[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)
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C O N T E N T S
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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
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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.
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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.
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\9\ Section 211, Asset Quality--Loan Portfolio Diversification, OTS
Regulatory Handbook, January 1994.
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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.
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\10\ Section 350, Independent Audit, OTS Regulatory Handbook,
January 1994.
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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.
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\11\ The ``Big Five'' accounting firms are Andersen LLP, Deloitte &
Touche LLP, Ernst & Young LLP, KPMG LLP, and PricewaterhouseCoopers
LLP.
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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.''
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\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).
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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:
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\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
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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\
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\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:
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\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.
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\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\
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\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)
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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.
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\18\ On February 14, 2001, OTS also issued two consent orders
against Superior's holding companies.
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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\
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\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.