Bank Lawyer's Blog

Enhanced Recordkeeping Proposal: Kill It Before It Multiplies

One of BLB's favorite gadflies, Bert Ely, was at it again last week (paid subscription required). This time, his incredulity was focused on an FDIC proposal to require the country's largest banks (those with over two million deposit accounts) to implement more "robust" (and expensive) systems for determining more quickly, upon failure of the bank, whether a deposit is inured, uninsured, or partially insured. While Bert concedes that the proposed rule initially burdens only 36 banks, "one could imagine a scenario when this regulation could easily be extended to all banks." "One" could. It's called "trickle down" regulation. The CFPB's "race to the overbearing bottom" is a classic example. Therefore, argues Bert, "all banks" should oppose it.

While Bert criticizes the difficulty and expense (FDIC estimates the 36 banks will have to spend $328 million in system upgrades) of the proposal, his real criticism is that, based on recent history, the "proposed rule bears no relationship to reality."

Inasmuch as the FDIC has had the power (since the enactment of FIDICA in 1991) to protect the uninsured deposits of a failed bank if that was a less costly alternative to letting the uninsured depositors "eat cake," and since the panicked lines of depositors at IndyMac in 2008 encouraged The Care Bair and her successor to favor to overwhelmingly favor protecting all depositors in subsequent failures (in 482 of 512 post-IndyMac failures, Ely asserts), there is little likelihood that the FDIC would not protect all depositors from a public relations standpoint. Moreover, Ely argues, because protecting all depositors usually protects the "franchise value" of the failed bank, acquiring institutions are usually motivated to pay enough for the deposits and non-mortally wounded assets of the failed bank that liquidation and "stiffing" the uninsured depositors is not likely to ever be the least costly alternative.

Bert also argues that liquidation "can be very disruptive to the failed bank's lending and other nondeposit relationships. He cites the 2009 liquidation of New Frontier in Greeley, Colorado, as one instance in which local businesses were negatively impacted. Being familiar with that specific example, I can vouch for the veracity of Ely's opinion. Finally, Bert argues that the FDIC's recent concern with the continuing liquidity of banks (especially large banks) in crisis situations would be hampered by liquidations in which uninsured depositors were not paid, and might induce uninsured (and even insured) depositors in other banks to stage runs (ala IndyMac).

All-in-all, says Bert, this proposal is a bad idea and "the FDIC should kill it."

Amen.

How Safe Is Too Safe?

Consultant Paul Schaus recently wrote an opinion piece for the American Banker (paid subscription required) in which I think he got the substance right but may have been a little off on some of the "shading." The title of his piece, "When Vendor Management Goes Too Far," and his opening paragraph, give the appearance that banks are taking regulatory guidance on vendor management "too literally" and that banks need to "lighten up--at least a bit." I was concerned when I read these opening sentences, because I thought that one thing banks don't need to do is to blow off regulatory guidance. However, reading on, Paul made some excellent points.

One of those points was that the portion of the guidance on third party relationships (for example, OCC Bulletin 2013-29) that states that banks should reserve in their vendor agreements the right to audit the vendor should be interpreted in the light of the "real world."

But bankers are wrong to think they have an inalienable right to audit under regulatory guidance. The largest bank technology vendors have hundreds or even thousands of bank clients. If every bank client demanded a right to audit and then followed through on visits, vendors would be hosting at least several banks per day, every day. They might as well offer group tours.

It may well be enough for banks to receive and review their vendors' third-party reports as part of their vendor management programs. Banks have the right to refuse to accept those audits, but in that case, I would wonder why the bank is doing business with a particular vendor in the first place.

If the vendor does not have third-party reviews, the bank will need to conduct the audit or retain an independent party to do one. But you definitely don't need to perform a surprise audit and show up at the data center without advance notice. Data centers are secure environments; if you are not on the approved list of visitors, you won't get in.

That advice is spot-on. I expressed the same opinion last week on a panel with an attorney for a major technology vendor, a vendor that would never consider giving each of its thousands of bank clients the right to individually audit the systems and controls of the vendor, for precisely those reasons articulated by Paul. That's why major vendors have an annual SASE 16 audit performed by a nationally recognized auditing firm and make the audit reports available to its customers. On this point, the regulatory guidance simply has to be interpreted in the light of the goal of the requirement in the guidance for having an audit performed, not upon a literal interpretation of the express wording of the guidance. I suppose "fundamentalists" might disagree with me, but I've never been a "guidance-thumper" myself.

Paul also addresses a comment he's heard from a number of banks, that when it comes to vendors (like lovers) "size matters." Again, I agree with Paul that this is not a valid interpretation of the regulatory guidance.

This is not the case. The OCC states that a bank must select "an appropriate third party and understand and control the risk posed by the relationship, consistent with the bank's risk appetite." Vendor management includes determining if the vendor's offering fits the bank's strategy, but the guidance does not dictate vendor size.

When bankers argue that they are wary of selecting a less well-known vendor, I often point out that under that logic, consumers would never entrust their community bank with deposits when they could open an account with Bank of America, Citibank or Wells Fargo. The truth is that bigger is not always better — and the biggest provider may not always be the right fit for a bank's needs.

On the other hand, it's my view that "two guys operating out of their garage" are always going to raise more red flags than one of the well-established Mastodon that occupy the particular "space." If a bank, especially a community bank with less sophisticated vendor management policies, processes and in-house expertise, wants to deviate from the "safe" course and hire "the next Bill Gates" over IBM as its vendor, it needs to be prepared to defend that decision to its examiners, who are not likely to be "cutting edge kind of guys." That may ultimately, as Paul worries, "suck innovation out of the banking industry." However, when it comes to vendor selection, how many community banks want to be the guys at the tip of the spear?

The bottom line is that banks simply must take the regulatory guidance seriously. While "overreacting" and "too literal" interpretations of that guidance can cause problems for some banks that do not need to exist, and Paul's observations are certainly valid on the points that he raises, I think that most banks will continue to opt to err on the side of "stifling innovation" as opposed to defending their choices to questioning examiners.

Camden Fine Fires Off A Fine Salvo

In  recent opinion piece for Bloomberg News, ICBA CEO Camden Fine was in fine fettle, ranting about his favorite topic: new regulatory burdens are strangling community while the largest banks are doing just fine, thank you very much. Among his salient points are the following:

The megabanks are benefiting from what Bloomberg View calculated is an $83 billion annual taxpayer subsidy, the value of implicit guarantees by the U.S. Treasury. Bloomberg View was correct to characterize the too-big-to-fail subsidy as “a major driver of the largest banks’ profits.”

Perversely, Federal Deposit Insurance Corp. data show that large banks have both the lowest credit quality and the lowest cost of funds in the industry. Community banks rank the highest in both categories even though they have had to compete for years against the megabanks’ access to cheaper money in pricing loans. In addition, community banks must compete against the big lenders’ lower comparative costs in handling regulatory paperwork.

While Cam complains that this is "morally wrong," I suspect that in a nation overrun with Pontius Pilates who sneer in the throes of their born-again relativism "What is 'truth'?," appealing to "morality" as a behavior influencer will have as much impact on Congress as a stern talking to by Pope Francis would have on Charlie Sheen. More effective on the morally challenged is likely to be his economic arguments.

Community banks should be putting their capital to work in the small towns, rural communities and middle-class urban enclaves they know well. Instead, they are focusing too many of their precious human resources on onerous paperwork and time-consuming compliance measures.

Community banks are the source of almost 60 percent of all small-business loans of less than $1 million, as well as mortgage and consumer loans tailored to the needs of their local communities. Large banking organizations with more than $50 billion in assets hold almost 40 percent of outstanding small loans to businesses, according to the Federal Reserve, but loans to small businesses aren’t a significant portion of large-bank lending. Small-business loans represent less than 5 percent of the large banks’ total domestic lending.

Cam outlines five specific steps Congress and the federal regulators could take to help community banks (and credit unions, for that matter, although Cam would choke on his own tongue before admitting it). They include:

• Easing up on some of the more onerous residential mortgage lending and servicing rules.
• Eliminating the requirement that community banks report on every new small business loan application.
• Requiring a cost-benefit analysis for all new regulations and prohibiting the issuance of any regulation where the cost exceeds the benefit.
• Raising the threshold to $350 million in assets for the requirement for an audit of a bank's internal controls.
• Eliminating the annual requirement for sending no-change privacy policies.

These are all helpful suggestions, but  I'm frankly surprised that he didn't also call for the carpet bombing of CFPB's D.C. headquarters and insist that Jamie Dimon's king-size bed be short-sheeted. Oh well, the year is not even half over. There's still time to get down to the really important stuff.

McKenna Drills Down On FDIC Lawsuit Against Auditors

My friend Francine McKenna wrote an article for Forbes recently, in which she had a lot more to say than I did about the FDIC's recent lawsuit against PricewaterhouseCoopers and Crowe Horwath based upon those firms' alleged malpractice as, respectively, outside and internal auditors of the failed Colonial Bank. Francine, a former big-firm audit professional-turned-critic, is not a fan of large audit firms.

Francine thinks that the FDIC's allegations against Crowe are "unusual."

PwC’s work papers give the FDIC a peek into PwC’s opinion of the quality of Crowe’s work. Regardless of what PwC thought, it seems the FDIC believes PwC did not do enough to compensate for any failings or verify the assertions about internal controls Crowe made on behalf of Colonial management.

Crowe is being held to the AICPA’s standards for consulting which, while stringent as an accountant’s code of ethics and interesting as a consulting standards framework, do not carry the force of law that the Sarbanes-Oxley Act and the PCAOB auditing standards do. You typically see the AICPA consulting standards cited when an audit firm performs technology consulting engagements that blow-up.

The FDIC says Crowe should have followed the professional standards promulgated by the Institute of Internal Auditors, an international professional organization for internal  auditors. Would an internal audit function staffed by Colonial employees instead of an outside vendor have been sued under the same circumstances? Why isn’t the FDIC also naming the Internal Audit Liaison Manager who Crowe, as a vendor, reported to? Employees, though, are usually protected from litigation at least up to some level of negligence.

The FDIC, however, is asserting gross negligence by Crowe. There clearly was concealment and collusion to perpetrate a fraud within the bank and from outside forces. According to a source who is an expert in internal audit services to public companies, internal controls are not very effective when executives collude and conceal information. This limitation is mentioned in the COSO internal control model and also, according to my source, should mitigate the liability of a consultant that wasn’t part of the scheme.

Francine also finds it strange that none of the audit partners involved in the alleged malpractice have been named in the FDIC's complaint.

It’s a wonder to me, though, that in three cases against PwC that allege professional malpractice and breach of duties, the partners responsible for the engagements at Colonial Bank and MF Global are not named nor is anyone willing to give them up. Two prominent plaintiffs lawyers, who try cases against the audit firms often, told me that this is highly unusual. The audit firms may not want to publicize the names of the partners involved in failures and professional malpractice but the plaintiffs almost always name them in the lawsuits and should have no interest in protecting them.

These two partners are still out there auditing. That doesn’t bode well for investors.

That might be a tad harsh. On the other hand, being a tad harsh is something to which I can relate. I trust Francine will stay on the case and eventually discover why the FDIC chose to pursue "unusual" claims against an outsourced internal audit firm while simultaneously taking of the "unusual" step of failing to name individual audit partners in the complaint. I can speculate as to Why the FDIC might wish to protect individual audit partners, but I'll take the highly "unusual" step of restraining myself.

Finally, Francine makes a point that I made about this lawsuit: the FDIC is angling for a settlement, and wants to survive the in pari delicto defense the defendants will raise for a sufficient amount of time to extract it. As Ms. McKenna so bluntly puts it, "...there will be settlements. Auditors never go to trial."

Big Accounting Gets Its Turn In The Dock

For those of you wondering when the accountants of a failed bank were finally going to get their ticket to ride, wait no longer. As Kevin LaCDroix reported on his blog a couple of weeks ago, the FDIC has sued both the internal and external audit firms of the failed Colonial Bank. Connoisseurs of fine FDIC litigation knew it was only a question of time before the FDIC attempted to grab the tails of big accounting firms' malpractice insurance policies and hitch a ride to the promised land. Colonial Bank provided a good couple of ponies to ride.

The complaint alleges that while Taylor Bean was carrying out its “increasingly brazen” fraud, PwC “repeatedly issued unqualified opinions” for Colonial’s financial statements, and Crowe “consistently overlooked serious internal control issues” – and, more the point, both failed to detect the fraud. The complaint alleges that if the firms had detected the fraud earlier, it would have prevented losses or additional losses that the bank suffered at the hands of Taylor Bean. The complaint asserts claims against the firms for professional negligence, breach of contract, and negligent misrepresentation. The complaint alleges that in the absence of the firm’s wrongful acts, the Taylor Bean fraud would have been discovered by 2007 or early 2008, and “losses currently estimated to exceed $1 billion could have been avoided.”

Giving credit to Thompson Reuters' Alison Frankel, Kevin raises a potential hitch in the FDIC's giddyup.

As Alison Frankel discusses in her On the Case blog (here), the accounting firms are likely to raise the in pari delicto defense, “which holds that one wrongdoer can't sue another for the proceeds of their joint misconduct” The FDIC has anticipated this defense in its complaint, alleging that the two bank employees that facilitated the Taylor Bean fraud were “rogue employees” who acted our of their own self-interest and not at the direction of or to the benefit of the bank, but rather to the detriment of the bank.

According to Frankel, counsel for PwC doesn't think much of that approach.

PwC is represented by Elizabeth Tanis of King & Spalding, who took issue in a statement with the FDIC's assertions. "The Colonial Bank executive who spearheaded the fraud on the Colonial Bank side has testified that her actions were motivated by a desire to prevent loss to the bank and to save an important client relationship. She further testified that (Taylor Bean) was paying Colonial Bank $20 million to $30 million per month in interest," Tanis said. Moreover, Tanis said, auditors can't be expected to have uncovered a fraud that was "so well-concealed that neither the FDIC nor the OCC discovered it, even when they performed targeted exams of the mortgage warehouse lending division, where the fraud occurred."

I think that we all know that what the FDIC is doing here has little to do with what it thinks it can ultimately get away with if this case ever makes it to trial. No, they understand that big accounting firms and their insurers make decisions with a bean-counting mentality. If they can buy their way out of this litigation for an amount that eliminates the crapshoot of litigation, avoids paying defense counsel's kid's annual tuition at Cornell, and passes the "spit-up-a-little-in-my-mouth" thresh hold, they'll likely elect to pay off the FDIC, regardless of whether or not they think the accountants actually committed malpractice. The FDIC needs to survive a motion to dismiss and its prospects will look worthwhile. Unless, of course, PwC decides to give Ms. Tanis & Co a chance to win the suit on summary judgment.

From a personal standpoint, I'd like to see the court rule on the in pari delicto defense. Then again, it's not my money at risk.

Ammunition For Loan Buyback Plaintiffs

A couple of years ago, I related a conversation I had with a banker whose bank was being sued by FNMA to force repurchase of loans that, FNMA alleged, breached the representations and warranties the bank made when it sold the loans to FNMA. The bank was opposing the buyback requests, in part, on the argument that the alleged breaches of warranties were not connected to the reasons that the loans defaulted and, therefore, did not cause the losses that FNMA alleged that it suffered. I told him at the time, that FNMA didn't care about connecting the dots of causation. It's position was (and presumably still is) "if you break, you must retake."

A blurb on Housing Wire's site today alerted us to a recent Southern District of New York court decision that supports the position of FNMA (although the lawsuit does not involve FNMA). Housing Wire linked to an article posted online by law firm O'Melveny & Myers that discusses the decision and its implications. Following are the opening and concluding paragraphs of that article.

On June 19, the Southern District of New York ruled that a residential mortgage originator that securitized those mortgages into mortgage-backed securities (“MBS” or “notes”) could be liable for alleged breaches of representations and warranties it made, to the insurance company that insured principal and interest payments to investors in the MBS, and could be forced to repurchase non-conforming mortgages even if (a) the breaches did not cause the underlying mortgages to default and (b) the underlying mortgages have not yet defaulted.

[...]

Currently there are many dozens -- if not hundreds -- of lawsuits against mortgage originators, seeking hundreds of billions of dollars due to alleged misrepresentations about the quality of mortgages sold into securitizations. Such suits can be brought by various parties, including, among others, an investor who purchased the MBS, the insurance company that insured the underlying mortgages and/or principal and interest payments on the MBS, the guarantor of the MBS, the servicer of the underlying mortgages, and the trustee of the mortgage pool. All of the above categories of plaintiffs will undoubtedly argue that the Syncora decision should apply equally in those cases. Defendants will counter by pointing out that with its emphasis on insurance principles, Syncora, on its face, makes clear that these different plaintiffs should not be conflated as their legal rights may vary. The case also demonstrates that the language used in the related documents can be determinative, as the court specifically relies on the terms in the operative agreements and observes that the parties could have included different language in their contract that could have provided for other rights and remedies.

Institutions facing such lawsuits may wish to re-evaluate their exposure, and possibly adjust reserves set aside to cover such risks, based on the type of plaintiff and the specific language in the securitization agreements at issue.

While I haven't yet read more than the synopsis provided by O'Melveny and Myers, it seems to me that FNMA's status as the guarantor of mortgage-backed securities secured by the loans that it buys, as well as the broad wording of FNMA's Sellers and Servicers Guides regarding the breadth of the warranties and representations that loan sellers and servicers make to FNMA, will make this decision an important arrow in FNMA's legal quiver. Moreover, the law firm's admonition to potential (and current) defendants to "re-evaluate their exposure" is wise. If the defendants don't "re-evaluate," their outside auditors are likely to do it for them.

Loan Repurchase Liability Balloons For BofA

About a year ago, we discussed how much Bank of America appeared to be flailing about in its attempts to get its rams around its total exposure to loan repurchase demands by Fannie Mae. According to a recent Housing Wire article by Jon Prior, the "bid-asked gap" between Fannie Mae and BofA on the total amount of repurchase liability is pretty large. So large, it appears, that BofA is telling Aunt Fannie, "Sue Me!"

The bank and the government-sponsored enterprise disagree over $7.9 billion in mortgages Fannie claims BofA should buy back because of faulty origination practices, up from $3.7 billion at the end of last year. The bank said it should not have to buy back the loans because borrowers made at least 25 monthly payments on them.

The claims stem from mortgages originated in 2006 and 2007, BofA Chief Financial Officer Bruce Thompson told investors Wednesday.

"We clearly have a disagreement," Thompson said. "Either they bring an action or there would be a settlement. Those would be the two ways this would get resolved."

Throw Freddie Mac into the mix, and repurchase claims rise to $11.1 billion. That's a chunk of change, even if BofA has already reserved $15.9 billion for repurchase claims. Moreover, private label investor claims are also growing, nearly doubling to $8.6 billion. Working through this mess has been painful (costing the bank $2.6 billion in the last quarter) and it's obvious that the pain for BofA will continue for some time to come.

Several years ago, Francine McKenna was berating the large audit firms for not raising the red flag regarding loan repurchase risks. I'd been raising the red flag on this blog as far back as 2005. Maybe we were both more lucky than smart (certainly that's true in my case). On the other hand, if even a quarter-wit like the author of this blog saw this iceberg looming in the distance, you have to wonder how the Masters of the Universe who ran one of the world's largest financial insitutions acted like the crew of the Titanic and ran headlong into it.

United Western: The OCC Responds

Over the weekend, I had a chance to read the opposing motions for summary judgment filed by United Western Bank and the OCC in the lawsuit filed by the bank to overturn the order of the Acting Director of the OTS to place the bank into an FDIC receivership in 2011. Late last week, the bank filed a motion to strike the OCC's entire statement of facts on the grounds that it was a back-door attempt to circumvent local rules on the length of pleadings in this particular type of case. However, I'm basing my personal bloviations on the entire motion and accompanying statement of facts filed by the OCC.

In my comments on the plaintiff's motion, I stated that I thought that the OCC would have to rebut the facts as alleged by the plaintiffs in some detail , not merely focus on the high bar the law sets to overturn the decision of the OTS. The OCC did that, although we'll see what happens to those "facts" when the judge rules on the plaintiff's motion to strike. Regardless, the judge has access to the entire administrative record and isn't bound by a party's selective inclusions, omissions, and spin. Unfortunately, at this stage, I am.

Given my personal experiences in dealing with the OTS, the FDIC, the FRB, and the OCC over the past five years, and with the OTS in connection with a strikingly similar situation ten years ago, I believe the plaintiff's allegations that there were no serious criticisms of the bank's business plan, which involved a focus on institutional deposits as a major source of low-cost funding that the bank used to invest in mortgage backed securities and other mortgage-related assets, until the economy slowed and then crashed. Although earlier reports of examination (ROEs) may have mentioned the liquidity risk posed by a concentration on such funding sources, I suspect that the ROEs also stated that the bank was aware of and adequately managing that risk. It wasn't until the economy tanked that the senior management and directors of the bank transformed themselves, in the eyes of the OTS, from geniuses to cud-chewing bovines. At that time, the business plan suddenly made no sense, was unsafe and unsound, and had to be changed as quickly as possible in the face of the worst recession since the 1930s. While the bank's management and board was trying to steer the bank in a new direction, you can't turn an aircraft carrier as quickly as you can a cigarette boat, especially when the current is flowing strongly against you and icebergs are bearing down from the windward side.

Of course, that wasn't the concern of the OTS. It's concern was the fact that the bank's risk profile had suddenly turned unfavorable because of outside circumstances, and that if it failed, the OTS supervisory personnel responsible for overseeing the bank might be criticized by the Office of the Inspector General of the FDIC for not acting forcefully enough, early enough. Bureaucratic butt-covering trumped all other considerations. From then on, the OTS made sure that it didn't cut the bank any slack. That attitude led to aggressive mandated writedowns in the value of securities and other real estate-related assets, increases to reserves, and hits to capital.

I also accept the plaintiff's allegation that the OTS decided long before the bank actually failed that it was doomed, but allowed the bank's management to go through a Chinese fire drill of ultimately fruitless capital-raising and liquidity-stabilizing efforts in order to give the ultimate dropping of the hammer on the bank's head a patina of inevitability. Although it's not alleged in any of the pleadings, and I have no information from outside sources, I suspect that the OTS personnel with decision-making authority may have decided that they simply didn't "like" the ownership and senior management of the bank, didn't want them in "the business" any longer, and weren't going to approve any recapitalization plan that involved any concessions on the part of the OTS (such as waiving certain conditions of the Cease and Desist Order and agreeing to a non-standard holding company guarantee). I think that if it had desired to do so, the OTS could have worked with the bank to structure a recapitalization plan, including certain waivers of the C&D's terms, but chose not to do so for reasons that may not be expressly revealed by the administrative record.

Even if the above assumptions and outright speculations might be correct, the problem for the plaintiff is that, ultimately, all the OTS has to show in order to prevail is that there was a rational basis for the Acting Director's determination that one of the following three grounds existed for the appointment of a receiver: (1) the bank was in an unsafe and unsound condition to transact business; (2) the bank was likely to be unable to pay its obligations or meet its depositors' demands in the normal course of business; or (3) the bank was undercapitalized and failed to submit a capital restoration plan that was acceptable to the OTS. The court must defer to the opinion of the Acting Director of the OTS on these matters unless the court determines, based solely on the administrative record, that the decisions of the Acting Director were arbitrary or capricious or lacked any rational basis. The plaintiff must overcome the presumption that the decisions of the director were not arbitrary or capricious by a preponderance of the evidence, again as reflected solely in the administrative record. As I've observed previously, this a high hurdle for a plaintiff to jump and is one important reason that few such lawsuits are brought.

All three grounds for the appointment of the FDIC as receiver seem to hinge on the rejection by the OTS of the bank's capital restoration plan, the undercapitalized status of the bank (albeit at a 5% core capital level), and the perceived "instability" of the commitments of the remaining institutional depositors not to withdraw their funds. The OTS articulated seven grounds for the rejection of the capital plan, all of which the plaintiff alleges are without a rational basis. The OCC, on the other hand, articulates in its motion several reasons to support its decision to reject the capital plan (including, for example, disapproval of the acquisition by the bank of a securities clearing business, "excessive" planned growth of the bank, and requirements by investors that certain requirements of the Cease and Desist Order be waived by the OTS). The alleged instability of the institutional depositors is also an issue where the OCC appears to have demonstrated a rational nexus between the facts as shown in the administrative record and the Acting Director's determination that a potential "liquidity crisis" could occur in the near future due to the OTS' rejection of the capital plan. While the plaintiff argues that there was no evidence that the remaining institutional depositors were likely to withdraw their deposits in the near term, the OCC alleges that the administrative record shows that the largest depositor had given the bank until February 15, 2011 to recapitalize, following which date, if recapitalization did not occur, the depositor would withdraw its funds (in an amount which exceeded the entire liquidity of the bank, according to the OCC). 

My concern for the plaintiff's case is that while knowledgeable bankers can conclude that if the OTS was interested in working with the bank's management to reach an accommodation with outside investors that would have addressed their concerns and permitted the bank to be recapitalized and to survive, it could have done so, the OTS can articulate reasons for its decisions not to do so that are based solely on the administrative record to prevent the plaintiff from meeting its burden. This case appears to be a prime example of why it's so tough to overturn a receivership decision. You can think that the OTS made a series of bad judgments, but it's difficult to prove that those judgments were made without a rational basis.

The case is not over. Each side gets another shot at replies. Moreover, I'm not being paid to parse the nuances, so the views expressed in this post are not finely honed. However, at this point, no matter what my heart tells me, my head tells me not to bet against the OCC.

A Tale Of Two (Spinning) Tops

A reader who toils in the credit union industry sent me an interesting juxtaposition in spin, one from the NCUA and one from a trade press publication. They both concern recent financial results announced by the NCUA for AEA Federal Credit Union, which was seized by the NCUA in December 2010 and placed into conservatorship. The NCUA injected a $20 million subordinated note that it allows AEA to count as capital. In a press release trumpeting how well AEA is turning things around, the NCUA sounds almost giddy.

AEA Federal Credit Union, which operates under the conservatorship of the National Credit Union Administration (NCUA), posted 2012 year-to-date net income of $839,096. Total assets at the end of the first quarter stood at $245.1 million, up from $230.6 million at year-end 2011. AEA Federal Credit Union’s net worth also improved by 18 basis points during the first three months of 2012, ending the first quarter at 2.85 percent.

[...]

Since Dec. 17, 2010, NCUA, the interim management team, and AEA Federal Credit Union’s employees have worked to dramatically improve the credit union’s financial condition and maintain services for the credit union’s 42,000 members. Deposits at AEA Federal Credit Union remain protected up to $250,000 through NCUA’s National Credit Union Share Insurance Fund.

Sounds like everything is just peachy at the formerly busted credit union, doesn't it?

Here's the take of the Credit Union Journal (paid subscription required) on the same financial results.

NCUA said this afternoon that AEA FCU, the one-time $410 million credit union which was victimized by a massive MBL fraud, continues to operate with zero capital, despite a $20 million emergency NCUA loan it is allowed to count as net worth.

AEA, whose former MBL director William Liddle is headed to jail as a result of the fraud, reported net income of $840,000 for the first quarter of 2012, but is still operating with negative $12 million of its own net worth. A new federal law allows such credit union and bank failures to count regulatory assistance, such as NCUA’s $20 million bailout loan, as regulatory net worth. As a result, NCUA says AEA actually has 2.85% net worth.

Are we talking about the same institution? Counting debt as net worth is a great trick. The FSLIC used it in connection with the Southwest Plan in the late 1980s, which allowed the FSLIC to hide the fact that it was technically insolvent, until Congress finally caught on and punished the FSLIC by merging it out of existence and transforming its operating head, the independent Federal Home Loan Bank Board, into the OTS (recently abolished by Dodd-Frank). Could the NCUA be following down FSLIC's weed-strewn road to perdition?

A couple of months ago, I sat through a presentation by a couple of "big guns" from our nation's capital, both lawyers who do a lot of credit union representation, and one who's a lobbyist for financial institutions. They told us that the NCUA was the reincarnation of the FSLIC and when the extent of its financial troubles came to light, the political fallout might be toxic. I have no idea whether or not this allegation is correct. However, using debt as equity and issuing a press release that trumpets an increase in "net worth" without noting that we're not talking about GAAP net worth, but the often-vilified "regulatory net worth," smacks of slathering not only lipstick, but eyeshadow and rouge, all over a rather corpulent porcine-like slab of flab.

Earlier this year, credit union industry pundits were raising questions about how big the losses might be at the NCUA and how the NCUA was publicly handling the disclosure of its potential problems. It looks like this is an issue that might gain some traction.

Ironically, although the NCUA is allowed to use debt instruments as equity infusions, a simple proposal to permit commercial banks to amortize commercial real estate loan losses over a ten-year period was killed by federal regulatory opposition because it would cause "regulatory accounting" to depart from GAAP and might permit banks to "mask" their "true" financial condition. The depth of cynicism in D.C. is beyond the comprehension of anyone other than professional politicians and members of organized criminal enterprises.

Drawing Lines In The Sand

HR 1723 was shot down last week. While I didn't talk to any of the bill's sponsors about it, I honestly don't think any of them thought that the bill stood a chance of passing. I think it was another case of community bankers, and those federal legislators who support them, laying down markers to build momentum for future legislative efforts following the 2012 elections, and to send messages to the federal banking regulators about hot button aspects of overly restrictive regulation that, community bankers contend, is choking off their ability to lend and, in some cases, to survive.

The American Bankers Association, which community bankers understand speaks for the largest, publicly traded banks, hamstrung the efforts of the bill's proponents by publicly opposing the bill on the grounds that it would cause uncertainty among investors about the validity of banks' financial statements. The fact that regulatory/GAP accounting differences could have been handled by detailed disclosures in the financial statements undercuts this argument, but, then, the ABA has seldom been a friend of the small banks. That's the job of the ICBA.

The federal regulators, of course, also opposed HR 1723. They despise any effort to tamper with GAAP principles in a manner that might preserve any too-small-to-save community banks, albeit this love affair with GAAP was actually an arranged marriage, forced down the regulators' throats in 1989 by Congress. In the good old days prior to the enactment of FIRREA, regulatory accounting principles were a favorite tool of federal regulators to try to preserve financial institutions during times of economic duress. While some argue that such accounting exceptions only compounded the agony, the experience of the agricultural bank rescue program in the 1980s, when extended loan loss amortization forbearance saved many agricultural banks, contradicts this shibboleth. Of course, these programs involve some risk, taking risk requires courage, and that's in short supply in the 21st century in D.C.  These days, the only "institutions" that seem to be within the regulators' cone of compassion are themselves and the too-big-to-fail banks. As to the rest, it's easier to just say "no" and let them eat cake.

HR 1723 is only one a number of bills that have been and will be introduced to try to regulate the regulators. It's going to be a long, hard slog.