Appeals of Material Supervisory Determinations:
Guidelines & Decisions
SARC- 97-01
(September 15, 1997)
Your appeal of material supervisory
determinations has been decided. Rulings not in favor of your institution
were made by the Supervision Appeals Review Committee (Committee) of the
Federal Deposit Insurance Corporation (FDIC) on September 4, 1997, and are
conveyed in this letter.
Before
deciding your appeal of supervisory determinations, the Committee considered
your request to appear in person. Based on the comprehensive nature of the
July 25, 1997, submission to Director Nicholas J. Ketcha Jr., the Committee
concluded that the record relating to your appeal was sufficiently complete
and that an oral presentation would not be productive.
The Committee gave careful consideration
to the issues you raise in your letter of July 25, 1997. Although the
Committee decided against the [Bank] (the Bank), in every appealed matter,
certain positive steps you appear to have taken since the examination are
appropriate and are recognized. Hopefully, your efforts to address the
criticisms enumerated in the January 9, 1997, Report of Examination (Report)
will serve to strengthen areas of identified weakness and will be reflected
in improved ratings at subsequent examinations.
The Committee’s findings on each
material supervisory determination appealed by the Bank are presented below
along with an explanation of the reason for the decision.
Loan Classifications
The Committee concluded that the Substandard
classifications assigned to the six loans listed in the Bank’s appeal are
appropriate. The interagency joint statement on classification of bank
assets and appraisal of securities in bank examinations provides that:
“Substandard loans are inadequately
protected by the current sound worth and paying capacity of the obligor or
of the collateral pledged, if any. Loans so classified must have a
well-defined weakness or weaknesses that jeopardize the liquidation of the
debt. They are characterized by the distinct possibility that the bank
will sustain some loss if the deficiencies are not corrected.”
The examiner’s judgment that each loan
was inadequately protected by the sound worth and paying capacity of the
obligor or of the collateral pledged is supported by the facts existing at
the time of the examination. The Bank’s position that the collateral
securing these loans sufficiently mitigates the greater than normal degree
of risk present is not supported. In each case, the Bank ignored the
uncertainty of the current sound worth of collateral, particularly in regard
to accounts receivable and inventory, and thus failed to recognize the risk
of loss to the Bank.
1. Customer A— The
company is highly leveraged, with debt-to-equity of 4-to-1.The company
exhibits poor operating performance with net income of only $7,000 on sales
of $4,000,000 for the fiscal year ending May 31, 1996. The $1,500,000
revolving line of credit has not been reduced to under $1,000,000 since
December 1994. Collateral, which includes two second deeds of trust on
personal residences, accounts receivable (AR), and inventory, provides
insufficient protection given borrower’s strained financial position. AR
turnover is slow and delinquency is high; inventory is possibly stale. As
of December 31, 1996, estimated collateral value, using appropriate
margins, approximated $1,487,000; indebtedness totaled $1,485,000.
2.Customer B— Borrowers’ financial statement
indicates significant financial strain, with annual gross income of
$139,200 and mortgage payments and real estate taxes of $100,100.
Primary collateral is a restaurant with an appraised value of
$810,000, securing an outstanding loan balance of $832,000. Additional
collateral consists of a second deed of trust on the borrowers’
personal residence, which is heavily encumbered by a prior lien.
Collateral value of the real estate remains uncertain, as
appraisal provided indicates improvements are not complete.
3. Customer C— These loans are classified in
accordance with Interagency Troubled Commercial Real Estate Loan
Classification Guidelines. The loans were past due and
foreclosure had been initiated during examination. In addition, public
records show the property was sold for $322,000 and the amount
of the outstanding debt, including accrued interest, was $369,477. In addition
to this implied loss of $47,477, the Bank no doubt
incurred additional legal and filing costs related to this credit.
The $322,000 sales price further calls into question the most recent
appraisal, which must have been grossly overstated given the estimated
appraised value was $850,000.
4. Customer D— Borrower lacks sufficient
capacity and is in a strained financial position. Net losses of
$1,500,000 and $170,000 reflected in financial statements for December
31, 1995, and the ten months ending October 31, 1996,
respectively. The company required capital infusion of $1,700,000 in early
1996 to sustain operations. Collateral consists of AR, inventory,
and junior liens on guarantors’ residences. At the time of examination,
reported collateral value was insufficient in relation to the
outstanding loan balance. Collateral support is uncertain given the
noted deficiencies relating to control of AR and inventory, as well as
the volume of payables reported by the borrower. Additionally, a
significant portion of AR are 90+ days past due. Real estate is subject to
significant prior liens and equity is limited. There is not
sufficient supportable collateral value to preclude a Substandard
classification.
5. Customer E— It is recognized that the
borrower has paid as agreed; however, there is a high level of risk present
given the company is potentially insolvent. The reliability of the
financial information is questionable, as the most recent
financial statement could not be reconciled to prior reporting periods. The
reported equity change in the business would have required a
$1,900,000 capital injection (allowing for reported current earnings
of $300,000); however, no explanation was provided by the borrower or
the Bank. The Bank’s position that collateral protection should
preclude classification is not supported. The Bank maintains it
has $287,000 of AR and inventory, a $100,000 note, a first deed of
trust with an aggregate estimated value of $184,000, and a second deed of
trust with limited equity of $35,000. AR and inventory are
appropriately excluded from consideration, as financial information
provided cannot be considered reliable. It is noted that the $100,000
note is matured. There is not sufficient supportable collateral value
to preclude a Substandard classification.
In regard to the appraisal issue, the Bank
is correct that appraisals would not have been required for
real estate collateral; however, the “Interagency Guidelines on Real
Estate Appraisals and Evaluations,” adopted October 27, 1994 (Financial
Institutions Letter 74-94), indicate that real estate
evaluations should have been prepared for each property to
appropriately document collateral values. Although this deficiency was
not highlighted in the Report, the guidance therein may be
instructive to management.
6. Customer F— At the time of the examination,
the company’s interim financial statement reflected an insolvent
financial condition and poor operating performance. Collateral consists
of a first and second lien on real estate owned by guarantors of
the company and a second lien on business assets with little or no value.
Adjusted by Bank management for foreclosure and selling costs, the
aggregate value of real estate collateral totaled $2,290,000 against an
outstanding loan balance of $2,280,000.
In regard to the Bank’s contention that the
examiners made an error in the Report, we note that the Report
clearly reflects only $2,280,000 of this line as being classified
Substandard. A $209,000 line the Bank claims the examiners failed to
notice as being paid is clearly not classified. Each individual
credit classified is distinctly identified on page 3b.4 of the Report and
the sum of the three credits is $2,280,000.
Customer G, Special Mention Listing
The Customer G loan possessed
characteristics which, at the time of the examination, fully supported the
examiner’s decision to list the loan as Special Mention. Contrary to Bank’s
understanding, a bank’s underwriting is specifically an issue in listing a
loan for Special Mention. In discussing the use of a Special Mention
designation, the Division of Supervision’s Manual of Examination
Policies provides, in part:
“…Often the bank’s weak origination and/or
servicing policies are the cause for the Special Mention
designation….”
Underwriting and credit administration
deficiencies discussed in commentary on page 3c.4 of the Report include an
aggregate loan commitment in excess of the Bank’s legal lending limit, the
lack of a conforming appraisal to support the credit extended (a violation
and policy contravention), several misrepresentations made by the
originating officer in the credit presentation, the lack of an objective
marketing and feasibility analysis, and the use of short-term commitments
from loan participants on a long-term project. The question of collateral
protection was not a primary concern, as the loan was not adversely
classified.
Capital Adequacy Rating
According to the Uniform Financial
Institutions Rating System, adopted by the Federal Financial Institutions
Examination Council on December 19, 1996, a Capital component rating
of “2” indicates “a satisfactory capital level relative to the
financial institution’s risk profile. A rating of “1” indicates a strong
capital level relative to the institution’s risk profile [emphasis added].”
The Committee concludes that a Capital
component rating of “2” is appropriate given adversely classified assets
currently represent 79% of the Bank’s Tier 1 capital plus the allowance for
loan and lease losses; the underwriting weaknesses identified; and the noted
management deficiencies in identifying, monitoring, and reporting risks in
the loan portfolio.
Asset Quality Rating
Under the Uniform Financial Institutions
Rating System, an Asset Quality component rating of ”4” is assigned
to “financial institutions with deficient asset quality or credit
administration practices. The levels of risk and problem assets are
significant, inadequately controlled, and subject the financial institution
to potential losses that, if left unchecked, may threaten its viability.”
The Committee believes a “4” rating to be
appropriate given the Bank’s high level of adversely classified assets and
deficient credit administration practices.
Management Rating
The Uniform Financial Institutions Rating
System provides the following guidance on the Management component
rating:
“The capability of the board of directors
and management, in their respective roles, to identify, measure,
monitor, and control the risks of an institution’s activities and to
ensure a financial institution’s safe, sound, and efficient operation
in compliance with applicable laws and regulations is reflected
in this rating….Sound management practices are demonstrated by: active
oversight by the board of directors and management; competent personnel;
adequate policies, processes, and controls taking into
consideration the size and sophistication of the institution;
maintenance of an appropriate audit program and internal control
environment; and effective risk monitoring and management information
systems.”
The Uniform Financial Institutions Rating
System provides that a rating of “4” indicates “deficient management and
board performance or risk management practices that are inadequate
considering the nature of an institution’s activities. The level of
problems and risk exposure is excessive. Problems and significant risks are
inadequately identified, measured, monitored, or controlled and require
immediate action by the board and management to preserve the soundness of
the institution. Replacing or strengthening management or the board may be
necessary.”
The Management component rating in
this case, or in any other case, is not premised on any individual incident
or isolated factor, nor is there a conditional, this–leads-to-that type of
relationship to the other rating components. That is not to say that
component ratings are assigned in isolation from each other. In this case,
the assigned rating of “4” is based upon the numerous deficiencies apparent
in the management and administration of the Bank, with the examiner
appropriately influenced by asset quality considerations. The following
responds to the specific issues raised by the bank.
1. Competence of Mr.… The rating of “4”
assigned to the Management component does not necessarily
imply Mr…. is incompetent. It does imply that the Bank’s board and
Mr.… as CEO of the Bank, need to take corrective action to address
the numerous management-related deficiencies highlighted in the Report of
Examination.
2. Customer G—The Committee is not persuaded
that the examiner-in-charge, in assigning the Management component
was distracted by a single error committed by Senior Credit Officer. In
fact, the examiner identified numerous other weaknesses, as discussed
fully on page 8 of the Report of Examination.
3. Other Management Deficiencies—
Bank Secrecy Act: Customer H—Bank
Secrecy Act (BSA) violation discussed in the appeal request was, as
noted by the Bank, reversed by the Regional Office on July 1, 1997. The
disputed violation of BSA regulations relating to the centralized
exemption list and customer exemption limits are viewed as technical
violations, but are nonetheless violations. Of more serious
concern is the poor implementation of the Bank’s BSA program, as
discussed on page 8.3 of the Report.
Appraisal Violations: As discussed
above under the heading of “Customer G Incident,” the appraisal
violations cited, as well as the lack of an adequate loan review
function and internal lending controls, is viewed as a serious management
weakness. The Bank’s contention that management’s essentially correct
views as to the value of real estate should be taken into account
in the Management component rating is without merit. The
relevant fact is that management had to make estimates for property
values for which appraisal were, by regulation, required.
Poor Supervision: The Bank
indicates the Report fails to provide specifics relating to the poor
supervision of the junior loan staff. While admittedly this point
is not fully developed, the Report does indirectly address this issue.
Specifically, senior management provided inadequate oversight of
junior lending staff by setting a poor example for them through
disregard for the Bank’s loan policy, failing to familiarize
themselves and staff with federal appraisal regulations, allowing
lax monitoring of loans, and inadequately reviewing credit presentations.
Liquidity Rating
The Uniform Financial Institutions Rating
System defines a “2” rating of Liquidity as indicating “satisfactory
liquidity levels and funds management practices. The institution has access
to sufficient sources of funds on acceptable terms to meet present and
anticipated liquidity needs. Modest weaknesses may be evident in funds
management practices.”
The Bank’s appeal position regarding the
Liquidity component rating is focused narrowly on the ratio of liquid
assets-to-total liabilities. The Bank’s appeal, however, does not take into
account the degree of reliance by the Bank on short-term, potentially
volatile sources of funds, including large certificates of deposit and
out-of-area deposits. The examiner properly commented on this issue in the
Report.
Composite rating
The Uniform Financial Institutions Rating
System provides the following definition of a Composite “3” rating:
“Financial institutions in this group
exhibit some degree of supervisory concern in one or more of the
component areas. These financial institutions exhibit a combination of
weaknesses that may range from moderate to severe; however, the
magnitude of the deficiencies generally will not cause a component to be
rated more severely than 4. Management may lack the ability or
willingness to effectively address weaknesses within appropriate time
frames. Financial institutions in this group generally are less
capable of withstanding business fluctuations and are more
vulnerable to outside influences than those institutions rated a
composite 1 or 2. Additionally, these financial institutions may be in
significant noncompliance with laws and regulations. Risk
management practices may be less than satisfactory relative to
the institution’s size, complexity, and risk profile. These
financial institutions require more than normal supervision, which
may include formal or informal enforcements actions. Failure appears
unlikely, however, given the overall strength and financial capacity of
these institutions.”
The Uniform Financial Institutions Rating System also
provides:
“…Each component rating is based on a
qualitative analysis of the factors comprising that component and
its interrelationship with the other components. When assigning a
composite rating, some components may be given more weight than others
depending on the situation at the institution….The ability of management
to respond to changing circumstances and to address the risks that
may arise from changing business conditions, or the initiation of new
activities or products, is an important factor in evaluating a
financial institution’s overall risk profile and the level of supervisory
attention warranted. For this reason, the management component is
given special consideration when assigning a composite rating.
The ability of management to identify, measure, monitor, and control the
risks of its operations is also taken into account when assigning each
component rating.”
The Report identifies asset quality as being
unsatisfactory and credit administration practices as being deficient. Risk
management practices are, as the Report indicates, less than satisfactory.
The Committee believes the composite rating assigned by the examiner
reflects the appropriate level of supervisory concern.
The Bank’s charge of “bias” by Regional Director George
J. Masa was not considered by the Committee, although the findings on which
the Bank premises its belief were considered and are addressed above. The
FDIC’s Office of the Ombudsman is available to individuals or institutions
who believe that FDIC policy or procedure has been unfairly or erroneously
applied or that the policy or procedure itself is unfair. The institution
may also file a complaint with the Office of the Ombudsman if it believes or
has any evidence that it has been subject to examiner retaliation, abuse, or
retribution because of its appeal of a material supervisory determination.
You may contact FDIC’s Irvine Office of the Ombudsman by calling (714)
263-7600.
The Scope of this review was limited to the facts and
circumstances that existed at the time of the examination and no
consideration was afforded any changes occurring after that date or to any
subsequent corrective action. In any proposed supervisory response to the
Report of Examination, the FDIC’s San Francisco Regional Office will address
the Bank’s actions since the examination.
This determination is considered the Federal Deposit
Insurance Corporation’s final supervisory decision.
By direction of the Supervision Appeals Review
Committee of the Federal Deposit Insurance Corporation.
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