After a securitization is completed, a bank retains the risk/reward profile associated with the residual cash flow (i.e., the cash flow after making payments to the investors in the asset-backed securities and ongoing fees associated with the securitization). The residual interest appears on the balance sheet of the securitizer but must be marked to market. There is no market where the value of the residual interest can be obtained. Rather, the determination of the value of the residual interest, both at the time of the securitization and thereafter, is estimated using the standard discounted cash flow analysis based on several assumptions. This can result in material differences in the value of the residual interest depending on the assumptions used. The failures of at least three U.S. banks—Superior Bank, First National Bank of Keystone, and Pacific Thrift and Loan—were caused by the alleged improper valuation of the residual interests or, equivalently, the improper appreciation of the risk on securitized assets.⁶⁹

Consider for example the case of Superior Bank of Hinsdale, Illinois that was closed in July 2001. In 1993, the bank started originating and then securitizing subprime home mortgages in large volumes. It eventually expanded into securitizing its subprime automobile loans. Its securitizations were being supported by both residual interests and overcollateralization. By June 30, 1995, the bank’s residual interests were almost 100% of Tier-1 capital; five years later it represented 348% of Tier-1 capital, meaning that the risk on the asset side was 3.5 times the risk on the liability side. As noted earlier, the first-loss risk retained by the bank in a securitization transaction is effectively the equity in a corporation. More to the point, if Superior Bank’s Tier 1 capital is the first-loss support, the bank’s equity holders effectively agreed to absorb the first-loss risk of $1, and correspondingly, the bank went out in the market to bear first-loss risk to the extent of $3.48. Further masking this risk was that Superior Bank was able to book profits on the sale of subprime loans under generally accepted accounting principles. Unfortunately, regulators did not see the financial difficulties with Superior Bank for quite sometime when regulators were required the bank to revalue its residual interests.⁷⁰

The Superior Bank case not only demonstrated the concern that bank risk could be masked, but it also highlighted the concerns with subprime lending. In a hearing before the Committee on Banking, Housing, and Urban Affairs of the U.S. Senate in February 2002 regarding the failure of Superior Bank, Thomas McCool, Managing Director of Financial Markets and Community Investment, stated: