Although improving, the bank remains in less than satisfactory condition. Asset quality is weak, earnings are poor, and management needs to make additional efforts to comply with the outstanding Memorandum of Understanding (MOU). Capital is less than satisfactory in relation to the present risk profile. Liquidity is satisfactory and the bank’s sensitivity to market risk is at manageable levels.
Memorandum of Understanding
The bank entered into a MOU on July 31, 2003, based on the October 21, 2002, FDIC examination findings. Three of the six provisions of the MOU have not yet been fully satisfied, including an inadequate Allowance for Loan and Lease Losses (ALLL), significant errors in recent Reports of Condition and Income, and lack of documentation on credit extensions. Refer to the Compliance with Enforcement Actions page for additional details.
Asset Quality – 4
Asset quality remains weak and is the primary impediment to improvement in the bank’s overall condition. As reflected on the Examination Data and Ratios page, the volume of adversely classified items has decreased by 12 percent since the prior examination, with the volume of adversely classified loans dropping by 24 percent. Despite the decrease, adverse classifications still represent 84 percent of Tier 1 Capital and the ALLL, and the severity of classifications has increased significantly. In particular, $1,015M and $140M are presently adversely classified Loss and Doubtful, respectively.
Examination classifications are concentrated in the commercial real estate portfolio. Loans adversely classified Loss (portions of three relationships totaling $890M) are commercial real estate loans that were adversely classified Substandard at the prior examination.
Most troubled credits result from past liberal lending practices exacerbated by the depressed regional economy, particularly the local fishing industry. In response to past regulatory criticisms, management has taken affirmative steps to strengthen credit administration by tightening overall underwriting standards, strengthening collection efforts, decreasing commercial real estate advance rates from 90 percent to 75 percent, and avoiding financing for speculative real estate acquisition and development projects. Although these actions have longer-term positive implications, present credit quality remains hindered by numerous workout situations and the deterioration of existing credits not previously subject to adverse classification. Additional detail regarding trends in the level of adversely classified loans can be found on the Analysis of Loans Subject to Adverse Classification page.
Loan Review and Internal Grading System
The defined scope of the internal loan review and grading system is adequate. However, management has been unable to comply with internally defined review frequency standards given the elevated personnel demands associated with working out problem assets. Additionally, assigned credit grades for several larger credits were inaccurate, as exemplified by the partial Loss classification of the Ima Deadbeat, Ltd., and Kringle relationships. In both cases, the credits were internally rated substandard. Additionally, several credits adversely classified Substandard were internally rated “watch.” To address this issue, management should more tightly define all credit grades and ensure that they are accurately applied.
President Allie C. Lincoln stated that management should be able to adhere to established loan review frequency standards by mid-2005, and that all grading definitions would be reviewed before year-end 2004.
Allowance for Loan and Lease Losses (ALLL)
The ALLL is inadequate by at least $325M, primarily due to liberal internal credit grading. Additionally, the ALLL allocation for non-watch list credits is inadequate based upon the bank’s recent loan loss experience on non-watch list loans. Specifically, the institution’s average loss rate on non-watch list loans since 2001 is approximately 0.75 percent; however, management only allocates 0.10 percent for residential mortgages and only 0.50 percent for all other non-watch list loans.
The Board of Directors agreed to make a $325M loan loss provision prior to filing the September 30, 2004, Reports of Condition and Income. President Lincoln initiated a review of the loan grading system during the examination, and stated that all existing reserve percentages will be reviewed.
Credit Administration and Lending Policies
Credit administration, although improving, requires further attention. As detailed on the Assets with Credit Data or Collateral Documentation Exceptions page, loans possessing documentation exceptions remain high. In particular, the following significant credit weaknesses should be promptly addressed:
- Credit Analysis on Participations Purchased – Pre-purchase credit analysis is not performed on participations purchased. An institution purchasing a loan participation should perform the same degree of independent credit analysis as if it were the originator.
- Inspections and Lien Waivers – Inspections are not performed and mechanic’s lien waivers are not obtained prior to making advances on construction loans. It is essential that inspections be performed and lien waivers obtained to protect the bank’s collateral and lien positions.
- Rent Rolls – Rent rolls and vacancy figures are not obtained on an ongoing basis for loans secured by commercial real estate. Rent roll and vacancy information are essential to properly monitor these types of loans.
- Perfection – The institution periodically allows perfected interests in collateral to lapse due to its failure to file timely Uniform Commercial Code continuation statements. (Refer to the Assets with Credit Data or Collateral Documentation Exceptions page for examples.) An effective “tickler” system to assist in keeping filings current is necessary to prevent a loss in collateral protection.
The bank’s loan policy is generally adequate with only minor enhancements recommended. (See the Risk Management Assessment page for additional detail.)
President Lincoln stated loan officers would immediately begin performing pre-purchase analyses on participations purchased. He also stated that the volume of documentation deficiencies is primarily due to understaffing, and indicated that management is in the process of hiring an additional loan clerk to assist in this area.
Other Real Estate (ORE)
The dollar volume of adversely classified ORE increased $535M, or 78 percent, since the previous examination. The ORE portfolio consists of commercial real estate previously written down to fair value. Further deterioration in carrying values is likely given the present condition and outlook for the local economy.
Several asset concentrations, including a fishing industry concentration, are listed on the Concentrations page of this Report. While these concentrations are not criticized in and of themselves, management does not currently have procedures in place to identify and monitor such concentrations. Given the potential for increased risk posed by asset concentrations, the Board of Directors should establish appropriate policies and procedures to ensure these risks are properly identified and monitored.
President Lincoln indicated he would develop procedures for monitoring concentrations of credit and present them to the Board for its review and approval by year-end 2004.
Disposition of Assets Classified Loss
President Lincoln stated that all assets classified Loss totaling $1,015M will be charged off by September 30, 2004.
Earnings - 4
Earnings performance remains poor. As detailed on the Analysis of Earnings page of this Report, the bank experienced significant net operating losses for both 2002 and 2003. Although the bank shows net income of $103M for the first six months of 2004, profits are substantially overstated due to inadequate provisions for loan losses. Once the additional recommended provision of $325M is made to the ALLL, the bank will show a pre-tax net operating loss of $222M for the first six months of 2004.
The poor earnings performance is a direct result of persistent poor asset quality, including a high level of ORE. The high level of nonperforming assets has weakened interest income, required high loan loss provisions, and increased overhead expenses. Although nonaccruals and other nonearning assets remain high, the net interest margin for the first six months of 2004 has actually improved as reflected on the Examination Data and Ratios page. This improvement is primarily the result of management’s ability to maintain interest rates in the loan portfolio at 9 percent, while reducing the average cost of funds to approximately 4.26 percent.
Total Noninterest Expense as a percentage of Average Assets has steadily increased over the last three years and has reached 3.82 percent as of June 30, 2004. Present overhead levels are nearly 100 basis points above comparable institutions, and results largely from expenses associated with ORE. Given the composition and level of problem assets, management does not expect ORE-related expenses to diminish in the near future. Overhead expenses will also increase with additional lending staff. Management plans to close the institution’s only branch office on September 30, 2004, in an effort to reduce overhead.
The 2005 budget forecasts net income of $226M. With the exception of inaccurate assumptions related to the level of provision expense, the budgeting process is adequate and the assumptions used are reasonable. Future profitability is primarily dependent on improved asset quality and controlling overhead expenses. Based on operational changes and cost-cutting measures already implemented, along with anticipated further reductions in troubled assets, it is possible that the bank will reflect a profit in 2005.
Chairman of the Board Sean Ratzlaff stated that the directorate and senior management would revise the budget to more accurately depict provision expense levels. He directed President Lincoln to have the revised budget ready for Board review and approval at its November 2004 meeting.
Management - 3
In aggregate, the performance of senior management and the Board of Directors remains less than satisfactory. The bank’s current financial condition is primarily the result of liberal lending policies and poor credit administration practices dating to the late-1990s. As documented in prior examination reports, the present management team aggressively pursued loan growth at the expense of prudent lending standards, and ultimately, asset quality. Although initial signs of more prudent loan underwriting and improved credit administration are evident, asset quality remains weak and significant aspects of the credit function remain deficient as discussed in greater detail under Asset Quality.
Board minutes indicate that Chairman of the Board Ratzlaff and President Lincoln dominate policy discussions and decisions. It appears that other Board members need to become more actively involved in the bank's affairs. For example, Director Michael D. Jones attended only 5 of the 12 Board meetings held since the previous examination. Regular attendance at Board and committee meetings is a prerequisite to fulfilling the duties of a director; directors who are unable to meet this obligation should consider resignation. The absence of formal objectives and the inadequacy of written policies have compounded the difficulties of the bank's directors, particularly the outside directors, in fully discharging their supervisory responsibilities.
Director Jones stated that he frequently travels out of town on business; however, he committed to attending Board meetings on a more regular basis.
Listed on the Violations of Laws and Regulations page are apparent violations of the Treasury Department’s Financial Recordkeeping regulations and the Federal Reserve Board’s Regulation O. The Financial Recordkeeping citation, regarding the late filing of Currency Transaction Reports, was also cited at the last FDIC examination. Although the number of late filings has declined, repeat infractions do not reflect favorably on the Board and management. The Board of Directors should implement improved controls and procedures to ensure late filings do not continue.
Chairman of the Board Ratzlaff committed to improved BSA and Financial Recordkeeping controls, and promised future compliance.
The bank’s 2000 strategic plan has not been maintained and is inconsistent with the present condition of the institution, the regional economy, and the local competitive environment. Specifically, the plan's assumptions do not consider the continuing decline of the local fishing industry, the potential impact of a new commercial bank in town, or the recent merger of two local savings and loan associations. Based on these factors, many of the goals and strategies in the plan are outdated and unrealistic. The Board should revise the current plan to include these factors and current conditions.
Chairman of the Board Ratzlaff stated that the strategic plan would be reviewed and updated before the end of 2004.
Audit and Internal Control
The audit and internal control function lacks independence. While the scope and frequency of the internal audit program are acceptable, Internal Auditor Jasmine Jackson reports directly to President Lincoln. Since President Lincoln is ultimately responsible for most of the day-to-day operations reviewed by the internal auditor, this situation compromises the independence of the internal audit program. The internal auditor should report directly to the Board of Directors or the Audit Committee of the Board to ensure the independence and effectiveness of the audit function. President Lincoln is also a member of the Audit Committee, which oversees the external audit function. His presence on the committee further limits audit independence. Several outside directors are qualified to serve on the Audit Committee, and it is recommended that committee membership consist entirely of outside directors.
Several internal control deficiencies are detailed under Item 5 of the Risk Management Assessment page of this Report. While these deficiencies are relatively minor, management reported that two of these items were corrected in the response to the last external audit. This error underscores the need for more independence in the audit function.
Chairman of the Board Ratzlaff stated that the Board would consider these recommendations at its next meeting. He also stated the internal control deficiencies would be addressed.
Reports of Condition and Income
Material errors were noted in the last three quarterly Reports of Condition and Income. In numerous cases, examiners were unable to reconcile bank records and workpapers with reported figures. The most significant errors relate to the inaccurate reporting of loans and ORE, and the inappropriate inclusion of gains on the sale of repossessed assets in interest income. These errors have served to overstate net interest income somewhat, although as stated previously, the primary reason for the improvement has been management’s ability to maintain loan portfolio rates while decreasing cost of funds.
Executive Vice President/Cashier John M. Gutierrez filed amended Reports of Condition and Income during the examination.
Capital - 3
Capital is less than satisfactory in relation to the bank's risk profile. The Adversely Classified Items Coverage Ratio remains high at slightly more than 84 percent. In addition, after making the needed ALLL provision, the bank has had net operating losses over the past two and a half years, and future profitability is questionable. The existing concentration in fishing industry loans, considering the industry’s current depressed condition and anticipated continuing decline, adds to capital concerns. The Tier 1 Leverage Capital ratio of 7.44 percent reflects current examination adjustments for assets classified Loss and the provision expense needed to replenish the inadequate ALLL.
President Lincoln pointed out that dividends have not been paid for five years. He further stated that no dividends would be paid until the Tier 1 Leverage Capital ratio exceeds 8 percent and bank earnings become positive and stable.
Liquidity - 2
The bank’s liquidity position is adequate. Asset growth has been minimal since the last FDIC examination and the loan portfolio is shrinking. Management has increased the bank’s investment in mortgage-backed securities with the portfolio maintaining slight appreciation. Non-core funding has increased slightly but management is using these funds appropriately. Off-balance sheet commitments are minimal. While the bank’s liquidity position and actual practices are generally satisfactory, no written funds management policy is in place.
President Lincoln stated that a written funds management policy would be developed and implemented by March 31, 2005.
Sensitivity to Market Risk - 2
The bank’s sensitivity to market risk relates primarily to interest rate risk, which is minimal. The balance sheet contains a low volume of potentially volatile assets, and funding sources reasonably match the bank's asset repricing structure. The bank does not engage in off-balance sheet derivative activity.
Although the bank has suffered from a lackluster net interest margin and overall poor earnings performance, the net interest margin has remained relatively stable when the substantial volume of nonperforming loans is removed from the calculation of Average Earning Assets. Management regularly monitors the bank's interest rate sensitivity position and presents detailed quarterly gap reports to the Board. The loan portfolio is composed primarily of adjustable-rate commercial loans and fixed-rate mortgage loans. Over the past two years, depositors have moved funds out of maturing time deposits and into money market demand accounts. Management actively manages rates on these deposits, as the local market is extremely competitive.
Meeting with the Directorate
A Board of Directors’ meeting was held on September 18, 2004. All directors were present with the exception of Director Henry P. Herrington. Will Smith, a partner with the bank’s external auditing firm, was also present. Assistant Regional Director Cynthia Jones represented the State Department of Banking. Field Supervisor Ira B. Sharp, Assistant Examiner Monica D. Powers, and the undersigned examiner represented the FDIC. All matters listed above were discussed with the Board. Most of the discussion concerned the increase in severity of adverse classifications, the need to improve the ALLL methodology, and management’s efforts to improve loan administration procedures. The Directorate’s and management’s commitments for corrective action are noted above. The Board strongly asserted that because of the improvement in the bank’s overall condition, the Memorandum of Understanding should be removed.
Each member of the Board of Directors is responsible for thoroughly reviewing this Report of Examination. Each Director must sign the Signatures of Directors page, which affirms that he or she has reviewed the Report in its entirety.