The failure of NextBank, N.A. in February and the liquidation of its card-related assets was a relatively unprecedented event in the ABS industry and has generated a great deal of interest and comment. Unfortunately, inaccurate information, and misunderstandings about NextBank's failure and the Federal Deposit Insurance Corporation's (FDIC) subsequent role as receiver for the failed bank remain prevalent in the marketplace. Readers of the Asset Securitization Report would be well served by an exploration of these matters.
NextBank, N.A. was a $700 million-asset Office of the Comptroller of the Currency-chartered institution headquartered in Phoenix, Ariz., but whose principal business locations were in the greater San Francisco area. The bank was wholly-owned by NextCard, Inc., and, in fact, virtually all of the bank's operational activities, including servicing, were actually conducted by the parent corporation. Its business consisted almost solely of the origination of individual consumer credit card accounts, primarily through on-line internet advertising and application processes. Customers were offered various co-branding and enhancement opportunities, as well as the ability to personalize their cards with individual photographs. Back-office processing was provided by First Data Resources, Inc.
NextBank's only significant financing source (other than deposits which it accepted in amounts of $100,000 or more) was the NextCard Credit Card Master Note Trust. The Master Trust, which issued its first series in 1999, was a more-or-less conventional credit card ABS trust vehicle for which the bank was the servicer, and which, among other features, required the bank to maintain a Transferor's Interest of 9%.
In the months prior to the failure of the bank, its parent, NextCard, was up for sale. NextCard hired Goldman Sachs to sell the company, and despite numerous efforts, no sale materialized. At the time of its failure, the bank was under a prompt corrective action directive from the OCC. At closing, the OCC said the bank had been operating in an "unsafe and unsound manner and had experienced a substantial dissipation of assets and earnings through unsafe and unsound practices" which were likely to deplete all or substantially all of the bank's capital. On February 7, 2002, the OCC closed the bank and appointed the FDIC as its receiver.
FDIC as Receiver
The FDIC functions in three capacities. Most fundamentally, it is an insurance agency - it insures up to $100,000 of every insured deposit account (and some, like custodial and trust accounts, are insured for more) in every bank and thrift institution in the country - and as such is the custodian of the two federal insurance funds, the Bank Insurance Fund and the Savings Association Insurance Fund. Ancillary to this function, the FDIC serves as a regulator and supervisor for many of the institutions that maintain those insured accounts. It is the primary federal supervisor of state-chartered banks that are not members of the Federal Reserve System and back-up supervisor to national banks, state member banks, and thrifts. Finally, the FDIC serves as receiver for a failed financial institution when it is closed by its chartering authority.
It is important to understand the FDIC's role when it is appointed receiver of a failed financial institution. When acting as receiver, the FDIC is subject to the powers and responsibilities set out in the Federal Deposit Insurance Act, including the power to exercise any authority of the institution's shareholders, directors, or officers. This is similar but not identical to the role of a trustee in bankruptcy. The FDIC marshals the assets of the institution and liquidates them in a manner that promotes the greatest return to the receivership. Actions that it takes as a receiver must be for the ultimate benefit of the receivership estate's creditors. When it pays off the insurance claims of depositors out of the insurance funds, the FDIC becomes subrogated to the claims of those depositors against the receivership. Accordingly, the applicable insurance fund is generally the largest creditor of any receivership. The investors in ABS transactions set up by the failed institution are generally not, however, creditors of the receivership.
The FDIC has a strong interest in winding up the affairs of the failed institution as quickly as possible. Indeed, FDIC receivership staff often begin planning for asset marketing and sale well before the anticipated date of appointment. The FDIC and its financial advisor, Banc One Capital Markets, began in late January 2002, the process of analyzing and marketing both the bank's positions in the Master Trust and the credit card accounts that remained on-book. At the same time, the FDIC engaged First Annapolis Consulting to direct the continuation of the servicing and to analyze the extent to which it could be improved or made more efficient.
In the months following appointment, the FDIC and BancOne conducted an extensive marketing campaign to sell both the card portfolio and NextBank's Trust interests, which were offered separately or as a package. Prospective purchasers had the opportunity to do extensive on-site due diligence and interview key officers involved in the origination and management of the portfolios. The process resulted in the successful sale to Merrick Bank of the bank's on-book portfolio, but there was no market interest in the Master Trust positions. In fact, bids we received imputed a negative value to these positions: we would have had to pay an acquirer to take them on.
In early July 2002, the FDIC became aware that the Trust portfolio's performance had reached a point where it satisfied conditions triggering early amortization under provisions of the Master Trust. In such case, the Master Trust required that principal collections allocated to investors be applied to paying down the outstanding certificate balances, and that the receivership as holder of the Transferor's Interest receive a rapidly dwindling portion of the cashflow. These amounts would no longer be sufficient to fund daily card advances, requiring an out-of-pocket expenditure by the receivership that it believed it was unlikely to recover and for which it would have to borrow funds. Accordingly, the receiver, acting under authority provided by the Act, notified the Trust that it would no longer be bound by the provisions of the Master Trust (including those under which it was required to add additional receivables to the Master Trust in order to maintain the level of Transferor's Interest), and simultaneously notified cardholders that it was shutting down all further credit advances on their cards.
The receivership recognized that, despite not being legally bound to continue performing under the Master Trust transfer and servicing provisions, to abruptly terminate all such activities would have been highly chaotic and not in the interests of the investors or itself as holder of the Transferor's Interest. Thus, the receivership has continued providing essential servicing functions for such time as has been necessary to enable the Trust to make alternative arrangements.
Receivership Early Amortization
As is common in ABS structures, the NextCard Master Trust contained a number of provisions that, upon the occurrence of certain events or the satisfaction of certain conditions, triggered early amortization of the Master Trust certificates. Among these was a provision that predicated the commencement of early amortization upon the insolvency of, or the appointment of the FDIC as receiver for, NextBank. The FDIC objected to plans to declare a receivership-based early amortization, asserting its statutory authority under the Act to avoid this trigger. On February 14, 2002, the FDIC s General Counsel issued a statement with respect to the NextBank Master Trust indicating the FDIC's position that "an automatic event, default, acceleration or early amortization based solely on insolvency or appointment of the FDIC as receiver is not enforceable against the FDIC." Ultimately, no receivership early amortization ensued.
The trigger clause seemed particularly counterproductive in the NextBank case. Without any proven prospect of economic harm, an early amortization based on receivership appointment would have required the receivership to take possibly drastic steps to protect its financial position, such as the immediate shut-off of the cardholders' open-to-buy, months before it would have been necessary under an economically meaningful early amortization trigger. Moreover, at the time, plans for back-up servicing were just being formulated. Most importantly, the early amortization would have severely limited the options available to the receiver for disposing of the institution's Master Trust interests, as well as the on-book portfolio, before it had any chance to carry through on a marketing program that had the potential for significantly higher returns.
The FDIC has used its statutory powers to avoid these so-called ipso facto clauses in other circumstances and this possibility was disclosed to investors in the Master Trust offering materials. It is not unreasonable to expect that in the future the FDIC may assert this authority in the case of transactions in which it deems that immediate commencement of early amortization solely on the basis of its appointment would not be in the best interests of the receivership.
Economic Early Amortization and the "Open-to-Buy"
The triggering of an early amortization on the basis of portfolio condition changed the economic analysis of the transaction for the receivership, and forced the FDIC to take several steps, including shutting off further credit to the cardholders. The FDIC's cashflow scenarios indicated that keeping the accounts open would seriously increase the loss to the receivership, and, ultimately, the insurance fund. By shutting off this "open-to-buy" the FDIC acted in the best interests of the receivership. Nonetheless, before taking this action, the FDIC carefully considered the impact it would have on the cardholders as well as on the Master Trust performance. In fact, the FDIC reviewed and discussed with the other interested parties a number of strategies to avoid this result. In the end, the economic realities of the portfolio and the lack of flexibility in the Master Trust documentation, including the legal necessity of obtaining unanimous investor consent for the most effective of the proposed modifications, made it impossible to avoid what ultimately transpired.
Portfolio Quality and Marketing Success: The FDIC's inability to find a buyer willing to step in and take over the bank's position in the Master Trust is a reflection of NextBank's unduly optimistic reliance on factors that either masked or failed to predict the inherent dangers in the portfolio it created. Simply stated, the Trust was significantly over-leveraged. That the trust-related marketing effort was ultimately unsuccessful is a reflection of the inherently substandard nature of the portfolio to begin with - a point underscored by the failure of the holding company's own pre-receivership marketing effort.
Servicing: The FDIC acted quickly to stabilize the servicing operation and brought to bear sufficient expertise to enable it to accurately assess the inherited servicing capabilities. In fact, we believe that the FDIC's efforts actually improved servicing performance in some areas. Save for the necessary closing of the open-to-buy, there is no evidence that the FDIC's actions contributed in any significant way to a decline in portfolio performance. When faced with the huge liquidity drain it would incur, the receivership had no choice but to cut off the cards. That this action would "dampen" pool performance is self-evident, but beside the point.
Additionally, the NextBank transaction, like many ABS transactions, put a cap on servicing cost reimbursement. Thus even if the FDIC had somehow materially increased servicing costs at NextBank, the increase would have had no effect on the investor return. In actuality, virtually since inception, NextBank's actual servicing costs well exceeded the servicing fees it was getting out of the deal - again, precisely one of the factors that led to its failure.
Not every participant in the marketplace will fully understand the roles and responsibilities of the FDIC in a bank failure. As a result, the FDIC's actions may have had consequences unanticipated by some. It is certainly clear that the way in which the transaction was structured did not adequately account for the possibility of the receivership of the servicer/transferor. One can reasonably anticipate that future deal documentation will address many of these eventualities in a manner that fairly allocates costs and risk amongst the parties. Moreover, it seems at best premature to conclude that the postponement of early amortization - or at least that based on triggers that have no economic significance - was detrimental to any of the parties to the Master Trust. In the end, we believe the FDIC's handling of the NextBank failure will prove to have served well not only its constituencies - the Bank Insurance Fund and the receivership estate's creditors - but the investing community as well. Although in future receiverships the FDIC may choose a different liquidation strategy than for NextBank, it will in any event pursue a path consistent with its mandate.
George Alexander and Ralph Malami of the FDIC's Division of Resolutions and Receiverships, and David N. Wall of the FDIC's Legal Division contributed to the preparation of this article.