Slide No. 1 - OBSERVATIONS FROM FDIC OIG MATERIAL LOSS REVIEWS CONDUCTED 1993-2003

Office of Inspector General
Office of Audits

Slide No. 2 - BACKGROUND Material Loss Provisions of Section 38(k) of Federal Deposit Insurance Act effective July 1, 1993

• Review agency’s supervision of institution, including Prompt Corrective Action (PCA)
• Ascertain why an institution’s problems resulted in a material loss to the insurance fund
• Make recommendations for preventing future losses

Slide No. 3 – BACKGROUND

FAILURES OF FDIC-SUPERVISED BANKS 1993 - 2003

This chart represents the number of FDIC-supervised bank failures from 1993 through 2003 and the number of FDIC-supervised bank failures that resulted in a material loss.

• In 1993, 19 FDIC-supervised banks failed with 1 of the failures resulting in a material loss to the insurance fund.
• In 1994, 9 FDIC-supervised banks failed with 3 of the failures resulting in a material loss to the insurance fund.
• In 1995, 4 FDIC-supervised banks failed with 2 of the failures resulting in a material loss to the insurance fund.
• In 1996, 3 FDIC-supervised banks failed with none of the failures resulting in a material loss to the insurance fund.
• In 1997, 1 FDIC-supervised bank failed with none of the failures resulting in a material loss to the insurance fund.
• In 1998, 1 FDIC-supervised bank failed with 1 of the failures resulting in a material loss to the insurance fund.
• In 1999, 3 FDIC-supervised banks failed with 1 of the failures resulting in a material loss to the insurance fund.
• In 2000, 4 FDIC-supervised banks failed with none of the failures resulting in a material loss to the insurance fund.
• In 2001, 1 FDIC-supervised bank failed with none of the failures resulting in a material loss to the insurance fund.
• In 2002, 4 FDIC-supervised banks failed with 1 of the failures resulting in a material loss to the insurance fund.
• In 2003, 1 FDIC-supervised bank failed with 1 of the failures resulting in a material loss to the insurance fund.

Slide #4- BACKGROUND OIG Material Loss Reviews - Slide No. 4 depicts a chart showing ten material loss reviews between 1993 and 2003.

1. Financial Institution: Bank of San Diego
Date Closed: 10/29/93
Loss (in millions): $39.4
Assets (in millions): $316.8
Location: San Diego, CA
Charter Year: 1978

2. Financial Institution: Bank of Hartford
Date Closed: 6/10/94
Loss (in millions): $31.3
Assets (in millions): 349.6
Location: Hartford, CT
Charter Year: 1919

3. Financial Institution: Bank of San Pedro
Date Closed: 7/15/94
Loss (in millions): $28.8
Assets (in millions): $123.4
Location: San Pedro, CA
Charter Year: 1975

4. Financial Institution: Bank of Newport
Date Closed: 8/12/94
Loss (in millions): $26.6
Assets (in millions): $174.3
Location: Newport Beach, CA
Charter Year: 1972

5. Financial Institution: First Trust Bank
Date Closed: 3/3/95
Loss (in millions): $34.5
Assets (in millions): $245.6
Location: Ontario, CA
Charter Year: 1887

6. Financial Institution: Pacific Heritage Bank
Date Closed: 7/28/95
Loss (in millions): $37.3
Assets (in millions): $155.6
Location: Torrance, CA
Charter Year: 1981

7. Financial Institution: BestBank
Date Closed: 7/23/98
Loss (in millions): $171.6
Assets (in millions): $314.0
Location: Boulder, CO
Charter Year: 1982

8. Financial Institution: Pacific Thift and Loan Company
Date Closed: 11/19/99
Loss (in millions): $52.0
Assets (in millions): $117.6
Location: Woodland Hills, CA
Charter Year: 1988

9. Financial Institution: Connecticut Bank of Commerce
Date Closed: 6/26/02
Loss (in millions): $63.0
Assets (in millions): $379.0
Location: Stamford, CT
Charter Year: 1964

10. Financial Institution: Southern Pacific Bank
Date Closed: 2/7/03
Loss (in millions): $100.0
Assets (in millions): $1,000.0
Location: Torrance, CA
Charter Year: 1982

Slide No. 5 - RESULTS OF REVIEW

Four Stages of a Bank Failure

Stage I: Strategy

Corporate Governance
• Change in philosophy
• Aggressive business plan
• Inattentive Board of Directors
• Emergence of a dominant person
• High-Risk lending
• Lack of expertise in high-risk( niche) lending area

Risk Management
• Lack of strategic plan
• Weak risk management

Lending Concentration
• Liberal underwriting
• Weak internal controls
• Aggressive growth

Stage II: Growth
Corporate Governance
• Some violations of laws and regulations
• Insider abuse
• Disregard for examiners’ concerns

Risk Management
• Poor risk diversification
• Financially strong image

Lending Concentration
• Rapid growth in niche (high-risk) area
• High level of fee income, but portfolio does not show loss rates
• Poor credit administration

Stage III: Deterioration
Corporate Governance
• Increased resistance to supervisory concerns
• Independent public accountant problems
• Memorandum of Agreement/Board of Directors Resolutions

Risk Management
• Earnings plateau/decline
• Inadequate Allowance for Loan and Lease Losses
• Capital impaired
Lending Concentration

• Significant loan amounts by type
• Growth plateaus
• Emergency of loan problems worsened by a declining economy

Stage IV: Failing
Corporate Governance
• Enforcement actions issued by regulatory agency
• Departure of key officials

Risk Management
• Severely deficient Allowance for Loan and Lease Losses
• Significant depletion of capital
• Need for massive capital infusion for bank to survive

Lending Concentration
• Massive Loan losses

Slide No. 6 - RESULTS OF REVIEW
Major Causes of Failure

• Inadequate corporate governance
• Weak risk management
• Lack of risk diversification - lending concentrations

Slide No. 7 - CORPORATE GOVERNANCE

Deficiencies by Boards of Directors directly led to failures:
• Change in philosophy/aggressive business plans and rapid growth
• Emergence of dominant person
• Lack of expertise in niche lending area
• Violations of laws and regulations
• Disregard for examiner’s concerns
• Internal control and audit deficiencies

Slide No. 8 - CORPORATE GOVERNANCE

SOUTHERN PACIFIC BANK CHANGE IN COMPOSITION OF LOAN PORTFOLIO

This figure (bar chart with 5 groups containing two items each) represents the changes in the loan portfolio of Southern Pacific at the end of 1995 and 1996.

1. Conforming Residential Mortgage Loans comprised 8 percent of Southern Pacific Bank's Loan Portfolio as of December 31, 1996.
2. Conforming Residential Mortgage Loans comprised 58 percent of Southern Pacific Bank's Loan Portfolio as of December 31, 1995.
3. Commercial Mortgage Loans comprised 7 percent of Southern Pacific Bank's Loan Portfolio as of December 31, 1996.


4. Commercial Mortgage Loans comprised 9 percent of Southern Pacific Bank's Loan Portfolio as of December 31, 1995.
5. Consumer Loans comprised 2 percent of Southern Pacific Bank's Loan Portfolio as of December 31, 1996.
6. Consumer Loans comprised 3 percent of Southern Pacific Bank's Loan Portfolio as of December 31, 1995.
7. Business Loans and Leases comprised 37 percent of Southern Pacific Bank's Loan Portfolio as of December 31, 1996.
8. Business Loans and Leases comprised 2 percent of Southern Pacific Bank's Loan Portfolio as of December 31, 1995.
9. Non-Conforming Residential Mortgage Loans comprised 46 percent of Southern Pacific Bank's Loan Portfolio as of December 31, 1996.
10. Non-Conforming Residential Mortgage Loans comprised 28 percent of Southern Pacific Bank's Loan Portfolio as of December 31, 1996

Slide No. 9 - CORPORATE GOVERNANCE

Aggressive Business Plans

• Pacific Heritage. Increased assets from $200 to $500 million in 4 years. Pursued high-risk/high-yield lending without following prudent underwriting standards.

• First Trust. Generated income through significant construction and development lending. Portfolio grew from $16 million in 1984 to $88 million in 1990, without proper policies and procedures in place.

•Pacific Thrift & Loan. Conducted expansionary program of securitizing subprime loans without regard to adequate policies, programs, and controls.

• BestBank. Increased credit card portfolio from $42 million to $314 million in about 2 years with little preplanning activities or analysis of the market before investment. Did not adopt or implement appropriate policies or procedures prior to funding new business ventures.

• Southern Pacific. Acquired or created 10 commercial and 1 consumer lending divisions from 1993 through 1999 with inadequate loan review program and inferior underwriting and administration practices. Loans were non-traditional, high-yield, high-risk.

Slide No. 10 - CORPORATE GOVERNANCE

Dominant Person

• Pacific Thrift & Loan - president was extremely influential and dominated the lending area.

• Southern Pacific - chairman of the board also served as president and remained a management figure throughout bank’s history.

• Connecticut Bank of Commerce - chairman of the board, who was also the majority stockholder, dominated bank management.

Slide No. 11 - CORPORATE GOVERNANCE

Lack of Expertise in Niche Lending Area

• BestBank. Management was unfamiliar with many aspects of banking, yet invested heavily in risky type of credit card lending.

• First Trust. Management ventured into direct real estate investments without adequate policies and procedures and without fully understanding the consequences of the new initiatives.

• Bank of Newport. Management positioned the bank to be dependent on the commercial real estate market but lacked expertise and experience in commercial real estate lending.

• Bank of San Pedro. Management displayed poor judgment in traditional banking activities (funds management and subsidiary operations) and lacked expertise to properly monitor the purchase and resale of mortgages.

Slide No. 12 - CORPORATE GOVERNANCE

Violating Laws and Regulations Examiners cited common violations of laws and regulations:

• Federal Reserve Board Regulation O, which prohibits loans to insiders
• FDIC Rules and Regulations section 323.4, which established appraisal requirements
• Legal lending limits established by states
• Federal Reserve Act sections 23A and 23B, which prohibit improper transactions between affiliates

Slide No. 13 - CORPORATE GOVERNANCE

Disregard for Examiner’s Concerns

Examiners identified problems and made recommendations that were not adequately addressed by the bank.

• Connecticut Bank of Commerce: risk diversification, risk management, loan underwriting, and loan administration.

• Bank of San Diego: bank management, capital adequacy, classified asset reduction, credit concentration reductions, loan policy revisions, maintenance of sufficient loan loss reserves, and budget and profit plan modifications.

•Bank of San Pedro: poor underwriting standards, subsidiary's real estate investment problems, control of overhead and expenses, reliance on volatile liabilities, inadequate Allowance for Loan & Lease Losses and capital levels, and ineffective funds management policy.

Slide No. 14 - CORPORATE GOVERNANCE

Internal Control and Audit Deficiencies

Banks lacked:

• adequate interaction between management, internal auditors, and external auditors
• strong internal audit function

Management did not:

• follow established policies
•implement and maintain a control environment that promoted risk management in operations
• implement prudent credit and loan administration policies and procedures

Slide No. 15 - WEAK RISK MANAGEMENT

Common Deficiencies

• Cash flow depended primarily on the performance of the real estate market (Pacific Heritage Bank)

•Subprime loans were securitized without regard to adequate policies, programs, and controls (Pacific Thrift and Loan)

•Subprime credit card lending increased without adequate planning or analysis of the market before investing (BestBank)

Slide No. 16 - WEAK RISK MANAGEMENT

Allowance for Loan and Lease Losses
• Insufficient risk rating systems
• Poor loan review processes
• Failure to consider impact on earnings and capital for new and riskier activities (subprime lending)

Slide No. 17 - LACK OF RISK DIVERSIFICATION

Slide No. 17 is a chart showing ten financial institutions and the lack of risk diversification.

1. Financial Institution: Bank of San Diego
Concentration: Construction and development real estate/commercial real estate.
Growth Period in Years: 1982 to 1991
Concentration as a percentage of capital: From 155 percent to 1,163 percent.

2. Financial Institution: Bank of Hartford
Concentration: Multi-family/commercial real estate
Growth Period in Years: 1984 to 1991
Concentration as a percentage of capital: From 163 percent to 238 percent

3. Financial Institution: Bank of San Pedro
Concentration: Construction and development real estate/commercial real estate
Growth Period in Years: 1984 to 1994
Concentration as a percentage of capital: From 215 percent to 808 percent

4. Financial Institution: Bank of Newport
Concentration: Construction and development real estate/commercial real estate
Growth Period in Years: 1984 to 1993
Concentration as a percentage of capital: From 171 percent to 582 percent

5. Financial Institution: First Trust Bank
Concentration: Direct real estate investing
Growth Period in Years: 1985 to 1990
Concentration as a percentage of capital: From 38 percent to 120 percent

6. Financial Institution: Pacific Heritage Bank
Concentration: Construction and development and real estate/commercial real estate
Growth Period in Years: 1985 to 1993
Concentration as a percentage of capital: From 192 percent to 709 percent

7. Financial Institution: BestBank
Concentration: Unsecured subprime loans for credit cards
Growth Period in Years: 1996 to 1998
Concentration as a percentage of capital: Total assets from 650 percent to 1,160 percent
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8. Financial Institution: Pacific Thrift and Loan
Concentration: Interest-only residual receivables
Growth Period in Years: 1997 to 1999
Concentration as a percentage of capital: From 69 percent to 776 percent (increase due mainly to depletion of capital)

9. Financial Institution: Connecticut Bank of Commerce
Concentration: Commercial real estate and out-of-territory lending
Growth Period in Years: 1996 to 2002
Concentration as a percentage of capital: Over 400 percent

10. Financial Institution: Southern Pacific Bank
Concentration: Suprime residential mortgage loans and commercial and industrial loans (industry concentrations)
Growth Period in Years: Residential - 1991 to 1993 and commercial - 1994 to 2000
Concentration as a percentage of capital: Residential no available and commercial over 223 percent.

Slide No. 18 - INDEPENDENT PUBLIC ACCOUNTANT CONCERNS

• Independent Public Accountants (IPA) for Pacific Thrift and Loan, Connecticut Bank of Commerce, and Southern Pacific Bank did not comply with American Institute of Certified Public Accountants Statement on Auditing Standards 58, Reports on Audited Financial Statements.
• Did not fairly, accurately, and promptly identify the actual financial condition of bank.
•Did not provide a written report of internal control weaknesses to bank’s audit committee and examiners.
•IPAs performed both annual financial statement audits and internal audits, a practice that is now prohibited for publicly-traded companies by the Sarbanes-Oxley Act and U.S. Securities and Exchange Commission.

Slide No. 19 - OTHER FACTORS IN FAILURES

Fraud and insider abuse was apparent in two failures
• BestBank engaged in high-risk credit card program administered by a third-party contractor who made delinquent accounts appear current, which delayed the recognition of $134 million in losses.
• Connecticut Bank of Commerce’s majority shareholder orchestrated a $20 million nominee loan scheme to obtain funds to purchase another bank.

Slide No. 20 - OBSERVATION NO. 1

Banks that fail often exhibit warning signs even though they appear to be financially strong.

Slide No. 21 - OBSERVATION NO. 2

Financial condition is no guarantee of future performance.

Slide No. 22 - OBSERVATION NO. 3

Banks that fail often assume more risk than bank management is capable of handling.

Slide No. 23 - OBSERVATION NO. 4

Inattentive or passive Board of Directors is a precursor to most problems.

Slide No. 24 - OBSERATION NO. 5

Banks reach a point at which problems become serious and ultimately intractable. Failure is unavoidable absent a significant capital contribution.

Slide No. 25 - PRIOR OIG RECOMMENDATIONS

The OIG material loss review reports made numerous recommendations implemented by the FDIC to help prevent future material losses. The recommendations pertained to examiner use of enforcement actions and addressed examiner assessment of:
• Corporate governance
• Risk management
• Risk diversification
• Subprime lending
• Securitizations

Slide No. 26 - FDIC INITIATIVES TO IMPROVE BANK SAFETY AND SOUNDNESS FDIC

Initiatives
• Risk-focused examinations
• Internal guidance issued on: 1) the impact of the Sarbanes-Oxley Act of 2002 ; 2) internal controls and the detection of fraud 3); subprime lending programs; and 4) real estate lending standards
• Rule changes for high-risk residual assets
• Risk-based capital requirements
• Outreach programs aimed at bank directors and senior banking officials
• Symposium on “Lessons Learned” from bank failures

Slide No. 27 – CONCLUSIONS

• Bank management ultimately determines how a bank will perform

• Bank failures will likely never go away

• Observations in this report may help the FDIC limit the cost impact of future bank failures on the Bank Insurance Fund