Hearing on "Analysis of the Failure of Superior Bank, FSB, Hinsdale, Illinois."

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.

By way of background, it is helpful to understand the following information about the nature of Superior’s organization, its principal business activity, and the financial outcome of that activity.

Superior was owned by two family interests through a series of holding companies, including Coast-to-Coast Financial Corporation (CCFC). As a federally chartered thrift, Superior operated across all state lines. In December 1992, CCFC merged a mortgage banking entity, Alliance Funding Company, Inc., with Superior to expand Superior’s mortgage lending business. Alliance specialized in "subprime" lending, that is, it originated first and second home mortgage loans to borrowers whose credit was below standard, perhaps because of a history of late payments or filing of personal bankruptcy.

After the merger with Alliance, Superior began generating subprime mortgages for resale, a process commonly referred to as securitization. Through this process, loans were assembled into pools and eventually sold to investors primarily in the form of highly rated mortgage securities. To attain high ratings, Superior had to offer credit enhancements. To explain, these enhancements protected investors from losses if the cash flows 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.

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.

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. However, Superior’s Board and management did not heed the regulators. Superior continued to decline to a point that it was

determined to be undercapitalized by the end of 2000 and write-downs of residual assets totaling $420 million were required to more accurately portray their fair value.

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 cash flow 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 cash flows 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.

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.

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 Bboard of Ddirectors or executive management. These recommendations included:

• placing limits on residual assets,
• establishing a dividend policy that reflects the possibility that estimated gains may not materialize,
• correcting capital calculations,
• writing down the value of various assets, and
• correcting erroneous data contained in Thrift Financial Reports to the OTS.

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 non-audit 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’’s 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 due care 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.

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.

While OTS examination reports identified many of the bank’s problems early on, OTS did not adequately follow-up and investigate the problems – particularly the residual assets carried by the bank. Also, the numerous recommendations contained in various OTS examination reports beginning in 1993 were not addressed by Superior’s management and did not receive further attention from the OTS. These issues included placing limits on residual assets, establishing a dividend policy with consideration given to the imputed but unrealized gains from the residual assets, errors in the calculation of the Allowance for Loan and Lease Losses, and Thrift Financial Report errors.

OTS appeared to rely mostly on representations made by the bank and validated by its outside auditors. Also, OTS placed undue reliance on the ability of the owners of the bank’s holding company to inject capital if it was ever needed. However, when an injection of capital was needed in 2001, the owners did not provide the necessary capital as they agreed to do in the OTS-approved recapitalization plan. Warning signs were evident for many years, yet no formal supervisory action was taken until July 2000, which ultimately proved too late. More timely action could potentially have avoided at least some of the ultimate loss.

Our review of examination reports dating back to 1993 indicated that OTS did not fully analyze and assess the potential risk that gains on securitization transactions presented to earnings and to assets of the institution. While OTS identified the volume of gains recorded and noted that the gains were unrealized and subject to change, they did not analyze and assess the bank’s performance without those gains or on a realized cash flow basis.

Coordination between regulators could have been better. OTS denied the FDIC’s initial request to participate in the regularly scheduled January 1999 safety and soundness examination, delaying any FDIC examiner on-site presence for approximately 1 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.

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.

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.

The FDIC Board of Directors determined that a conservatorship would be the least cost alternative for the Savings Association Insurance Fund. This decision was made, in part, because the FDIC did not have sufficient information to develop other possible resolution alternatives. The FDIC’s access to Superior was limited partly based on the fact that Superior’s owners were in the process of implementing an OTS-approved capital restoration plan purported to address Superior’s capital problems. Superior’s owners did not implement the approved plan, and OTS notified Superior of its critically undercapitalized condition 1 day prior to consideration of the Failing Bank Case for Superior by the FDIC Board of Directors. Consequently, complete information on a range of resolution alternatives was not available to the FDIC to make the least cost decision for Superior’s resolution.

The FDIC has made progress in preparing remaining assets in the receivership for sale and most sales efforts should be completed in the second quarter of 2002. We are continuing to track the FDIC’s progress.

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.

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 1990s, 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.

Lastly, 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.

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