For those that subscribe to my blog, I apologize for being away so long.  I am have finally finished my law degree and am now working on passing the bar.  Hopefully I’ll have a little time to post some new material after the Holidays.  Hope everyone has a happy and safe Holiday season.

Tom

This article was my final paper for my Banking Law Seminar class in the Spring of 2008.  I thought about piecing it out in a series but decided it was better to post it in its entirety.  The way you view it today is exactly how I submitted it without modification aside from the title page.  The date was April 16^th of 2008.  I earned the very highest grade possible with it.  I hope you enjoy it.

By:  Thomas L. Antoine 

INTRODUCTION

        The housing industry has been the center of the recent financial crisis troubling the nation and dominates current financial news.  Government Sponsored Enterprises (GSEs) have been swept up in the turbulence and possibly a major contributor to these problems.  This paper will discuss the history of Fannie Mae and Freddie Mac as an example of the GSE.  An explanation of how GSEs are regulated will be outlined and the current business and economic climate will be discussed.  GSEs are integral in the packaging of Mortgage Backed Securities (MBS).  A discussion of how MBSs are valued is an important part of understanding the regulation of Fannie Mae and Freddie Mac and their roll in the economy.  Currently, there are pressing calls for new or different federal regulation on the front burner in Washington.  The impact of how proposed revisions may or may not impact GSEs will be reviewed. 

BREIF HISTORY of GSEs

The most commonly known GSEs are Fannie Mae, Freddie Mac, and Ginnie Mae.  The Federal National Mortgage Association (FNMA) is commonly called Fannie Mae.  The FNMA originated in 1938 as part of Franklin D. Roosevelt’s New Deal and a part of an effort to stimulate home ownership that started with the Home Owner’s Loan Act of 1933.[1]  The national housing market had collapsed in the wake of the Great Depression and private lenders were apprehensive to invest in home loans. Fannie Mae was established to provide local banks with federal money to finance home mortgages.[2]  This was an attempt to make housing more affordable in a time when home ownership was on the decline.  1968, due to fiscal pressures created by the Vietnam War, Lyndon B. Johnson privatized Fannie Mae in order to remove it from the national budget. Currently it is traded under the symbol FNM.  The origin of Freddie Mac occurred in 1970 shortly after Fannie Mae was privatized.  The business name is the Federal Home Loan Mortgage Corporation (FHLMC).  It was created to expand the secondary market for mortgages at the same time the Bank Holding Company Act (BHCA) Amendments were enacted.[3]  Freddie Mac was intended to address concerns that Fannie Mae would monopolize the market. Freddie Mac is traded under the symbol FRE. 

Other GSEs include the Government National Mortgage Association (GNMA) and SLM Corporation, formerly USA Education.  SLM Corporation is commonly known as Sallie Mae, a publicly traded corporation.  They are the United States’ largest student loan company.  The company primarily provides federally guaranteed student loans originated under the Federal Family Education Loan Program (FFELP).  Sallie Mae also provides resources to assist students, parents, and professionals guidance with the financial aid process.  GNMA, known as Ginnie Mae, is a U.S. government-owned corporation within the Department of Housing and Urban Development (HUD).[4]  Ginnie Mae provides guarantees on mortgage-backed securities (MBS) guaranteed by federally insured loans.  These loans are issued by the Federal Housing Administration, Department of Veterans Affairs, Rural Housing Service, and Office of Public and Indian Housing. Ginnie Mae securities are the only MBSs that are guaranteed by the United States government.  This creates confusion as to whether Fannie Mae and Freddie Mac carry the same protection.

GENERAL OPERATION of FANNIE MAE and FREDDIE MAC

Both Fannie Mae and Freddie Mac have common business purposes.  Each is a government-sponsored enterprise (GSE) of the United States.[6]  Both companies are stockholder-owned corporations authorized to make loans and loan guarantees.  Neither GSE is backed or funded by the U.S. government, nor do the securities they issue benefit from any explicit government guarantee or protection.  Along with other entities, Fannie Mae and Freddie Mac buy mortgages on the secondary market, pool them, and sell them as mortgage-backed securities to investors on the open market.[7]  This secondary mortgage market helps to replenish the supply of lendable money for mortgages and ensures money continues to be available for new home purchases.  Their common names, Fannie Mae and Freddie Mac, are used for ease of identification. 

How these GSE’s operate is unique to other corporations.  Fannie Mae and Freddie Mac generate profits for stock holders while enjoying the benefits of exemption from taxation and oversight as well as implied government backing.[8]  Depending on the source, it is reported that Fannie Mae and Freddie Mac have controlled between 40 and 60 percent of the nation’s secondary mortgage market.  Fannie Mae and Freddie Mac are the only two Fortune 500 companies that are not required to inform the public about any financial difficulties that they may be having.[9]  Both companies are exempt from registration filing requirements with the Securities and Exchange Commission (SEC) under their respective Charters.[10]  Therefore, the corporations’ quarterly and annual financial reports are not available on the SEC’s Electronic Data Gathering, Analysis, and Retrieval system (EDGAR).  However, both corporations are required to make analogous disclosures available. These financial disclosures include Information Statements similar to the 10K yearly and 10Q quarterly Information Statements and Supplements.  The Fannie Mae and Freddie Mac statements are available from the corporations’ Investor Relations Departments.   In addition to these unique reporting requirements, Fannie Mae and Freddie Mac are subject to special regulation under the Housing and Urban Development (HUD) department.

OVERVIEW of REGULATORY SYSTEMS

Government-sponsored enterprises are unique in how they are regulated.  The Federal Housing Enterprises Financial Safety and Soundness Act of 1992 (the GSE Act) established the current regulatory structure for the GSEs.  The GSE Act is codified under Title 12 Chapter 46 for Government Sponsored Enterprises.[11]  The Act focuses on Protection of taxpayers from liability of the GSE operation.  The legislation divided the Federal Government’s regulatory responsibilities of Fannie Mae and Freddie Mac between the Secretary of Department of Housing and Urban Development (HUD) and the Director of the Office of Federal Housing Enterprise Oversight (OFHEO). [12]  Under the GSE Act, the Secretary of HUD is charged with general regulatory authority over Fannie Mae and Freddie Mac in all areas other than the GSEs’ financial safety and soundness, which is the responsibility of the Director of OFHEO.  The Director is authorized, without the review or approval of the Secretary, to make determinations and take regulatory actions necessary to ensure the safety and soundness of GSEs.[13]   Those actions may include the establishment of capital standards and examinations of the enterprises.[14]  The examinations may be used to determine the capital levels of the enterprises, assist in decisions to appoint conservators for the enterprises, and include administrative enforcement actions.   

In addition to GSE health, financial actions are also closely monitored.  The enterprises must submit reports of their financial status to the Director for review.[15]  A GSE must seek approval of payments of capital distributions to its shareholders from the Director.[16]  Excessive compensation by the enterprises to any executive officer of the enterprises is prohibited under section 4518 of the title.  The management of the office, including the establishment and implementation of annual budgets, the hiring of, and compensation levels for, personnel of the office, and annual assessments for the costs of the office must be included in the Director’s review.

The director of the OFHEO, James B. Lockhart III, reports to the Secretary of HUD.  The current Secretary of HUD is Alphonso Jackson.  The actions of HUD are dictated by the Real Estate Settlement Procedures Act (RESPA) along with the Truth In Lending Act (TIL).  These statutes are designed to deter abuse by requiring disclosure of closing terms, financial terms, and the operation of HUD to protect consumers.[17]  RESPA applies to all federally related mortgage loans except loans for business purpose, temporary financing, loan conversions, and secondary market transactions. [18]  This means that the secondary securities bundled and sold by the GSEs are not covered by RESPA oversight.  Similarly, mortgage broker transactions that are table-funded are not secondary market transactions and do fall under RESPA either. Neither the creation of a dealer loan or dealer consumer credit contract, nor the first assignment of such loan or contract to a lender, is a secondary market transaction and do come under RESPA purview which HUD is responsible for enforcing.

HUD’s authority includes setting the level of, and enforcing, three affordable housing goals.  The first, goal includes compliance with fair lending requirements, issuance of TIL statements, and the like.  Second, the Secretary must collect loan-level data from the GSEs regarding their mortgage purchase activities.  Then create and make available to the public a database of non-proprietary GSE loan purchase data.  Finally, HUD must review new proposed GSE programs.  HUD has express authority to disapprove any program that the Secretary determines is not authorized under a GSE’s Charter or the Act for purposes that are not in the public interest.  The actions of Fannie Mae and Freddie Mac and reports made by the Secretary of HUD are closely monitored because Banks use the mortgage backed securities that they hold to calculate their Risk Weighted Assets which is used in determining whether the bank meets Regulatory Capital Requirements.[19]  The standard is imposed by the International Lending and Supervision Act 12 U.S.C. §3907. 

The Secretary of HUD is not responsible for reporting on the safety and soundness of HUD that is the Director of OFHEO’s responsibility.  The Director of OFHEO is required to compile data on GRE safety and soundness and report it to the US Senate Committee on Banking, Finance and Urban Affairs and the United States House Committee on Financial Services.  Currently, the Senate Committee members include Senator Chris Dodd Chairman (D-CT) and Richard C. Shelby Ranking Member (R-AL) among others. The House Committee members include Barney Frank, Chairman (D-MA) and Spencer Bachus, Ranking Member (D-AL).  The Director must submit two yearly reports to these Committees.  Not later than June 15 of each year, a written report on actions taken, and being undertaken for the financial safety and soundness of each GSE must be submitted.[20]  The report includes recommendations for legislation to enhance the financial safety and soundness of each GSE.  In addition to this report another is required on March 15 of each year.  The March report requires the Director to include written documentation of the year’s requests of enforcement actions by the Director to the Attorney General.  Specific data on the total number of requests made by the Director, number of requests that resulted in the commencement of litigation by the Department of Justice, and other related data is required.  These measures primarily target consumer protection and attempt to safeguard taxpayers from potential GSE corporate misbehavior. 

TREND of FUTURE REGULATION

The housing industry is at the epicenter of the nation’s current financial problems and has prompted discussion regarding reformation of the GSEs responsible for creating mortgage backed securities.  The Department Of The Treasury’s “Blueprint For A Modernized Financial Regulatory Structure” with Henry M. Paulson, Jr. as Secretary includes discussion on where legislation may or may not be going.  Those components of the plan that affect Fannie Mae and Freddie Mac are part of the short, intermediate, and possibly long term recommendations.  The short term recommendations include expanding government to regulate loan origination.  Two intermediate recommendations will likely have an impact one includes transitioning Thrifts to Bank Charters.  The other intermediate change would merge the Securities and Exchange Commission with the Federal Trade Commission.[21] These recommendations are supported by developments in asset securitization.  The asset securitization process includes pooling single mortgage loans with other mortgage loans in a portfolio of assets and selling securities backed by the pool of mortgage loans (MBSs) to obtain funding from the public with which to originate new mortgage loans.   

The Blue Print acknowledges that mortgage backed securities is where GSEs hold a key role. “The advent of the residential mortgage securitization market and the large growth of both government-sponsored enterprises (“GSEs”), such as ‘Fannie Mae’ and ‘Freddie Mac’, and other asset-backed securities markets have shrunk traditional depository institutions’ share of the overall residential mortgage market.”[22]  In 2005 Fannie Mae’s and Freddie Mac’s combined book of MBSs represented 40 percent of the total residential mortgage debt outstanding, slightly down from the 43 percent share at the end of 2004.  In total, GSEs and non-GSE corporations that securitize mortgages control between 60 to 65 percent of the total residential mortgage market.  The Blue Print continues to say that “despite recent stress in the securities market, there is still a robust level of GSE securitization.”[23]  The report calls for prudential regulation of Government-Sponsored Enterprises but does not offer suggestions that are different than today’s regulation.  The report acknowledges that the GSEs’ unique structure does not fit well within any regulatory structure. Even though no explicit guarantee backs the GSEs’ obligations, Government sponsorship provides each GSE with a set of benefits not available to other financial institutions.  The sponsorship creates the appearance of a guarantee and perceived stableness of GSEs.

Paulson’s plan includes what is named the Prudential Financial Regulatory Agency (PFRA).  Given the existing market misperception that the federal government stands behind the GSEs’ obligations, the Blue Print states that the “optimal structure implies that PFRA should not regulate the GSEs.” [24]  PFRA’s regulation of the GSEs would likely serve to strengthen that misperception even further.  However, the plan does recommend employment of a separate regulator to address the issues in the near-term.  Paulson believes a separate regulator would be an important signal that the GSEs do not have government guarantees.  The report contends that in order to ensure that the GSEs operate in a safe and sound manner the regulatory structure needs to maintain a flexible framework for regulating the “wholesale financing activities” of Fannie Mae and Freddie Mac.  In the long term Paulson states that there should be a continued evaluation of the need for separate GSE charters, a hint that these charters may not continue.  This leaves whether GSEs will be completely privatized or taken into a government agency unresolved. 

The control of private sector systems is also addressed in the Blue Print.  The Blue Print proposes introducing a Corporate Finance Regulator (CRE) to monitor the activity of these private firms.[25]  It is recommended that the CRE should be responsibility for general issues related to corporate oversight in public securities markets. Those responsibilities would include the SEC’s current oversight of corporate disclosures, governance, accounting oversight, and other similar issues.  The Depository Trust & Clearing Corporation (DTCC) which is currently regulated by the Securities and Exchange Commission (SEC) is one of the companies that the CRE would regulate.  A subsidiary of DTCC is the Fixed Income Clearing Corporation (FICC).  FICC is designed to ensure orderly settlement in the government and mortgage-backed securities marketplaces.  The FICC is composed of two divisions, the Government Securities Division (GSD) and the Mortgage-Backed Securities Division (MBSD).[26]  The MBSD provides automated post-trade comparison, position netting, risk management, and pool notification services to the mortgage-backed securities market.  That market is largely comprised of Government National Mortgage Association, Federal Home Loan Mortgage Corporation, Fannie Mae and Freddie Mac.

When comparing the current regulatory systems for GSEs to the proposed revisions in the Blue Print it is difficult to discern any real differences between the two.  Real change is needed.  Currently, if there was a financial collapse within any of these companies, U.S. taxpayers would likely bail out hundreds of billions of dollars in outstanding debt.  A recent investigation by the Justice Department and the SEC looked into the accounting practices at Freddie Mac.  They revealed accounting errors in the amount of 4.5 to 4.7 billion dollars which resulted in the termination of three of the company’s top executives.[27]  In addition, the current Director Alphonso Jackson announced his resignation at a brief press conference on March 3 2008, citing personal and family matters. He will step down April 19 of this year.[28]  Jackson is currently under a grand jury investigation by the Justice Department, the FBI, and the HUD inspector general for impropriety in awarding federal HUD contracts.[29]  It is likely that those investigations have precipitated the discussion to re-evaluate the regulation of Fannie Mae and Freddie Mac within the Blue Print.  The ongoing investigations by the Congress House Finance Services subcommittee will likely determine how the Department of Treasury writes their proposal on regulating GSEs and the future role of the proposed Corporate Finance Regulator.  Fannie Mae, Freddie Mac and the secondary mortgage market that they dominate will have to adjust.  Nowhere in the blue print does it discuss expanding regulation to the financial modeling of mortgage backed securities that the GSEs develop.  Rather, it focuses on regulating mortgage approvals and leaves the bundling and securitization of those mortgages to the GSEs’ discretion.  This leaves the debate of whether marked-to-model valuation of mortgage backed securities is appropriate for another time. 

SUMMARY of MARKED TO MODEL 

In October 1997, Congress enacted the Multifamily Assisted Housing Reform and Affordability Act (MAHRA), commonly referred to as the ‘‘mark-to-market’’ legislation.[30]  Congress decided to disengage from the regulatory constraints and contractual obligations that resulted from the Section 8 production programs.[31]  In accounting and finance, mark to market is the act of assigning a value to a position held in a financial instrument based on the current market price for that instrument or similar instruments.  The intent was to rescue HUD from bankruptcy due to a glut of section 8 housing that had been approved in the prior six years.  The influx of this inventory would have sent HUD into default because rising supply made those contracts unattractive to private developers and investors.  HUD is a vast banker and asset manager, in 1998 it had over $42 billion in loan risk outstanding through FHA insurance or HUD-held loans.  At the time HUD had an annual contractual outflow of about $20 billion through all forms of Section 8.[32]

The market for this type of investment is limited.  Developers and investors are drawn primarily because HUD underwrites the construction loans and there are long term federal tax credits available to float the investment.  In general, the credit is allowed by the invested to be used over a 10-year credit period (the “Credit Period”) with respect to each qualified low-income building. The Credit Period begins with the taxable year in which the building is placed in service or, at the election of the taxpayer, with the next succeeding taxable year.[33]  The Tax Code requires the building to retain qualified low-income status for at least 15 years after the compliance period (the “Extended Use Period”).  For an existing building, the Credit Period for the acquisition and rehabilitation expenditures will not begin until those rehabilitation costs are completed.[34]  There are also restrictions on eviction and other requirements that impact the financial performa of these types of properties.  Congress realized that making a major mistake on evaluating property for marked-to-market treatment, or just being unlucky in the new market operations, could put the property back into default and developed an elaborate evaluation procedure.[35] 

Despite these concerns the program had favorable results and rescued HUD from certain failure.  The concept was so successful it was applied to the residential mortgage market a few years later, generally.  The problem is that when the market price cannot be objectively determined because there is no real day-to-day market available, assets are being ‘marked to model’ using estimated valuations.  This happens with unique property such as real estate where values are derived from financial modeling and sometimes marked to fantasies rather than realities. Mortgage backed securities are marked in a similar manner as the HUD section 8 programs.  The financial industry depended on the reliability of the HUD regulated actions of the GSEs namely Freddie Mac and Fannie Mae.  This has proven to be catastrophic and one of the largest reasons for the world’s current financial crisis including the recent struggles of Bears, Stearns, & Co. Inc., Deutsche Bank AG, Citigroup Inc., and others.

CONCLUSION 

      Government Sponsored Entities, Fannie Mae and Freddie Mac are at or near ground zero in the new millennia’s housing crisis.  It is likely that these entities will be the focus of much media attention in the months to come.  Current regulation of these GSEs has contributed directly to the present business and economic climate.  Their unique position in both the housing industry and the securities market poses difficult challenges to regulators.  Any regulation on how they operate will impact the lending industry in general and effect how financial markets operate.  However, the Marked-to-Model practice for valuing mortgage backed securities must be addressed in some form.  This practice has proven to be a driving factor in mortgage lending practices.  Serious consideration must be given to the wisdom of marking the value of real property based securities to a market or model rate.  Historically, real property has been recognized as unique and individual in every other context.  Treating real estate and real estate based products as a commodity will prove to be the impetus of much congressional debate and new legislation.  The U.S. Treasury’s Blue Print for a Stronger Regulatory Structure has left the discussion of change in current regulation of Freddie Mac and Fannie Mae for the future.

                Recent success of company has been attributed to a mixture of conservative banking and bold moves by their CEO Richard K. Davis.  Despite current widespread banking problems U.S. Bancorp raised dividends to 6%, in December 2007 which yields a new annual payout of $1.70 per share.  The company reports their lack of worry from a very conservative business model.  USB claims to be content to grow at a slower rate.  This may not be entirely their choice due in part to legal problems faced by the commercial lending side of their business.  Otherwise, USB has avoided aggressive lending practices unlike strategies used by other large banks in recent years.  USB’s press release points out that the company has raised its dividend for 36 straight years, and their charter has paid a dividend in the past 145 consecutive years.^[i]  These solid numbers have attracted Warren Buffett’s attention.  Buffett increased his holdings in U.S. Bancorp by 76.59% last year.^[ii] 

                This January U.S. Richard Davis announced “During 2007, we returned 111% of earnings to shareholders in the form of dividends and share buybacks.”^[iii]  Davis reported that the company’s credit quality remains sound.  Both net charge-offs and nonperforming assets increased during the fourth quarter, but the growth was moderate and as expected.^[iv]  He warned that USB will not be immune to the current stress in the residential real estate markets and mortgage-related industries.  Davis reassured that given the Company’s overall credit risk profile, increases in net charge-offs and nonperforming assets in the coming year will be manageable.  Davis is eluding to potential questions regarding USB’s capitalization requirements enforced by the OCC, as previously discussed.

                US Bancorp is not a problem company yet, but returns of 111% of earnings in a deteriorating environment need to be scrutinized carefully.  Loan loss provisions and write offs are climbing exponentially.  This is not the environment to come to shareholders and make the case for returns of 111% of earnings.^[v]  Investors who are receiving 111% of earnings need to question the financial accounting practices justifying the returns.  As attorneys we need to question these types of actions.  The most obvious answer to this current behavior is that USB is taking advantage of the current preferred tax rate on dividends of 15% as opposed to ordinary income levels.  This decision is likely to eventually come back to haunt U.S. Bancorp. Banks must proscribe Regulatory Accounting Principles which are more stringent than the General Accepted Accounting Principles that were manipulated by Enron Corp. and WorldCom.  The executives and Board of Directors owe the shareholders fiduciary duties and are subject to civil action for breach of their duties under the Investment Company Act.^[vi]  The Sarbanes-Oxley Act of 2003 codified many accounting safe stops that the banking industry had been using.^[vii]  General Counsel Lee Mitau and CEO Richard Davis are primarily responsible for the accuracy of the financial statements.  This is evidenced by their prominent certification of the 10-K report.

                Last year U.S. Bancorp had a market cap of $55.8 billion as opposed to $55.06 this year.  Its shares were traded at around $32.44 with P/E ratio of 12.45.  USB’s current P/E ratio is 13.18, their shares closed at $31.83 on March 4^th, 2008. The dividend yield of U.S. Bancorp stocks is 5.2%.  U.S. Bancorp 2008 year end financials show their fourth-quarter profit fell 21 percent, hurt by losses from loans, money market mutual funds, and a legal settlement.^[viii]  Net income for the Minneapolis-based company fell to $942 million from $1.19 billion a year earlier.^[ix]  The fall was due primarily to a $107 million valuation loss on asset-backed commercial paper and a $215 million legal litigation involving the Visa/NOVA lawsuit.^[x]  There are no ongoing issues noted.  The Visa Restructuring and Card Association Litigation are noted as a contingent liability.^[xi]

The rise of U.S Bancorp to one of the largest financial holding companies in the United States is marked by the evolution of banking law.  Generally, Congress has worked to allow both growth and to ensure the safety and soundness of the industry though Title 12 legislation.  History is still in the making.  Current leadership in the banking industry and actions by Congress will be watched with a critical eye in the coming years.  The only guarantee is that face of the banking industry will prove to be quite different tomorrow than it is today.  U.S. Bancorp is one of those few institutions whose actions will lend a direct hand in what that face will be through its yet-to-be-determined successes and failures.

               The banking industry has seen rapid growth and expansion over the past two decades.  This has occurred in two ways.  Banks have expanded their area coverage spreading across the nation in an effort to gobble up market share.  They have also expanded into new areas of business.  Historically regulators have been leery of both ways in which banks have recently broadened their power.  This Part of the series expands on the regulatory discussion from Part III and the historical background outlined in Part II of the series.  In all, U.S. Bancorp, the holding company, has twenty subsidiaries.  Of the twenty subsidiaries five are banks.  All of these banks are nationally chartered banks, including U.S. Bank N.A, U.S. Bancorp’s largest bank.[i]   Further, because all of these banks are nationally chartered they are under the supervision and may be examined by the Office of the Comptroller of Currency (“OCC”).[ii]  Additionally, all of the Banks are members of the Federal Insurance Deposit Corporation (FDIC).[iii]

                As a national association, U.S. Bank’s operation is governed by title 12, section 24 of the United States Code.  The Code states the corporate powers of national association in eleven subsections.  All of these subsections are essentially the same as what a non-banking corporation can do except for the seventh.  The seventh subsection states that a bank may only carry out functions within the business of banking or necessary to carry on the business of banking.[iv]  The majority opinion is that this means the activity must be “convenient or useful in connection with the performance of one of the bank’s established activities pursuant to its express powers under the National Bank Act.”[v]  U.S. Bank N.A. offers countless services under three broad categories: Personal Banking, Small Business, and Commercial & Government.  All of the services offered by the bank therefore must be either pursuant to one of the Bank’s express powers, or convenient in connection with an express power.  For example, U.S. Bank has the express power to take deposits.[vi]  An incidental power to that would be to run ATM’s that take deposits electronically or run small branches within large retail stores.  However, an incidental power would not include insurance coverage of on a car that was bought with a purchase money security interest provided by U.S. Bank.  But again, U.S. Bancorp could run a different subsidiary that could offer such insurance, and does with U.S. Bancorp Insurance Services, LLC. 

                Furthermore, because U.S. Bank is a nationally charter bank and not a state chartered bank, the Office of the Comptroller regulates the bank, as opposed to the FDIC which is charged with regulating state banks.  The OCC issues regulations and interpretive letters regarding the kinds of activities that a national bank can participate in.  As stated in the preceding paragraph, there is a lot of uncertainty in what incidental powers national banks have and the OCC is the first stop when a bank wants to branch out into a new business.  The OCC also has the responsibility of enforcing capital requirements against U.S. Bank.[vii]  There are three tests that the OCC uses to evaluate the capital of a national bank, the Tier 1 capital ratio, the “risk-based capital requirement”, and the “leverage limit.”[viii]  To be categorized as “Well Capitalized” tier 1 Risk-Based Capital Requirement as a Percent of Insured Bank Assets must be greater than 6%.[ix]  U.S. Bank as a tier 1 capital ratio of 6.5% which makes it “well capitalized”.[x]  Also, the risk-based capital requirement and the leverage limit must be greater than 10% and 5% respectively to be “well capitalized.”  U.S. Bank exceeds both and qualifies.[xi]  This is good because for U.S. Bancorp to remain a FHC, all of its subsidiary banks must remain “well capitalized.”

                The OCC defines “well managed” as an institution that has received a satisfactory rating in its most recent supervisory examination or subsequent review and at least a “satisfactory” rating for management, if such a rating is given.  Whether an institution is well managed is determined by the OCC when it does its CAMELS ratings.  The ratings go from 1 to 5 with 1 being the best.  A rating of at least a 2 is “well managed”.[xii]  We can assume that U.S. Bank N.A. is classified as well managed but we cannot know for sure because these documents are confidential and remain the property of the OCC after the reports are made.[xiii]              U.S. Bank NA is both well capitalized and well managed.  This means that it is a low risk bank allowing it much more freedom than would be allowed otherwise.  The bank itself gets perks such as fewer examinations, (with certain asset requirements) and a streamlined notice process for acquisitions.[xiv]  The largest incentive however goes to holding company, allowing it to be a FHC as opposed to a BHC as discussed in Part III of the series.

                Another subsidiary that U.S. Bancorp holds is NOVA information systems.  NOVA is a merchant payment processing company.  It holds an extensive network, which process credit card payments for its clients.  Today NOVA is the third larges of such processors processing over a billion transactions annually.[xv]  Additionally, by the second half of 2008, NOVA will be capable of processing all major credit card brands by adding the American Express network.[xvi]  The company has Canadian and European affiliates called NOVA Information Systems Canada and Elavon Merchant services respectively.  In all NOVA is in 30 countries and servicing transactions for over a million locations around the world.  In 2001, NOVA became a wholly owned subsidiary of U.S. Bancorp.  U.S. Bancorp is allowed to hold a data processing company under the Bank Holding Company Act.[xvii]  Data processing has been specifically picked out as being “closely related to banking” or “proper incident thereto.”  Therefore, U.S. Bancorp would not have to achieve the status of a FHC in order to hold NOVA, BHC status is sufficient to engaging in financial data processing.

These expansions of the banking industry while rather modest in U.S. Bancorp’s case have been broader.  The mega banks Citigroup and Bank of America leaving U.S. regulatory systems struggling to keep up with the evolving market place.  To quote the Department of the Treasury’s Blueprint for a Modernized Regulatory Structure:  “The United States has the strongest and most liquid capital markets in the world. This strength is due in no small part to the U.S. financial services industry regulatory structure, which promotes consumer protection and market stability. However, recent market developments have pressured this regulatory structure, revealing regulatory gaps and redundancies.”[xviii]  This statement illustrates the dichotomy in our marketplace.  Although we have historically seen dramatic declines in our market places and economy from time to time this relative uncertainty may be the price we pay for strong long term growth and success of our economy.

This Part was written with the contribution of David Holtcamp 

The banking industry is heavily regulated.  Recently that regulation has come under critical review.  The Department of the Treasury has issued their Blueprint for a Modernized Financial Regulatory Structure.  To understand why bank regulation is a major topic of discussion is no great mystery.  However, understanding the current general regulatory structure is important in deciphering why there is a call for reform.  This part addresses how Financial Holding Companies are regulated using U.S. Bancorp as a model.

U.S. Bancorp is a Financial Holding Company (FHC) and thus it is subject to the regulation and examination of the Board of Governors of the Federal Reserve.[i]  To become a FHC, U.S. Bancorp had to take four steps.  First it had to be recognized as a Bank Holding Company (BHC).[ii]  A BHC, as defined by the Bank Holding Company Act, is any company that has control over any bank or control over any other company that controls a bank.[iii]  Second, all of U.S. Bancorp’s FDIC insured subsidiaries must be well-capitalized and well-managed.[iv]  Third, each of those subsidiaries must receive at least a satisfactory examination rating pursuant to the Community Reinvestment Act.[v]Finally, U.S. Bancorp must file with the Federal Reserve Board declaring that it elects to be a FHC.[vi]

                U.S. Bancorp has complied with all of these regulations and is now a FHC.  First, U.S. Bancorp holds 5 banks as defined by the Bank Holding Act and thus is a Bank Holding Company.[vii]  Second, as discussed later in the other parts of this expose, U.S. Bancorp’s banks are well-capitalized and well-managed.  Third, U.S. Bank, N.A. received an “outstanding” overall rating in all but two of the states that it operates in.[viii]  Finally, U.S. Bancorp has filed and is now an FHC. 

                 U.S. Bancorp’s standing as a financial holding company as compared to a normal bank holding company significantly increases the types of investments that it is able to make.  First, all BHC must get approval from the Federal Reserve Board to acquire any existing bank or to even acquire more than 5 percent of a bank’s voting shares.[ix]  Second, a BHC’s activities are restricted to banking,[x] managing and controlling banks or other subsidiaries as allowed by the Act,[xi] and activities that are so closely related to banking as to be “proper incident thereto.”[xii]  Finally, BHC’s are not allowed to own shares in any company that owns shares in “any” other company that accounts for more than five percent of any class of voting securities.[xiii]  This means that BHCs cannot hold more than a five percent interest in an investment bank, and further, any non-banking related company such as PepsiCo for example. 

               As a FHC, U.S. Bancorp is able to conduct activities that are (1) financial in nature, (2) incidental to such financial activity, and (3) complementary to a financial activity.[xiv]  This allows FHC’s to enter into the markets such as insurance and securities, of which they were not allowed to enter into before the Financial Services Modernization Act (Gramm-Leach-Bliley Act) was passed in 1999, permitting FHC’s.  In fact, today U.S. Bancorp operates eight total insurance companies.[xv]  Further, FHCs are allowed to purchase shares in any company as long as they do not actively manage or operate that company while it owns the shares.[xvi]  Therefore, now U.S. Bancorp could operate an investment bank because it is financial in nature and could even own shares of PepsiCo.

                The Federal Reserve Board of Governor has the duty of overseeing the activities of BHCs as well as FHCs.  There are four major regulations that U.S. Bancorp must comply with.[xvii]  First, it must give notice to the Fed about any acquisitions within 30 days of commencement.  There is no longer a need for U.S. Bancorp to notify the Federal Reserve Board of Governors before acquiring shares of another bank.  It merely has to notify it within 30 days of commencing such activity.  If the Fed does not object then it is deemed to accept.  This streamlines these activities.  Second, if the Fed requires, it must submit reports on U.S. Bancorp’s financial conditions.[xviii]  Third, the Fed is allowed to examine U.S. Bancorp and its subsidiaries for compliance with all laws and regulations.[xix]  Finally, the Fed has nearly the exact same power as the federal banking agencies have over FDIC insured banks.[xx]

          Although the Federal Reserve Board of Governors single handedly regulates banking activities of U.S. Bancorp, it is also a publicly traded corporation, incorporated in the state of Delaware.  This means that it also falls under the oversight of the SEC and must follow the rules proscribed by the Security Exchange Acts of 1933 and 1934.  Further, Delaware state law governs the rules of incorporation of U.S. Bancorp.  These federal and state law regulations are not exclusive to BHC’s or Banks.  They are applicable to corporations in general.  it is important to know that U.S. Bancorp must also follow these regulations because there is a general call for reform in this area of regulation. 

          The Blueprint for a Modernized Financial Regulatory Structure proposes sweeping changes that could merge the SEC into a larger conglomeration of regulatory agencies.  Currently, there is not any commitment regarding how these agencies will change.  This is primarily due to the fact that we are in an election season.  Look forward to some historical changes in how banks and other financial institutions are regulated shortly after the new Congress and White House Administration settle in.

I regret that my site has been the target of a rash of content theft.  Nearly half my material has been taken for use by others without my permission.  As a result, I have pulled some material and have suspended publishing several articles that are ready.  There is some recourse available that I will take to resolve the issue.  Currently, I am in the midst of preparing for my final exams for the semester.  I will return to resolve this problem as well as post new material once my exams are completed.

          USB’s business activities are governed by a board of directors which is comprised of fourteen members.  The current President and CEO is Richard Davis.  Other key executives include vice presidents Andrew Cerere the Chief Financial Officer, Lee Mitau General Counsel and Corporate Secretary.  Richard Davis is relatively young at the age of 50.  His current salary is $625,024 with long term compensation totaling $5,916,496.  In addition to these impressive numbers, his stock options total $18,777,212.[i]   Additionally, Davis was a key leader in the successful mergers of Firstar Corporation with U.S. Bancorp in 2001, Firstar with Mercantile Bancorporation in 1999, and Star Banc Corporation with Firstar in 1998. 

          Davis has more than 30 years of experience in the banking industry.  He earned a bachelor’s degree in economics from California State University.[ii]  Prior to joining the company in 1993 he was executive vice president of Bank of America and of Security Pacific.  From 1998 until 2001 he was Vice Chairman of Consumer Banking of Firstar Corporation.  After the merger of Firstar Corporation and U.S. Bancorp in February 2001 and until October 2004, Davis served as Vice Chairman of U.S. Bancorp.  He also served as Chief Operating Officer of U.S. Bancorp from October 2004 until December 2006.[iii]  Davis was responsible for Consumer Banking, including Retail Payment Solutions (card services), and he assumed additional responsibility for Commercial Banking until 2003.  Davis became President in October 2004 and U.S. Bancorp’s chairman of the board of directors, replacing Jerry A. Grundhofer, on December 11, 2007. 

            Davis serves on the boards of ten companies.  They include, Xcel Energy, Inc., the American Bankers Association, the Minnesota Orchestra, the National Underground Railroad Freedom Center, the Guthrie Theatre and the Minneapolis YMCA.  In addition Davis serves on the boards of Visa U.S.A. and Visa International, which begs the question of whether there was any conflict of interest present in the recent anti-trust lawsuit between Visa and USB’s subsidiary NOVA payment systems.

U.S. Bancorp (USB) operates under the second-oldest continuous national charter, originally Charter #24.  Earlier charters have expired as banks were closed or acquired.  USB’s charter was granted during Abraham Lincoln’s administration in 1864 following the passage of the National Banking Act (NBA) codified under Title 12.  The NBA was a response to a credit crunch during the Civil war when the Treasury was empty forcing Congress to demand payment in spice rather than bank credit.  The NBA succeeded in stabilizing credit problems and promoted a stable business climate working in conjunction with the National Currency Act which standardized national currency. ^[i]  U.S. Bancorp is a national Bank Holding Company (BHC) and is governed by the Federal Reserve Board.^[ii]  They are the tenth largest in the country and incorporated in Delaware in 1929 and fall within the conscript of Security and Exchange Commission regulation as well.  Both areas of regulation will be discussed within.  Today U.S. Bancorp has grown to operate in twenty five mid-western and western states at 2,419 locations with 5,003 branded ATMs.^[iii] 

USB’s size developed from a number of aggressive mergers governed by the National Bank Consolidation and Merger Act (NBCMA).^[iv]  The NBCMA requires all mergers to be approved by the Comptroller of Currency, the board of directors, and shareholder ratification which is otherwise similar to corporate mergers.  One string of USB’s merger history started with the merger of First Wisconsin National Bank and Star Bank of Cincinnati creating Firstar in 1999.^[v]  This initial bank holding corporation was comprised of First Wisconsin, the Bank of Iowa, Federated Bank, First Colonial Bancshares Corp., Investors Bank and First National Cincinnati.  Five months later a larger move was made when Firstar Holding acquired Mercantile Bancorporation of St. Louis, Missouri (MBM).  MBM had held Mark Twain Bancshares, Firstbank of Illinois, Hawkeye Bancorporation, and.  The final major acquisition was Firstar’s buyout of U.S. Bancorp, headquartered in Minneapolis, Minnesota in 2001.  Firstar changed its name to U.S. Bancorp after the last merger.  U.S. Bancorp, also a holding company, held the original charter from one of the strains of bank acquisitions that U.S. Bancorp had completed.  Those banks included United States National Bank of First Bank System, Inc. of Minneapolis, Minnesota, First National Bank of Minneapolis and First National Bank of St. Paul, both of which had been founded in 1864 the later held the original charter.

Although the history of large national bank holding companies read somewhat like the first book of Genesis the interest is in the pattern of growth and acquisition.  The last flurry of activity that made U.S. Bancorp who they are today involved a group of large acquisitions.  At the time those mergers were scrutinized and looked at with skepticism, where by today’s standards they would be more on the medium size.  All mergers are subject to the approval of the Comptroller.  First the Comptroller reviews the proposed merger to ensure it is consistent with NBCMA.  Upon the Comptroller’s approval the board of director reviews the action and votes on whether it will be recommended to the shareholders.  Recommendation requires a majority vote by the board of directors.  Once recommended, the shareholders review the recommendation and decide to ratify the merger.  The merger must be ratified and confirmed by the shareholders under a two-thirds majority.^[vi]  In USB’s case most of the acquisitions met little resistance but some were controversial. 

           During the merger of Firstar and USB, the Hotel Employees and Restaurant Employees International Union (HRIU) launched a website www.firstarwatch.com to provide information on the bank’s movements.^[vii]  HRIU’s claimed that many of its members had entrusted Firstar to manage their retirement money through mutual funds, a 401k plans, or union and company pension plans.  One major concern was that as Firstar grew they became more distant from communities through mergers and acquisitions and engaged in business practices that did not have HRIU’s members in their best interests.  The organization claimed that USB was not meeting its requirements under the Community Reinvestment Act (CRA).  The CRA requires financial institutions to demonstrate that their deposit facilities serve the convenience and needs of the communities in which they are created to do business.^[viii]  Compliance is measured by three criteria, investment, service, and lending.  Banks must meet credit needs, assistance with credit needs, and lending needs of their service areas.  Enforcement of the act is executed through actions on applications that the depository facilities have before the Comptroller.  The Comptroller will review the applicant’s standing and could refuse to approve the applications until the requirements of the CRA are met.^[ix] 

          Aside from the potential of bumping up against the CRA the watchdog group drew the attention of the U. S. Department of Justice in an investigation of money laundering.  Money Laundering and Financial Crimes Strategy Act of 1998 required the Secretary of the Treasury, in consultation with the Attorney General and other relevant agencies, including state and local agencies, to coordinate and implement a national strategy to address money laundering.^[x]  Firstarwatch.com provided information on a controversial loan to Adams Mark, a national hotel company that had also been repeatedly sued for discrimination.^[xi]  The loan Adams Mark sought was to finance a new 1,600 room hotel in Chicago.   The group accused Firstar of entering a speculative hotel loan.  The attention from these issues frustrated US Bancorp’s plans of expansion towards the end of their expansion period.  Currently U.S. Bank holds an outstanding Community Reinvestment Act rating.^[xii]

These articles are a summary of our look at U.S. Bancorp;  In light of recent turmoil within the financial industries my colleague David Holtkamp and I have put together a summary of our research.  David focused on the regulatory agencies (parts III and IV) and I on all other aspects of this series.   

U.S Bancorp is one of the largest financial holding companies in the United States.  It has total assets of over $237 Billion.[i]  The purpose of this series is to give a general overview of U.S. Bancorp and how it grew to such proportions.  Part I will discuss the history of U.S. Bancorp from germination to the beanstalk that it has become.  The leadership of the company will be examined in part II.  Parts III and IV will analyze the regulatory environment of U.S. Bancorp and its subsidiaries.  Finally, Part V will consider the past and present success of the company. 

     The reality faced by the secondary loan market is that housing prices have fallen.  This means in many cases there is no longer enough equity in the property to cover both the primary loan and the secondary loan amounts.  In the event that a debtor defaults, instead of foreclosing on the home and forcing a sale the junior lenders are looking to other means of mitigating the damage.  They may write the failed loan down as a loss, sell the debt at a discount, negotiate with the senior lender and other solutions.  Consequently, financial institutions and banks are constricting their lending practices.  This includes reducing open lines of credit on equity, forgiving the interest, selling the mortgage to third parties and other remedial measures.  The problem with foreclosing is that the junior lender may lose all of the principle on the loan.  Many of the primary lenders will negotiate buyouts of the secondary loans in an attempt to protect their own interest in the property.  The Wall Street Journal reports that lenders are rethinking home equity loans (titled the same).  So what does it all mean?

     Lenders are concerned that borrowers will recognize the dilemma faced by the junior lien holders and lose all incentive to pay the secondary loan.  The principles behind the transactions and problems faced by the secured parties are good illustrations how secured transactions function.   Under-capitalization generally upsets the secured interest because the debtor no longer has incentive to honor the obligations.   The junior lien holder is in a weaker position than the senior lien holder.  The strategy employed by the junior lien holder varies by the situation because foreclosure hurts the junior creditor more than it helps them.  This potentially frustrates the interests of the senior creditor because the junior lender is more likely not to act on a loan default sitting on what equity would be available to refinance the primary mortgage.  This inaction increases the odds that the primary loan will also slip into default.

     The economic pressures that the failed secondary loans place on our economy hit in a few ways.  One way is because our tax system absorbs part of the bad debt as a reduction in the lender’s tax liability.  Another indirect impact is through consumer debt.  The consumer market suffers from tougher lending criteria and higher interest rates from primary and secondary loan products.  The regimented race notice legal method of filing seems appropriate to deal with the problem because some order must be used to manage the chaos defaulting debtors leave behind.  Priority helps the creditors manage the risk and understand the consequences of their relative positions.  Business thrives when there is certainty in the market.  The practice helps to keep the cost of borrowed money down even during a downturn in the market.