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81–953 PDF 2002

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

(

COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

PAUL S. SARBANES, Maryland, Chairman

CHRISTOPHER J. DODD, Connecticut

TIM JOHNSON, South Dakota

JACK REED, Rhode Island

CHARLES E. SCHUMER, New York

EVAN BAYH, Indiana

ZELL MILLER, Georgia

THOMAS R. CARPER, Delaware

DEBBIE STABENOW, Michigan

JON S. CORZINE, New Jersey

DANIEL K. AKAKA, Hawaii

PHIL GRAMM, Texas

RICHARD C. SHELBY, Alabama

ROBERT F. BENNETT, Utah

WAYNE ALLARD, Colorado

MICHAEL B. ENZI, Wyoming

CHUCK HAGEL, Nebraska

RICK SANTORUM, Pennsylvania

JIM BUNNING, Kentucky

MIKE CRAPO, Idaho

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)

CONTENTS

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)

(1)

ANALYSIS OF THE FAILURE OF

SUPERIOR BANK, FSB, HINSDALE, ILLINOIS

THURSDAY, FEBRUARY 7, 2002

U.S. SENATE, COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS, Washington, DC.

The Committee met at 10:40 a.m., in room SD–538 of the Dirksen Senate Office Building, Senator Paul S. Sarbanes (Chairman of

the Committee) presiding.

OPENING STATEMENT OF CHAIRMAN PAUL S. SARBANES

Chairman SARBANES. Let me call this hearing to order.

First of all, I want to thank our witnesses for their patience. We

obviously have no control over this situation.

The vote was supposed to be at 5 minutes after 10 a.m. So, I

thought we will begin the hearing after the vote, which seemed to

make the most sense. The vote then got delayed somewhat, so it

is a little later than would otherwise have been the case. But I do

think we now have an uninterrupted period ahead of us. So, I

think we will be able to carry this hearing through to completion.

I certainly hope so.

This morning, the Committee holds another hearing on the failure of Superior Bank, an insured depository institution. We are

very pleased to have as our witnesses this morning: Jeffrey Rush,

Jr., the Inspector General of the U.S. Department of the Treasury;

Gaston Gianni, Jr., Inspector General of the Federal Deposit Insurance Corporation; and Thomas McCool, the Managing Director for

Financial Markets and Community Investments of the General Accounting Office, GAO.

Our witnesses will present their respective analyses of the causes

of Superior’s failure and offer their recommendations for preventing similar occurrences in the future.

The Committee completed its first hearing on the failure of Superior on October 16. Actually, it was scheduled for the morning of

September 11 and, in fact, began that morning, I, operating on the

premise that we were not going to let the terrorists close down the

Government of the United States. Twenty minutes later, the Capitol police showed up and threw us out of the hearing room and

said, you would better get out of the Capitol complex.

At the resumed hearing on October 16, we received testimony

from the regulators, Ellen Seidman, Director of the Office of Thrift

Supervision, and John Reich, Board Member of the FDIC, and also

from three private-sector financial experts: Bert Ely, Professor

George Kaufman, and Karen Shaw Petrou.

2

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 In- surance 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

3

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 $421⁄2 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

4

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 highrisk 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.

5

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.

6

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

7

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

8

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 reVerDate 11-MAY-2000 08:43 Oct 07, 2002 Jkt 000000 PO 00000 Frm 00012 Fmt 6633 Sfmt 6633 0207.TXT SBANK4 PsN: SBANK4
9

cent 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 securitization. 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 CurVerDate 11-MAY-2000 08:43 Oct 07, 2002 Jkt 000000 PO 00000 Frm 00013 Fmt 6633 Sfmt 6633 0207.TXT SBANK4 PsN: SBANK4
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rency, 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.

11

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 securitization 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.

12

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

13

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 tripwires 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.

14

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

15

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

16

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?

17

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

18

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

19

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 semiannual 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.]

20

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 reguVerDate 11-MAY-2000 08:43 Oct 07, 2002 Jkt 000000 PO 00000 Frm 00024 Fmt 6633 Sfmt 6633 0207.TXT SBANK4 PsN: SBANK4
21

lators 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

22

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 finanVerDate 11-MAY-2000 08:43 Oct 07, 2002 Jkt 000000 PO 00000 Frm 00026 Fmt 6633 Sfmt 6633 0207.TXT SBANK4 PsN: SBANK4
23

cial. 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.

24

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.

25

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

26

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

27

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:]

28

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

29

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

30

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 auto- mobile 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.

31

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.

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• 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 conVerDate 11-MAY-2000 08:43 Oct 07, 2002 Jkt 000000 PO 00000 Frm 00036 Fmt 6633 Sfmt 6621 0207.TXT SBANK4 PsN: SBANK4
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centration 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

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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 ne- cessitate 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

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paying excessive bonuses to senior officers. Between March and July 2001, a total

of $220,000 in bonuses had been paid to 10 senior executives. An OTS official said

he had not been aware of the bonuses.

We also reported that the PCA restrictions over the use of brokered deposits

might warrant regulatory review. These PCA restrictions serve to curb or reverse

growth, and thus risk, by limiting an institution’s funding sources. For Superior,

these restrictions were automatically triggered in 2000. However, the intended restriction did not appear particularly effective. Int June 2000, brokered deposits totaled $367.2 million, and dropped to $80.9 million by June 2001, a month before it’s closing. Insured deposits in June 2000 totaled $1.1 billion and by June 2001 totaled

$1.5 billion, effectively replacing the drop in brokered deposits. Although Superior’s replacement of brokered deposits with retail insured deposits was within the technical rules of the regulation, we believe the process was not within the intent, particularly with respect to FDIC’s potential costs in resolving failures, and curbing

growth.

Status of Ongoing Audit and Investigation

We conducted our review of Superior in accordance with generally accepted Government auditing standards. However, we were unable to fully assess certain aspects of OTS’s supervision of Superior. This was due to delays in getting access to

documents obtained through 24 subpoenas issued by OTS after July 27, 2001. It is

our intention to review these documents and to issue a separate report.

We are also currently working with the Office of Inspector General, Federal Deposit Insurance Corporation, and the United States Attorney of the Northern District of Illinois, to determine whether there were any violations of Federal law in

connection with the failure of Superior. We will report on the result of that work

at an appropriate time.

Mr. Chairman, this concludes my prepared statement. I would be pleased to respond to any questions you or the other Members of the Committee may have.

—————

PREPARED STATEMENT OF GASTON L. GIANNI, JR.

INSPECTOR GENERAL, FEDERAL DEPOSIT INSURANCE CORPORATION

FEBRUARY 7, 2002

Mr. Chairman, and Members of the Committee, I appreciate the opportunity to

appear before this Committee today on the July 2001 failure of Superior Bank, Federal Savings Bank (Superior). My office has prepared a full report providing answers to the nine topics you asked us to address concerning this failure. That report

has been provided for the record. In accordance with the Federal Deposit Insurance

Act, the Office of Thrift Supervision (OTS) was the Primary Federal Regulator for

Superior, responsible for such activities as performing examinations of the safety

and soundness of the bank. The Federal Deposit Insurance Corporation’s (FDIC)

responsibilities included providing deposit insurance and exercising its special

examination authority. The scope of our review included an analysis of Superior’s

operations from 1991 until its failure on July 27, 2001. We also evaluated the regulatory supervision of the institution over the same time period.

For purposes of our testimony, our responses to the nine topics you raised are

summarized into four key concerns: Why did this bank fail? What was the role of

the principal auditor? What did the regulators do? Why did this failure result in

such a large loss to the deposit insurance fund? We will also provide the Committee

with the status of the FDIC’s resolution of the failed Superior Bank.

Background

By way of background, it is helpful to understand the following information about

the nature of Superior’s organization, its principal business activity, and the financial outcome of that activity.

Superior was owned by two family interests through a series of holding companies, including Coast-to-Coast Financial Corporation (CCFC). As a Federally chartered thrift, Superior operated across all State lines. In December 1992, CCFC

merged a mortgage banking entity, Alliance Funding Company, Inc., with Superior

to expand Superior’s mortgage lending business. Alliance specialized in ‘‘subprime’’

lending, that is, it originated first and second home mortgage loans to borrowers

whose credit was below standard, perhaps because of a history of late payments or

filing of personal bankruptcy.

After the merger with Alliance, Superior began generating subprime mortgages

for resale, a process commonly referred to as securitization. Through this process,

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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

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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:

38

• 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

39

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.

40

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.

41

1The 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.

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.

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.

42

2The Pritzkers are the owners of the Hyatt Hotels, and the Dwormans are prominent New

York real estate developers. 3This 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.) 4OTS 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.

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 ac- quired 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.

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 re- ceiver 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

43

5These interests are known as residuals because they receive the last cashflows from the

loans. 6Tier 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.

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.

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.

44

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,

45

7SFAS No. 140: Accounting for Transfers and Servicing of Financial Assets and

Extinguishments of Liabilities, issued September 2000, replaced SFAS No. 125. 8This 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.

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

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

46

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 offiVerDate 11-MAY-2000 08:43 Oct 07, 2002 Jkt 000000 PO 00000 Frm 00050 Fmt 6633 Sfmt 6621 0207.TXT SBANK4 PsN: SBANK4
47

9Section 211, Asset Quality—Loan Portfolio Diversification, OTS Regulatory Handbook, January 1994.

cials 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.

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

48

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.

49

10Section 350, Independent Audit, OTS Regulatory Handbook, January 1994. 11The ‘‘Big Five’’ accounting firms are Andersen LLP, Deloitte & Touche LLP, Ernst & Young

LLP, KPMG LLP, and PricewaterhouseCoopers LLP.

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.

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 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 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 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 signifiVerDate 11-MAY-2000 08:43 Oct 07, 2002 Jkt 000000 PO 00000 Frm 00053 Fmt 6633 Sfmt 6621 0207.TXT SBANK4 PsN: SBANK4
50

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. § 1820(b) (2000). 13OTS Memorandum to Regional Directors from John F. Downey, Director of Supervision, Regarding FDIC Participation on Examinations, April 5, 1995. 14Statement 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.

cant 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 ‘‘con- sistent with FDIC’s prior commitments to reduce costs to the industry, reduce burden, and eliminate duplication of efforts.’’ 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:

‘‘The FDIC’s written request should demonstrate that the institution represents a potential or likely failure within a 1 year time frame, or that

there is a basis for believing that the institution represents a greater than

normal risk to the insurance fund and data available from other sources is

insufficient to assess that risk.’’

As testimony before this Committee last fall documented, FDIC’s off-site review

in 1998 was the first time that serious questions had been raised about Superior

Bank’s strategy and finances. As FDIC Director John Reich testified,

‘‘The FDIC’s off-site review noted significant reporting differences between

the bank’s audit report and its quarterly financial statement to regulators,

increasing levels of high-risk, subprime assets, and growth in retained interests and mortgage servicing assets.’’ 14

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 offiVerDate 11-MAY-2000 08:43 Oct 07, 2002 Jkt 000000 PO 00000 Frm 00054 Fmt 6633 Sfmt 6621 0207.TXT SBANK4 PsN: SBANK4
51

15 12 C.F.R. Part 570.

cials 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:

• 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,

52

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. 17Section 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. § 1831o) 18On February 14, 2001, OTS also issued two consent orders against Superior’s holding companies.

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.

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

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.

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

53

19 Bank and Thrift Regulation: Implementation of FDICIA’s Prompt Regulatory Action Provisions, Nov. 1996, GAO/GGD–97–18, page 71.

and enforcement tools, to stop unsafe and unsound practices before they result in losses, reduced capital levels, or failure.’’ 19

Further, PCA implicitly contemplates that a bank’s deteriorating condition and

capital would take place over time. In some cases, problems materialize rapidly, or

as in Superior’s case, long-developing problems are identified suddenly. In such

cases, PCA’s requirements for a bank plan to address the problems can potentially

delay other more effective actions.

It is worth noting that while Section 38 uses capital as a key factor in determining an institution’s condition, Section 39 gives Federal regulators the authority

to establish safety and soundness related management and operational standards

that do not rely on capital, but could be used to bring corrective actions before problems reach the capital account.

Similar Problems Had Occurred in Some Previous Bank Failures

The failure of Superior Bank illustrates the possible consequences when banking

supervisors do not recognize that a bank has a particularly complex and risky portfolio. Several other recent failures provide a warning that the problems seen in the

examination and supervision of Superior Bank can exist elsewhere. Three other

banks, BestBank, Keystone Bank, and Pacific Thrift and Loan (PTL), failed and had

characteristics that were similar in important aspects to Superior. These failures involved FDIC (PTL and BestBank) and the Office of the Comptroller of the Currency

(Keystone).

BestBank was a Colorado bank that closed in 1998, costing the insurance fund

approximately $172 million. Like Superior, it had a business strategy to target

subprime borrowers, who had high delinquency rates. BestBank in turn reported

substantial gains from these transactions in the form of fee income. The bank had

to close because it falsified its accounting records regarding delinquency rates and

subsequently was unable to absorb the estimated losses from these delinquencies.

Keystone, a West Virginia bank, failed in 1999, costing the insurance fund approximately $800 million. While fraud committed by the bank management was the

most important cause of its failure, Keystone’s business strategy was similar to Superior’s and led to some similar problems. In 1993, Keystone began purchasing and

securitizing Federal Housing Authority Title I Home improvement Loans that were

originated throughout the country. These subprime loans targeted highly leveraged

borrowers with little or no collateral. The securitization of subprime loans became

Keystone’s main line of business and contributed greatly to its apparent profitability. The examiners, however, found that Keystone did not record its residual interests in these securitizations until September 1997, several months after SFAS

No. 125 took effect. Furthermore, examiners found the residual valuation model deficient, and Keystone had an unsafe concentration of mortgage products.

PTL was a California bank that failed in 1999, costing the insurance fund approximately $52 million. Like Superior Bank PTL entered the securitization market

by originating loans for sale to third-party securitizing entities. While PTL enjoyed

high asset and capital growth rates, valuation was an issue. Also, similar to Superior Bank, the examiners overrelied on external auditors in the PTL case. According

to the material loss review, Ernst & Young, PTL’s accountant, used assumptions

that were unsupported and optimistic.

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