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, 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). 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, both OTS and FDIC had  given Superior a composite CAMEL  “2” rating and, at this time, FDIC  began to rely only on off-site monitoring of superior.
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 (FAS) 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 App. 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 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 cash flows or other assets  after the pool’s obligations to other investors have been satisfied.
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. 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.
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 the 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 Bank’s 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 cash flows 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 cash flows 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 (i.e., 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 the securitization of loans.  Under FAS No. 125, “Accounting for Transfers and Servicing of Financial  Assets and Extinguishments of Liabilities,” 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 cash flows 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.
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 FAS 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 Bank’s 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  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 cash flows are discounted from the date that the credit  enhancement becomes available.  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 over-collateralized 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-1990s, that indicated supervisory  concerns with Superior Bank’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 bank’s  apparent strong operating performance and higher-than-peer leverage  capital;
OTS relied heavily on management’s expertise and assurances; and
OTS relied on the external 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. 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 that 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.
Superior’s business strategy as a lender to high-risk borrowers was clearly  visible in data that 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 cash flow 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 that underlying mortgage pools had prepayment rates  exceeding those used in the 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 towards 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, 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.
In the case of Superior Bank, the external auditor, Ernst & Young, one of  the “Big Five” accounting firms, 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  Superior’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 that the bank’s failure was inevitable.

		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 1980s and early 1990s, 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 bank’s 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.” 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.” “The FDIC’s written request should demonstrate that the institution represents a potential  or likely failure within a one year time frame, or that there is a basis for believing that the  institution represents a greater than normal risk to the insurance fund and data available  from other sources is insufficient to assess that risk.” “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.”
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 it they should agree to FDIC’s participation. Ongoing  litigation between FDIC and Superior and concern that Superior’s “poor  opinion” of FDIC would “jeopardize  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 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 problems 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 2 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 Jan. 24,  2000.) The first action, the “Part 570 Safety and Soundness Action,”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: 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. 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.
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.
The PCA directive required the bank to submit a capital restoration plan  by March 14, 2001. Superior Bank, now with new management, submitted  a plan on that date, that, after several amendments (detailed in the  chronology in app. 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 July16, 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.
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. “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.”
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 FAS 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 over-relied 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.

Appendix I: Summary of Key Events Associated with the Failure of Superior Bank

An abbreviated chronology of key events is described in table 1 below.  Some details have been left out to simplify what is a more complicated  story.  Readers should also keep in mind that ongoing investigations are  likely to provide additional details at a later date.

Summary:
What GAO Found

The Federal Deposit Insurance Corporation (FDIC) has projected that the failure of Superior Bank could cost the deposit insurance fund as much as $526 million. A major reason for the failure was Superior Bank's business strategy of originating and securing subprime loans on a large scale. In addition to the concentration in risky assets, the bank did not properly value and account for the interests that it had retained in pooled home mortgages. Superior's external auditor, Ernst & Young, also failed to detect the improper valuation of Superior's retained interest until the Office of Thrift Supervision (OTS) and FDIC insisted that the issue be reviewed by the auditor's national office. Federal regulators did not identify and act on the bank's problems early enough to prevent a loss to the deposit insurance fund. Both OTS and FDIC were aware of the substantial concentration of retained interests that Superior held, but they took little action because of the apparently high level of earnings, the apparently adequate capital, and the belief that the bank's management was conservatively managing the institution.