Material Loss Review of First Priority Bank, Bradenton, Florida
As required by section 38(k) of the Federal Deposit Insurance Act (FDI Act), the Office of Inspector General (OIG) conducted a material loss1 review of the failure of First Priority Bank (FPB), Bradenton, Florida. On August 1, 2008, the State of Florida, Office of Financial Regulation (OFR), closed FPB and named the FDIC as receiver. On August 19, 2008, the FDIC notified the OIG that FPB’s total assets at closing were $241 million, and the estimated loss to the Deposit Insurance Fund (DIF) was $72 million.
When the DIF incurs a material loss with respect to an insured depository institution for which the FDIC is appointed receiver, the FDI Act states that the Inspector General of the appropriate federal banking agency shall make a written report to that agency which reviews the agency’s supervision of the institution, including the agency’s implementation of FDI Act section 38, Prompt Corrective Action (PCA), ascertains why the institution’s problems resulted in a material loss to the DIF, and makes recommendations to prevent future losses.
The audit objectives were to: (1) determine the causes of the financial institution’s failure and resulting material loss to the DIF and (2) evaluate the FDIC’s supervision2 of the institution, including implementation of the PCA provisions of section 38. Appendix I contains details on our objectives, scope, and methodology; Appendix 2
contains a glossary of terms. The FDIC’s response to the draft of this report is contained in Appendix 3. Acronyms used in the report are listed in Appendix 4. This report presents the FDIC OIG’s analysis of FPB’s failure and the FDIC’s efforts to require FPB’s management to operate the bank in a safe and sound manner. The FDIC OIG is performing similar analyses regarding the failure of other FDIC-supervised financial institutions. A planned capping report will summarize our observations on the major causes, trends, and common characteristics of failures resulting in a material loss to the DIF. Recommendations in the capping report will address the FDIC’s supervision of the institutions, including implementation of the PCA provisions of section 38.
BACKGROUNDFPB was a state-chartered nonmember bank, which received approval to open for business on March 27, 2003 subject to certain conditions by the OFR. The bank was insured by the FDIC effective December 8, 2003. FPB, which was headquartered in Bradenton, Florida:
FPB did not have a holding company, subsidiaries, or affiliates. FPB’s local marketplace was, at one time, characterized by rapidly appreciating real estate values. However, real estate values experienced a significant downturn, causing severe deterioration in FPB’s asset value, excessive operating losses, and severely eroded capital, and the real estate construction industry was negatively impacted.
DSC’s Atlanta Regional Office (ARO) and OFR alternated safety and soundness examinations of FPB, conducting six examinations from June 2004 through May 2008.3 DSC also conducted a visitation concurrently with an OFR examination during June 2004 and another visitation during August 2007. At the September 2007 examination,
FPB’s composite rating was downgraded to 4,4 indicating unsafe and unsound practices or conditions and a distinct possibility of failure if such conditions and practices were not satisfactorily addressed and resolved. As a result of the May 2008 examination, FPB’s composite rating was downgraded to 5, indicating extremely unsafe and unsound practices or conditions; critically deficient performance, often with inadequate risk management practices; and great supervisory concern. Institutions in this category pose a significant risk to the DIF and have a high probability of failure.
Further, with respect to selected component ratings, as indicated in the figure below, at the November 2006 examination, FPB’s management rating was downgraded to 3, and asset quality was downgraded to 2. At the following September 2007 examination, FPB’s asset quality ratings were downgraded to 4. As a result of the May 2008 examination, examiners downgraded FPB’s asset quality and liquidity ratings to 5.
FPB's Composite, Management, Asset Quality, and Liquidity Ratings[ D ]
To address examination concerns, including apparent violations of laws and regulations, inadequate risk management controls, and other safety and soundness issues, the OFR and the FDIC jointly issued a Memorandum of Understanding (MOU) in February 2008, and the FDIC issued a PCA Directive to FPB in June
2008. Additionally, in February 2008, the FDIC notified FPB that the Corporation considered the bank to be in “troubled condition” and added the institution to the FDIC’s formal problem bank list.
Details on FPB’s financial condition, as of June 2008, and for the 5 preceding calendar years follow in Table 1.
RESULTS IN BRIEF
FPB failed primarily due to bank management’s aggressive pursuit of asset growth concentrated in high-risk CRE loans with inadequate loan underwriting and a lack of other loan portfolio and risk management controls. Resulting losses severely eroded FPB’s earnings and capital, and negatively impacted liquidity, leading to the bank’s failure and a material loss to the DIF. Specifically:
Management. FPB’s Board of Directors (BOD) did not ensure that bank management identified, measured, monitored, and controlled the risk of the institution’s activities. In addition, the BOD did not ensure that corrective actions were implemented in response to examiner and auditor recommendations. Although FPB developed a business plan governing its activities, the plan was not kept current or followed. Further, FPB rapidly expanded branch and lending operations without sufficient attention to associated risk management controls. Although
rapid asset growth, declining asset quality, and poor earnings further increased liquidity risk, bank management did not put into place the necessary controls for liquidity management, including an adequate contingency liquidity plan (CLP).5
Asset Quality. FPB’s CRE/ADC loans were concentrated in a rapidly growing local marketplace. A significant portion of the loan portfolio included high-risk terms, such as high loan-to-value ratios, interest-only with balloon payments, and interest reserves used to capitalize interest expense. However, FPB did not follow sound loan underwriting standards and administration practices, including those pertaining to: (1) effectively identifying loan portfolio risk; (2) obtaining current appraisals and financial statements on borrowers and guarantors; (3) ensuring appropriate use and control over interest reserves; and (4) providing appropriate reports to the BOD on loan concentrations, speculative lending, and interest reserves. Also, FPB did not maintain a sufficient allowance for loan and lease losses (ALLL). As asset quality declined and losses were recognized, FPB’s liquidity position became critical, and earnings and capital were eroded.
Supervision. The FDIC and OFR conducted timely examinations of FPB. Additionally, the FDIC provided oversight through its off-site monitoring process and accelerated examinations as a result of identified deficiencies. As a result of the November 2006 examination, the FDIC delayed its approval of three FPB branch applications until FPB provided information on how the bank would address those examination concerns. As a result of the September 2007 examination, and after various discussions between OFR and FPB regarding the bank’s condition and proposed regulatory actions, the FDIC, in conjunction with the OFR, took supervisory action in February 2008 to address management’s failure to implement corrective actions in response to audit and examiner concerns. Such concerns included, but were not limited to, inadequate management oversight, poor asset quality, the need to increase capital and improve earnings, an inadequate ALLL, noncompliance with laws and regulations, and an outdated liquidity policy. Further, in March and May 2008, the FDIC notified FPB of applicable restrictions under PCA when FPB fell below the well capitalized category, and in June 2008, the FDIC issued a PCA Directive. The FDIC has authority to take a wide range of supervisory actions. In the case of FPB, however, supervisory actions were not always timely and effective in addressing the bank’s most significant problems.
The FDIC has taken steps to improve its supervisory review of business plans, oversight of financial institutions that have CRE loan concentrations and use interest reserves, and CLPs. However, FPB’s loan documentation and administration deficiencies should have warranted greater concern as a result of the 2006 examination. Specifically, during that examination, FPB was in a de novo6 status; the loan portfolio had begun to deteriorate and was highly concentrated in high-risk ADC loans; loan administration issues, identified as early as the FDIC’s 2004 examination, were uncorrected or in need of improvement; ALLL was inadequate; and FPB’s risk profile was
increasing. Greater concern regarding FPB’s loan documentation and administration deficiencies could have led to elevated supervisory attention and earlier supervisory action.
Examinations in 2004 and 2005 resulted in a 2 rating for FPB management. At subsequent examinations, the rating was progressively downgraded, indicating deficient BOD and management performance, risk management practices that were inadequate, and excessive risk exposure. By 2006, the bank’s problems and significant risks had been inadequately identified, measured, monitored, or controlled and required immediate action by FPB’s BOD and management to preserve the safety and soundness of the institution. In addition, FPB rapidly expanded the bank’s branch operations without regard to loan documentation and administration deficiencies and the inadequacy of other risk management controls.Ineffective BOD and Management
Examiner concerns with FPB’s BOD and management were noted at the bank’s examinations conducted in 2004 and 2005, including concerns related to excessive growth; noncompliance with laws and regulations and the OFR and FDIC final orders regarding the bank’s charter and deposit insurance approval; and FPB’s business plan.7 Many of those issues continued throughout the bank’s existence. FPB examinations showed a continuing pattern of inadequate risk management for the loan portfolio, beginning with the first examination in June 2004; growing severity regarding the lack of loan documentation; inadequate loan administration; and significant loan portfolio deterioration, culminating in an increasing risk profile for the institution. The loan documentation and administration deficiencies were repeated and compounded as noted in the 2005 through 2008 examinations. Table 2, which follows, provides examples of examiner comments and recommendations related to FPB’s BOD and management.
Table 2: Examples of Examiner Comments and Recommendations Regarding FPB’s BOD and Management Performance
* In August 2007, the FDIC conducted a visitation, which accelerated OFR’s 2007 examination and identified substantial deterioration in FPB’s condition.
Risk Management. FPB did not ensure that adequate risk management controls were implemented and followed and did not implement corrective actions in a timely manner to adequately address deficiencies identified by examiners and auditors related to the bank’s inadequate risk management controls for loan documentation, administration, and monitoring.
FPB’s loan policy stated that the bank would avoid concentrations of credit, defined as loans or certain groups of loans which, when aggregated, exceeded 25 percent of the bank’s equity capital and reserves, including combinations of loans secured by types of collateral that were particularly vulnerable to volatile market conditions. However, in contravention of this policy, FPB’s BOD and senior management focused on a strategy of aggressively growing the bank’s assets, consisting primarily of high-risk CRE loans with a heavy concentration in ADC loans. As early as the December 2004 examination, FPB’s CRE loans totaled nearly 65 percent of the loan portfolio. Total assets from June 2004 through June 2008 grew, on a cumulative basis, over 516 percent from $41 million to over $258 million, with the majority of the growth occurring in 2004 through 2006— during FPB’s de novo period. However, given such growth and an increased risk profile that resulted from FPB’s BOD and management’s decision to pursue such lending activity, the bank did not adequately identify, measure, monitor, and report regularly to the BOD on these concentrations, speculative lending, and interest reserves.
The September 2007 ROE noted that while FPB had made some improvement, the bank’s overall portfolio risk identification, measuring, monitoring, and reporting practices were ineffective. In fact, inadequate loan documentation and administration were also identified and reported by examiners in the bank’s last examination report dated May 2008. Specifically, the FDIC’s May 2008 examination concluded that during FPB’s brief history, the bank had operated with an aggressive loan growth strategy that included poorly structured and underwritten real-estate-dependent loans in a highly competitive market. The decline in real estate values and construction activity had resulted in many projects being delayed or abandoned. Nevertheless, because the bank’s risk management and loan administration practices were inadequate, the BOD was slow to recognize the increasing risk in FPB’s loan portfolio and lending program as residential real estate values started to decline.
Inadequate Actions for Apparent Violations of Regulatory Requirements.
retraining of officers and employees to prevent future infractions. Further, the Examination Manual states that it is important that the correction of all apparent violations of laws and regulations be instituted promptly, regardless of their perceived importance.
With respect to the regulatory orders, FPB did not comply with specific conditions included in the following:
FPB’s BOD and management failed to implement adequate controls to ensure compliance with laws, regulations, and other regulatory requirements, even though apparent violations were reported in each of the bank’s six examinations.
Deviations from FPB’s Business Plan. Contrary to the FDIC’s final order approving FPB’s deposit insurance, FPB significantly deviated from its business plan by quickly exceeding financial projections and budgets and realizing net losses during its de novo period that were significantly higher than planned losses. In addition, FPB disregarded loan documentation and administration controls that were outlined in its business plan. Further, the bank’s business plan indicated that the bank planned to make commercial, residential, and construction loans, including real estate acquisitions and improvements; however, the plan did not provide information regarding FPB’s intentions to concentrate its loan operations in CRE/ADC loans, which can present high risks for institutions, and rapidly expand by opening five branch offices. FPB also did not follow certain risk management controls outlined in its business plan that impacted its lending policy and practices.
Proposed financial institutions are expected to submit business plans with their initial applications for federal deposit insurance. According to the FDIC Statement of Policy on Applications for Deposit Insurance, and in compliance with sections 5 and 6 of the FDI Act, the FDIC must be assured that the proposed institution does not present an undue risk to the DIF. The FDIC expects that proposed institutions will submit a business plan commensurate with the capabilities of its management and the financial commitment of the incorporators. Any significant deviation from the business plan within the first 3 years of operation—the de novo phase—must be reported by the insured depository institution to the primary federal regulator before consummation of the change. Business plans that rely on high-risk lending, a special-purpose market, or significant funding from sources other than core deposits, or that otherwise diverge from conventional bank-related financial services, require specific documentation as to the suitability of the proposed activities for an insured institution. Similarly, additional
documentation of a business plan is required where markets to be entered are intensely competitive or economic conditions are marginal. Business plans also include information on projected financial data for a 3-year period.
Soon after FPB’s opening, examiners concluded that the bank had significantly deviated from its business plan and initial financial projections, and FPB’s asset growth had quickly exceeded the revised October 2003 projections. FPB’s July 2004 revised business plan and financial projections reflected the significant deviations which included, but were not limited to (1) increased asset growth, (2) expanding branch office operations, and (3) an additional capital infusion. In addition, FPB did not follow risk management controls outlined in the bank’s business plan related to its loan portfolio (see Table 3 for examples).Table 3: FPB’s Business Plan Compared to FPB’s Actions
FPB Branch Offices. FPB’s original business plan was conservative; however, the bank soon departed from its plan and embarked on an aggressive growth/branching strategy. Of particular note is the bank’s decision to rapidly expand branch operations. As indicated in Table 4, applications for three FPB branch offices were submitted, accepted, and approved by the FDIC after its November 2006 examination began, during which significant examiner concerns regarding the bank’s compliance with laws and regulations, loan administration and documentation, CRE/ADC concentration, inadequate ALLL, inadequate BOD and management performance, deviations from the banks business plan, and weak earnings were reported.
Table 4: FPB Application History and Examiner Concerns
During the November 2006 examination, the examiner noted that aggressive branching plans underscored the need to significantly improve the loan review and administration functions. Further, during the examination, the bank’s chief loan officer resigned, creating additional loan monitoring challenges. Within its short existence, FPB opened five branch offices and three loan production offices (LPO) without adequate consideration of examiner concerns regarding the bank’s loan documentation and administration and other risk management control weaknesses and inadequate monitoring and management of the bank’s growth. In addition, FPB’s additional branch offices increased the bank’s overhead costs; placed additional strain on earnings, which had been historically weak; and contributed to the bank’s increasing reliance on non-core deposits to fund its asset growth.
Lack of a Comprehensive CLP. FPB did not implement sound liquidity risk management controls that included a comprehensive CLP. As a result, when FPB’s asset quality severely deteriorated, the bank’s liquidity position was impacted by negative publicity related to the bank’s financial condition. According to the Examination Manual, CLPs
should be in force and should include strategies for handling liquidity crises and procedures for addressing cash flow shortfalls in emergency situations. The manual also states that financial institutions should have an adequate CLP in place to manage and monitor liquidity risk, ensure that an appropriate amount of liquid assets is maintained, measure and project funding requirements during various scenarios, and manage access to funding sources.
FPB demonstrated warning indicators that should have prompted FPB of the need for a comprehensive CLP and increased monitoring of the bank’s liquidity position by the bank’s BOD and management. For example, FPB exhibited indicators such as:
The FDIC issued Financial Institution Letter—FIL-59-2003—entitled, Use of the Federal Reserve’s Primary Credit Program in Effective Liquidity Management, dated July 23, 2003, which provides interagency guidance on the need for financial institutions to develop CLPs, in addition to other liquidity risk management controls, and informs depository institutions that a contingency plan should be part of the bank’s liquidity management program. In addition, the Examination Manual includes 13 suggested elements that should be included in CLPs. However, FPB’s CLP included only 3 of those 13 elements. FPB’s CLP identified sources of funding but did not identify the conditions related to their use and circumstances where the institution might use them. For example, the CLP did not:
Further, FPB’s CLP was not diversified to allow consideration of potential providers of funds and the underlying stability, availability, and flexibility of funding sources.
FPB’s BOD and management had failed to implement adequate controls to monitor the bank’s liquidity risk. The September 2007 examination identified significant deterioration in FPB’s loan portfolio, a high level of adverse classifications, significant downgrades in loans from the bank’s internal watch list, and an inadequate ALLL. After October 2007, FPB’s asset liability committee failed to monitor, strategize, and otherwise plan for FPB’s liquidity needs, even though the bank’s financial condition was severely deteriorating.
FPB’s loan portfolio deterioration became even more critical after the bank’s September 2007 examination, which identified significant deterioration in FPB’s asset quality. FPB’s liquidity position was monitored solely by the chief financial officer, who managed the bank’s liquidity by focusing almost exclusively on maintaining sufficient liquidity to avert a crisis. As FPB’s financial position continued to deteriorate due to poor asset quality, the bank’s liquidity position was adversely affected. Specifically, FPB’s net interest margin declined, and earnings and capital positions were adversely affected. In addition, FPB was required to pledge investment securities to secure the bank’s lines of credit. Further, the bank lacked adequate controls and potential sources to address liquidity shortfalls and the resultant crises, and negative publicity impacted the bank’s liquidity position.Regulatory Supervision Related to Management
According to the Examination Manual, the quality of management is probably the single most important element in the successful operation of a bank. The BOD is responsible for formulating sound policies and objectives for the bank, effective supervision of its affairs, and promotion of its welfare, while the primary responsibility of senior management is implementing the BOD’s policies and objectives in the bank’s day-to-day operations. Also according to the manual, the capability and performance of management and the BOD is rated based upon, but not limited to, an assessment of compliance with laws and regulations.
Generally, FPB provided written responses to each examination and promised corrective actions, and examiners generally followed up on any recommendations at the next examination. However, in response to the 2006 examination, the FDIC followed up with FPB between examinations, requiring FPB to provide information on addressing the 2006 examination loan administration and documentation issues and improving earnings (both management and earnings were rated 3 at the 2006 examination). In its response to the FDIC on January 29, 2007, FPB stated it had taken steps to hire new management, including a chief credit officer and commercial loan portfolio manager; increased the loan department staff; and initiated actions to improve loan administration. Although the FDIC accepted FPB’s response, FPB failed to implement actions to sufficiently address the 2006 examination results and to prevent the continued deterioration of FPB’s financial condition.
In addition, according to the DSC Case Manager Procedures Manual, the risk posed by any particular institution is a function of the business plan pursued, management’s competency in administering the institution’s affairs, and the quality and implementation of risk management programs. Regarding FPB’s business plan, examiner concerns seemed to focus on the bank’s financial projections and did not include an assessment of FPB’s planned business strategy and risk management controls compared to the bank’s actual practices. Although DSC required FPB to provide updated financial and budget data, DSC did not require FPB to provide a revised business plan that addressed the bank’s concentrations in CRE/ADC loans that presented high risks to the bank and the bank’s plan to mitigate such risk through appropriate loan documentation, administration, and lending strategies.
Regarding FPB’s branch office activities, examiners downgraded FPB’s management and earnings ratings from 2 to 3 and downgraded asset quality from 1 to 2 as a result of the 2006 examination. According to the DSC Case Manager Procedures Manual, an application can be removed from expedited processing if DSC determines that the bank’s application presents significant supervisory concerns, including a management rating of 3. Accordingly, after the November 2006 examination, the FDIC removed three FPB branch applications (for FPB’s third, fourth, and fifth branch offices) from the expedited approval process because the BOD and management had not:
The FDIC’s decision-making process for FPB’s branch applications included an assessment of FPB’s financial data and branching strategy. In addition, pursuant to sections 5 and 6 of the FDI Act, DSC officials evaluated FPB’s applications for branch offices to conclude on the:
DSC officials also evaluated the applications to determine whether FPB’s corporate powers were consistent with the purposes of the FDI Act.
Before the FDIC approved FPB’s applications for its third and fourth branch offices, the FDIC proactively required FPB to respond to the November 2006 examination deficiencies, submit revised financial projections reflecting the proposed branches, and discuss the bank’s earnings improvement plan. In its response, FPB projected net income of $263,000, which DSC considered realistic. In addition, FPB stated that in August 2006, FPB had hired a chief credit officer, who was expected to have a positive impact on credit administration and portfolio monitoring systems, and hired a new senior lender in December 2006. Additionally, the BOD stated its commitment to correct the weaknesses noted in the ROE and provided corrective action plans to address the weaknesses.
Regarding FPB’s application for its fifth branch office, the FDIC requested FPB to provide a copy of the bank’s strategic/business plans for 2007 and 2008, including assumptions and branching plans; supporting assumptions for the 2007 budget; and copies of CRE loan concentration reports provided to the BOD. The FDIC reviewed FPB’s revised financial projections, which included the three branches in 2007 and a conservatively maintained ALLL throughout the 2-year period and reflected a nominal loss of $28,000 in 2007 and net income of $693,000 in 2008. However, from the time FPB responded to the FDIC’s concerns related to the third and fourth branch offices to its response for the fifth branch, the bank’s net income projections for 2007 had changed from $263,000 to a projected net loss of $28,000—a decrease of $291,000.
Nevertheless, the FDIC concluded that:
Additionally, FPB committed to the FDIC that it had no additional branching plans through 2008. However, soon after FPB’s last branch office opened on July 16, 2007, the FDIC’s offsite analysis and follow-up visitation conducted in July and August 2007, respectively, identified significant deterioration in FPB’s financial condition, earnings, and asset quality; and loan documentation and administration deficiencies, indicating ineffective corrective actions to address prior examiner concerns and FPB’s deficient risk management controls. Further, the FDIC assessed FPB’s branch applications based on statutory requirements and delayed application approvals; however, the actions taken and promised by FPB ultimately did not resolve examiner concerns, overall operational deficiencies, or earnings performance issues (see Table 2).
Previous guidance related to business plans did not provide a definition of significant deviations; accordingly, in June 2008, DSC’s ARO issued guidance for determining what constitutes a major deviation or material change in business plans for de novo institutions during the first 3 years of operation. That guidance states that examiners should consider whether changes have occurred in growth levels, asset and liability mix or products offered, and plans for branch offices or LPOs.
Although FPB had not developed a comprehensive CLP, examiners did not recommend that the bank review and revise its CLP to adequately address the 13 plan elements listed in the Examination Manual. FPB had not developed controls that could have identified the specific circumstances under which secondary sources of funds should be used and the manner in which those funds would be used to provide liquidity for the bank.
Subsequent to FPB’s failure, DSC issued additional guidance related to liquidity risk and CLPs. The FDIC’s Liquidity Risk Management guidance, dated August 26, 2008, urges the financial institution BOD to establish a formal CLP that establishes quantitative liquidity risk guidelines. The guidance also states that CLPs should identify the institution’s liquidity risk profile and the types of stress events that may be faced including, but not limited to, a deterioration in asset quality, becoming less than well capitalized, the need to fund unplanned asset growth, loss of access to market funding sources, and the impact of negative press coverage. The guidance also reiterates many of the CLP elements that FPB’s CLP did not include, as discussed earlier.
FPB’s asset quality was rated 1 at its 2004 and 2005 examinations. At subsequent examinations, FPB’s asset quality rating was progressively downgraded, indicating that the bank’s level of risk and problem assets were significant and inadequately controlled and subjected the bank to potential losses that threatened the viability of the institution. By the May 2008 examination, examiners concluded that FPB’s asset quality or credit administration practices were critically deficient and presented an imminent threat to the institution’s viability.
FPB’s asset quality deteriorated as total adversely classified items increased to over $65.7 million in 2008. In particular, loan classifications significantly increased, from $5.7 million in 2006 to over $60.1 million in 2008. Corresponding increases in the FPB’s adversely classified loans and ALLL were also significant (see Table 5). At the November 2006 examination, adversely classified loans represented 15.66 percent of capital, and by May 2008, adversely classified loans totaled more than 403 percent of capital.Table 5: FPB Asset Classifications and ALLL
In addition to identification of the $5.7 million in adversely classified assets at the 2006 examination, examiners identified another $4.6 million in assets as “Special Mention,” referring to loans that had potential weaknesses that deserved management’s close attention and, if left uncorrected, could result in deterioration of the status of those assets.Examiner Concerns and Recommendations Regarding Asset Quality
Examiner concerns regarding FPB’s asset quality related to its concentration in high-risk CRE/ADC loans and the bank’s lack of adequate loan documentation and administration (see Table 6, which follows). A significant portion of the CRE/ADC loan portfolio included high-risk terms, such as high loan-to-value ratios, an interest-only basis with balloon payments, and interest reserves used to capitalize interest expense.
Table 6: Examples of Examiner Comments and Recommendations Regarding FPB’s Asset Quality
* Refer to Table 2 for additional examples of examiner comments and recommendations related to FPB’s asset quality, including those for the FDIC’s August 2007 visitation.
Concentration in CRE and ADC Loans
FPB’s concentration in CRE loans was first noted during the FDIC’s December 2004 examination when those loans comprised 65 percent of the loan portfolio. DSC ROEs and examination work papers documented that steady and rapid increases in CRE-related exposure followed as indicated below.
On December 12, 2006, the federal banking agencies issued joint guidance on CRE lending entitled, Guidance on Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices. According to the guidance, the FDIC and the other federal banking agencies acknowledged that a concentration in CRE loans, coupled with weak loan underwriting and depressed CRE markets, has contributed to significant loan losses.8
However, FPB focused and concentrated its loan portfolio in CRE/ADC loans, which increased its level of risk, and failed to ensure that adequate risk management controls were developed and implemented. Examiners recommended several actions to mitigate the bank’s CRE risk. However, bank management failed to implement actions to adequately address those recommendations, and asset quality continued to decline. Further, beginning with the November 2006 examination, and continuing through the May 2008 examination, examiners identified a high level of adverse classifications along with significant downgrades of classified loans, an inadequate ALLL
methodology, and inadequately funded ALLL. As asset quality declined and losses were properly recognized, FPB’s liquidity position became deficient, and earnings and capital were eroded.
Interest Reserves. FPB did not have appropriate controls related to the use and reporting of interest reserves. FPB’s December 8, 2003 loan policy stated the bank should include provisions in the loan agreement that provide for the discontinuation of funding of the interest reserve in the event the project falls behind projected performance goals. However, FPB did not always follow this policy in that management extended or re-funded the interest reserves for many loans. In addition, FPB did not maintain complete records on the extent and number of loans funded with interest reserves or the extent of loans for which interest reserves had been funded multiple times. Through reconstruction of FPB records, the OIG determined that FPB used about $8.9 million in interest reserves to fund loans. Of that amount, $4.5 million (about 51 percent) was associated with FPB’s adversely classified loans. The use of interest reserves helped to mask the deterioration of these loans.
DSC has issued guidance on the use of interest reserves. In November 2007, the ARO issued guidance entitled, Identification and Analysis of Interest Reserves at Risk Management Examinations. In April 2008, DSC issued examiner guidance reiterating the November 2007 ARO guidance. In addition, in June 2008, DSC issued guidance to examiners and FDIC-supervised financial institutions on the use of interest reserves that describes the use of interest reserves in ADC lending, examines the risk this underwriting practice could present, and identifies “red flags” that should alert lenders to potential problems at each stage of the ADC cycle.
Allowance for Loan and Lease Losses. FPB’s methodology for determining the ALLL did not comply with interagency policy. According to the Interagency Policy Statement on the Allowance for Loan and Lease Losses (FIL-105-2006), dated December 13, 2006, each institution must analyze the collectibility of its loans and maintain an ALLL at a level that is appropriate and determined to be in accordance with Generally Accepted Accounting Principles (GAAP).9 An appropriate ALLL covers estimated loan losses on individually evaluated loans that are determined to be impaired as well as estimated loan losses inherent in the remainder of the loan and lease portfolio.
Although the November 2006 examination concluded that FPB’s ALLL methodology was adequate, examiners recommended that FPB increase the ALLL by $1.1 million due to adversely classified loans that totaled $5.7 million. However, in subsequent examinations, examiners’ conclusions regarding the adequacy of the ALLL methodology changed. Specifically, examiners concluded that FPB’s ALLL methodology did not comply with interagency guidance included in FIL-105-2006. Examiners recommended significant increases in FPB’s ALLL to compensate for FPB’s inaccurate methodology and to provide for the increased amount of adversely classified loans examiners identified.
Examiners determined that shortages in ALLL could be attributable to the bank’s slow identification of problem loans and to an ineffective ALLL methodology that failed to follow the interagency policy on ALLL and GAAP. As FPB’s assets deteriorated and the need to substantially increase the ALLL became apparent, earnings and capital were significantly impacted. FPB reported net losses for almost each year of operation (see Table 7).Table 7: FPB Net Income or Loss (Dollars in Thousands)
* Data is as of June 30, 2008 UBPR Report.
According to the FDIC’s documentation on FPB’s applications, revised financial projections provided by FPB reflected that FPB expected a nominal loss of $28,000 for 2007 and showed a net income of $693,000 for 2008. However, as indicated in Table 7, the financial projections were grossly inaccurate. Further, during the exit meeting with OFR examiners after the bank’s September 2007 examination, FPB officials attributed the bank’s earnings problem to the bank’s strategy for new branch offices at a time when the real estate market began to decline and stated that the lack of earnings was a “self-inflicted” problem.
Regulatory Supervision Related to Asset Quality
FPB’s loan administration deficiencies should have warranted greater supervisory concern during the November 2006 examination when FPB was still in a de novo status and had experienced significant growth in its loan portfolio between 2004 and 2006. In addition, FPB exhibited the following risk factors that DSC has determined to be associated with de novo institutions:
FPB’s BOD and management aggressively grew its loan portfolio although the bank had not adequately identified, measured, monitored, or controlled risks; including implementing actions to address examiner concerns related to loan documentation and administration deficiencies. Specifically, as a result of the 2006 examination, DSC concluded that FPB’s loan portfolio had begun to deteriorate noticeably and was highly concentrated in CRE/ADC loans, which presented a higher risk for the bank; loan administration issues, which had been identified as early as the 2004 examination and by internal auditors in 2004 and 2005, remained uncorrected or in need of improvement. DSC also concluded that FPB’s risk profile was increasing.
According to the Examination Manual, the asset quality rating reflects the quantity of existing and potential credit risk associated with the loan and investment portfolios, and other assets. The ability of management to identify, measure, monitor, and control credit risk and the evaluation of the adequacy of the ALLL are also reflected in the asset quality rating. The Examination Manual provides guidance on which rating level is appropriate based on issues identified by examiners. For example, the Examination Manual states that a rating of 3 is assigned when:
At the November 2006 FDIC examination, examiners assessed the condition of the bank’s loan portfolio and concluded that asset quality was satisfactory; however, noticeable loan portfolio deterioration had occurred since the prior examination. Adversely classified loans exceeded $5.7 million, which represented 15.66 percent of Tier 1 Leverage Capital. In addition, loans cited as Special Mention for their underwriting deficiencies exceeded $4.6 million. Collectively, $10.3 million in criticized loans represented 28.31 percent of Tier 1 Leverage Capital.
Examiners also concluded that, while the level and severity of classified loans was low in relation to capital, noticeable loan portfolio deterioration had occurred since the last examination. Examiners also noted that the emergence of substandard and loss loans in the bank’s third year of operations was unusual and reflected increased significance given the elevated and increasing risk profile of the institution and the bank’s pattern of weak underwriting practices. As a result, examiners made several recommendations to improve FPB’s risk management for CRE/ADC loans (see Tables 2 and 6).
In addition, at the 2006 examination, although examiners concluded that FPB’s methodology for determining the adequacy of the ALLL was adequate, examiners also concluded that, based on the significant amount of adversely classified loans, FPB would need to increase the ALLL by up to $1.1 million by December 31, 2006.
Further, at the November 2006 examination, examiners noted that risk management policies and practices for the loan function were not adequate and identified numerous loan administration shortcomings that appeared to be systemic in nature. Despite modest improvements since the prior examination related to loan documentation and administration weaknesses, the examiners emphasized the need for further improvement. For example, the ALLL was inadequate, a significant number of loan files were found to be deficient, and exceptions to supervisory loan-to-value guidelines reported to the BOD each quarter were found to improperly exclude certain loans.
However, the examiners’ evaluation of FPB’s asset quality at the November 2006 examination was based on the total of adversely classified loans—15.66 percent of Tier 1 Leverage Capital—and did not consider the systemic nature of deficiencies in loan documentation and administration or a qualitative assessment of the bank’s elevated CRE risk exposure, which the examiner concluded might adversely impact the bank’s financial condition. DSC officials stated that the loan documentation and administration deficiencies identified during the 2006 examination were addressed in the examiners’ decision to downgrade FPB’s management to 3 and asset quality to 2.
After the November 2006 examination, DSC’s offsite monitoring of FPB’s condition in July 2007 reflected a significant increase in past due and nonaccrual loans and additional charge-offs based on March 31, 2007 financial data. Although FPB’s earnings continued to be weak, the bank was scheduled to open three branch offices in 2007. As a result of these concerns, the DSC regional office requested the DSC field office to conduct a targeted visitation to review the actions taken by FPB management to:
OFR to accelerate its scheduled full-scope examination, which was conducted in September 2007. The FDIC also issued a problem bank memorandum in January 2008.
On February 8, 2008, the OFR and the FDIC jointly issued an MOU10 to FPB. The MOU, among other things, required FPB to:
Although the 2008 MOU addressed issues related to FPB’s asset quality and loan administration and documentation, greater concern during the 2006 examination, regarding the severity of these deficiencies and FPB’s history of not adequately addressing these issues for more than 2 years, could have led to elevated supervisory attention and earlier supervisory action.
IMPLEMENTATION OF PCA
The purpose of PCA is to resolve problems of insured depository institutions at the least possible long-term cost to the DIF. PCA establishes a system of restrictions and mandatory and discretionary supervisory actions that are to be triggered depending on an institution’s capital levels. Part 325 of the FDIC’s Rules and Regulations implements PCA requirements by establishing a framework for taking prompt corrective action against insured nonmember banks that are not adequately capitalized.
The FDIC evaluated FPB’s capital position; assigned capital component ratings; included capital-related provisions in informal and formal actions, including a PCA Directive, in accordance with regulatory guidelines; and provided PCA notification letters. The FDIC’s November 2005 examination concluded that FPB’s declining trend in
capital ratios was a result of the bank’s asset growth and that, in order to remain well capitalized given its significant growth rate, FPB had raised additional capital through a second stock offering. In fact, FPB’s rapid growth from 2003 to 2006—the bank’s de novo period— was supported by significant stock issuances to raise more than $35 million in capital, as shown in Table 8 below.Table 8: FPB Capital Stock Issuances
As of December 31, 2007, DSC officials concluded that FPB’s capital position had deteriorated and, considering FPB’s decline in capital, excessive level of problem assets, significant concentration in CRE loans relative to capital, and questionable earning prospects, the institution’s capital was considered to be marginal. On February 8, 2008, the FDIC and OFR jointly issued an MOU. The MOU included provisions related to capital and required FPB to:
In its Consolidated Report of Condition and Income (Call) Report, dated December 31, 2007, FPB reported that it held brokered deposits totaling $13.5 million. On March 14, 2008, the FDIC issued a letter restricting FPB’s use of brokered deposits because FPB’s capital category fell below the well capitalized category. In response to the FDIC’s letter, FPB notified the FDIC that it had not rolled over or renewed any brokered deposits.
On May 1, 2008, the FDIC notified FPB that based on its March 31, 2008 Call Report data, FPB was considered to be significantly undercapitalized for PCA purposes. The FDIC required FPB to develop and submit a capital restoration plan (CRP) within 45 days of April 30, 2008. The plan was to provide information on:
The bank submitted its CRP on June 6, 2008, which the FDIC reviewed and requested FPB to update. On June 25, 2008, the FDIC issued a PCA Directive. Mandatory actions included the submission of another CRP and restrictions on asset growth, acquisitions, new activities, new branches, payment of dividends or making any other capital distribution, or payment of management fees.
PCA’s focus is on capital, and capital can be a lagging indicator of an institution’s financial health. In addition, the use of PCA Directives depends on the accuracy of capital ratios in a financial institution’s Call Reports. FPB’s capital remained in the well capitalized to adequately capitalized range long after its operations had begun to deteriorate because of problems related to management, asset quality, risk management controls, and net losses. In particular, the ALLL was significantly underfunded which overstated capital and underreported the deterioration of the loan portfolio.
FPB’s efforts to comply with the MOU to improve the bank’s condition and raise additional capital proved unsuccessful. Further, by the time FPB’s capital level fell below the required threshold necessary to implement PCA, the bank’s condition had deteriorated to the point at which the institution could not raise additional needed capital, estimated to total $30 million, through its BOD or find other investors to assist in capitalizing the bank.
On February 12, 2009, the Director, DSC, provided a written response to the draft report. DSC’s response is provided in its entirety as Appendix 3 of this report. In its response, DSC agreed with the OIG’s conclusions regarding the causes of FPB’s failure and the resulting material loss to the DIF, and DSC’s supervisory activities related to FPB. DSC also agreed that the November 2006 examination results related to the loan documentation and administration deficiencies should have warranted greater supervisory action.
DSC also stated that it has undertaken a number of initiatives related to the supervision of financial institutions that have high-risk lending activities, including concentrations in CRE and/or the use of interest reserves.
Additionally in December 2008, DSC conducted on-site visitations of certain financial institutions that resulted in downgraded ratings and initiating corrective programs.
It should be noted the OIG did not conclude on specific examination ratings or supervisory actions. Rather, we evaluated the FDIC’s overall supervision of the institution. In this regard, we concluded that greater supervisory concern was warranted as a result of the 2006 examination due to the deficiencies identified, the de novo status of the institution, and its increasing risk profile.
OBJECTIVE, SCOPE, AND METHODOLOGY
Due to the limited nature of the audit objectives, we did not assess DSC’s overall internal control or management control structure. We performed a limited review of FPB’s management controls pertaining to its operations as discussed in the finding section of this report. For purposes of the audit, we did not rely on computer-processed data to support our significant findings or conclusions. Our review centered on interviews, ROEs, and correspondence and other evidence to support our audit.
The Government Performance and Results Act of 1993 (the Results Act) directs Executive Branch agencies to develop a customer-focused strategic plan, align agency programs and activities with concrete missions and goals, manage and measure results to justify appropriations and authorizations, and design budgets that reflect strategic missions. For this material loss review, we did not assess the strengths and weaknesses of DSC’s annual performance plan in meeting the requirements of the Results Act because such an assessment was not part of the audit objectives. DSC’s compliance with the Results Act is reviewed in OIG program audits of DSC operations.
Regarding compliance with laws and regulations, we performed tests to determine whether the FDIC had complied with the provisions of PCA and limited tests to determine compliance with certain aspects of the FDI Act. Additionally, we assessed the risk of fraud and abuse related to our objectives in the course of evaluating audit evidence.
GLOSSARY OF TERMS
|Adversely Classified Assets||
Assets subject to criticism and/or comment in an ROE. Adversely classified
assets are allocated on the basis of risk (lowest to highest) to three
|Concentration||A concentration is a significantly large volume of economically related assets that an institution has advanced or committed to a certain industry, person, entity, or affiliated group. These assets may, in the aggregate, present a substantial risk to the safety and soundness of the institution.|
|Loan Loss Reserve also called Allowance for Loan and Lease Losses (ALLL)||Federally insured depository institutions must maintain an ALLL level that is adequate to absorb the estimated credit losses associated with the loan and lease portfolio (including all binding commitments to lend). To the extent not provided for in a separate liability account, the ALLL should also be sufficient to absorb estimated loan losses associated with off-balance sheet loan instruments such as standby letters of credit.|
|Memorandum of Understanding (MOU)||An informal corrective administrative action for institutions considered to be of supervisory concern but which have not deteriorated to the point where they warrant formal administrative action. As a general rule, an MOU is to be considered for all institutions rated a composite 3.|
|Prompt Corrective Action (PCA)||The purpose of PCA is to resolve the problems of insured depository institutions at the least possible long-term cost to the DIF. Part 325 of the FDIC Rules and Regulations, 12 Code of Federal Regulations section 325.101, et. seq., implements section 38, Prompt Corrective Action, of the FDI Act, 12 United States Code section 1831(o), by establishing a framework for taking prompt supervisory actions against insured nonmember banks that are less than adequately capitalized. The following terms are used to describe capital adequacy: Well Capitalized, Adequately Capitalized, Undercapitalized, Significantly Undercapitalized, and Critically Undercapitalized.|
|Uniform Bank Performance Report (UBPR)||The UBPR is an individual analysis of a financial institution’s financial data and ratios that includes extensive comparisons to peer group performance. The Federal Financial Institutions Examination Council produces the UBPR quarterly, from Call Report data submitted by banks, for use by banking supervisors, bankers, and the general public.|
February 12, 2009
Pursuant to Section 38(k) of the Federal Deposit Insurance Act (FDI Act), the Federal Deposit Insurance Corporation's Office of Inspector General (OIG) conducted a material loss review of First Priority Bank (FPB), Bradenton, Florida, which failed on August 1, 2008. This memorandum represents the response of the Division of Supervision and Consumer Protection (DSC) to the OIG's Draft Report received January 23, 2009.
We are pleased that the OIG generally agrees with the results of DSC's supervisory processes. The OIG found that the FDIC and the State of Florida, Office of Financial Regulation conducted timely examinations of FPB; the OIG agreed with the ratings assigned at each regulatory examination; and the OIG found that DSC properly exercised its responsibilities under Prompt Corrective Action and followed its internal policies in processing applications for the establishment of branches.
Second, we agree with the OIG's assessment that FPB failed primarily due to management's aggressive pursuit of asset growth concentrated in high-risk Commercial Real Estate (CRE) loans with inadequate loan underwriting and lack of other loan portfolio and risk management controls. The resulting loan losses severely eroded FPB's earnings and capital, leading to the bank's failure and a material loss to the Deposit Insurance Fund.
Lastly, we agree, in hindsight, with the OIG's assessment that credit administration deficiencies identified by examiners should have warranted supervisory action at the 2006 examination. Examiners had identified weaknesses at the prior two examinations and made recommendations for improvements, yet management did not fully implement these recommendations. The identified weaknesses were then exacerbated by rapidly deteriorating economic conditions, most notably in the Construction and Development (C&D) sector.
In light of the economic deterioration and its impact on FPB and other similarly situated institutions, DSC undertook a number of initiatives of which we wish to make OIG aware:
ACRONYMS IN THE REPORT
|ADC||Acquisition, Development, and Construction|
|ALLL||Allowance for Loan and Lease Losses|
|ARO||Atlanta Regional Office|
|BOD||Board of Directors|
|CAMELS||Capital, Asset Quality, Management, Earnings, Liquidity, and Sensitivity to Market Risk|
|CD||Certificate of Deposit|
|C&D||Cease and Desist|
|CFO||Chief Financial Officer|
|CLP||Contingency Liquidity Plan|
|CRE||Commercial Real Estate|
|CRP||Capital Restoration Plan|
|DIF||Deposit Insurance Fund|
|DRR||Division of Resolutions and Receiverships|
|DSC||Division of Supervision and Consumer Protection|
|FDI||Federal Deposit Insurance|
|FHLB||Federal Home Loan Bank|
|FIL||Financial Institution Letter|
|FPB||First Priority Bank|
|GAAP||Generally Accepted Accounting Principles|
|LPO||Loan Production Office|
|MOU||Memorandum of Understanding|
|OFR||Office of Financial Regulation|
|OIG||Office of Inspector General|
|PCA||Prompt Corrective Action|
|ROE||Report of Examination|
|UBPR||Uniform Bank Performance Report|
|UFIRS||Uniform Financial Institution Rating System|
|Last updated 3/16/2009|