Federal Deposit
Insurance Corporation

Federal Deposit Insurance Corporation

We have audited the statements of financial position as of December 31, 1956 and 1995, of the-two deposit insurance funds administered by the Federal Deposit Insurance Corporation (FDIC), the related statements of income and fund balance, and the statements of cash flows for the years then ended. We have also audited the statements of financial position as of December 31, 1996, and January 1, 1996, of the FSLIC Resolution Fund, which is also administered by FDIC, and the related statement of income and accumulated deficit and the statement of cash flows for the year ended December 31, 1996.

In our audits of the Bank Insurance Fund (BIF), the Savings Association Insurance Fund (SAIF), and the FSLIC Resolution Fund (FRF), we found

The following sections discuss our conclusions in more detail. They also discuss (1) the scope of our audits, (2) additional information including recent legislation affecting SAIF and an update on the current status of FRF liquidation activities and funding, (3) FDIC's progress in addressing reportable conditions¹ identified during our 1995 audits, and reportable conditions identified during our 1996 audits, (4) recommendations from our 1996 audits, and (5) 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, 1996 and 1995, and the results of its operations and its cash flows for the years then ended.

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, 1996 and 1995, 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, 1996, and January 1, 1996, and the results of its operations and its cash flows for the year ended December 31, 1996.

As discussed in notes 1 and 2 of FRF's financial statements, on January 1, 1996, FRF assumed responsibility for liquidating the assets and satisfying the obligations of the Resolution Trust Corporation (RTC).² This statutorily mandated merger resulted in a significant one-time transfer of assets and liabilities into FRF on January 1, 1996. For this reason, FDIC concluded that providing year-end 1995 comparative information on FRF would not be practical on a fully consistent basis of accounting, and therefore only presented FRF's financial statements for 1996. Additionally, the transfer of RTC’s assets and liabilities into FRF required FDIC to make certain adjustments and reclassifications to 1996 opening balances on FRF's statement of financial position to ensure consistent treatment in presentation. For this reason, certain amounts on FRF's January 1, 1996, statement of financial position will not be readily traceable to the combined year-end 1995 balances reported on FRF's and RTC's statements of financial position.

As discussed in note 8 of FRF's financial statements, there are approximately 120 pending lawsuits which stem from legislation that resulted in the elimination of supervisory goodwill and other forbearances from regulatory capital. These lawsuits assert various legal claims including breach of contract or an uncompensated taking of property resulting from the FIRREA provisions regarding minimum capital requirements for thrifts and limitations as to the use of supervisory goodwill to meet minimum capital requirements. One case has resulted in a final judgment of $6 million against FDIC, which was paid by FRF, and another case to which FDIC is a party defendant and where a judgment of $26.9 million (plus post judgment interest) has been entered is currently on appeal. FDIC has established a reserve on FRF's financial statements for this second judgment. The remainder of these cases are pending in the Court of Federal Claims with the United States as the named defendant.

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 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. As of May 20, 1997 -- the end of our fieldwork -- only one of these three cases had gone to trial, and the trial was still ongoing. Until the amount of damages are determined by the court the amount of additional 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 will depend on the facts and circumstances, including the wording of agreements between thrift regulators and acquirers of troubled savings and loan institutions.

As discussed in note 8 of FRF's financial statements, FDIC believes that judgments in such cases are properly paid from the Judgment Fund.³ The extent to which FRF will be the source for paying other judgments in such cases is uncertain.

OPINION ON FDIC MANAGEMENT'S ASSERTIONS
ABOUT THE EFFECTIVFNESS 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

FDIC management fairly stated that those controls in place on December 31, 1996, 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. These weaknesses in internal controls, although not considered material weaknesses, represent significant deficiencies 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. While these weaknesses did not significantly affect the financial statements of the three funds, misstatements may nevertheless occur in other FDIC-reported financial information on the funds as a result of these internal control weaknesses. These weaknesses are 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

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

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 1996 and May 1997. Our audits were conducted in accordance with generally accepted government auditing standards.

ADDITIONAL INFORMATION ON
SAIF’S CAPITALIZATION AND
FRF’S LIOUIDATION ACTIVITIES

The following sections discuss (1) the affect of 1996 legislation on SAIF's capitalization and (2) FRF's liquidation activities and status of funding at year-end 1996.

1996 Legislation Resulted
in SAIF's Capitalization

In our 1995 audit report, we noted that a significant differential in premium rates charged by BIF and SAIF developed in 1995 after BIF achieved its designated capitalization level and FDIC lowered premium rates charged to BIF-insured institutions.⁴ We reported that, absent a legislative solution, this premium rate differential would likely remain for many years. We noted that, while SAIF's reserves continued to increase during 1995, its ratio of reserves to insured deposits was still substantially below its designated capitalization level. We also noted that such a differential in premium rates could result in further decreases to SAIF's assessment base beyond those already being experienced. We reported that this could jeopardize the stability of the Fund and increase the risk of a default on the thrift industry's obligation to pay the annual interest on 30-year bonds issued by the Financing Corporation (FICO) in an earlier attempt to resolve the thrift crisis of the 1980s.⁵

As discussed in notes 1 and 7 of SAIF's financial statements, on September 30, 1996, the Congress enacted the Deposit Insurance Funds Act of 1996 (DIFA). DIFA included provisions to capitalize SAIF to its designated ratio of reserves to insured deposits. SAIF was fully capitalized through a special assessment totaling $4.5 billion against SAIF-assessable deposits. The special assessment was sufficient to increase SAIF's reserves to the Fund's designated reserve ratio of $1.25 for each $100 of insured deposits effective as of October 1, 1996. DIFA also provided that banks bear part of the cost of the future annual FICO bond interest, which previously had been paid from SAIF-member assessments. The DIFA provisions resulting in the capitalization of SAIF and the spreading of the annual FICO bond interest between banks and thrifts effectively addressed the insurance premium disparity between BIF and SAIF. The legislation also provides for the merger of BIF and SAIF on January 1, 1999, if no thrift institution exists on that date.⁶

Status of FRF's Liquidation
Activities and Funding

As discussed earlier, on January 1, 1996, FRF assumed responsibility for the assets and liabilities of the former RTC. During 1996, FDIC continued its liquidation activities for FSLIC-related assets and liabilities, as well as those of the former RTC. As shown in table 1, the majority of FRF's losses from liquidation activities have been realized as of December 31, 1996.

Losses are realized when failed financial institution assets at receiverships are disposed of and the proceeds from the asset dispositions are not sufficient to repay amounts disbursed by FRF to receiverships and are recorded on FRF's financial statements as receivables from thrift resolutions. Losses are also realized when assets FRF purchases from terminating receiverships (investments in corporate-owned assets) are later disposed of for less than the price FRF paid when it purchased the assets from the receiverships. Uncertainties still exist with regard to the unrealized losses, as the amount will not be known with certainty until all remaining assets and liabilities are liquidated.

In total, the Congress made available $149.2 billion in funding to cover liabilities and losses associated with the former FSLIC and RTC resolution activities, of which $105 billion was made available to the former RTC.⁷ Of the $105 billion in funding available, $91.3 billion 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. In total, $135.5 billion was received to cover liabilities and losses associated with the former FSLIC and RTC resolution activities.

As shown in table 2, after reducing the total amount of funding received by the amount of estimated funds needed, $6.6 billion in available funds will remain.

The final amount of unused funds will not be known with certainty until all of FRF's remaining assets and liabilities are liquidated. Further, $13.7 billion in loss funds not received by RTC prior to RTC's termination are available until December 31, 1997, for losses incurred by the SAIF, if the conditions set forth in the Resolution Trust Corporation Completion Act are met.⁸ Also, according to the act, unused loss funds will be returned to the general fund of the Treasury.

REPORTABLE CONDITIONS

The following sections discuss (1) FDIC's progress in addressing reportable conditions identified during our 1995 audits and (2) reportable conditions found during our 1996 audits.

Progress on Weaknesses
Identified in Previous Audits

In our 1995 audit report on the three funds administered by FDIC, we identified reportable conditions which affected FDIC's ability to ensure that internal control objectives were achieved.⁹ These weaknesses related to FDIC's internal controls designed to ensure that (1) estimated recoveries for failed institution assets were determined in accordance with FDIC's estimation methodology, were supported by asset file information, and incorporated the impact of events through year-end, (2) time and attendance reporting procedures were effective, and (3) electronic data processing controls were effective. During 1996, FDIC's actions addressed the weaknesses we identified in our 1995 audit report.

For example, during our 1995 audits, we identified weaknesses in FDIC's controls to ensure that recovery estimates for assets acquired from failed financial institutions complied with FDIC's revised asset recovery estimation methodology, including being supported by asset file documentation, and weaknesses in the cut-off date for asset recovery information used by FDIC in its year-end allowance for loss estimation process. FDIC's implementation of the Standard Asset Valuation Estimation methodology and related Asset Loss Reserve project in 1996 have addressed our previously identified weaknesses surrounding FDIC's use of noncurrent asset recovery values and the lack of adherence to its asset recovery estimation methodology. Additionally, although we continued to find instances where relevant file documentation was not always used in estimating asset recovery values during our 1996 audits, these problems did not affect the financial statements, and appear to be a result of first-year implementation issues. We will continue-to review individual asset recovery estimates during 1997.

During our 1995 audits, we also continued to identify weaknesses in FDIC's time and attendance reporting process. We reported that we had continued to identify deficiencies in adherence to required procedures in preparing time and attendance reports, separation of duties between timekeeping and data entry functions, and reconciliation of payroll reports to time cards. During 1996, FDIC implemented new time and attendance reporting procedures to address these deficiencies. The new procedures were intended to streamline and improve the time and attendance reporting process by focusing accountability for verifying the accuracy of time reports with supervisors, segregating the timekeeping and data entry functions, and redefining post audit responsibilities for time and attendance reporting. We found that the implementation of these new procedures effectively addressed the internal control issues we identified in the time and attendance reporting process in our prior year audits.

During our 1995 audits, we also identified a weakness related to FDIC's electronic data processing general controls. This weakness, because of its sensitive nature, was communicated in a separate correspondence to FDIC management, along with our recommendations for corrective action. During 1996, FDIC took action which effectively addressed the issue we raised in this separate correspondence. Additionally, in our final audit of the Resolution Trust Corporation's (RTC) 1995 financial statements,¹⁰ we identified weaknesses related to general controls over RTC's computerized information systems which required corrective actions. During our 1996 audits, we found that FDIC took action to address a number of these general control weaknesses. Several other general control related issues had not been fully addressed by FDIC at the time of completion of our 1996 audits. However, we believe the issues are not significant enough to be considered a reportable condition.

Reportable Conditions
Identified In 1996

The following reportable conditions represent significant deficiencies in FDIC's internal controls and should be corrected by FDIC management.

1.Controls over the integrity of information used to calculate the allowance for losses on receivables from resolution activities and investment in corporate-owned assets need to be improved. Specifically, FDIC did not have effective procedures in place to ensure that 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.

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. Much of the data are gathered from decentralized sources and some of the operations performed on the data are handled in a decentralized manner. Consequently, it is critical that procedures be in place to ensure the accuracy and quality of the data and that such procedures clearly require review for accuracy and quality of the data used in the year-end allowance for losses calculation. However, during our 1996 audits, we found deficiencies in FDIC's procedures for reviewing the compiled data and the related calculations. As a result, FDIC management did not consistently have assurance that the estimated recoveries were properly recorded, processed, and reliable.

For example, FDIC personnel made errors in calculating the estimated recoveries for a portfolio of equity investments. The resulting error of about $97 million was not detected by FDIC. In addition, FDIC made a number of errors in the process of updating the June 30, 1996, estimated recoveries for assets maintained at failed institution receiverships. The estimated recoveries for many of these assets were erroneously changed and some were inadvertently deleted. In addition, FDIC did not always follow its procedures for discounting recovery estimates during its update process, resulting in improper discount rates being used to derive the updated values for a number of assets. Finally, we also found instances where FDIC personnel did not review the integrity of the estimated recoveries on securities assets prior to including these recoveries in the allowance for losses calculations.

The nature of these errors was such that, had an effective process been in place for reviewing the compiled data and related calculations, FDIC could have identified and corrected the errors. The errors we identified generally caused estimated asset recoveries to be understated and the related allowance for losses to be overstated at December 31, 1996. While the effect of these misstatements was not material, misstatements in future financial statements could occur if corrective action is not taken.

FDIC has proposed enhanced review procedures for 1997 which, if properly implemented, should reduce the risk of future errors or misstatements. We will assess the effectiveness of these review procedures during our 1997 audits.

2.FDIC's oversight of asset servicers contracted to manage and dispose of failed financial institution assets needs to be strengthened. 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 personnel did not always ensure that (1) contracted asset servicers have adequate controls over daily collections and bank reconciliations, (2) servicers, fees and reimbursable expenses are valid, accurate and complete, and

(3) servicers' loan system calculations relating to the allocation of principal and interest are accurate.

As of December 31, 1996, approximately $4.8 billion of the $8.7 billion (about 55 percent) in FDIC's inventory of failed financial institution assets was serviced by contracted asset servicers. These servicers accounted for over $3.7 billion of the $5.9 billion (about 63 percent) in FDIC's collections during 1996 related to asset management and disposition activities. Consequently, it is critical that FDIC maintain an effective contractor oversight program.

FDIC attributes some of the problems noted above to reorganizations and realignments of responsibilities as a result of the merging of RTC activities into FDIC during 1996 coupled with the continued downsizing of the Corporation. Division of Finance (DOF) officials informed us that they intend to implement a full visitation program which will include oversight procedures addressing each of the deficiencies noted above. DOF anticipates having its revised visitation program begin operation in July 1997. Additionally, DOF and the Division of Resolutions and Receiverships (DRR) have established a task force to develop Memorandums of Understanding to more clearly define their oversight roles, with concurrence from the Division of Administration. We will assess the adequacy of FDIC's corrective actions during our 1997 audits.

In addition to the weaknesses discussed above, we noted other less significant matters involving FDIC's system of internal accounting controls and its operations which we will be reporting separately to FDIC.

RECOMMENDATIONS

To address weaknesses identified in this year's audits in the process for calculating the allowance for losses on receivables from resolution activities and investment in corporate-owned assets, we recommend that the Chairman of the Federal Deposit Insurance Corporation direct the heads of the Division of Resolutions and Receiverships and the Division of Finance to implement formal procedures for reviewing data used in the allowance for losses calculations. Such procedures should provide for

To address weaknesses identified in this year's audits in contracted asset servicer oversight, we recommend that the Chairman of the Federal Deposit Insurance Corporation direct the heads of the Division of Resolutions and Receiverships and Division of Finance to enhance their contractor oversight program to ensure that their procedures for overseeing contracted asset servicers are followed. Such procedures should ensure

CORPORATION COMMENTS
AND OUR EVALUATION

In commenting on a draft of this report, FDIC acknowledged the internal control weaknesses cited in the report and commented on initiatives it has underway to address the issues raised regarding the allowance for losses calculation and oversight of contracted asset servicers. We plan to evaluate the adequacy and effectiveness of these corrective actions as part of our 1997 financial audits.

FDIC's comments also discuss the changing environment the Corporation faced during 1996 and continues to face today, the condition of FDIC-insured institutions and the deposit insurance funds, and progress made by the Corporation in addressing internal control weaknesses identified in our 1995 financial audits.

Robert W. Gramling
Director, Corporate Audits and Standards

May 20, 1997

¹Reportable 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. A material weakness is a reportable condition in which the design or operation of the internal controls 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.

²The Resolution Trust Corporation was created by the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA) to manage and resolve all troubled savings associations that were previously insured by FSLIC and for which a conservator or receiver was appointed during the period January 1, 1989, through August 8, 1992. This period was extended to September 30, 1993, by the Resolution Trust Corporation Refinancing, Restructuring, and Improvement Act of 1991 and was further extended on December 17, 1993, to a date not earlier than January 1, 1995, nor later than July 1, 1995, by the Resolution Trust Corporation Completion Act of 1993 (RTC Completion Act). The RTC Completion Act stated that the final date would be determined by the Chairperson of the Thrift Depositor Protection Oversight Board. On December 5, 1994, the Chairperson made the determination that RTC would continue to resolve failed thrift institutions through June 30, 1995. Finally, the RTC Completion Act required RTC to terminate its operations no later than December 31, 1995.

³The Judgment Fund is a permanent, indefinite appropriation established by 31 U.S.C. Sec. 1304, and is administered by the Department of the Treasury.

⁴We had previously reported on the potential for a significant differential in premium rates to develop between BIF and SAIF in 1995, as well as the potential consequences of such a differential, in De-posit Insurance Funds:

Analysis of Insurance Premium Dis'parity Between Banks and Thrifts (GAO/AIMD-95-84, March 3, 1995).

⁵FICO was established in 1987 to recapitalize the Federal Savings and Loan Insurance Fund, the former insurance fund for thrifts. FICO was funded mainly through the issuance of public debt offerings which were initially limited to $10.8 billion but were later effectively capped at $8.2 billion by the RTC Refinancing, Restructuring, and Improvement Act of 1991. Neither FICO's bond obligations or the interest on these obligations are obligations of the United States nor are they guaranteed by the United States. The annual FICO interest obligation, on average, equals approximately $780 million.

⁶The Deposit Insurance Funds Act directs the Secretary of the Treasury to conduct a study of issues relevant to developing a common charter for all insured depository institutions and the abolition of separate and distinct charters between banks and savings associations, and to make recommendations with respect to establishing a common charter.

⁷ 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, which was only available for obligation until April 1, 1992. In December 1993, the RTC Completion Act removed the April 1, 1992, deadline, thus making the balance of the $25 billion that was not obligated prior to April 1, 1992, $18.3 billion, available to RTC for resolution activities.

⁸The RTC Completion Act makes available to SAIF, during the 2-year period beginning on the date of RTC's termination, any of the $18.3 billion in appropriated funds made available by the RTC Completion Act and not needed by RTC. However, prior to receiving such funds, FDIC must first certify, among other things, that SAIF cannot fund insurance losses through industry premium assessments or Treasury borrowings without adversely affecting the health of its member institutions and causing the government to incur greater losses.

⁹ Financial Audit: Federal Deposit Insurance Corporation’s 1995 and 1994 Financial Statements (GAO/AIMD-96-89, July 15, 1996).

¹⁰ Financial Audit: Resolution Trust Corporation's 1995 and 1994 Financial Statements (GAO/AIMD-96-123, July 2, 1996).