[Flagstar Letterhead]
August 23, 2005
Securities and Exchange Commission
Division of Corporation Finance
Mail Stop 4561
450 Fifth Street, N.W.
Washington, D.C. 20549
Attention: Mr. Kevin Vaughn, Accounting Branch Chief
Re: Flagstar Bancorp, Inc.
Form 10-K filed March 23, 2005
Supplemental Response dated March 22, 2005
File No. 001-16577
Dear Mr. Vaughn:
We are writing in response to your letter dated July 7, 2005 (the
"Comment Letter") regarding our Annual Report on Form 10-K filed March 23, 2005.
As our outside counsel discussed with Angela Jackson of your office, we did not
receive the Comment Letter until Ms. Jackson provided it to us via facsimile on
July 26, 2005 after we discovered its existence. This letter is being provided
to you today pursuant to our subsequent request for an extension of time
discussed with you by our outside legal counsel on August 19, 2005.
Please note that our responses below reflect our outside counsel's
understanding with Ms. Jackson that we may defer any amendments to our prior
filings with the Commission pending your review of this letter. In particular,
we understand the Staff will review our responses below, as well as the Item 4
disclosure in our June 30, 2005 Form 10-Q filed on August 9, 2005, in
considering whether any amendments to our 2004 Form 10-K and our March 31, 2005
Form 10-Q would be necessary.
Our responses to the Comment Letter are set forth below, in each case
preceded by a reproduction of the corresponding comment.
Comment No. 1. We note your response to comment 17 from our letter dated
December 21, 2004 and the revised disclosures included in your
Form 10-K for the year ended December 31, 2004. Please advise
us as follows with respect to the operations of Flagstar
Credit Corporation:
o Your disclosure on page 76 of your December 31, 2004
Form 10-K indicates that as part of certain
contractual arrangements, you provide performance
guarantees on certain pools of loans which
Mr. Kevin Vaughn
August 23, 2005
Page 2
were underwritten and originated by you. Advise us as
to whether these loans were subsequently sold in the
secondary market;
o Tell us in detail how these reinsurance arrangements
affect your accounting for loan sales under SFAS 140.
Response No. 1. The contractual arrangements referred to in Comment No. 1 of
the Comment Letter are private mortgage re-insurance
arrangements entered into by our subsidiary, Flagstar Credit
Corporation ("Credit"), with unaffiliated insurance companies.
Credit provides private mortgage insurance with respect to
mortgage loans underwritten and originated by us. In all
cases, a substantial portion of Credit's risk under these
insurance policies is ceded to other mortgage insurance
companies by way of these re-insurance arrangements. The
re-insurers provide first loss coverage and coverage for
losses over a stated maximum. Credit retains an intermediate
tranche of insurance coverage. The performance guarantees
described in our Form 10-K refer to Credit's retention of this
intermediate tranche of insurance coverage. Management
believes that Credit's exposure to risk of loss from this
intermediate tranche of insurance coverage exists only in the
event of catastrophic events which have a remote likelihood of
occurrence. The Staff should note that no claim has ever been
paid by Credit on these mortgage insurance policies.
Many of the mortgage loans for which Credit provides mortgage
insurance are sold by us in the secondary market. We treat
these sales as true sales for purposes of SFAS 140 because
these loans are legally isolated notwithstanding the fact that
our subsidiary provides policies of loan insurance on some of
these loans.
All mortgage loans, whether or not insured by Credit, that we
sell in secondary market transactions are sold under
contractual arrangements that convey full title to the buyer.
As a result, the transferred mortgage loans are fully isolated
from us and from our creditors, even in a bankruptcy or other
receivership situation. The buyer has the right to pledge or
exchange the purchased loans and there is no condition that
constrains that right. We do not maintain effective control of
the loans through any agreement that either entitles or
obligates us to repurchase or redeem the loans before their
maturity or gives us the ability to unilaterally cause the
purchaser to return the loans to us. The mortgage insurance
policies provided by Credit do not constitute any type of
retained interest in the sold mortgage loans. Consequently, we
believe that all conditions under SFAS 140 are met with
respect to the sale of these insured loans.
Mr. Kevin Vaughn
August 23, 2005
Page 3
Comment No. 2. In your response to comment 27 from our letter dated December
21, 2004, you indicated that loans sold to the Federal Home
Loan Bank of Indianapolis (FHLBI) are done so on a
non-recourse basis with no interests retained other than
mortgage servicing rights. The FHLBI, however, states on their
website (www.fhlbi.com) that under their Mortgage Purchase
Program (MPP), "local institutions issue home mortgages and
retain a major share of their credit risk while selling the
mortgages to the FHLBI, which accepts the interest rate and
warehousing risks." Please address the following:
o Tell us whether you share in the credit risk of those
loans sold to the FHLBI and describe the nature of
your risk-sharing arrangements and any retained
interests;
o Tell us how you recorded any credit enhancements,
recourse provisions or retained interests in your
financial statements;
o Provide us sample journal entries that reflect how
you record these credit enhancements and retained
interests upon transfer and over the life of the
loan;
o Tell us how you determined that these risk-sharing
arrangements do not result in a retained interest in
loans sold to the FHLBI;
o Tell us whether you pay fees to or receive fees from
the FHLBI to provide credit enhancement on the loans
sold, and if so, how you record those amounts;
o Tell us whether any of your insurance subsidiaries
underwrite supplemental mortgage insurance that is
used to provide credit enhancements on loans sold to
the FHLBI. If so, clearly explain to us the terms of
those arrangements and how they function;
o In your response you indicate that your loan sale
agreements with the FHLBI are similar to loan
agreements with Freddie, Fannie and other secondary
market participants. Please tell us as to whether
your loan sales to any of these other participants
contain similar risk-sharing provisions or credit
enhancement fee structures.
Response No. 2. When we sell loans to the FHLBI under their Mortgage Purchase
Program ("MPP") we do not retain any credit risk with respect
to these loans. We have no liability whatsoever to FHLBI with
respect to payment or other defaults on these loans. To the
extent the description of the MPP on the FHLBI website suggest
otherwise, we believe it is simply incorrect.
Mr. Kevin Vaughn
August 23, 2005
Page 4
As noted in our previous response to the Staff, we do retain
mortgage servicing rights ("MSRs") in mortgage loans sold by
us to FHLBI. Under these MSRs we continue to service the sold
mortgage loans and retain a servicing fee equal to 25 basis
points of the unpaid principal balances.
In connection with the creation of each pool of mortgage loans
sold by us under the MPP, FHLBI creates a Spread Lender Risk
Account ("LRA") for our benefit which is maintained for a
period of 11 years from the date the final loan of the pool is
conveyed to FHLBI. Monthly contributions are made to the LRA
out of regular principal and interest payments made to FHLBI
on the mortgage loans in the pool until it is fully funded,
typically in an amount equal to 0.30% of the outstanding
principal balance of the underlying mortgage loans. Amounts in
the LRA established for a particular pool of mortgage loans
sold by us to FHLBI are available to FHLBI and its mortgage
insurers to reimburse them for credit losses on the mortgage
loans included in such pool only. Excess amounts in the LRA
may be released to us from time to time, subject to the
conditions stated in the loan sale agreement. Credit losses
incurred by FHLBI (or mortgage insurers) in excess of amounts
in the LRA may be rolled forward until additional
contributions are made to the LRA, but are not recoverable
from us. To the extent credit losses on the mortgage loans are
reimbursed from the LRA it will reduce the amount potentially
distributable to us from the LRA. However, in no event do we
have any obligation to contribute funds to the LRA or any
requirement to return any amounts previously distributed from
the LRA to us. In our view, the potential loss of this highly
contingent future benefit does not represent a credit risk to
us or any type of significant retained interest in the
underlying mortgage loans. Therefore, no entries are recorded
at the date of sale or over the life of the loan.
We reflect the MSRs on our balance sheet as an asset which is
amortized based upon the expected prepayment rate of the
underlying loans. Mortgage servicing fees are recognized as
income as earned.
We do not attribute any value to the LRA associated with a
pool of loans sold under the MPP due to the highly
subordinated and contingent nature of our right to receive
future distributions of amounts placed in the LRA by FHLBI. We
believe that all amounts in an LRA will likely be utilized to
cover credit losses and, as a result, no distributions to us
from the LRA are anticipated. Accordingly, we do not record an
asset for an LRA and we do not recognize any income for an LRA
until such time as cash is actually received by us from an
Mr. Kevin Vaughn
August 23, 2005
Page 5
LRA. Conversely, since we have no liability to fund and do not
otherwise contribute to the LRA, no liability is recorded.
We pay for supplemental mortgage insurance to cover any losses
exceeding those absorbed by the LRA and mortgage insurance
maintained by FHLBI. The premium for this additional mortgage
insurance is paid at closing in a single lump sum and is
treated by us as a transaction expense that is netted against
the sale proceeds. Neither we nor any of our affiliated
companies pay any other fees to or receive fees from FHLBI to
provide mortgage insurance or any other credit enhancement for
the mortgage loans sold to FHLBI. Flagstar Credit Corporation
does not underwrite supplemental mortgage insurance for any
loans sold by us to FHLBI.
Our loan sales agreements with Freddie, Fannie and other
secondary market participants do not contain an LRA or similar
structures. However, our loan sales to Freddie, Fannie and
other secondary market participants are similar in that they
are true sale transactions with no recourse to us and the
loans have been legally isolated for bankruptcy purposes.
Comment No. 3. In light of the significant recourse you appear to retain on
loans sold FHLBI and the fact that you do not use a QSPE or
other intermediary as part of that transfer, please tell us
what evidence you obtained and provided to your auditors to
support your assertion in your response to comment 27 that the
loans were legally isolated. Accordingly, more clearly explain
to us how you determined that you met all the criteria in
paragraph 9 of SFAS 140 for sale treatment for loans sold to
FHLBI. In future filings, please revise to clearly disclose
how the loans transferred to the FHLBI meet each of the
criteria for sale treatment set forth in paragraph 9 of SFAS
140.
Response No. 3. As discussed in our response to Comment No. 2 above, there is
no significant recourse as a result of our loan sales to the
FHLBI. Rather, the FHLBI looks to the LRA rather than us for
the reimbursement in the case of credit loss.
The loan sales for which we retain the servicing rights and an
interest in the LRA account are in fact true sales and the
loans sold are legally isolated. Our contractual arrangements
with FHLBI convey full title to FHLBI. As a result, the
transferred mortgage loans are fully isolated from us and from
our creditors, even in a bankruptcy or other receivership
situation. The FHLBI has the right to pledge or exchange the
loans received and there is no condition that constrains that
right. We do not maintain effective control of the loans
through any agreement that both entitles and obligates us to
repurchase or redeem
Mr. Kevin Vaughn
August 23, 2005
Page 6
the loans before their maturity or the ability to unilaterally
cause FHLBI to return specific assets. Consequently, we
believe that all conditions under SFAS 140 are met to
recognize the sale. Because of the immaterial amount of loans
sold by us to FHLBI, our external auditors did not require
further evidence supporting our position.
We will include disclosure in future filings which disclose
how the loans transferred to the FHLBI meet each of the
criteria for sale treatment under SFAS 140.
Comment No. 4. We note your response to comment 24 from our letter dated
December 21, 2004. We reissue the following components of that
comment which were not addressed in your response:
o Please tell us in detail how you calculated the
negative provision for the secondary market reserves
in 2002 as presented in your tables on pages 53 and
79 of your 2003 Form 10-K. Tell us the factors that
led to your determination that a reduction of the
reserves was necessary.
o Clearly explain how that reduction was reflected in
your Statement of Earnings. If you recorded this
reduction as an increase in your Gain on sale of the
loans line item, explain why you believe that was
appropriate.
o Reconcile the trends within the reserve and its
related provisions with the trends in your sales of
loans and repurchases of assets.
Response No. 4. The 2002 negative provision for the secondary market reserve
resulted from reclassifications we made in 2003 at the request
of our banking regulator to segregate a reserve for secondary
market exposure separate and apart from the allowance for loan
losses. This required us to reduce the allowance for loan
losses by a corresponding amount. With that change for 2003,
we then made reclassifications to the 2002 audited financial
statements for comparability.
We determined the balance of the secondary market reserve at
year-end 2003 based upon consideration of the following
factors: (i) volume of loans sold over each of the preceding
five years; (ii) actual repurchase history for loans in each
of those years; (iii) further anticipated repurchases; (iv)
losses arising from those repurchases; and (v) actual recovery
history.
After determining the 2003 ending balance, we then calculated
hypothetical secondary market reserve balances for each of the
preceding five years using the same factors. This process
enabled us
Mr. Kevin Vaughn
August 23, 2005
Page 7
to derive a beginning balance for 2002 by calculating the
year-end balance for 2001. It also enabled us to determine the
ending balance for 2002.
Analyzing the components that comprised the allowance for loan
losses in 2002, we were then able to identify the charge-offs
and recoveries that actually related to secondary market
sales. These were also transferred to the 2002 secondary
market reserve, with a corresponding adjustment to the
allowance for loan losses. Having determined the 2002
beginning balance, the 2002 ending balance, and the actual
charge-offs and recoveries during 2002 for the secondary
market reserve, the provision amount had to be a negative
amount as a reconciling matter.
For income statement purposes, we reflected this reduction as
an increase in our Gain on Sale of Loans line item. This
provided a symmetrical result to the usual practice of
recording provisions (i.e., debits) against the Gain on Sale
account to reflect the effect of estimated losses inherent in
the loan portfolios sold.
The trends within the reserve and the related provision
reflect the anticipated losses from potential repurchases.
Loan sales and loan repurchases do not necessarily correlate,
nor do expected losses from the repurchases. For instance,
notwithstanding our higher loan sale volume in 2003 as
compared to 2002, our repurchase history for 2003 indicates a
lower repurchase percentage due to stricter underwriting
standards and automated validation of appraisals. Our loss
rate is also affected by our recovery rates on any losses
incurred, either from the loan brokers that provided us with
the loans initially or from the mortgage insurers covering the
loans.
Comment No. 5. We note your response to prior comment 33 and the revisions
made to your segment footnote in your Form 10-K for the year
ended December 31, 2004. Your presentation of "revenues" does
not seem appropriate given the fact that these amounts are
shown net of interest expense. In addition, the amount
presented as revenues has not been reconciled to your
Statement of Earning as required by SFAS 131. In future
filings, please revise to either remove this measure from your
segment disclosures or properly label it based on its
components.
Response No. 5. We revised our segment disclosure in our June 30, 2005 Form
10-Q to label revenue components in response to the Staff's
comment, and will continue this disclosure in future filings.
Mr. Kevin Vaughn
August 23, 2005
Page 8
Comment No. 6. Please revise to provide the disclosures required by Item 307
of Regulation S-K with respect to your disclosure controls and
procedures.
Response No. 6. The disclosure required by Item 307 of Regulation S-K
regarding our disclosure controls and procedures was
inadvertently not included in our Annual Report on Form 10-K
for the year ended December 31, 2004. However, this disclosure
has been included in subsequent filings on Form 10-Q and,
accordingly, the current assessment of management of our
disclosure controls and procedures has been disclosed. As a
result, it does not seem worthwhile to amend our Form 10-K at
this time to include disclosure that has been superseded by
subsequent filings.
Comment No. 7. We note your statement that the chief executive officer and
chief financial officer have concluded that the company's
disclosure controls and procedures are not effective. Please
revise to disclose in reasonable detail the basis for your
officers' conclusions. In addition, we note that the company
identified the existence of several material weaknesses in its
Form 10-K for the year ended December 31, 2004. Please
disclose the specific steps that you have taken, if any, to
remediate the material weaknesses and disclose whether you
believe that the material weaknesses still exist.
Response No. 7. We note for the Staff the following disclosure contained in
our Form 10-Q for the period ended June 30, 2005 which we
believe fully addresses the disclosure items raised in Comment
7.
"Item 4. Controls and Procedures
a) Disclosure Controls and Procedures. A review and evaluation
was performed by our principal executive and financial
officers regarding the effectiveness of our disclosure
controls and procedures as of June 30, 2005, pursuant to Rule
13a-15(b) of the Securities Act of 1934. Based on that review
and evaluation, the principal executive and financial officers
have concluded that our current disclosure controls and
procedures, as designed and implemented, are not operating
effectively as a result of the material weaknesses reported in
Item 9A-Controls and Procedures to our Annual Report of Form
10-K for the year ended December 31, 2004.
b) Changes in Internal Controls. During the quarter ended June
30, 2005, we have implemented changes to our internal control
over financial reporting identified in connection with the
evaluation required by Rule 13a-15(d) of the Securities Act of
1934 in order to address each of the six areas of material
weaknesses identified in Item
Mr. Kevin Vaughn
August 23, 2005
Page 9
9A-Controls and Procedures of our Annual Report on Form 10-K
for the year ended December 31, 2004. The changes implemented
during the quarter are:
o Weakness related to our accounting for derivative
activities. We are implementing an ongoing continuing
education program for accounting personnel that
includes the areas of derivatives, allowance for loan
losses and transfers and servicing of financial
assets.
o Weakness related to recording of accrued interest
receivable. We have refined our processes relating to
the calculation and recording of accrued interest on
mortgage loans.
o Weaknesses related to the documentation of the
evaluation of the appropriateness of accounting
estimates. We have enhanced documentation of
significant accounting estimates.
o Weaknesses surrounding the recording of non-routine
journal entries. We have enhanced documentation of
controls surrounding the recording of non-routine
journal entries. We have also engaged an outside
accounting consultant to provide additional guidance
with respect to non-routine transactions and entries.
o Weaknesses related to validation and evaluation of
data. We are implementing controls over the
validation and evaluation of data used to support
certain transactions and estimates including the
valuation of interest rate lock commitments.
o Weakness related to company-level controls. We have
taken the following steps to enhance company-level
controls:
o Implementation of an accounting system wide
automation process to reduce manual
processes;
o Adding experienced personnel to the
accounting department;
o Establishment of a financial internal audit
department as a separate unit from the
operational, regulatory and compliance
internal audit functions;
o Hiring additional financial internal
auditors;
o Adding additional expertise to the audit
committee;
Mr. Kevin Vaughn
August 23, 2005
Page 10
o Engaging an outside consultant to assist
with improving our internal control
methodologies and testing in conjunction
with the Sarbanes Oxley Act of 2002;
o Establishment of a formal disclosure
committee process for periodic review of
financial statements;
o Complete development of a comprehensive
program to review, evaluate and improve
security covering user access rights to
certain critical applications.
Although we believe that each of the weaknesses will be
remediated, there can be no assurance that the remediation
will be completed by December 31, 2005."
Flagstar Bancorp hereby acknowledges that:
o it is responsible for the adequacy and accuracy of the
disclosure in the filings;
o Staff comments or changes to disclosure in response to staff
comments in the filings reviewed by the staff do not foreclose
the Commission from taking any action with respect to the
filing; and
o it may not assert staff comments as a defense in any
proceeding initiated by the Commission or any person under the
federal securities laws of the United States.
[signature is on following page]
Mr. Kevin Vaughn
August 23, 2005
Page 11
We trust that the forgoing is responsive to your comments. If you have
any questions regarding the foregoing or require further information, please
contact the undersigned at (248) 312-5580 or our outside counsel Jeremy Johnson
of the Kutak Rock LLP law firm at (202) 828-2463.
Sincerely,
FLAGSTAR BANCORP, INC.
/s/ Paul D. Borja
---------------------------------------
By: Paul D. Borja
Its: Executive Vice President and Chief
Financial Officer