Bank One Puts Mortgage Insurance Unit In Gear

When Bank One started what turned out to be a year-long quest to be the first bank to move into the private mortgage insurance market under a new method of risk sharing, the obstacles did not come from the Office of the Comptroller of the Currency, they came from the states. Now that Bank One’s Private Mortgage Insurance Co., Inc. has been in business for a month after 6 blessing from Maine’s insurance regulator, the focus has shifted to the growth potential for the unit.

The OCC had approved other banks’ applications for reinsuring mortgage risk using the excess of loss method. By that method, the reinsurer gets a percentage of the premium from the primary insurer, usually around 20%, and the reinsurer will pay claims above a certain percentage, called the claims frequency rate, which is around 8% now.

But the quota share method, applied for by Bank One’s insurance subsidiary, is exactly the opposite. It is a pro rata sharing of both the premium and all the expenses of an insurance policy. The percentage can be split between the reinsurer and the primary insurer any way, but Bank One Insurance Group wanted to have a 50%-50% arrangement with the original insurer, also known as the fronting company.

Chuck Bennett, Bank One Insurance Group’s chief financial officer, said after just one month, it’s impossible to pinpoint how well the venture is doing, but that it is expected to be profitable in the first year. Bank One National Bank has contributed $8 million in capital to the business and hopes to see $2 million in revenue at the end of this year. Bennett said in addition to a section of the 125-employee Bank One Insurance Group that is focused on reinsurance accounting and risk, the bank is utilizing the resources of the fronting companies, and has hired an outside management firm in Vermont, American Risk Management, to help with coordination with the Maine department of insurance, and to keep Bank One "aware of the environment," Bennett said.

"It’s starting out small," he said, explaining that the private mortgage insurance division probably will account for around 3% of the $150- million-asset insurance company’s total business this year, although that percentage is expected to rise.

With quota share, although the reinsurer gets a smaller targeted margin than using excess of loss, it also gets a higher percentage of the premiums, and losses are a little more predictable. Plus, most important to Bank One, "It’s more of a true risk share," Bennett said. "It puts you in the same position the initial underwriter is in." Otherwise, he said, "You’re not true partners with your fronting company. They’re only concerned up to their risk level, but not after."

Bennett said the bank aims to have the private mortgage insurance division become a true profit center for the bank. "It tends to add to our control of the insurance products that are sold to our customers," he said. "It allows us to reach better conclusions for our customers."

While the OCC approved the application, several states gave Bank One the cold shoulder, citing the bank’s inexperience in the area, the mere fact that it was a bank and not an insurer, and worries about safety and soundness. Bank One officials believe the refusals came after successful lobbying by various insurance trade groups fearful of competition from the banking giant.

Vermont approved the quota share scheme, but said Bank One could only take 25% of the risk. Vermont is home to many mortgage insurance companies, which Bank One believes lobbied successfully to limit the amount of risk the new PMI company could take.

But even Maine, eager to become the home of a new kind of business, was not going to write Bank One a blank check. It set restrictions Bank One must live with while enjoying a 50%-50% split, including a 20 to 1 ratio of risk, more stringent than the industry standard of 25 to 1, and a capital requirement of $6 million. Although most states only require annual reporting for operations relatively small in size, as Bank One’s is now, Maine called for quarterly reports.

Bennett said the limit from Maine seemed strict given Bank One’s history of reinsuring other products, including unemployment and various life insurance products. He said on most products Bank One takes more than 75% of the risk, and unemployment insurance, for example, the bank reinsures at 100%.

Bank One’s venture in Maine is a partnership with two major insurers: United Guaranty and PMI. In Bank One’s arrangement, the consumer pays the premium, the original insurer books and processes the policy, then Bank One enters the picture and buys 50% of the risk from the insurer. Bank One pays the original insurer a processing fee of about 20%, Bennett said. If a claim occurs, the two companies split it down the middle.

The Milwaukee-based Bank One Insurance Group in total generates between $1.5 billion and $2 billion in insurance sales with a pretax profit of around $325

million.

FASB fixes Business Combos

In the quiet meeting before the storm, the Financial Accounting Standards Board tidied up a few loose ends in its business combinations project before getting down to the contentious business on Feb. 3 of how to account for purchased intangible assets.

The board clarified some points on when to review goodwill impairment indicators after a company has acquired another company. It said that if there are certain indicators that goodwill is potentially impaired at the date of acquisition, it should be reviewed no later than two years after acquisition and only if more than one indicator is present at acquisition.

Other issues included the question of whether an impairment indicator is specific to an individual asset group to which goodwill can be allocated, and should the goodwill other than that allocable to the specific asset group be reviewed for impairment? The board decided it should not.

The board also decided that an impairment indicator specific to goodwill that can be allocated to individual asset groups should be reviewed for impairment at the individual level. That approach is sort of a "bottom up" approach, rather than the "top down" approach, which requires that the goodwill be reviewed at the aggregate asset-group level. The board continued with the bottom up approach, deciding that review should begin with individual asset groups if an impairment indicator is specific to goodwill and to an individual asset group.

The board added that there is no need to review at the aggregate asset level if all goodwill can be allocated to individual asset groups.

Modernization May Hit Partisan Roadblocks

Congressional handicappers are giving long odds that Congress will pass financial modernization legislation this year, or in the two-year life of this Congress. While the reportedly imminent nomination of Undersecretary of the Treasury John D. Hawke is a positive sign, partisan rifts may be too strong.

In comments at an insurance agents’ conference in Washington, Rep. Jim Maloney, D-Conn., a member of the House Banking Committee, warned that the key issue remaining is the role that the Treasury Department will play in the future of banking industry regulation.

He predicted that, "If the Treasury is not involved, Secretary Bob Rubin will recommend a veto of the bill to the president." Maloney, a supporter of the insurance industry, called the expansion of bank regulatory powers "dangerous and contradictory.

"Congress should not legislate advantages to one group or another," he said. His comments were made at the National Association of Professional Insurance Agents annual legislative conference, held in Washington last week.

Sen. Phil Gramm, R-Texas, chairman of the Senate Banking Committee, has committed himself to a financial modernization bill by the end of February and will meet with the panel’s ranking minority member, Sen. Paul S. Sarbanes, D-Md., this week to see if a bipartisan approach can be forged. And Reps. James A. Leach, R-Iowa, chairman of the House Banking Committee, and John J. LaFalce, D-N.Y., ranking minority member, have prepared different versions of financial modernization legislation. Three days of intense hearings on the issue will be held in mid-February, Leach said last week. Gramm has not yet planned hearings.

Isaac B. Lustgarten, a partner in Schulte Roth & Zabel in New York, said his talks with House Banking staffers indicate the Leach bill will be little changed from "the final state" of the legislation last fall, when a filibuster by Gramm and other Republicans effectively killed the bill.

But in a private briefing, those attending the conference were told to be pessimistic that the Gramm model will succeed. "The approach that Gramm is taking will only lead to ‘disaster,’" one congressional staffer told the agents’ group. "They are ramming this through," he said.

SEC Letter: Warning Or Threat?

The Securities and Exchange Commission’s recent crackdown on earnings management, reported widely several weeks ago, may be little more than a warning, but it may also be ammunition.

The agency sent a letter to select bank holding companies last month telling them that it might investigate their banks’ loan-loss reserves.

The SEC has let it be known that it is not happy with the generous loan-loss reserves banks have set aside for a rainy day, viewing them as a form of earnings management rather than healthy prudence, and so against generally accepted accounting principles (GAAP). The conundrum this creates for banks is that the banking regulators want to see the strong allowances. The situation came to a head this fall when SunTrust was required to restate earnings to the tune of several million dollars.

The letter, which was addressed to a generic "Chief Financial Officer," advised that the banks’ 1998 annual reports "may be selected for review." The language was so seemingly casual that some analysts saw it as an almost friendly admonition to follow GAAP.

"So it’s not a ‘we’ve looked at your charges and disagree with them’ (letter); it’s a kind of a reminder letter. I think long term this is just a friendly reminder, ‘The accounting rules are there, follow them.’ This is just pulling the boys in," said Hal Schroeder, senior bank analyst at Keefe Bruyette & Woods.

Other bank watchers were not so sanguine.

"This is like a comment letter in advance," said Michael Joseph, partner at Ernst & Young. "This could be ammunition for the SEC for those they feel haven’t complied, (the agency can say) ‘We told you already.’ These are things the SEC is looking to see in this year’s annual reports and I will expect banks to be criticized if they don’t comply."

Banks must file annual reports by March.

Ohio goes Forward, Favoring Banks

In the first fallout from a lawsuit seeking to set aside Ohio’s restrictive laws dealing with bank insurance sales, the Ohio Insurance Department told a federal magistrate Jan. 27 it will stipulate that a state law barring banks from selling title insurance is pre-empted by federal law.

But a banking industry lawyer says the stipulation is of little practical value because the main count, which seeks to pre-empt a law which bars banks from selling insurance to no more than 50% of their customers, will remain in place. Lawyers for the Ohio insurance department said they will contest that claim.

After a scheduling conference, Ohio banks and their allies said they are encouraged by a federal court ruling they believe will facilitate a quick decision on a lawsuit that claims state insurance laws unfairly discriminate against national bank sale of insurance.

The case is a derivative suit to the 1996 Supreme Court ruling in Barnett, which held that states cannot "prevent or significantly interfere" with the ability of a national bank to sell insurance.

The Barnett case dealt with overt laws or rules that blatantly and, according to the Supreme Court, illegally barred national banks from selling insurance. This case deals with laws and rules that indirectly bar bank sales of insurance.

The Ohio rule bars bank sales of title insurance outright, and requires that banks can sell other types of insurance only to non-customers. It is done through a law known as the "controlled business statute."

The suit was filed Oct. 6. In a scheduling conference Jan. 27 a federal magistrate in Columbus allowed state and national insurance groups to intervene in the case, but only with the understanding that the issue will be decided based on the law, and not on protracted discovery proceedings. Under the schedule agreed upon by the parties, all briefs in the case must be filed by March 15. A friend-of-the-court brief is due from the Office of the Comptroller of the Currency Feb. 3.

Alan Berliner, assistant director and chief counsel to the Ohio insurance department, said the department will have its stipulation on the title insurance issue in the court’s hands this week. But, he said, the agency will continue to challenge the banking industry’s argument that its controlled business statute unfairly discriminates against bank sales of insurance.

He also said, "We want to dispose of it as promptly as reasonably possible."

Commenting on the title insurance issue, Michael Crotty, deputy general counsel for litigation at the American Bankers Association, said the insurance department stipulation was meaningless–although Berliner contested that interpretation.

Crotty said that even if the state insurance department admits the title insurance law is pre-empted by federal law, "it still means banks can sell insurance only if they promise to comply with the principal purpose statute, which says that banks cannot do more than 50% of their insurance business with their own customers.

"And that is ridiculous because banks are likely to sell title insurance only to their own customers," Crotty said.

The scenario is similar to a case in upstate New York dealing with state laws which barred Canandaigua National Bank from selling property/casualty insurance to its own customers. The law was enacted in response to the Barnett decision.

A federal court judge in Rochester ruled last March that the law illegally, if indirectly, barred national banks from selling insurance. In that case, the judge declined to allow lengthy discovery proceedings, and also decided the case relatively promptly based on the law.

"These restrictions prohibit us from effectively meeting the financial needs of our customers," said William K. Browning, president of Huntington National Bank’s insurance operations. Huntington is based in Columbus. "Consumers in Ohio can benefit from more competition, which these existing Ohio laws actually prohibit," he said.

Approximately 20 states have either elected not to enforce discriminatory state laws against national banks or have amended their laws to give banks operating in those states insurance sales authority since the Supreme Court decision, according to Reynolds. While most other states do not restrict bank insurance sales, Ohio is one of only a handful of states that have not recognized the Barnett Bank decision, he said.

The plaintiffs include Huntington, the ABI, the Ohio Bankers Association and the American Bankers Association Insurance Association.

Banks Scramble To Counter Checkfree

As the bill payment and presentment powerhouse Checkfree announced it would partner with an Internet portal last week, analysts and the media were quick to paint the move as a rejection of banks, which were moving on-line too slowly.

By hooking up with a major portal–Checkfree has not yet identified its partner as of Financial Modernization Report’s deadline, although many industry insiders suspect it to be Yahoo!–Checkfree is planning to put the process of consumers moving to conduct their business over the Internet on the fast track, leaving the banking industry in the dust.

But, there is hope–if you’re a big bank. E-commerce industry analysts suspect that the move will not shut banks out completely, as long as they have the dollars to buy their way onto some other portal.

Citibank and Bank One, for instance, have become the exclusive branded banks with Netscape and Excite!, respectively. The access hasn’t come cheap, each one costing in the ballpark of $100 million, but bankers figure the traffic will pay the price. One industry analyst said that banks are not going to make money with the fees from bill presentment and payment anyhow, and the value to the bank of allowing customers to pay their bills on-line is to get their attention so they can sell them more profitable products.

Ironically, Checkfree’s main competitor is in fact a bank. Citibank has partnered with Microsoft in the race to come up with the best Internet billing mousetrap. Even more ironic, said Avivah Litan, director of research for the Gartner Group, is that the Microsoft venture, renamed Transpoint, is really not the formidable threat the industry frets about. The firm’s pilot program, promised and delayed for more than a year, is still not ready for public consumption. Litan said the industry is frightened of the name brand, but there is little substance to back it up. One sticking point is that the piece of technology Citibank was supposed to bring to the venture, called Pay Anyone, has yet to work. The idea behind Pay Anyone is that the customer can pay all of his or her bills on-line, whether or not all of them have been presented by the vendor. Litan said she believes Pay Anyone, which Citibank had developed for its own banking operation, and now must adapt to fit many, is necessary to compete effectively with Checkfree.

Derivatives Harbor Coming This Week

Legislation establishing a legal scheme to handle the failure of a counterparty to a derivatives transaction will likely be introduced as part of a new bankruptcy bill in the House this week, a move that could ease mortgage lenders’ ability to hedge interest-rate risk and to securitize assets.

Washington sources said the bill is expected to contain a provision that would better isolate the special purpose vehicle in a securitization from bankruptcies via a safe harbor. The provision would clarify that asset-backed and mortgage-backed securities structured with junior tranches do not give a debtor the right to take the whole asset, disrupting the cash flow to the investor. The Bond Market Association enthusiastically endorses this provision.

But despite a consensus that the legislation is necessary and bipartisan support, its chances for passage, either promptly or even later this year, remain cloudy. Insiders said the credit card industry and its supporters in Congress, realizing the importance of the provision, want to link it to the omnibus bankruptcy legislation they are pushing.

The bill is driven by potential problems to the financial system posed by the near failure last fall of Long-Term Capital Management, a hedge fund, according to sources. LTCM was involved in all types of complex derivatives transactions, and market players worried that its failure would have created a domino effect stemming from the inability of mortgage lenders and other financial institutions to close derivatives transactions, and so disrupted the market.

Sources said the bill would impose a means-test on those filing for bankruptcy, a concept opposed by liberals in Congress and the Clinton administration.

The primary provisions of the bill would strengthen language in the bankruptcy code and the Federal Deposit Insurance Act, protecting the enforceability of termination and close-out netting, and relative provisions of certain financial agreements and transactions under the two laws.

Tax Break Bill Gets Rethink, Reintroduction

A bill that would bring tax relief for community banks and attempt to level the playing field between small banks and credit unions that failed last year is being reworked and should be reintroduced by mid-February.

The bill, called the Qualified Community Lender Bill, will be reintroduced by Rep. Tom Campbell, R-Calif., and will give community banks tax credits on a scale depending on their size. Because credit unions are tax exempt, legislation last year easing restrictions on their membership was seen as a danger to community banks.

Last year’s version of the bill, also introduced by Campbell, originally called for qualifying banks to pay no taxes on the first $250,000 of profit and 15% on the next $750,000–a break from the standard 34% corporate rate they ordinarily would have paid. The bank would pay the prevailing rate on any profits over $1 million.

Patrick Kennedy, partner at law firm Kennedy, Barris & Lundy, who is helping write the altered version of the bill, said the decision to make the savings come as a tax credit is common sense.

"In order to reduce the rates you have to go into the primary-rate schedules in the Internal Revenue Code. It’s more simple and focused to accomplish this through a tax credit. It won’t create a special tax rate for an industry," he said. He added that the savings for banks should work out to be the same as under the original bill.

To qualify, banks must have under $1 billion in assets and at least 60% of lending to the community, and have shareholders in the home state or a contiguous state.

Charles DeWitt, legislative director for Campbell, said the bill is in the final stages of preparation for introduction, including getting scored, or having the amount of money the Treasury will lose estimated to get a sense of the effect on the national revenue. Although Campbell feels strongly about the legislation, which has been pushed by several state banking associations, he will need to find some other piece of legislation to offset the loss from giving bankers tax credits. DeWitt said the bill would probably be referred to the House Ways and Means Committee, with perhaps some time in the Joint Tax Committee, which is the tax version of the Congressional Budget Office.

S-Corporation may expand to more banks

First State Bank of Junction, Texas, jumped on the S-Corporation bandwagon back when the statute could only help banks with fewer than 35 shareholders. Now there is a bill in Congress which would hike the number to 150, essentially doubling the number of banks which can take advantage of the tax savings to about 2,000–a large chunk of all the private banks in the country.

First State Bank’s decision to elect S Corp. tax status was "pretty simple" according to Dennis Smith, vice president of operations: "It’s just a dollars and cents issue."

Under the old C-Corporation structure, the $22-million-asset bank’s profits were taxed twice: at the corporate and shareholder levels. Smith said that the bank stands to save one-third, or about $100,000, of earnings that can be shared with the small band of investors.

First State is one of a growing tide of banks making the status switch. Tax expert Marc Levy of Arthur Andersen has logged quite a few miles recently traveling to advise clients on how to join the ranks of nearly 1,100 banks that are already S Corp. firms.

Rep. Marge Roukema, R-N.J., this year introduced legislation similar to that introduced last year in the Senate that would bump up the number of eligible shareholders to 150 from the current 75, and expand the definition of "shareholder" to include Individual Retirement Accounts. It would also consider bank directors’ stock the same as common stock, to avert the restriction on S Corp. status that the bank only have one kind of stock, and to clarify that interest on investment securities held by a bank does not conflict with the passive investment income restrictions normally on S Corps.

Ron Ence, legislative director for the Independent Bankers Association of America, estimated that based on a survey of his members the number of banks electing S Corp. status would double with the passage of the bill. The member survey showed that 30% had already elected S corp., and another 40% wanted to but could not because they had too many shareholders or had shareholders through IRAs.

Carol Kulish, a principal at Deloitte, said she believes the legislation has a decent shot at passage this year.

"The likely vehicle for this would be broader tax cut legislation, budget reconciliation or tax simplification legislation," she said, noting that with the sizable budget surplus, Republicans have made it known that tax cuts are a priority.

Zions: Melding Tradition And Iinnovation

A traditional bank facing the future, Zions First National Bank plans to continue relying on old-time banking to bring in core earnings, although it is tackling some of the most innovative areas to keep up with the times and provide capital to experiment with.

One of the bank’s new businesses puts it at the forefront of the latest technology in e-commerce, digital signatures. But even then, President and CEO A. Scott Anderson wants it to be known that although management believes strongly in the future importance of digital signatures, its primary goal is not simply to pioneer new technology.

"I want to emphasize we’re not trying to escape from being a banker. A well-run regional bank in good times ought to be able to make a 17%-to-18% ROE (return on equity). Extra income is icing on the cake, helps us increase return and prepare for the future. We want to make sure we’re at the forefront so we don’t become a dinosaur," he said.

Perhaps partly because the nearly $17-billion-asset bank is among a handful with insurance-selling power grandfathered in its charter, Salt Lake City-based Zions has the luxury of spending more time concentrating on new endeavors, such as its year-old subsidiary Digital Signature Trust Co.

Digital signatures are like ID cards in Cyberspace, an electronic way to ensure that parties in an on-line transaction are who they claim to be and the transmitted information is secure. Zions sees the business of acting as a certification authority and repository for digital signatures as a natural for banks.

"Banks have been in the business of IDing people and notarizing their signatures since the beginning of time. We expect to keep banks in this part of the business," said David Hemingway, vice chairman of investments for Zions Bancorp, the bank’s holding company. "The more we looked at this, the more we said, ‘This looks an awful lot like a trust product,’" Anderson added.

Pricing The New Product

The bank’s pricing for digital signatures varies according to the type of service: transactions, consulting-type services, or the delivery of turnkey solutions to users. An example of the latter is a fee for automating the function of letters of credit using digital signatures. The fee would include a software package, which could be free in the case of, for example, a cash management customer that does a high volume of business. Hemingway added that he believes this business has more potential impact on the banking industry than any other because of the move toward the Internet as the medium of choice in commerce.

The American Bankers Association gave the western bank the nod this fall to be the chief technology supplier in its digital certification subsidiary, ABAecom. It offers certificate authorization to banks, which can in turn sell the service to customers. Hemingway said the authority is probably not necessary for a $24.95 book from Amazon.com, but more security is needed for major transactions between companies. The digital signature assures each party that their counterpart is who they claim to be and the message sent is the entire, uncorrupted message.

"We think this will help banks build stronger relationships with customers and boost their own on-line products," Hemingway said.

In addition to serving as a back office for the ABA, which does much of the marketing of the service, the Zions subsidiary’s salespeople are scouring the country to sell the service. Already the firm serves the ANX automotive network, an exchange between auto manufacturers and their suppliers run out of Detroit. The digital signature firm also provides the authentication for San Francisco-based Stockpower Inc., which bypasses brokers and allows stocks to be traded directly on-line. Finally, the project that sparked Zions’s interest in digital signatures but has yet to come to fruition, is the cyberization of its home state’s court system. The state is working on a new infrastructure and will soon have all official court documents authorized by Digital Signature Trust.

The digital signature subsidiary is not yet in the black, and management declined to part with details of the amount of money put into the business, or when it is expected to be profitable. Officials said, however, that the firm has already issued 100,000 signatures.

Revenue Bonds Still In Infancy

Another first for the bank is the year-old business of underwriting municipal revenue bonds from the bank subsidiary, a power granted by the Office of the Comptroller of the Currency (OCC) first to Zions in December 1997, and since only to UMB of Kansas City and Memphis-based Bank of Commerce. To date Zions has underwritten six deals in the Intermountain area worth about $32 million, and holds a spot as eighth-largest municipal advisor in the country, based on the number of deals. The bank operating subsidiary’s public finance group has offices in several states and can underwrite deals anywhere in the country. Analysts said the new power to underwrite municipal revenue bonds complements the bank’s existing municipal bond underwriting business, supplementing its revenue stream, but is nothing earth-shattering.

Analysts agreed that the company has the luxury to be creative because it does the basics well.

Denis Laplante, analyst at Fox-Pitt Kelton, chalked up the digital signature business’s lack of revenue to R&D but is not worried for the bottom line given the bank’s superior track record for average earnings-per-share growth–17% annually over the last five years.

"Banks have been the source of cash management services for corporate America and I think this is the next step to this," he said.