chairman Sarbanes. Anyone want to add to that?
    Mr. Rush. I found that article curious in that none of the 
regulators rely upon appropriated funds to carry out their 
mission. And while I do not doubt that within any of the 
agencies that are at issue here, the Board of Governors at the 
Fed, the Corporation or the OCC or the OTS over at Treasury, 
they are all struggling with trying to structure themselves in 
a way to get the most from the funds that they do use. This is 
not a tax or budget issue. And so, I frankly found the report 
of the OMB statement in the American Banker to be somewhat 
curious.
    A more direct response to what we have found in our audit 
work at both OTS and OCC, there is some unevenness in expertise 
and in capacity from office to office. But I certainly cannot 
say from our recent audit experience we are concerned about the 
capacity of the two regulators to do their jobs. They do not 
have people problems that we can easily perceive.
    Chairman Sarbanes. What is the GAO's view of that?
    Mr. McCool. I think that we have not actually examined the 
human capital capacity of the regulators recently, but GAO has 
taken the position across the Government that there are 
obviously human capital challenges, especially as the Baby Boom 
ages and the more experienced examiners may start to retire. 
The regulators are all aware of this and trying to plan for it, 
trying to do proper succession planning.
    But from a capacity perspective, I think there would be the 
potential loss of experienced examiners in the future that 
could be something of concern. I do not know that they do not 
have sufficient resources currently, but they may be worried 
about replacing experienced people who may be retiring in the 
near future.
    Chairman Sarbanes. Well, now, you have been given--you, I 
am talking about the FDIC, but the other banking regulators--
exceptions to the regular pay scales in order to be able to 
hold on to qualified and experienced people. Am I correct in 
that regard?
    Mr. Gianni. That is correct, Mr. Chairman. In addition, 
from a standpoint in the past, the FDIC, like the rest of the 
Government, has undergone a number of buy-outs, offered a 
number of buy-outs for its employees. Each time when they 
offered those buy-outs, the experts in the bank examination 
area were not able to participate in those buy-out programs.
    We are constantly refreshing our examiner workforce every 
year. So, we are hiring to deal with any attrition. And I 
believe, over time, the examination cadre has remained 
relatively stable.
    Chairman Sarbanes. I only mention that because the budget 
submitted by the President, in effect, vitiates what was a 
package arrangement last year with respect to providing similar 
pay treatment for the Securities and Exchange Commission for 
losing expertise. And the effort was to enable them to do what 
bank regulators are doing in order to hold onto some of their 
people. That was enacted by the Congress as part of a package 
which repealed a number of fees that were leveled on the 
securities industry.
    The securities industry, which was in favor of repealing 
the fees--to no one's surprise--was also supportive, as we 
moved the legislative package through, of this special pay 
treatment or comparable pay treatment for SEC employees as the 
bank regulators have. But the Director of OMB has shelved the 
comparable pay treatment for the SEC. So, it is a very 
interesting development.
    My own view is that it has clearly contravened the spirit 
of the legislation, which had those things packaged together. 
Had anyone envisioned that there would be a repudiation of the 
spirit of the arrangement, then we should have thought of 
making the repeal of the fees contingent upon providing the pay 
treatment. So, we are quite upset about that and we are now 
examining ways to try to deal with it, and I think it is very 
unfair to the SEC.
    Also, it has compounded their problems since employees at 
the SEC who were under a lot of stress because of the 
difference in any event, had their expectations significantly 
raised because they thought this problem would be taken care 
of. And now the Director of OMB has in effect spurned them. So, 
I mention that as an aside.
    I want to ask about this agreement that was reached in late 
January between the FDIC and other banking regulators to expand 
the authority of the FDIC to examine insured banks and thrifts. 
I think this is an important step.
    Comptroller Hawke is quoted in the American Banker of 
January 30 as follows:

    Don Powell and I are both very close friends and long-time 
colleagues. We both felt that it was very worthwhile to embody 
this arrangement in a memorandum of understanding that would 
make clear for our successors what we think the relationships 
between the agencies ought to be.

    Well, of course, you know it is possible that future FDIC 
chairmen and comptrollers may not have the same rapport. They 
might change the agreement and so forth. How do we address that 
issue? If we think this is not a desirable arrangement, how can 
we ensure that it will stay in place?
    Mr. Gianni. I will take the first lead on this. I do not 
question Mr. Hawke's characterization. I think that the new 
Chairman of the FDIC does bring, is bringing a sense of 
building the team and outreaching to the other regulators to 
try to work in a collaborative manner. I think as long as we 
have people of goodwill, the process will work.
    However, what the board gives, the board can take and the 
board changes from time to time. And at one point in our 
history, when we only had three board members, the board took 
away backup examination authority from the FDIC. And 
repeatedly, in my semi-annual reports to the Congress and to my 
agency, I am pushing that the full complement of the board be 
filled because it is only when we have a full complement of the 
board will the FDIC really have its true independence. That 
will put three board members principally with interests of the 
FDIC and then the Comptroller and the Director of OTS as 
rounding out the board. So, I think it is important that fifth 
position be filled and I think the way to fix it is through 
statute. Give that backup examination authority to the chairman 
and require the chairman to coordinate with his colleagues, or 
her colleagues, as the case might be.
    Chairman Sarbanes. Do either of the other panelists have 
any view on that issue?
    Mr. Rush. The only view, sir, is that I think you have to 
correct it by statute. There is no body of regulations that you 
could count on over time to give you the result that a statute 
can give you.
    Chairman Sarbanes. Do you agree with that, Mr. McCool?
    Mr. McCool. I would agree. The only caveat I would suggest 
is that, again, it is also hard to legislate cooperation.
    Chairman Sarbanes. Well, Mr. Gianni's proposal actually 
puts the authority in a specific place. He said there should be 
consultation. But he did not share the authority.
    Mr. Gianni. That is correct. It would rest with the 
Chairman.
    Chairman Sarbanes. Well, chairmen always like to hear that.
    [Laughter.]
    Mr. Gianni. I might get an eraser.
    [Laughter.]
    Chairman Sarbanes. After Keystone Bank failed in September 
1999, that resulted in a loss of about $700 million to the 
fund. The Federal banking regulators in September 2000, a year 
later, promulgated a proposed rule to impose stricter capital 
rules and limit the concentration of residuals. The comment 
period for the proposed rule closed on December 26, 2000. Now 
Keystone failed in September 1999. September 2000, a year 
later, they promulgated a rule. The comment period for the 
proposed rule closed at the end of that year. And at our first 
hearing in October 2001, there was no final rule. We spent a 
good deal of time on that at that hearing. Finally, at the end 
of November 2001, the Federal bank regulators jointly announced 
the publication of a final rule.
    Now, I have two questions. First of all, if you have any 
view of the substantive adequacy of the rule, how you perceive 
it substantively. And second, why it took so long to complete 
it. Do you have any insights into that process, particularly in 
light of the recognized risks that were posed by holding 
residuals. We had, it seems to me, a serious problem here on 
our hands and we took an inordinate amount of time to finally 
close to a rule. And this Committee certainly pushed it very 
hard at that hearing in October. And of course, finally, at the 
end of November, the agencies came up with a rule. I would be 
interested in your responses on those two questions.
    Mr. Gianni. I will jump into it. On the first part----
    Chairman Sarbanes. That comes from sitting in the middle, 
Mr. Gianni.
    [Laughter.]
    Mr. Gianni. From the substantive standpoint, I think, as I 
said in my testimony, I think it is going to work. It does 
build in some greater assurances and greater protection. So, I 
think on the substantive basis, it moved in the right 
direction.
    On the latter question, this was rulemaking by committee. 
This was a guidance that came out of the Federal Financial 
Institution Examination Council, FFIEC, and where the 
regulators are coming together to work together to try to 
formulate policies, regulations, and joint procedures. We are 
currently looking at the process, Mr. Rush, myself and the IG 
at the Federal Reserve are currently looking at how that 
process is working.
    But what appeared to be happening was that, in the past, 
there was not a strong leadership from the top to move the 
agenda along. And what happens is that we left it at the staff 
level to work on these initiatives. And there was not that 
impetus and push from the top to get the job done. We are 
looking at how that process is working. Mr. Powell is now the 
Chairman of the FFIEC and has tasked people within the 
Corporation to bring some more accountability to the FFIEC 
process. We hope that he is successful. We are studying the 
process and we will come out with a joint report later this 
year.
    Chairman Sarbanes. Does anyone want to add anything to 
that?
    Mr. McCool. I would just suggest that, again, our view I 
think is that, from a substantive perspective, that the policy 
appears to make sense.
    I think, as Gaston was suggesting, part of the issue is 
that you had, again, as you always do on these FFIEC issues, 
four regulators who will come at things with a slightly 
different perspective. The other is that this was a very 
difficult thing to try to figure out. And we do not know, and 
we will find out, if there are any unintended consequences that 
come out of the rule that was written.
    And this is part of what, again, only experience will teach 
us, whether they went too far, did not go far enough. The issue 
with financial products is that they are always changing, they 
are always evolving, and you come up with a set of rules that 
seems to fit. They may fit in some set of circumstances and not 
others that are closely but not exactly the same. So, I think 
that, again, part of it was that it was a hard problem--there 
were some issues there. I think, again, that the fact that the 
regulators often come at things from a different perspective 
also will cause a lot of these processes just to take time. But 
I also do agree that more leadership would also help to move 
things along better than they have been moving.
    Chairman Sarbanes. Well, this may be an arena in which 
Congressional oversight can play a role as well. I have always 
thought that there is too much of a tendency to define 
Congressional action in terms of actually passing a statute. 
And of course, that is often a very important part of 
establishing the right framework. But I think there is a very 
important role to be played by Congressional oversight, which 
particularly calls the regulators to their tasks, so to speak. 
So this is a matter that we will keep cognizance of.
    I want to turn now and ask about the outside auditor in 
this instance and the accountants and what we might learn from 
all of that. There was a sharp disagreement, as I understand 
it, between the outside auditors, the accountants, and the 
regulators with respect to the valuation of these residual 
assets. Is that correct?
    Mr. Gianni. Yes, sir.
    Chairman Sarbanes. What is your recommendation as to what 
should be done when bank regulators come up against, when you 
have this clash between the bank regulators' perception of what 
the appropriate accounting should be and the position taken by 
the supposedly outside independent auditors?
    Mr. Gianni. At the present time, the statute allows the 
regulators to impose stricter requirements than the accounting 
profession. So the statute gives the regulators the opportunity 
to impose more stringent requirements.
    I think that where a disagreement of this magnitude occurs, 
that it is imperative that the disagreement be raised through 
an organization. Oftentimes, it is very difficult to get 
resolution at the staff level, at the examiner level. And I 
think what needs to happen is that those instances where major 
disagreements are occurring between the examiner and either the 
accountants or the board of directors or the management of an 
institution, it is imperative that the regulator create a 
culture that makes the examiners comfortable with raising 
issues, so that they can be decided at the appropriate level 
within the organization. And in this particular case, the 
disagreement persisted for a year and in the end, the 
regulators were proven to be right.
    Chairman Sarbanes. When Ellen Seidman was before the 
Committee at the October hearing, then the OTS Director, she 
recommended, ``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.'' What is your view of that 
recommendation? Do you have a view on that, Mr. Rush?
    Mr. Rush. I am familiar with her recommendation. My own 
view is, and it is not one that I have developed, but my view 
now is that the law already grants sufficient authority to the 
regulator to make final decisions with respect to accounting 
rules, and that if you create this new regime, such as a new 
piece of legislation that creates new rights for institutions, 
I am not sure you are going to address the issue rather than 
maybe drag it out a little longer than you want. This is a 
problem if you cannot force, if the regulator cannot make final 
decisions as to how you will classify the risk associated to 
capital and make judgments about the nature of restrictions 
that then follow at an institution, you have lost the battle. 
Maybe there ought to be an opportunity for the regulated 
industry to be heard within a new process, but I am not sure I 
would be comfortable with new legislation that creates a right 
under law to hold open a dispute for 30 days, 60 days, or any 
other period of time.
    Chairman Sarbanes. So, you think the authority already 
exists.
    Mr. Rush. I do not think you can fairly read current law--
--
    Chairman Sarbanes. Although I think it is clear in the 
Superior situation that the bank regulators, in effect, were 
deferring or delaying while they had this hassle----
    Mr. Rush. That is correct.
    Chairman Sarbanes. ----with the accountant. And it was not 
until the accountants agreed to reverse themselves--in other 
words, they got an agreement on the valuation--that the 
regulators then moved ahead to take regulatory action. Is that 
not what happened?
    Mr. Rush. That is correct. And that is why PCA will never 
accomplish what you want if you can tell the regulator you must 
stand off while we work out this dispute. While you do that, 
you continue to expose the funds to increased risk.
    Chairman Sarbanes. Do you have a view on this, Mr. McCool?
    Mr. McCool. I am not sure whether this additional authority 
is really necessary. I am not a lawyer. I cannot speak to that. 
But I would think that under the current PCA rules, that the 
regulators can basically take action without waiting for an 
accounting dispute to be worked out if they think that there is 
something wrong with the capital calculation, and the capital 
is not sufficient to support the risks.
    Chairman Sarbanes. Did any of you in your inquiry determine 
whether the outside auditors were also doing consulting work 
for Superior Bank?
    Mr. Gianni. Yes, Mr. Chairman, we did take a look at that. 
The accountant who was doing the audit opinion, the financial 
audit opinion, was also providing other services, specifically, 
valuation services. And the fees for the valuation services 
were twice as much as the fees, at least twice as much as the 
fees for the financial. It sounds like a repeat of history or 
what is going on in the halls of Congress now.
    A couple of things. I think that, from a Federal 
standpoint, the standards for the Federal auditing community, 
the General Accounting Office Yellow Book standards, as we love 
to call them, have recently been changed to prevent this type 
of activity. And in reading the papers and some of the 
literature that has been put out by the AICPA, it appears that 
they are becoming more agreeable to frowning on that type and, 
in fact, prohibiting that type of activity going on when you 
are engaged in a financial operation or financial statement.
    Chairman Sarbanes. Was the consulting work that they were 
doing, did that have to do with valuing the residuals?
    Mr. Gianni. In my opinion, it was in direct conflict, yes. 
The examiners----
    Chairman Sarbanes. So, on the one hand, they valued the 
residuals and then on the other hand, as the ``independent 
auditor'', they, in effect, certified the value of the 
residuals which they had consulted in determining. Is that the 
way it worked?
    Mr. Gianni. Well, it would have been nice if they did do 
the value of the assets. Unfortunately, they did not.
    What they did is they attested to the appropriateness of 
the methodology used in valuing the assets. They did not go 
behind the process of valuing the assets to verify and attest 
to the assumptions used to validate those assumptions. They 
basically said----
    Chairman Sarbanes. That is pretty clever.
    [Laughter.]
    They are not actually on the hook on the asset. They just 
do the methodology. But then they come along and okay what is 
presented on the basis of having approved this methodology.
    Mr. Gianni. That is the way it worked in Superior.
    Chairman Sarbanes. Well, no wonder the fund is going to be 
out this very significant amount of money. I have one final 
question. This has been a very helpful panel.
    I would like each of you, if you could, what do you think 
we need legislation to do, if anything, in order to address 
some of the problems which Superior made manifest?
    Mr. McCool. I would suggest what you suggested earlier. I 
think Congressional oversight of the regulators is what is 
needed from Congress, to look at how the regulators are going 
about doing their business, to ask questions about whether they 
are developing expertise and moving along regulations that are 
necessary to deal with new risks. I do not necessarily see any 
need for new legislation. I think there would be a lot of use 
for Congress looking at the implementation of existing 
legislation and to make sure that it is going in the direction 
that Congress intended.
    Chairman Sarbanes. What about legislation that gave power 
to the FDIC to move in if they wanted to examine?
    Mr. McCool. Well, I think there is a lot of----
    Chairman Sarbanes. There is an agreement now.
    Mr. McCool. Yes. I think to give FDIC the back-up authority 
they need and probably a legislative fix would be useful.
    Chairman Sarbanes. Mr. Gianni.
    Mr. Gianni. I have, in addition to giving the Chairman the 
authority for back-up exams, I also think that it has been over 
12 years since we passed legislation on Prompt Corrective 
Action. The environment has changed. It is different.
    It is time to relook at Prompt Corrective Action. There may 
be a need to raise the tripwires. I certainly think, from a 
resolution standpoint, where an institution fails, that right 
now, the FDIC--I am talking from the standpoint of the 
insurer--FDIC does not get involved in the Prompt Corrective 
Action process until we hit the 2 percent tripwire and go below 
2 percent. As we have seen in the number of instances, when we 
hit 2 percent, institutions close relatively fast and we are 
left with a lot of loss on our hands.
    In order for us to meet the requirements, in order for the 
FDIC to better meet the requirements of the least-cost test, I 
think it would be helpful if the legislation would allow FDIC 
to enter the bank to begin the process at a higher level, 
rather than just at the critical level as it is right now. So, 
there is two prongs.
    Chairman Sarbanes. Yes. Well, I am very interested in this 
because I think we have to give more attention to preventing 
these situations from developing. And obviously, that is very 
cost effective. It seems to me that the industry should have a 
keen interest in doing this because if you accept these 
projections of OMB, and I know that there is some argument 
about them, they are going to get a boost in the assessments. 
Let me just read this paragraph to you. The projected increase 
in assessments on BIF-insured banks indicate that OMB analysts 
expect the funds ratio to fall below 1.25 percent next year. As 
of September 30, its ratio stood at 1.32 percent. And then you 
have the problem of the separate SAIF fund as opposed to the 
BIF fund. These things are going down because they are taking a 
hit with the various failures of institutions. So, to the 
extent that we could prevent these failures--Mr. Rush's 
reference to the arson investigators. We are very good at that 
in this country. But it does raise the question, why don't we 
put some of those resources up front into preventing those 
fires from happening in the first place? Because what is 
happening now, in addition to the cost to the fund, it is a 
real blow, I think, to public confidence, and obviously, right 
now, at an extremely sensitized period. But every time one of 
these things happens, it raises a further doubt in the public's 
mind.
    Mr. Gianni. I think you are right, Mr. Chairman. The fund 
right now, like you said, is at 1.32 percent, if in the BIF, we 
experience losses in the magnitude of $1.8 billion, the fund 
hits the 1.25 percent level and we have to begin to consider 
assessing premiums for deposit insurance.
    Chairman Sarbanes. Right.
    Mr. Gianni. One of the ways of at least diffusing the risk 
is merging the funds. I think there are proposals that have 
been put forward on deposit insurance reform to that end. With 
the series of losses that we have experienced, if, in the 
future, a sizable loss were to occur, the fund would be 
undercapitalized and we would have to, at the least opportune 
time, put assessments on the banks.
    Whereas, the proposal for deposit insurance reform would 
again give the FDIC a little bit more latitude to decide when 
to raise or lower the fund level within a range, I think sounds 
reasonable.
    Chairman Sarbanes. The problem is that an asymmetrical 
argument is being made, which is you should not raise it when 
things are difficult and you are having failings and the fund 
is diminishing. And that is what the economic circumstance is. 
On the other hand, when things are going very well and 
everything seems to be working, then you should not raise it 
then either because it is argued you do not really need it. So, 
you are caught out, so to speak. As I listened to the proposals 
and the arguments being made for them, I have not yet heard 
anyone resolve that asymmetrical approach to this issue. But 
they may do so as we work at it. We will see.
    Mr. Rush, on legislation, do you have any ideas?
    Mr. Rush. Sure. And before I get to that, let me be sure it 
is clear. We agree that there are going to be additional 
failures. This is not merely an OMB projection. Within our 
community, we are already planning for and anticipating those 
failures in the current fiscal year for my office, 
unfortunately.
    I agree that we need to rethink PCA both as it relates to 
the statutory construct and the regulations. It comes too late 
and relies solely on reports on capital, this lagging 
indicator, as a basis to deal with problems and really reduces 
our ability to prevent problems. I hope the regulations and the 
regulators begin to think with the help of the institutions 
more about other indicators that need to be taken into account. 
Certainly the rapid growth indicators, the concentration 
indicators, have got to be brought into the equation.
    We have been talking about something as it relates to 
Superior or we have been talking in the hundreds of percent of 
residual assets over tangible capital when the existing 
handbook for examiners talks about concentrations greater than 
25 percent. Yet, throughout this period of time, I am back to 
your chart. The line on the left continues to go up and nothing 
happens until we get the accountants to agree with us that 
there is something terribly wrong with the valuation methods 
that are being used. But, to be brief, I guess the answer ought 
to be, yes, let us relook at legislation and particularly as it 
relates to PCA.
    Chairman Sarbanes. Okay. I have one final question which is 
off the topic, but I am just curious. What are your views on 
how these regulatory agencies are funded in terms of from 
whence they obtain their budgets? Who wants to take that one 
on?
    Mr. McCool. Well, I guess one of the things that GAO has 
always suggested is that, in a way similar to OTS and OCC, that 
FDIC and the Fed might also charge for their examinations, 
which they currently do not do. And that is one thing that as a 
position we have taken in the past.
    The issue of self-funding again is an interesting one. I 
know that we also have been mandated by the legislation you 
referred to earlier to look at the possibility of self-funding 
for the SEC, which is a project we are about to initiate. So, 
we are going to be looking at self-funding from a number of 
perspectives in the near-future.
    Chairman Sarbanes. Anyone else want to take that on?
    Mr. Gianni. I know what Mr. Hawke's proposal is. It is an 
interesting proposal. I understand his argument. I think that I 
personally have concern that the regulators are dependent on 
the people that they are regulating for their fees. It just 
intuitively shows a conflict in my own mind. So that perhaps a 
better way of funding the OTS and the OCC could be arrived at. 
I do not have that solution yet, but, obviously, we have the 
fund, the insurance fund which the FDIC is funded by.
    How that process would work, who would make the decisions 
as to what funds were going to OTS and OCC, right now, the 
board makes the decisions for FDIC.
    Chairman Sarbanes. Mr. Rush.
    Mr. Rush. Mr. Orwell would be pleased to know that he was 
right and that we still do not know what to call a tax.
    [Laughter.]
    I do not have a recommendation, but user fees or fee 
structures of any kind to provide for Government services 
really constitute a tax. I find it remarkable in Treasury--I am 
in one of those agencies that has to come in and fight for an 
appropriation each year and make an argument as to why my 
office provides some public service. I am surrounded by bureaus 
and offices that rely upon other ways for funding.
    I am not sure that is in anyone's interest. When you made 
your comments about the asymmetrical argument about raising the 
funding during times when we do not need money, and not having 
the ability to raise money at a time when we need money, you 
begin to deal with the real issue of what are we really funding 
and who are we fooling by calling this tax something other than 
a tax?
    I have bank accounts and the people that I do business with 
pay fees based upon those accounts, and they fund some very 
important activities in this country. Whether or not we will 
ever consider those activities activities that ought to be 
appropriated by our Federal Government, I do not want to argue. 
But I think it is clearly inappropriate for us to look at these 
activities as other than a tax. That is probably what they are.
    Chairman Sarbanes. Well, if your concern is to make sure 
that the regulators have adequate resources with which to do 
their job, and that if they fail to do their job, it has far-
reaching consequences for the workings of our economic system, 
then you have to give a lot of careful thought as to what's the 
best way to achieve that, particularly over time, so you do not 
have the fluctuations up and down of the moment. We have a 
moment now when people are up here running around and it may do 
lots of things. Who knows? But then when that recedes, the 
question then becomes--what happens? And that is not what we 
need. We need to get this thing at a proper level and on a 
proper course and sustain it and develop the competence that 
ensures the integrity of these markets and ensures that we do 
not have these egregious practices that end up--the people who 
end up taking it in the neck are always, or virtually always, 
the little people, in a sense. So, I think we need to give 
careful thought. Well, that is the subject of a different 
hearing.
    We thank you all very much for coming. You have been very 
helpful and we thank you for these very carefully done and 
thorough studies and we will stay in close touch on this issue.
    Mr. Gianni. Thank you, Mr. Chairman.
    Chairman Sarbanes. I would note that next Tuesday, the 
Committee will begin a series of hearings related to the issues 
raised not only by Enron, but Enron and other similar 
situations. And our first witnesses will be five former 
chairmen of the Securities and Exchange Commission, who all 
have agreed to come in and, in effect, launch this set of 
hearings, which we have now projected for the balance of this 
month and into March. We hope out of that to gain some 
perceptions and reach some conclusions about the structure, 
about systemic changes and alterations that might be made in 
the structure that would, if not preclude, at least 
significantly reduce, the likelihood of similar occurrences.
    The hearing stands adjourned.
    [Whereupon, at 12:25 p.m., the hearing was adjourned.]
    [Prepared statements and additional material supplied for 
the record follow:]
             PREPARED STATEMENT OF SENATOR PAUL S. SARBANES
    This morning, the Senate Committee on Banking, Housing, and Urban 
Affairs holds its second oversight hearing on the failure of an insured 
depository institution, Superior Bank, FSB. Our witnesses are: The 
Honorable Jeffrey Rush, Jr., Inspector General of the Department of the 
Treasury, The Honorable Gaston L. Gianni, Jr., Inspector General of the 
Federal Deposit Insurance Corporation, and Mr. Thomas McCool, the 
Managing Director for Financial Markets and Community Investments of 
the General Accounting Office. Our witnesses will present their 
respective analyses of the causes of Superior's failure and offer their 
recommendation for preventing similar losses in the future.
    The Committee completed its first hearing on the failure of 
Superior on October 16. At that time, we received testimony from the 
regulators--Ellen Seidman, Director of the Office of Thrift 
Supervision, and John Reich, Board Member of the FDIC--and also from 
three financial experts, Bert Ely, George Kaufman, and Karen Shaw 
Petrou.
    On July 27, 2001, the OTS closed Superior Bank after finding that 
the bank was critically undercapitalized. The OTS concluded that 
Superior's problems arose from a ``high-risk business strategy'' and 
that ``Superior became critically undercapitalized largely due to 
incorrect accounting treatment and aggressive assumptions for valuing 
residual assets.''
    As of March 1, 2001, Superior reported assets of $1.9 billion. That 
would make it the largest U.S. insured depository institution by asset 
size to fail since 1992. The FDIC estimates that Superior's failure win 
result in a loss to the Savings Association Insurance Fund (SAIF) of 
approximately $350 million.
    Since our last hearing, there have been significant developments.
    First, regulatory developments have addressed two issues that were 
raised in the last hearing. On November 29, 2001, the Federal bank 
regulators jointly ``announced the publication of a final rule that 
changes their regulatory capital standards to address the treatment of 
recourse obligations, residual interests, and direct credit substitutes 
that expose banks, bank holding companies, and thrifts . . . to credit 
risk.'' This new rule addresses the question of large holdings of risky 
residual assets, as happened in Superior's case. On January 29, 2002, 
the FDIC announced an agreement among the Federal bank regulators that 
expands the FDIC's examination authority and makes it easier for the 
FDIC to examine insured banks and thrifts about which it has concerns. 
This addresses situations in which the FDIC wants to participate in an 
examination but the primary regulator refuses.
    Second, on December 10, the FDIC and OTS reached a $460 million 
settlement agreement with Superior's holding companies and their 
owners, the Pritzker and Dworman interests.
    Third, with respect to the resolution, the FDIC as conservator has 
operated the Bank. On November 19, Charter One Bank, FSB, bought 
Superior's deposit franchise and other assets for a premium of $52.4 
million. The FDIC is in the process of selling the Bank's remaining 
assets.
    The focus of today's hearings is the findings and recommendations 
of the Treasury, the FDIC, and the GAO. In requesting these three 
agencies in the wake of Superior's failure to assess the reasons why 
the failure of Superior Bank resulted in such a significant loss to the 
deposit insurance fund, I specified nine specific areas of analysis, 
including the timeliness of regulatory response, the role of the 
outside independent auditor, and coordination among the regulators. I 
also requested their recommendations for preventing future bank 
failures, with their attendant losses. Their recommendations take on a 
new urgency as depository continue to fail, at a cost not only to the 
insurance fund but also to public confidence in our banking system. 
Since the failure of Superior just 7 months ago, four other insured 
banks have failed, with a potential cost to the BIF of some $250-$450 
million.
                               ----------
                PREPARED STATEMENT OF JEFFREY RUSH, JR.
           Inspector General, U.S. Department of the Treasury
                            February 7, 2002
    Mr. Chairman, Senator Gramm, Members of the Committee, I am 
delighted to appear before this Committee to discuss our review of the 
failure of Superior Bank, FSB (Superior), Oakbrook Terrace, Illinois.
    As you know, Superior was supervised by the Office of Thrift 
Supervision (OTS), an agency of the Department of the Treasury. Under 
the provisions of the Home Owners Loan Act (HOLA), OTS is responsible 
for chartering, examining, supervising, and regulating Federal savings 
associations and Federal savings banks.
    HOLA authorizes OTS to examine, supervise, and regulate State-
chartered savings associations insured by the Savings Association 
Insurance Fund. HOLA also authorizes OTS to provide for the 
registration, examination, and regulation of savings associations, 
affiliates, and holding companies.
    The Federal Deposit Insurance Corporation Improvement Act of 1991 
(FDICIA) mandates that the Inspector General of the appropriate Federal 
banking agency shall make a written report to that agency whenever the 
deposit insurance fund 
incurs a material loss. A loss is deemed material if it exceeds the 
greater of $25 million or 2 percent of the institution's total assets 
at the time the Federal Deposit Insurance Corporation (FDIC) initiated 
assistance or was appointed receiver. FDICIA further mandates a 6 month 
deadline for the report to the appropriate Federal banking agency. On 
February 6, 2002, as mandated by the FDICIA, my office issued a report 
on the material loss review (MLR) to the Director OTS, and to the 
Chairman FDIC and the Comptroller General of the United States.
    In my statement today, I first provide an overview of Superior 
followed by our findings and observations on: (1) the causes of 
Superior's failure; (2) OTS's supervision of Superior, including the 
use of Prompt Corrective Action (PCA); and (3) a status report on our 
on-going audit and investigation of this bank failure.
Overview of Superior
    Superior's failure is the largest and most costly thrift failure 
since 1992. FDIC has estimated that Superior's failure could cost the 
Savings Association Insurance Fund (SAIF) about $350 million. At the 
time of its closing in July 2001, Superior had just over $1.9 billion 
in booked assets, which were largely funded with FDIC insured deposits 
of about $1.5 billion.
    Superior was originally established in 1988. Superior was formerly 
known as Lyons Savings Bank of Countryside, Illinois, and acquired for 
about $42.5 million. Beginning in 1993, Superior embarked on a business 
strategy of significant growth into subprime home mortgages and 
automobile loans. Superior transferred the loans to a third party, who 
then sold ``asset-backed securities'' to investors. The repayment of 
these securities was supported by the expected proceeds from the 
underlying subprime loans.
    For Superior, the securitization of subprime loans created what is 
referred to as a residual asset arising from the sold securities and a 
portion of the loan proceeds that flowed back to Superior. 
Securitization of subprime loans generated large, noncash earnings and 
overstated capital levels due to applicable accounting conventions at 
the time. Superior more than doubled in asset size from about $974 
million in 1993 to $2.3 billion in 2001.
    Valuing the residual assets was a critical thrift judgment, which 
depended on the thrift's ability to accurately estimate several factors 
affecting the underlying cashflows such as default rates and loan 
prepayments. The large, noncash earnings generated from the subprime 
loan securitizations masked actual losses from flawed residual asset 
valuation assumptions and calculations. Superior's true operating 
results did not become evident to OTS or FDIC until October 2000 when 
they discovered the inaccurate accounting practices and faulty 
valuation practices. This led to massive write-downs at the thrift.
Causes of Superior's Failure
    Superior's insolvency in July 2001 followed a series of accounting 
adjustments resulting in losses and capital depletion. When the 
principal owners failed to implement a capital restoration plan that 
would have entailed a capital infusion of about $270 million, OTS 
deemed Superior equity insolvent by $125.6 million.
    While the immediate causes of Superior's insolvency in 2001 appear 
to be incorrect accounting and inflated valuations of residual assets, 
the root causes of the Superior's failure go back to 1993. Indeed, we 
believe that Superior exhibited many of the same red flags and 
indicators reminiscent of problem thrifts of the 1980's and early 
1990's. These included (1) rapid growth into a new high-risk activity 
resulting in an extreme asset concentration; (2) deficient risk 
management systems relative to validation issues; (3) liberal 
underwriting of subprime loans; (4) unreliable loan loss provisioning; 
(5) economic factors affecting asset value; and (6) nonresponsive 
management to supervisory concerns.
Rapid Growth and Asset Concentration
    The impact of the residual assets accounting and valuation 
adjustments on capital was extensive and occurred in just a year's 
time. Superior's capital fell three capital categories from 
``adequately capitalized'' in March 2000 to ``critically 
undercapitalized'' by March 2001. Such large capital depletion due to a 
single asset type clearly reflected an unsafe and unsound practice and 
condition due to an asset concentration. From the beginning, Superior's 
concentration in residual assets was apparent. Those assets were valued 
at $18 million or 33 percent of tangible capital in 1993, and grew to 
over $996 million or 352 percent of tangible capital by 2000.
    Besides the concentration, Superior's risk profile was even greater 
due to higher than normal credit risk of the underlying subprime loans 
supporting the residual assets. Despite the heightened risks of 
Superior's business strategy, it generally maintained capital 
equivalent to thrifts engaged in traditional lending activities.
Deficient Risk Management Systems
    Superior lacked sufficient controls and systems commensurate with 
Superior's complex and high-risk business activities. For example, 
Superior lacked established goals for diversification or preset 
exposure limits established by management and approved by the board. 
Rather than establish risk limits, management actually appeared to 
encourage growth. One example was the compensation incentives paid to 
employees and that was tied to increased loan volume.
    Superior also lacked financial information systems that could be 
reasonably 
expected to support Superior's complex business strategy. For example, 
financial systems were not fully integrated, and to some extent relied 
on manual inputs to generate aggregate balances. Controls and systems 
over the valuation of residual assets were also weak. Superior relied 
on an outside third party, Fintek, Inc. of Orangeburg, New York, for 
the securitizations and residual asset valuation models rather than 
performing these functions internally. But, Superior paid inadequate 
attention to Fintek and lacked sufficient controls to ensure that key 
valuation functions were reliable. For example, fundamental stress 
testing incorporating varying discount rates, default rates, and 
prepayments were either lacking or deficient.
Liberal Underwriting
    Credit risk was one of the key factors that ultimately affected the 
residual asset valuations given the dependency on the expected 
cashflows from the underlying loans. Credit risk also arose from the 
recourse provisions that Superior provided to investors to enhance the 
sale of asset-backed securities. Although exposed to credit risk from 
several fronts, the supervisory records indicate Superior had liberal 
underwriting practices and inadequate review procedures to detect 
inflated appraisals. As stated earlier, we found indications that 
employee bonuses had been tied to increased loan volume. Superior 
increased the risk by reducing lending quality standards beginning in 
1998 and continuing through 2000.
    The liberal underwriting was especially evident with Superior's 
subprime automobile loan business. Automobile loan originations went 
from $38.7 million in 1995 to nearly $350 million (mostly for used 
cars) in 1999, a nine-fold increase. The auto loan portfolio had grown 
to $578.9 million by 2000. Delinquencies and loan losses mounted and 
the subprime automobile program was discontinued in 2000, but not until 
Superior had lost an estimated $100 million.
Unreliable Loan Loss Provisioning
    OTS's and FDIC examination files characterized Superior's 
understanding of the Allowance for Loan and Lease Losses (ALLL) 
provisioning process as seriously deficient. At times examiners would 
note material excess provisioning, at other times material excess 
shortfalls.
    For example, in 1994 and 1995, OTS advised Superior of the improper 
inclusion of $1.6 million and $2.6 million, respectively, of residual 
reserves in the ALLL. The excess provisioning effectively overstated 
the risk-based capital levels because regulations allow thrifts to 
include a portion of the ALLL. The overstated risk-based capital levels 
may have allowed Superior to pay dividends of approxiamtely $11.3 
million in excess of Superior's own dividend policy and capital level 
goals, and may have also allowed Superior to avert PCA brokered deposit 
restrictions as early as 1995, a time when Superior undertook 
significant growth.
    The OTS also found in 2000 that Superior's ALLL for automobile 
loans did not cover all the associated risks, lacked specificity, and 
would not result in adequate allowances. At the time, Superior's 
available ALLL balance totaled $2.6 million to cover the auto loan 
portfolio of $578.9 million. Examiners determined that Superior needed 
at least $14.1 million.
Economic Factors
    One reason subprime lending is considered a high-risk activity is 
that an economic slowdown will tend to adversely affect subprime 
borrowers earlier and more severely than standard-risk borrowers. Given 
Superior's focus on subprime lending and concentration in residual 
assets supported by subprime loans, economic and market factors 
presented added risks and greater management challenges.
    Superior's profitability was dependent on the cashflows of the 
subprime loans supporting the residual assets. For subprime loans, 
prepayments occur more frequently than for prime loans both when 
interest rates decline and borrowers, credit worthiness improves. 
Increased competition in the subprime markets also increases 
prepayments as borrowers prepay loans to refinance at more favorable 
terms. Superior experienced greater than expected prepayments and 
default rates, which adversely affected residual asset valuations.
Non-responsive Management to Supervisory Concerns
    OTS raised supervisory concerns over several areas as early as 
1993. However, the supervisory record reflects a pattern, whereby 
thrift management promises to address those supervisory concerns either 
were not fulfilled or were not fully responsive. Of note were 
supervisory concerns regarding the residual assets risks in 1993. At 
the time, Superior's management provided OTS oral assurances that 
Superior would reduce risk by upstreaming residual assets to the 
holding company. However, Superior only upstreamed $31.1 million out of 
an estimated total of at least $996 million between 1993 and 2000.
    OTS warnings also included the need for Superior to establish 
prescribed exposure limits based on risk considerations such as 
anticipated loans sales and anticipated capital support. Again, thrift 
management and the board never established such limits or guiding 
policies covering the residual asset risks.
OTS's Supervision of Superior
    In the early years, OTS's examination and supervision of Superior 
appeared inconsistent with the institution's increasing risk profile 
since 1993. It was not until 2000 that OTS expanded examination 
coverage of residual assets and started meaningful enforcement actions. 
But by then it was arguably too late given Superior's high level and 
concentration in residual assets. At times certain aspects of OTS 
examinations lacked sufficient supervisory skepticism, neglecting the 
increasing risks posed by the mounting concentration in residual 
assets. OTS's enforcement response also proved to be too little and too 
late to curb the increasing risk exposure, and at times exhibited signs 
of forbearance. We believe that it was basically Superior's massive 
residual assets concentration and OTS's delayed detection of problem 
residual asset valuations that effectively negated the early 
supervisory intervention provisions of Prompt Corrective Action.
    We believe OTS's supervisory weaknesses were rooted in a set of 
tenuous assumptions regarding Superior. Despite OTS's own increasing 
supervisory concerns, OTS assumed (1) the owners would never allow the 
bank to fail; (2) Superior management was qualified to safely manage 
the complexities and high risks of asset securitizations; and (3) 
external auditors could be relied on to attest to Superior's residual 
asset valuations. All of these assumptions proved to be false.
Delayed Supervisory Response
    Superior's high concentration of residual assets magnified the 
adverse effects of the accounting and valuation adjustments leading to 
its insolvency in July 2001. As early as 1993, OTS examiners expressed 
concerns about Superior's residual assets. However, it was not until 
December 1999 that Federal banking regulators issued uniform guidance 
over asset securitizations and related residual assets (referred to as 
``retained interests'' in the guidance). Additionally, the associated 
accounting standards were not issued until 1996 with Statement of 
Financial Accounting Standards (SFAS) No. 125, followed by clarifying 
guidance in 1998, 1999, and the replacement guidance SFAS No. 140 in 
2000.
    Notwithstanding the absence of regulatory and accounting guidance, 
we believe OTS neglected to use existing supervisory guidance over 
concentrations to limit Superior's growth and risk accumulation 
beginning in 1993. OTS's regulatory handbook alerts examiners to a 
concentration risk when that concentration exceeds 25 percent of 
tangible capital. Superior's asset concentration in 1993 was 33 
percent. Concentration continued to grow to a high of 352 percent of 
tangible capital in 2000. Besides the rapid growth, there were other 
early warning signs of Superior's high risk that OTS appeared to have 
neglected.

 Superior's residual assets clearly surpassed all other thrifts 
    in the country. At one point in time, the interest strip component 
    of residual assets stood at $643 million--more than the combined 
    total for the next highest 29 thrifts supervised by OTS. In terms 
    of Superior's capital exposure, this residual component amounted to 
    223 percent of capital compared to 72 percent for the next highest 
    institution.
 OTS headquarters advised field officials in 1997 that subprime 
    loans were considered high risk and warranted additional examiner 
    guidance.
 Superior inaccurately reported residual assets in its Thrift 
    Financial Reports (TFR's) as early as 1993.

    We believe that Superior's persistent unfulfilled promises to 
address the residual asset risks were perhaps the most telling 
supervisory red flag. OTS originally expressed concern over residual 
assets in 1992 when Superior acquired its mortgage banking business. At 
that time, Superior gave oral assurances that either selling or 
upstreaming the residual assets to the holding company would control 
the risk. But residual assets only continued to grow in the following 
years. OTS continually recommended but did not require Superior to 
reduce its residual asset levels. Instead, OTS accepted Superior's 
assurances that residual assets would be reduced or that residual 
assets would be properly managed. Examiners and OTS officials also 
believed that Superior's principal owners would provide financial 
assistance should the risks adversely affect Superior.
Ineffective Enforcement Action
    OTS did not actively pursue an enforcement action to limit 
Superior's residual asset growth with a Part 570 Safety and Soundness 
Compliance Plan (also known as a Part 570 notice) until July 2000. One 
of the Part 570 provisions required Superior to reduce residual assets 
to no greater than 100 percent of core capital within a year.
    In our MLR, we questioned whether the Part 570 notice was a 
sufficient sanction given Superior management's prior unfilled 
commitments to address the residual asset risks. In fact, Superior 
submitted an amended Part 570 compliance plan in September 2000 and 
again in November 2000, in effect delaying the Part 570 process by 4 
months. Moreover, the action was never effected in terms of OTS 
officially accepting the plan, and eventually was taken over by 
subsequent supervisory events. Although grounds existed for a more 
forceful enforcement action such as a Temporary Cease & Desist order, 
two OTS senior supervisory officials chose the Part 570 notice because 
it was not subject to public disclosure, whereas other actions are 
subject to public disclosure. OTS that public disclosure of an 
enforcement action might impair Superior's ability to obtain needed 
financing through loan sales.
    Aside from the timing and forcefulness of the enforcement action, 
we also observed that the Part 570 notice attempted to reduce the 
concentration risk partly by reducing residual assets to no greater 
than 100 percent of capital. However, there were no provisions to 
further mitigate risks by requiring additional capital coverage. This 
latter enforcement aspect was not addressed until 2001 through other 
enforcement actions.
Examination Weaknesses Over Valuation and Accounting Problems
    Superior's residual asset exposure clearly grew beginning in 1993. 
Yet, OTS examinations of the residual asset valuations lacked 
sufficient coverage during the rapid growth years up through 1999. 
Examiners did not exhibit the supervisory skepticism normally shown 
over traditional loans. Instead examiners appeared to have unduly 
relied on others to attest to the carrying value of Superior's residual 
assets, despite noted TFR reporting errors since 1993.
    One specific examination weakness was the lack of sufficient on-
site coverage of Fintek at Orangeburg, New York. Fintek provided 
Superior with consulting services including the basis for the valuation 
models, underlying assumptions, and calculations. Yet, OTS prior 
examination coverage of the valuation process was not conducted in 
Orangeburg but instead at Superior's offices in Oakbrook Terrace, 
Illinois. It was not until March 2001 that OTS expanded its examination 
coverage and completed meaningful testing at Fintek, which ultimately 
led to Superior's residual 
assets write-down of $150 million in July 2001. We believe the lack of 
meaningful on-site examination coverage at Fintek could be attributed 
to several reasons:

 OTS lacked detailed examination procedures covering third 
    party service providers such as Fintek. Although a 1991 OTS 
    examination bulletin describes some of the risk of using a third 
    party service provider such as consultants, it does not outline the 
    supervisory obligations of an examiner in this area.
 Securitized assets were relatively new and complex activities, 
    and examiners may not have had sufficient related expertise to 
    readily recognize the risks and implications of inaccurate 
    valuations, and thus identify when closer scrutiny was warranted. 
    Indeed, OTS's expanded on-site coverage at Fintek in 2001 was 
    seemingly undertaken at FDIC's urging.

    A senior OTS official indicated that prior to 2000 there was no 
compelling reason to be concerned with the residual valuations, and 
examiners expressed confidence in Superior's management who appeared 
knowledgeable of the asset securitization business. However, we believe 
there were indications that closer and earlier on-site examination 
coverage over the valuation process was warranted. Besides the 
concentration and subprime risks, Superior did not provide sufficient 
internal audit coverage of the valuation area. In fact, audit committee 
meetings were infrequent and Fintek operations were ``off-limits'' 
despite the many critical services that were provided to Superior.
Undue Reliance Placed on External Auditors
    OTS examiners unduly relied on the external auditors to ensure that 
Superior was following proper accounting rules for residual assets. 
According to OTS's 1995 Regulatory Handbook on Independent Audits, 
examiners ``may rely'' on an external auditor's findings in ``low-
risk'' areas. In high-risk areas, examiners are to conduct a more in-
depth review of the auditors work, including a review of the underlying 
workpapers. Nevertheless, an in-depth examiner review of the auditor's 
workpapers did not occur until late 2000. The 2000 expanded coverage 
led to the determination that Superior had incorrectly recorded 
residual asset by as much as 50 percent, and that the external auditors 
could not provide sufficient support for Superior's fair value modeling 
or accounting interpretations.
    Another example of undue reliance relates to one of the provisions 
of the July 2000 Part 570 enforcement action. Superior was required to 
obtain an independent review of the valuation services produced by 
Fintek. Superior used the same accounting firm that was auditing its 
financial statements ending June 30, 2000. Current auditing standards 
do not preclude using the same firm for valuation services and 
financial statement audits. But the supervisory record does not show 
whether examiners even attempted to assess whether the auditor's 
validations might warrant further examiner review. In addition, OTS 
records show that the required independent validation had not been 
completed as specifically required, and there was no indication that 
OTS ever raised this with Superior in terms of inadequate corrective 
action.
    We believe much of OTS's earlier examinations (1993-1999) that 
lacked normal supervisory skepticism to test, validate and verify 
Superior's valuations and procedures can be attributed to a combination 
of reasons. The supervisory files and interviews with supervisory 
officials lead us to believe that examiners may not have been fully 
sensitive to the complexities of a new product for which there was 
little guidance to assess risk. The apparent supervisory indifference 
to Superior's mounting risks from 1993 through 1999 was partly 
sustained by the belief in bank management's expertise, coupled with 
examiners' undue reliance on the external auditors to attest to 
Superior's valuations and accounting practices.
Factors Impacting Prompt Corrective Action
    Prompt Corrective Action (PCA) provides Federal banking regulators 
an added enforcement tool to promptly address undercapitalized banks 
and thrifts. PCA consists of a system of progressively severe 
regulatory intervention that is triggered as an institution's capital 
falls below prescribed levels. PCA does not replace or preclude the use 
of other available enforcement tools (that is, cease and desist order, 
removal actions) that address unsafe and unsound banking practices 
before capital becomes impaired.
    We believe that some of PCA's early intervention provisions may 
have been 
negated by OTS's delayed supervisory response in detecting problems. 
OTS also appeared to have exercised regulatory forbearance by delaying 
the recognition of Superior's true capital position in early 2001. OTS 
also may have failed to enforce one of the PCA restrictions over senior 
executive officer bonuses. Superior's ability to quickly replace 
brokered deposits with insured retail deposits possibly raises an 
aspect of PCA that may warrant further regulatory review.
Delayed Examiner Follow-Up/Delayed Detection
    PCA is dependent on a lagging indicator because capital depletion 
or the need for capital augmentation occurs only as quickly as bank 
management or regulators recognize problems. Our report notes several 
instances where supervisory delays likely resulted in not recognizing 
Superior's true capital position, and as such likely delayed the 
automatic triggering of certain PCA provisions. These include:

 Delayed examiner follow-up on the 1994 and 1995 reported ALLL 
    deficiencies effectively resulted in overstated capital levels as 
    early as 1996, and again in 1997 and 1999. Had Superior's true 
    capital level been known, perhaps the PCA restriction over the use 
    of brokered deposits could have been invoked earlier to stem the 
    growth and buildup of high-risk, residual assets.
 The delayed detection of the $270 million incorrect accounting 
    practice in 2000 and the inaccurate $150 million residual asset 
    valuations in May 2001 also overstated capital levels. Had these 
    two problems been detected earlier, Superior Bank would likely have 
    been subject to several PCA provisions earlier, such as submitting 
    a capital restoration plan, PCA's 90 day closure rule, and the 
    severest PCA restrictions such as requiring FDIC prior written 
    approval for certain transactions.

    The large number of different problem areas leading to Superior 
Bank's insolvency does little to evoke the notion that PCA had been a 
diminished enforcement action. Rather, OTS's delayed detection of so 
many critical problem areas suggests that the benefits of PCA's early 
intervention provisions is as much dependent on timely supervisory 
detection of actual, if not developing, problems, as it is on capital.
Indications of Regulatory Forbearance
    We believe that OTS on several occasions extended to Superior 
regulatory forbearance. These forbearances took the form of either 
delaying the recognition of known write-downs or providing liberal 
regulatory interpretations of transactions that effectively allowed 
Superior to remain above certain PCA capital levels.
Valuations Delayed
    After determining Superior had used incorrect accounting practices 
in January 2001, the resulting $270 million write-down effectively 
lowered Superior's capital position to the ``significantly 
undercapitalized'' level. By May 7, 2001, examiners had clear 
indications that Superior's overly optimistic valuation assumptions 
would necessitate additional write-downs of at least $100 million. This 
additional write-down would have effectively lowered Superior's capital 
below the 2 percent ``critically undercapitalized'' level, at which 
time PCA's severest mandatory restrictions would have been triggered. 
It appears that the additional write-down had not been immediately made 
due to OTS's acceptance of Superior's proposed capital restoration plan 
on May 24, 2001.
Assets Not Recorded
    Another example of forbearance relates to Superior applying an 
accounting rule (for example, ``right of setoff '') that allowed it to 
exclude certain assets from being reported in the March 2001 TFR's. The 
associated assets were loans that Superior had committed to sell, and 
Superior's accounting treatment effectively served to keep their 
regulatory capital above the ``critically undercapitalized'' level. The 
sales transaction did not meet either regulatory or accounting 
standards for the right of setoff treatment. Again it appears OTS's 
approval of the capital restoration plan in May 2001 became the 
overriding consideration precluding the needed adjustment to the March 
2001 TFR.
Noncash Capital Contribution
    In another instance, Superior included in the March 2001 TFR a 
noncash capital contribution consisting of $81 million in residual 
assets from the holding company. The contribution effectively served to 
keep Superior's capital above the ``critically undercapitalized'' 
level. OTS's Regulatory Handbook does not generally permit the 
inclusion of noncash assets for determining tangible capital. Although 
the OTS handbook does provide some flexibility on a case-by-case basis, 
Superior's tenuous financial condition at the time seemed to have 
merited closer adherence to the prescribed regulatory policy. OTS 
requested on May 3, 2001 that Superior provide additional documentation 
in the form of legal and accounting opinions in support of the 
transaction. Aside from providing Superior additional time, it seemed 
incongruous that OTS would accept the residual asset contribution at a 
time Superior needed to reduce, not increase, its residual asset 
exposure.
Preferential Application of Risk-Based Capital Requirements
    Superior's capital restoration plan approved by OTS on May 24, 
2001, included provisions to sell and pledge assets to finance a part 
of the underlying capitalization arrangement. At issue is OTS's 
assessment as to how much capital Superior would need to apply against 
the sold loans and pledged assets. The level of capital that OTS 
approved under the capital plan was less than normally needed by as 
much as $148 million according to FDIC calculations. This short fall 
arises from OTS allowing Superior relief from existing risk based 
capital standards, which requires subjecting the pledged assets to a 
single risk weight of 100 percent. Instead, OTS approved a graduated 
scale extending over 9 years, starting out at 50 percent less than the 
existing capital requirement, and increasing each subsequent year. The 
existing capital requirement would not have been reached until June 
2005. According to an FDIC memo to OTS, the relief afforded Superior 
was not consistent with existing capital treatment by the other 
regulatory agencies on recourse arrangements.
    In our report, we also discuss two other observations relative to 
PCA. We determined that Superior might have violated the PCA mandatory 
restriction against paying excessive bonuses to senior officers. 
Between March and July 2001, a total of $220,000 in bonuses had been 
paid to 10 senior executives. An OTS official said he had not been 
aware of the bonuses.
    We also reported that the PCA restrictions over the use of brokered 
deposits might warrant regulatory review. These PCA restrictions serve 
to curb or reverse growth, and thus risk, by limiting an institution's 
funding sources. For Superior, these restrictions were automatically 
triggered in 2000. However, the intended restriction did not appear 
particularly effective. Int June 2000, brokered deposits totaled $367.2 
million, and dropped to $80.9 million by June 2001, a month before it's 
closing. Insured deposits in June 2000 totaled $1.1 billion and by June 
2001 totaled $1.5 billion, effectively replacing the drop in brokered 
deposits. Although Superior's replacement of brokered deposits with 
retail insured deposits was within the technical rules of the 
regulation, we believe the process was not within the intent, 
particularly with respect to FDIC's potential costs in resolving 
failures, and curbing growth.
Status of Ongoing Audit and Investigation
    We conducted our review of Superior in accordance with generally 
accepted Government auditing standards. However, we were unable to 
fully assess certain aspects of OTS's supervision of Superior. This was 
due to delays in getting access to documents obtained through 24 
subpoenas issued by OTS after July 27, 2001. It is our intention to 
review these documents and to issue a separate report.
    We are also currently working with the Office of Inspector General, 
Federal Deposit Insurance Corporation, and the United States Attorney 
of the Northern District of Illinois, to determine whether there were 
any violations of Federal law in connection with the failure of 
Superior. We will report on the result of that work at an appropriate 
time.
    Mr. Chairman, this concludes my prepared statement. I would be 
pleased to respond to any questions you or the other Members of the 
Committee may have.
                               ----------
              PREPARED STATEMENT OF GASTON L. GIANNI, JR.
        Inspector General, Federal Deposit Insurance Corporation
                            February 7, 2002
    Mr. Chairman, and Members of the Committee, I appreciate the 
opportunity to appear before this Committee today on the July 2001 
failure of Superior Bank, Federal Savings Bank (Superior). My office 
has prepared a full report providing answers to the nine topics you 
asked us to address concerning this failure. That report has been 
provided for the record. In accordance with the Federal Deposit 
Insurance Act, the Office of Thrift Supervision (OTS) was the Primary 
Federal Regulator for Superior, responsible for such activities as 
performing examinations of the safety and soundness of the bank. The 
Federal Deposit Insurance Corporation's (FDIC) 
responsibilities included providing deposit insurance and exercising 
its special 
examination authority. The scope of our review included an analysis of 
Superior's operations from 1991 until its failure on July 27, 2001. We 
also evaluated the regulatory supervision of the institution over the 
same time period.
    For purposes of our testimony, our responses to the nine topics you 
raised are summarized into four key concerns: Why did this bank fail? 
What was the role of the principal auditor? What did the regulators do? 
Why did this failure result in such a large loss to the deposit 
insurance fund? We will also provide the Committee with the status of 
the FDIC's resolution of the failed Superior Bank.
Background
    By way of background, it is helpful to understand the following 
information about the nature of Superior's organization, its principal 
business activity, and the financial outcome of that activity.
    Superior was owned by two family interests through a series of 
holding companies, including Coast-to-Coast Financial Corporation 
(CCFC). As a Federally chartered thrift, Superior operated across all 
State lines. In December 1992, CCFC merged a mortgage banking entity, 
Alliance Funding Company, Inc., with Superior to expand Superior's 
mortgage lending business. Alliance specialized in ``subprime'' 
lending, that is, it originated first and second home mortgage loans to 
borrowers whose credit was below standard, perhaps because of a history 
of late payments or filing of personal bankruptcy.
    After the merger with Alliance, Superior began generating subprime 
mortgages for resale, a process commonly referred to as securitization. 
Through this process, loans were assembled into pools and eventually 
sold to investors primarily in the form of highly rated mortgage 
securities. To attain high ratings, Superior had to offer credit 
enhancements. To explain, these enhancements protected investors from 
losses if the cashflows from the underlying mortgage loans were 
insufficient to pay the principal and interest due on the securities. 
These credit enhancements shifted the risk from the investors to 
Superior. If a borrower did not repay a loan, Superior would absorb the 
loss and still be responsible for making payments to investors.
    During 1993, Superior originated and securitized approximately $275 
million of subprime mortgage loans. That amount grew significantly each 
subsequent year and reported net income was similarly increasing during 
that time. By 1996, Superior's return on assets (ROA) was 7.56 percent, 
which gave it the distinction of having the highest return on assets of 
any insured thrift in the Nation--over 12 times more than the average 
thrift operating in the United States. This ROA would prove to be very 
misleading, as it was not based on actual cash being received by 
Superior.
    In reality, the actual net income was solely based on gains of 
security sales--not revenues from ordinary lines of business. As a 
result, Superior actually operated at a loss every year from 1995 
through 1999. By 1999, an operating loss of $26.6 million was 
overshadowed by almost $186 million in booked gains resulting from the 
sales. Again these gains were shown for financial reporting purposes 
but did not exist as cash. Nonetheless, Superior paid substantial 
dividends on the reported income and other financial benefits to its 
holding company.
Why Did the Bank Fail?
    The failure of Superior Bank was directly attributable to the 
Bank's Board of Directors and executives ignoring sound risk management 
principles. They:

 Permitted excessive concentrations in residual assets 
    resulting from subprime lending rather than diversifying risk and 
    did so without adequate financial resources to absorb potential 
    losses;
 Supported flawed valuation and accounting for residual assets 
    that resulted in the recognition of unsubstantiated and 
    unreasonable gains from securitizations;
 Paid dividends and other financial benefits without regard to 
    the deteriorating financial and operating condition of Superior; 
    and
 Overlooked a wide range of accounting and management 
    deficiencies.

    These risks went effectively unchallenged by the principal auditor, 
Ernst and Young (E&Y). The firm issued unqualified audit opinions each 
year starting in 1990 through June 30, 2000, despite mounting concerns 
expressed by Federal regulators. As a result, the true financial 
position and results of operations of Superior were overstated for many 
years. Superior's reported net income before taxes totaled over $459 
million for the 9 year period from 1992 through 2000, derived mainly 
from unrealized gains from securitization transactions. But these gains 
were calculated based on overly optimistic and unsubstantiated 
valuations of residual assets and unreasonable assumptions about the 
timing of when the cash would be received.
    Once the residual assets were appropriately valued and generally 
accepted accounting principles were correctly applied, Superior was 
deemed insolvent and OTS appointed the FDIC as receiver on July 27, 
2001. At the time, estimated losses to the Savings Association 
Insurance Fund due to the failure ranged from $426-$526 million.
Excessive Concentrations in Residual Assets
    After Superior began securitizing subprime loans, the residual 
assets grew rapidly in real and comparative terms. From 1995 to 2000 
residual assets grew from just over $65 million to a peak of $977 
million as of June 30, 2000, when Superior ceased securitization 
activities. As a percentage of capital, the residual assets grew from 
just over 100 percent of capital in 1995 to almost 350 percent of 
capital at June 30, 2000. This increase in concentrations warranted 
increased supervisory attention.
    A tenet of sound banking operations is effective risk management 
and diversification. However, Superior's Board of Directors resisted 
regulatory recommendations made as early as 1993 for setting limits on 
the amount of residual assets held by the institution. This allowed 
securitization activities to expand beyond the safety net provided by 
Superior's capital base. Ultimately, during the January 2000 
examination, OTS, working with the FDIC, concluded that Superior's 
actual capital could not support its primary business activities.
    The regulators also warned Superior about its high-risk lending 
activities and liberal and unsupported assumptions used in valuing and 
accounting for residual assets. The FDIC and OTS recommended that 
Superior determine the fair market value of the residual assets and 
make the necessary adjustments. But, Superior's Board and management 
did not heed the regulators. Superior continued to decline to a point 
that it was determined to be undercapitalized by the end of 2000 and 
write-downs of residual assets totaling $420 million were required to 
more accurately portray their fair value.
Flawed Valuation and Accounting
    Let me explain a bit more about the valuing and accounting for the 
so-called ``gains.'' The bank and its external auditor used liberal 
interpretations of generally accepted accounting principles to book 
gains from securitization transactions. Superior made unrealistic 
assumptions about the cashflow from pools of loans, and then booked the 
entire gain on sale, or ``profit,'' upfront. Although booking the gain 
was generally allowed under generally accepted accounting principles, 
this represents a major difference from the way most thrifts recognize 
loan income--accruing income over the life of the loan--and should have 
received closer scrutiny by the Board of Directors and external 
auditors. In addition, proper valuation and discounting to present 
value is required under generally accepted accounting priniciples.
    Also, it appears that OTS overly relied on accounting information 
provided by the bank and validated by E&Y. Not until the January 2000 
examination and subsequent October 2000 field visitation, both of which 
included FDIC involvement, did it become apparent to OTS that this over 
reliance may have been a mistake. By this time, significant 
overvaluation of residual assets had occurred and Superior needed 
recapitalization to remain viable.
    When the OTS and FDIC examiners reviewed E&Y work papers in 2000, 
they discovered that E&Y had made ``fundamental errors'' in addition to 
those we discussed previously. E&Y allowed Superior to claim cashflows 
immediately even though they would not be received until several years 
later. This along with unrealistic assumptions led OTS and FDIC 
examiners to determine that Superior's assets were over valued by at 
least $420 million as of December 31, 2000.
Paying Unearned Dividends and Other Financial Benefits
    The higher valuations and resulting inflated net income allowed 
Superior to pay huge dividends to its holding company. Virtually all of 
these dividends were paid from so-called gains recognized from 
securitized transactions. In actuality Superior was experiencing net 
operating losses from 1995 until it failed. The impact of the reported 
gains on net income and dividends paid is detailed in our report and 
shown in the following table.


    Also noteworthy during the year 2000, at a time when Superior was 
losing money and would have been prohibited from making any dividend 
payments, it consummated a series of transactions with its holding 
company that resulted in an additional $36.7 million of financial 
benefit to the holding company. OTS examiners determined that these 
transactions were improper because they violated banking laws and 
regulations pertaining to transactions with affiliates. The most 
egregious of these transactions occurred when the bank sold loans to 
its holding company at less than fair market value, and the holding 
company quickly resold the loans reaping immediate profit of $20.2 
million. The holding company never paid for the loans.
Overlooking Accounting and Management Deficiencies
    At Superior, the Board of Directors did not adequately monitor on-
site management and overall bank operations. Numerous recommendations 
contained in various OTS examination reports beginning in 1993 were not 
addressed by the Board of Directors or executive management. These 
recommendations included:
 Placing limits on residual assets,
 Establishing a dividend policy that reflects the possibility 
    that estimated gains may not materialize,
 Correcting capital calculations,
 writing down the value of various assets, and
 Correcting erroneous data contained in Thrift Financial 
    Reports to the OTS.

What Was the Role of the Principal Auditor?
    E&Y, the bank's external auditor from 1990 through 2000, gave 
Superior unqualified audit opinions every year and did not question the 
valuations or calculations involving Superior's assets and capital 
levels. In 1999, E&Y did not question the actions of Superior when it 
relaxed underwriting standards for making mortgage loans and also used 
more optimistic assumptions in valuing the residual assets. In 2000, 
when examiners from the OTS and FDIC started questioning the valuation 
of the residual assets, E&Y steadfastly maintained that the residual 
assets were being properly valued by the bank.
    During that time, E&Y also was providing nonaudit services to 
Superior. These services included reviewing the accounting methodology 
for the residual assets, which the firm concluded was reasonable. Not 
until January 2001, did E&Y agree with the regulators' position that 
the value of the residual assets should be reduced by $270 million due 
to incorrect application of generally accepted accounting principles 
requiring appropriate discounts and valuation. Our work indicated that 
E&Y also did not:

 Expand sufficiently its 2000 audit after OTS and FDIC 
    questioned the valuations of Superior's residual assets in the 
    January 2000 examination;
 Ensure that Superior made adjustments to capital required by 
    OTS as part of the 2000 audit;
 Disclose as a qualification to its 2000 unqualified audit 
    opinion that Superior may not have been able to continue as a 
    ``going concern'' because of its weak capital position as reflected 
    in poor composite ratings by Federal regulators; and
 Perform a documented, independent valuation of Superior's 
    residual assets as part of the annual audits, but instead only 
    reviewed Superior's valuation methodology and did not perform 
    sufficient testing on securitization transactions.

    OTS concluded that Superior's June 30, 2000 financial statements 
were not fairly stated, contrary to the E&Y opinion. OTS recommended to 
the Board of Directors that the opinion of E&Y should be rejected and 
the financial statements restated.
What Did the Regulators Do?
    Banking and thrift regulators must also ensure that the accounting 
principles used by financial institutions adequately reflect prudent 
and realistic measurements of assets. The FDIC as insurer must 
coordinate with the primary Federal regulators who conduct examinations 
of the institutions. In addition, the Congress has enacted legislation 
addressing Prompt Corrective Action standards when a financial 
institution fails to maintain adequate capital. These processes were 
not fully effective with respect to Superior.
OTS Did Not Appropriately Limit the Risk Assumed by the Bank
    While OTS examination reports identified many of the bank's 
problems early on, OTS did not adequately follow-up and investigate the 
problems--particularly the residual assets carried by the bank. Also, 
the numerous recommendations contained in various OTS examination 
reports beginning in 1993 were not addressed by Superior's management 
and did not receive further attention from the OTS. These issues 
included placing limits on residual assets, establishing a dividend 
policy with consideration given to the imputed but unrealized gains 
from the residual assets, errors in the calculation of the Allowance 
for Loan and Lease Losses, and Thrift Financial Report errors.
    OTS appeared to rely mostly on representations made by the bank and 
validated by its outside auditors. Also, OTS placed undue reliance on 
the ability of the owners of the bank's holding company to inject 
capital if it was ever needed. However, when an injection of capital 
was needed in 2001, the owners did not provide the necessary capital as 
they agreed to do in the OTS-approved recapitalization plan. Warning 
signs were evident for many years, yet no formal supervisory action was 
taken until July 2000, which ultimately proved too late. More timely 
action could potentially have avoided at least some of the ultimate 
loss.
    Our review of examination reports dating back to 1993 indicated 
that OTS did not fully analyze and assess the potential risk that gains 
on securitization transactions presented to earnings and to assets of 
the institution. While OTS identified the volume of gains recorded and 
noted that the gains were unrealized and subject to change, they did 
not analyze and assess the bank's performance without those gains or on 
a realized cashflow basis.
Coordination Between Regulators Was Less than Effective
    Coordination between regulators could have been better. OTS denied 
the FDIC's request to participate in the regularly scheduled January 
1999 safety and soundness examination, delaying any FDIC examiner on-
site presence for approximately one year. The FDIC has special 
examination authority under section 10(b) of the Federal Deposit 
Insurance Act to make special examination of any insured depository 
institution. An earlier FDIC presence on-site at the bank may have 
helped to reduce losses that will ultimately be incurred by the Savings 
Association Insurance Fund. FDIC examiners were concerned over the 
residual interest valuations in December 1998. However, when OTS 
refused an FDIC request for a special examination, FDIC did not pursue 
the matter with its Board. Working hand-in-hand in the 2000 
examination, regulators were able to uncover numerous problems, 
including residual interest valuations.
Prompt Corrective Action Was Ineffective
    In 1991, the Congress enacted Section 38 of the Federal Deposit 
Insurance Act entitled Prompt Corrective Action, or PCA. Under PCA, 
regulators may take increasingly severe supervisory actions when an 
institution's financial condition deteriorates. The overall purpose of 
PCA is to resolve the problems of insured depository institutions 
before their capital is fully depleted and thus limit losses to the 
deposit insurance funds. For those institutions that do not meet 
minimal capital standards, regulators may impose restrictions on 
dividend payments, limit management fees, curb asset growth, and 
restrict activities that pose excessive risk to the institution. 
Unfortunately, none of this occurred at Superior until it was too late 
to be effective. A PCA notice was issued to Superior on February 12, 
2001, less than 6 months before it failed.
    The failure of Superior Bank underscores one of the most difficult 
challenges facing bank regulators today--how to limit risk assumed by 
banks when their profits and capital ratios make them appear 
financially strong. Risk-focused examinations adopted by all the 
agencies have attempted to solve this challenge; however, the recent 
failures of Superior Bank, First National Bank of Keystone, and 
BestBank demonstrated the need for further improvement.
    In addition, beginning with the January 2000 examination, we 
believe that the OTS used a methodology to compute Superior's capital 
that artificially increased the capital ratios, thus avoiding 
provisions of PCA. OTS used a post-tax capital ratio to classify 
Superior as ``adequately capitalized.'' If a pre-tax calculation had 
been used, Superior would have been ``undercapitalized,'' and more 
immediately subjected to various operating constraints under PCA. These 
constraints may have precluded Superior management from taking actions 
late in 2000 that were detrimental to the financial condition of the 
institution.
Loss to the Savings Association Insurance Fund
    As of December 31, 2001 the FDIC estimated that Superior's failure 
will result in a range of loss to the Savings Association Insurance 
Fund of approximately $300 to $350 million. This loss estimate includes 
the benefit of a settlement agreement in the amount of $460 million 
entered into between the FDIC and owners of the bank's holding 
companies. Under the agreement, an affiliate of the bank's former 
holding company paid $100 million to the Government in December 2001 
and agreed to pay an additional $360 million in equal annual 
installments without interest over 15 years, starting in December 2002. 
If these payments are not made, the losses will substantially increase.
Resolution of Superior
    The FDIC Board of Directors determined that a conservatorship would 
be the least cost alternative for the Savings Association Insurance 
Fund. This decision was made, in part, because the FDIC did not have 
sufficient information to develop other possible resolution 
alternatives. The FDIC's access to Superior was limited partly based on 
the fact that Superior's owners were in the process of implementing an 
OTS-approved capital restoration plan purported to address Superior's 
capital problems. Superior's owners did not implement the approved 
plan, and OTS notified Superior of its critically undercapitalized 
condition 1 day prior to consideration of the Failing Bank Case for 
Superior by the FDIC Board of Directors. Consequently, complete 
information on a range of resolution alternatives was not available to 
the FDIC to make the least cost decision for Superior's resolution.
    The FDIC has made progress in preparing remaining assets in the 
receivership for sale and most sales efforts should be completed in the 
second quarter of 2002. We are continuing to track the FDIC's progress.
New Rule To Amend the Regulatory Capital Treatment of
Residual Assets
    On November 29, 2001 the Federal bank and thrift regulatory 
agencies issued a new rule that changes, among other things, the 
regulatory capital treatment of residual assets in asset 
securitizations. The rule, which became effective on January 1, 2002, 
addresses the concerns associated with residuals that exposed financial 
institutions like Superior Bank to high levels of credit and liquidity 
risk interests. Essentially the new rule limits residual assets to 25 
percent of capital. In our opinion, had Superior Bank operated in 
accordance with this new rule, it would not have incurred the losses it 
did and may have avoided failure.
Recommendations
    Our review identified areas in which we believe regulatory 
oversight could be strengthened. These include:

 Reviewing the external auditor's working papers for 
    institutions that operate high-risk programs, such as subprime 
    lending and securitizations;
 Following up on ``red flags'' that indicate possible errors or 
    irregularities;
 Consulting with other regulators when they encounter complex 
    assets such as those at Superior Bank; and
 Following up on previous examination findings and 
    recommendations to ensure bank management has addressed examiner 
    concerns.

    In a related audit report that we will be releasing in the near 
future, we are recommending that the FDIC take actions to strengthen 
its special examination authority. Last week, the FDIC Board of 
Directors authorized an expanded delegation of authority for its 
examiners to conduct examinations, visitations, or other similar 
activities of insured depository institutions. This expanded delegation 
implements an interagency agreement outlining the circumstances under 
which the FDIC will conduct examinations of institutions not directly 
supervised by the FDIC.
    While this agreement represents progress for interagency 
examination coordination, it still places limits on the FDIC's access 
as insurer. Had the provisions of this agreement been in effect in the 
1990's, it would not have ensured that the FDIC could have gained 
access to Superior Bank without going to its Board when it requested so 
in December 1998. At that time, the bank was 1-rated from the previous 
OTS examination and there was disagreement as to whether there was 
sufficient evidence of material deteriorating conditions. To guarantee 
the FDIC's independence as the insurer, we believe that the statutory 
authority for the FDIC's special examination authority should be vested 
with the FDIC Chairman.
    Last, we will be recommending that FDIC take the initiative in 
working with other regulators to develop a uniform method of 
calculating the relevant capital 
ratios used to determine an insured depository institution's Prompt 
Corrective Action category.
Conclusion
    In summary, the ability of any bank to operate in the United States 
is a privilege. This privilege carries with it certain fundamental 
requirements: accurate records and financial reporting on an 
institution's operations, activities, and transactions; adequate 
internal controls for assessing risks and compliance with laws and 
regulations; as well as the utmost credibility of the institution's 
management and its external auditors. Most of these requirements were 
missing in the case of Superior Bank. A failure to comply with 
reporting requirements, inadequate internal controls, a continuing 
pattern of disregard of regulatory authorities, flawed and 
nonconforming accounting methodology, and the potential for the 
continuation of unsafe and unsound practices left regulators with 
little choice but to close Superior Bank on July 27, 2001.
    Superior Bank and the resulting scrutiny it has received will 
hopefully provide lessons learned on the roles played by bank 
management, external auditors, and the regulators so that we may better 
avoid through improved communication, methodologies, and policies, the 
events that led to the institution's failure.
    Mr. Chairman, this concludes my statement. I would be happy to 
answer any questions you or other Members of the Committee may have.
                 PREPARED STATEMENT OF THOMAS J. McCOOL
     Managing Director, Financial Markets and Community Investment
                     U.S. General Accounting Office
                            February 7, 2002
    Mr. Chairman and Members of the Committee, we are pleased to be 
here to discuss our analysis of the failure of Superior Bank, FSB, a 
Federally chartered savings bank located outside Chicago, IL. Shortly 
after Superior Bank's closure on July 27, 2001, the Federal Deposit 
Insurance Corporation (FDIC) projected that the failure of Superior 
Bank would result in a $426-$526 million loss to the deposit insurance 
fund.\1\ The magnitude of the projected loss to the deposit insurance 
fund resulted in questions being raised by Congress and industry 
observers about what went wrong at Superior, how it happened, and what 
steps can be taken to reduce the likelihood of a similar failure.
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    \1\ The amount of the expected loss to the insurance fund is still 
in question. To settle potential claims, former coowners of Superior 
entered into a settlement with FDIC and OTS in December 2001. The 
settlement calls for a payment to FDIC of $460 million, of which $100 
million already has been paid. The remaining $360 million is to be paid 
over the next 15 years. The ultimate cost to the insurance fund will be 
determined by the proceeds that FDIC obtains from the sale of the 
failed institution's assets and other factors.
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    Our testimony today (1) describes the causes of the failure of 
Superior Bank; (2) discusses whether external audits identified 
problems with Superior Bank, and; (3) evaluates the effectiveness of 
Federal supervision of Superior, including the coordination between the 
primary regulator--the Office of Thrift Supervision (OTS)--and the 
FDIC. Finally, we discuss the extent that issues similar to those 
associated with Superior's failure were noted in Material Loss Reviews 
conducted by inspectors general on previous bank failures.
    Our testimony is based on our review of OTS and FDIC files for 
Superior Bank, including reports of on-site examinations of the bank 
and off-site monitoring and analysis, and interviews with OTS and FDIC 
officials, including officials in the Chicago offices who had primary 
responsibility for Superior Bank. The scope of our work on the conduct 
of Superior's external auditors was limited due to the ongoing 
investigation and potential litigation by FDIC and OTS on issues 
surrounding the failure of Superior Bank.
Summary
    The key events leading to the failure of Superior Bank were largely 
associated with the business strategy adopted by Superior Bank's 
management of originating and securitizing subprime loans on a large 
scale. This strategy resulted in rapid growth and a high concentration 
of extremely risky assets. Compounding this concentration in risky 
assets was the failure of Superior Bank's management to properly value 
and account for the interests it had retained in pooled home mortgages.
    Superior Bank generated high levels of ``paper profits'' that 
overstated its capital levels. When Federal regulators were finally 
able to get Superior Bank to apply proper valuation and reporting 
practices, Superior Bank became significantly undercapitalized. When 
the owners of Superior Bank failed to contribute additional capital, 
the regulators were forced to place Superior into receivership.
    Superior's external auditor, Ernst & Young, also failed to detect 
the improper valuation of Superior's retained interests until OTS and 
FDIC insisted that the issue be reviewed by Ernst & Young's national 
office. As noted earlier, FDIC and OTS are investigating the role of 
the external auditor in Superior's failure, with an eye to potential 
litigation.
    Federal regulators were clearly not effective in identifying and 
acting on the problems at Superior Bank early enough to prevent a 
material loss to the deposit insurance fund. OTS, Superior's primary 
supervisor, bears the main responsibility for not acting earlier. 
Superior may not have been a problem bank back in the mid-1990's, but 
the risks of its strategy and its exposure to revaluation of the 
retained interests merited more careful and earlier attention. FDIC was 
the first to recognize the problems in Superior's financial situation, 
although the problems had grown by the time that FDIC recognized them 
in late 1998.
    Both agencies were aware of the substantial concentration of 
retained interests that Superior held, but the apparently high level of 
earnings, the apparently adequate capital, and the belief that the 
management was conservatively managing the institution limited their 
actions. Earlier response to the ``concerns'' expressed in examination 
reports dating to the mid-1990's may not have been sufficient to avoid 
the failure of the bank, but it likely would have prevented subsequent 
growth and thus limited the potential loss to the insurance fund.
    Problems in communication between OTS and FDIC appear to have 
hindered a coordinated supervisory approach. FDIC has recently 
announced that it has reached agreement with the other banking 
regulators to establish a better process for determining when FDIC will 
use its authority to examine an insured institution. While GAO welcomes 
improvements in this area, neither OTS nor FDIC completely followed the 
policy in force during 1998 and 1999, when OTS denied FDIC's request to 
participate in the 1999 examination. Thus, following through on policy 
implementation will be as important as the design of improved policies 
for involving FDIC in future bank examinations.
Background
    Superior Bank was formed in 1988 when the Coast-to-Coast Financial 
Corporation, a holding company owned equally by the Pritzker and 
Dworman families,\2\ acquired Lyons Savings, a troubled Federal savings 
and loan association. From 1988 to 1992, Superior Bank struggled 
financially and relied heavily on an assistance agreement from the 
Federal Savings and Loan Insurance Corporation (FSLIC).\3\ Superior's 
activities were limited during the first few years of its operation, 
but by 1992, most of the bank's problems were resolved and the effects 
of the FSLIC agreement had diminished. OTS, the primary regulator of 
Federally chartered savings institutions, had the lead responsibility 
for supervising Superior Bank while FDIC, with responsibility to 
protect the deposit insurance fund, acted as Superior's backup 
regulator. By 1993, OTS and FDIC had given Superior a composite CAMEL 
``2'' rating \4\ and, at this time, FDIC began to rely only on off-site 
monitoring of Superior.
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    \2\ The Pritzkers are the owners of the Hyatt Hotels, and the 
Dwormans are prominent New York real estate developers.
    \3\ This assistance agreement included capital protection 
provisions and called for reimbursement of expenses for collecting 
certain problem assets, payment of 22.5 percent of pre-tax net income 
to 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 were filed.)
    \4\ OTS and the other regulators use the Uniform Financial 
Institution Rating System to evaluate a bank's performance. CAMEL is an 
acronym for the performance rating components: capital adequacy, asset 
quality, management administration, earnings, and liquidity. An 
additional component, sensitivity to market risk, was added effective 
January 1, 1997, resulting in the acronym CAMELS. Ratings are on a 1 to 
5 scale with 1 being the highest, or best, score and 5 being the 
lowest, or worst, score.
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    In 1993, Superior's management began to focus on expanding the 
bank's mortgage lending business by acquiring Alliance Funding Company. 
Superior adopted Alliance's business strategy of targeting borrowers 
nationwide with risky credit profiles, such as high debt ratios and 
credit histories that included past delinquencies--a practice known as 
subprime lending. In a process known as securitization, Superior then 
assembled the loans into pools and sold interest in these pools--such 
as rights to principal and/or interest payments--through a trust to 
investors, primarily in the form of AAA-rated mortgage securities. To 
enhance the value of these offerings, Superior retained the securities 
with the greatest amount of risk and provided other significant credit 
enhancements for the less risky securities. In 1995, Superior expanded 
its activities to include the origination and securitization of 
subprime automobile loans.
    In December 1998, FDIC first raised concerns about Superior's 
increasing levels of high-risk, subprime assets and growth in retained 
or residual interests. However, it was not until January 2000 that OTS 
and FDIC conducted a joint exam and downgraded Superior's CAMELS rating 
to a ``4,'' primarily attributed to the concentration of residual 
interest holdings. At the end of 2000, FDIC and OTS noted that the 
reported values of Superior's residual interest assets were overstated 
and that the bank's reporting of its residual interest assets was not 
in compliance with the Statement of Financial Accounting Standards 
(SFAS) No. 125. Prompted by concerns from OTS and FDIC, Superior 
eventually made a number of adjustments to its financial statements. In 
mid-February 2001, OTS issued a Prompt Corrective Action (PCA) notice 
to Superior because the bank was significantly undercapitalized. On May 
24, OTS approved Superior's PCA capital plan. Ultimately, the plan was 
never implemented, and OTS closed the bank and appointed FDIC as 
Superior's receiver on July 27, 2001. (A detailed chronology of the 
events leading up to Superior's failure is provided in Appendix I.)
Causes of Superior Bank's Failure
    Primary responsibility for the failure of Superior Bank resides 
with its owners and managers. Superior's business strategy of 
originating and securitizing subprime loans appeared to have led to 
high earnings, but more importantly its strategy resulted in a high 
concentration of extremely risky assets. This high concentration of 
risky assets and the improper valuation of these assets ultimately led 
to Superior's failure.
Concentration of Risky Assets
    In 1993, Superior Bank began to originate and securitize subprime 
home mortgages in large volumes. Later, Superior expanded its 
securitization activities to include subprime automobile loans. 
Although the securitization process moved the subprime loans off its 
balance sheet, Superior retained the riskier interests in the proceeds 
from the pools of securities it established. Superior's holdings of 
this retained interest exceeded its capital levels going as far back as 
1995.
    Retained or residual interests \5\ are common in asset 
securitizations and often represent steps that the loan originator 
takes to enhance the quality of the interests in the pools that are 
offered for sale. Such enhancements can be critical to obtaining high 
credit ratings for the pool's securities. Often, the originator will 
retain the riskiest components of the pool, doing so to make the other 
components easier to sell. The originator's residual interests, in 
general, will represent the rights to cashflows or other assets after 
the pool's obligations to other investors have been satisfied.
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    \5\ These interests are known as residuals because they receive the 
last cashflows from the loans.
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    Overcollateralization assets are another type of residual interest 
that Superior held. To decrease risk to investors, the originator may 
overcollateralize the securitization trust that holds the assets and is 
responsible for paying the investors. An originator can 
overcollateralize by selling the rights to $100 in principal payments, 
for instance, while putting assets worth $105 into the trust, 
essentially providing a cushion, or credit enhancement, to help ensure 
that the $100 due investors is paid in event of defaults in the 
underlying pool of loans (credit losses). The originator would receive 
any payments in excess of the $100 interest that was sold to investors 
after credit losses are paid from the overcollateralized portion.
    As shown in Figure 1, Superior's residual interests represented 
approximately 100 percent of Tier 1 capital on June 30, 1995.\6\ By 
June 30, 2000, residual interest represented 348 percent of Tier 1 
capital. This level of concentration was particularly risky given the 
complexities associated with achieving a reasonable valuation of 
residual interests.
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    \6\ Tier 1 capital consists primarily of tangible equity capital--
equity capital plus cumulative preferred stock (including related 
surplus)--minus all intangible assets, except for some amount of 
purchased mortgage servicing rights.


    Superior's practice of targeting subprime borrowers increased its 
risk. By targeting borrowers with low credit quality, Superior was able 
to originate loans with interest rates that were higher than market 
averages. The high interest rates reflected, at least in part, the 
relatively high credit risk associated with these loans. When these 
loans were then pooled and securitized, their high interest rates 
relative to the interest rates paid on the resulting securities, 
together with the high valuation of the retained interest, enabled 
Superior to record gains on securitization transactions that drove its 
apparently high earnings and high capital. A significant amount of 
Superior's revenue was from the sale of loans in these transactions, 
yet more cash was going out rather than coming in from these 
activities.
    In addition to the higher risk of default related to subprime 
lending, there was also prepayment risk. Generally, if interest rates 
decline, a loan charging an interest rate that is higher than market 
averages becomes more valuable to the lender. However, lower interest 
rates could also trigger higher than predicted levels of loan 
prepayment--particularly if the new lower interest rates enable 
subprime borrowers to qualify for refinancing at lower rates. Higher-
than-projected prepayments negatively impact the future flows of 
interest payments from the underlying loans in a securitized portfolio.
    Additionally, Superior expanded its loan origination and 
securitization activities to include automobile loans. The credit risk 
of automobile loans is inherently higher than that associated with home 
mortgages, because these loans are associated with even higher default 
and loss rates. Auto loan underwriting is divided into classes of 
credit quality (most commonly A, B, and C). Some 85 percent of Superior 
Banks auto loans went to people with B and C ratings. In Superior's 
classification system, these borrowers had experienced credit problems 
in the past because of unusual circumstances beyond their control (such 
as a major illness, job loss, or death in the family) but had since 
resolved their credit problems and rebuilt their credit ratings to a 
certain extent. As with its mortgage securitizations, Superior Bank was 
able to maintain a high spread between the interest rate of the auto 
loans and the yield that investors paid for the securities based on the 
pooled loans. However, Superior's loss rates on its automobile loans as 
of December 31, 1999 were twice as high as Superior's management had 
anticipated.
Valuation of Residual Interests
    Superior Bank's business strategy rested heavily on the value 
assigned to the residual interests that resulted from its 
securitization activities. However, the valuation of residual interests 
is extremely complex and highly dependent on making accurate 
assumptions regarding a number of factors. Superior overvalued its 
residual interests because it did not discount to present value the 
future cashflows that were subject to credit losses. When these 
valuations were ultimately adjusted, at the behest of the regulators, 
the bank became significantly undercapitalized and eventually failed.
    There are significant valuation issues and risks associated with 
residual interests. Generally, the residual interest represents the 
cashflows from the underlying mortgages that remain after all payments 
have been made to the other classes of securities issued by the trust 
for the pool, and after the fees and expenses have been paid. As the 
loan originator, Superior Bank was considered to be in the ``first-
loss'' position (that is, Superior would suffer any credit losses 
suffered by the pool, before any other investor.) Credit losses are not 
the only risks held by the residual interest holder. The valuation of 
the residual interest depends critically on how accurately future 
interest rates and loan prepayments are forecasted. Market events can 
affect the discount rate, prepayment speed, or performance of the 
underlying assets in a securitization transaction and can swiftly and 
dramatically alter their value.
    The Financial Accounting Standards Board (FASB) recognized the need 
for a new accounting approach to address innovations and complex 
developments in the financial markets, such as securitization of loans. 
Under SFAS No. 125, ``Accounting for Transfers and Servicing of 
Financial Assets and Extinguishments of Liabilities,'' \7\ which became 
effective after December 31, 1996, when a transferor surrenders control 
over transferred assets, it should be accounted for as a sale. The 
transferor should recognize that any retained interest in the 
transferred assets should be reported in its statement of financial 
position based on the fair value. The best evidence of fair value is a 
quoted market price in an active market, but if there is no market 
price, the value must be estimated. In estimating the fair value of 
retained interests, valuation techniques include estimating the present 
value of expected future cashflows using a discount rate commensurate 
with the risks involved. The standard states that those techniques 
shall incorporate assumptions that market participants would use in 
their estimates of values, future revenues, and future expenses, 
including assumptions about interest rates, default, prepayment, and 
volatility. In 1999, FASB explained that when estimating the fair value 
for retained 
interests used as a credit enhancement, it should be discounted from 
the date when it is estimated to become available to the transferor.\8\
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    \7\ SFAS No. 140: Accounting for Transfers and Servicing of 
Financial Assets and Extinguishments of Liabilities, issued September 
2000, replaced SFAS No. 125.
    \8\ This concept is reiterated in FASB's A Guide to Implemention of 
Statement 125 on Accounting for Transfers and Servicing of Financial 
Assets and Extinguishments of Liabilities: Questions and Answers, 
Issued July 1999 and revised September 1999. When estimating the fair 
value of credit enhancements (retained interest), the transferor's 
assumptions should include the period of time that its use of the asset 
is restricted, reinvestment income, and potential losses due to 
uncertainties. One acceptable valuation technique is the ``cash out'' 
method, in which cashflows are discounted from the date that the credit 
enhancement becomes available.
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    Superior Bank did not properly value the residual interest assets 
it reported on its financial statements. Since those assets represented 
payments that were to be received in the future only after credit 
losses were reimbursed, they needed to be discounted at an appropriate 
risk-adjusted rate, in order to recognize that a promise to pay in the 
future is worth less than a current payment. Superior did not use 
discounting when valuing its residual interest related to 
overcollateralization. However, as a credit enhancement, the 
overcollateralized asset is restricted in use under the trust and not 
available to Superior until losses have been paid under the terms of 
the credit enhancement. The result was that Superior Bank reported 
assets, earnings, and capital that were far in excess of their true 
values. In addition, there were other issues with respect to Superior's 
compliance with SFAS No. 125. When Superior finally applied the 
appropriate valuation techniques and related accounting to the residual 
interests in early 2001, at the urging of OTS, Superior was forced to 
take a write-off against its capital and became ``significantly 
undercapitalized.''
Regulators' Concerns About the Quality of the External Audit
    Federal regulators now have serious concerns about the quality of 
Ernst & Young's audit of Superior Banks financial statements for the 
fiscal year ending June 30, 2000. This audit could have highlighted the 
problems that led to Superior Bank's failure but did not. Regulators' 
major concerns related to the audit include: (1) the inflated valuation 
of residual interest in the financial statements and (2) the absence of 
discussion on Superior's ability to continue in business in the 
auditor's report.
    The accounting profession plays a vital role in the governance 
structure for the banking industry. In addition to bank examinations, 
independent certified public accountant audits are performed to express 
an opinion on the fairness of bank's financial statements and to report 
any material weaknesses in internal controls. Auditing standards 
require public accountants rendering an opinion on financial statements 
to consider the need to disclose conditions that raise a question about 
an entity's ability to continue in business. Audits should provide 
useful information to Federal regulators who oversee the banks, 
depositors, owners, and the public. When financial audits are not of 
the quality that meets auditing standards, this undermines the 
governance structure of the banking industry.
    Federal regulators believed that Ernst & Young auditors' review of 
Superior's valuation of residuals failed to identify the overvaluation 
of Superior's residual interests in its fiscal year 2000 financial 
statements. Recognizing a significant growth in residual assets, 
Federal regulators performed a review of Superior's valuation of its 
residuals for that same year and found that it was not being properly 
reported in accordance with Generally Accepted Accounting Principles 
(GAAP). The regulators believed the incorrect valuation of the 
residuals had resulted in a significant overstatement of Superior's 
assets and capital. Although Ernst & Young's local office disagreed 
with the regulators findings, Ernst & Young's national office concurred 
with the regulators. Subsequently, Superior revalued these assets 
resulting in a $270 million write-down of the residual interest value. 
As a result, Superior's capital was reduced and Superior became 
significantly undercapitalized. OTS took a number of actions, but 
ultimately had to close Superior and appoint FDIC as receiver.
    An FDIC official stated that Superior had used this improper 
valuation technique not only for its June 30, 2000, financial 
statements, but also for the years 1995 through 1999. To the extent 
that was true, Superior's earnings and capital were likely overstated 
during those years, as well. However, in each of those fiscal years, 
from 1995 through 2000, Superior received an unqualified, or ``clean,'' 
opinion from the Ernst & Young auditors.
    In Ernst & Young's audit opinion, there was no disclosure of 
Superior's questionable ability to continue as a going concern. Yet, 10 
months after the date of Ernst & Young's audit opinion on September 22, 
2000, Superior Bank was closed and placed into receivership. Auditing 
standards provide that the auditor is responsible for evaluating 
``whether there is a substantial doubt about the entity's ability to 
continue as a going concern for a reasonable period of time.'' This 
evaluation should be based on the auditor's ``knowledge of relevant 
conditions and events that exist at or have occurred prior to the 
completion of fieldwork.'' FDIC officials believe that the auditors 
should have known about the potential valuation issues and should have 
evaluated the ``conditions and events'' relating to Superior's retained 
interests in securitizations and the subsequent impact on capital 
requirements. FDIC officials also believe that the auditors should have 
known about the issues at the date of the last audit report, and there 
was a sufficient basis for the auditor to determine that there was 
``substantial doubt'' about Superior's ``ability to continue as a going 
concern for a reasonable period of time.'' Because Ernst & Young 
auditors did not reach this conclusion in their opinion, FDIC has 
expressed concerns about the quality of the audit of Superior's fiscal 
year 2000 financial statements.
    FDIC has retained legal and forensic accounting assistance to 
conduct an investigation into the failure of Superior Bank. This 
investigation includes not only an examination of Superior's lending 
and investment practices but also a review of the bank's independent 
auditors, Ernst & Young. It involves a thorough review of the 
accounting firm's audit of the bank's financial statements and role as 
a consultant and advisor to Superior on valuation issues. The major 
accounting and auditing issues in this review will include: (1) an 
evaluation of the overcollateralized assets valuation as well as other 
residual assets; (2) whether ``going concern'' issues should have been 
raised had Superior Bank's financials been correctly stated and; (3) an 
evaluation of both the qualifications and independence of the 
accounting firm. The target date for the final report from the forensic 
auditor is May 1, 2002. OTS officials told us that they have opened a 
formal investigation regarding Superior's failure and have issued 
subpoenas to Ernst & Young, among others.
Effectiveness of OTS and FDIC Supervision of Superior Bank
    Our review of OTS's supervision of Superior Bank found that the 
regulator had information, going back to the mid-1990's, that indicated 
supervisory concerns with Superior's substantial retained interests in 
securitized, subprime home mortgages and recognition that the bank's 
soundness depended critically on the valuation of these interests. 
However, the high apparent earnings of the bank, its apparently 
adequate capital levels, and supervisory expectations that the 
ownership of the bank would provide adequate support in the event of 
problems appear to have combined to delay effective enforcement 
actions. Problems with communication and coordination between OTS and 
FDIC also created a delay in supervisory response after FDIC raised 
serious questions about the operations of Superior. By the time that 
the PCA directive was issued in February 2001, Superior's failure was 
probably 
inevitable.
Weaknesses in OTS's Oversight of Superior
    As Superior's primary regulator, OTS had the lead responsibility 
for monitoring the bank's safety and soundness. Although OTS identified 
many of the risks associated with Superior's business strategy as early 
as 1993, it did not exercise sufficient professional skepticism with 
respect to the ``red flags'' it identified with regards to Superior's 
securitization activities. Consequently, OTS did not fully recognize 
the risk profile of the bank and thus did not address the magnitude of 
the bank's problems in a timely manner. Specifically:

 OTS's assessment of Superior's risk profile was clouded by the 
    banks apparent strong operating performance and higher-than-peer 
    leverage capital;
 OTS relied heavily on management's expertise and assurances; 
    and
 OTS relied on the extemal audit reports without evaluating the 
    quality of the external auditors' review of Superior's 
    securitization activities.

OTS's Supervision of Superior was Influenced by its Apparent High 
        Earnings
and Capital Levels
    OTS's ratings of Superior from 1993 through 1999 appeared to have 
been heavily influenced by Superior's apparent high earnings and 
capital levels. Beginning in 1993, OTS had information showing that 
Superior was engaging in activities that were riskier than those of 
most other thrifts and merited close monitoring. Although neither 
subprime lending nor securitization is an inherently unsafe or unsound 
activity, both entail risks that bank management must manage and its 
regulator must consider in its examination and supervisory activities. 
While OTS examiners viewed Superior Bank's high earnings as a source of 
strength, a large portion of these earnings represented estimated 
payments due sometime in the future and thus were not realized. These 
high earnings were also indicators of the riskiness of the underlying 
assets and business strategy. Moreover, Superior had a higher 
concentration of residual interest assets than any other thrift under 
OTS's supervision. However, OTS did not take supervisory action to 
limit Superior's securitization activities until after the 2000 
examination.
    According to OTS's Regulatory Handbook, greater regulatory 
attention is required when asset concentrations exceed 25 percent of a 
thrift's core capital.\9\ As previously discussed, Superior's 
concentration in residual interest securities equaled 100 percent of 
Tier 1 capital in June 30, 1995 and grew to 348 percent of Tier 1 
capital in June 30, 2000. However, OTS's examination reports during 
this period reflected an optimistic understanding of the implications 
for Superior Bank. The examination reports consistently noted the risks 
associated with such lending and related residual interest securities 
were balanced by Superior's strong earnings, higher-than-peer 
leverage capital, and substantial reserves for loan losses. OTS 
examiners did not question whether the ongoing trend of high growth and 
concentrations in subprime loans and residual interest securities was a 
prudent strategy for the bank. Consequently, the CAMELS ratings did not 
accurately reflect the conditions of those components.
---------------------------------------------------------------------------
    \9\ Section 211, Asset Quality--Loan Portfolio Diversification, OTS 
Regulatory Handbook, January 1994.
---------------------------------------------------------------------------
    Superior's business strategy as a lender to high-risk borrowers was 
clearly visible in data that the OTS prepared comparing it to other 
thrifts of comparable size. Superior's ratio of nonperforming assets to 
total assets in December 1998 was 233 percent higher than the peer 
group's median. Another indicator of risk was the interest rate on the 
mortgages that Superior had made with a higher rate indicating a 
riskier borrower. In 1999, over 39 percent of Superior's mortgages 
carried interest rates of 11 percent or higher. Among Superior's peer 
group, less than 1 percent of all mortgages had interest rates that 
high.
    OTS's 1997 examination report for Superior Bank illustrated the 
influence of Superior's high earnings on the regulator's assessment. 
The 1997 examination report noted that Superior's earnings were very 
strong and exceeded industry averages. The report stated that the 
earnings were largely the result of large imputed gains from the sale 
of loans with high interest rates and had not been realized on a 
cashflow basis. Furthermore, the report recognized that changes in 
prepayment assumptions could negatively impact the realization of the 
gains previously recognized. Despite the recognition of the dependence 
of Superior's earnings on critical assumptions regarding prepayment and 
actual loss rates, OTS gave Superior Bank the highest composite CAMELS 
rating, as well as the highest rating for four of the six CAMELS 
components--asset quality, management, earnings, and sensitivity to 
market risk--at the conclusion of its 1997 examination.
OTS Relied on Superior's Management and Owners
    OTS consistently assumed that Superior's management had the 
necessary expertise to safely manage the complexities of Superior's 
securitization activities. In addition, OTS relied on Superior's 
management to take the necessary corrective actions to address the 
deficiencies that had been identified by OTS examiners. Moreover, OTS 
expected the owners of Superior to come to the bank's financial rescue 
if necessary. These critical assumptions by OTS ultimately proved 
erroneous.
    From 1993 through 1999, OTS appeared to have had confidence in 
Superior's management's ability to safely manage and control the risks 
associated with its highly sophisticated securitization activities. As 
an illustration of OTS reliance on Superior's management assurances, 
OTS examiners brought to management's attention in the 1997 and 1999 
examinations underlying mortgage pools had prepayment rates exceeding 
those used in revaluation. OTS examiners accepted management's response 
that the prepayment rates observed on those subpools were abnormally 
high when compared with historical experience, and that they believed 
sufficient valuation allowances had been established on the residuals 
to prevent any significant changes to capital. It was not until the 
2000 examination, when OTS examiners demanded supporting documentation 
concerning residual interests, that they were surprised to learn that 
such documentation was not always available. OTS's optimistic 
assessment of the capability of Superior's management continued through 
1999. For example, OTS noted in its 1999 examination report that the 
weaknesses it had detected during the examination were well within the 
board of directors' and management's capabilities to correct.
    OTS relied on Superior Bank's management and board of directors to 
take the necessary corrective action to address the numerous 
deficiencies OTS examiners identified during the 1993 through 1999 
examinations. However, many of the deficiencies remained uncorrected 
even after repeated examinations. For example, OTS expressed concerns 
in its 1994 and 1995 examinations about the improper inclusion of 
reserves for the residual interest assets in the Allowance for Loan and 
Lease Losses. This practice had the net effect of overstating the 
institution's total capital ratio. OTS apparently relied on 
management's assurances that they would take the appropriate corrective 
action, because this issue was not discussed in OTS's 1996, 1997, or 
1999 examination reports. However, OTS discovered in its 2000 
examination that Superior Bank had not taken the agreed-upon corrective 
action, but in fact had continued the practice. Similarly, OTS found in 
both its 1997 and 1999 examinations that Superior was underreporting 
classified or troubled loans in its Thrift Financial Reports (TFR). In 
the 1997 examination, OTS found that not all classified assets were 
reported in the TFR and obtained management's agreement to ensure the 
accuracy of subsequent reports. In the 1999 examination, however, OTS 
found that $43.7 million in troubled assets had been shown as 
repossessions on the most recent TFR, although a significant portion of 
these assets were accorded a ``loss'' classification in internal 
reports. As a result, actual repossessions were only $8.4 million. OTS 
conducted a special field visit to examine the auto loan operations in 
October 1999, but the review focused on the classification aspect 
rather than the fact that management had not been very conservative in 
charging-off problem auto credits, as FDIC had pointed out.
    OTS also appeared to have assumed that the wealthy owners of 
Superior Bank would come to the bank's financial rescue when needed. 
The 2000 examination report demonstrated OTS's attitude toward its 
supervision of Superior by stating that failure was not likely due to 
the institution's overall strength and financial capacity and the 
support of the two ownership interests comprised of the Alvin Dworman 
and Jay Pritzker families.
    OTS's assumptions about the willingness of Superior's owners not to 
allow the institution to fail were ultimately proven false during the 
2001 negotiations to recapitalize the institution. As a result, the 
institution was placed into receivership.
OTS Placed Undue Reliance on the External Auditors
    OTS also relied on the external auditors and others who were 
reporting satisfaction with Superior's valuation method. In previous 
reports, GAO has supported having examiners place greater reliance on 
the work of external auditors in order to enhance supervisory 
monitoring of banks. Some regulatory officials have said that examiners 
may be able to use external auditors' work to eliminate certain 
examination procedures from their examinations--for example, 
verification or confirmation of the existence and valuation of 
institution assets such as loans, derivative transactions, and accounts 
receivable. The officials further said that external auditors perform 
these verifications or confirmations routinely as a part of their 
financial statement audits. But examiners rarely perform such, 
verifications because they are costly and time consuming.
    GAO continues to believe that examiners should use external 
auditors' work to enhance the efficiency of examinations. However, this 
reliance should be predicated on the examiners' obtaining reasonable 
assurance that the audits have been performed in a quality manner and 
in accordance with professional standards. OTS's Regulatory Handbook 
recognizes the limitations of examiners' reliance on external 
auditors,\10\ noting that examiners ``may'' rely on an external 
auditor's findings in low-risk areas. However, examiners are expected 
to conduct more in-depth reviews of the external auditor's work in 
high-risk areas. The handbook also suggests that a review of the 
auditor's workpapers documenting the assumptions and methodologies used 
by the institution to value key assets could assist examiners in 
performing their examinations.
---------------------------------------------------------------------------
    \10\ Section 350, Independent Audit, OTS Regulatory Handbook, 
January 1994.
---------------------------------------------------------------------------
    In the case of Superior Bank the external auditor, Ernst & Young, 
one of the ``Big Five'' accounting firms,\11\ provided unqualified 
opinions on the bank's financial statements for years. In a January 
2000 meeting with Superior Bank's Audit Committee to report the audit 
results for the fiscal year ending June 30, 1999, Ernst & Young noted 
that ``after running their own model to test the Bank's model, Ernst & 
Young believes that the overall book values of financial receivables as 
recorded by the Bank are reasonable considering the Bank's overall 
conservative assumptions and methods.'' Not only did Ernst & Young not 
detect the overvaluation of Supe-
rior's residual interests, the firm explicitly supported an incorrect 
valuation until, at the insistence of the regulators, the Ernst & Young 
office that had conducted the audit sought a review of its position on 
the valuation by its national office. Ultimately, it was the incorrect 
valuation of these assets that led to the failure of Superior Bank. 
Although the regulators recognized this problem before Ernst & Young, 
they did not do so until the problem was so severe the bank's failure 
was inevitable.
---------------------------------------------------------------------------
    \11\ The ``Big Five'' accounting firms are Andersen LLP, Deloitte & 
Touche LLP, Ernst & Young LLP, KPMG LLP, and PricewaterhouseCoopers 
LLP.
---------------------------------------------------------------------------
Although FDIC Was First To Raise Concerns About Superior,
Problems Could Have Been Detected Sooner
    FDIC raised serious concerns about Superior's operations at the end 
of 1998 based on its off-site monitoring and asked that an FDIC 
examiner participate in the examination of the bank that was scheduled 
to start in January 1999. At that time, OTS rated the institution a 
composite ``1''. Although FDIC's 1998 off-site analysis began the 
identification of the problems that led to Superior's failure, FDIC had 
conducted similar off-site monitoring in previous years that did not 
raise concerns.
    During the late 1980's and early 1990's, FDIC examined Superior 
Bank several times because it was operating under an assistance 
agreement with FSLIC. However, once Superior's condition stabilized and 
its composite rating was upgraded to a ``2'' in 1993, FDIC's review was 
limited to off-site monitoring. In 1995, 1996, and 1997, FDIC reviewed 
the annual OTS examinations and other material, including the banks 
supervisory filings and audited financial statements. Although FDIC's 
internal reports noted that Superior's holdings of residual assets 
exceeded its capital, they did not identify these holdings as concerns.
    FDIC's interest in Superior Bank was heightened in December 1998 
when it conducted an off-site review, based on September 30, 1998 
financial information. During this review, FDIC noted--with alarm--that 
Superior Bank exhibited a high-risk asset structure. Specifically, the 
review noted that Superior had significant investments in the residual 
values of securitized loans. These investments, by then, were equal to 
roughly 150 percent of its Tier 1 capital. The review also noted that 
significant reporting differences existed between the bank's audit 
report and its quarterly financial statement to regulators, that the 
bank was a subprime lender, and had substantial off-balance sheet 
recourse exposure.
    As noted earlier, however, the bank's residual assets had been over 
100 percent of capital since 1995. FDIC had been aware of this high 
concentration and had noted it in the summary analyses of examination 
reports that it completed during off-site monitoring, but FDIC did not 
initiate any additional off-site activities or raise any concerns to 
OTS until after a 1998 off-site review that it performed. Although 
current guidance would have imposed limits at 25 percent, there was no 
explicit direction to the bank's examiners or analysts on safe limits 
for residual assets. However, Superior was clearly an outlier, with 
holdings substantially greater than peer group banks.
    In early 1999, FDIC's additional off-site monitoring and review of 
OTS's January 1999 examination report--in which OTS rated Superior a 
``2''--generated additional concerns. As a result, FDIC officially 
downgraded the bank to a composite ``3'' in May 1999, triggering higher 
deposit insurance premiums under the risk-related premium system. 
According to FDIC and OTS officials, FDIC participated fully in the 
oversight of Superior after this point.
Poor OTS-FDIC Communication Hindered a Coordinated Supervisory Strategy
    Communication between OTS and FDIC related to Superior Bank was a 
problem. Although the agencies worked together effectively on 
enforcement actions (discussed below), poor communication seems to have 
hindered coordination of supervisory strategies for the bank.
    The policy regarding FDIC's participation in examinations led by 
other Federal supervisory agencies was based on the ``anticipated 
benefit to FDIC in its deposit insurer role and risk of failure the 
involved institution poses to the insurance fund.'' \12\ This policy 
stated that any back-up examination activities must be ``consistent 
with FDIC's prior commitments to reduce costs to the industry, reduce 
burden, and eliminate duplication of efforts.''
---------------------------------------------------------------------------
    \12\ Each Federal banking agency is responsible for conducting 
examinations of the depository institutions under its jurisdiction. 
FDIC is the Federal banking regulator responsible for examining 
Federally insured State-chartered banks that are not members of the 
Federal Reserve System. In addition, FDIC may conduct a special 
examination of any insured depository institution whenever the FDIC's 
Board of Directors decides that the examination is necessary to 
determine the condition of the institution for insurance purposes. 12 
U.S.C. Sec. 1820(b) (2000).
---------------------------------------------------------------------------
    In 1995, OTS delegated to its regional directors the authority to 
approve requests by FDIC to participate OTS examinations.\13\ The 
memorandum from OTS headquarters to the regional directors on the FDIC 
participation process states that:
---------------------------------------------------------------------------
    \13\ OTS Memorandum to Regional Directors from John F. Downey, 
Director of Supervision, Regarding FDIC Participation on Examinations, 
April 5, 1995.

        ``The FDIC's written request should demonstrate that the 
        institution represents a potential or likely failure within a 1 
        year time frame, or that there is a basis for believing that 
        the institution represents a greater than normal risk to the 
        insurance fund and data available from other sources is 
---------------------------------------------------------------------------
        insufficient to assess that risk.''

    As testimony before this Committee last fall documented, FDIC's 
off-site review in 1998 was the first time that serious questions had 
been raised about Superior Bank's strategy and finances. As FDIC 
Director John Reich testified,

        ``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.'' \14\
---------------------------------------------------------------------------
    \14\ Statement of John Reich, Acting Director, Federal Deposit 
Insurance Corporation, on the Failure of Superior Bank, FSB, before the 
Committee on Banking, Housing, and Urban Affairs, U.S. Senate, 
September 11, 2001.

    Because of these concerns, FDIC regional staff called OTS regional 
staff and discussed having an FDIC examiner participate in the January 
1999 examination of Superior Bank. OTS officials, according to internal 
e-mails, were unsure if they should agree to FDIC's participation. 
Ongoing litigation between FDIC and Superior and concern that 
Superior's ``poor opinion'' of FDIC would ``jeopardize [OTS's] working 
relationship'' with Superior were among the concerns expressed in the 
e-mails. OTS decided to wait for a formal, written FDIC request to see 
if it ``convey[ed] a good reason'' for wanting to join in the OTS 
examination.
    OTS and FDIC disagree on what happened next. FDIC officials told us 
that they sent a formal request to the OTS regional office asking that 
one examiner participate in the next scheduled examination but did not 
receive any response. OTS officials told us that they never received 
any formal request. FDIC files do contain a letter, but there is no way 
to determine if it was sent or lost in transit. This letter, dated 
December 28, 1998, noted areas of concern as well as an acknowledgment 
that Superior's management was well regarded, and that the bank was 
extremely profitable and considered to be ``well-capitalized.''
    OTS did not allow FDIC to join their exam, but did allow its 
examiners to review work papers prepared by OTS examiners. Again, the 
two agencies disagree on the effectiveness of this approach. FDIC's 
regional staff has noted that in their view this arrangement was not 
satisfactory, since their access to the workpapers was not sufficiently 
timely to enable them to understand Superior's operations. OTS 
officials told us that FDIC did not express any concerns with the 
arrangement and were surprised to receive a draft memorandum from 
FDIC's regional office proposing that Superior's composite rating be 
lowered to a ``3,'' in contrast to the OTS region's proposed rating of 
``2.''
    However, by September 1999, the two agencies had agreed that FDIC 
would participate in the next examination, scheduled for January 2000.
    In the aftermath of Superior's failure and the earlier failure of 
Keystone National Bank, both OTS and FDIC have participated in an 
interagency process to clarify FDIC's role, responsibility, and 
authority to participate in examinations as the ``backup'' regulator. 
In both bank failures, FDIC had asked to participate in examinations, 
but the lead regulatory agency (OTS in the case of Superior and the 
Office of the Comptroller of the Currency in the case of Keystone) 
denied the request. On January 29, 2002, FDIC announced an interagency 
agreement that gives it more authority to enter banks supervised by 
other regulators.
    While this interagency effort should lead to a clearer 
understanding among the Federal bank supervisory agencies about FDIC's 
participation in the examinations of and supervisory actions taken at 
open banks, it is important to recognize that at the time that FDIC 
asked to join in the 1999 examination of Superior Bank, there were 
policies in place that should have guided its request and OTS's 
decision on FDIC's participation. As such, how the new procedures are 
implemented is a critical issue. Ultimately, coordination and 
cooperation among Federal bank supervisors depend on communication 
among these agencies, and miscommunication plagued OTS and FDIC at a 
time when the two agencies were just beginning to recognize the 
problems that they confronted at Superior Bank.
The Effectiveness of Enforcement Actions Was Limited
    As a consequence of the delayed recognition of problems at Superior 
Bank, enforcement actions were not successful in containing the loss to 
the deposit insurance fund. Once the problems at Superior Bank had been 
identified, OTS took a number of formal enforcement actions against 
Superior Bank starting on July 5, 2000. These actions included a PCA 
directive.
    There is no way to know if earlier detection of the problem at 
Superior Bank, particularly the incorrect valuation of the residual 
assets, would have prevented the bank's ultimate failure. However, 
earlier detection would likely have triggered enforcement actions that 
could have limited Superior's growth and asset concentration and, as a 
result, the magnitude of the loss to the insurance fund.
    Table 1 describes the formal enforcement actions. (Informal 
enforcement actions before July 2000 included identifying ``actions 
requiring board attention'' in the examination reports, including the 
report dated January 24, 2000.) The first action, the ``Part 570 Safety 
and Soundness Action,'' \15\ followed the completion of an on-site 
examination that began in January 2000, with FDIC participation. That 
formally notified Superior's Board of Directors of deficiencies and 
required that the board take several actions, including:
---------------------------------------------------------------------------
    \15\ 12 C.F.R. Part 570.

 Developing procedures to analyze the valuation of the bank's 
    residual interests, including obtaining periodic independent 
    valuations;
 Developing a plan to reduce the level of residual interests to 
    100 percent of the bank's Tier 1 or core capital within 1 year;
 Addressing issues regarding the bank's automobile loan 
    program; and
 Revising the bank's policy for allowances for loan losses and 
    maintaining adequate allowances.

    On July 7, 2000, OTS also officially notified Superior that it had 
been designated a ``problem institution.'' This designation placed 
restrictions on the institution, including on asset growth. Superior 
Bank submitted a compliance plan, as required, on August 4, 2000.\16\ 
Due to the amount of time that Superior and OTS took in negotiating the 
actions required, this plan was never implemented, but it did serve to 
get Superior to cease its securitization activities.
---------------------------------------------------------------------------
    \16\ In response to OTS requests on September 1 and October 27, 
2000, Superior's board provided additional information on September 29 
and November 13, 2000.


    While Superior and OTS were negotiating over the Part 570 plan, 
Superior adjusted the value of its residual interests with a $270 
million write-down. This, in turn, led to the bank's capital level 
falling to the ``significantly undercapitalized'' category, triggering 
a PCA directive that OTS issued on February 14, 2001.\17\
---------------------------------------------------------------------------
    \17\ Section 38 of the Federal Deposit Insurance Act authorizes PCA 
directives when a bank's capital falls below defined levels. In an 
effort to resolve a bank's problems at the least cost to the insurance 
fund, Section 38 provides that supervisory actions be taken and certain 
mandatory restrictions be imposed on the bank (12 U.S.C. Sec. 1831o)
---------------------------------------------------------------------------
    The PCA directive required the bank to submit a capital restoration 
plan by March 14, 2001.\18\ Superior Bank, now with new management, 
submitted a plan on that date, that, after several amendments (detailed 
in the chronology in Appendix I), OTS accepted on May 24, 2001. That 
plan called for reducing the bank's exposure to its residual interests 
and recapitalizing the bank with a $270 million infusion from the 
owners. On Ju1y 16, 2001, however, the Pritzker interests, one of the 
two ultimate owners of Superior Bank, advised OTS that they did not 
believe that the capital plan would work and therefore withdrew their 
support. When efforts to change their position failed, OTS appointed 
FDIC as conservator and receiver of Superior.
---------------------------------------------------------------------------
    \18\ On February 14, 2001, OTS also issued two consent orders 
against Superior's holding companies.
---------------------------------------------------------------------------
    Although a PCA directive was issued when the bank became 
``significantly undercapitalized,'' losses to the deposit insurance 
fund were still substantial. The reasons for this are related to the 
design of PCA itself. First, under PCA, capital is a key factor in 
determining an institution's condition. Superior's capital did not fall 
to the ``significantly undercapitalized'' level until it corrected its 
flawed valuation of its residual interests. Incorrect, financial 
reporting, such as was the case with Superior Bank, will limit the 
effectiveness of PCA because such reporting limits the regulators' 
ability to accurately measure capital.
    Second, PCA's current test for ``critically undercapitalized,'' is 
based on the tangible equity capital ratio, which does not use a risk-
based capital measure. Thus it only includes on-balance sheet assets 
and does not fully encompass off-balance sheet risks, such as those 
presented in an institution's securitization activities. Therefore, an 
institution might become undercapitalized using the risk-based capital 
ratio but would not fall into the ``critically undercapitalized'' PCA 
category under the current capital measure.
    Finally, as GAO has previously reported, capital is a lagging 
indicator, since an institution's capital does not typically begin to 
decline until it has experienced substantial deterioration in other 
components of its operations and finances. As noted by OTS in its 
comments on our 1996 report:

        ``PCA is tied to capital levels and capital is a lagging 
        indicator of financial problems. It is important that 
        regulators continue to use other supervisory and enforcement 
        tools, to stop unsafe and unsound practices before they result 
        in losses, reduced capital levels, or failure.'' \19\
---------------------------------------------------------------------------
    \19\ Bank and Thrift Regulation: Implementation of FDICIA's Prompt 
Regulatory Action Provisions, Nov. 1996, GAO/GGD-97-18, page 71.

    Further, PCA implicitly contemplates that a bank's deteriorating 
condition and capital would take place over time. In some cases, 
problems materialize rapidly, or as in Superior's case, long-developing 
problems are identified suddenly. In such cases, PCA's requirements for 
a bank plan to address the problems can potentially delay other more 
effective actions.
    It is worth noting that while Section 38 uses capital as a key 
factor in determining an institution's condition, Section 39 gives 
Federal regulators the authority to establish safety and soundness 
related management and operational standards that do not rely on 
capital, but could be used to bring corrective actions before problems 
reach the capital account.
Similar Problems Had Occurred in Some Previous Bank Failures
    The failure of Superior Bank illustrates the possible consequences 
when banking supervisors do not recognize that a bank has a 
particularly complex and risky portfolio. Several other recent failures 
provide a warning that the problems seen in the examination and 
supervision of Superior Bank can exist elsewhere. Three other banks, 
BestBank, Keystone Bank, and Pacific Thrift and Loan (PTL), failed and 
had characteristics that were similar in important aspects to Superior. 
These failures involved FDIC (PTL and BestBank) and the Office of the 
Comptroller of the Currency (Keystone).
    BestBank was a Colorado bank that closed in 1998, costing the 
insurance fund approximately $172 million. Like Superior, it had a 
business strategy to target subprime borrowers, who had high 
delinquency rates. BestBank in turn reported substantial gains from 
these transactions in the form of fee income. The bank had to close 
because it falsified its accounting records regarding delinquency rates 
and subsequently was unable to absorb the estimated losses from these 
delinquencies.
    Keystone, a West Virginia bank, failed in 1999, costing the 
insurance fund approximately $800 million. While fraud committed by the 
bank management was the most important cause of its failure, Keystone's 
business strategy was similar to Superior's and led to some similar 
problems. In 1993, Keystone began purchasing and securitizing Federal 
Housing Authority Title I Home improvement Loans that were originated 
throughout the country. These subprime loans targeted highly leveraged 
borrowers with little or no collateral. The securitization of subprime 
loans became Keystone's main line of business and contributed greatly 
to its apparent profitability. The examiners, however, found that 
Keystone did not record its residual interests in these securitizations 
until September 1997, several months after SFAS No. 125 took effect. 
Furthermore, examiners found the residual valuation model deficient, 
and Keystone had an unsafe concentration of mortgage products.
    PTL was a California bank that failed in 1999, costing the 
insurance fund approximately $52 million. Like Superior Bank PTL 
entered the securitization market by originating loans for sale to 
third-party securitizing entities. While PTL enjoyed high asset and 
capital growth rates, valuation was an issue. Also, similar to Superior 
Bank, the examiners overrelied on external auditors in the PTL case. 
According to the material loss review, Ernst & Young, PTL's accountant, 
used assumptions that were unsupported and optimistic.


















































































































































































































































































































































































































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