Material Loss Review of Freedom Bank of Georgia, Commerce, Georgia
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 Freedom Bank of Georgia (Freedom), Commerce, Georgia. On March 6, 2009, the Georgia Department of Banking and Finance (GDBF) closed the institution and named the FDIC as receiver. On March 20, 2009, the FDIC notified the OIG that Freedomís total assets at closing were $176.4 million and the material loss to the Deposit Insurance Fund (DIF) was $36.2 million. Since that time, the loss decreased to $35.8 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 agencyís supervision of the institution, including the agencyís implementation of FDI Act section 38, Prompt Corrective Action (PCA); ascertains why the institutionís 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 institutionís failure and resulting material loss to the DIF and (2) evaluate the FDICís supervision2 of the institution, including implementation of the PCA provisions of section 38 of the FDI Act. Appendix 1
contains details on our objectives, scope, and methodology; Appendix 2 contains a glossary of terms; Appendix 4 contains a list of acronyms used in the report.
This report presents the FDIC OIGís analysis of Freedomís failure and the FDICís efforts to ensure Freedomís management operated the bank in a safe and sound manner. We are not making recommendations. Instead, as major causes, trends, and common characteristics of financial institution failures are identified in our reviews, we will communicate those to management for its consideration. As resources allow, we may also conduct more in-depth reviews of specific aspects of the FDICís supervision program and make recommendations, as warranted.
Freedom was a state-chartered non-member bank, established by the GDBF and insured by the FDIC effective February 17, 2004. Freedom, which was headquartered in Commerce, Georgia:
A summary of Freedomís total assets, deposits, loans, and net income or loss, as of December 2008, and for the 4 preceding calendar years follow in Table 1.
Table 1: Financial Condition of Freedom
CAUSES OF FAILURE AND MATERIAL LOSS
Freedom failed primarily due to the bankís rapid growth and the Board of Directorsí (BOD) failure to ensure that bank management identified, measured, monitored, and controlled the risk associated with the institutionís lending activities. Specifically, bank management materially deviated from its business plan and did not exercise proper oversight over the bankís significant concentrations in residential real estate construction and development. In addition, loan underwriting, credit administration, and other risk management practices were
inadequate. Deficient oversight of high concentrations, coupled with weak risk management practices and controls, negatively impacted the bankís ability to effectively manage operations in a declining economic environment.
The weaknesses in Freedomís loan portfolio were accentuated by a downturn in the bankís market area. Declining earnings resulting from the deteriorating quality of loans in Freedomís concentrations, in the face of an economic downturn, severely eroded the bankís capital. In turn, the bankís liquidity became deficient considering the level of risk exposure to the bankís capital and earnings; and the wholesale funding sources that Freedom used to fund its asset growth were restricted. The GDBF ultimately closed Freedom due to the bankís capital position and inability to meet liquidity needs. The resulting loss to the DIF at closing was estimated at $35.8 million.Asset Growth
The rate of Freedomís asset growth, which included concentrations in CRE/ADC loans, quickly and significantly exceeded the bankís projected growth included in Freedomís original business plan that the FDIC had approved. More specifically, Freedomís original business plan projected that assets at the end of the bankís first year would total $24.6 million and would be comprised primarily of CRE/ADC loans. In October 2004, Freedom revised its business plan to update the bankís financial projections. The revised plan, approved by the FDIC, projected even greater growth.
As shown in Figure 1 below, Freedom consistently and significantly exceeded the asset growth projections included in the bankís original business plan. Figure 1 also shows that the bankís actual growth during calendar years 2006 and 2007 significantly exceeded the asset growth projections in Freedomís revised business plan.
Although Freedomís growth consistently exceeded the bankís projections, the bankís rate of asset growth was generally less than the bankís peer group,3 as indicated below in Figure 2.
Freedom developed and maintained a high concentration in CRE/ADC loans. As shown in Table 2, the bankís concentrations in CRE/ADC loans, as a percent of the bankís total capital, were significantly above the bankís peer group averages from 2004 through 2008.
Table 2: CRE/ADC Concentrations to Total Capital Compared to Peer
According to FIL-104-2006, entitled Concentrations in Commercial Real Estate, Sound Risk Management Practices, dated December 12, 2006, such concentrations can pose substantial potential risks and can inflict large losses on institutions. Although the guidance does not specifically limit a bankís CRE lending, the guidance provides the following supervisory
criteria for identifying financial institutions that may have potentially significant CRE loan concentrations warranting greater supervisory scrutiny:
FIL-104-2006 describes a risk management framework that institutions should implement to effectively identify, measure, monitor, and control CRE concentration risk. That framework includes effective oversight by bank management, including the BOD and senior executives, portfolio stress testing and sensitivity analysis, sound loan underwriting and administration, and portfolio management practices. As discussed later, Freedomís management did not establish such controls, and that proved detrimental to the bankís viability.
The GDBFís June 2008 examination indicated that Freedomís concentrations in ADC loans totaled 413.39 percent of total capital as of March 31, 2008, more than four times the supervisory criteria identifying banks that may have potentially significant ADC concentrations warranting greater supervisory scrutiny. The ROE also noted that this level of concentrations highly exposed the bankís earnings and capital to adverse market conditions. Further, according to the GDBF, while the bank historically maintained a high level of concentrations in ADC lending, Freedom did not take action to improve identification, measurement, monitoring, and controls of concentration risks.Risk Management Practices
Freedom management did not: (1) develop and effectively implement key risk management practices consistent with FIL-104-2006 to identify, measure, monitor, and control the risks related to the bankís CRE/ADC concentrations; (2) establish sound loan underwriting and credit administration practices, including those recommended by its external auditor and examiners; and (3) maintain a sufficient allowance for loan and lease losses (ALLL).
Key Risk Management Practices Related to Concentrations
Loan Underwriting and Credit Administration Practices
The FDIC, GDBF, and a firm hired by Freedom identified the need for the bank to improve loan underwriting, credit administration, and, in general, controls associated with CRE/ADC concentrations. However, the bank failed to take adequate and timely action to address those concerns.
Freedomís failure to implement recommendations made over 3 consecutive years to improve these aspects of its operations limited the bankís ability to identify, measure, monitor, and mitigate heightened risks associated with its loan portfolio.
Adversely Classified Assets and Allowance for Loan and Lease Losses
According to the 2004 through 2007 ROEs, asset quality was rated 1 or 2, and the allowance for loan and lease losses (ALLL) was considered adequate for the risk inherent in the loan portfolio. However, the firm that conducted the independent loan review in 2006 determined that Freedomís level of adversely classified loans was increasing. In addition, the firm noted that watch grade loans had weaknesses that, if not addressed, could lead to further decline in asset quality. Among other things, the firm recommended that Freedom obtain up-to-date financial information to support repayment ability, project future cash flow using payment assumptions, and enforce repayment plans. Consistent with the 2006 independent loan review, adversely classified assets increased from less than 1 percent at the 2006 examination, to about 5 percent in 2007, and then to 18 percent of total assets in 2008. CRE/ADC loans comprised the majority of the $27.7 million of adversely classified items, with the remaining classifications primarily attributable to other real estate owned and contingent liabilities. The $27.7 million of adversely classified items represented 187.29 percent of the total of Freedomís Tier 1 Capital and ALLL and resulted in deficient earnings and capital. In addition, the GDBF 2008 examination concluded that Freedomís ALLL was underfunded, meaning that the allowance account did not include a reasonable estimate of the credit losses included in the loan portfolio.
At the GDBFís 2008 examination, examiners concluded that Freedomís methodology for determining its ALLL was not in compliance with FIL-105-2006, Interagency Policy Statement on the Allowance for Loan and Lease Losses, dated December 13, 2006. The ALLL interagency policy states that 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).5An 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. The policy further indicates that management should document qualitative factors for determining estimated losses. Qualitative factors that should be considered include:
Freedomís methodology determined estimated losses in groups of non-impaired loans by multiplying the groupsí book balances against historical loss percentages in peer group data. As a result, Freedomís methodology only addressed a few of the relevant factors listed in the policy.Reliance on Wholesale Funding Sources and Liquidity Management
Freedom pursued a risky business strategy that included heavy reliance on wholesale funding sources to fund its asset growth concentrated in CRE/ADC loans. In addition, the bank did not develop an adequate contingency liquidity plan (CLP).
Wholesale Funding Sources
Freedomís funding structure centered on high-cost volatile funds to fund its growth, including Federal Home Loan Bank (FHLB) borrowings, time deposits of $100,000 or greater, and Internet certificates of deposit (CD). As of March 31, 2008, Freedomís liquidity levels were low due to an increasing level of nonperforming assets, and because a significant level of deposits being held as collateral was not available as a funding source. Accordingly, the bankís ability to meet funding obligations was threatened. As Freedomís financial condition deteriorated, access to funding sources, namely FHLB advances and brokered deposits, became restricted. Further, the bank was subject to restrictions on the interest rates it could pay on other deposits, making it difficult for Freedom to attract such deposits.6
As shown in Table 3, for the years ended December 2004 through December 2008, Freedom was heavily dependent on high-cost, non-core volatile funding sources such as FHLB borrowings and time deposits of $100,000 or greater. Except for 2008, Freedom consistently exceeded its peer group average for net non-core funding.
Table 3: Freedomís Non-Core Funding Sources and Net Non-Core
a Percentile represents Freedomís ranking within the bankís designated peer group average, meaning that Freedomís ratio was higher than 89 percent of the institutions in its peer group in December 2006.
b The FHLB borrowing lines were reduced in excess of 50 percent due to a large percentage of the pledged commercial loans deemed to be nonconforming.
A bankís net non-core funding dependence ratio indicates the degree to which the bank is relying on non-core/volatile liabilities to fund long-term earning assets. Generally, a lower ratio reflects less risk exposure, whereas higher ratios indicate greater risk exposure and a reliance on funding sources that may not be available in times of financial stress or adverse changes in market conditions.
A heavy reliance on potentially volatile liabilities to fund asset growth is a risky business strategy because the availability and access to these funds may be limited in the event of deteriorating financial or economic conditions, and assets may need to be sold at a loss in order to fund deposit withdrawals and other liquidity needs.
The GDBFís June 2008 examination concluded that the bankís net non-core dependence ratio was excessiveóat 44.35 percent as of March 31, 2008óindicating great risk exposure and potentially unavailable funding sources. That ratio had increased to 56.07 percent as of June 30, 2008. The GDBF June 2008 ROE stated that bank management should take immediate action to improve liquidity and funds management, including reducing the bankís dependence on volatile funds.
Contingency Liquidity Planning
Freedom did not have a CLP that addressed, at a minimum, all sources and uses of funding, current and expected availability of any secondary sources of funding, and marketing strategies to attract core deposits. As discussed previously, when the bankís financial condition deteriorated in 2008, various sources of funding were restricted, and bank management was not successful in obtaining sufficient liquidity for the institution.
Examiners noted that management had not developed a sources and uses of funds statement to (1) assess future liquidity needs or address the borrowersí failure to pay and (2) indicate the effect of operating losses on liquidity. A more detailed sources and uses statement could have helped to project the liquidity position of Freedom. The GDBF
recommended in the 2008 examination that Freedom develop a written liquidity contingency plan and enhance its sources and uses of funds reporting to improve liquidity management.
According to the Examination Manual, CLPs should be in force and 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.
OVERVIEW AND ASSESSMENT OF FDIC SUPERVISION
The FDICís examinations and off-site review identified key concerns for attention by bank management, including the high concentration levels and weak risk management practices that ultimately led to the bankís failure. Together with the GDBF, the FDIC pursued enforcement action in 2008 as the bankís financial condition deteriorated prior to failure in 2009. However, more supervisory attention may have been warranted, in light of the bankís de novo7 status, material deviation from its business plan, and significant CRE/ADC concentrations at the FDICís 2005 and 2007 examinations and after the 2007 examination during off-site reviews. In addition, more aggressive supervisory follow-up to ensure the bank implemented corrective actions for recommendations related to ADC loan concentrations, loan underwriting, and credit administration practices may have mitigated, to some extent, Freedomís losses.Overview of FDIC Supervision
As a de novo bank, Freedom was subject to additional supervisory oversight and regulatory controls, such as adherence to conditions8 established by the GDBF, which granted Freedomís charter, and by the FDIC, which approved the bankís application for deposit insurance. Those conditions included, but were not limited to, operating within the parameters of the bankís business plan and obtaining annual financial statement audits. In addition, Freedom was subject to an increased examination frequency, with examinations during the first 3 years conducted on a 12-month schedule.
The GDBF and FDIC alternated safety and soundness examinations of Freedom, conducting 5 examinations from August 2004 through June 2008. Table 4 lists Freedomís examination dates, who conducted the examination, and the CAMELS component and composite ratings.
Table 4: Freedomís Examination History
* Financial institution regulators and examiners use the Uniform Financial Institutions Rating System (UFIRS) to evaluate a bankís performance in six components represented by the CAMELS acronym: Capital adequacy, Asset quality, Management practices, Earnings performance, Liquidity position, and Sensitivity to market risk. Each component, and an overall composite score, is assigned a rating of 1 through 5, with 1 having the least regulatory concern and 5 having the greatest concern.
The FDIC conducted its first visitation of Freedom concurrently with the GDBFís August 2004 examination. Although the FDIC did not make any formal recommendations, the visitation identified rapid loan growth, underwriting concerns, and large cumulative losses, which included the bankís pre-opening expenses. The FDICís 2004 visitation also determined that Freedom was developing an ADC concentration that represented 73.6 percent of total capital and 23.1 percent of total loans.
In 2005 and 2006, the FDIC and GDBF, respectively, conducted examinations and determined that the bankís overall condition was satisfactory. The FDICís 2005 examination noted that the bankís ADC reporting would be enhanced to include the bankís anticipated concentration in ADC lending. At that time, according to UBPRs and based on the FDICís supervisory guidelines, Freedom had already established CRE/ADC concentrationsówith CRE representing 371 percent and ADC representing 147 percent of total capital, respectively. The FDIC also concluded that Freedomís total assets and deposits were consistent with the asset and deposit projections included in the bankís revised business plan.
The FDICís February 2007 examination identified and reported Freedomís significant CRE/ADC concentrations and included recommendations to improve Freedomís operations. These recommendations related to Freedomís identification and monitoring of loan concentrations, loan underwriting and credit administration, and improvements needed in the bankís risk management controls.
Between the 2007 and 2008 examinations, the FDICís supervisory approach was limited to off-site review activities.9 These efforts were conducted quarterly from March 2007 through March 2008 (except for September 2007) and noted concerns related, but not limited, to
asset growth, reliance on volatile funding, and other risk factors. In response to FDIC inquiries during this time frame, Freedomís management reported that changes in the residential construction market would not have a material impact on the bank. However, bank managementís assertions later proved to be incorrect.
On March 31, 2008, the FDIC completed an off-site review of the institutionís December 31, 2007 Consolidated Reports of Condition and Income (Call) Report data and noted significant concentrations in ADC and CRE of 431 percent and 204 percent, respectively, and a high probability of downgrade to Freedomís CAMELS and composite ratings. In addition, the off-site review noted that the level of increasing problem assets was expected to continue in light of the market conditions. As a result of the bankís deteriorating financial condition, the GDBF accelerated the 2008 examination from the scheduled date of August 2008 to June 2008. Although ARO officials could not provide documentation indicating that the acceleration decision was based on DSCís off-site monitoring, ARO officials stated that the acceleration of the Stateís examination was at the very least a mutual decision by the regional office and the GDBF. The GDBFís June 2008 examination revealed that the overall condition of the institution was poor and the viability of the institution was questionable. The FDIC conducted a visitation in November 2008 to obtain an update on Freedomís liquidity status and contingency planning, as well as a summary of the FHLB findings of its onsite collateral review10 at the bank. In September 2008, the FDIC and the GDBF required Freedom to begin reporting its liquidity position until further notice. The bankís liquidity reports revealed a declining liquidity position for Freedom.
On December 17, 2008, the GDBF, in consultation with the FDIC, issued a Cease and Desist Order (C&D). The C&D required Freedom management to, among other things:
On March 6, 2009, the GDBF closed Freedom because of its severely deteriorated financial condition and inability to raise additional capital and appointed the FDIC as receiver of the bank.
OIG Assessment of FDIC Supervision
The FDIC and GDBF conducted regular examinations of Freedom and reported issues that led to the bankís ultimate failure. However, more aggressive or timelier supervisory actions could have been taken based on the risk presented by the bankís (1) CRE/ADC concentrations, including those identified through off-site review; (2) material deviations from its business plan; (3) dependence on volatile funding; and (4) inadequate contingency liquidity plan.
Consideration of Risk Presented by CRE/ADC Concentrations. Freedomís rapid growth and CRE/ADC concentrations resulted in a high-risk profile for the institutionó particularly given its de novo statusóand consistently exceeded supervisory guidelines. This high-risk profile, however, did not result in elevated supervisory concern or actions early enough to sufficiently mitigate Freedomís vulnerability to substantial losses.
Supervisory guidance, risk factors, and supervisory monitoring that should have resulted in elevated supervision by the FDIC include the following.
of original projected levels, and the bankís net income was higher than the original third year projection.
It was apparent from the 2007 ROE that examiners conducted procedures to address the issues in the PEP memorandum. For instance, the ROE stated that Freedom had a concentration in ADC loans that represented 585 percent of Tier 1 Capital, as of December 31, 2006. This concentration level was more than 5 times above the 100 percent supervisory criteria that FIL-104-2006 indicates may warrant greater supervisory scrutiny. In addition, Freedomís CRE level was more than twice that of its peer group, and the bankís ADC level was more than three times its peer groupís concentration. Further, the FDICís 2007 examination reported that the bank planned a 30-percent increase in assets, with significant increases in ADC loans, which already greatly exceeded the supervisory criteria in FIL-104-2006. Examiners also noted that the bankís asset growth was continuing to outpace Freedomís capital. Finally, the ROE for this examination included several recommendations related to Freedomís risk management processes, controls related to the bankís CRE/ADC concentrations, and Freedomís loan policy.
Although the ROE included annotations indicating that bank management had agreed to consider or implement the recommendations, the FDICís transmittal letter for the ROE did not require a formal response or status reports on corrective actions. According to the DSC Case Manager Procedures Manual, for institutions rated a 1 or 2, the transmittal letter can merely reference the examination report and request the BOD to review the report and note its review in the BOD minutes. For those institutions with moderate concerns, the transmittal letter should include a brief discussion of problem areas and a request for a written response. Based on the above guidance and considering the significance of the recommendations included in the February 2007 ROE, it may have been prudent for the FDIC to specifically request that Freedomís BOD provide a written response to the ROE that would have outlined the planned and/or actual corrective actions to address the FDICís concerns and identified deficiencies.
Finally, in spite of the risks identified in the PEP memorandum and ROE, the FDIC rated Freedomís asset quality as a ď1Ē in the 2007 ROE. The rating was based, in part, on the fact that (1) the level of adverse classifications totaled approximately $719,000, were generally confined to one relationship, and the adversely classified asset ratio was 5.64 percent; (2) the past-due ratio was 2.04 percent; and (3) bank management had identified all classified loans. However, the risks identified in the PEP memorandum and subsequent examination seem to be in contrast with the broader definition of a 1-rating, which, in part, indicates that asset quality was of minimal supervisory concern.
Revision and Adherence to the Business Plan. 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 operationóthe de novo phaseóas required by the FDICís Final Order for Deposit Insurance must be reported by the insured depository institution to the primary federal regulator 60 days before consummation of the change.
Freedom requested approval of its revised business plan in November 2004, stating that the only significant variance from the original business plan was the rapid asset growth the bank had experienced. In fact, Freedomís actual total assets as of September 30, 2004, had already grown to $41.3 millionófar exceeding the projected total assets of $24.6 million as of December 30, 2004 in its original business plan. The FDIC advised Freedom in December 2004 that it had no objection to the revised plan. The only condition the FDIC imposed was that the bank should ensure it maintained a Tier 1 Leverage ratio of at least 8 percent until February 2007.
The Examination Manual states that examiners should review and evaluate current business plans and any changes thereto since the previous examination. In that regard, the FDIC addressed the business plan in visitations and examinations conducted in 2004 through 2007 and noted the following:
Of note in the aforementioned reports is the fact that the 2004 visitation memorandumó issued before the revised business plan was submitted for approvalóincluded key findings of rapid loan growth and early-on underwriting concerns. However, the report concluded that loan quality issues appeared to be contained largely due to managementís actions. That trend of findings largely continued in 2005 and 2006; that is, high growth in excess of projections was noted. The FDIC expressed limited or no concern based on the FDICís conclusion that Freedomís asset quality was considered to be strong with nominal adverse classifications and past due loans. With regard to the FDICís 2007 ROE, the conclusion that there had been no major deviations or material changes to the business plan seems inconsistent with the difference between projected and actual real estate loans discussed above, and with the fact that, as of December 2006, Freedomís total actual assets exceeded original projections by about 140 percent and revised projections by 36 percent. It should be noted, however, that at the time this examination was conducted, DSC had not issued guidance to examiners that defined what would constitute a ďmaterial deviationĒ from a business plan. Further, ARO officials advised us that regional practice did not consider growth in excess of projections as a material deviation.
In August 2009, DSC issued a memorandum that provides supplementary guidance to its examiners for processing deposit insurance applications and requests for changes in business plans by de novo institutions and provides guidance regarding supervision and examination procedures for de novo institutions for which the FDIC is the primary federal regulator. While the guidance notes that examiner judgment is critical in determining a major change or deviation in business plan, it specifically states that any variance between projected and actual asset levels exceeding 25 percent will be considered a material deviation from the business plan. Going forward, new deposit insurance orders for state nonmember institutions will require institutions to obtain prior approval from the FDIC on any proposed major change or deviation in their business plan. Finally, in those instances when an institution has implemented a material change in its business plan without providing prior notice or obtaining the FDICís prior non-objection, the assessment of civil money penalties or other enforcement action against the institution or other appropriate parties should be considered.
Off-site Monitoring. Because February 2007 was the end of the de novo period for Freedom and the bankís composite and component ratings were 1 or 2, the bankís next full-scope examination was scheduled to be conducted by the GDBF 18 months later. The FDICís intervening off-site reviews of Freedom identified heightened risk the bank was facing. However, the results of the reviews did not result in substantial adjustments to the FDICís supervisory strategy.
As shown in Table 5, for the first two quarterly off-site reviews conducted for quarters ending March and June 2007, the FDIC generally had positive observations regarding Freedomís loan portfolio and management. However, at the time of these reviews, Freedomís level of concentrations in CRE/ADC loans was significantly high and substantially exceeded the levels that the 2006 supervisory guidance identified as warranting increased attention. A subsequent off-site review conducted in March 2008 based on December 2007 Call Report data, did identify several risk areas that should have resulted in greater supervisory attention.
Table 5: Results of the FDICís Off-site Reviewa of Freedom
a According to the FDIC Case Manager Procedures Manual, off-site reviews must be completed and approved 3Ĺ months after each Call Report date. This generally provides 45 days to complete the off-site reviews once Call Report data is finalized -- generally 45 days after the Call Report financial date.
b Multiflag represents the process of combining multiple risk measures such as the REST, Statistical CAMELS Off-site Rating (SCOR), SCOR-Lag, Young Institutions, and Consistent Grower. According to the FDIC, institutions with multiple exceptions are considered to be high-risk institutions.
Further, as shown below in Table 6, Freedom was flagged for review in March 2008 based on its December 31, 2007 financial data. The primary concerns noted were the bankís rapid
loan growthówhich was concentrated in CRE/ADC loansóand the probability of downgrades in the bankís CAMELS ratings.
Table 6: Probability of Downgrades in Component and Composite Ratings
According to the Examination Manual, limited scope examinations and visitations may be used to determine changes in an institutionís risk profile and to follow up on SCOR results. In this case, based on the December 2007 review, the FDIC did not conduct a visitation to assess the bankís financial condition. Instead, the FDIC decided to closely monitor Freedom, noting that the onsite GDBF examination was scheduled for the third quarter of 2008.
Although the GDBFís examination was accelerated from August to June 2008, 2 months had elapsed since the off-site measures reflected increased risk, and 16 months had elapsed since the previous examination. Furthermore, while the timing of the 2008 examination was consistent with FDIC policies for examination of a 1- or 2-rated bank, this lag in detailed examination coverage may have prevented more thorough coverage of the risks and timelier supervisory actionóand perhaps took away opportunities to minimize the loss that the institution ultimately suffered.
Volatile Liability Dependence. As early as the January 2005 examination, the FDIC reported that bank management relied on CDs acquired through the Internet and FHLB advances to fund growth. Although the bankís internally-calculated net non-core dependence ratio continually increased, management considered the majority of the large CDs to be stable deposits of loyal customers. The bankís net non-core funding dependence ratio ranged from a level of 27.65 percent in December 2004 to a high of 47.01 percent in December 2007. As early as the January 2005 examination, the FDIC reported that bank management relied on CDs acquired through the Internet and FHLB advances to fund growth. Although the bankís internally-calculated net non-core dependence ratio continually increased, management considered the majority of the large CDs to be stable deposits of loyal customers. The bankís net non-core funding dependence ratio ranged from a level of 27.65 percent in December 2004 to a high of 47.01 percent in December 2007.
According to the Examination Manual, funds management practices should ensure that liquidity is not maintained at a high cost, or through undue reliance on funding sources that may not be available in times of financial stress or adverse changes in market conditions. However, the FDIC did not take exception to, or require the bank to reduce, its dependence on potentially volatile funding sources. The FDIC could have expressed a greater level of concern and/or required the bank to develop strategies for reducing the volatility of its funding at the 2007 examination because (1) at that time, Freedomís net non-core funding dependence ratio was reported at 46.87 percent at December 31, 2006óan increase from the 43 percent reported at the prior examination of Freedom, (2) Freedomís dependence ratios consistently
exceeded its peer group, and (3) a bankís access to secondary funding sources can be limited when its financial condition deteriorates.
Contingency Liquidity Plan. The GDBF June 2008 ROE stated that bank management lacked a CLP and had not developed a sources and uses of funds statement to assess future liquidity needs. In contrast, the FDIC concluded at the bankís 2007 examination that liquidity contingency arrangements were adequate and funds management practices were satisfactory.
The FDICís Examination Manual 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.
Based on our review of the above plan, which was in effect at the time the FDIC conducted its 2007 examination, we determined that the plan did not include the following elements:
However, the FDIC had not identified deficiencies in the CLP or recommended that the bank enhance the plan before, or as a result of, its 2007 examination
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 institutionís capital levels. Part 325 of the FDICís Rules and Regulations implements PCA requirements by establishing a framework for taking prompt corrective action against insured nonmember banks that are not adequately capitalized.
Table 7, on the next page, shows how Freedomís capital ratios compared to the bankís peer group for each examination and the change in capital ratios between the August 2004 examination and the June 2008 examination. In addition, Table 7 shows that Freedomís capital ratios were significantly lower than the bankís peer group for each examination conducted by the FDIC and the GDBF.
Table 7: Freedomís Capital Ratios Compared to Peer
* Not applicable because the UBPR data for these ratios was determined to be unreliable.
As of September 30, 2008, Freedomís capital ratios were as follows:
On November 7, 2008, the FDIC informed Freedom that, based on the September 30, 2008, Call Report, the bank reported Total Risk-Based Capital of 6.60 percent Ė below the 8 percent threshold as required by PCA, which placed the bank in the Undercapitalized category. Based on this capital category, Freedom had to comply with various restrictions. Those restrictions were related, but not limited to, asset growth, dividends, other capital distributions, and management fees. Freedom was also required to file a written capital restoration plan with the FDIC within 45 days. Although Freedom was not using brokered deposits, this capital category prohibited the bank from accepting, renewing, or rolling over any brokered deposits. In early November 2008, the bank contracted with an investment banker to assist with raising capital. The agreement with the investment banker included seeking capital investors, selling fixed assets, or finding a merger partner. The bank also took several measures to preserve capital, including significant expense reductions, limiting new loans, and improving earnings with the installation of an interest rate floor on new and renewing loans. The bank also worked for several months seeking capital injections from board members and existing shareholders but with minimal success.
The ARO also received a Troubled Asset Relief Program Application from Freedom Bancshares, Inc., the holding company for the bank in November 2008. The application was subsequently withdrawn by the holding company in early December 2008.
The December 2008 C&D included, among other things, provisions related to capital and required Freedom to:
Freedom responded to the FDIC on January 7, 2009 that it was working to restore capital to adequate levels. The FDIC issued a letter to Freedom on February 9, 2009, stating that, based on December 31, 2008 Call Report data, the bank was considered to be Significantly Undercapitalized. On February 25, 2009, the FDIC issued a letter when Freedom became Critically Undercapitalized, and GDBF closed the bank on March 6, 2009.
After we issued our draft report, we met with management officials to further discuss our results. Management provided additional information for our consideration, and we revised our report to reflect this information, as appropriate. On September 16, 2009 the Director, Division of Supervision and Consumer Protection (DSC), provided a written response to the draft report. That response is provided in its entirety as Appendix 3 of this report.
DSC reiterated the OIGís conclusions that Freedom Bank failed primarily due to a rapid growth strategy and the Board of Directorsí failure to ensure that Freedomís management identified, measured, monitored, and controlled the risks associated with the institutionís lending activities. As it relates to our assessment of the FDICís supervision of Freedom, DSC acknowledged the need for more stringent supervisory attention for de novo institutions. DSC further noted that the FDIC recently extended the de novo period from the current 3-year period to 7 years for examinations, capital, and other requirements, and that material changes in business plans for newly insured institutions will require prior FDIC approval during the first 7 years of operation.
OBJECTIVES, SCOPE, AND METHODOLOGY
We performed the audit field work at the DSC offices in Atlanta, Georgia.Internal Control, Reliance on Computer-processed Information, Performance Measurement, and Compliance With Laws and Regulations
Consistent with the audit objectives, we did not assess DSCís overall internal control or management control structure. We relied on information in DSC systems, reports, ROEs, and interviews of examiners to understand Freedomís management controls pertaining to causes of failure and material loss as discussed in the body of this report.
We obtained data from various systems but determined that information system controls were not significant to the audit objectives, and therefore, did not evaluate the effectiveness of information system controls. We relied on our analysis of information from various sources, including ROEs, correspondence files, and testimonial evidence to corroborate data obtained from systems that were used to support our audit conclusions.
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, and prepare and report on annual performance plans. For this material loss review, we did not assess the strengths and weaknesses of DSCís annual performance plan in meeting the requirements of the Results Act because such an assessment is not relevant to the audit objectives. DSCís compliance with the Results Act is reviewed in program audits of DSC operations.
Regarding compliance with laws and regulations, we performed tests to determine whether the FDIC had complied with provisions of PCA and limited tests to determine compliance with certain aspects of the FDI Act. The results of our tests were discussed, where appropriate, in the report. 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 examination report. Adversely classified assets are allocated on the basis of risk (lowest to highest) into three categories: Substandard, Doubtful, and Loss.|
|Allowance for Loan and Lease Losses (ALLL)||Federally insured depository institutions must maintain an ALLL that is adequate to absorb the estimated loan 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 loan.|
|Cease and Desist Order (C&D)||A C&D is a formal enforcement action issued by a financial institution regulator to a bank or affiliated party to stop an unsafe or unsound practice or a violation of laws and regulations. A C&D may be terminated when the bankís condition has significantly improved and the action is no longer needed or the bank has materially complied with its terms.|
|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.|
|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 1831o, 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: (1) Well Capitalized, (2) Adequately Capitalized, (3) Undercapitalized, (4) Significantly Undercapitalized, and (5) Critically
A PCA Directive is a formal enforcement action seeking corrective action or compliance with the PCA statute with respect to an institution that falls within any of the three categories of undercapitalized institutions.
|Uniform Bank Performance Report (UBPR)||The UBPR is an individual analysis of financial institution financial data and ratios that includes extensive comparisons to peer group performance. The report is produced by the Federal Financial Institutions Examination Council for the use of banking supervisors, bankers, and the general public and is produced quarterly from Call Report data submitted by banks.|
September 16, 2009
Pursuant to Section 38(k) of the Federal Deposit Insurance Act (FDI Act), the Federal Deposit Insurance Corporationís Office of Inspector General (OIG) conducted a Material Loss Review of Freedom Bank of Georgia (FBG), Commerce, Georgia, which failed on March 6, 2009. The Division of Supervision and Consumer Protection (DSC) received the OIGís Draft Audit Report (Report) on September 2, 2009, providing information on the cause of failure and an assessment of the FDICís supervision of FBG.
The Report notes FBG failed primarily due to a rapid growth strategy and the Board of Directorsí failure to ensure FBG management identified, measured, monitored, and controlled the risk associated with the institutionís lending activities. Declining earnings, resulting from rapidly deteriorating asset quality in the commercial real estate (CRE)/acquisition, development, and construction (ADC) concentrations, combined with the economic downturn, severely eroded capital. Liquidity became deficient and secondary funding sources became restricted. FBG ultimately closed due to its capital position and inability to meet liquidity needs.
The Report indicates that FBG, due to its de novo status, was subject to additional supervisory oversight and regulatory controls. The examinations, visitation, and offsite monitoring conducted by DSC and the Georgia Department of Banking and Finance identified key concerns for management attention, including high concentration levels and weak risk management practices. The Report concludes more supervisory attention may have been warranted at earlier examinations and as a result of offsite reviews.
In recognition that stringent supervisory attention is necessary for de novo institutions, DSC recently extended our supervisory program so that these institutions receive a full scope examination every year for seven years, as opposed to three years. Further, DSC has issued updated guidance reminding examiners to take appropriate supervisory action when capital levels are inadequate for CRE concentrations or funding risks are imprudently managed.
Thank you for the opportunity to review and comment on the Report.
ACRONYMS IN THE REPORT
|ADC||Acquisition, Development, and Construction|
|ALLL||Allowance for Loan and Lease Losses|
|ARO||Atlanta Regional Office|
|BBR||Bank Board Resolution|
|BOD||Board of Directors|
|C&D||Cease and Desist Order|
|CALL||Consolidated Reports of Condition and Income|
|CAMELS||Capital, Asset Quality, Management, Earnings, Liquidity, and Sensitivity to Market Risk|
|CLP||Contingency Liquidity Plan|
|CRE||Commercial Real Estate||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|
|GDBF||Georgia Department of Banking and Finance|
|OIG||Office of Inspector General|
|PCA||Prompt Corrective Action|
|REST||Real Estate Stress Test|
|ROE||Report of Examination|
|SCOR||Statistical CAMELS Offsite Rating|
|UBPR||Uniform Bank Performance Report|
|UFIRS||Uniform Financial Institution Rating System|
|Last updated 11/19/2009|