avoiding redundancies with the business risk functions. Moreover, when the products were presented to the board, the CFO and president of the consumer loan division of SifiBank were the corporate officers engaged with the board on this initiative with negligible input from the enterprise CRO. Compounding this problem was the fact that none of the board members had any mortgage or risk background and so little pushback from the board occurred on the potential risks of these products.
Simultaneous to the bank’s origination of these loans, SifiInvestment Bank realized that it could expand its structured finance business by selling CDS that had mortgages as the reference asset. Senior management of the capital markets group convinced the board that these new products would be able to serve a wide range of investor appetites and transform credit risk transfer in the mortgage market by allowing CDS buyers to seek credit protection against mortgage defaults while allowing credit investors to participate in mortgage financing without actually originating or owning the loans on balance sheet. For SifiInvestment Bank it could both be involved in creating the CDS for market as well as take positions (i.e., sell CDSs) and create a stable income stream over time from the premiums paid by CDS buyers. With the bank projecting very low defaults looking into the future, it seemed like a sound business decision in 2004. By 2008 SifiInvestment Bank was reeling from losses that it incurred under its CDS program. As mortgage loans defaulted, the bank as seller of CDS protection was forced to cover losses of its counterparties. These losses, as well as those emanating from the bank’s retained portfolio, were the primary source of capital erosion for the bank. Had the federal government not stepped in when it did, SifiBank was most likely going to fail within a short period of time.
As these losses were being publicized, creditors and other Wall Street counterparties began pulling back from SifiBank. Lines of credit for the bank were at first being renewed at higher rates but over time access for credit dried up. Spreads on ABCP issued by SifiBank widened to such a degree as to be prohibitive for the company in raising short-term financing. Banks no longer wanted to enter into repo agreements with SifiBank and more concerning, the bank began experiencing considerable withdrawal of deposits in the weeks preceding the announcement of financing from the government.8
In order to meet its production targets for its new mortgage program, SifiBank had streamlined a number of its processes and controls in underwriting, closing and servicing loans. Operational efficiencies in mortgage production can mean the difference between becoming a market leader or a follower. SifiBank management pressed hard to place itself as one of the top three mortgage originators in the country before the crisis and to do so meant finding ways to reduce the operational burdens of the loan manufacturing process.
Streamlining bank processes included allowing some loan production staff to bundle closing documents together and sign off with little review of what was being signed. Loan programs allowed many borrowers to avoid having to produce documents verifying their income and employment. Servicing staff was further reduced because, after all, mortgage defaults were expected to remain low. Automation was accelerated in both underwriting and collateral valuation where possible, thus reducing the number of underwriters and property appraisals in the process.
To no one’s surprise, fraud, both internal and external was rampant in these programs and surfaced once loan defaults began rising during the crisis. Counterparties and investors in securities created by SifiBank sued the company for billions of dollars of repurchases based on claims that the loans violated the terms of the contract relating to fraud and misrepresentation. Loan documents went missing during this period and once the deluge of defaults hit the bank, it did not have sufficient servicing resources to handle the caseload. Many borrowers were erroneously foreclosed on as a result, which caught the attention of the media, regulators and litigators. SifiBank faced billions of dollars of legal damages and settlements as state attorneys general and the U.S. Justice Department lodged suits against the bank.
The government’s decision to intervene and prop SifiBank up at the beginning of the financial crisis was very difficult. On the one hand, the government realized that there was a reasonable likelihood that not intervening could lead to SifiBank’s insolvency. If the third-largest U.S. bank were to fail, it would send shock waves through an already weak financial sector potentially resulting in a cascade of bank failures and precipitating an economic depression. But in saving SifiBank, the government risked not only the ire of the U.S. taxpayer but also created a perverse incentive that if a bank was perceived as too-big-to-fail, it could continue to engage in risky behavior knowing that eventually the company would be bailed out.
The government financing for Sifibank came with several strings attached. The government insisted that the CEO and chairman must be replaced as well as several key members of the executive team and board of directors. The bank was also forced into an agreement in which the U.S. Treasury would receive a large number of warrants, effectively allowing the government to exercise options to buy its stock in SifiBank at a favorable price that it held as part of the agreement. The government would also have greater involvement over key decisions for a period of time until the bank was able to repay its obligation to the government. These events ushered in an unprecedented amount of scrutiny for SifiBank and while the morale of company employees took a massive hit, over time it allowed the bank to remake its tarnished image to the public, investors and employees by reinvigorating the principles that had led the company to greatness in its early years.
Within several months of the ouster of the CEO and chairman, the board hired a new CEO, who had formerly been the enterprise CRO of a major competitor and had 20-plus years of banking experience running commercial bank businesses. With this background SifiBank was well on its way to becoming an industry leader in risk management. On the day the new CEO took office he called for the separation of the combined position of CEO and chairman in order to reduce potential conflicts of interest. He further went on to describe his vision for the bank, which was to be built upon a foundation of strong risk management that would allow the bank to operate prudently in all economic environments while positioning itself to grow its businesses profitably and creating significant value for shareholders, customers and employees. SifiBank was to become a risk-centric organization and one that would be admired by its peers and customers over time. But even with that vision, the bank faced regulatory headwinds that posed a number of challenges for the new management team.
BANK REGULATORY LANDSCAPE
Unlike many other industries, the banking sector is heavily regulated by a patchwork of federal and state regulatory authorities. The larger the institution, the greater the regulatory scrutiny that occurs, and this has only heightened since the financial crisis. As a national bank, SifiBank’s primary regulator for safety and soundness of its operation is the OCC. In this capacity, the OCC maintains regular contact with the bank, in fact deploying 75 examiners headed by an examiner-in-charge (EIC). This team actually works onsite at SifiBank and has regular access to management, reports and other information, allowing the examination team to stay abreast of ongoing developments at the bank.
The OCC has a responsibility to ensure the bank operates in a safe and sound fashion and to carry out these responsibilities the OCC conducts periodic standard and as needed targeted examinations. SifiBank receives a 1–5 (best to worst performance) rating each year by the OCC referred to as a CAMELS rating, which comprises an assessment of the bank’s capital adequacy (C), asset quality (A), management quality (M), earnings (E), liquidity (L), and sensitivity to market risk (S). The OCC has an array of punitive actions that it can take to ensure the bank complies with regulatory standards and policies. The examination process is critically important to SifiBank as the OCC’s findings on a particular exam could lead to severe monetary penalties as well as cease and desist orders that could limit the bank’s ability to operate in certain ways. The OCC appears at SifiBank’s board meetings and provides a summary of their findings and any management required actions (MRAs) they demand from the management team following a major exam.
Since SifiBank has a bank holding company structure it is also overseen from that standpoint by the Federal Reserve Board (FRB).
A repurchase agreement, or repo, is a sale of securities (such as Treasury instruments) typically over a short window of time (e.g., overnight). The seller buys back the securities at the end of the contractual period and in this manner the seller is in a borrowing position. A reverse repo looks at the repo transaction from the perspective of the buyer of the securities and puts them in an effective lending position.
