Federal Deposit
Insurance Corporation

To the Board of Directors
Federal Deposit Insurance Corporation

We have audited the statements of financial position as of December 31, 1997 and 1996, of the three funds administered by the Federal Deposit Insurance Corporation (FDIC), the related statements of income and fund balance (accumulated deficit), and the statements of cash flows for the years then ended. In our audits of the Bank Insurance Fund (BIF), the Savings Association Insurance Fund (SAIF), and the FSLIC Resolution Fund (FRF), we found

-- the financial statements of each fund were reliable in all material respects;

-- although certain internal controls should be improved, FDIC management fairly stated that internal controls in place on December 31, 1997, were effective in safeguarding assets from material loss, assuring material compliance with relevant laws and regulations, and assuring that there were no material misstatements in the financial statements of the three funds administered by FDIC; and

-- no reportable noncompliance with laws and regulations we tested.

The following sections discuss our conclusions in more detail. They also present information on (1) the scope of our audits, (2) the current status of FRF liquidation activities and funding, (3) FDIC's Year 2000 efforts, (4) FDIC's progress in addressing reportable conditions¹ identified during our 1996 audits, and a reportable condition identified during our 1997 audits, (5) recommendations from our 1997 audits, and (6) the Corporation's comments on a draft of this report and our evaluation.

OPINION ON BANK INSURANCE FUND'S
FINANCIAL STATEMENTS

The financial statements and accompanying notes present fairly, in all material respects, in conformity with generally accepted accounting principles, the Bank Insurance Fund's financial position as of December 31, 1997 and 1996, and the results of its operations and its cash flows for the years then ended.

At FDIC's request, we provided an audit opinion in March 1998 on the Bank Insurance Fund's financial statements in order to facilitate FDIC's Securities and Exchange Commission (SEC) reporting needs resulting from BIF's 1996 asset securitization transaction.

As discussed in note 7 of BIF's financial statements, FDIC has securitized some BIF receivership assets in two separate securitization deals as part of FDIC's efforts to maximize the return from the sale or disposition of assets. The deals were accomplished through the creation of Real Estate Mortgage Investment Conduit (REMIC) trusts. To facilitate the securitizations, BIF provided limited guarantees to cover certain losses on the securitized assets up to a specified maximum. Because of the limited guarantee provided by BIF, and the public holding of the securities from the 1996 securitization, the REMIC trust was required to include BIF's audited financial statements as an exhibit in its Form 10-K report for the year ended December 31, 1997.

OPINION ON SAVINGS ASSOCIATION INSURANCE
FUND'S FINANCIAL STATEMENTS

The financial statements and accompanying notes present fairly, in all material respects, in conformity with generally accepted accounting principles, the Savings Association Insurance Fund's financial position as of December 31, 1997 and 1996, and the results of its operations and its cash flows for the years then ended.

OPINION ON FSLIC RESOLUTION FUND'S
FINANCIAL STATEMENTS

The financial statements and accompanying notes present fairly, in all material respects, in conformity with generally accepted accounting principles, the FSLIC Resolution Fund's financial position as of December 31, 1997 and 1996, and the results of its operations and its cash flows for the years then ended.

As discussed in note 9 of FRF's financial statements, a contingency exists from the over 120 lawsuits pending against the United States government in the United States Court of Federal Claims. These lawsuits assert that certain agreements were breached when Congress enacted and the Office of Thrift Supervision implemented legislation affecting the thrift industry.

On July 1, 1996, the United States Supreme Court concluded that the government is liable for damages in three other cases, consolidated for appeal to the Supreme Court, in which the changes in regulatory treatment required by the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) led the government to not honor its contractual obligations. However, because the lower courts had not determined the appropriate measure or amount of damages, the Supreme Court returned the cases to the Court of Federal Claims for further proceedings. Until the amount of damages is determined by the court, the amount of costs from these three cases is uncertain. Further, with respect to the other pending cases, the outcome of each case and the amount of any possible damages remain uncertain.

Claims against the federal government are generally paid from the Judgment Fund, a permanent, indefinite appropriation established by 31 U.S.C. 1304, and administered by the Department of the Treasury. However, the Department of the Treasury may determine that payment of a judgment is otherwise provided for by another dedicated source of funds. FDIC believes that FRF should not be considered a dedicated source of funds for payment of such judgments against the United States. Because the Department of the Treasury has not yet determined the source of payment for these judgments, the extent to which FRF will be responsible for any payments is uncertain.

OPINION ON FDIC MANAGEMENT'S ASSERTIONS
ABOUT THE EFFECTIVENESS OF INTERNAL CONTROLS

For the three funds administered by FDIC, we evaluated FDIC management's assertions about the effectiveness of its internal controls designed to

-- safeguard assets against loss from unauthorized acquisition, use, or disposition;

-- assure the execution of transactions in accordance with provisions of selected laws and regulations that have a direct and material effect on the financial statements of the three funds; and

-- properly record, process, and summarize transactions to permit the preparation of reliable financial statements and to maintain accountability for assets.

FDIC management fairly stated that those controls in place on December 31, 1997, provided reasonable assurance that losses, noncompliance, or misstatements material in relation to the financial statements would be prevented or detected on a timely basis. FDIC management made this assertion based on criteria established under the Federal Managers' Financial Integrity Act of 1982 (FMFIA). FDIC management, in making its assertion, also fairly stated the need to improve certain internal controls.

Our work also identified the need to improve certain internal controls, as described in a later section of this report. The weakness in internal controls, although not considered a material weakness,² represents a significant deficiency in the design or operation of internal controls which could have adversely affected FDIC's ability to fully meet the internal control objectives listed above. The internal control weakness relates to FRF only, and although the weakness did not materially affect FRF's financial statements, misstatements may nevertheless occur in other FDIC-reported financial information for FRF as a result of the internal control weakness. The weakness is discussed in detail in a later section of this report.

COMPLIANCE WITH LAWS
AND REGULATIONS

Our tests for compliance with selected provisions of laws and regulations disclosed no instances of noncompliance that would be reportable under generally accepted government auditing standards. However, the objective of our audits was not to provide an opinion on overall compliance with laws and regulations. Accordingly, we do not express such an opinion.

OBJECTIVES, SCOPE, AND METHODOLOGY

FDIC's management is responsible for

-- preparing the annual financial statements in conformity with generally accepted accounting principles;

-- establishing, maintaining, and evaluating the internal control to provide reasonable assurance that the broad control objectives of FMFIA are met; and

-- complying with applicable laws and regulations.

We are responsible for obtaining reasonable assurance about whether (1) the financial statements are free of material misstatement and presented fairly, in all material respects, in conformity with generally accepted accounting principles and (2) FDIC management's assertion about the effectiveness of internal controls is fairly stated, in all material respects, based upon the criteria established under FMFIA. We are also responsible for testing compliance with selected provisions of laws and regulations and for performing limited procedures with respect to certain other information in FDIC's annual financial report.

In order to fulfill these responsibilities, we

-- examined, on a test basis, evidence supporting the amounts and disclosures in the financial statements;

-- assessed the accounting principles used and significant estimates made by management;

-- evaluated the overall presentation of the financial statements;

-- obtained an understanding of the internal controls related to safeguarding assets, compliance with laws and regulations, including the execution of transactions in accordance with management's authority, and financial reporting;

-- tested relevant internal controls over safeguarding, compliance, and financial reporting and evaluated management's assertion about the effectiveness of internal controls; and

-- tested compliance with selected provisions of the Federal Deposit Insurance Act, as amended; the Chief Financial Officers Act of 1990; and the Federal Home Loan Bank Act, as amended.

We did not evaluate all internal controls relevant to operating objectives as broadly defined by FMFIA, such as those controls relevant to preparing statistical reports and ensuring efficient operations. We limited our internal control testing to those controls necessary to achieve the objectives outlined in our opinion on management's assertion about the effectiveness of internal controls. Because of inherent limitations in any internal control, losses, noncompliance, or misstatements may nevertheless occur and not be detected. We also caution that projecting our evaluation to future periods is subject to the risk that controls may become inadequate because of changes in conditions or that the degree of compliance with controls may deteriorate.

We conducted our audits between July 1997 and May 1998. Our audits were conducted in accordance with generally accepted government auditing standards.

FDIC provided comments on a draft of this report. FDIC's comments are discussed and evaluated in a later section of this report.

CURRENT STATUS OF FRF'S
LIQUIDATION ACTIVITIES AND FUNDING

FDIC, as administrator of FRF, is responsible for liquidating the assets and liabilities of the former Resolution Trust Corporation (RTC), as well as the former FSLIC's assets and liabilities.³ As shown in table 1, the majority of FRF's losses from liquidation activities have been realized as of December 31, 1997.

Table 1: FRF's Realized and Unrealized Losses as of December 31, 1997
(Dollars in billions)

The accumulated deficit for FRF includes losses that have already been realized, as well as future estimated losses from assets and liabilities not yet liquidated. Losses are realized when failed financial institution assets in receiverships are disposed of and the proceeds are not sufficient to repay amounts payable to FRF. Losses are also realized if assets that FRF purchases from terminating receiverships are later sold for less than the purchase price. Losses are also realized when certain estimated liabilities associated with FRF's liquidation activities are paid out. Uncertainties still exist with regard to the unrealized losses, and the final amount will not be known with certainty until all remaining assets and liabilities are liquidated.

In total, $135.5 billion was received to cover liabilities and losses associated with the former FSLIC and RTC resolution activities. Of the $135.5 billion total, $91.3 billion⁴  was received by RTC through December 31, 1995, the date of RTC's termination, to cover losses and expenses associated with failed institutions from its caseload. FRF received $44.2 billion to cover the liabilities and losses associated with the former FSLIC activities.

As shown in table 2, after reducing the total amount of funding received by the amount of recorded accumulated deficit, an estimated $8.5 billion in available funds will remain. The RTC Completion Act requires FDIC to deposit in the general fund of the Treasury any funds transferred to RTC pursuant to the Completion Act but not needed for RTC-related losses. Also, after providing for all outstanding RTC liabilities, FDIC must transfer to the Resolution Funding Corporation (REFCORP) the net proceeds from the sale of RTC-related assets. Any such funds transferred to REFCORP pay the interest on REFCORP bonds issued to provide funding for the early RTC resolutions. Any payments to REFCORP benefit the U.S. Treasury, which is otherwise obligated to pay the interest on the bonds. Separately, any FSLIC-related funds remaining are to be deposited to the U.S. Treasury. The final amount of unused funds will not be known with certainty until all of FRF's remaining assets and liabilities are liquidated.

Table 2: Estimated Unused Funds After Completion of FRF's Liquidation Activities
(Dollars in billions)

INFORMATION ON FDIC'S
YEAR 2000 EFFORTS

The Year 2000 computing crisis is a sweeping and urgent information technology challenge facing public and private organizations.⁵ In addition to facing Year 2000 issues with its internal systems, FDIC, as administrator of the deposit insurance funds, faces exposure and potential loss from banks and thrifts that fail to adequately address their own Year 2000 system issues. In addition, as regulator, FDIC has responsibility to ensure that the banks it oversees are adequately addressing systems issues related to the Year 2000.

In February 1998, we testified on FDIC's progress in addressing the Year 2000 challenges it faces.⁶ In summary, we found that FDIC is taking action to address its Year 2000 risks. With regard to FDIC's efforts to correct its internal systems, we concluded that at the time of our testimony, FDIC was behind in assessing whether its systems were Year 2000 compliant. In response, FDIC has revised its project plan to include earlier completion dates for certain phases of the project and is allocating resources to support the plan. In addition, as discussed in the notes to FDIC's financial statements,⁷ FDIC is currently assessing, testing, modifying, or replacing its automated systems in order to ensure that they become Year 2000 compliant.

We also testified that FDIC is devoting considerable effort and resources to ensure that the banks it oversees mitigate their Year 2000 risks. FDIC is also working closely with the other banking regulators to provide guidance and supervision for the banking and savings institution industries as a whole. However, as discussed in the notes to BIF's and SAIF's financial statements, as of December 31, 1997, the potential exposure to the deposit insurance funds resulting from the Year 2000 problem was not estimable. During 1998, FDIC is continuing its monitoring efforts, and is gathering additional data to analyze and estimate potential exposure to the insurance funds from the potential Year 2000 problems of the banks and thrifts it insures. We will evaluate FDIC's analysis of exposure to the insurance funds from banks' and savings institutions' Year 2000 problems during our audits of FDIC's 1998 financial statements.

REPORTABLE CONDITIONS

The following sections discuss (1) FDIC's progress in addressing reportable conditions identified during our 1996 audits and (2) reportable conditions found during our 1997 audits.

Progress on Weaknesses
Identified in Previous Audits
In our 1996 audit report on the three funds administered by FDIC, we identified two reportable conditions which affected FDIC's ability to ensure that internal control objectives were achieved.⁸ These weaknesses related to FDIC's internal controls designed to ensure that (1) contracted asset servicers properly safeguarded failed institution assets and accurately reported financial information to FDIC and (2) data used in the calculation of the year-end allowance for losses was adequately reviewed for accuracy prior to inclusion in the year-end calculation.

First, during our 1996 audits, we found that FDIC had limited assurance that contracted asset servicers properly safeguarded failed institution assets and accurately reported financial information to FDIC because of deficiencies in FDIC's contractor oversight program. Specifically, FDIC's contractor oversight procedures did not ensure that (1) contracted asset servicers had adequate controls over daily collections and bank reconciliations, (2) servicers' fees and reimbursable expenses were valid, accurate, and complete, and (3) servicers' loan system calculations relating to the allocation of principal and interest were accurate.

During 1997, FDIC implemented a contracted asset servicer visitation program to address the specific areas of weaknesses noted during our 1996 audits. Also, FDIC completed an interdivisional memorandum of understanding to clarify the roles and responsibilities related to contractor oversight. As a result, we found that FDIC's new procedures ensured that contracted asset servicers had adequate controls over daily collections and bank reconciliations and loan system calculations relating to the allocation of principal and interest. Although we continued to find instances where FDIC oversight personnel did not ensure that servicer fees and expenses were valid and accurate, we concluded that the extent of the problems was not significant to BIF's and FRF's financial statements. We will discuss this matter further in a management letter.

During our 1997 audits, we found that the action FDIC took to address the second reportable condition was not fully effective. Therefore, we are continuing to report the weakness regarding integrity of data used for calculating the allowance for losses as a reportable condition. Additional details are provided below.

Reportable Condition
Identified in 1997
FDIC estimates recoveries on assets acquired from failed financial institutions and uses these estimates to calculate the allowance for losses on receivables from resolution activities and investment in corporate-owned assets. FDIC uses multiple data sources to calculate the estimated recoveries from these assets. Generally, FDIC estimates recoveries on loans, real estate owned, equity in subsidiaries, and other assets (including furniture and fixtures and miscellaneous receivables) using its Standard Asset Valuation Estimation (SAVE) process. FDIC values securities and other types of equity interests outside of its SAVE process.

During our 1996 audits, we found that FDIC did not have effective procedures in place to ensure that recovery estimates received from the various sources were adequately reviewed for accuracy prior to being included in the year-end calculation of the allowance for losses. In response to our finding, FDIC implemented enhanced review procedures intended to mitigate the occurrence of errors and ensure the quality and reasonableness of the recovery estimates. The new procedures required certification that recovery estimates submitted for inclusion in the allowance for loss calculations had been formally reviewed for accuracy.

During our 1997 audits, we continued to note problems with recovery estimates for FRF assets not valued as part of FDIC's SAVE process. For example, we found that significant errors were made in estimating the recoveries for a portfolio of partnership interests, causing the portfolio to be undervalued by $125 million. In addition, we found unsupported recoveries and other errors in the estimated recoveries for another portfolio of debt and equity securities causing the portfolio to be overvalued by $26 million. The estimated recoveries for both the partnership interests and debt and equity securities portfolios described above had been certified and reviewed for accuracy by FDIC personnel. The combined effect of the above valuation errors was an understatement of FRF's estimated recoveries and an overstatement of its allowance for losses on amounts due from receiverships.

FRF assets valued outside of FDIC's SAVE process were valued using various, inconsistent methods with varying degrees of examination of underlying documentation. This situation, combined with ineffective verification and review increases the risk that errors will occur and remain undetected by FDIC.

In addition to the weaknesses described above, we noted other less significant matters involving FDIC's system of internal accounting controls and FDIC's electronic data processing controls which we will be reporting separately to FDIC in two management letters.

RECOMMENDATIONS

In order to address the above weakness, we recommend that the Chairman of FDIC direct the heads of the Division of Resolutions and Receiverships and the Division of Finance to implement an improved process for estimating recoveries for securities and other assets currently being valued outside of its Standard Asset Valuation Estimation process. The process should have the objectives of producing valid and defensible estimates for financial statement purposes. In addition, FDIC should reemphasize the importance of the review and certification procedures for the estimated recoveries on assets valued outside of its standard asset valuation process.

CORPORATION COMMENTS AND OUR EVALUATION

In commenting on a draft of this report, FDIC acknowledged the reportable condition cited in our report and described its planned approach to improve the reliability of estimated recovery value for FRF assets valued outside of the SAVE process. We plan to evaluate the adequacy and effectiveness of these corrective actions as part of our audits of FDIC's 1998 financial statements. FDIC's comments also address the progress made in addressing the reportable condition regarding contractor oversight discussed in our 1996 report.

Robert W. Gramling
Director, Corporate Audits
and Standards

May 15, 1998

¹ Reportable conditions involve matters coming to the auditor's attention relating to significant deficiencies in the design or operation of internal controls that, in the auditor's judgment, could adversely affect an entity's ability to (1) safeguard assets against loss from unauthorized acquisition, use, or disposition, (2) ensure the execution of transactions in accordance with management's authority and in accordance with laws and regulations, and (3) properly record, process, and summarize transactions to permit the preparation of financial statements and to maintain accountability for assets.

² A material weakness is a reportable condition in which the design or operation of the internal control does not reduce to a relatively low level the risk that losses, noncompliance, or misstatements in amounts that would be material in relation to the financial statements may occur and not be detected within a timely period by employees in the normal course of their assigned duties.

³ On January 1, 1996, FRF assumed responsibility for all remaining assets and liabilities of the former RTC.

⁴ FIRREA provided an initial $50 billion to RTC. The Resolution Trust Corporation Funding Act of 1991 provided an additional $30 billion. The Resolution Trust Corporation Refinancing, Restructuring, and Improvement Act of 1991 provided $25 billion in December 1991, of which $6.7 billion was obligated prior to the April 1, 1992 deadline. In December 1993, the RTC Completion Act removed the April 1, 1992, deadline, thus making the remaining $18.3 billion available to RTC for resolution activities. Prior to RTC's termination on December 31, 1995, RTC drew down $4.6 billion of the $18.3 billion that was made available by the RTC Completion Act.

⁵ For the past several decades, information systems have typically used two digits to represent the year, such as "98" for 1998, in order to conserve electronic data storage and reduce operating costs. In this format, however, 2000 is indistinguishable from 1900 because both are represented as "00." As a result, if not modified, computer systems or applications that use dates or perform date- or time-sensitive calculations may generate incorrect results beyond 1999.

⁶ Year 2000 Computing Crisis: Federal Deposit Insurance Corporation's Efforts to Ensure Bank Systems Are Year 2000 Compliant (GAO/T-AIMD-98-73, February 10, 1998).

⁷ See the following notes to FDIC's financial statement: number 16 for BIF; number 13 for SAIF; and number 17 for FRF.