Blind Risk: The Failure of Superior Bank

It was like a scene from the movie It’s a Wonderful Life, sans the snow and angels’ wings. On a steamy afternoon last July, hundreds of Superior Bank FSB depositors lined up to see if the money they had left in the hands of the failed Oakbrook Terrace, Illinois-based thrift was safe. To some observers, however, Superior’s collapse called to mind another Hollywood flick: The Perfect Storm, a 1999 film about an unusual confluence of climatalogical events that sparked a devastating Atlantic storm.

“You had improper accounting, a board that didn’t adequately monitor management and bank operations, and regulators who weren’t as aggressive as they could have been,” says John Geiringer, a former Illinois state bank regulator and now a Chicago banking attorney.

“Combine that with issues of risk diversification and an ownership that didn’t step up to the table when it was needed, and you had all the ingredients for a failure,” adds Geiringer, who works for Barack Ferrazzano Kirschbaum Perlman & Nagelberg LLC. “Everyone involved wound up with egg on their faces.”

Superior’s collapse was, indeed, a doozy, with enough subplots to justify its epic price tag. The privately held thrift had, at its peak, $2.3 billion in assets and 17 branches in the Chicago area, and it was a big national player in the subprime mortgage and auto lending arenas. Only a few years ago, it was hailed as an industry high-flier. Now, Superior’s failure is expected to cost the Savings Association Insurance Fund (SAIF) $350 million, making it the costliest thrift bailout in a decade.

For directors everywhere, Superior’s story offers some important lessons. While the events surrounding the failure were complicated, investigative reports by three government agencies, congressional testimony, and interviews with people familiar with the situation all point to poor risk management and oversight from the board as a primary culprit.

Like many financial institutions today, Superior pooled most of its loans into securities. To make those securities more saleable to investors, it held onto many of the riskiest parts of the loans. That, too, isn’t an unusual practice. But the sheer volume of those so-called residual assets was unprecedented. By 2000, Superior had some $996 million in these assets on its balance sheetu00e2u20ac”more than the 29 closest thrifts combined, according to regulators.

In the best of cases, such residuals are difficult to value. Those tied to subprime loans, which are subject to higher default and prepayment risks than other loan classes, are even trickier. Despite that, Superior took an optimistic approach, in essence betting that the loans would perform similar to those in higher asset classes. That enabled it to book extraordinarily high noncash gains on its securities sales and made the company’s capital position look much healthier than it actually was.

How bad was it? According to Bert Ely, an Arlington, Virginia banking consultant who tracked Superior’s progress, regulatory filings indicate that the $487 million in gain-on-sale income reported by Superior between 1995 and 1999 exceeded its pretax income by more than $72 million. “In effect, Superior consistently lost money before recording its gain-on-sale income,” he says.

When the economy soured and regulators began to dig deeper, Superior’s prospects took a turn for the worse. In early 2001, the company was forced to book a $270 million writedown on its portfolio. Later that year, another $150 million adjustment was booked. When its owners failed to inject more capital into the institution, it was shut down.

In the flurry of finger pointing that has followed, few of the principals have emerged unscathed. The thrift’s ownership was split evenly between Chicago’s Pritzker family, one of the nation’s wealthiest, and Alvin Dworman, a long-time Pritzker friend and wealthy New York real estate developer. The Pritzkers are politically well connected and boast a $10 billion fortune that includes, among other things, a controlling stake in hotel giant Hyatt Corp. As one official with the Office of Thrift Supervision noted, “This is a family with substantial resources, so I’d expect they’d understand how these asset values can change over time.”

A spokesman for the Pritzker family did not return phone calls seeking comment, while an attorney representing Dworman did not respond to phone and e-mail messages.

In this post-Enron era, the accounting treatment also has been questioned. The company’s auditors at Ernst & Young gave the thrift a clean bill of health each year between 1995 and 1999, even as its problems mounted. One possible reason according to Gaston Gianni, Jr., inspector general for the Federal Deposit Insurance Corp: The firm made at least twice as much money off of consulting services provided to Superior than it did from accounting. Among its consulting roles was the approval of Superior’s residual valuation methods, which its accounting arm then validated. “It was a direct conflict,” Gianni says.

Nor have the regulators themselves escaped scrutiny. As late as 1999, the OTS and the FDIC had top-drawer CAMELS 1 ratings on Superior. With hindsight, critics wonder how such a risky strategy could have progressed so far without sparking greater concern.

For all that, some of the harshest criticisms are saved for Superior’s directors. The board was loaded with insiders, including a vice president of the Pritzker Family Foundation, the presidents of two Superior affiliate companies, and at least two company officers.

Investigators charge that directors ceded control of many vital functions to the company’s ownership, and to its chairman, a longtime Superior employee who was said to be a domineering force on the board. Regulators have faulted directors for their poor oversight of a high-risk strategy that evolved, slowly and steadily, over an eight-year period, saying the board didn’t establish adequate risk management and diversification policies, disregarded supervisory recommendations, and failed to ensure that the thrift followed existing laws and regulations.

Directors also approved $188 million in dividend payouts to owners during the thrift’s salad days. In retrospect, those payments, based on results produced by faulty numbers, ate into Superior’s capital position and left it even more vulnerable to collapse.

Superior’s directors are presently defendants in one lawsuit, a class action brought on behalf of a group of uninsured depositors. In total, some 1,400 uninsured depositors collectively lost $65 million in the collapse. “This wasn’t a risky investment deal. These were people who put their money in the bank, and were led to believe [by bank employees] that the money would be insured,” says Clint Krislov, the Chicago attorney representing the plaintiffs.

Since the owners didn’t deal directly with depositors, he adds, it’s the officers and directors who set the policies that are targeted by his suit. “The way the system plays out, you have to chase those individuals for the money.” Geiringer also counts an uninsured depositor as a client, so other lawsuits are possible.

And while they haven’t yet been subject to government sanctions, a December settlement between regulators and Superior’s owners “contemplates possible future enforcement actions against some former officers or directors,” says OTS spokesman Sam Eskenazi.
“The directors deny any allegations of wrongdoing, and will vigorously oppose the complaint,” says Stephen Novack, a partner with the Chicago law firm of Novack and Macey, which is representing the directors in the suit. “We are confident that, when all the facts and known and considered, the directors will be vindicated.”

Superior’s ill-fated journey began in 1988, when the Pritzkers and Dworman paid $42.5 million for the failed Lyons Savings Bank, a $1.5 billion thrift in suburban Chicago. To facilitate their ownership, the Pritzkers and Dworman each created shell companies, which owned 50% each of the Nevada-based holding company, Coast to Coast Financial Corp., that owned the thrift.

By 1993, Superior had regained its footing and received a CAMELS 2 rating from both the OTS and FDIC. From there, the thrift’s sights were set on growth. It leveraged the acquisition of Alliance Funding Co.u00e2u20ac”a subprime mortgage banking firm in Orangeburg, New York, that featured programs for borrowers with recent bankruptcies and those who wanted high loan-to-value ratios. Alliance boasted 11 offices and, at its peak, a nationwide network of more than 800 brokers.

Almost immediately, Superior began to “vacuum up subprime mortgages,” and, later, subprime auto loans, from around the country, warehouse those loans on its balance sheet, and then securitize them while retaining the servicing rights, Ely says. To bankroll the strategy, Superior used a combination of consumer and brokered deposits.

On paper, the strategy appeared to be wildly successful. Superior’s asset size ballooned from $974 million in 1993 to $2.3 billion in 2001. Largely on the strength of gains from the sales of its securitizations, the thrift reported an eye-popping return on assets of 7.25% by 1996, according to the FDIC, compared to an industry average of 0.60%.
But trouble loomed behind those numbers. To raise the credit ratings on its securitiesu00e2u20ac”and thus boost its gains on their salesu00e2u20ac”Superior kept on its balance sheet many of the riskiest parts of those loans.

Assigning accurate values to such residual assetsu00e2u20ac”including interest-only strips and overcollateralization accountsu00e2u20ac”requires solid estimates of such factors as default and prepayment rates, and economic conditions, to predict the cash flows that will follow. For Superior, the risks were significantly enhanced, both by sheer volumes and by the subprime nature of the loans. Most of the thrift’s borrowers were B-credits or lower. Such loans pay higher interest rates, but also are prone to higher levels of default and prepayment.

Yet the thrift didn’t, perhaps couldn’t, make those complex estimates itself, relying instead on a third partyu00e2u20ac”Fintek Inc., another member of the CCFC familyu00e2u20ac”to make the calculations. Fintek significantly overvalued Superior’s residuals, failing to “discount to present value the future cash flows that were subject to credit losses,” according to a report by the General Accounting Office.

Worse, regulators say, management and the board appear to have had little knowledge or understanding about how the valuations were derived. “Superior paid inadequate attention to Fintek, and lacked sufficient controls to ensure that key valuation functions were reliable,” Jeffrey Rush, inspector general for the Treasury Department, told the U.S. Senate Banking Committee.

In retrospect, it was almost inevitable Superior’s loan portfolio would eventually begin to falter. Yet, as then-FDIC Director John Reich said in his Senate testimony, the residuals “were deeply subordinated, at a first loss position, to more senior claims on the $4 billion in subprime loans that Superior sold to investors.”

Compensating for that added risk, Rush testified, should have mandated higher capital requirements. Yet, “despite the heightened risks of Superior’s business strategy, Superior generally maintained capital equivalent to thrifts engaged in traditional lending activities,” he said. Indeed, according to the GAO, at one time the residuals alone amounted to 348% of the thrift’s tier 1 capital. “This level of concentration was particularly risky given the complexities associated with achieving a reasonable valuation of residual interests,” the GAO report stated.

Superior’s boardu00e2u20ac”and specifically its chairman, Nelson Stephensonu00e2u20ac”seemed oblivious to such risks, investigators say. Stephenson, an 11-year Superior veteran and an architect of the securitization strategy, “dominated” the board, according to the FDIC inspector general’s report, consistently asserting his confidence in both Superior’s strategy and the willingness of the Pritzkers to stand behind the company.

Stephenson “was a very persuasive person who knew the most about Superior’s operations,” the report quotes OTS officials as saying. He also “adamantly supported Superior’s accounting methodologies … and sanctioned overall business strategies that clearly ignored any avenues to diversify Superior’s high-risk and volatile asset base,” the FDIC report states.

This, Gianni argued, should have been a red flag for Superior’s board. His report calls the domination of a board by its chairman a “high-risk indicator,” and asserts that the board as a group shirked its responsibilities to limit the amount of risky residuals on its books.

Stephenson could not be reached for comment.

If the board failed to provide proper oversight, then regulators, too, came up short. Between 1993 and 1996, as Superior ramped up its strategy, the OTSu00e2u20ac”relying largely on audit information supplied by Ernst & Youngu00e2u20ac”assigned Superior “2” ratings for safety and soundness, and in 1997 boosted the rating to “1,” a level it maintained when the OTS commenced its examination in early 1999. Much of the effort in that exam was focused on rising auto loan chargeoffs and what then-OTS Director Ellen Seidman called an “inadequate asset classification system.” In March, the OTS lowered its rating to “2.”

As occurred in several other recent high-profile failures, including the colossal 1999 collapse of the First National Bank of Keystone in West Virginia, regulators bickered over procedure as Superior wavered. In 1999, the OTS blocked the FDIC’s efforts to participate in the thrift’s examinations. Seidman said Superior’s owners were involved in litigation with the agency on an unrelated matter and were “concerned about giving an FDIC examiner full access to its books and records while in the midst of litigation.”

Nonetheless, the FDIC, using data obtained by the OTS, assigned a “3” rating to Superior, to reflect the rising concentration of residuals on its books and differences between the bank’s audit statements and its quarterly financial statements.

As scrutiny increased, Superior’s management and board resisted efforts to correct its residual concentration, saying there was no problem. Its stance was supported by Fitch Inc., which assigned Superior’s long-term debt an investment-grade BBB rating. “Extensive analysis of historic prepayment and credit performance of existing loan pools [by Superior] provides a basis for rational accounting,” Fitch reported in May 1999.

Things turned uglier the next year, however, as Superior was hit by rising defaults and prepayments. Regulators, working with new securitization guidelines sparked by the 1999 Keystone failure, began to dig harder. The FDIC joined the OTS for the 2000 examination. The results revealed “extremely high concentrations of high-risk assets, inadequate management and controls, inaccurate reporting and a lack of documentation/support” for the residual holdings, Reich testified.

That spring, both agencies lowered their CAMELS ratings on Superior to “4,” ordering it to boost capital and loan-loss reserves. In July, the OTS sent Superior’s board a “notice of deficiency,” requiring directors to obtain independent valuations for its residuals, revise its loan-loss reserve policies, and reduce its residual asset holdings. Two days later, Superior was officially classified as a “problem institution.”

At first, the board appeared to respond favorably. Seidman noted that the company halted its securitization activity immediately, and, a month later, submitted a compliance plan to the OTS. When regulators returned near the end of 2000, however, many of those plansu00e2u20ac”including the establishment of tougher limits and policies on residual asset holdingsu00e2u20ac”had not been fulfilled.

According to investigators, Superior’s leadership seemed indifferent, even defiant. Seidman noted that when the OTS ordered Superior that December to make further changes in its accounting treatment for residuals, “management and E&Y continued to disagree” with the regulators. Superior’s problems were “exacerbated … by management and board recalcitrance in acting on regulatory recommendations, directives and orders,” she added.

A letter that month to the OTS from CEO and President Neal Halleran, opposing a proposal to amend the treatment of residual interests, typified the mood:

“Clearly, residual interests generated from the sales of loans that have been made to subprime and non-conforming borrowers can present greater valuation challenges, which if mishandled can be particularly dangerous during periods of market volatility,” Halleran wrote. ” … [But] the fact that there have been some egregious cases of deficient management of retained interests and securitization programs does not justify subjecting the system as a whole to rules” that would have “adverse consequences for many financial institutions.

“At Superior Bank, we have given large numbers of borrowers an opportunity not only to own their own homes, but also to prove they can be creditworthy,” Halleran added. “And we have done so without taking on undue liquidity, credit or interest-rate risk.”

Those words would quickly come back to haunt Superior. In January, an official from Ernst & Young’s headquarters acknowledged that his firm’s accounting treatment was faulty. A reevaluation ensued, and in February, the OTS issued a prompt corrective action (PCA) directive to the board, saying that Superior was “significantly undercapitalized.” It ordered the board to submit a plan to restore capital levels and issued several cease and desist orders requiring Superior to halt most lending activities. At about the same time, Stephenson and William Bracken, the chief financial officer, resigned.

In March, the board restated its financial statements and took a $270 million writedown on its books. The move reduced the thrift’s capital ratios to 2.08%, and both agencies cut their CAMELS ratings on Superior to “5”u00e2u20ac”the lowest-possible level. Later that month, Superior’s board submitted its PCA plan. It called, among other things, for selling the residual assets to a separate Pritzker-owned entity. But while CCFC also made a small capital infusion to keep Superior temporarily afloat, the OTS and Pritzkers bickered over a broader agreement to save the thrift.

An apparent agreement was struck in May, calling for the Pritzkers to invest about $350 million into Superior to shore up its position and take over the 50% owned by Dworman. But when further writedowns were required, the Pritzkersu00e2u20ac”apparently concluding that their investment would merely be a downpaymentu00e2u20ac”decided to cut their losses. On July 27, the FDIC took possession of Superior. “I think it was a business decision, and they were willing to risk the reputational damage that would flow from that decision,” Geiringer says.

It will likely take years to sort out the full impact of Superior’s failure. But some things are already clear. Given the calamity of the situation, the owners appear to have made out fairly well. The Pritzkers agreed last December to a deal that absolves them from any future liability in exchange for payments of $100 million upfront and another $360 million spread interest-free over the next 15 years, valuing to the settlement at about $335 million in current dollars. The dividend payments, assuming they were reinvested to gain 10% annually, would account for about two-thirds of the settlement total, Ely estimates.

“[The] Pritzker family interests … believe the agreement reflects their historical commitment to stand by their investments and are convinced the agreement is the right thing to do,” according to a statement issued by the family following the accord.

In addition, the Pritzkers are cooperating with a government investigation into Ernst & Young’s role and stand to get 25% of any government winnings from the firm. While Ernst & Young has denied any wrongdoing, the FDIC has been investigating its role “with an eye to potential litigation,” GAO Managing Director Thomas McCool told senators. He said a review of the bank’s records shows that “the firm explicitly supported an incorrect valuation” of Superior’s residuals.

In addition, he firm is the subject of an ongoing grand jury investigation in Chicago related to the failure.

A spokesman for Ernst & Young, Les Zuke, counters, “The inspector general of the FDIC reported to the Senate Banking Committee that the failure of Superior Bank was directly attributable to the bank’s board of directors and executives ignoring sound risk-management principles. We believe that this factor, and the refusal of the bank’s owners to follow through on an agreed-upon recapitalization plan, coupled with the deteriorating economy, led to the ultimate takeover of Superior by the FDIC. … The bank’s failure was not caused by any action of ours, and we intend to defend vigorously any claims against us.”

The owners’ settlement will likely spare SAIF a hefty payout. FDIC spokesman David Barr says that the $350 million loss estimate was calculated before the deal with the Pritzkers. But the failure still is a devastating psychological blow. In the five years prior to Superior’s failure, SAIF paid out just $24 million in claims to depositors. SAIF’s reserves-to-deposit ratio was 1.37% at the end of 2001u00e2u20ac”compared to 1.43% a year earlieru00e2u20ac”and could go lower as the Superior mess is sorted out. At 1.25%, higher deposit insurance premiums for the industry would kick in.

Many observers fault regulators for not catching Superior’s troubles earlier. In his report, Gianni said “warning signs were clearly evident as early as 1994 that should have resulted in further investigation by the examiners,” but nothing happened.

To be sure, the case posed some special challenges. George Kaufman, a business professor at Loyola University Chicago, who has followed the situation closely, reckons that the wealth and reputation of the owners may have been intimidating to examiners. The Pritzkers have been big donors to the Democratic Party and, reportedly, called upon several big-name officials, including former Comptroller Eugene Ludwig and Washington litigator Lanny Davis, President Clinton’s lawyer during the Monica Lewinsky affair, for help. “If you’re an OTS examiner getting paid $50,000, and you’re supposed to go up against powerful people like the Pritzkers, it’s not fair,” he says.

But critics say that the regulators’ reliance on outside auditing reports was dangerous, while its attempts now to blame Ernst & Young for the failure are largely unwarranted. “The regulators are trying to duck their own responsibilities and pass the buck to someone else,” Ely says.

Kaufman, a former bank director, thinks boards and managements should push regulators to be more aggressive in their enforcement efforts. “The industry winds up footing the bill when you have situations like this,” he says. “The good guys in the industry need to ride herd on the regulators to move faster.” No signs of such dramatic action appear imminent, though some improvements have emerged. In response to recent big-ticket failures, for instance, the FDIC’s board recently gave its agency, the ultimate insurer, greater authority to participate in examinations. In March, the OTS cut 43 positions in Chicago, though it’s not clear if any were tied to the failure.

For directors, the lessons from Superior are in many ways similar to those told during past failures. Despite the recent economic downturn, the thrift industry appears to be as healthy as ever. In 2001, the industry reported record profits and an average ROA of 1.16%, according to the FDIC. Assets were up more than 6% for the year, to $1.3 trillion, and net interest margins also rose.

These are signs that Superior was atypicalu00e2u20ac”a victim of poor oversight and, perhaps, hubris, on the part of directors and management. “They adopted a very flawed business strategy of going to the bottom of the housing finance credit pool, and it wasn’t going to work,” Ely says. “And then they deluded themselves for a long time, even when it was apparent they were in trouble.”

But hidden within the collapse are warnings that all directors would be wise to heed. Banking is, at its core, a risk management business. Directors are expected to exercise their duties of care and loyalty in representing the institution. While they need not be experts at everything, they must exercise strong oversight and understand the basics of their institutions’ strategiesu00e2u20ac”regardless of the wealth or involvement of their owners.

In recent years, a growing number of institutions have jumped into higher-risk strategies, such as subprime lending and securitization, in pursuit of greater profitability. In her testimony, Seidman lauded efforts to employ “innovative” strategies, but said boards must monitor such activities closely. “The key … is for officers and directors to know and understand the risks an institution is taking. This is part of their fiduciary responsibility.”

In Superior’s case, the board failed to establish appropriate goals for diversification and exposure limits, Rush testified, nor did it ensure that the company had the right controls, incentive structures, and technology systems in place to manage an inherently risky strategy.

Worse, instead of trying to limit risk-taking, the board appeared to encourage it: Employees’ compensation packages were heavy on incentives that encouraged increased loan volumes, according to Rush’s report, while the company lowered its underwriting standards between 1998 and 2000. At the same time, its liberal approvals of dividend payments made matters worse. By Ely’s figuring, the owners gathered an 18.1% return on their investments between 1992 and 1999.

Was the board deceived by its own management, chairman, and accountants, all of which appear to have painted a picture of unqualified success? Or was it in some way more complicit than meets the eye in Superior’s downfall?
Answers to such questions may never be known publicly. But Kaufman believes there’s one overriding lesson for all directors to take from this epic collapse: If something looks too good to be true, it probably is. “If you have a risky business strategy, you have to ask, ‘Is this something we have the expertise to manage?’” he says. “The odds are against a small bank in suburban Chicago being able to manage a high-risk strategy effectively. Superior’s directors should have known that.”