Decisions on Bank Applications
FEDERAL DEPOSIT INSURANCE CORPORATION
IN RE:. Fremont Bank Fremont, California
Application Pursuant to Section 24 of the Federal Deposit Insurance Act for Consent to Continue to Engage Directly as Principal in Real Estate Investment Activities and for Consent to Continue to Indirectly Engage as Principal Through a Wholly-Owned Subsidiary in Real Estate Investment Activities That May Not Be Permissible for a Subsidiary of a National Bank
Pursuant to the provisions of section 24 of the Federal Deposit Insurance Act ("FDI Act") Fremont Bank, Fremont, California ("Bank"), has filed an application with the Federal Deposit Insurance Corporation ("FDIC"). The Bank requests the FDIC's consent to continue to engage directly as principal in real estate investment activities, and to continue to indirectly engage in real estate investment activities through Investmark, Inc. ("Subsidiary"), a wholly-owned subsidiary of the Bank which holds real estate investment properties.
The activity of holding real estate investment properties may not be permissible. 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.
The Bank has been involved in real estate activities since 1984. Both the Bank and the Subsidiary participate in speculative residential land acquisition, site development, construction, and rental of properties in the Bank's market area on a speculative basis for sale to third parties. The Bank offers financing to these third parties. The Bank's major real estate ventures consist of two single family subdivisions and three building lots in various stages of development. The Subsidiary's investments are limited to a partially completed residential subdivision and another residential subdivision in the planning stage. The Bank intends to continue to engage only in the types of real estate investment activities that are presently conducted.
In determining if a significant risk to the deposit insurance fund exists in the proposal, the Board of Directors of the FDIC ("Board") considered the risks associated with real estate investment activities. The Board also considered the parameters under which savings associations may engage in 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 the Bank's application to determine 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 the Bank'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 and managerial resources and future earnings prospects of the Bank to determine its ability to support real estate investment activities; (3) capital adequacy (as assessed using the Bank's "consolidated" and "bank only" leverage and risk-base? capital ratios, with all investment real estate at the sank level and all investments in the Subsidiary 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 existence of a separate corporate entity for the activities, and the proposed subsidiary structure and its management policies and practices, to determine if the Bank is adequately protected from litigation risk; (5) the Bank's policies relating to extensions of credit to third parties for real estate investment related transactions to determine if they protect the Bank from concentrations of risk; (6) the Bank's policies on engaging in transactions in which insiders are involved to determine if they protect the bank from potential insider abuse; (7) the Bank's policies relating to the conditioning of loans on the purchase of real estate from the Bank or Subsidiary and the extending of Credit by the Bank to third parties for the purpose of acquiring real estate from the Bank or Subsidiary 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 Bank proposes to limit its total real estate investment to 33 percent of capital. As of September 30, 1995, the Bank's real estate investments represented approximately 18 percent of the Bank's Tier 1 capital and approximately 2 percent of the Bank's total assets. Given the high risk nature of the real estate activities in question, including the development of real estate and the construction of houses on a speculative basis, the wide fluctuations in operating results which have been experienced, the Bank's extension of end-loan financing, and the lack of a fully developed business plan, the Board has determined that the proposed investment limit is unsuitable. The Board will require that a real estate investment limit of 20 percent of Tier 1 capital be imposed, and that the nature of the real estate activities be limited to the types of activities described in the Bank's application. Furthermore, in order to ensure that the Bank's capital is sufficient to support both traditional banking activities and real estate investment activities, the Board will require that the Bank's capital, after deducting the Bank's aggregate investment in the Subsidiary, 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 the Bank make this calculation quarterly; if capital falls below the level of a well capitalized institution, the Bank shall inform the FDIC and submit a plan to restore capital to the well capitalized level.
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 the Bank 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 the Bank's capital category for purposes of Prompt Corrective Action be determined, and the Bank'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 the Bank is "critically undercapitalized" as defined under Part 325 of the FDIC's Rules and Regulations.
To satisfy the requirements of section 24 of the Federal Deposit Insurance Act, the Board will require that the Bank transfer all directly held real estate investments to the Subsidiary, or divest all directly held real estate investments by December 19, 1996. To protect the corporate veil between the Subsidiary and the Bank, thus mitigating litigation risks, the Board will require that the Bank and the Subsidiary take the necessary actions to make sure that the Subsidiary operates in a manner so as to ensure a separate corporate existence as a majority-owned subsidiary which: is adequately capitalized; is physically separate and distinct in its operations from the operations of the Bank; maintains separate accounting and other corporate records; observes separate formalities such as separate board of directors' meetings; maintains 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; contracts with the Bank for any service on terms and conditions comparable to those available to or from independent entities; and conducts business pursuant to separate policies and procedures designed to inform customers and prospective customers of the Subsidiary that the Subsidiary is a separate organization from the Bank, including the placement of specific language on any debt instrument or contract with a third party disclosing that the Bank itself is not responsible for payment or performance.
To safeguard against conflicts of interest that may prejudice the interest of depositors or harm minority shareholders of the Bank, the Board will require that the Bank 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.
To maintain safe and sound underwriting standards and to reduce or preclude the potential for breaches of fiduciary duty, and thus protect the Bank and the deposit insurance fund on an ongoing basis, the Board will require that: (a) the Bank not condition any loan on the purchase or rental of real estate from any subsidiary engaged in real estate investment activities, and (b) the Bank 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 practices, 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 the Bank, 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 before 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 Subsidiary were an affiliate of the Bank 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 the Bank's real estate investments are sufficiently diversified within the Subsidiary; and (2) the collateral requirements and investment limitations of section 23A shall not apply to loans made by the Bank to third parties to finance bona fide purchases of real estate from the Subsidiary provided such loans are consistent with safe and sound banking practices 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 the Bank, as those prevailing at the time for other comparable transactions. Any such loans made by-the Bank 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 (1) the Bank's proposal to continue to engage directly as principal in real estate investment activities does not satisfy the requirements of section 24 of the FDI Act and, therefore, should be denied; and (2) the Bank's proposed retention of interest in real estate investment activities does not pose a significant risk to the deposit insurance fund, provided certain conditions are observed and, therefore, approval, subject to conditions in the Order, is warranted.
THE BOARD OF DIRECTORS
FEDERAL DEPOSIT INSURANCE CORPORATION