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SARC-2003-01 (October 14, 2003)

Background
[Bank] (the “Bank”), filed an appeal with the Federal Deposit Insurance Corporation’s (“�౦��Ϸ����”) Division of Supervision and Consumer Protection (“DSC”) on May 14, 2003. The Bank challenged ten findings derived from the �౦��Ϸ����’s August 19, 2002 Report of Examination (the “Examination”).¹

On June 19, 2003, the DSC Director granted the Bank’s appeal with regard to certain, apparent violations of law and regulation cited in the Examination. The Director referred the remaining issues to the Supervision Appeals Review Committee (“Committee”) for review pursuant to the �౦��Ϸ����’s Guidelines for Appeals of Material Supervisory Determinations (the “Guidelines”). ² As provided by the Guidelines, the Committee reviewed the appeal for consistency with the policies, practices and mission of the �౦��Ϸ����, including those of DSC, and the overall reasonableness of, and the support offered for, the respective positions advanced. The Guidelines also provide that only findings that are “material supervisory determinations” (“MSDs”) are eligible for review through the Committee process. The Committee therefore limited its review to MSDs.

Procedural Matters
MOU Not Appealable: Among the items appealed by the Bank is a Memorandum of Understanding (“MOU”).³ As stated in the Guidelines, however, the decision to initiate an informal enforcement action such as a MOU is not a material supervisory determination.⁴ MOUs are voluntary commitments made by the board of directors of a financial institution.⁵ DSC’s decision to ask the Bank to voluntarily enter into a proposed MOU is therefore not subject to review by this Committee.

September 22nd Document: After the close of the hearing, the Bank submitted a document dated September 22, 2003. The September 22nd document is essentially a second supplemental submission. It addresses issues which the Bank has addressed several times before, beginning with the Bank’s appeal (which was more than 100 pages long with voluminous attachments), the Bank’s first supplemental submission dated August 15, 2003, and at the hearing.⁶ The Bank has had numerous opportunities to present its position throughout this process.⁷ Indeed, the Committee was not obligated to hold the hearing, to order the release of confidential documents, or to allow the filing of the first supplemental submission. The Committee finds that the September 22nd document offers no new arguments and so will not consider its substance.

Disclosure of Confidential and Privileged Documents Complete: The Bank has asked the Committee to release the redacted portions of internal documents previously provided to the Bank. Those documents were released even though they would ordinarily be treated as confidential. The Committee has reviewed the materials released to the Bank as well the redacted text. The Committee has determined that the documents were released in accordance with the Committee’s instructions. No further documents or redacted portions of documents will be released.

Statements Made in Letter Do Not Amount to New MSDs: As indicated above, the DSC Director granted the Bank’s appeal with regard to certain apparent violations of law and regulation cited in the Examination.⁸ These apparent violations involved extensions of credit by the bank to its affiliate, X Corporation (“X”). In granting the Bank’s appeal, the DSC Director noted that the Bank’s arrangement with its affiliate and the manner in which it was administered “are of concern and could present an unsafe and unsound banking practice.”⁹ Following further correspondence, the Bank advised the Director that his statement was itself a MSD and should be referred to the Committee for review. The Director declined. The Bank then wrote to the Committee. The Bank contends DSC has determined that the arrangement is an unsafe and unsound banking practice. It asks the Committee to confirm that the determination is before the Committee on appeal.¹⁰

The Director’s statement that the arrangement “could” present an unsafe/unsound banking practice is not subject to review by this Committee. The Director’s statement is not a MSD as defined in the Guidelines. Moreover, when read in context, it is clear the Director was simply clarifying that he continued to have concerns independent of whether or not the facts gave rise to violations of law or regulation. As indicated in the Guidelines, ¹¹ the �౦��Ϸ���� encourages institutions to express their views and concerns throughout the examination/supervisory process. In turn, it is appropriate that �౦��Ϸ���� staff share their concerns with the institution.

Aside from his statement that the arrangement could present an unsafe and unsound banking practice, the Director concurred with the Regional Office view that the Bank had acceded to the affiliate arrangement without sound analyses and was vulnerable to risk. In subsequent correspondence, the Bank submitted post-examination reports compiled on the Bank’s behalf, contended that these reports dispelled any such concerns, objected to DSC’s referral of the matter to the Regional Office, and asked the Director to either reverse himself or refer these additional statements to the Committee as MSDs.

After deliberation, the Committee is referring to the Region the DSC finding that “the Bank has acceded to its affiliate arrangement without sound analysis” and “the Bank is vulnerable in bearing substantial and disproportionate amount of risk in the arrangement with …” These findings are unnecessary to support the MSDs under review. They should be considered in the overall context of the continuing review of the Bank relationship.¹²

Analysis and Findings
Based upon the submissions and oral presentations of the parties, the Committee finds that the material supervisory determinations set forth in the Examination are reasonable, appropriately supported, and consistent with the policies, practices and mission of the �౦��Ϸ����. The Committee therefore denies the Bank’s appeal.

Subprime Designation of the Bank’s Credit Program and Portfolio: The federal banking agencies jointly issued a document entitled Expanded Examination Guidance for Subprime Lending Programs (“Expanded Guidance”), on January 31, 2001.¹³ The Expanded Guidance applies to financial institutions that target the subprime market through programs that employ tailored marketing, underwriting, and risk selection. The Expanded Guidance also identifies borrower characteristics that may indicate an institution is targeting the subprime lending market. Applying that criteria to the facts in this case, the determination that the Bank’s credit card program and resulting portfolio are subprime, is appropriate.

The Bank has established a credit card program targeting college students, who typically have limited or no credit histories. Credit card lending is the Bank’s predominant line of business. Credit Card related assets resulting from the Bank’s subprime credit card program totaled $118 million and represented 55 percent of the Bank’s total assets. The Bank’s marketing strategy and underwriting criteria have generated a credit card portfolio with the following subprime characteristics:

• As of June 30, 2003, almost 70 percent of credit card customers had FICO scores of 660 or below; more than 40 percent had scores of 600 or below;
  
• At the time accounts were originated, 57 percent of the customers whose accounts were retained by the Bank, and 50 percent of the customers whose accounts were sold to a securitization trust of which the Bank is a beneficiary, had no FICO score;
  
• A significant volume of delinquent credit card customers;
  
• An above average loss rate that has significantly increased since the Bank began its rapid expansion of the credit card program in 1999;
  
• A low payment rate that is well below those experienced by prime credit card lenders; and
  
• Fee and interest income levels that were inconsistent with prime credit card lender results.

The Bank primarily contested the subprime designation on the basis that the Bank’s principal loss rates are not significantly higher than those experienced by prime issuers. The Bank has presented a creditable case that it has developed a system for screening and approving cardholders among a marked segment of college students and entering freshmen, producing a portfolio which has, to date, outperformed other subprime portfolios. The Committee recognizes that the principal loss rate, to date, is not as high as those experienced by some subprime credit card portfolios.

Nonetheless, the credit card program has generated a credit card portfolio that clearly exhibits the subprime characteristics listed above. These facts sufficiently demonstrate that the Bank’s credit card program has generated a credit card portfolio that exhibits a higher risk of default than loans to prime credit card borrowers. Accordingly, the designation of the Bank’s credit lending program as subprime is appropriate.

Substandard Classification of Residual Interests: The Uniform Agreement on the Classification of Assets and Appraisal of Securities Held by Banks (“Uniform Agreement”) addresses examination treatment of adversely classified assets.¹⁴ The Uniform Agreement provides definitions for “Substandard,” “Doubtful,” and “Loss” categories of assets. More specifically, the Uniform Agreement states that a Substandard asset will have a “well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the bank will sustain some loss if the deficiencies are not corrected.” The Uniform Agreement also defines the term “sub-investment quality” and established specific guidance for the classification of sub-investment quality investments. It states that a sub-investment quality designation “generally includes securities rated below the four highest grades, nonrated securities of equivalent quality…” The �౦��Ϸ���� continues to apply the Uniform Agreement to residual interests derived from asset backed securitization transactions, such as the interests retained by the Bank. ¹⁵

Under these guidelines, the Bank’s residual interests exhibit well-defined weaknesses and are characterized by the distinct possibility of loss. The Bank’s residual interests consist of subordinated notes totaling $18.2 million, interest-only strip receivable totaling $11.3 million, and cash collateral accounts (i.e., spread accounts) totaling $8.7 million. These residual interests resulted from the Bank’s subprime credit securitization activities and derive their value from the cash flows generated by the underlying pool of subprime credit card loans. As mentioned, these subprime assets displayed an above average loss rate, low principal payment rate, and other weaknesses. A key weakness is that the reported value of the residual interests are volatile, subject to material changes in value given changes to underlying assumptions about pool performance. Also, the residual interests are illiquid, there being little or no market for such assets. These factors, together with the subprime nature of the Bank’s credit card portfolio, support a finding that the residual interests should be classified substandard.

In addition, under the Uniform Agreement, the subordinated notes are clearly subject to adverse classification. The subordinated notes in this case were rated Ba3 by Moody’s and BB by Standard and Poor’s (both ratings represent the fifth highest grade by the respective agencies). The interest-only strip and cash collateral account are subordinated to the subordinate notes and therefore present a higher risk of loss.

The Bank’s primary argument regarding the quality of the subordinated notes is that the risk of default is infinitesimal, based on credit card loss rates. This argument is not persuasive, given the several other factors that Moody’s and Standard and Poor’s ratings rely upon and that the Bank has not adequately addressed. These factors include principal payment rates, early amortization, marketability, and volatility resulting from economic conditions, competitive pressures, and customer behavior.

The classification of the Bank’s residual interest was consistent with the Uniform Agreement and established examination procedures. In light of their sub-investment ratings, their volatility, questionable marketability, and the quality of the underlying assets, the subordinated notes were appropriately classified Substandard.

Capital Adequacy Rating: The Uniform Financial Institution Rating System (“Rating System”) defines a Capital Adequacy rating of “4” as “a deficient level of capital. In light of the institution’s risk profile, viability of the institution may be threatened. Assistance from the shareholders or other external sources of financial support may be required.”¹⁶

The Examination revealed that the credit card-related assets resulting from the Bank’s subprime credit card program represented 55 percent of the Bank’s total assets and more than 400 percent of the Bank’s Tier 1 capital. Adversely classified assets approximated $51 million and represented more than 152 percent of the Bank’s Tier 1 capital and reserves. At the time of the examination, the Bank had not performed an internal capital assessment that quantified the amount of the capital needed to offset the risk in the subprime lending activities, despite previous requests to do so. In addition, the Bank’s sole shareholder failed to provide financial statements that would detail access to additional capital. The rating assigned to the Bank was consistent with Rating System guidelines. The Capital Adequacy rating of “4” assigned in the Examination is therefore deemed appropriate.

Asset Quality Rating: The Rating System defines an Asset Quality rating of “4” as assigned to “financial institutions with deficient asset quality or credit administration practices. The level of risk and problem assets are significant, inadequately controlled, and subject the financial institution to potential losses that, if left unchecked, may threaten its viability.”

As noted earlier, adversely classified assets approximated $51 million and represented more than 152 percent of the Bank’s Tier 1 capital and reserves. Adversely classified assets largely consisted of residual interests and credit card receivables resulting from the Bank’s subprime credit card program and credit card securitization activities. The asset portfolio lacked diversification as the majority of portfolio is centered in the subprime credit card portfolio. Two concentrations of credit were based on the Bank-owned subprime credit card receivables and the residual interests in the securitized portion of the subprime loan portfolio. Based on these factors, the Asset Quality rating was consistent with the Rating System guidelines. Accordingly, the Asset Quality rating of “4” is appropriate.

Management Rating: The Rating System defines a Management rating of “3” as indicating “management and board performance that need improvement or risk management practices that are less than satisfactory given the nature of the institution’s activities. The capabilities of management or the board of directors may be insufficient for the type, size, or condition of the institution. Problems and significant risks may be inadequately identified, measured, monitored, or controlled.”

The Examination described the following management weaknesses: The Bank held an excessive level of adversely classified assets and maintained a concentration in subordinate residual interests resulting from the Bank’s subprime credit card program; capital levels were deficient; weaknesses in the Bank’s securitization activities were noted for the third consecutive examination; management’s monitoring of credit card re-aging and credit line increase was inadequate; repeat contraventions of policy statements regarding Asset Securitizations, expanded Subprime Guidance, and Interest Rate Risk were noted; internal audit weaknesses were noted. In light of the deficiencies, the Management rating assigned was consistent with the Rating System guidelines. Accordingly, the Management rating of “3” is found to be appropriate.

Composite Rating: The Rating System defines a composite “4” as appropriate for financial institutions that “generally exhibit unsafe and unsound practices or conditions. There are serious financial or managerial deficiencies that result in unsatisfactory performance. The problems range from severe to critically deficient. The weakness and problems are not being satisfactorily addressed or resolved by the board of directors and management. Financial institutions in this group generally are not capable of withstanding business fluctuations. There may be significant noncompliance with laws and regulations. Risk management practices are generally unacceptable relative to the institution’s size, complexity, and risk profile. Close supervisory attention is required, which means, in most cases, formal enforcement action is necessary to address the problems. Institutions in this group pose a risk to the deposit insurance fund. Failure is a distinct possibility if the problems and weaknesses are not satisfactorily addressed and resolved.”

In light of the overall poor quality of the Bank’s assets, the deficient capital levels, as well as a number of other identified weaknesses detailed in the component areas and described in the Examination, it is clear that the Composite rating was consistent with the Rating System guidelines. Although the improvement in the Bank’s condition and operations from the May 2001 examination to the current Examination is evidenced by the upgrade in the composite rating from a “5” to a “4”, continued improvement is needed. The Composite rating of “4” is deemed appropriate.

Designation of the Bank as in “Troubled Condition” and a “Problem Bank”: These designations are required as a result of the Composite rating assigned to the Bank. Section 303.101(c) of the �౦��Ϸ���� Rules and Regulations provides that the term “troubled condition” includes any insured state nonmember bank that has a composite rating of 4 or 5 under the Uniform Financial Institution Rating System. The �౦��Ϸ����’s Case Managers Procedures Manual, section 3.3, requires the designation of “Problem Bank” for all banks assigned a Composite rating of “4.” The designations of the Bank as in “troubled condition” and a “Problem Bank” are consistent with the applicable regulations and �౦��Ϸ���� procedures.

Conclusion
For the reasons set forth above, the Bank’s appeal is denied.

By direction of the Supervision Appeals Review Committee of the �౦��Ϸ���� dated October 14, 2003.
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1 The findings challenged by the Bank are: (1) designation of the Bank’s credit card lending program as subprime; (2) classification of residual interests retained by the bank in connection with its securitization activities as substandard; (3) apparent violations of section 23A and 23B of the Federal Reserve Act and Regulation O of the Board of Governors of the Federal Reserve System; (4) Capital component rating of “4”; (5) Asset Quality component rating of “4”; (6) Management component rating of “3”; (7) Composite rating of “4”; (8) finding that the Bank is in “troubled condition”; (9) recommendation that the Bank be designated a “Problem Bank”; (10) issuance of proposed Memorandum of Understanding.
2 60 Fed. Reg. 15923 (March 28, 1995).
3 The Bank entered into the MOU on April 28, 2003, after the Examination.
4 60 Fed. Reg. at 15929
5 DOS/DCA Formal and Informal Action Procedures Manual, pg. 6-3
6 At the outset of the hearing, John M. Reich, Chairman of the Committee, noted that Michael Zamorski, a member of the Committee and Director of the Division of Supervision and Consumer Protection, would not vote on the matter. However, consistent with the �౦��Ϸ����’s Guidelines, Mr. Zamorski did participate in the meeting. The preamble to the Guidelines states that directors of divisions charged with supervisory and compliance responsibility would “bring to the Committee the necessary judgement to make well-informed decisions concerning determinations under review.” The Division director did not make the material supervisory determinations under review.
7 The Bank has also submitted several letters to the Committee seeking various forms of relief and clarification, including letters dated July 2, 2003, July 25, 2003, August 12, 2003, and August 28, 2003.
8 Examination, pgs. 24-30. These apparent violations referenced sections 23A and 23B of the Federal Reserve Act and Regulation O of the Board of Governors of the Federal Reserve System.
9 June 19, 2003 letter.
10 August 28, 2003 letter.
11 60 Fed. Reg. at 15927
12 In addition, the Bank has complained that during a previous examination of the Bank in 2001, the Kansas City Regional Office retroactively required the Bank to change its accounting treatment for Accrued Interest Receivables. According to the Bank, this change required the Bank to make changes in its securitization practices, causing the Bank to incur $18 million in expenses that have affected its capital. The Committee finds that this is not an MSD in this proceeding and is not relevant. Consequently, the issue has not been considered in making the Committee’s determination.
13 Financial Institution Letter 9-2001.
14 Also see, "Manual of Exam Policies, Securities and Derivatives Examination Guidance", section 3.2
15 The continuing applicability of the Uniform Agreement was confirmed by the federal banking agencies through the issuance of the Interagency Guidance on Asset Securitization Activities.
     Financial Institution Letter -109-99 (December 13, 1999). This document requires the classification as loss of any residual interest not subject to conservative and reasonable valuations.
16 "Manual of Exam Policies, Uniform Financial Institutions Rating System", section 1.1, III.