Decisions on Bank Applications
California State Bank
FEDERAL DEPOSIT INSURANCE CORPORATION
California State Bank Covina, California
Application Pursuant to Section 24 of the Federal Deposit Insurance Act for Consent to Continue to Indirectly Engage as Principal Through two Wholly-Owned Subsidiaries in Real Estate Investment Activities That May Not Be Permissible for a National Bank
STATEMENT
Pursuant to the provisions of Section 24 of the Federal Deposit Insurance Act ("FDI Act") California State Bank, Covina, California ("CSB"), has filed an application with the Federal Deposit Insurance Corporation ("FDIC"). CSB requests the FDIC's consent to continue to indirectly engage in real estate investment activities through Citrus State Development Corporation ("Citrus") and Granada Realty Services, Inc. ("Granada"), two wholly-owned subsidiaries of CSB which hold real estate investment properties. Citrus and Granada are hereinafter referred to collectively as the "Real Estate Development Subsidiaries".
The activity of holding real estate investment properties may not be a permissible activity for a National bank or a subsidiary of a National bank. State chartered FDIC-insured banks may not engage as principal in an activity prohibited to nationally chartered banks unless they obtain consent from the FDIC. Consent may not be granted unless the bank is in compliance with applicable capital standards and the FDIC determines that the activity poses no significant risk to the deposit insurance fund. California State law permits the holding of real estate investment properties by banks and their subsidiaries. In determining if a significant risk to the deposit insurance fund exists in the proposal, the FDIC's Board of Directors (the "Board") considered the risks associated with real estate investment activities.
Investments in real estate, at any stage of the development process or even completed properties, can be generally characterized as risky in that there is a high degree of variability or uncertainty of returns on invested funds. The cyclical downturn in the real estate market in the late 1980's and early 1990's, and the impact of that downturn on financial institutions, provides an illustration of the market risk presented by real estate investment. In addition to the high degree of variability, real estate investments possess many risks that, while not entirely unique, are not readily comparable to typical equity investments (e.g., common stock). Real estate markets are for the most part localized, investments are normally not securitized, financial information flow is often poor, and the market is generally not very liquid.
Real estate investment risk is higher than for most traditional bank assets, such as loans or debt securities. Real estate investment can increase interest rate risk, optimum investment periods are typically long-term, real estate is relatively lacking in liquidity, and real estate is subject to specialized risks such as environmental liability. In addition, real estate investment is of questionable benefit in the diversification of a financial institution's portfolio of assets. The experience and expertise of management is a critical factor, and there is much anecdotal evidence to suggest that the lack of adequate management creates a significant level of risk of loss.
Due to the risks outlined above, real estate investment activities appear suitable to a bank only on a very limited scale and under restrictive conditions designed to control the various risks posed to the bank and the deposit insurance fund.
In addition to considering the general risks associated with real estate investment activities, the Board also considered the specifics of CSB's application in determining if a significant risk to the deposit insurance fund exists.
In evaluating this application, the Board reviewed the following: (1) the type and level of CSB's current and proposed real estate investment to determine if the type of activity and level of investment are suitable for an insured depository institution; (2) the financial condition and managerial resources of CSB as well as the performance and prospects of the Real Estate Development Subsidiaries to determine CSB's ability to support real estate investment activities; (3) capital adequacy (as assessed using CSB's "consolidated" and "bank only" leverage and risk-based capital ratios, with all investments in the Real Estate Development Subsidiaries excluded from capital in the "bank only" capital calculation) to determine the impact to capital in the event that the entire real estate investment was lost; (4) the proposed subsidiary structure and its management policies and practices to determine if CSB is adequately protected from litigation risk; (5) CSB's policies relating to extensions of credit to third parties for subsidiary related transactions to determine if they protect CSB from concentrations of risk; (6) CSB's policies on engaging in transactions in which insiders are involved to determine if they protect the bank from potential insider abuse; (7) CSB's policies relating to the conditioning of loans on the purchase of real estate from the Real Estate Development Subsidiaries and the extending of credit by CSB to third parties for the purpose of acquiring real estate from the Real Estate Development Subsidiaries to determine if they prevent undesirable tying relationships and to determine if they are adequate to ensure that sound credit underwriting is maintained; and, (8) the provisions of sections 23A and 23B of the Federal Reserve Act to determine the appropriateness of applying these restrictions to the real estate investment activities. The Board also considered the parameters under which savings associations may engage in real estate investment activities.
CSB has been involved in real estate activities through the Real Estate Development Subsidiaries since 1984. These real estate activities consist of acquiring small tracts of land within established neighborhoods in the San Gabriel Valley, improving the land, and, constructing single family residences. Typically, tracts acquired contain an existing structure with large acreage; after acquisition, the property is subdivided to make additional house lots. Currently, the Real Estate Development Subsidiaries own twenty house lots, sixteen of which have houses in various stages of construction. The twenty house lots are divided among six separate projects. If its application is approved, CSB intends to. confine its real estate investment activities to the types presently conducted and proposes to limit its total real estate investment to 30 percent of capital. As of September 30, 1995, CSB's outstanding and total (including undrawn lines of credit to the Real Estate Development Subsidiaries) investment in the Real Estate Development Subsidiaries represented approximately 20 percent and 47 percent of CSB's Tier 1 capital, respectively.
In conducting its real estate investment activities, CSB and the Real Estate Development Subsidiaries attempt to minimize risk inherent in such activities by following sound policies, conducting feasibility studies and obtaining current appraisals on proposed projects, dealing with well known and established developers, diversifying real estate investments based on geographic market or type, limiting investments to smaller projects in established subdivisions, requiring nonrecourse agreements to CSB on any third party borrowings obtained by the Real Estate Development Subsidiaries, limiting the ability of insiders to be involved with the real estate investment activities, and, not financing end-loans on properties developed by the Real Estate Development Subsidiaries. The Real Estate Development Subsidiaries do not, however, construct houses on a pre-sold basis.
Overall, CSB has been favorably impacted by its real estate investment activities; however, the wide variation in the earnings of Real Estate Development Subsidiaries reflect the risk inherent in real estate investment. The bulk of the Real Estate Development Subsidiaries' profits to date were earned prior to 1990. In 1991, as a result of poor economic conditions and declining real estate values, the Real Estate Development Subsidiaries had to recognize significant write downs on real estate investment properties. Losses recognized by the Real Estate Development Subsidiaries during this time contributed to reduced earnings for CSB. The Real Estate Development Subsidiaries have only been nominally profitable since that time; however, they do expect to recover at least some of the write downs as they bring their current properties to market.
CSB's overall financial condition is sound and appears to have the ability to withstand potential risks associated with the holding of investment property at the subsidiary level while continuing to exceed its minimum capital requirements.
In this case, due to the positive factors outlined above, the Board will allow CSB to continue its real estate investment activities, provided certain conditions are observed, including limiting CSB's total real estate investment to 20% of Tier 1 capital. CSB's proposed investment limitation of 30% is not considered suitable given the general risks associated with real estate investment activities, the added risk presented by the construction of houses on a speculative'basis, and, the wide fluctuations in the Real Estate Development Subsidiaries operating results. Although CSB's outstanding investment at September 30, 1995 approximates the 20% limitation, the lines of credit to the Real Estate Development Subsidiaries are considered part of CSB's total investment and, therefore, the Board will require CSB to submit a plan to reduce the total investment to the 20% level. Furthermore, in order to ensure that CSB's capital is sufficient to support both traditional banking activities and real estate investment activities, the Board will require that CSB's capital, after deducting CSB's total investment in the Real Estate Development Subsidiaries, equal or exceed the level required for a "well capitalized" institution pursuant to Part 325.103(b)(1) of the FDIC's Rules and Regulations. The Board will require that CSB make this calculation quarterly; if capital falls below the level of a well capitalized institution, CSB shall inform the FDIC and submit a plan to restore capital to the well capitalized level.
In order to monitor ongoing real estate investment activities (current and planned investments up to the 20 percent level) and to provide the FDIC with an opportunity to object to any planned investment which appears to contain excessive risk, the Board will require that CSB submit an investment plan to the Regional Director of the FDIC's Division of Supervision annually.
To ensure that the deposit insurance fund is adequately compensated for and sufficiently protected from additional risk, the Board will require that CSB's capital category for purposes of Prompt Corrective Action be determined, and CSB's risk adjusted deposit insurance premium be assessed, based on "bank only" capital ratios. The deduction of these real estate investments, however, will not be used to determine whether CSB is "critically undercapitalized" as defined under Part 325 of the FDIC's Rules and Regulations.
In order to protect the corporate veil between the Real Estate Development subsidiaries and parent, thus mitigating litigation risks, the Board will require that CSB and the Real Estate Development Subsidiaries take the necessary actions to establish, and the Real Estate Development Subsidiaries operate in a manner so as to ensure separate corporate existences as majority-owned subsidiaries which: are adequately capitalized; are physically separate and distinct in their operations from the operations of CSB; maintain separate accounting and other corporate records; observe separate formalities such as separate board of directors' meetings; maintain a board of directors with one or more independent, knowledgeable outside directors and management expertise capable of conducting activities in a safe and sound manner; contract with CSB for any service on terms and conditions comparable to those available to or from independent entities; and conduct business pursuant to separate policies and procedures designed to inform customers and prospective customers of the Real Estate Development Subsidiaries that the Real Estate Development Subsidiaries are separate organizations from CSB, including the placement of specific language on any debt instrument or contract with a third party disclosing that CSB itself is not responsible for payment or performance.
In order to safeguard against conflicts of interest that may prejudice the interest of depositors or harm minority shareholders of CSB, the Board will require that CSB not engage, directly or indirectly through any subsidiary, in any real estate investment related activity or other transaction with insiders or their related interests without the prior written consent of the Regional Director of the FDIC's Division of Supervision.
In order to maintain safe and sound underwriting standards and to reduce or preclude the potential for breaches of fiduciary duty, and thus protect CSB and the deposit insurance fund on an on-going basis, the Board will require that: (a) CSB not condition any loan on the purchase or rental of real estate from any subsidiary engaged in real estate investment activities, and (b) CSB not extend credit to any borrower to acquire real estate from any subsidiary engaged in real estate investment activities unless it is consistent with safe and sound banking practice, does not involve more than the normal degree of risk of repayment and is made on terms and under circumstances, including credit standards, that are substantially the same or at least as favorable to CSB, as those prevailing at the time for comparable transactions.
The Board will require that any potential conflict of interest relating to real estate investment activities be identified, appropriately resolved if possible, and approved by the bank's board of directors prior to consummation of any transaction.
To prevent objectionable transactions pertaining to these activities and to ensure that all transactions are conducted in a safe and sound manner, the Board will require that transactions relating to the real estate investment activities comport with the restrictions of sections 23A and 23B of the Federal Reserve Act to the same extent as though the Real Estate Development Subsidiaries were affiliates of CSB as defined under sections 23A and 23B, with the exception that (1) the 10 percent limitation on covered transactions under 23A shall not apply as CSB's real estate investments are sufficiently diversified within the Real Estate Development Subsidiaries; and (2) the collateral requirements and investment limitations of section 23A shall not apply to loans made by CSB to third parties to finance bona fide purchases of real estate from the Real Estate Development Subsidiaries provided such loans are consistent with safe and sound banking practice and do not involve more than the normal degree of risk of repayment and the loans are extended on terms and under circumstances, including credit standards, that are substantially the same, or at least as favorable to CSB, as those prevailing at the time for other comparable transactions. Any such loans made by CSB will be reviewed by examiners at each regular safety and soundness examination conducted by the FDIC.
For the reasons outlined above, the Board has concluded that CSB's retention of interest in real estate does not pose a significant risk to the deposit insurance fund, provided the above conditions are observed, and therefore approval of the application, subject to conditions in the Order, is warranted.
THE BOARD OF DIRECTORS
FEDERAL DEPOSIT INSURANCE CORPORATION