Superior Bank was formed in 1988 when the Coast-to-Coast Financial Corporation, a holding company owned equally by the Pritzker and Dworman families, acquired Lyons Savings, a troubled federal savings and loan association. From 1988 to 1992, Superior Bank struggled financially and relied heavily on an assistance agreement from the Federal Savings and Loan Insurance Corporation (FSLIC). Superior’s activities were limited during the first few years of its operation, but by 1992, most of the bank’s problems were resolved and the effects of the FSLIC agreement had diminished. OTS, the primary regulator of federally chartered savings institutions, had the lead responsibility for supervising Superior Bank while FDIC, with responsibility to protect the deposit insurance fund, acted as Superior’s backup regulator. By 1993, both OTS and FDIC had given Superior a composite CAMEL “2” rating and, at this time, FDIC began to rely only on off-site monitoring of superior. In 1993, Superior’s management began to focus on expanding the bank’s mortgage lending business by acquiring Alliance Funding Company. Superior adopted Alliance’s business strategy of targeting borrowers nationwide with risky credit profiles, such as high debt ratios and credit histories that included past delinquencies—a practice known as subprime lending. In a process known as securitization, Superior then assembled the loans into pools and sold interest in these pools—such as rights to principal and/or interest payments—through a trust to investors, primarily in the form of AAA-rated mortgage securities. To enhance the value of these offerings, Superior retained the securities with the greatest amount of risk and provided other significant credit enhancements for the less risky securities. In 1995, Superior expanded its activities to include the origination and securitization of subprime automobile loans. In December 1998, FDIC first raised concerns about Superior’s increasing levels of high-risk, subprime assets and growth in retained or residual interests. However, it was not until January 2000 that OTS and FDIC conducted a joint exam and downgraded Superior’s CAMELS rating to a “4,” primarily attributed to the concentration of residual interest holdings. At the end of 2000, FDIC and OTS noted that the reported values of Superior’s residual interest assets were overstated and that the bank’s reporting of its residual interest assets was not in compliance with the Statement of Financial Accounting Standards (FAS) No. 125. Prompted by concerns from OTS and FDIC, Superior eventually made a number of adjustments to its financial statements. In mid-February 2001, OTS issued a Prompt Corrective Action (PCA) notice to Superior because the bank was significantly undercapitalized. On May 24, OTS approved Superior’s PCA capital plan. Ultimately, the plan was never implemented, and OTS closed the bank and appointed FDIC as Superior’s receiver on July 27, 2001. (A detailed chronology of the events leading up to Superior’s failure is provided in App. I.) Primary responsibility for the failure of Superior Bank resides with its owners and managers. Superior’s business strategy of originating and securitizing subprime loans appeared to have led to high earnings, but more importantly its strategy resulted in a high concentration of extremely risky assets. This high concentration of risky assets and the improper valuation of these assets ultimately led to Superior’s failure. In 1993, Superior Bank began to originate and securitize subprime home mortgages in large volumes. Later, Superior expanded its securitization activities to include subprime automobile loans. Although the securitization process moved the subprime loans off its balance sheet, Superior retained the riskier interests in the proceeds from the pools of securities it established. Superior’s holdings of this retained interest exceeded its capital levels going as far back as 1995. Retained or residual interests are common in asset securitizations and often represent steps that the loan originator takes to enhance the quality of the interests in the pools that are offered for sale. Such enhancements can be critical to obtaining high credit ratings for the pool’s securities. Often, the originator will retain the riskiest components of the pool, doing so to make the other components easier to sell. The originator’s residual interests, in general, will represent the rights to cash flows or other assets after the pool’s obligations to other investors have been satisfied. Overcollateralization assets are another type of residual interest that Superior held. To decrease risk to investors, the originator may overcollateralize the securitization trust that holds the assets and is responsible for paying the investors. An originator can overcollateralize by selling the rights to $100 in principal payments, for instance, while putting assets worth $105 into the trust, essentially providing a cushion, or credit enhancement, to help ensure that the $100 due investors is paid in event of defaults in the underlying pool of loans (credit losses). The originator would receive any payments in excess of the $100 interest that was sold to investors after credit losses are paid from the overcollateralized portion. As shown in figure 1, Superior’s residual interests represented approximately 100 percent of tier 1 capital on June 30, 1995. By June 30, 2000, residual interest represented 348 percent of tier 1 capital. This level of concentration was particularly risky given the complexities associated with achieving a reasonable valuation of residual interests. Superior’s practice of targeting subprime borrowers increased its risk. By targeting borrowers with low credit quality, Superior was able to originate loans with interest rates that were higher than market averages. The high interest rates reflected, at least in part, the relatively high credit risk associated with these loans. When these loans were then pooled and securitized, their high interest rates relative to the interest rates paid on the resulting securities, together with the high valuation of the retained interest, enabled Superior to record gains on the securitization transactions that drove its apparently high earnings and high capital. A significant amount of Superior’s revenue was from the sale of loans in these transactions, yet more cash was going out rather than coming in from these activities. In addition to the higher risk of default related to subprime lending, there was also prepayment risk. Generally, if interest rates decline, a loan charging an interest rate that is higher than market averages becomes more valuable to the lender. However, lower interest rates could also trigger higher than predicted levels of loan prepayment—particularly if the new lower interest rates enable subprime borrowers to qualify for refinancing at lower rates. Higher-than-projected prepayments negatively impact the future flows of interest payments from the underlying loans in a securitized portfolio. Additionally, Superior expanded its loan origination and securitization activities to include automobile loans. The credit risk of automobile loans is inherently higher than that associated with home mortgages, because these loans are associated with even higher default and loss rates. Auto loan underwriting is divided into classes of credit quality (most commonly A, B, and C). Some 85 percent of Superior Bank’s auto loans went to people with B and C ratings. In Superior’s classification system, these borrowers had experienced credit problems in the past because of unusual circumstances beyond their control (such as a major illness, job loss, or death in the family) but had since resolved their credit problems and rebuilt their credit ratings to a certain extent. As with its mortgage securitizations, Superior Bank was able to maintain a high spread between the interest rate of the auto loans and the yield that investors paid for the securities based on the pooled loans. However, Superior’s loss rates on its automobile loans as of December 31, 1999 were twice as high as Superior’s management had anticipated. Superior Bank’s business strategy rested heavily on the value assigned to the residual interests that resulted from its securitization activities. However, the valuation of residual interests is extremely complex and highly dependent on making accurate assumptions regarding a number of factors. Superior overvalued its residual interests because it did not discount to present value the future cash flows that were subject to credit losses. When these valuations were ultimately adjusted, at the behest of the regulators, the bank became significantly undercapitalized and eventually failed. There are significant valuation issues and risks associated with residual interests. Generally, the residual interest represents the cash flows from the underlying mortgages that remain after all payments have been made to the other classes of securities issued by the trust for the pool, and after the fees and expenses have been paid. As the loan originator, Superior Bank was considered to be in the “first-loss” position (i.e., Superior would suffer any credit losses suffered by the pool, before any other investor.) Credit losses are not the only risks held by the residual interest holder. The valuation of the residual interest depends critically on how accurately future interest rates and loan prepayments are forecasted. Market events can affect the discount rate, prepayment speed, or performance of the underlying assets in a securitization transaction and can swiftly and dramatically alter their value. The Financial Accounting Standards Board (FASB) recognized the need for a new accounting approach to address innovations and complex developments in the financial markets, such as the securitization of loans. Under FAS No. 125, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities,” which became effective after December 31, 1996, when a transferor surrenders control over transferred assets, it should be accounted for as a sale. The transferor should recognize that any retained interest in the transferred assets should be reported in its statement of financial position based on the fair value. The best evidence of fair value is a quoted market price in an active market, but if there is no market price, the value must be estimated. In estimating the fair value of retained interests, valuation techniques include estimating the present value of expected future cash flows using a discount rate commensurate with the risks involved. The standard states that those techniques shall incorporate assumptions that market participants would use in their estimates of values, future revenues, and future expenses, including assumptions about interest rates, default, prepayment, and volatility. In 1999, FASB explained that when estimating the fair value for retained interests used as a credit enhancement, it should be discounted from the date when it is estimated to become available to the transferor. Superior Bank did not properly value the residual interest assets it reported on its financial statements. Since those assets represented payments that were to be received in the future only after credit losses were reimbursed, they needed to be discounted at an appropriate risk- adjusted rate, in order to recognize that a promise to pay in the future is worth less than a current payment. Superior did not use discounting when valuing its residual interest related to overcollateralization. However, as a credit enhancement, the overcollateralized asset is restricted in use under the trust and not available to Superior until losses have been paid under the terms of the credit enhancement. The result was that Superior Bank reported assets, earnings, and capital that were far in excess of their true values. In addition, there were other issues with respect to Superior’s compliance with FAS No. 125. When Superior finally applied the appropriate valuation techniques and related accounting to the residual interests in early 2001, at the urging of OTS, Superior was forced to take a write-off against its capital and became “significantly undercapitalized.” Federal regulators now have serious concerns about the quality of Ernst & Young’s audit of Superior Bank’s financial statements for the fiscal year ending June 30, 2000. This audit could have highlighted the problems that led to Superior Bank’s failure but did not. Regulators’ major concerns related to the audit include (1) the inflated valuation of residual interest in the financial statements and (2) the absence of discussion on Superior’s ability to continue in business in the auditor’s report. The accounting profession plays a vital role in the governance structure for the banking industry. In addition to bank examinations, independent certified public accountant audits are performed to express an opinion on the fairness of bank’s financial statements and to report any material This concept is reiterated in FASB’s A Guide to Implemention of Statement 125 on Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities: Questions and Answers, Issued July 1999 and revised September 1999. When estimating the fair value of credit enhancements (retained interest), the transferor’s assumptions should include the period of time that its use of the asset is restricted, reinvestment income, and potential losses due to uncertainties. One acceptable valuation technique is the “cash out” method, in which cash flows are discounted from the date that the credit enhancement becomes available. weaknesses in internal controls. Auditing standards require public accountants rendering an opinion on financial statements to consider the need to disclose conditions that raise a question about an entity’s ability to continue in business. Audits should provide useful information to federal regulators who oversee the banks, depositors, owners, and the public. When financial audits are not of the quality that meets auditing standards, this undermines the governance structure of the banking industry. Federal regulators believed that Ernst & Young auditors’ review of Superior’s valuation of residuals failed to identify the overvaluation of Superior’s residual interests in its fiscal year 2000 financial statements. Recognizing a significant growth in residual assets, federal regulators performed a review of Superior’s valuation of its residuals for that same year and found that it was not being properly reported in accordance with Generally Accepted Accounting Principles (GAAP). The regulators believed the incorrect valuation of the residuals had resulted in a significant overstatement of Superior’s assets and capital. Although Ernst & Young’s local office disagreed with the regulators findings, Ernst & Young’s national office concurred with the regulators. Subsequently, Superior revalued these assets resulting in a $270 million write-down of the residual interest value. As a result, Superior’s capital was reduced and Superior became significantly undercapitalized. OTS took a number of actions, but ultimately had to close Superior and appoint FDIC as receiver. An FDIC official stated that Superior had used this improper valuation technique not only for its June 30, 2000, financial statements, but also for the years 1995 through 1999. To the extent that was true, Superior’s earnings and capital were likely overstated during those years, as well. However, in each of those fiscal years, from 1995 through 2000, Superior received an unqualified, or “clean,” opinion from the Ernst & Young auditors. In Ernst & Young’s audit opinion, there was no disclosure of Superior’s questionable ability to continue as a going concern. Yet, 10 months after the date of Ernst & Young’s audit opinion on September 22, 2000, Superior Bank was closed and placed into receivership. Auditing standards provide that the auditor is responsible for evaluating “whether there is a substantial doubt about the entity's ability to continue as a going concern for a reasonable period of time.” This evaluation should be based on the auditor's “knowledge of relevant conditions and events that exist at or have occurred prior to the completion of fieldwork.” FDIC officials believe that the auditors should have known about the potential valuation issues and should have evaluated the "conditions and events" relating to Superior's retained interests in securitizations and the subsequent impact on capital requirements. FDIC officials also believe that the auditors should have known about the issues at the date of the last audit report, and there was a sufficient basis for the auditor to determine that there was “substantial doubt” about Superior's “ability to continue as a going concern for a reasonable period of time.” Because Ernst & Young auditors did not reach this conclusion in their opinion, FDIC has expressed concerns about the quality of the audit of Superior's fiscal year 2000 financial statements. FDIC has retained legal and forensic accounting assistance to conduct an investigation into the failure of Superior Bank. This investigation includes not only an examination of Superior’s lending and investment practices but also a review of the bank's independent auditors, Ernst & Young. It involves a thorough review of the accounting firm's audit of the bank's financial statements and role as a consultant and advisor to Superior on valuation issues. The major accounting and auditing issues in this review will include (1) an evaluation of the over-collateralized assets valuation as well as other residual assets, (2) whether “going concern” issues should have been raised had Superior Bank's financials been correctly stated, and (3) an evaluation of both the qualifications and independence of the accounting firm. The target date for the final report from the forensic auditor is May 1, 2002. OTS officials told us that they have opened a formal investigation regarding Superior’s failure and have issued subpoenas to Ernst & Young, among others. Our review of OTS’s supervision of Superior Bank found that the regulator had information, going back to the mid-1990s, that indicated supervisory concerns with Superior Bank’s substantial retained interests in securitized, subprime home mortgages and recognition that the bank’s soundness depended critically on the valuation of these interests. However, the high apparent earnings of the bank, its apparently adequate capital levels, and supervisory expectations that the ownership of the bank would provide adequate support in the event of problems appear to have combined to delay effective enforcement actions. Problems with communication and coordination between OTS and FDIC also created a delay in supervisory response after FDIC raised serious questions about the operations of Superior. By the time that the PCA directive was issued in February 2001, Superior’s failure was probably inevitable. As Superior’s primary regulator, OTS had the lead responsibility for monitoring the bank’s safety and soundness. Although OTS identified many of the risks associated with Superior’s business strategy as early as 1993, it did not exercise sufficient professional skepticism with respect to the “red flags” it identified with regards to Superior’s securitization activities. Consequently, OTS did not fully recognize the risk profile of the bank and thus did not address the magnitude of the bank’s problems in a timely manner. Specifically: OTS’s assessment of Superior’s risk profile was clouded by the bank’s apparent strong operating performance and higher-than-peer leverage capital; OTS relied heavily on management’s expertise and assurances; and OTS relied on the external audit reports without evaluating the quality of the external auditors’ review of Superior’s securitization activities. OTS’s ratings of Superior from 1993 through 1999 appeared to have been heavily influenced by Superior’s apparent high earnings and capital levels. Beginning in 1993, OTS had information showing that Superior was engaging in activities that were riskier than those of most other thrifts and merited close monitoring. Although neither subprime lending nor securitization is an inherently unsafe or unsound activity, both entail risks that bank management must manage and its regulator must consider in its examination and supervisory activities. While OTS examiners viewed Superior Bank’s high earnings as a source of strength, a large portion of these earnings represented estimated payments due sometime in the future and thus were not realized. These high earnings were also indicators of the riskiness of the underlying assets and business strategy. Moreover, Superior had a higher concentration of residual interest assets than any other thrift under OTS’s supervision. However, OTS did not take supervisory action to limit Superior’s securitization activities until after the 2000 examination. According to OTS’s Regulatory Handbook, greater regulatory attention is required when asset concentrations exceed 25 percent of a thrift’s core capital. As previously discussed, Superior’s concentration in residual interest securities equaled 100 percent of tier 1 capital in June 30, 1995 and grew to 348 percent of tier 1 capital in June 30, 2000. However, OTS’s examination reports during this period reflected an optimistic understanding of the implications for Superior Bank. The examination reports consistently noted that the risks associated with such lending and related residual interest securities were balanced by Superior’s strong earnings, higher-than-peer leverage capital, and substantial reserves for loan losses. OTS examiners did not question whether the ongoing trend of high growth and concentrations in subprime loans and residual interest securities was a prudent strategy for the bank. Consequently, the CAMELS ratings did not accurately reflect the conditions of those components. Superior’s business strategy as a lender to high-risk borrowers was clearly visible in data that OTS prepared comparing it to other thrifts of comparable size. Superior’s ratio of nonperforming assets to total assets in December 1998 was 233 percent higher than the peer group’s median. Another indicator of risk was the interest rate on the mortgages that Superior had made with a higher rate indicating a riskier borrower. In 1999, over 39 percent of Superior’s mortgages carried interest rates of 11 percent or higher. Among Superior’s peer group, less than 1 percent of all mortgages had interest rates that high. OTS’s 1997 examination report for Superior Bank illustrated the influence of Superior’s high earnings on the regulator’s assessment. The 1997 examination report noted that Superior’s earnings were very strong and exceeded industry averages. The report stated that the earnings were largely the result of large imputed gains from the sale of loans with high interest rates and had not been realized on a cash flow basis. Furthermore, the report recognized that changes in prepayment assumptions could negatively impact the realization of the gains previously recognized. Despite the recognition of the dependence of Superior’s earnings on critical assumptions regarding prepayment and actual loss rates, OTS gave Superior Bank the highest composite CAMELS rating, as well as the highest rating for four of the six CAMELS components—asset quality, management, earnings, and sensitivity to market risk—at the conclusion of its 1997 examination. OTS consistently assumed that Superior’s management had the necessary expertise to safely manage the complexities of Superior’s securitization activities. In addition, OTS relied on Superior’s management to take the necessary corrective actions to address the deficiencies that had been identified by OTS examiners. Moreover, OTS expected the owners of Superior’ to come to the bank’s financial rescue if necessary. These critical assumptions by OTS ultimately proved erroneous. From 1993 through 1999, OTS appeared to have had confidence in Superior’s management’s ability to safely manage and control the risks associated with its highly sophisticated securitization activities. As an illustration of OTS reliance on Superior’s management assurances, OTS examiners brought to management’s attention in the 1997 and 1999 examinations that underlying mortgage pools had prepayment rates exceeding those used in the revaluation. OTS examiners accepted management’s response that the prepayment rates observed on those subpools were abnormally high when compared with historical experience, and that they believed sufficient valuation allowances had been established on the residuals to prevent any significant changes to capital. It was not until the 2000 examination, when OTS examiners demanded supporting documentation concerning residual interests, that they were surprised to learn that such documentation was not always available. OTS’s optimistic assessment of the capability of Superior’s management continued through 1999. For example, OTS noted in its 1999 examination report that the weaknesses it had detected during the examination were well within the board of directors’ and management’s capabilities to correct. OTS relied on Superior Bank’s management and board of directors to take the necessary corrective action to address the numerous deficiencies OTS examiners identified during the 1993 through 1999 examinations. However, many of the deficiencies remained uncorrected even after repeated examinations. For example, OTS expressed concerns in its 1994 and 1995 examinations about the improper inclusion of reserves for the residual interest assets in the Allowance for Loan and Lease Losses. This practice had the net effect of overstating the institution’s total capital ratio. OTS apparently relied on management’s assurances that they would take the appropriate corrective action, because this issue was not discussed in OTS’s 1996, 1997, or 1999 examination reports. However, OTS discovered in its 2000 examination that Superior Bank had not taken the agreed-upon corrective action, but in fact had continued the practice. Similarly, OTS found in both its 1997 and 1999 examinations that Superior was underreporting classified or troubled loans in its Thrift Financial Reports (TFR). In the 1997 examination, OTS found that not all classified assets were reported in the TFR and obtained management’s agreement to ensure the accuracy of subsequent reports. In the 1999 examination, however, OTS found that $43.7 million in troubled assets had been shown as repossessions on the most recent TFR, although a significant portion of these assets were accorded a “loss” classification in internal reports. As a result, actual repossessions were only $8.4 million. OTS conducted a special field visit to examine the auto loan operations in October 1999, but the review focused on the classification aspect rather than the fact that management had not been very conservative in charging-off problem auto credits, as FDIC had pointed out. OTS also appeared to have assumed that the wealthy owners of Superior Bank would come to the bank’s financial rescue when needed. The 2000 examination report demonstrated OTS’s attitude towards its supervision of Superior by stating that failure was not likely due to the institution’s overall strength and financial capacity and the support of the two ownership interests comprised of the Alvin Dworman and Jay Pritzker families. OTS’s assumptions about the willingness of Superior’s owners not to allow the institution to fail were ultimately proven false during the 2001 negotiations to recapitalize the institution. As a result, the institution was placed into receivership. OTS also relied on the external auditors and others who were reporting satisfaction with Superior’s valuation method. In previous reports, GAO has supported having examiners place greater reliance on the work of external auditors in order to enhance supervisory monitoring of banks. Some regulatory officials have said that examiners may be able to use external auditors’ work to eliminate certain examination procedures from their examinations—for example, verification or confirmation of the existence and valuation of institution assets such as loans, derivative transactions, and accounts receivable. The officials further said that external auditors perform these verifications or confirmations routinely as a part of their financial statement audits. But examiners rarely perform such verifications because they are costly and time consuming. GAO continues to believe that examiners should use external auditors’ work to enhance the efficiency of examinations. However, this reliance should be predicated on the examiners’ obtaining reasonable assurance that the audits have been performed in a quality manner and in accordance with professional standards. OTS’s Regulatory Handbook recognizes the limitations of examiners’ reliance on external auditors, noting that examiners “may” rely on an external auditor’s findings in low-risk areas. However, examiners are expected to conduct more in-depth reviews of the external auditor’s work in high-risk areas. The handbook also suggests that a review of the auditor’s workpapers documenting the assumptions and methodologies used by the institution to value key assets could assist examiners in performing their examinations. In the case of Superior Bank, the external auditor, Ernst & Young, one of the “Big Five” accounting firms, provided unqualified opinions on the bank’s financial statements for years. In a January 2000 meeting with Superior Bank’s Audit Committee to report the audit results for the fiscal year ending June 30, 1999, Ernst & Young noted that “after running their own model to test the Bank’s model, Ernst & Young believes that the overall book values of financial receivables as recorded by the Bank are reasonable considering the Bank’s overall conservative assumptions and methods.” Not only did Ernst & Young not detect the overvaluation of Superior’s residual interests, the firm explicitly supported an incorrect valuation until, at the insistence of the regulators, the Ernst &Young office that had conducted the audit sought a review of its position on the valuation by its national office. Ultimately, it was the incorrect valuation of these assets that led to the failure of Superior Bank. Although the regulators recognized this problem before Ernst & Young, they did not do so until the problem was so severe that the bank’s failure was inevitable. FDIC raised serious concerns about Superior’s operations at the end of 1998 based on its off-site monitoring and asked that an FDIC examiner participate in the examination of the bank that was scheduled to start in January 1999. At that time, OTS rated the institution a composite “1.” Although FDIC’s 1998 off-site analysis began the identification of the problems that led to Superior’s failure, FDIC had conducted similar off-site monitoring in previous years that did not raise concerns. During the late 1980s and early 1990s, FDIC examined Superior Bank several times because it was operating under an assistance agreement with FSLIC. However, once Superior’s condition stabilized and its composite rating was upgraded to a “2” in 1993, FDIC’s review was limited to off-site monitoring. In 1995, 1996, and 1997, FDIC reviewed the annual OTS examinations and other material, including the bank’s supervisory filings and audited financial statements. Although FDIC’s internal reports noted that Superior’s holdings of residual assets exceeded its capital, they did not identify these holdings as concerns. FDIC’s interest in Superior Bank was heightened in December 1998 when it conducted an off-site review, based on September 30, 1998 financial information. During this review, FDIC noted—with alarm—that Superior Bank exhibited a high-risk asset structure. Specifically, the review noted that Superior had significant investments in the residual values of securitized loans. These investments, by then, were equal to roughly 150 percent of its tier 1 capital. The review also noted that significant reporting differences existed between the bank’s audit report and its quarterly financial statement to regulators, that the bank was a subprime lender, and had substantial off-balance sheet recourse exposure. As noted earlier, however, the bank’s residual assets had been over 100 percent of capital since 1995. FDIC had been aware of this high concentration and had noted it in the summary analyses of examination reports that it completed during off-site monitoring, but FDIC did not initiate any additional off-site activities or raise any concerns to OTS until after a 1998 off-site review that it performed. Although current guidance would have imposed limits at 25 percent, there was no explicit direction to the bank’s examiners or analysts on safe limits for residual assets. However, Superior was clearly an outlier, with holdings substantially greater than peer group banks. In early 1999, FDIC’s additional off-site monitoring and review of OTS’s January 1999 examination report—in which OTS rated Superior a “2”— generated additional concerns. As a result, FDIC officially downgraded the bank to a composite “3” in May 1999, triggering higher deposit insurance premiums under the risk-related premium system. According to FDIC and OTS officials, FDIC participated fully in the oversight of Superior after this point. Communication between OTS and FDIC related to Superior Bank was a problem. Although the agencies worked together effectively on enforcement actions (discussed below), poor communication seems to have hindered coordination of supervisory strategies for the bank. The policy regarding FDIC’s participation in examinations led by other federal supervisory agencies was based on the “anticipated benefit to FDIC in its deposit insurer role and risk of failure the involved institution poses to the insurance fund.” This policy stated that any back-up examination activities must be “consistent with FDIC’s prior commitments to reduce costs to the industry, reduce burden, and eliminate duplication of efforts.” “The FDIC’s written request should demonstrate that the institution represents a potential or likely failure within a one year time frame, or that there is a basis for believing that the institution represents a greater than normal risk to the insurance fund and data available from other sources is insufficient to assess that risk.” “The FDIC’s off-site review noted significant reporting differences between the bank’s audit report and its quarterly financial statement to regulators, increasing levels of high-risk, subprime assets, and growth in retained interests and mortgage servicing assets.” Because of these concerns, FDIC regional staff called OTS regional staff and discussed having an FDIC examiner participate in the January 1999 examination of Superior Bank. OTS officials, according to internal e-mails, were unsure it they should agree to FDIC’s participation. Ongoing litigation between FDIC and Superior and concern that Superior’s “poor opinion” of FDIC would “jeopardize working relationship” with Superior were among the concerns expressed in the e-mails. OTS decided to wait for a formal, written FDIC request to see if it “convey a good reason” for wanting to join in the OTS examination. OTS and FDIC disagree on what happened next. FDIC officials told us that they sent a formal request to the OTS regional office asking that one examiner participate in the next scheduled examination but did not receive any response. OTS officials told us that they never received any formal request. FDIC files do contain a letter, but there is no way to determine if it was sent or lost in transit. This letter, dated December 28, 1998, noted areas of concern as well as an acknowledgment that Superior’s management was well regarded, and that the bank was extremely profitable and considered to be “well-capitalized.” OTS did not allow FDIC to join their exam, but did allow its examiners to review work papers prepared by OTS examiners. Again, the two agencies disagree on the effectiveness of this approach. FDIC’s regional staff has noted that in their view this arrangement was not satisfactory, since their access to the workpapers was not sufficiently timely to enable them to understand Superior’s operations. OTS officials told us that FDIC did not express any concerns with the arrangement and were surprised to receive a draft memorandum from FDIC’s regional office proposing that Superior’s composite rating be lowered to a “3,” in contrast to the OTS region’s proposed rating of “2.” However, by September 1999, the two agencies had agreed that FDIC would participate in the next examination, scheduled for January 2000. In the aftermath of Superior’s failure and the earlier failure of Keystone National Bank, both OTS and FDIC have participated in an interagency process to clarify FDIC’s role, responsibility, and authority to participate in examinations as the “backup” regulator. In both bank failures, FDIC had asked to participate in examinations, but the lead regulatory agency (OTS in the case of Superior and the Office of the Comptroller of the Currency in the case of Keystone) denied the request. On January 29, 2002, FDIC announced an interagency agreement that gives it more authority to enter banks supervised by other regulators. While this interagency effort should lead to a clearer understanding among the federal bank supervisory agencies about FDIC’s participation in the examinations of and supervisory actions taken at open banks, it is important to recognize that at the time that FDIC asked to join in the 1999 examination of Superior Bank, there were policies in place that should have guided its request and OTS’s decision on FDIC’s participation. As such, how the new procedures are implemented is a critical issue. Ultimately, coordination and cooperation among federal bank supervisors depend on communication among these agencies, and miscommunication plagued OTS and FDIC at a time when the two agencies were just beginning to recognize the problems that they confronted at Superior Bank. As a consequence of the delayed recognition of problems at Superior Bank, enforcement actions were not successful in containing the loss to the deposit insurance fund. Once the problems at Superior Bank had been identified, OTS took a number of formal enforcement actions against Superior Bank starting on July 5, 2000. These actions included a PCA directive. There is no way to know if earlier detection of the problems at Superior Bank, particularly the incorrect valuation of the residual assets, would have prevented the bank’s ultimate failure. However, earlier detection would likely have triggered enforcement actions that could have limited Superior’s growth and asset concentration and, as a result, the magnitude of the loss to the insurance fund. Table 2 describes the formal enforcement actions. (Informal enforcement actions before July 2000 included identifying “actions requiring board attention” in the examination reports, including the report dated Jan. 24, 2000.) The first action, the “Part 570 Safety and Soundness Action,”followed the completion of an on-site examination that began in January 2000, with FDIC participation. That formally notified Superior’s Board of Directors of deficiencies and required that the board take several actions, including: developing procedures to analyze the valuation of the bank’s residual interests, including obtaining periodic independent valuations; developing a plan to reduce the level of residual interests to 100 percent of the bank’s Tier 1 or core capital within 1 year; addressing issues regarding the bank’s automobile loan program; and revising the bank’s policy for allowances for loan losses and maintaining adequate allowances. On July 7, 2000, OTS also officially notified Superior that it had been designated a “problem institution.” This designation placed restrictions on the institution, including on asset growth. Superior Bank submitted a compliance plan, as required, on August 4, 2000. Due to the amount of time that Superior and OTS took in negotiating the actions required, this plan was never implemented, but it did serve to get Superior to cease its securitization activities. While Superior and OTS were negotiating over the Part 570 plan, Superior adjusted the value of its residual interests with a $270 million write-down. This, in turn, led to the bank’s capital level falling to the “significantly undercapitalized” category, triggering a PCA directive that OTS issued on February 14, 2001. The PCA directive required the bank to submit a capital restoration plan by March 14, 2001. Superior Bank, now with new management, submitted a plan on that date, that, after several amendments (detailed in the chronology in app. I), OTS accepted on May 24, 2001. That plan called for reducing the bank’s exposure to its residual interests and recapitalizing the bank with a $270 million infusion from the owners. On July16, 2001, however, the Pritzker interests, one of the two ultimate owners of Superior Bank, advised OTS that they did not believe that the capital plan would work and therefore withdrew their support. When efforts to change their position failed, OTS appointed FDIC as conservator and receiver of Superior. Although a PCA directive was issued when the bank became “significantly undercapitalized,” losses to the deposit insurance fund were still substantial. The reasons for this are related to the design of PCA itself. First, under PCA, capital is a key factor in determining an institution’s condition. Superior’s capital did not fall to the “significantly undercapitalized” level until it corrected its flawed valuation of its residual interests. Incorrect financial reporting, such as was the case with Superior Bank, will limit the effectiveness of PCA because such reporting limits the regulators’ ability to accurately measure capital. Second, PCA’s current test for “critically undercapitalized,” is based on the tangible equity capital ratio, which does not use a risk-based capital measure. Thus it only includes on-balance sheet assets and does not fully encompass off-balance sheet risks, such as those presented in an institution’s securitization activities. Therefore, an institution might become undercapitalized using the risk-based capital ratio but would not fall into the “critically undercapitalized” PCA category under the current capital measure. “PCA is tied to capital levels and capital is a lagging indicator of financial problems. It is important that regulators continue to use other supervisory and enforcement tools, to stop unsafe and unsound practices before they result in losses, reduced capital levels, or failure.” Further, PCA implicitly contemplates that a bank’s deteriorating condition and capital would take place over time. In some cases, problems materialize rapidly, or as in Superior’s case, long-developing problems are identified suddenly. In such cases, PCA’s requirements for a bank plan to address the problems can potentially delay other more effective actions. It is worth noting that while Section 38 uses capital as a key factor in determining an institution’s condition, Section 39 gives federal regulators the authority to establish safety and soundness related management and operational standards that do not rely on capital, but could be used to bring corrective actions before problems reach the capital account. The failure of Superior Bank illustrates the possible consequences when banking supervisors do not recognize that a bank has a particularly complex and risky portfolio. Several other recent failures provide a warning that the problems seen in the examination and supervision of Superior Bank can exist elsewhere. Three other banks, BestBank, Keystone Bank, and Pacific Thrift and Loan (PTL), failed and had characteristics that were similar in important aspects to Superior. These failures involved FDIC (PTL and BestBank) and the Office of the Comptroller of the Currency (Keystone). BestBank was a Colorado bank that closed in 1998, costing the insurance fund approximately $172 million. Like Superior, it had a business strategy to target subprime borrowers, who had high delinquency rates. BestBank in turn reported substantial gains from these transactions in the form of fee income. The bank had to close because it falsified its accounting records regarding delinquency rates and subsequently was unable to absorb the estimated losses from these delinquencies. Keystone, a West Virginia bank, failed in 1999, costing the insurance fund approximately $800 million. While fraud committed by the bank management was the most important cause of its failure, Keystone’s business strategy was similar to Superior’s and led to some similar problems. In 1993, Keystone began purchasing and securitizing Federal Housing Authority Title I Home Improvement Loans that were originated throughout the country. These subprime loans targeted highly leveraged borrowers with little or no collateral. The securitization of subprime loans became Keystone’s main line of business and contributed greatly to its apparent profitability. The examiners, however, found that Keystone did not record its residual interests in these securitizations until September 1997, several months after FAS No. 125 took effect. Furthermore, examiners found the residual valuation model deficient, and Keystone had an unsafe concentration of mortgage products. PTL was a California bank that failed in 1999, costing the insurance fund approximately $52 million. Like Superior Bank, PTL entered the securitization market by originating loans for sale to third-party securitizing entities. While PTL enjoyed high asset and capital growth rates, valuation was an issue. Also, similar to Superior Bank, the examiners over-relied on external auditors in the PTL case. According to the material loss review, Ernst & Young, PTL’s accountant, used assumptions that were unsupported and optimistic. An abbreviated chronology of key events is described in table 1 below. Some details have been left out to simplify what is a more complicated story. Readers should also keep in mind that ongoing investigations are likely to provide additional details at a later date.

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