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.