Federal Deposit Insurance Corporation
Office of Audits
Office of Inspector General
Washington, D.C. 20434

DATE: August 14, 2003

MEMORANDUM TO: Michael J. Zamorski, Director, Division of Supervision and Consumer Protection

FROM: Russell A. Rau [Electronically produced version; original signed by Russell Rau], Assistant Inspector General for Audits

SUBJECT: Material Loss Review of the Failure of Southern Pacific Bank, Torrance, California (Audit Report Number 03-036)

In accordance with section 38(k) of the Federal Deposit Insurance Act (FDI Act), 12 U.S.C. 1831o, the Office of Inspector General (OIG) conducted a review of the failure of Southern Pacific Bank (SPB), Torrance, California. On February 7, 2003, the California Commissioner of Financial Institutions closed the institution and named FDIC as receiver. At the time of failure, SPB reported total assets of approximately $1.1 billion. On February 14, 2003, FDIC’s Division of Finance notified the OIG that the estimated cost of the failure to the Bank Insurance Fund (BIF) would be $134.5 million. As of June 30, 2003, this estimated loss had declined to $100 million due to higher than expected proceeds from asset sales.

As mandated by the FDI Act, the audit objectives were to: (1) ascertain why the bank’s problems resulted in a material loss to the insurance fund and (2) assess the FDIC’s supervision of the bank, including implementation of the Prompt Corrective Action (PCA) requirements of Section 38 of the FDI Act. (Note: A material loss is defined by section 38 of the FDI Act, in general, as a loss that exceeds the greater of $25 million or 2 percent of the institution’s total assets at the time the FDIC was appointed receiver. See the glossary (Appendix X) at the end of this report for an explanation of this and other terms and acronyms used throughout this report.) In this report, we address each of these objectives and discuss our findings as part of our analysis of the bank’s failure and the regulators’ efforts to require SPB’s management to operate the bank in a safe and sound manner. Appendix I contains additional information on our objectives, scope, and methodology.

BACKGROUND

SPB was chartered as an industrial loan company (ILC) by the State of California on March 1, 1982, under the name of Southern Pacific Thrift & Loan. (Note: An industrial loan company, industrial bank, or other similar institution, which is an institution organized under the laws of a state which, on March 5, 1987, had in effect or had under consideration in such state's legislature a statute that required or would require such institution to obtain insurance under the FDI Act (12 U.S.C. 1811 et seq.) - ( I ) which does not accept demand deposits that the depositor may withdraw by check or similar means for payment to third parties; ( II ) which has total assets of less than $100,000,000; or ( III ) the control of which is not acquired by any company after August 10, 1987. The current California Financial Code (CA FC), section 1400, pertains to the licensing and regulation of industrial banks and states that any reference to the term industrial loan company means industrial bank. CA FC section 105.5 defines an industrial bank to mean a corporation organized for the purpose of engaging in the industrial banking business, and section 105.7 defines industrial banking business to include the making of loans and acceptance of deposits, including deposits evidenced by investment or thrift certificates, but excluding demand deposits. The 1996 California legislation that created the California Division of Financial Institutions also authorized the use of the word bank by thrift and loan companies, such as SPB, in their names. Effective October 8, 1997, Southern Pacific Thrift & Loan changed its name to Southern Pacific Bank.) The institution received federal deposit insurance on November 5, 1987. Initially, the institution originated residential mortgage loans and sold the loans and servicing rights to its parent, Imperial Bank. SPB remained a direct subsidiary of Imperial Bank until January 1992 when Imperial Bank formed Imperial Credit Industries, Inc. (ICII), and contributed all of the outstanding stock of SPB to ICII. (Note: ICII was SPB’s holding company. By March 31, 2002, ICII had a capital deficit of approximately $97 million. ICII was publicly traded on the NASDAQ until it was delisted on May 15, 2002. In July 2003, ICII filed for protection from creditors under Chapter 11 of the federal bankruptcy law. ICII listed $190 million in liabilities and $20 million in assets in its filing in U.S. Bankruptcy Court in Los Angeles.) Appendix II contains an ICII organizational chart. SPB and Imperial Bank were subject to regulation, supervision, and examination under both California and federal law, by the California Department of Financial Institutions (DFI) and by the FDIC, respectively. (Note: The DFI was created on July 1, 1997. DFI was formed by consolidating the divisions of Credit Unions and Industrial Loan Companies from the Department of Corporations into the former State Banking and Savings and Loan Departments. Prior to July 1, 1997, SPB was supervised by the California Department of Corporations (DOC).) But by law, ICII was not subject to Bank Holding Company Act (BHCA) regulations. ICII annually filed a Form 10 K, Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934, with the Securities and Exchange Commission. Each year ICII’s 10-K stated that it was not regulated or supervised by the DFI, FDIC, Federal Reserve Board or any other bank regulatory authority, except with respect to:

• the general regulatory and enforcement authority of the DFI and the FDIC over transactions and dealings between ICII or any of its affiliates and SPB; and,
• the specific limitations regarding ownership of the capital stock of a parent company of any industrial bank and the payment of dividends.

In the early 1990s, SPB grew rapidly from aggressive marketing for deposits and from bulk mortgage loan purchases, mostly from affiliates. (Note: Section 2(k) of the Bank Holding Company Act, 12 USC 1841et seq., defines the term ''affiliate'' to mean any company that controls, is controlled by, or is under common control with another company.) SPB warehoused mortgage loans, but also held a small portfolio for investment purposes. (Note: Loans originated through a line of credit are essentially warehoused until sold into the secondary market. Warehousing allows a mortgage banker to leverage capital, thus permitting increased loan production.) The bank nearly tripled in asset size from $452 million at the February FDIC 1993 examination to nearly $1.4 billion by year-end 1994. However, $1.1 billion of total assets were mortgage loans held for sale (also known as pre-sold loans), which were generally on the books for less than 90 days. (Note: Held for sale, or pre-sold loans are loans purchased for subsequent sale in the market. These loans were generally not permanent in nature and were typically on the bank's books for less than 90 days.)

At the beginning of 1994, SPB’s total assets were greater than $500 million for the first time, crossing the asset threshold of Section 36 of the FDI Act and thus requiring SPB management to prepare, annually, reports that included the following (Note: The Federal Deposit Insurance Corporation Improvement Act (FDICIA) of 1991 added Section 36 to the Federal Deposit Insurance Act (FDI Act), codified to 12 U.S.C. 1831m, and Part 363 of the FDIC Rules and Regulations, codified to 12 C.F.R. Part 363 implements Section 36 of the FDI Act. FDICIA contained accounting, corporate governance, and regulatory reforms designed to correct weaknesses in the deposit insurance system. Among other measures, FDICIA’s early warning reforms provide for timely disclosure of internal control weaknesses. FDICIA also established audit and reporting requirements for insured depository institutions with total assets of $500 million or more and their independent public accountants.):

• Financial statements prepared in conformity with generally accepted accounting principles (GAAP).
• A written assertion about the effectiveness at year-end of the institution’s internal controls over financial reporting.
• A written assertion about the institution’s compliance during the year with federal laws and regulations relative to (a) insider loans and (b) dividend restrictions and state laws and regulations relative to dividend restrictions.

In addition, Section 36 required SPB management to engage an independent accountant to provide the following reports annually:

• An audit report on the GAAP-basis financial statements.
• An examination-level attestation report on management’s assertion about financial reporting controls.

The financial statement audit, performed in accordance with generally accepted auditing standards (GAAS), and the examination of management’s assertion about financial reporting controls, performed in accordance with the American Institute of Certified Public Accountants’ (AICPA) Statement on Standards for Attestation Engagements (SSAE), were required to be filed with the FDIC and other regulatory agencies within the 90 days following SPB’s fiscal year-end. SPB management was also required to file with the regulators any management letter, qualification, or other report within 15 days following receipt from SPB’s independent accountant.

SPB’s parent, ICII, conducted its core business segments primarily through SPB where ICII originated loans and leases. SPB historically obtained the liquidity necessary to fund its parent ICII’s former residential mortgage banking operations and its own investing activities through deposits and, if necessary, through borrowings under lines of credit and from the Federal Home Loan Bank (FHLB).

In 1995, ICII began to reposition, transform and diversify its core business activities from the traditional mortgage banking operations of originating and selling conforming residential mortgage loans to offering higher margin loan, lease, investment, and financial services products. ICII diversified its loan and lease products by focusing on the creation and acquisition of additional finance businesses as described below:

• Non-Conforming Residential Lending – Non-conforming residential lending was conducted through ICII's subsidiary, Southern Pacific Funding Corporation (SPFC), a mortgage banking company that originated, purchased, and sold high-yielding, single family non-conforming mortgage loans. (Note: SPFC was a specialty finance company engaged in the business of originating, purchasing, and selling non-conforming mortgage loans secured primarily by one-to-four family residences. The majority of the Company's loans were made to owners of single family residences who used the loan proceeds for purposes such as mortgage refinancing, home purchase, debt consolidation, home improvements, and educational expenditures. SPFC focused primarily on lending to individuals who had significant equity in the value of their homes but had impaired or limited credit histories. As a result, SPFC's customers were less likely to qualify for loans from conventional mortgage lenders and generally paid higher interest rates than interest rates charged by conventional mortgage lenders.) SPFC commenced operations in January 1993 as a division of SPB and after April 1995, operated as a subsidiary of ICII before completing an initial public offering of its common stock in June 1996.
  
  
• Business Finance Lending – Business finance lending was conducted through Imperial Business Credit, Inc. (IBC), an ICII wholly-owned commercial leasing company specializing in lending to small businesses and three divisions of SPB: Coast Business Credit (CBC), the Loan Participation and Investment Group (LPIG) and the Auto Lend Group (Auto Lend).
  
  
• Commercial Mortgage Lending – ICII conducted its commercial mortgage lending operations through the Income Property Lending Division (IPLD) of SPB. IPLD was formed in February 1994 to expand ICII’s apartment and commercial property lending business and focused on the small loan market for apartments and commercial loans consisting of loans less than $2.5 million.
  
  
• Consumer Lending – ICII conducted consumer lending operations through the Auto Lending Division (ALD) and Consumer Credit Division (CCD) of SPB. ICII eventually closed ALD operations in February 1999 because of the significant losses incurred from this business. ICII also closed its CCD operations in December 1998 because they did not generate returns that met profitability expectations.
  
  
• Franchise Lending – Franchise lending was conducted through ICII's subsidiary, Franchise Mortgage Acceptance Corporation, LLC (FMAC), a full-service franchise finance company engaged in the business of originating loans and equipment leases to top-tier established franchisees of national and regional franchise concepts. ICII eventually divested itself of FMAC.

SPB historically obtained the liquidity necessary to fund ICII’s former residential mortgage banking operations and SPB’s investing activities through deposits and, if necessary, through borrowings under lines of credit and from the Federal Home Loan Bank (FHLB). By 1996, the bank’s business lines were expanded to include commercial lending, franchise financing, and asset-based lending through the bank’s acquisition of CBC from Coast Federal Savings and Loan. Business operations conducted through divisions of SPB were primarily financed through deposits, capital contributions from ICII to SPB, a warehouse line of credit and FHLB borrowings. CBC specialized in higher yield and higher risk commercial loans to several major industries including airlines, telecommunications, technology, and entertainment.

As part of the repositioning and diversification process, ICII's loan portfolio composition as a percentage of total loans and leases outstanding at December 31, 1996, changed as shown in Figure 1 below.

Figure 1: Change in Composition of ICII’s Loan Portfolio

[This image appears in the non-508-compliant version of the audit report.]

Text description of Figure 1: This figure shows the change in composition of ICII’s loan portfolio by loan types by escalating risk (lower to higher risk). Two points in time, December 31, 1996, and December 31, 1995, are shown. For December 31, 1996, the loan types by escalating risk and their percentage of the portfolio are: Conforming Residential Mortgage Loans, 8%; Commercial Mortgage Loans, 7%; Consumer Loans, 2%; Business Loans and Leases, 37%; and Non-conforming Residential Mortgage Loans, 46%. For December 31, 1995, the loan types by escalating risk and their percentage of the portfolio are: Conforming Residential Mortgage Loans, 58%; Commercial Mortgage Loans, 9%; Consumer Loans, 3%; Business Loans and Leases, 2%; and Non-conforming Residential Mortgage Loans, 28%.

Source: ICII’s 1996 Securities and Exchange Commission Form 10-K.

As noted above, ICII’s conforming residential mortgage loans, commercial mortgage loans, and consumer loans decreased, while higher risk non-conforming residential mortgage loans and business loans and leases increased as a percentage of total outstanding loans and leases.

SPB’s parent, ICII, repositioned, transformed, and diversified its core business activities from the traditional mortgage banking operations to offering higher-margin loan, lease, investment and financial services products. The effect of this major change was reflected in SPB’s loan portfolios, most notably in its lower-risk loans secured by one-to-four family residential properties and higher-risk commercial and industrial loan portfolio as shown in Figure 2.

Figure 2: Change in SPB’s Loan Portfolio Mix from 1987 to 2002

[This image appears in the non-508-compliant version of the audit report.]

Text description of Figure 2: The following shows the change in SPB’s loan portfolio mix from 1987 to 2002 by percentage of the loan portfolio for both loans secured by 1-4 family residential properties and commercial and industrial loans. The percentage of the loan portfolio of loans secured by 1-4 family residential properties for the following years are: 1987, 27.8%; 1988, 46.6%; 1989, 71.7%; 1990, 54.7%; 1991, 49.7%; 1992, 89.5% 1993, 91.1%;1994, 92.4%; 1995, 71.1%; 1996, 33.9%; 1997, 21.1%; 1998, 12.9%; 1999, 8.7%; 2000, 5.6%, 2001, 3.8%; and 2002, 6.1%. The percentage of the loan portfolio of commercial and industrial loans for the following years are: 1987, 5.2%; 1988, 0.72%; 1989, 0.13%; 1990, 0.15%; 1991, 0.1%; 1992, 0.0% 1993, 0.0%; 1994, 0.27%; 1995, 7.5%; 1996, 36.7%; 1997, 52.4%; 1998, 66.8%; 1999, 70.9%; 2000, 68.2%, 2001, 67.1%; and 2002, 65.4%.

Source: SPB Call Reports.

From 1987 through 1999, SPB’s composite CAMELS rating fluctuated between a 2 and a 3. (Note: Financial institution regulators use the Uniform Financial Institutions Rating System to evaluate a bank's performance. Six areas of performance are evaluated and given a numerical rating of 1 through 5, with 1 representing the least degree of concern and 5 the greatest degree of concern. The six performance areas are: Capital adequacy, Asset quality, Management practices, Earnings performance, Liquidity position, and Sensitivity to market risk. A composite CAMELS rating is an overall rating given to a bank based on the six performance areas. A rating of 1 through 5 is given. A rating of 1 indicates strong performance; 2 reflects satisfactory performance; 3 represents below-average performance; 4 refers to marginal performance that could threaten the viability of the institution; and, 5 is considered critical, unsatisfactory performance that threatens the viability of the institution.) However, during the 1996 examination by FDIC and DFI, examiners had several concerns that required SPB’s Board of Directors to oversee improvements in the bank’s compliance with laws, regulations, and statutes; adherence to lending policies; quality of assets; and, internal controls, practices, and policies over operations. Overall, for the first time, examiners concluded that the Board and management had not been effective in managing, supervising, or administrating the growth of SPB. These concerns persisted until the failure of SPB in 2003. Following the 1996 examination SPB entered into a joint memorandum of understanding (MOU) with the FDIC and DFI on September 30, 1996. This was the first informal action against SPB. Table 1 summarizes SPB’s examination history and supervisory actions from 1992 through 2003.

Table 1:  FDIC and California DFI Supervisory Actions for SPB from 1992 to 2003

Source: FDIC and California DFI reports of examination and related correspondence.

SPB’s board of directors stipulated to an FDIC Cease and Desist Order (C&D) that became effective on December 15, 2000. This was the first formal action against SPB by the FDIC. The Order required SPB to retain qualified management, increase capital, reduce classified assets, restrict dividends and bonuses, and improve other operations. On December 31, 2000, the bank was considered significantly undercapitalized for PCA purposes, because the bank’s Total Risk-Based Capital ratio decreased to 5.57 percent, Tier 1 Risk-Based Capital ratio decreased to 2.86 percent, and Tier 1 Leverage Capital ratio decrease to 2.82 percent. On December 31, 2001, the bank was considered undercapitalized for PCA purposes because its Total Risk-Based Capital ratio increased only to 6.34 percent, Tier 1 Risk-Based Capital ratio increased only to 3.51 percent, and Tier 1 Leverage Capital ratio increased only to 3.03 percent. Although SPB’s capital improved, on February 1, 2002, FDIC required SPB’s Board to prepare and submit a capital restoration plan by March 1, 2002, and inform the board of the restrictions under Section 38 of the FDI Act. SPB remained in substantial noncompliance with FDIC’s order as of December 2002. The DFI issued a similar enforcement action, a Final Order, that became effective on January 3, 2001.

After several revisions, SPB’s capital plan was accepted on May 24, 2002. The plan required that SPB increase Tier 1 capital by a minimum of $55 million by July 22, 2002, through capital injections and/or through the sale of certain assets. SPB failed to meet the capital plan, and on July 25, 2002, FDIC notified SPB that it was significantly undercapitalized for PCA purposes. A revised capital plan was submitted on November 26, 2002, that called for one of ICII’s senior debt holders to acquire approximately 80-percent ownership of SPB by directly purchasing $30 million in common stock. On November 18, 2002, the senior debt holder filed a Notice of Change of Control with the FDIC, and it was accepted for processing on December 11, 2002. Subsequently, in January 2003 and while FDIC was reviewing the senior debt holder’s pending Notice, the senior debt holder decided to withdraw the pending Notice and notified the FDIC and other interested parties of the decision on January 23, 2003. Without another source of capital, the SPB was determined to be critically undercapitalized as of December 31, 2002, and closed on February 7, 2003. Appendix III contains a chronology of significant events in SPB’s history.

RESULTS OF AUDIT

SPB failed because of ineffective corporate governance, leading to a material loss to the Bank Insurance Fund. Specifically, the individual who served both as the Chairman and President of the bank’s holding company, ICII, and as the Chairman and interim President of SPB dominated the operations of the bank, and the Board failed in its responsibilities. Under these circumstances, bank management:

• pursued a strategy of high-growth, high-risk commercial lending without proper risk management processes;
• concentrated the bank’s lending in the telecommunications, technology, entertainment, and airline industries, without adequate underwriting;
• operated the bank and its largest commercial lending division under an incentive bonus program that rewarded key executives based on reported profits, without balancing performance measures related to the safety and soundness of the institution;
• frequently ignored examiner recommendations; and
• did not correct significant problems identified in internal reviews, allowing internal control and other problems at the bank to persist.

Additionally, SPB’s external auditor did not assure adequate disclosure of SPB’s financial condition, results of operations, and internal control weaknesses. As a result, the bank experienced significant losses in its commercial loan portfolio. Furthermore, the downturn in the telecommunications and technology sectors in the early 2000s and the impact of the September 11th terrorist attacks on the airline industry exacerbated the deterioration in the bank’s portfolio.

In addition to the estimated loss to the Bank Insurance Fund, SPB suffered losses of over $325 million in the bank’s commercial and industrial portfolio from 1997 to 2002. In the mid- to late 1990s, SPB dramatically shifted its business strategy from mortgage lending to high-risk commercial lending. The bank changed its focus to higher-risk loans, with potentially higher yields, concentrating in the telecommunications, technology, entertainment, and airline industries. Many of these new business lines were pursued without an adequate loan review program and internal loan grading system. Inferior underwriting and credit administration, combined with the rapid growth in these product lines without an adequate provision for loan losses, led to increasing asset problems and adverse classifications. SPB’s attempts to resolve these problems through loan workout strategies increased the bank’s exposure and delayed the full recognition of losses. Although SPB’s holding company provided capital infusions of $125 million and purchased SPB assets of $31 million from 1997 to 2002, the bank’s continuing losses led to a depletion of the capital needed to sustain operations.

With respect to the supervision of SPB, the FDIC and state examiners conducted annual examinations, consistently identifying and reporting deficiencies and taking various informal and formal enforcement actions, but these actions were of limited effect in reducing the risk of a material loss to the insurance fund. Examiner guidance is needed for assessing the capital requirements and provision for losses associated with high-risk commercial loans. FDIC and state examiners conducted annual examinations of SPB from 1993 until its closure. The examiners repeatedly identified and reported on significant, yet uncorrected problems at the bank. The regulators also required the bank to operate under two MOUs, in 1996-1997 and 1999-2000, and one C&D Order from 2000 until SPB failed. However, we identified two areas where supervision could be improved:

• examination guidance and assistance is needed for determining the appropriate amount of equity capital needed for high-risk commercial loans; and
• examination guidance is needed for assessing the provision for loan losses associated with high-risk commercial loans, including the use of peer group average ratios, historical loan loss averages, and adjustments for qualitative risk factors such as new areas of lending, new management, and high loan growth.

The FDIC implemented PCA in accordance with the requirements of Section 38 of the FDI Act. However, PCA was not fully effective due to the inadequate provision for loan losses that overstated SPB’s income and capital for several years and to the bank’s failure to execute its approved capital plan.

Other Issue: Federal Oversight of ILC Parent Holding Companies

Of the 10 material loss reviews we have conducted, this is the second involving industrial loan companies – the 1999 failure of Pacific Thrift and Loan was the other. In the case of SPB, its parent holding company, ICII, was not subject to the regulatory oversight provided under the BHCA. However, the FDIC was authorized by law to examine any affiliate of SPB, including its parent company, to determine the relationship between SPB and its parent/affiliate and the effect of such a relationship on the bank. Our report contrasts the oversight and authority provided under the BHCA with that which is available by statute to FDIC for parent holding companies of industrial loan companies such as ICII. We also intend to conduct an audit specifically focusing on non-bank bank holding companies and the potential risks, if any, which may result from the reduced level of federal oversight for holding companies not covered by the BHCA.

This report contains six recommendations designed to improve the bank supervision process and promote the safety and soundness of FDIC-supervised institutions.

FINDINGS AND RECOMMENDATIONS

SPB’s Board of Directors (Board) and senior management exhibited a pattern of mismanagement and failed to provide an adequate system of corporate governance. (Note: Senior management refers to executive officers and excludes directors. For financial institutions, corporate governance is the manner in which their Board of Directors and senior management govern their business and affairs. Corporate governance affects the way corporate objectives are set and aligns corporate activities and behaviors to ensure safe and sound business operations and compliance with laws and regulations. Effective corporate governance considers the interests of stakeholders and, ultimately, protects depositors’ interests.) The Board’s failure to provide adequate oversight was a principal cause of the bank’s failure, which happened in large part because the Chairman dominated the Board. The bank engaged in high-growth, high-risk strategies in the mid-late 1990s with liberal underwriting, but without proper risk management processes. The Board and senior management disregarded various laws and banking regulations and frequently ignored examiner recommendations and enforcement actions, which resulted in a large number of non-performing loans at the bank’s asset-based lending division, Coast Business Credit (CBC); Auto Financing Division; PrinCap Mortgage Warehouse Inc. (SPBs wholly-owned subsidiary); and its leveraged syndicated credit division, Loan Participation Investment Group (LPIG). Adding to these problems was: the lack of adequate internal control, such as segregation of duties; inadequate preparation of workpapers for Call Reports; miscalculation of discounts on loans to facilitate the sale of other real estate; lost held-for-sale loan files; poor accounting for specific reserves; lack of conformity with SPB’s policies and procedures; and questionable opinions by the external auditor, who also performed internal review services. To achieve an effective corporate governance environment, the Board (including the audit committee), senior management, internal review, and external audit must all be in place and working cohesively. As discussed below, this did not occur at SPB.

Board of Directors

The Chairman of the Board (COB) of SPB also held the positions of President and COB at SPB’s parent holding company, ICII. This individual was the one constant management figure through most of the bank’s history. SPB’s Board meetings were held simultaneously with ICII’s Board meetings. Many of the internal routine exceptions noted by examiners involved loan servicing performed by affiliated and unaffiliated third parties without adequate oversight. Weak internal operations existed and continued from examination to examination because the bank was so integrated with its parent holding company, ICII. According to the April 14, 1997 examination, the “distinction was blurred between the bank and its [parent] as a stand alone entity.” Examiners had stressed the importance of maintaining a separation between the bank, ICII and its affiliates, and other third parties, but these concerns were repeatedly ignored. The continued lack of adherence to Sections 23A and 23B of the Federal Reserve Act, codified to 12 U.S.C. §§ 371c and 371c-1, and various California Financial Code regulations suggests that the bank lacked the ability or willingness to comply with applicable requirements. Transactions with affiliates were not monitored for compliance with federal regulations which subsequently led to continued violations (see Appendix IV).

In an April 14, 1997 Report of Examination (ROE), FDIC examiners stated that the “Board and management had not been effective in managing, supervising, or administering the growth of the bank.” This difficulty was the result of the Board and management’s failure to properly manage and adapt to the growth experienced in the early 1990s. During that time, the bank’s assets grew from less than $100 million to over $1 billion. The significant growth was the result of increased transactions with its parent company and affiliates. The Board and management lacked the knowledge of regulatory requirements, effective management skills, and the ability to properly account for these transactions.

In a joint June 21, 1999 examination conducted by the FDIC and California Department of Financial Institutions (DFI), the examiners determined that ICII had become more involved with the bank and had expanded SPB’s Board to include five ICII directors. Significant losses in the CBC, Auto Lending Division, and LPIG portfolios, as well as SPB’s wholly–owned subsidiary, PrinCap Mortgage Warehouse, Inc., were due to a lack of adequate Board supervision. These losses are discussed below.

• Auto Lending Division – Significant losses were attributable to a lack of SPB’s management oversight in the administration of the division. The thrift discontinued funding auto paper through this division in June 1999. The portfolio was reduced by sales, losses on sales and valuation write-downs.
  
  
• CBC – Adverse loan classifications dramatically increased. However, SPB’s management believed that the classifications were low and appropriate for an asset-based loan portfolio and typical for that industry. Credit managers were extending funds to very weak borrowers with the belief that the borrowers would recover financially. This practice had gone unsupervised by senior bank management.
  
  
• PrinCap Mortgage Warehouse, Inc. (PrinCap) – Significant losses were the result of fluctuations in the loan securitization market and ineffective servicing practices, which resulted in significant increases in classifications.
  
  
• LPIG – Significant losses occurred in the LPIG division as the result of concentration of syndicated credits in the airline, telecommunication, technology, and entertainment industries.

In the FDIC’s January 22, 2001 examination, examiners noted that, “… the Board of Directors had failed to properly supervise the bank or to implement sound policies and objectives.” Some examples of inadequate supervision by the Board and SPB management identified by examiners follow:

• Excessive management turnover – From 1997 through 2001 SPB had three presidents, two chief executive officers, and three chief financial officers.
  
  
• SPB experienced growth by sacrificing the quality of its activities – The bank operated with a decentralized entrepreneurial management structure in which business development dominated the corporate cultural at the expense of sound loan administration and prudent credit judgment.
  
  
• Numerous occurrences of alleged borrower frauds – Senior managers sacrificed prudent credit judgment because bonuses were paid based on corporate growth and profitability.
  
  
• Repeat transactions with affiliates – Board and management were consistently cited for apparent violations of Sections 23A and 23B of the Federal Reserve Act.

According to FDIC’s Manual of Examination Policies, the quality of management is probably the single most important element in the successful operation of a bank. Management includes both the Board of Directors, which is elected by the shareholders, and the executive officers, who are appointed to their positions by the Board. Examiner guidance in DSC Examination Modules addresses various control and performance standards in evaluating bank management. These standards include whether a bank's board has established policies to maintain a system that effectively measures and monitors risk and to implement corrective actions recommended by auditors and supervisory authorities. To determine whether a bank's risks are adequately identified, measured, monitored, and controlled, the examiners evaluate whether the Board has:

• identified and assessed major risks that influence the success or failure of the bank,
• established adequate policies and procedures given the size and complexity of the bank,
• implemented adequate controls to ensure adherence to bank policies and legal and regulatory requirements, and
• implemented appropriate systems to monitor the bank's activities.

The Board’s failure to provide adequate oversight of SPB resulted in concentrations of affiliate transactions, concentrations of credit risk, high-risk lending, and a disregard for banking laws, regulations, and examiner recommendations. FDIC and State of California ROEs from 1992 through 2002 identified numerous matters requiring Board attention pertaining to the lending function. These areas included basic tenets of banking, such as affiliate transactions, risk management, asset quality, loan policies, and loan administration.

Senior Management

SPB senior management did not fulfill its responsibilities to operate the bank in a safe and sound manner. Specifically, senior management allowed the agressive growth of concentrated high-risk assets. Management did not ensure appropriate loan administration procedures or provide a sufficient Allowance for Loan and Lease Losses (ALLL) which contributed to the collapse of SPB.

The bank’s poor condition had occurred, according to FDIC examiners, largely during the COB’s stewardship. The Board had abdicated its management oversight role to the bank’s COB who also served as the bank’s interim President from December 2000 to July 2001. The examiners stated that: “The bank is characterized by a decentralized, entrepreneurial management structure in which individual managers are given bonus incentives related to growth and profitability.” Examiners also stated: “The entrepreneurial management philosophy has created a climate where business development has dominated the bank’s corporate culture at the expense of sound loan administration and prudent credit judgment.”

Bonus Incentives Drive Poor Loan Underwriting

Management focused on the quantity of loans as opposed to the quality of loans due to the lucrative bonuses tied to performance incentives (see Table 2). This bonus structure encouraged the following practices:

• initiating high-risk loans without commensurately higher reserves, and
• restructuring such loans to mask their non-current status or lack of payment.

Senior management allowed the aggressive growth of high-risk assets that eventually led to the bank’s demise. During the joint June 26, 2000, examination, FDIC and DFI examiners reported that CBC managers were continuing the risky practice of advancing additional funds to weak borrowers in the hope they would recover financially. Such workout loans whose repayment was not predicated on identifiable or historical sources of cash, or that may have had intangible collateral of questionable value, tended to be highly speculative and exposed the bank to increased risk. The effect of keeping some of these loans current, as opposed to charging them off, helped maintain higher profit margins for SPB’s CBC division and increased bonuses based on performance.

Several executives had employment agreements that included bonus incentives based on overall pre-tax profits, and in the case of CBC, the asset-based lending division of SPB, bonuses were based only on the division’s profits even though the overall organization was losing money. During October 2000, a former SPB president, who served from 1998 until 2000, met with FDIC management and stated that while he was president of SPB, CBC had been allowed to operate independently from his oversight. During that time, CBC’s portfolio represented from 32 to 42 percent of the bank’s total assets. He indicated that CBC’s senior executive staff did not report to him, but reported directly to the President/CEO of the bank’s parent holding company, ICII. He further stated that CBC’s executive officers were under contract with ICII and received annual bonuses based solely on pre-tax profitability at CBC as calculated from internally generated figures at CBC. These incentives appeared to have resulted in the failure to report problem loans and a propensity to liberally restore credits. Internal risk ratings of loans in the CBC portfolio failed to accurately reflect the high degree of risk inherent in the loan portfolio, and management did not properly account for problem loans that should have been placed on a nonaccrual status. (Note: A nonaccrual loan is not earning the contractual rate of interest in the loan agreement as a result of financial difficulties experienced by the borrower.)

The FDIC examiners identified two executive officers at CBC who received annual bonuses paid in an amount equal to 1.5 percent of CBC’s annual pre-tax profit prior to the payment of bonuses provided for in their employment contracts. The OIG examined SPB’s parent holding company records during this review and obtained a list of bonuses paid to 58 CBC employees during 1998. Although the OIG does not have the corresponding employment agreements, many of the bonuses paid to these executives and non-executives were significant (see Table 2). CBC’s loan portfolio grew from $289 million in 1996 to $765 million in 2000. In addition, the individual who served as the ICII President/CEO and SPB COB, and the individual who served as SPB’s president from 1994 -1998 and as vice-chairman of SPB’s Board in 1999, received bonuses tied to a percentage of overall company pre-tax profits. Tables 2a-d show examples of employee salaries and bonuses.

Table 2a: Examples of SPB and ICII Employee Salaries and Bonuses from 1994 to 2001—ICII President and CEO and SPB Chairman

Source: SPB and ICII records.

Table 2b: Examples of SPB and ICII Employee Salaries and Bonuses from 1994 to 2001—SPB President (who resigned as SPB President in December 1998 and as Vice-Chairman of SPB in September 1999)

Source: SPB and ICII records.

Table 2c: Examples of SPB and ICII Employee Salaries and Bonuses from 1994 to 2001—CBC Executives

Source: SPB and ICII records.

Table 2d: Examples of SPB and ICII Employee Salaries and Bonuses from 1994 to 2001—CBC Employees

Source: SPB and ICII records.

During the June 26, 2000 examination, FDIC examiners suggested that management review the calculations and compensation agreements for the two CBC executive officers and upon renewal or extension of their contracts, consider adding other incentive criteria, such as asset quality and accuracy of loan grades. In the December 15, 2000 C&D Order issued by the FDIC, the bank was restricted from paying bonuses to executive officers without the prior written consent of the FDIC Regional Director. In addition, the bank was required to adopt a comprehensive employee compensation plan.

Lack of Response to Examination Recommendations

The FDIC and DFI cited SPB's Board and management for noncompliance with existing policies and continuous violations of laws and regulations. Appendix IV shows accounting problems, internal control weaknesses, and apparent violations of law cited by the regulators. Senior management's failure to address these concerns led to an increase in the volume of adversely classified loans. Examiners identified several problems:

• poor underwriting and overreliance on enterprise values,
• inadequate risk diversification,
• aggressive marketing of deposits and bulk mortgage loan purchases, mostly from affiliates,
• higher-yield and higher-risk commercial lending to major industries, including airlines, telecommunications, technology, and entertainment,
• participations in Shared National Credits (SNCs), several of which involved the same industries in which CBC had concentrated,
• subprime lending in commercial and multi-family real estate,
• asset-based lending to businesses showing signs of credit unworthiness,
• overadvances to businesses with anticipation of possible turnaround profits (CBC relied on borrower turnaround projections), and
• large provisions to allowances were needed to cover loan losses experienced by SPB and as a result of these large provisions, SPB experienced excessive operating losses.

Section 4.1 of FDIC’s Manual of Examination Policies provides the following:

The primary responsibility of executive management is implementation of the Board's policies and objectives in the bank's day-to-day operations. A bank's performance with respect to asset quality and diversification, capital adequacy, earnings capacity and trends, and liquidity and funds management is, to a very significant extent, a result of decisions made by the bank's directors and officers. When significant problems exist in a bank's overall condition, consideration must be given to management's degree of responsibility. At a minimum, assessment of management by bank examiners should include the following considerations:

• Existing management's past record of performance in guiding the bank;
• Whether loan losses and other weaknesses are recognized in a timely manner;
• Past compliance with supervisory agreements, commitments, orders, etc.; and
• Capability of management to develop and implement acceptable plans for problem resolution.

In reports of examinations from 1995 until the bank’s failure in 2003, examiners identified violations of Sections 23A and 23B of the Federal Reserve Act, Part 362 of the FDIC Rules and Regulations, and various other California Financial Code regulations as shown in Appendix IV. The examinations also contained references to the Board and management regarding the increase in classified assets; deficiencies in accounting and control systems and risk management systems; and a lack of centralized control in the volume of acquisitions made by the parent or the bank. Each affiliate and/or subsidiary operated autonomously, without direct guidance or controls in place to properly govern the unit. Inadequate due diligence or disregard of due diligence was evident with almost every business acquisition. The May 11, 1998 joint examination by FDIC and DFI identified severe accounting and internal control weaknesses that subsequently led management to overstate its year-end cash position by $11 million. Significant unreconciled differences in general ledger accounts totaled approximately $2.5 billion. With the subsequent change in management (new SPB president as of December 1998), and with the help of a contractor, the unreconciled differences were corrected. However, the ongoing accounting and control deficiencies created concerns regarding the institution’s overall condition, its management, capital levels, and asset quality. SPB’s earnings during this time were strong but were adversely affected by the accounting and control deficiencies.

The FDIC examiners reported in 2002 that the bank had been operating with:

• inadequate capital,
• large operating losses,
• high management turnover over during the last four examinations,
• net loan losses in excess of $330 million for the last 3 years, and
• an excessive amount of adversely classified loans.

The deterioration in asset quality required large provisions to the ALLL and depleted capital excessively, whereby SPB had reached the point of imminent failure without a substantial infusion of capital. Loan classifications were further increased by 45 percent as the result of examination findings. The volume of nonaccrual loans were determined to be at high levels, which represented 200 percent of the ALLL. Although SPB made a $55.3 million provision for losses in the first 9 months of 2002, the ALLL was still underfunded by $15.9 million as of December 31, 2002.

Inadequate Board and management supervision is evidenced by SPB’s poor loan administration practices, lax collection policies and procedures, and an underfunded ALLL. The bank’s risk profile increased, yet the Board failed to take significant actions to address this high risk-profile.

Internal Review

SPB management and the Board did not correct all problems identified in internal reviews and, therefore, did not fulfill their responsibility to ensure that the system of internal controls at SPB operated effectively. SPB’s internal review contractor reported numerous accounting problems, internal control weaknesses, and apparent violations of law and regulations to SPB's management and the Board. However, they failed to take all necessary corrective actions to address these problems. As a result, material deficiencies identified by regulators in subsequent examinations and internal control problems were allowed to continue at SPB, increasing the risk of loss of assets. A list of accounting problems, internal control weaknesses, and apparent violations cited by the regulators in their reports of examination is in Appendix IV.

According to Financial Institution Letter (FIL) 133-1997, Interagency Policy Statement on the Internal Audit Function and Its Outsourcing, issued December 22, 1997, by the four federal banking agencies, effective internal control is a foundation for the safe and sound operation of a banking institution or savings association. (Note: FIL 133-1997 was replaced by FIL 133-2003, Interagency Policy Statement on the Internal Audit Function and Its Outsourcing, on March 17, 2003. The new policy statement updated the agencies’ internal audit guidance as a result of the Sarbanes-Oxley Act of 2002, reflected the agencies’ experience with the 1997 policy, and incorporated recent developments in internal auditing. The sections cited above were not changed. There are four federal regulators of banks and savings and loan institutions: the Board of Governors of the Federal Reserve System (Federal Reserve Board or FRB), the FDIC, the Office of the Comptroller of the Currency (OCC), and the Office of Thrift Supervision (OTS). For more information, see Primary Federal Regulator in the Glossary. Internal control is a process, brought about by an institution's Board, management, and other personnel, designed to provide reasonable assurance that the institution will achieve the following internal control objectives: efficient and effective operations, including safeguarding of assets; reliable financial reporting; and, compliance with applicable laws and regulations. Internal control consists of five components that are a part of the management process: control environment, risk assessment, control activities, information and communication, and monitoring activities. The effective functioning of these components is essential to achieving the internal control objectives.) The Board and senior managers of an institution are responsible for ensuring that the system of internal control operates effectively. Their responsibility cannot be delegated to others within the institution or to outside parties. An important element of an effective internal control system is an internal audit function. When properly structured and conducted, internal audit provides directors and senior management with vital information about weaknesses in the system of internal control so that management can take prompt, remedial action. The FIL also states that to properly discharge their responsibility for internal control, directors and senior management should foster forthright communications and critical examination of issues so that they will have knowledge of the internal auditor's findings and operating management's solutions to identified internal control weaknesses. Internal auditors should report internal control deficiencies to the appropriate level of management as soon as they are identified. Significant matters should be promptly reported directly to the Board (or its audit committee) and senior management. In periodic meetings with management and the manager of internal audit, the audit committee should assess whether internal control weaknesses or other exceptions are being resolved expeditiously by management.

Before November 1996, bank personnel performed internal reviews at SPB. However, the regulators criticized SPB’s internal review function in several ROEs. For example, in 1993 no internal reviews were conducted. In 1994, an SPB manager was designated internal auditor while retaining his managerial responsibilities, resulting in a lack of segregation of duties. Finally, in 1995, the regulators pointed out that SPB's internal review function reported deficiencies, but the deficiencies remained uncorrected.

In November 1996, ICII's Board and audit committee outsourced the internal review function for ICII and its affiliates, including SPB, to KPMG Internal Audit Services, a division of KPMG LLP. This arrangement continued until 2002. After KPMG took over internal review responsibilities, regulators noted that SPB's internal control practices and procedures improved. Regulators also noted that the frequency and extent of internal reviews were appropriate for the nature and complexity of the institution. However, subsequent examinations continued to identify material deficiencies.

Our review of internal review reports, audit committee minutes, and other correspondence determined that KPMG’s internal review services for SPB were adequate. The frequency and extent of review and testing by KPMG were consistent with the nature, complexity, and risk found in SPB's on- and off-balance sheet activities. In addition, KPMG reported numerous accounting problems, internal control weaknesses, and apparent violations of law and regulations to SPB's Board. However, SPB management and the Board failed to take all necessary corrective actions, resulting in repeat internal review findings and the continuation of internal control problems at SPB.

External Audit

In reports on SPB’s financial statements, KPMG LLP rendered unqualified opinions and unqualified attestations on internal controls despite SPB’s numerous and repeated accounting problems, internal control weaknesses, and apparent violations of laws and regulations (see Appendix IV). At a minimum, KPMG should have added explanatory language to its reports. As a publicly traded company, ICII's financial statements and KPMG's opinions on the statements were publicly available. However, by not publicly disclosing SPB’s problems, KPMG defeated the purpose of accounting rules and public disclosure, i.e., to fairly, accurately, and promptly inform the public of the actual financial performance of SPB. At the same time, KPMG did not issue management letters to the bank and holding company's Boards after the 2000 and 2001 audits to inform the Boards of the bank’s internal control problems in writing. (Note: SPB was closed before its 2002 audit was completed.) These management letters would have, in turn, been forwarded by the bank to the regulators and could have been used to aid in supervising the bank. Furthermore, in addition to being SPB's independent auditor for the purpose of expressing an opinion on the financial statements, KPMG also provided non-audit services such as internal review, due diligence, and consulting to SPB and ICII. Therefore, KPMG had an apparent conflict of interest that would now be prohibited by the Sarbanes-Oxley Act of 2002, Public Law 107-204.

KPMG Did Not Assure Adequate Disclosure of SPB’s Condition

ICII’s Board engaged the accounting firm of KPMG LLP to audit the financial statements of both ICII and its subsidiaries, including SPB. Altogether, KPMG was SPB’s external auditor from 1986 until it was closed. During that period, KPMG issued unqualified opinions on SPB’s financial statements for each of the years we reviewed – 1990 through 2001 – and did not add any explanatory language to its opinions until 2001, when KPMG rendered a going concern opinion. (Note: There was substantial doubt that the bank had the resources needed to continue to operate. For more information, see Going Concern Determination in the Glossary.)

The AICPA’s Statement on Auditing Standards (SAS) 58, Reports on Audited Financial Statements, as amended, provides guidance on financial statement audit reports. Such reports may contain an unqualified opinion, an unqualified opinion with explanatory language, a qualified opinion, an adverse opinion, or a disclaimer of opinion. SAS 58, paragraph 11, states that certain circumstances, while not affecting the auditor’s unqualified opinion, may require the auditor to add an explanatory paragraph or other explanatory language to the standard report. SAS 58, paragraph 11, provides several examples in which explanatory language would be required, including: “The financial statements are affected by uncertainties concerning future events, the outcome of which is not susceptible of reasonable estimation at the date of the auditor’s report,” and: “There has been a material change between periods in accounting principles or in the method of their application.” In addition, the auditor may add an explanatory paragraph to emphasize a matter regarding the financial statements as prescribed in SAS 58, paragraph 37: “In some circumstances, the auditor may wish to emphasize a matter regarding the financial statements, but nevertheless intends to express an unqualified opinion. For example, he may wish to emphasize that the entity is a component of a larger business enterprise or that it has had significant transactions with related parties, or he may wish to emphasize an unusually important subsequent event or an accounting matter affecting the comparability of the financial statements with those of the preceding period.”

Our review of KPMG’s work papers and communications with SPB’s Board disclosed that KPMG knew about SPB’s apparent violations of laws and regulations and internal control and accounting problems through regulatory reports as well as its own audits and internal reviews. Appendix IV contains a list of the problems identified by examiners. Nevertheless, KPMG issued unqualified opinions without adding explanatory language about these problems. KPMG did not issue an opinion with explanatory language regarding SPB’s ability to continue as a going concern until after the regulators’ November 2001 report – when regulators rated SPB a composite 5 and issued a Prompt Corrective Action Directive because the bank was undercapitalized.

To comply with paragraph 11 of SAS 58, KPMG should have added explanatory language to several of its reports. KPMG should have disclosed that SPB's financial statements could have been affected by the uncertainty of the future resolution of large reconciling items, that there had been a material change between periods in application of accounting principles resulting in the reconciliation problems, and that there could be other recurring accounting problems. For example, the 1998 ROE states that, as a result of a systems conversion that began in August 1997 and other accounting problems, SPB had nearly $2.5 billion in unreconciled items in its loan control account and $900 million in unreconciled items in its cash accounts. From 1993 through 1998, KPMG reported account reconciliations as a problem in its management letters to SPB. Total assets at the bank were about $1.5 billion at the end of 1997 and $1.9 billion at the end of 1998. Therefore, therefore the financial statements could have been materially misstated, and KPMG should have acknowledged that the bank had an amount about twice its total assets in suspense accounts waiting to be properly classified. If even a small percentage of the unreconciled items were written off, the amount could have been material. Furthermore, the 1998 ROE also contained numerous references to accounting problems at SPB and stated several times that SPB management's failure to properly control accounts made the integrity and validity of financial statements questionable and caused the filing of incorrect Call Reports. (Note: Federal Financial Institutions Examination Council (FFIEC) Consolidated Reports of Condition and Income from banks and Office of Thrift Supervision (OTS) Thrift Financial Reports from savings associations – collectively referred to as Call Reports – are sworn statements of financial condition that are submitted to FDIC quarterly in accordance with federal regulatory requirements in Title 12 of the Code of Federal Regulations. Call reports consist of a balance sheet, income statement, and other supplemental information and provide detailed analyses of balances and related activity.)

Further, in accordance with paragraph 37 of SAS 58, KPMG should have added explanatory language to some of its reports regarding the comparability of financial statements. Because of the unreconciled cash and loan accounts, large unreconciled balances would have existed at the end of 1997 and 1998, making it impossible to accurately determine the balance of the cash and loan accounts at SPB. Thus, the financial statements may not have reflected the true financial condition of the bank and could not have been comparable with those of the preceding period.

KPMG Did Not Provide a Written Report of SPB’s Internal Control Weaknesses to SPB’s Audit Committee and Regulators

KPMG did not issue management letters after its 2000 and 2001 audits. Although not required by auditing standards, it would have been prudent for KPMG to have issued management letters for those audits in view of internal control problems at the bank.

SAS 60, Communication of Internal Control Related Matters Noted in an Audit, as amended, provides guidance on identifying and reporting conditions that relate to an institution's internal control over financial reporting observed during an audit of financial statements in accordance with generally accepted auditing standards. Letters issued in accordance with SAS 60 are generally referred to as management letters. SAS 60 requires that reportable conditions observed during an audit be communicated to the audit committee, preferably in writing, or to individuals with a level of authority and responsibility equivalent to that of an audit committee in organizations that do not have one. Reportable conditions are matters coming to an auditor's attention that, in his or her judgment, should be communicated to the audit committee because they represent significant deficiencies in the design or operation of internal control that could adversely affect the institution's ability to record, process, summarize, and report financial data consistent with the assertions of management in the financial statements. Such deficiencies may involve the internal control components of (a) the control environment, (b) risk assessment, (c) control activities, (d) information and communication, and (e) monitoring.

Also, banks are required by FDIC Rules and Regulations codified to 12 C.F.R. § 363.4(c), of the FDIC Rules and Regulations, to file a copy of any management letter, qualification, or other report issued by its independent public accountant with the FDIC, the appropriate federal banking agency, and any appropriate state bank supervisor within 15 days after receipt. In addition, Section 36 of the FDI Act gives FDIC, in consultation with the other federal banking agencies, authority to set accounting and auditing standards for institutions subject to Section 36. Corresponding guidance in SAS 60 states: “When there are requirements established by governmental authorities to furnish such reports, specific reference to such regulatory authorities may be made.”

Under SAS 60, management letters are not required if the Board has previously been made aware of the problem and acknowledged its consideration of the problem. Indeed, the regulators’ reports of examination covering the same periods as KPMG’s 2000 and 2001 audits identified significant internal control weaknesses and other problems at the bank. These weaknesses included an inadequate ALLL and apparent violations of laws and regulations, including the filing of inaccurate Call Reports, violation of lending limits, impermissible investments, and unlawful related-party transactions. Furthermore, our analysis of the adequacy of the ALLL (see Finding B, later in this report) indicates that the allowance was significantly understated during this time and that appropriate adjustments may have been sufficient to downgrade SPB’s capital category designation for purposes of PCA. Also, properly stating the ALLL would have reduced SPB’s operating results, which were already at a net loss for 2000 and 2001. Since KPMG did not issue management letters for its 2000 and 2001 audits, the audit firm did not formally disclose whether there were reportable conditions found during the audit. To ensure full disclosure to regulatory authorities, independent public accountants should disclose reportable conditions in a management letter or other correspondence. This would ensure that regulators are made aware of any significant internal control issues noted by the independent auditors.

Recommendation

We recommend that the Director, DSC:

1. Evaluate and pursue opportunities to emphasize and obtain written reports from independent auditors performing bank audits to bank boards of directors disclosing all reportable conditions found during audits.

Some Services Provided by KPMG Would Now Be Prohibited

KPMG had an apparent conflict of interest because its auditors performed annual financial statement audits at the same time other KPMG staff provided internal review, tax, and consulting services to SPB and ICII. Although not a violation of law at the time, this practice is now prohibited under the Sarbanes-Oxley Act and U.S. Securities and Exchange Commission (SEC) rules.

On July 30, 2002, the Sarbanes-Oxley Act of 2002 was enacted. It contains new requirements for public companies and established a new regulatory body for public accounting firms. In addition to including earlier SEC rules on auditor independence, it prescribes new requirements for registered public accounting firms and prohibits them from providing any professional services other than those provided in connection with the audit or review of the financial statements of their public clients. Subsequently, the SEC issued rules implementing the congressional mandate and strengthening requirements regarding auditor independence. Overall, the rules are intended to provide greater assurance to investors that independent auditors are performing their public responsibilities.

Requirements for external auditors under the Sarbanes-Oxley Act, most of which became effective May 6, 2003, are shown in Table 3. The table has also been annotated to show which issues affected by the Act would have been relevant to KPMG’s work at SPB.

Table 3: Sarbanes-Oxley Act Requirements for External Auditors

Source: Sarbanes-Oxley Act of 2002.

KPMG was SPB’s external auditor from 1986 until SPB was closed in 2003. SPB’s parent company, ICII, also contracted with KPMG for annual financial statement audits for itself and its subsidiaries, including SPB. As an example of a practice that is now prohibited, KPMG provided internal review services to ICII and SPB from 1996 through 2002 and performed other non-audit work such as tax, due diligence, and consulting services. In fact, KPMG was paid more for non-audit services than for its annual audits for the years 1999 through 2001. (Note: Total audit and non-audit costs were not available for 2002 because SPB was closed before its 2002 audit was completed. Further, before 1999, KPMG did not provide a breakdown of audit and non-audit fees in its SAS 61 letters to ICII’s and SPB’s boards of directors.) Fees paid to KMPG for audit and other services provided in 1999 through 2001 are summarized in Tables 4a-c and Figure 3.

Table 4a: Fees Paid to KPMG for Services Provided from 1999 to 2001 (total audit fees)

Source: KPMG letters to SPB required under SAS 61, Communication with Audit Committees

Table 4b: Fees Paid to KPMG for Services Provided from 1999 to 2001 (total non-audit fees)

Source: KPMG letters to SPB required under SAS 61, Communication with Audit Committees

Table 4c: Fees Paid to KPMG for Services Provided from 1999 to 2001 (total audit and non-audit fees)

Source: KPMG letters to SPB required under SAS 61, Communication with Audit Committees

Figure 3: Breakdown of Fees Paid to KPMG from 1999 to 2001

[This image appears in the non-508-compliant version of the audit report.]

Text description of Figure 3: The fees paid to KPMG from 1999 to 2001 include 39.6% for Annual Audit fees and 60.4% for Non-Audit Services. The Non-Audit Services of 60.4% further break out to 11.7% for Tax Matters, 39.8% for Internal Review, and 8.9% for Consulting.

Source: KPMG letters to SPB required under SAS 61, Communication with Audit Committees.

Failure To Diversify the Risk in the Bank’s Loan Portfolio

The primary cause of SPB becoming critically undercapitalized was bank management’s failure to diversify the risk in the bank’s risky loan portfolio. Specifically, management pursued a business strategy that focused on high loan growth through potentially high-risk, high-yield financing. In addition, the bank had concentrations in higher-yield and high-risk commercial loans involving the telecommunications, technology, entertainment, and airline industries. In the early 1990s, SPB grew rapidly from $56.5 million as of December 31, 1990, to $1.4 billion as of December 31, 1993. In 1995, SPB began to reposition, transform, and diversify its core business activities. That is, SPB switched from its mortgage banking operations of originating and selling conforming residential mortgage loans to commercial lending, funding mortgage banking operations, and asset-based lending through the bank's acquisition of CBC. CBC specialized in higher-yield and higher-risk commercial loans in several major industries including airlines, telecommunications, technology, and entertainment. In addition, the bank held a portfolio of participations in SNCs, several of which included the same industries listed above in which CBC had concentrated its investments. For the most part, SPB’s problems began to appear in the late 1990s when the bank’s loans in these sectors grew significantly, from $600 million in 1999 to $850 million in 2000. Asset quality had dramatically deteriorated due to weak management processes, poor loan administration practices, and high-risk workout strategies for problem credits that resulted in increased classifications. By the end of 2001, the economy was deteriorating and the compounded effects of September 11, 2001, were being felt. In particular, these events caused the airline and telecommunications credits to deteriorate at a rapid rate.

High-Risk Asset Portfolio

From 1997 through 2002, SPB suffered losses of over $325 million in the bank's commercial and industrial loan portfolios. These incurred losses caused the bank to fail and a material loss to the BIF.

SPB specialized in higher-yield and higher-risk commercial loans to the major industries previously noted, had concentrations of credit in commercial and multi-family real estate and extended mortgage warehouse lines to mortgage loan originators. The bank's underwriting standards were generally liberal as the bank targeted borrowers generally categorized as having weakened credit histories and charged interest rates commensurate with the increased risk. In the absence of an industry-wide definition of subprime commercial loans and for the purposes of this report, we use the term subprime to describe SPB’s commercial loan portfolios. During the April 1997 FDIC examination, examiners first described SPB’s loan portfolio as being centered in subprime lending, making it more sensitive to economic downturns than competing institutions with more strict underwriting requirements. From 1997 through 2002, ROEs continually noted that SPB’s borrowing base was generally subprime and warned that this type of borrowing base was riskier than the standard borrower base because subprime borrowers were normally more susceptible to economic downturns.

From 1994 and 1999 (see Figure 2) the bank changed its business strategy from engaging in mortgage lending to high-risk commercial lending. By the end of 2002, an excessive amount of problem assets in the commercial and industrial loan portfolio resulted in credit losses of $325 million that dramatically depleted the bank’s equity capital.

The major losses were centered in the bank’s largest loan division, CBC, which specialized in asset-based lending. Table 5 below provides a description of CBC’s portfolio size and losses compared to the bank’s total assets and losses.

Table 5: Comparison of CBC’s Asset Size and Losses to Those of SPB from 1996 to 2002

Source: FDIC reports of examination.

At December 31, 1993, SPB had assets of $1.4 billion and was offering FDIC-insured investment certificates, which are functionally equivalent to bank certificates of deposit. SPB also engaged in the origination of residential and income-producing real estate secured mortgage loans for its own portfolio. As a subsidiary of ICII, SPB’s primary assets consisted of mortgage loans held for sale that were originated or acquired by the ICII Mortgage Banking Business. At December 1994, the bank’s loan portfolio was divided into two major groups:

• mortgage loans originated and serviced by the bank, approximating $200 million; and
• mortgage loans originated and serviced by the parent company ICII, approximating $1,100 million. These loans were usually held on the bank’s books for less than 90 days, and were considered held for sale.

Expansion into High-Risk Assets

From 1993 through 1999, SPB management engaged in a high-risk lending strategy and expanded into commercial lending, the funding of mortgage banking operations, and asset-based lending to companies and borrowers with weakened credit histories. During that period, the bank created or acquired 10 new commercial-based lending divisions or loan portfolios and 1 consumer lending division (see Appendix V). According to FDIC examiners, many of these new business lines were pursued without an adequate loan review program and internal loan grading system. In addition, inferior underwriting and credit administration practices during a high-growth period in 1998 and 1999 exacerbated the credit problems. From 1992 through 2002, the bank suffered losses of over $373 million, of which about $325 million were in the bank’s commercial and industrial loan portfolio in 1997 through 2002.

As early as 1993, FDIC examiners voiced concern with growing asset problems. At the FDIC February 2, 1993 examination, the examiners described the overall condition of the bank as satisfactory. The bank's primary business activity was the funding of mortgage loans to be held for sale. The bank’s asset base had grown dramatically over the previous year, from $439 million to $777 million in average assets, during which time it became involved with the funding of mortgage loans, to be held for sale, for its parent, ICII. Essentially, the SPB was being used as a conduit to generate deposits to fund ICII's mortgage banking operations. ICII, which wholly-owned the bank at that time, originated the majority of the loans that were funded by the bank. As the asset base increased, ICII injected capital to protect against potential losses. Although total assets increased significantly, the risk involved was partially mitigated due to the short time the loans are actually held by the bank.

By the January 10, 1994 examination, examiner concerns arose over growing asset problems relative to the bank's permanent assets, and the level of adverse classifications represented an increase of 80 percent over the previous examination level. Adversely classified items totaled $14.7 million, of which $12.9 million, 87 percent, represented adversely classified loans. In addition, examiners noted that if ICII’s mortgage banking operations experienced significant deterioration in pre-sold loan quality and a corresponding loan origination volume decline, SPB would have a relatively riskier portfolio.

During the period of 1998–1999, adversely classified loans increased 113 percent, from $54.9 million to $116.7 million. See Table 5 for a breakdown of asset classifications and losses by examination date.

Overall, the bank’s assets were non-traditional and comprised of higher-yield and higher-risk credits. Such an asset composition was considered more susceptible to general economic conditions and cycles in industry sectors. From May 1998 through February 2001, ROEs warned that SPB would be vulnerable to national economic fluctuations due to the subprime nature of the loan portfolios. The vulnerability was primarily due to two characteristics of the thrift’s asset base: first, the borrowing base was generally subprime, which made the borrowers sensitive to economic fluctuations; second, some portfolios were sensitive to particular economic trends. For the 12 months ended December 31, 2000, the bank suffered a large loss of about $117 million, resulting in a negative 6 percent return on average assets. The principal cause of the loss was large loan loss provisions. According to examiners, however, the loan losses could be attributed to weak underwriting practices and lack of management oversight rather than economic conditions.

Coast Business Credit Division

The January 16, 1996, FDIC examination of SPB disclosed that in September 1995, the bank had acquired CoastFed Business Credit Corporation (CBBC) from Coast Federal Bank, FSB (Coast). At the time of the transaction, CBBC was a wholly-owned asset-based lending subsidiary of Coast. Immediately following the acquisition, SPB liquidated CBBC as a separate corporate entity, merged it into SPB, and renamed the division Coast Business Credit (CBC). The FDIC San Francisco Regional Office never received a merger or consolidation application regarding the acquisition and requested that SPB explain the transaction and review the application requirements of Part 303.3 of the FDIC Rules and Regulations, 12 C.F.R. §303.3, and section 18(c) of the FDI Act.

In a letter dated July 31, 1996, outside counsel for SPB responded that no regulatory application was necessary. Section 18(c) (1) of the FDI Act, codified to 12 U.S.C. §1828, provides that:

Except with the prior written approval of the responsible agency, which shall in every case referred to in this paragraph be the Corporation, no insured depository institution shall (A) merge or consolidate with any noninsured bank or institution.

Attorneys for the bank argued that the term noninsured institution was narrowly defined and included only depository institutions in which the deposits were not insured by the FDIC. According to FDIC legal counsel, SPB’s argument was contrary to the long-standing interpretation espoused by FDIC. The term noninsured institution included any noninsured entity, which would include any corporation or partnership. As a result, the definition would clearly include an entity such as CBCC, and SPB would have had to file a merger application with the FDIC before dissolving and merging CBBC into a division of the bank. On December 10, 1996, the Executive Vice President of the bank responded to the FDIC’s application request, stating that SPB had agreed to cooperate with the FDIC and provide available information; however, the bank’s response should not be construed as an admission that a merger application was required. The San Francisco Regional Director notified SPB in a March 10, 1997, letter that its regular merger application involving CBCC had been approved after the fact.

CBC focused on asset-based lending, through underwriting criteria based on cash flow and collateral rather than on earnings and net worth. Borrowers tended to be at the marginal end of the credit spectrum and generally did not qualify for credit on more conventional terms. Although the CBC was a division of the bank, CBC operated as an independent company. CBC historically concentrated its lending efforts in the technology industry. CBC loans were categorized based on the type of collateral securing the loan:

• Accounts Receivable Loans – Accounts receivable loans were revolving lines of credit that were secured principally by accounts receivable. Each borrower’s customers normally made their payments directly to CBC, usually on a daily basis. CBC deposited the payments daily and applied the funds to the borrowers’ loan balances.
  
  
• Inventory Loans. – Inventory loans were typically revolving lines of credit secured by eligible inventory that was restricted to raw materials and finished goods. Inventory loans were generally made in conjunction with accounts receivable loans to qualifying borrowers.
  
  
• Participation Loans – Participation loans consisted of term loans or revolving lines of credit in which CBC and other lenders (banks or other asset-based lenders) jointly lent to borrowers when the loan amount exceeded the lending limits of an individual lender.
  
  
• Other Loans – CBC also made term loans secured by real property, equipment, or other fixed assets. These were typically term loans with 3- to 5-year amortization periods, but were due and payable upon termination of the master loan and security agreement.

CBC Portfolio Deterioration

One of the causes of the weaknesses in the CBC loan portfolio was the poor restructuring of problem credits. The management of problem credits at CBC was ineffective and had significantly contributed to the volume and severity of adverse classifications. Two practices that exacerbated asset quality problems at CBC were the transfer of ownership and funding of over-advances. (Note: Often when a commercial borrower's financial condition declines to a level at or near insolvency, bank management pursues "peaceful possession" of the borrower’s company. A peaceful possession entails a release of the guarantors from their obligations as long as they agree to release the company to the bank without legal interference. Management then transfers ownership to a third-party workout specialist in belief that he or she will be able to either turn the company's financial condition around and/or find investors to put money into the company. In instances involving workout credits, bank management may advance funds to struggling companies over the amount supported by collateral (over-advance). This is done with the expectation that the third-party workout specialists/investors will be able to eventually turn the company around.) CBC disregarded the tenets of proper asset-based lending and caused an increase in loss exposure and substandard classifications and the deferral of loss recognition. Furthermore, SPB’s internal risk ratings did not accurately reflect the high degree of risk inherent in the loan portfolio of CBC. FDIC examiners found that the internal loan review team and the bank’s Problem Asset Committee had not accurately rated the CBC portfolio, despite an accurate portrayal of the 15 other SPB portfolios. SPB’s credit review process was not allowed to operate with a sufficient degree of independence in evaluating the CBC portfolio, resulting in inaccurate risk ratings, the deferral of loss recognition, and an under-funded loan loss reserve.

During the January 1996 examination, examiners found that the credit administration of the purchased portfolio was inadequate. CBC had already experienced loan losses of about $2.1 million since it was acquired in 1995. The examiners noted several weaknesses, which included the lack of lockbox arrangements and the lack of quarterly bank inspections of accounts receivables. Most of the loans were serviced by the institutions that sold them to the bank, and the bank appeared to be placing an undue level of responsibility on the servicers to monitor CBC’s loan portfolio. In addition, the servicers also monitored delinquencies in the serviced portfolios with little actual review performed by SPB management.

CBC continued to grow dramatically through 1998 and established aircraft-related sector concentrations. The 1998 ROE stated that because SPB’s loan portfolio was centered in subprime lending, the bank was more sensitive to economic downturns than competing institutions with stricter underwriting requirements. A large percentage of the loans were secured with real estate and, because many of these loans were backed with junior liens, collateral values could be reduced or eliminated when property values declined. Examiners advised that a recessionary environment could also impact the bank's auto lending portfolio because subprime borrowers are normally more susceptible to economic downturns and could be among the first employees to lose their jobs.

The June 1999 FDIC examination found that classifications in the CBC portfolio rose from $10 million, with no loss classifications at the last examination, to $62 million, of which $13 million was classified as loss. According to the ROE, although credit administration within CBC was capable, CBC management had a propensity to extend over-advances to very weak borrowers on the belief that the borrowers would turn their businesses around. This practice, which previously went unchecked by senior bank management, caused an expansion in the bank’s loss exposure. As a result, examiners suggested closer supervision over CBC by senior management and the Board. At the June 26, 2000 FDIC examination, examiners found that the bank had taken steps to institute requirements for approval of over-advances at higher management levels outside of CBC. Nevertheless, the oversight provided by the Senior Loan Committee proved ineffective, and the same type of risky workout strategies continued unabated.

By January 2001 credit losses had overwhelmed operating income and dramatically depleted the bank's equity capital. Risk was exacerbated by the higher-risk nature of the bank's liberal underwriting guidelines. About 79 percent of the bank's outstanding loans were concentrated in CBC, the Income Property Lending Division (IPLD), and the Loan Participation Investment Group (LPIG) portfolios: CBC represented 48 percent, the IPLD portfolio represented 23 percent, and the LPIG represented 8 percent. (Note: The IPLD made property rehabilitation loans to higher-risk customers based on the "as completed" collateral value of multi-family income-producing properties. As of October 2002, the IPLD had $242 million in total assets. Approximately 70 percent of the portfolio was secured by apartment buildings and 30 percent was secured by commercial property. Prior to 2001, all of the loans in the portfolio were classified as held for sale. During 2001, management changed its strategy and decided to retain the loans that were risk weighted at 50 percent and to sell the loans that were risk rated at 100 percent. The quality of the portfolio was generally viewed as adequate. According to examiners, although collateral properties could be categorized as class B or class C, management had priced the loans accordingly. In 1995, the bank formed the LPIG to invest in and purchase senior secured debt of other companies (participations) offered by commercial banks in the secondary market. The principal types of loans in the LPIG's portfolio were revolving lines of credit and long-term loans or letters of credit, the majority of which were reviewed under the Shared National Credit Program. Bank management stopped originating new commitments in 1998 and anticipated continued reductions in the outstanding balances as the portfolio matured.) Although SPB received a capital infusion from ICII, the viability of the bank remained uncertain. Net loan losses realized in 2000 were centered on CBC and LPIG, with net loan charge-offs of over $73 million and $32 million, respectively. The amount of charge-offs represented an aggressive attempt to rid the CBC and LPIG portfolios of problem assets. Over-advances on loans at CBC significantly contributed to the $122 million in operating losses suffered in the previous 2 years. The practice of over-advancing funds to weak borrowers had ceased. However, the previous liberal lending practices had resulted in a weakened portfolio that would likely continue to be plagued with high levels of problem loans and losses.

By the February 2002 FDIC examination, approximately 76 percent of the bank’s credit losses ($72 million) in 2001 and 74 percent of the adversely classified loans ($185 million) were originated at CBC. These problem loans were attributed to deterioration in enterprise-value type loans, as well as the economic downturn and specific weaknesses in the telecommunications and technology sectors. (Note: Enterprise value can be defined as the imputed value of a business. This valuation is often based on the anticipated or imputed sale value, market capitalization, or net worth of the borrower. The sale value is normally some multiple of sales or cash flow based on recent mergers or acquisitions of other firms in the borrower's industry. This enterprise value is often relied upon in the underwriting of leveraged loans to evaluate the feasibility of a loan request, determine the debt reduction potential of planned asset sales, assess a borrower's ability to access the capital markets, and to provide a secondary source of repayment. Consideration of enterprise value is appropriate in the credit underwriting process. However, enterprise value and other intangible values, which can be difficult to determine, are frequently based on projections and may be subject to considerable change. Consequently, reliance upon them as a secondary source of repayment can be problematic.) According to the ROE, significant losses at CBC beginning in 1998 could be traced to management's departure from lending based upon "hard” collateral. Management changed its collateral requirements and began approving "cash stream" loans. (Note: Cash stream loans are loans for which debt service is derived from consumer cash collections or consumer monthly payments. Collateral for such loans includes enterprise value; multiples of earnings before interest, taxes, depreciation, and amortization; and subscriber-based collections.) This lending change proved to be problematic and its repercussions were still being experienced over 3 years later.

CBC Problem Loan Workout Strategies

During the June 1999 FDIC examination, examiners identified weaknesses in how CBC managed problem loan workout strategies and warned that credit administration at CBC needed improvement. CBC had been allowed to operate autonomously from the bank. CBC’s managers were under employment contracts with ICII, and had been paid substantial salaries. In addition, they received annual bonuses based solely on pre-tax profitability at CBC as calculated from internally generated reports. These incentives appeared to have resulted in the failure to report problem loans and a propensity to liberally restructure credits.