Federal Deposit Insurance Corporation
Office of Audits
Office of Inspector General
Washington, D.C. 20434

February 6, 2002

The Honorable Paul S. Sarbanes
Chairman, Committee on Banking,
Housing, and Urban Affairs
United States Senate
Washington, D.C. 20510

Dear Mr. Chairman:

In response to your August 1, 2001 request, my office has completed a review of issues related to the failure of Superior Bank, FSB. Our report provides an independent assessment of Superior Bank’s failure and includes responses to the nine specific topics you raised in your request letter.

The failure of Superior Bank was directly attributable to bank management and the board of directors ignoring sound risk management principles and failing to adequately oversee Superior operations. Specifically, these bank officials:

• permitted the institution to concentrate its business too heavily in high-risk assets (residual assets resulting from Superior’s securitizing or reselling loans, a detailed explanation of which is provided in our report) without maintaining adequate financial resources to withstand potential losses;

• used unrealistic and overly optimistic assumptions to record the value of residual assets in the institution’s accounting records;

• supported liberal interpretations of accounting principles that enabled the institution to recognize enormous gains on sales of residual assets and report impressive net income figures that masked the net operating losses the institution was actually experiencing; and

• paid dividends and executed other transactions that benefited Superior’s holding company but further depleted the institution’s capital.

Superior’s external auditors, Ernst &Young (E&Y), rendered unqualified opinions every year from 1990 through 2000 and supported the bank’s valuations of residual assets and its methodology for calculating gains on sales of those assets. Even after the regulators began questioning the valuations in January 2000, the firm steadfastly maintained that the bank was properly valuing the assets in accordance with accounting principles. It was not until 1 year later that E&Y reversed its position and agreed with the regulators’ opinion that the value of the residual assets should be adjusted to comply with those same principles—requiring a $270 million reduction in the bank’s accounting records. The regulators later identified $150 million more in write-downs to the residual assets so their value would be fairly presented. Once these accounting adjustments were made, Superior was deemed insolvent.

Further, in our opinion, E&Y did not:

• encourage certain disclosures in the bank’s financial statements that would have been expected under the circumstances,

• perform sufficient tests and other procedures to ensure the proper valuation of residual assets on the bank’s accounting records, and

• identify or disclose a significant misstatement of Superior’s loan loss reserves.

While Office of Thrift Supervision (OTS) examination reports identified many of the bank’s problems early on, OTS did not adequately follow up and investigate the problems, particularly the valuation of residual assets carried by the bank. OTS appeared to rely mostly on representations made by the bank and validated by E&Y. OTS also placed undue reliance on the ability of the wealthy 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 agreed to but subsequently did not provide the necessary capital. Warning signs were evident for many years, yet no formal supervisory action was taken by OTS until July 2000, which ultimately proved too late.

Coordination between regulators could have been better. OTS denied a request by the Federal Deposit Insurance Corporation (FDIC) to participate in the January 1999 examination of Superior. Instead, OTS allowed the FDIC to meet with the OTS examination team off-site to discuss concerns approximately 1 week before the end of the examination. FDIC regional management did not raise this issue to the FDIC Board of Directors to gain access through the FDIC’s special examination authority. OTS and the FDIC did work together in the January 2000 examination and more clearly identified the problem with the residual asset valuations. Even then, however, the regulators initially relied on bank management and E&Y assurances that the bank was properly accounting for its securitization activities and did not immediately put a halt to these transactions to the detriment of Superior.

The early intervention provisions of Section 38 of the Federal Deposit Insurance Act, commonly referred to as Prompt Corrective Action (PCA), require regulators to address problems before the financial condition of a failing institution deteriorates significantly. PCA did not work in the case of Superior. The capital ratios at Superior did not accurately reflect the financial position of the institution because the ratios were based on inflated asset valuations. In addition, beginning with OTS's 2000 examination, we believe that OTS used a methodology to compute Superior’s capital that artificially increased the capital ratios, thus avoiding provisions of PCA. By using a post-tax capital ratio for the first time that we were able to determine, Superior was classified as "adequately capitalized." If a pre-tax calculation had been used, Superior would have been "undercapitalized," thus more immediately subjecting Superior 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.

The federal banking agencies have attempted to address these PCA issues through the adoption of risk-focused examination programs and risk-based capital requirements. In addition, on November 29, 2001, the agencies issued a new rule that changes, among other things, the regulatory capital treatment of residual interests 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.

Our review identified other areas in which we believe regulatory oversight could be strengthened. Specifically, the bank regulatory agencies should focus attention on policies and procedures for:

• reviewing external auditors’ working papers for institutions that operate high-risk programs, such as subprime lending and securitizations;

• following up on warning signs that indicate possible fraud or other 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.

In a related vein, we will be issuing an audit report in the near future that discusses in detail restrictions that have been placed on the FDIC’s use of special examination authority as we believe occurred at Superior. We note in the report that the FDIC’s Board of Directors recently authorized an expanded delegation of authority for the FDIC to conduct examinations, visitations, or other similar activities of insured depository institutions. The delegation also implemented an interagency agreement that outlines the circumstances under which the FDIC will conduct examinations of institutions not directly supervised by the FDIC. While this agreement represents progress for better interagency coordination of examination activities, we are concerned that limitations remain that may impede the FDIC’s ability to independently assess risks to the insurance funds.

Accordingly, in our report, we are recommending that the FDIC take actions to strengthen its special examination authority, primarily by seeking a legislative change to vest special examination authority in the FDIC Chairman. In addition, we will be recommending that the FDIC take the initiative in working with other regulators to develop a uniform method of calculating the relevant capital ratios to determine an insured depository institution’s capital category for PCA purposes.

I appreciate the opportunity to respond to the Committee’s concerns regarding the failure of Superior Bank. If I can be of further assistance, please contact me at (202) 416-2026.

Sincerely,

[Electronically produced version; original signed by Gaston L. Gianni]

Gaston L. Gianni, Jr.
Inspector General

INTRODUCTION

We conducted this review at the request of Senator Paul S. Sarbanes, Chairman of the U.S. Senate Committee on Banking, Housing, and Urban Affairs. In his August 1, 2001 letter on the July 2001 failure of Superior Bank, FSB (Superior), the Chairman requested the Federal Deposit Insurance Corporation (FDIC) Inspector General (IG) to review why the failure of Superior Bank resulted in such a significant loss to the Savings Association Insurance Fund administered by the FDIC and requested that we make recommendations for preventing any such loss in the future. The Chairman also raised a number of concerns pertaining to the bank’s failure and actions taken by the federal regulators, including nine topics he asked the IG to specifically address. In addition, the Chairman requested similar reviews from the Inspector General of the Department of the Treasury, who has responsibility for conducting audits of the Office of Thrift Supervision (OTS), and the Comptroller General of the United States, who supervises the U.S. General Accounting Office (GAO). (Note: The OTS was the primary federal regulator for Superior. In this capacity, the OTS was responsible for conducting the regular examinations of the institution.)

This report presents the results of our review, which was conducted independently of the reviews performed by the Treasury Department Office of Inspector General and GAO. To facilitate reader access to our observations and conclusions, we have structured our report into the following sections:

1. Results in Brief -- presents an overview of this report,
2. Background -- presents a historical perspective of Superior, and
3. Topics Requested by the Chairman -- presents a detailed response to each of the nine topics requested by Senator Sarbanes. Each section is designed to stand alone; therefore, there may be occasional repetition within the various topics due to their inter-related nature.

At the conclusion of this report, we have included a glossary and several appendixes, which provide additional information on the issues presented in this report.

The failure of Superior Bank was directly attributable to the Board of Directors and executive management ignoring sound risk diversification principles as evidenced by excessive concentrations in residual assets related to subprime lending. (Note: In Superior’s case, the residual assets consisted of two distinct parts. The first part was the residual interest that represented excess cash flows from the difference between the interest rates charged on the loans, which served as collateral for the securitizations, and the interest rate paid on the securities. The second part consisted of an overcollateralization account. Refer to Topics 2, 4, and Appendix B for a more detailed discussion of these two accounts. The term subprime refers to the credit characteristics of borrowers who typically have weakened credit histories that include payment delinquencies, previous charge-offs, judgements, or bankruptcies. These borrowers may also display reduced repayment capacity as measured by credit scores, debt-to-income ratios, or other criteria that may encompass borrowers with incomplete credit histories.) This risk was compounded by Superior’s use of flawed accounting methodologies and unrealistic valuation assumptions, which were validated by its external auditors, Ernst & Young (E&Y). As a result, the true financial condition of Superior was not apparent while the bank reported inflated net income and capital levels from 1993 until it failed. Superior reported over $430 million of net income from 1993 though 1999 derived mainly from the valuation of the residual interests Superior retained when it securitized and sold its subprime loans (residual assets). Most, if not all, of this income was overstated. During this same time frame, Superior paid out approximately $200 million in dividends.

Ultimately, at the conclusion of its January 2000 examination, OTS instructed Superior to revalue the residual assets and downgraded the rating of the institution. In the months following the examination, Superior management:

1. did not implement OTS instructions to correct accounting irregularities;
2. continued providing erroneous Thrift Financial Reports to OTS;
3. sold loans to its holding company at less than fair market value, allowing the holding company to make an immediate profit of $20.2 million; and
4. extended credit to affiliates, which when added to the above loan sale to the holding company, totaled $36.7 million.

The actions of the Board and executive management resulted in the transference of funds to holding companies, also owned by Superior’s owners, at the expense of the institution’s capital. This transference had the effect of unduly enriching those companies and, potentially, their owners.

Once the residual assets were appropriately calculated and valued by regulators and by an outside party, the true financial condition of Superior was determined and the bank was declared insolvent. The Office of Thrift Supervision (OTS) closed the institution and appointed the FDIC as receiver on July 27, 2001. The failure resulted in FDIC recording an estimated loss of $426 million to the Savings Association Insurance Fund (SAIF) at closure, out of an estimated range of $426 - $526 million.

In addition to the roles played by the Board of Directors, executive management, and E&Y, the failure of Superior Bank is attributed to the following:

• OTS not aggressively limiting the risk assumed by the bank,

• Limited cooperation among federal regulators, and

• Untimely and ineffective Prompt Corrective Actions (PCA).

The Board of Directors did not adequately monitor on-site management and overall bank operations. In particular, the board:

1. did not establish adequate risk management and diversification policies and procedures,
2. disregarded supervisory recommendations and criticisms,
3. failed to ensure the bank’s adherence to all laws and regulations, and
4. was dominated by the Chairman, who pursued actions contrary to OTS positions.

Superior’s management apparently either misunderstood or disregarded the risks associated with the securitization process and the methods to control those risks. Superior’s management operated a high-risk business, which entailed aggressively making loans to people with poor credit histories (subprime borrowers) and then securitizing these loans. Superior retained the residual assets after the securities were sold to investors. (Refer to Topics 2, 4, and Appendix B for a more detailed discussion of residual assets.) Superior’s board resisted setting limits on the amount of residual assets held by the institution, which allowed management free rein to expand this area beyond the safety net provided by Superior’s capital base. Despite being primarily funded by deposits insured by the FDIC, the thrift did not operate within the typical parameters of insured depository institutions.

Executive management regularly disregarded examiner recommendations. From 1993 forward, Superior’s management did not implement numerous recommendations contained in OTS examination reports. These recommendations included placing limits on residual interests, establishing a dividend policy that addressed paying dividends based on unrealized net income derived from residual interests, and correcting errors in the capital calculations and Thrift Financial Reports. Management did not make regulatory adjustments to the bank’s records, write-down defaulted loans and receivables, or comply with the requirements of a supervisory corrective action addressing the valuation of certain residual assets.

The thrift also apparently violated Federal Reserve Act requirements by making uncollateralized extensions of credit totaling $36.7 million to its holding company and affiliates. The majority of these extensions of credit happened during the last quarter of 2000 after it became apparent there were no profits to support continued dividend payments. The extensions of credit resulted in part from Superior selling loans to its holding company at less than fair market value. Superior’s holding company quickly resold the loans for a $20 million profit.

The bank was dominated by one individual - the Chairman of the Board of Directors. Although Superior’s retail operation was located in the Chicago area, the Chairman worked in New York and was instrumental in developing and coordinating Superior’s principal lines of business. He often asserted to OTS management and examiners that Superior’s ownership would always stand behind Superior in the event it ran into financial problems. According to OTS examiners, "he was a very persuasive person who knew the most about Superior’s operations."

Reportedly, the Chairman pursued courses of action contrary to OTS positions. For example, during the October 2000 OTS field visit, the Chairman disagreed with regulators on accounting issues related to the valuation of certain residual assets. The Chairman adamantly supported Superior’s accounting methodologies as properly applying Generally Accepted Accounting Principles (GAAP), and sanctioned overall business strategies that clearly ignored any avenues to diversify Superior’s high-risk and volatile asset base. Subsequently, he resigned in January 2001 in the face of overwhelming evidence that Superior’s accounting methodologies were flawed.

The bank used liberal interpretations of Statement of Financial Accounting Standard (FAS) 125 supported by E&Y to book huge imputed gains. Superior made favorable assumptions about the future returns from pools of loans and then booked the entire "profit" up front. Although allowed under generally accepted accounting principles, this represents a significant difference from the way thrifts typically recognize loan income – accruing income over the life of the loan.

It appears OTS 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 did it become apparent to OTS that, from 1993 forward, it may have relied too heavily upon Superior management’s financial statements and E&Y’s repeated unqualified audit opinions of those financial statements. The OTS did not determine the impact of the uncertainties over the accounting treatment accorded to Superior’s residual interest assets until it was too late. When the OTS and the FDIC examiners reviewed E&Y working papers in 2000, they discovered that E&Y had made "fundamental errors" in the calculation of the value of the residual assets. Specifically, E&Y allowed the valuation of estimated cash flows on an accelerated basis even though the cash flows would not be received for several years. Because these cash flows were not properly discounted, and other valuation assumptions were not supportable, examiners determined that Superior’s assets were over-valued by at least $420 million as of December 31, 2000.

On October 16, 2001, the Director of OTS testified before the Senate Banking Committee about the incorrect accounting treatment and unrealistic assumptions for valuing Superior’s residual assets. "The risk from a concentration in residuals at Superior was exacerbated by a faulty accounting opinion by the institution’s external auditors that caused capital to be significantly overstated, and by management and board recalcitrance in acting on regulatory recommendations, directives and orders," the Director said.

While OTS examination reports identified many of the bank’s problems early on, OTS did not adequately follow up and investigate the problems. As noted above, Superior did not implement several OTS recommendations, which did not receive further attention from the OTS. OTS appeared to rely mostly on representations made by the bank and the opinions of its outside auditors. OTS also placed undue reliance on the ability of the wealthy owners of the bank’s holding companies 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. Many warning signs were evident as early as 1995, yet no supervisory corrective actions were taken until July 2000, which ultimately proved too late.

Examination reports dating back to 1993 indicated that OTS did not fully analyze and assess the potential impact of imputed gains on earnings and the institution. While OTS identified the volume of imputed gains recorded and noted that the gains were unrealized and subject to change, the OTS did not analyze and assess the bank’s performance without those gains or on a realized cash flow basis. In effect, OTS placed undue reliance on unrealized income that was subject to significant market and economic volatility.

Coordination between regulators could have been better. Our analysis determined that the most critical lack of coordination and communication between the OTS and the FDIC was prior to the January 1999 safety and soundness examination when OTS would not allow the FDIC to participate on-site at the examination. Although the FDIC has authority under section 10(b)(3) of the Federal Deposit Insurance Act to conduct a special examination of any insured depository institution, there are required procedures that can inhibit timely and justified access. When OTS did not agree to let the FDIC participate in the 1999 examination of Superior, the issue was not raised to the FDIC Board of Directors for consideration. Had the FDIC participated, the two regulators working together may have been more effective in minimizing losses to the SAIF.

The early intervention requirement of the law allowing regulators to address problems before the franchise value of a failing institution deteriorates significantly, did not work at Superior Bank. PCA provides regulators with expanded supervisory powers to prevent an institution from becoming critically undercapitalized. 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. 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. The federal banking agencies have attempted to address this challenge through the adoption of risk-focused examination programs and risk-based capital requirements. However, the recent failures of Superior Bank, First National Bank of Keystone, and BestBank demonstrate that further improvement is needed.

Acquisition of Lyons Savings Bank and Formation of Superior’s Holding Companies

In December 1988, two wealthy families acquired Lyons Savings Bank, a Federal Savings Bank, Countryside, Illinois (Lyons) for $42.5 million, with assistance from the former Federal Savings and Loan Insurance Corporation (FSLIC). Lyons was a failing thrift institution with $1.5 billion in assets and $1.7 billion in liabilities. Lyons was renamed Superior Bank, Federal Savings Bank (Superior) in April 1989, with its home office located in Hinsdale, Illinois.

The two families formed three holding companies, Coast-to-Coast Financial Corporation (CCFC), Coast Partners (CP) and UBH, Inc. (UBH), for the purpose of acquiring and operating Superior. CCFC was owned by a complex set of companies/trusts controlled by the two families. Various holding company reports list nine affiliated higher-tier holding companies/trusts, including CP and UBH. CP and UBH were predominantly shell companies, each representing one family's interests and each with their primary activity the ownership of 50 percent of CCFC. CCFC, in turn, owned 100 percent of Superior as well as several other small financial services affiliates with operations that complemented Superior. In June 1999, CCFC established Superior Holdings, Inc. (SHI), as an intermediate holding company of Superior Bank and transferred the bank's common stock to SHI.

According to testimony presented by the Director of the Office of Thrift Supervision (OTS), the two families asked for and received a waiver in connection with the acquisition of Lyons from the former Federal Home Loan Bank Board of various filing and reporting requirements for all but three holding companies of the acquired institution - CCFC, CP and UBH. Only these three holding companies were required to file periodic reports and/or financial information. Throughout the history of Superior, OTS examinations indicated that the bank's only dealings with holding company affiliates involved either CCFC or its wholly-owned subsidiaries. As a result, OTS focused its holding company examinations of Superior on CCFC and its subsidiaries, including SHI.

During its first few years, Superior operated under a FSLIC Assistance Agreement. The agreement identified conditions of purchase whereby CCFC acquired Lyons with loss coverage and yield subsidies on certain covered assets. The loss coverage would reimburse Superior for certain losses incurred on these assets, and the yield subsidies guaranteed a certain rate of return on the covered assets. The covered assets initially included $565 million in assets, consisting principally of commercial real estate loans and investments in subsidiaries. The agreement concentrated management’s efforts on resolving problem assets through asset sales and write-downs, and supporting claims under the agreement. By December 1992, most of the institution’s problem assets were resolved and the effects of the FSLIC Assistance Agreement had diminished.

Superior's Shift to Mortgage Lending Operations

Starting in 1993, Superior’s management began to focus on expanding the institution’s mortgage lending business. The owners of CCFC founded a mortgage banking entity known as Alliance Funding Company, Inc. (Alliance) in 1985. In 1990, the owners contributed Alliance to CCFC. From January 1991 until December 1992, Alliance was owned and operated by CCFC and was an affiliate of Superior. Alliance specialized in originating and selling first and second home mortgage loans to non-conforming borrowers. In December 1992, CCFC merged Alliance with Superior and Alliance became a division of the institution. Superior entered the securitization arena in 1993 and, due to the incorporation of the mortgage company, Alliance was able to provide a supply of subprime residential mortgages for Superior to fund, package, and sell to parties who would complete the securitization process. As with most mortgage bankers, Superior was generally not holding these loans in its portfolio, but rather it was securitizing the loans. Superior, like many issuers, held on to the securities with the greatest amount of risk and provided significant credit enhancements for the other securities. (Note: A credit enhancement is a method of protecting investors from losses if the cash flows from the underlying loans are insufficient to pay the principal and interest due on the securities.)

Superior Bank's Securitization Process and Accounting

Superior Bank’s process for securitizing and accounting for assets evolved from 1993 until its closure in 2001. (Refer to Appendix B for a general overview of the securitization process.) Prior to becoming a division of Superior, Alliance had several years’ experience securitizing assets. Operating as a unit, Superior and Alliance used three different types of transactions in order to provide credit enhancements to achieve a AAA rating for their securitized products. The first two methodologies were used in the early years of the securitization process. The third form was used beginning in 1995 and continued until 2000.

First Methodology

The following information was obtained from a report prepared by Superior’s Chairman of the Board. In 1993 and part of 1994, Superior’s securitization process involved pledging a deposit account to assure the surety bond provider that sufficient funds would be available to achieve a zero loss assumption. The requirement for limiting potential losses through the use of a credit enhancement was necessary to attain a AAA rating. Superior deposited cash with a trustee who retained the funds in a short-term deposit account as pledged collateral for the securitizations. The excess spread was used to offset any losses in the underlying loans supporting the securitizations. According to this report from Superior’s Chairman of the Board, accounting pronouncements did not require the value of the deposit account to be discounted. The report stated that at that time, Generally Accepted Accounting Principles (GAAP) required the pledging of assets to be disclosed in the financial statements; therefore, their availability was restricted because they were pledged. However, this transaction using the pledged deposit account was not advantageous to Superior. The amount of loans supporting the security was equivalent to the outstanding securities. The interest income earned on the pledged deposit account was substantially less than the interest rate that was paid on the outstanding securities, which resulted in a disparity between the cash inflows and outflows. Since Superior was paying out more interest on the securities than the interest that Superior was receiving on the deposit accounts, this resulted in a negative impact on Superior’s earnings.

Second Methodology

For the remainder of 1994, Superior used a junior/senior securitization structure. These transactions involved issuing AAA rated securities equal to approximately 90 percent of the underlying mortgages as senior bonds. The remaining 10 percent were issued as junior bonds with a potentially lower rating. The junior bonds became the credit enhancement for the senior issue. In other words, the excess spread account and the junior bonds would absorb any losses up to the amount of the junior bonds issued before the senior class would suffer any loss. (Note: The residual interests represent claims on the cash flows that remain after all obligations to investors and any related expenses have been satisfied. The residual interests represent funds required to build reserves and pay loan losses, servicing fees, and liquidation expenses. Any excess money, after all expenses have been met, provides a return to the holder of the residual interests. When the loans for the pools originate, they bear a stated interest rate. The securitized instruments are issued to investors at a lower rate than the stated rate on the loans. The difference between the rate that the loans are earning versus what the securitized pools are paying to investors is called the residual interest or excess spread. The excess spread account absorbed losses first. As long as the excess spread was sufficient to absorb the losses, there was little if any threat that the junior class would have to absorb any losses. Therefore, the junior class was only subject to nominal risk of loss. The junior bonds were either retained by the institution or sold to a third party at par.

If the junior class was retained by the institution, the report from Superior’s Chairman of the Board stated that they did not require discounting since the financial statements reflected that they were pledged or subordinated to the senior class bonds. Also, if the bank retained the junior bonds, the interest earned on the underlying loans approximated the interest expense of issuing the junior bonds. Additionally, excess servicing collections, also known as the excess interest spread, were released to the institution each month, thereby increasing the institution’s cash flow.

Despite the economical feasibility from a cash flow standpoint, the issuance of the junior/senior bonds required greater initial cash resources to fund since only 90 percent of the bonds were issued to third parties if the bank retained the junior portion. This structure was used in completing Superior’s initial adjustable rate mortgage securitizations.

Third Methodology

Superior began using a reconfiguration of the overcollateralization (OC) account in 1995, replacing the first and second methodologies, and used this method until they ceased securitization activities in June 2000. (Note: Overcollateralization is a type of credit enhancement in which the principal amount of collateral used to secure a given transaction exceeds the principal of the securities issued. As the term implies, the value of the assets collateralizing the securities issued exceeds the face value of the securities.) In addition to the securitizing of the subprime residential mortgages, Superior began an automobile division in 1994. This division originated and securitized subprime auto loans although on a much smaller scale than the operations of the mortgage division. (Note: The term subprime refers to the credit characteristics of borrowers who typically have weakened credit histories that include payment delinquencies, previous charge-offs, judgements, or bankruptcies. These borrowers may also display reduced repayment capacity as measured by credit scores, debt-to-income ratios, or other criteria that may encompass borrowers with incomplete credit histories.) The economies of the third accounting methodology afforded Superior the most advantageous method of increasing revenues through their securitization activities by permitting Superior to build the OC account incrementally over time with the excess interest they earned from the securitizations rather than establishing the bulk of the account at the onset of the transaction.

Superior’s Securitization Process Using the Third Methodology

To begin the process, Superior and Alliance would either originate the loans, purchase them from brokers located throughout the United States, or use a combination of the two. Approximately 30 percent of the loans were generated in-house with the remaining 70 percent originated by brokers. Once an optimum level of loans was achieved, the loans were sold to a trust that would in turn finish the securitizing process. One of the factors contributing to Superior’s expansion in the securitization arena was the inclusion of credit enhancements. Superior used the OC account and the residual interest as internal credit enhancements. An external credit enhancement Superior used was the mortgage pool insurance provided by Financial Guaranty Insurance Company. The insurance company would cover loan losses that exceeded a specified level in the securitization for a specified fee. In exchange for this guaranty, the insurance company would establish requirements, such as the establishment of internal credit enhancements, as part of the securitization agreement with the institution.

When the securitizing process was complete, the bonds were ready to be sold in the secondary market. The establishment and maintenance of the OC account began once the bonds were ready for sale. For example, if $100 million in bonds was securitized, the trust might issue only $98 million in bonds. The remaining $2 million in bonds established the OC account. In other words, the OC account represented the amount by which the collateral loan pool owned by the trust exceeded the outstanding Class A bond principal. In this example, the amount of the collateral loan pool owned by the trust would exceed the Outstanding bond principal by $2 million.

Over the ensuing months, the excess interest spread, which normally would have been remitted to Superior, was transferred to the OC account. (Note: The excess spread is the difference between the stated rate of return received on the loans and the stated rate of return paid on the securities.) The excess spread was segregated in this account until a minimum percentage requirement was attained as specified in the securitization agreement between Superior and the surety or insurance company. The funds were then used to repurchase outstanding issues of the bonds. By retiring the bonds earlier, the OC account increased and less interest expense was paid on the outstanding bonds. After the required minimum level in the OC account was reached, the excess interest either reverted to Superior or was used either partially or in its entirety to repurchase additional outstanding bonds from the issue. If any losses on the underlying loans were incurred, either the excess interest spread or the collateral in the OC account was used to absorb the losses. If the OC account was required to absorb losses, which would reduce the balance in the account, the residual interests would be required to replenish the OC account.

The entire valuation process associated with securitizations is driven by assumptions. Since institutions cannot predict future events with 100 percent accuracy, they must make best estimates pertaining to the market forces that can affect the values of these instruments. For example, Superior securitized subprime mortgage and auto loans, which can present more risk than conventional loans. Therefore, an estimate of the potential loss rate would conceptually be higher than loss rates for conventional loans. Also, a review of the economic climate can give an institution information concerning the estimate of prepayments. If the economy is in a falling rate environment and the subprime borrowers are in the process of credit repair, they may be able to refinance their loans at a lower interest rate. This can result in higher prepayments in the securitizations. Superior had been in the securitizing business since 1993. Therefore, they had some historical experience with previous securitizations on which to base their estimates. This is not to say that all securitizations will behave in the same manner, it just provides a starting point to use for comparative purposes. The review of prior securitizations can assist in minimizing the principal risk associated with securitizations which is the failure of the anticipated future income to materialize due to changing market conditions or through the use of flawed or liberal assumptions.

Superior Bank’s Demise

Superior aggressively expanded its asset base with a concentration of subprime securitizations. This resulted in Superior’s recording large gains, which were not realized, but created the appearance of an increase in capital. In 1999 Superior decreased the discount rate used to value the residuals which served to overvalue the assets while at the same time relaxing credit standards that further increased the risk of non-payment of the loans underlying new securitizations. These actions served to worsen Superior’s financial condition. Additionally, the regulatory authorities detected accounting inaccuracies, which resulted in a sizeable write-down to the overcollateralization account and the residual interests. The OTS and Superior attempted to arrive at a viable recapitalization plan; however, when the time came for the owners to implement the plan, they refused. On July 25, 2001, Superior’s Board of Directors executed an Agreement and Consent to the Appointment of a Conservator or Receiver and on July 27, 2001 OTS appointed the FDIC as conservator and receiver of Superior.

The next section of this report presents a detailed response to each of the nine topics listed in Senator Sarbanes’ request. This next section details the specifics relating to the examinations conducted by the OTS from 1993 through 1999, and the 2000 and 2001 examinations in which the FDIC participated. It also covers the accounting methodology used by Superior, the incorrect application of these accounting principles, an assessment of E&Y’s auditing techniques, and the regulatory actions taken in response to the deteriorating condition of the institution.

TOPICS REQUESTED BY THE CHAIRMAN OF THE U.S. SENATE COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

There were three primary factors that led to the failure of Superior Bank including:

• The Board of Directors did not provide adequate oversight of Superior,
• Superior management’s expansion of high-risk assets resulted in the depletion of the capital base, and
• The external auditors did not detect material misstatements resulting from improper accounting.

The Superior Bank Board of Directors was not receptive to the Office of Thrift Supervision’s (OTS) regulatory recommendations for placing limitations on the excessive growth of residual assets held by the institution. (Note: The residual assets consist of the residual interests and the overcollateralization (OC) account. The residual interests consist of the difference between the interest received on the underlying loans supporting the securitizations and the interest paid on the securitizations. The OC account is comprised of residual interests that are segregated into a separate account in accordance with the securitization agreement. Refer to Topics 2 and 4 for a more detailed discussion of residual interests and the OC account.) The board did not refrain from increasing the residual asset balance until the OTS issued a Part 570 directive in July 2000 requiring the institution to file a plan to cease their activities in this area. (Note: Part 39 of the FDI Act requires each appropriate federal banking agency to promulgate final regulations under this Act, which are safety and soundness standards. These standards encompass three broad areas including operational and managerial standards, asset quality, earnings, and stock valuation standards, and compensation standards. 12 CFR Part 570 and the guidelines in its appendixes were issued by the OTS as required by Part 39 of the FDI Act. This section addresses the submission and review of safety and soundness compliance plans and issuance of orders to correct safety and soundness deficiencies.) Superior Bank’s management made a decision to expand the residual assets in 1993 at the onset of the securitization program. The inordinate growth of the residual assets until the restrictions were placed on the institution led to an excessive concentration in these high-risk assets. Problems were noted with Superior’s high-risk lending program. Additionally, Superior could not support the assumptions pertaining to the discount rate at the 2000 examination. Despite the unqualified audit opinions from E&Y, during the October 2000 visitation the FDIC and OTS examiners determined that the accounting methodology applied to the overcollateralization (OC) account was incorrect. The effect of these two events, the overvaluation of the residual interests ($150 million) and the miscalculation of the OC account ($270 million), resulted in Superior suffering losses totaling approximately $420 million for these two accounts.

Failure of the Board of Directors to Provide Adequate Oversight of Superior

Despite warnings from the Office of Thrift Supervision (OTS), the board did not impose a limitation on the residual interests that Superior recorded. Superior embarked on the full-scale operation of the securitization business directed at borrowers with non-conforming credit histories in the first quarter of 1993 and added the subprime automobile division in 1994. (Note: The term subprime refers to the credit characteristics of borrowers who typically have weakened credit histories that include payment delinquencies, previous charge-offs, judgements, or bankruptcies. These borrowers may also display reduced repayment capacity as measured by credit scores, debt-to-income ratios, or other criteria that may encompass borrowers with incomplete credit histories.) The OTS maintained an annual presence and conducted safety and soundness examinations each year at Superior from 1991 through 2001, with the exception of 1998. After Superior became involved in the securitization process in 1993, the OTS examiners recommended in 1994 that the board establish limits for the amount of securitizations that they would permit the institution to carry on its books. The OTS also indicated the potential risks associated with the increasing volume of residual assets. The OTS listed the residual assets as a concentration in their examination reports; however, they stated that their concern was mitigated due to Superior’s capital levels. Management was permitted to continue adding these high-risk credit enhancements. The addition of residual assets was only curtailed when the OTS issued a Part 570 directive to Superior in July 2000 to formulate a plan to limit the residual interests to 100 percent of Tier 1 capital.

Superior was designated as a problem institution shortly after the January 2000 examination, in which the Federal Deposit Insurance Corporation (FDIC) participated, when its composite rating was downgraded from a composite "2" to a "4." The downgrade was attributable to Superior’s high-risk lending activities. Another contributing factor was management’s liberalization of the assumptions used in the valuation process following the January 1999 OTS examination. The examiners levied specific criticisms relating to the residual interests and the unrealistic assumptions that management used to value the assets. Also, there were numerous problems with the level of adversely classified assets, particularly in the auto division, and management’s reflection of these assets in the Thrift Financial Reports (TFRs). (Note: Adversely classified assets are allocated on the basis of risk. Classifications are expressions of different degrees of risk of a common factor – the risk of repayment.) The OTS, with FDIC participation, conducted a visitation of the institution in October 2000. Although bank management, on behalf of the board, informed the OTS that the deficiencies noted in the 2000 examination had been corrected, the visitation proved otherwise. Loss classifications that should have been charged-off were renamed and reclassified on the balance sheet. Some of the loss classifications had been eliminated; however, the overall corrective action taken in response to the reports was less than satisfactory. The board had failed its fiduciary responsibility to ensure that management abided by instructions given by the OTS.

Unsupported assumptions connected with the asset valuation problems continued into the 2001 examination. Large write-downs were required for the overcollateralization (OC) account and eventually for the residual interests. The institution was on the brink of insolvency when the OTS issued a Prompt Corrective Action (PCA) Directive on February 14, 2001. The owners began negotiating for a recapitalization plan with the OTS. When the time came for the owners to implement the final plan and inject the necessary capital into the bank, the owners did not implement the agreement.

Superior’s Management Decision to Expand High-Risk Assets Depleted the Capital Base

As mentioned above, Superior Bank began engaging in mortgage securitizations comprised of loans to borrowers with non-conforming credit profiles during the first quarter of 1993. Although the institution had several other divisions, such as the retail division that made more traditional types of loans, Superior adopted the securitization process as its primary business with a focus on mortgage lending. During 1994, Superior incorporated automobile lending into its securitizing activities. By June 1995, the residual assets became a concentration at the institution in excess of 100 percent of capital. As early as 1994, the OTS recommended that Superior’s board place limits on the amount of residual assets that would be permitted in the institution. The board did not heed this recommendation and did not make any attempts to curb the growth of the residual assets until the OTS imposed a Part 570 directive in July 2000. (See Topic 2 for more details on the levels of concentrations and the valuation of the residual assets at various times during Superior’s life.)

Beginning in 1998, Superior’s management decided that they wanted to further expand this segment of their business. However, as they attempted to expand this area, the credit quality of the underlying loans in the securitizations began to deteriorate as evidenced by the increase in delinquency and loss rates. The growth coupled with management’s liberal assumptions enabled Superior to record a large income based on "gain on sale" accounting. (Note: Assumptions must be made related to the loss rates, prepayment speeds, and discount rates in order to value the residual interests.) These gains were imputed and recorded; however, the bank had not received the cash finalizing the transaction. (Note: Imputed gains are generated from the sale of securitized loans, and the calculations used to measure those gains are based on various assumptions and estimates that are subject to change.) Based on the accuracy or inaccuracy of the assumptions, the income had not been realized even though it was recognized as a gain for financial reporting purposes. (Refer to Topic 5 for a detailed discussion of Superior’s earnings.)

At the January 2000 examination, the examiners criticized the high-risk lending activities and downgraded the institution’s composite rating to a "4." Additionally, liberal and unsupported assumptions used by Superior to value the residual interests were also criticized. The examiners questioned whether the provisions of Financial Accounting Standards (FAS) 125 were applied correctly to the OC account. (Note: The overcollateralization account is a type of credit enhancement, which is a method of protecting investors from losses if the cash flows from the underlying loans are insufficient to pay the principal and interest due on the securities. Refer to Topics 2 and 4 for a more detailed discussion of the OC account.) During a review of Ernst & Young’s (E&Y) audit workpapers, a memo was discovered in the file that indicated Superior had applied FAS 125 accurately. The OTS and the FDIC examiners accepted E&Y’s conclusions. After the 2000 examination was completed, the institution’s composite rating was downgraded due to various deficiencies including the high-risk lending program, the use of unsupported liberal assumptions associated with the residual interests, and the potential overvaluing of the OC account, all of which could have had a negative impact on Superior’s capital position. At the conclusion of the examination, Superior was instructed to revalue the residual interests with supportable assumptions. By June 30, 2000, the residual assets equaled 345 percent of tangible capital. In July 2000, the OTS issued a Part 570 Directive which required the board to develop a plan in compliance with the OTS’s Part 570 to reduce the level of residual assets to no greater that 100 percent of Tier 1 capital within a 1 year time period.

The OTS and the FDIC returned in October 2000 for a visitation to determine if the deficiencies noted in the 2000 examination were addressed and corrected. Instead of improvement, the examiners found that conditions were deteriorating. The examiners determined that the accounting treatment used to value the OC account was incorrect. It was during this visitation that the different perceptions of the valuation of the OC account among the examiners, E&Y, and the institution culminated. After numerous discussions between the institution, the regulators, and the accountants, it was decided that the accounting methodology was incorrect and the OC account was overvalued. E&Y conducted an analysis of the account and determined that the OC account and the residual interests would require substantial write-downs. The write-downs had a detrimental impact on Superior’s capital position. The write-downs and losses, coupled with the owners’ unwillingness to recapitalize the institution resulted in the OTS closing Superior on July 27, 2001.

External Auditors Failed to Ensure Proper Accounting

When Superior began the securitization process, the OTS evaluated the assumptions that Superior used at the OTS’s annual examinations to validate the valuations. In 1996, the OTS brought in a specialist from its Southeast Region to review all of the residual interest assets. The examination reports reflected no deficiencies with the assumptions that Superior was using to value the residual assets. The 1997 and 1999 examination reports did not reflect any findings relating to the assumptions Superior was using. However, following the 1999 examination, Superior liberalized its assumptions, which increased the value of the residual interests.

When Superior initially recorded the residual interests, it used a 15 percent discount rate in the present value calculation to establish the value of the residual interests. In the January 2000 OTS examination, it was noted that Superior was using an 11 percent discount rate. Bank management indicated that the discount rate was reduced after the expected ongoing prepayment experience was more estimable. Management’s change from 15 percent to 11 percent during 1999 created substantial additional value in the residual interests. Superior did not have adequate documentation to support this reduction in the discount rate. At the June 30, 1999 audit, E&Y, Superior’s external auditors opined that the 11 percent discount rate was valid; however, the information that the firm used to support this contention was stale. Additionally, E&Y only performed limited testing of the residuals. The OTS recommended that Superior revalue the residual interests using a 15-percent discount rate. The FDIC’s Division of Resolutions and Receiverships personnel who reviewed the residual interests and their underlying loan pools after Superior was closed stated that a more accurate discount rate for these assets would be in the range of 20-25 percent.

The OTS and the FDIC regulators determined that the accounting methodology applied to the OC account was not correct. According to the OTS and the FDIC, E&Y misapplied the provisions of FAS 125 by not calculating present value to determine the value of the OC account. The Financial Accounting Standards Board issued "Question and Answer" guidance on FAS 125 in September 1998, December 1998, and in July 1999. The information in the December 1998 and the July 1999 guidance supported discounting the value of credit enhancements for the period in which the funds are restricted. According to the securitization agreements, the OC account was restricted and the funds were not immediately available to Superior. The OC account was to be released incrementally over the life of the securitization. Therefore, the OC account should have been discounted to reflect this period in which the account balance was restricted and not available for Superior’s use. This methodology is in keeping with "cash-out" accounting, which requires the discounting of the value until the funds are released to the entity. Conversely, "cash-in" accounting does not require the discounting of the value since the funds are not restricted and are immediately available. Superior was applying the cash-in accounting methodology to value the OC account even though the funds were not available to the institution upon collection. (Refer to Topics 2 and 5 for detailed discussions of the misapplication of FAS 125.)

A series of disagreements ensued among the federal banking regulators, bank management, and the external auditors, which was drawn out until January 11, 2001 when the issue was resolved. At that time, a national partner of E&Y decided that the regulators were correct in their assessment of FAS 125 and the institution and the regional partner of E&Y were incorrect in their interpretation and application of FAS 125.

E&Y revalued the OC account and residual interests. Based on a revaluation of the residual interests and their related accounts, Superior suffered extreme depreciation in these assets, which adversely affected the institution’s capital level. The approximate adjustments for the two accounts totaled $420 million, with a $270 million reduction to the OC account and a $150 million write-down to the residual interests. Based on the remaining business activities, Superior could not rebound from the deficient capital level it had sustained from the securitization activities.

Topic 2 -The levels of concentration and amount of valuation in residual interests held by Superior and the treatment of the residuals by OTS.

Once Superior began its securitization process, the levels of this activity expanded rapidly. From 1995 until the institution closed, concentrations of residual assets exceeded 100 percent of Superior’s capital. The Office of Thrift Supervision (OTS) had an annual presence in the institution, with the exception of 1998, and conducted safety and soundness examinations each year. The OTS used capital markets specialists to review the securitizations beginning in 1996. Because of the external auditors’ misapplication of Financial Accounting Standards (FAS) 125 and the institution’s use of liberal assumptions to value the residual interests, the residual interests and the overcollateralization (OC) accounts were overvalued, which in turn overstated the capital of the institution. The valuation of the residual interests was questioned at the January 2000 examination. Once the overvaluation of the residual interests and the overstatement of the OC account were confirmed during the October 2000 visitation and the March 2001 examination, the true state of Superior’s capital deterioration became evident.

Superior Bank Engages in the Securitization Business

Superior Bank adopted the securitization of residential mortgages to borrowers with non-conforming credit histories as its primary business after the incorporation of Alliance Funding Company, Inc. (Alliance), a former affiliate, as a division of Superior. The incorporation of Alliance as a division of Superior occurred on December 1, 1992. When Alliance was an affiliate of Superior, it specialized in originating, purchasing, and selling first and second home mortgage loans to non-conforming borrowers. Alliance operated through a network of 968 brokers located throughout the United States. The addition of Alliance as a division of the institution brought additional expertise and personnel to enable a rapid expansion in this market niche.

In 1994, Superior expanded its subprime securitization activities to incorporate subprime automobile lending and securitization. (Note: The term subprime refers to the credit characteristics of borrowers who typically have weakened credit histories that include payment delinquencies, previous charge-offs, judgements, or bankruptcies. These borrowers may also display reduced repayment capacity as measured by credit scores, debt-to-income ratios, or other criteria that may encompass borrowers with incomplete credit histories.) This activity was not pursued as aggressively as the mortgage securitization. Therefore, the total dollar volume from the automobile securitization activities was nominal in relation to the mortgage securitization activities.

Although concentrations of residual assets were noted in Office of Thrift Supervision (OTS) Reports of Examination, in 1998 Superior began to rapidly expand its efforts in the subprime securitization market. (Note: The residual assets consist of the residual interests and the overcollateralization (OC) account. The residual interests consist of the difference between the interest received on the underlying loans supporting the securitizations and the interest paid on the securitizations. The OC account is comprised of residual interests that are segregated into a separate account in accordance with the securitization agreement. Refer to Topics 2 and 4 for a more detailed discussion of residual interests and the OC account.)

Residual Interests – A By-Product of the Securitization Process

Various types of financial instruments may arise as a result of the securitization process. One of these is a class known as residual interests. The residual interests represent claims on the cash flows that remain after all obligations to investors and any related expenses have been satisfied. The residual interests represent funds required to build reserves and pay loan losses, servicing fees, and liquidation expenses. Any excess money, after all expenses have been met, provides a return to the holder of the residual interests. When the loans for the pools originate, they bear a stated interest rate. The securitized instruments are issued to investors at a lower interest rate than the stated rate on the loans. The difference between the interest rate that the loans are earning versus what the securitized pools are paying to investors is called the residual interest. Residual interests may be retained by the sponsors of the securities or sold to investors in the form of securities known as interest-only strips. Superior retained the residual interests from its securitizations. The problems for Superior began when they amassed large quantities of these high-risk assets.

Accounting for Superior Bank's Securitizations

Because residual interests were not common in the financial markets, information on default rates, discount rates, and prepayment rates of securitizations consisting of subprime loans was not readily available for comparative purposes. (Note: A discount rate is an interest rate used to convert future receipts or payments to their present value.) Unexpected market events can dramatically affect the discount rates or the default rates, thereby affecting the value of the asset and impairing the collectability of the future income stream. The use of liberal and unsupported assumptions can result in inaccuracies in financial statements and require material write-downs of the residual interests.

Superior recorded the values of the residual interests using a cash flow model. The cash flow model was based on assumptions, including discount rates, default rates, and prepayment rates, that Superior made concerning the portfolio of subprime loans underlying the securitized assets. In the 1993 through the 1999 Reports of Examination, the OTS did not take exception to the assumptions that Superior used since they appeared to be reasonable. (Note: This includes all years except 1998, which is excluded since the OTS did not perform an examination of Superior in 1998.) However, following the January 1999 examination, Superior changed to more liberal assumptions. They lowered the discount rate used to value the residual interests, which in turn increased the value of the asset. Also, the revised prepayment and loss rates were not consistent with actual performance. At the conclusion of the January 2000 examination, the OTS was highly critical of the high-risk lending activities and the liberal and unsupported assumptions used by the institution.

Besides the regulatory criticism relating to the liberal assumptions used to value the residuals, Superior encountered other accounting difficulties. The Federal Deposit Insurance Corporation (FDIC) participated in the January 2000 examination with the OTS. Several capital markets specialists were in attendance from both agencies. The examiners questioned whether the provisions of Statement of Financial Accounting Standards (FAS) 125 were applied correctly to the overcollateralization (OC) account. Because of the institution’s clean audit reports from Ernst &Young (E&Y), the examiners relied on E&Y’s conclusions. After the 2000 examination was completed, the institution’s composite rating was downgraded primarily because of the high-risk lending program, the use of the unsupported liberal assumptions associated with the residual interests, and the potential overvaluing of the OC account, all of which could have had a negative impact on Superior’s capital position.

The OTS and the FDIC returned to the institution in October 2000 for a visitation to determine management’s compliance with the January 2000 report recommendations. It was at this visitation that the different perceptions of the valuation of the OC account between the examiners, E&Y, and the institution culminated. In September 1998, December 1998, and July 1999, the Financial Accounting Standards Board Special Report issued "Question and Answer" guidance on FAS 125. The information in the December 1998 and July 1999 guidance, specifically question No. 75, supported discounting the value of credit enhancements for the period in which the funds are restricted. According to the securitization agreements, the OC account was restricted and the funds were not immediately available to Superior. The OC account was to be released incrementally over the life of the securitization. Therefore, the OC account should be discounted to reflect this period in which the account balance was restricted and not available for Superior’s use. This methodology is in keeping with cash-out accounting, which requires the discounting of the value until the funds are released to the entity. Conversely, cash-in accounting does not require the discounting of the value since the funds are not restricted and are immediately available. Superior was applying the cash-in accounting methodology to value the OC account even though the funds were not available to the institution upon collection.

After numerous discussions between the institution, the owners, the regulators, and the accountants, it was decided that the accounting methodology was incorrect and the OC account was overvalued. E&Y conducted an analysis of the account and determined that the OC account would require a material write-down of $270 million to reflect the discounting that should have been applied in accordance with FAS 125. The residual interests also required a revaluation because Superior could not support their rationale for changing to more liberal assumptions. A substantial write-down of approximately $150 million was required to reflect reasonable assumptions associated with the residual interests. The write-down in the OC account had a significant detrimental impact on Superior’s capital position as of December 31, 2000 rendering Superior significantly undercapitalized for PCA purposes. The write-down required for the overvaluation of the residual interests was never reflected in the Thrift Financial Reports (TFR) because the bank and OTS were anticipating the implementation of a recapitalization plan.

Concentration Level and Dollar Amount of Superior’s Securitization Activities

The following table details the concentration levels of the residual assets as a percentage of capital and their dollar volume as of financial statement dates at various OTS examinations.

Table 1: Concentration Levels and Dollar Volume of Superior’s Residual Assets

Source: OTS Reports of Examination, OTS October 2000 Field Visitation Report, and March 16, 2001 off-site examination memorandum.

Note: In the table above, core capital includes tangible capital and qualifying intangible assets. Tangible capital includes common stockholders’ equity, additional paid-in capital, retained earnings, noncumulative perpetual preferred stock (less any contra accounts), pledged deposits, minority interests in the equity accounts of consolidated subsidiaries, and unrealized gains and losses on available for sale securities. Equity capital includes perpetual preferred stock, common stock, additional paid-in capital, unrealized gains and losses on available for sale securities, retained earnings, and other components of equity capital.

OTS’s Treatment of Superior’s Residual Assets

The residual assets were the credit enhancements that Superior was obligated to provide through the securitization agreements in order to achieve a particular rating to enhance the marketability of the securitized bonds. From the onset of Superior’s subprime securitizations, the OTS examiners noted in their examination reports the increasing levels in the residual assets retained by Superior; however, the OTS rated Superior a composite "1" or "2" from 1993 through 1999 despite the growing amount of these high-risk assets. Table 2 indicates the examination dates and the CAMEL(S) ratings assigned by the OTS. In cases where the individual components were not available, only the assigned composite rating is listed. An intervening downgrade assigned by the FDIC is also reflected in Table 2.

Table 2: Examination Ratings for Superior Bank, FSB

Source: OTS and FDIC Reports of Examination.

The CAMEL(S) rating reflects the risks in financial institutions. Since Superior had such a large volume of high-risk assets, which affected every component of the CAMELS rating, a lower CAMEL(S) rating should have been assigned earlier to reflect this risk.

Treatment in the Early Years 1993 - 1999

As soon as Superior became involved in the securitization activities in1993, the OTS examiners were expressing their concerns for the level of residual interests and the additional risks posed by these instruments and their underlying mortgages. The 1993 report indicated that of the $10.87 million combined net income reported for the 6 months ending June 30, 1993, $8.1 million was generated through the mortgage banking area. The OTS Report of Examination recommended that Superior’s Board of Directors establish limits for the amount of residuals that the institution would retain as a percentage of capital in order to contain the risk in the mounting asset. Also, the 1993 report instructs management that the residual interests were reported inaccurately on the Thrift Financial Reports (TFR). (Note: Superior listed the residual interests on the TFRs as derivative securities. The OTS stated that they should be shown on the TFR as excess mortgage servicing rights.)

During the 1993 examination, the OTS cautioned that Superior should develop a comprehensive dividend policy addressing the impact of both cash and payment in kind dividends on all capital levels, with and without the book value of the residual interests. No mention of this recommendation was noted in subsequent examinations. In a December 21, 2001 OTS response to an FDIC Office of Inspector General (OIG) letter requesting clarification on several issues, the OTS stated that at that time, the Board promised to review the dividend policy and make any necessary changes by December 31, 1993. The OTS reiterated the need for a dividend policy in a February 8, 1994 meeting with Superior’s management, who again stated that its intent was to submit a current dividend policy. A review of the OTS files indicates that a new policy was not submitted. Instead Superior continued to adhere to a dividend based on 50 percent of net income. The OTS stated that Superior’s computation of net income followed Generally Accepted Accounting Principles (GAAP.) Also, based on Superior’s reported financial condition, the requested amounts of the dividend payments fell within the OTS regulatory rules.

In 1994, the OTS Examiner-in-Charge (EIC) cautioned Superior about the increasing levels of residual interests. The board still had not established specific limits for the amount of residual interests. Additionally, management did not address the recommendation in the 1993 OTS examination regarding correctly identifying the residual interests on the TFRs. As a result, Superior was still submitting inaccurate TFRs to the OTS because the residual interests were misclassified on the TFRs. The 1995 examination noted that the amount of the residual interests now exceeded 100 percent of capital.

One of the most significant issues raised during the 1994 and 1995 examinations was Superior’s erroneous calculation of the Allowance for Loan and Lease Losses (ALLL). The inclusion of a percentage of the ALLL in supplemental capital for purposes of assessing the bank’s capital position makes the accuracy of the ALLL critically important. Depending on the amount in the ALLL, all or a portion of the ALLL up to 1.25 percent of risk weighted assets, is allowed to be included in supplemental capital. Superior’s ALLL was comprised of three individual pieces. One portion provided for loss contingencies in the retail banking division. A second piece covered the volume of loans originated, securitized, and sold in the mortgage banking unit. The third piece was a valuation established to protect the institution from the devaluation of the residual interests due to fluctuations in the business cycle. The OTS Examiner-in-Charge (EIC) criticized Superior’s inclusion of the third portion in the ALLL since it was not established because of credit conditions and should therefore be excluded from the ALLL. Because this portion was included, the ALLL was overstated which in turn overstated the capital level. Despite the second admonishment in 1995 for including erroneous amounts in the ALLL, Superior did not take affirmative action to correct the inaccuracies. No further mention was made of the inclusion of the inaccurate valuation amounts in the ALLL until the 2000 examination when massive adjustments were made to the account. The ALLL was detailed in the ensuing reports (1996 – 1999); however, the examiners did not mention or criticize the inclusion of erroneous valuation amounts. In the December 21, 2001 response from the OTS to the FDIC OIG concerning this issue, the OTS stated that at that time there was little guidance concerning the activities in which Superior was involved. According to the risk-based capital guidance, the loans underlying the securitizations were required to be converted as if they were on-balance sheet equivalents. Because of this requirement, the OTS viewed the converted off-balance sheet loans and the ALLL as if they were both items on the balance sheet at Superior. (Note: This is a method used in the calculation of risk-weighted assets whereby the off-balance sheet items are multiplied by a risk factor that converts or transforms the risk into a balance sheet equivalent.) Future implementation guidance of FAS 125 issued in July 1998, December 1998, and July 1999 provided clarification on the accounting issues. At the January 2000 examination, it became clear to the OTS that the residual assets should be carried at fair value without the support of a reserve. At this time, Superior was required to net the interest rate risk and credit risk components of the reserve against the residual assets for TFR reporting purposes and exclude the remainder of the ALLL attributable to the residual assets from the risk-based capital calculations.

The OTS conducted an intensified examination of the securitization process in 1996. The OTS Washington Office enlisted the assistance of a capital markets specialist from the OTS Southeast Region to conduct the review of this area. The examiner thoroughly reviewed Superior’s assumptions, which were used to establish valuations for the residual interests. At the conclusion of the examination, the OTS examiner stated that the valuations seemed reasonable, and no criticisms in this area were noted in the Report of Examination. The 1997 and 1999 examinations showed similar results. The regional capital markets specialists reviewed the securitizations and nothing extraordinary was noted. Overall, the EIC of both examinations indicated that no material supervisory concerns were noted and that overall risk management practices were satisfactory. The major concern was the level of the residual assets in relation to capital; however, the examiners’ stated that their concerns were mitigated by strong capital levels. The 1997 and the 1999 reports, as well as subsequent correspondence did not indicate that the OTS took any actions to restrain Superior’s level of residual interest assets.

After receiving and reviewing the OTS Report of Examination dated January 25, 1999, the FDIC believed that the OTS’s composite rating of "2" was not representative of the risk posed by the institution. The FDIC evaluates the examination reports that are submitted by the other banking agencies to determine if the ratings reflect the risk in the institution in order to reduce potential losses to the funds. Because of the risk in Superior’s securitizations, the level of repossessions, and the residual assets’ inordinate size in relation to capital, the FDIC downgraded Superior to a composite "3" for risk- related insurance premium purposes. The OTS did not agree with the downgrade. The OTS thought that the FDIC’s reasons for downgrading the rating were unsupported; therefore, the OTS thought that the rating change was too harsh.

Following the 1999 examination, Superior liberalized its assumptions for valuing the mortgage-related residual interests, thereby, increasing the value of the residuals.

Treatment in the Latter Years 2000 - 2001

The FDIC participated with the OTS in the 2000 examination. Numerous flaws were noted with the altered assumptions for valuing Superior’s mortgage related residual assets. There was no documentation, such as comparable industry figures, to support the newly implemented assumptions. The concentration of residual assets was escalating and the board had still taken no action to curtail the amount of residuals acquired by the institution. The OTS advised the board to adopt restrictions on the amount of residuals in relation to the capital protection. Additionally, adverse classifications attained an excessive level because of the high-risk lending program. Policies, including the classification and ALLL, needed revamping to include all significant institutional activities.

In 2000, the OTS recommended that management implement procedures to determine the fair market value of the residual interests and adjust the carrying values of these assets accordingly, since it appeared that write-downs might be necessary due to the use of the unsupported assumptions. The examiners from both agencies questioned the accounting associated with the OC account. A DOS examiner stated that the OTS was reassured by management that E&Y had expressed an unqualified opinion in the firm’s audit reports, which included information pertaining to the accounting methodology for the OC account. Because of E&Y’s clean audit reports, examiners from the FDIC and the OTS relied on E&Y’s assessment of the validity of the OC account.

Also, the ALLL was grossly overstated due to the inclusion of valuations for the residual assets. The value of the ALLL was reduced from $128 million to $2.6 million at the conclusion of the 2000 examination to exclude ineligible funds that were in the ALLL. Additionally, the 2000 report disclosed that Superior was still incorrectly reporting the residual assets in the TFR. At the conclusion of the examination, Superior was accorded a composite rating of "4."

On July 1, 2000, because of the concerns noted at the January 2000 examination, the FDIC downgraded Superior to a category "C" for risk-related premium purposes. The OTS concurred with the reclassification. On July 5, 2000, the OTS issued to Superior a Notice of Deficiency and Requirements for Submission of a Part 570 Safety and Soundness Compliance Plan. The Part 570 directive was issued based on the results of the 2000 examination. The Part 570 directive required a plan outlining procedures for the revaluation and sensitivity testing of the residual assets. It also included provisions for the internal control function, credit underwriting standards, and the revision of the ALLL policy, including procedures to maintain the ALLL at a level commensurate with the risks at the institution. The directive also required Superior to formulate a plan to reduce its investment in residual assets to 100 percent of Tier 1 leverage capital within a year. This is the first documented evidence since the recommendation made in the 1994 OTS examination that the OTS placed any limitations on the extent of Superior’s maximum involvement in residual assets. Superior submitted the compliance plan to the OTS on August 4, 2000.

To confirm whether Superior had implemented corrective measures stemming from the January 2000 examination report, the OTS scheduled a visitation in October of 2000 with FDIC participation. After reviewing the information on the OC account, both agencies determined that the accounting methodology was not correct and that the account was overstated. E&Y and Superior’s management disagreed with the examiners’ assessment that the account was incorrectly stated. This was the beginning of a several month long controversy which was ultimately resolved by E&Y’s New York National Office which agreed with the regulatory agencies in January 2001 that the accounting for the OC account was incorrect and adjustments were necessary to reflect the correct total.

The OTS, with FDIC participation, conducted an examination on March 19, 2001. Superior ceased its securitization activities and gain on sale accounting associated with the mortgage division on June 30, 2000. Because of the high level of risk and the disproportionate size of the residual assets in relation to capital, the examination focused on the residual assets that remained on the institution’s books. After E&Y’s New York Office agreed with the regulatory authorities, a $270 million write down was required to adjust the value of the OC account. This dropped the institution from its former status as a well and/or adequately capitalized institution to a significantly undercapitalized institution. Further, Superior was still unable to provide documentation to support the assumptions used to value the residual interests. The examiners calculated that additional write-downs of approximately $150 million would be required as of December 31, 2000.

Because of the required year-end adjustments for the OC account, but prior to the adjustment for the overvaluation for the residual interests, Superior was designated as "significantly undercapitalized" for PCA purposes. The OTS issued a PCA Directive to Superior on February 14, 2001 and a consent Cease and Desist Order to two of the holding companies, Superior Holdings, Inc. and CCFC, as of the same date. Superior was required to submit a Capital Plan by March 14, 2001. Superior met the deadline; however, the OTS did not consider the plan acceptable.

Capital problems resurfaced at the end of the first quarter of 2001 when expenses from discontinued operations threatened to lower Superior’s capital designation to "critically undercapitalized." In April 2001, retroactive to March 31, 2001, CCFC injected $81 million in residual interests in order to avoid any further decline of Superior’s capital level. This "injection" of residual interests further increased the holdings of Superior’s residual assets and kept the institution above the critically undercapitalized benchmark for PCA purposes. The OTS responded to the FDIC OIG’s questions regarding this issue in OTS’s written response dated December 21, 2001. The OIG inquired why the OTS permitted Superior to count the residual interests towards their capital when the OTS Handbook specifically states that the inclusion of non-cash contributions as a source of capital is not an acceptable practice. The OTS responded by stating that the transaction was in conformance with GAAP. According to the OTS response, the OTS Handbook is only meant as guidance and is not an authoritative source; therefore, deviations from the handbook must be analyzed on a case by case basis. The contributed residual interests were part of Superior’s proposed Capital Plan. Under the plan, the residual interests would be purchased from Superior by a special purpose vehicle. The residual interests would be converted into cash within 60 days of the Capital Plan’s approval date. Therefore, the OTS did not disapprove the transaction.

Additionally, contrary to accounting standards, Superior netted certain assets and liabilities in order to reduce their totals, which in turn assisted in increasing their tangible capital ratios above the 2 percent threshold. The OTS responded to the FDIC OIG’s questions regarding this issue in their written response dated December 21, 2001. In correspondence dated May 3, 2001, the OTS questioned whether Superior was using the right of setoff properly. (Note: The right of setoff issue evolved from the sale of certain mortgage loans that were purportedly under commitment for sale to various financial intermediaries. FASB Interpretive Opinion No. 39 sets requirements in order to establish the right of setoff. The effect of the setoff is the reduction of certain assets by the corresponding amount of liabilities. This in effect, reduces the total assets and liabilities.) The examiners from both the OTS and the FDIC were to review this issue during the 2001 examination. An OTS memorandum indicated that it was unlikely that Superior should have used the right of setoff when filing the March 31, 2001 TFR. However, prior to any final determination on this issue, the OTS approved Superior’s Capital Plan. At this time, the OTS’s choice was to either implement the Capital Plan or place Superior into receivership. The OTS considered the right of setoff issue "somewhat moot."

The Capital Plan that the OTS conditionally accepted stated that the residual assets would be purchased by the holding company through a series of transactions including cash injections from the owners, third party financing, and the pledging of bank assets. The OTS did not require Superior to write down the value of the residual interests during the 2001 examination since the plan listed the sale price of the residual assets as $10 million over the book value. Additionally, the OTS did not require Superior to restate its March 31, 2001 TFR, which listed the residual interests at amounts exceeding their true value.

Other adverse examination findings in the March 2001 examination included out of balance accounts, an unsecured receivable from Superior’s second tier holding company and required reductions to servicing assets. (Note: CCFC transferred ownership of Superior to Superior Holding, Incorporated (SHI), which became Superior’s first tier holding company. CCFC owned SHI and CCFC became Superior’s second tier holding company.) The out of balance accounts consisted of two accounts entitled "Other Receivables." The first account consisted of deficiency balances on auto loans after disposal of the autos, plus losses on the sale of repossessed autos. Some of the items dated back to November 1999. The total loss in this account was $3.4 million. The second account consisted of an unreconciled difference from another general ledger account involving principal and interest advances on securities. The total loss on this account was $4.6 million. Beginning in April 1999, Superior had transactions with its second tier holding company, CCFC. At the 2001 examination, it was discovered that Superior had a receivable on its books from CCFC for $36.7 million. Superior sold loans to CCFC. CCFC in turn sold these loans for a $20.2 million profit. The bulk of the $36.7 million balance represented profits from the sale of loans by CCFC that were owed to Superior. The OTS listed this receivable as a violation between Superior and CCFC for engaging in transactions that were not at arms length and for extending unsecured credit to an affiliate. Lastly, Superior had advances related to six closed securities that should have been written off. The securities were called as of April 30, 1999 and Superior, as servicer, failed to collect the advances totaling $4.9 million due from the trust. Additionally, the OTS criticized the unprofitable status of the institution.

According to the FDIC’s draft March 19, 2001 Report of Examination, if all of the losses noted at the examination were charged-off and all adjustments were made, the institution was insolvent as of that examination. Because of the ongoing negotiations with the owners concerning the capital restoration plan, the OTS did not require Superior to charge-off the $150 million revaluation of the residual interests. The FDIC 2001 draft report was not finalized and remitted to the institution.

OTS Treatment of the Residuals - Subprime Automobile Loans

Superior expanded its market in subprime loans with the addition of subprime automobile lending in 1994. The first OTS exam after this business line became fully operational was conducted in 1997. This examination criticized management for omitting delinquent auto loans and repossessions in their TFRs.

At the 1999 examination, the OTS noted that the auto division had an unacceptable level of delinquencies and losses. Once again, management was criticized for excluding assets, which should have been listed as adversely classified assets on the TFRs. The OTS required Superior to establish specific valuation reserves for loss classifications totaling $12.5 million. The OTS recommended that management amend the classification system to ensure accurate regulatory reporting and establish all appropriate allowances. Additionally, the OTS recommended that Superior revise and expand the ALLL policy to cover all of the pertinent business of the institution.

The FDIC participated in the 2000 examination with the OTS. Adversely classified assets and higher than anticipated loss rates, which were more than double the original estimates, continued to mount in the automobile division. Superior was instructed to follow the Uniform Credit Classification and Account Management Policy, which had been adopted by all of the federal banking regulators. (Note: This policy was adopted by the OTS in 1987. However, OTS examiners in 1999 and 1997 did not use the policy to classify loans at Superior that fell within the scope of this policy. The OTS did not require Superior to follow the policy until the 2000 examination.) (Refer to Topic 5 for additional information on the OTS’s lack of enforcement of the requirements of this policy’s guidelines at previous examinations.) The OTS also charged-off a $12 million asset swap between Superior and Western Trading, an advertising concern. Superior "sold" worthless auto loans, which should have been charged-off, for future advertising credits. Despite tightening lending standards twice and reducing the lending volume, the auto division was not profitable. The OTS again criticized management for incorrectly risk weighting assets associated with the automobile division for purposes of calculating risk-based capital. Superior’s unsuccessful subprime automobile lending operations ceased in December 2000. Expenses associated with the disposition of this division continued to impair income in 2001.

Topic 3 -The regulator’s reliance on and oversight of accounting information provided by the institution and its external auditors.

The Office of Thrift Supervision (OTS) did not independently determine the value of Superior’s residual assets – residual interest and overcollateralization accounts – or take enforcement action when its examiners found errors in Superior’s Thrift Financial Reports (TFR). Instead, OTS relied on Superior’s management and its external auditor, Ernst & Young (E&Y) for the valuations of significant assets. The OTS placed undue reliance on the unqualified opinions that E&Y gave on Superior’s annual audited financial statements. Because of the high-risk nature of subprime lending – Superior’s principal line of business – OTS should have more closely scrutinized the value of Superior’s residual assets and conducted more frequent reviews of E&Y’s workpapers. (Note: The term subprime refers to the credit characteristics of borrowers who typically have weakened credit histories that include payment delinquencies, previous charge-offs, judgements, or bankruptcies. These borrowers may also display reduced repayment capacity as measured by credit scores, debt-to-income ratios, or other criteria that may encompass borrowers with incomplete credit histories.) In addition, OTS should have required Superior to file corrected TFRs when material errors were found, and taken enforcement actions against Superior and its management when Superior continued to file erroneous TFRs.

Reliance on and Oversight of Superior’s External Auditor

Superior management, with the advice of its external auditor, Ernst & Young (E&Y), utilized accounting practices that made the institution appear more profitable than it was. This, in turn, enabled Superior to make substantial dividend payments in accordance with its dividend policy, take on more risk in the form of additional securitizations and deflect regulatory concern by holding out its overstated capitalization ratios and additional profitability. E&Y, the bank’s external auditor from 1990 through 2000, gave Superior unqualified audit opinions and did not question the valuations or calculations involving Superior’s assets and capital structure. Ultimately, in 2000, the OTS and the FDIC examiners questioned the incorrect calculation of the overcollateralization account and the valuation of the residual interests. After the January 2000 OTS examination, but before ceasing securitization activities on June 30, 2000, Superior increased the amount of risk in these assets.

E&Y Advised Superior’s Audit Committee

According to minutes from an Audit Committee Meeting of Superior’s Board of Directors held on January 27, 2000, E&Y’s Engagement Partner (E&Y Partner) gave a summary of the audit results completed for the fiscal year ended June 30, 1999. E&Y Partner presented a package to the Audit Committee that identified E&Y’s: audit approach, areas of audit emphasis, required communications, next fiscal year’s audit approach, summary of emerging technologies and related risks, an overview of the audit process, and a summary of audit differences. The E&Y Partner went through each area identifying key points during the audit process. He also noted the various reports that were issued by E&Y as a result of the audit process and that all such issued reports contained audit opinion letters, which noted no exceptions.

Subsequent to the presentation by E&Y’s Partner, a detailed discussion relative to financial receivables (a/k/a residual interests) and the audit steps performed during the review processes by E&Y ensued between E&Y’s Partner and an Audit Committee member. (Note: Financial Receivables is a term used by E&Y to describe a financial component of Superior’s securitization transaction. Financial receivables, also known as residual interests in collateralized mortgage obligations, represent the net present value of future cash flows of the bank’s residual interests from sales of loans over the estimated life of the loans. Expected net cash flows would be reduced to reflect adjustments for estimated prepayments, losses, and discounts at rate management believes to be similar to a yield required by a third party investor.) E&Y’s Partner explained in detail the audit process and the testing techniques that E&Y utilized to evaluate the underlying assumptions and the model utilized by the bank. He also detailed that the firm’s audit processes included a review of the bank’s balance sheet carrying values of financial receivables and related assets, recoverability analysis of financial receivables, and the related income statement accounts. According to the January 27, 2000, meeting minutes, E&Y’s Partner noted that, "E&Y had an overall comfort with the assumptions utilized by the Bank and the resulting values." E&Y’s Partner noted that after running the firm’s own model with varying assumptions to test the bank’s model, "E&Y 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." Clearly, as of June 30, 1999, E&Y concurred with the assumptions and the model used by Superior management to value the financial receivables.

Next, the Audit Committee and E&Y’s Partner entered into a discussion relative to Statement of Financial Accounting Standards (FAS) 140 (FAS 140 replaced FAS 125 and became effective after March 31, 2001), which would be required to be utilized by the bank for the fiscal year 2001. (Note: FAS 125 was effective for transfers and servicing of financial assets and extinguishments of liabilities occurring after December 31, 1996 through March 31, 2001. FAS 140, a replacement of FAS 125 although most of its provisions are carried over into FAS 140, took effect after March 31, 2001.) It was noted that the primary effect of FAS 140 on the bank would be that it would require the bank to provide greater disclosures of the accounting assumptions it used to record the book value and related income of the financial receivables. The disclosure would require a comparison to actual results achieved, such as Constant Prepayment Rate (CPR) speeds, discount rates, and loan loss reserve rates. (Note: CPR = Constant Prepayment Rate. The percentage of outstanding mortgage loan principal that prepays in one year, based on the annualization of the single monthly mortality, which reflects the outstanding mortgage loan principal that prepays in one month.) According to the minutes, the bank’s current model used a higher discount rate at inception and the ARM loan portfolio did not estimate the effect of using a prepayment ramp on the ARM portfolio. (Note: The term is a concept often used with home equity loans and manufactured-housing transactions to describe a series of increasing monthly prepayment speeds, prior to a plateau, on which the expected average life of a security is based.) It was also noted that the overall discount rates being utilized by Superior, considering all factors, were comparable to current market discount rates used by other third parties.

In further discussing Superior’s "conservative methods," E&Y’s Partner noted that, "CPR factors, discount rates, loan prepayment fees and other conservative factors used by Superior may need to be reviewed and potentially adjusted to reflect current market factors to more closely track actual results under reporting required by FAS 125." Immediately following the Partner’s caution were unattributed statements that implied that Superior did not have to worry about the impact of FAS 140 disclosure requirements. The minutes state, "However, it was further noted that based on an initial review, changes in these factors and methods would result in offsetting changes in reported values. Confirming the factors and methods used to facilitate the disclosure requirements of FAS 125 would likely result in the use of different assumptions without substantially changing the initial valuation recorded by Superior." We could not determine from reviewing the minutes whether E&Y’s Partner or one of Superior’s board members made the two statements.

As of January 27, 2000, E&Y took the position that Superior’s accounting methodology and valuation assumptions for its financial receivables were in conformance with Generally Accepted Accounting Principles (GAAP) but might be impacted by FAS 140, which required additional disclosures in the financial statements.

OTS Reviewed E&Y’s Workpapers

OTS’s Regulatory Handbook, Section 350, Independent Audit, issued August 16, 1995, provides guidelines for examiners about the use of the external auditor’s annual work. The annual external audit should be used to assist in the financial analysis of institutions to identify areas of supervisory concern or accounting complexity and to detect trends and information not otherwise revealed in the monitoring of institutions. The independent auditor performs procedures that evaluate the reliability of financial statement assertions and certain assertions included in the Thrift Financial Report (TFR). According to the AICPA’s Statements on Auditing Standards (SAS), specifically SAS No. 31, Evidential Matter, audit objectives are established to test the numerous assertions (both implicit and explicit) that are included in a client’s financial statements. These assertions can be grouped into the following five categories: existence and occurrence, completeness, rights and obligations, valuation or allocation, and presentation and disclosure.

Section 350 states that examiners should use the annual audit to supplement the examination process whenever possible. Examination personnel are encouraged to review the audit workpapers when planning examinations. The review is intended to help determine the scope of the examination, identify areas where examination procedures can be supplemented by audit work, identify audit work that can be relied on for certain financial statement assertions, and identify high-risk areas that require expanded procedures. Examiners may rely on the audit work findings in low-risk areas. In such cases, examiners should request that the auditor provide copies of the key workpapers. In high-risk areas, examiners should use the audit evidence to plan and supplement examination procedures. Examiners should also consider exercising the OTS’s authority to direct auditors to perform specific or additional audit procedures. In such cases, the regional accountant should be consulted.

OTS 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 did it become apparent to OTS that it may have relied too heavily upon Superior management’s financial statements and E&Y’s unqualified audit opinions of those financial statements. OTS did not detect the uncertainties over the accounting treatment accorded to Superior’s residual interests and overcollateralization (OC) account early enough to correct the problem before Superior failed.

According to the OTS Chicago Regional Accountant, examiners conduct reviews of external audit workpapers to help them scope their examination and focus on the higher risk areas present in an institution. Examiners also try to eliminate areas or reduce the amount of work they would ordinarily do after determining the extent to which the external auditor conducted its audit. His explanation was in concert with Section 350 that states that after reviewing the auditor’s workpapers, the examiner may decide to do some or all of the following:

1. reduce the scope of the examination in certain areas based on the extent, scope, and findings of the audit;
2. expand the examination scope in certain high-risk areas based on the audit work;
3. expand the scope in certain areas based on the auditor’s findings that disclose matters of supervisory concern; and,
4. refer regulatory reporting issues to the regional accountant.

Section 350 provided the following examples of cases where a review of the audit workpapers and conversations with auditors could assist examiners in performing examinations.

1. An association has asset quality problems and reserves are deemed by the auditor to be adequate. The audit workpapers document management’s valuation estimates and indicate the audit procedures performed to test those estimates. After the review, the examiner would understand management’s approach and the exposure areas.

2. An association has aggressive accounting practices. The audit workpapers would document management’s reasons for the aggressive practices. After the review, the examiner would understand management’s rationale and could assess whether a less aggressive accounting practice would be more appropriate from a safety and soundness standpoint.

3. An association has serious internal control problems. The full extent of the problems should be discussed with the auditor to determine where the scope of the examination should be expanded.

4. An association has mortgage servicing assets. The audit workpapers would document the assumptions and methodologies used to value the servicing. If the findings are acceptable for safety and soundness reasons, the examiner could rely on the audit work.

Of the four examples cited above, Superior exhibited characteristics cited in virtually all four examples. According to Section 350, a review of the audit workpapers and a discussion with the auditor in each of the above examples would likely improve the examiner’s understanding of the differences in judgment or fact that might require examination adjustments to the TFR. They also illustrate how the examiner can focus scarce examination resources on problem areas by using some of the evidence gathered by the auditor.

OTS performed workpaper reviews in conjunction with the 1996 and the 2000 examinations and subsequent 2000 field visitation. During the 1996 workpaper review, OTS focused on Superior’s financial receivables. However, information was not available that addressed the scope and procedures performed by OTS to determine whether E&Y’s work could be relied upon, and the OTS was not critical of E&Y’s 1996 workpapers. The workpaper review performed by the OTS and the FDIC examiners in conjunction with the October 2000 visitation helped lead to the discovery of the incorrect accounting treatment for Superior’s OC account. The eventual restatement of the OC account was one of the major factors that ultimately led to the closing of this institution.

January 2000 Examination

During the January 2000 examination, a meeting involving the examiners from the OTS, the Federal Deposit Insurance Corporation (FDIC), and E&Y representatives (current and former partners assigned to Superior) provided a more in-depth review of the finan