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Appeals of Material Supervisory Determinations: Guidelines & Decisions

SARC-2001-02 (August 3, 2001)

At its meeting held on July 30, 2001, the Supervision Appeals Review Committee (Committee) of the Federal Deposit Insurance Corporation (FDIC) considered the appeal filed by [Bank] (Bank). In its appeal, the Bank contested certain material supervisory determinations contained in the safety and soundness examination, dated October 16, 2000, (Report) prepared by the FDIC.

Upon careful consideration of the issues raised in the appeal, the Committee determined that the component and composite Uniform Financial Institution Ratings and the loan classifications assigned at the examination were appropriate. Commissioner Steven D. Bridges of the Georgia Department of Banking and Finance, who was provided with a copy of the Bank’s letter and appeal, has advised the FDIC that the State strongly believes that the composite “3” rating assigned at the examination was appropriate.

The Committee’s rationale for the decision rendered in the Bank’s appeal is presented below.

Loan Classifications
The Bank appealed eight of the Substandard loan classifications assigned in the Report. The Acting Director of the Division of Supervision (Acting Director) granted the appeal of the classification of the A loan in the amount of $180,000. In addition, the Acting Director granted the appeal of the $133,000 loan to borrower B. The Committee denied the Bank’s appeal of the remaining Substandard classifications for the following reasons.

Customer C: The borrower’s credit history and credit score information, combined with late payments of this credit, albeit less than 30 days, are indicative of serious deficiencies in repayment capacity. In addition, a high loan-to-value (LTV) ration of 89 percent provides the distinct possibility that Bank will sustain some loss on this credit.

Customer D: The Bank indicates that the excess collateral protection in one loan is available to secure the rest of the borrower’s loans. However, no documentation was provided by the Bank to show that the loans are cross-collateralized. Four of the remaining six loans to the borrower have LTV ratios in excess of 90 percent, and payments are not made by the due dates. As a result, late fees assessed by the Bank are eliminating amortization of the principal balance for the majority of the loans. These facts, combined with concerns about the borrower’s repayment capacity, as evidenced by his credit history and a lack of cash flow statements on the income producing properties, support the Substandard classification.

Customer E: The borrowers performance on this credit and his credit history indicate a problem with repayment capacity. Foreclosure is imminent and, given the credit’s high LTV ratio, there is a distinct possibility of loss.

Customer F: The borrower recently filed Chapter 7 bankruptcy, indicating a diminished capacity to repay. Combined with a high LTV ratio of 89 percent, the potential for loss exists.

Customer G: Serious credit deficiencies, including prior charge-offs, an outstanding tax lien, and low credit scores, exist. The Bank’s appeal represents that a second mortgage made by another entity on the collateral for this loan protects the Bank from loss. However, this presumption is not considered valid in that the second mortgage was a seller financing arrangement in what appears to be a ‘no-money-down’ transaction. The Bank’s appeal also noted that this loan was originated after the examination’s loan review date. Examiners have the discretion to tailor the sample of loans reviewed depending upon the particular circumstances of the bank being examined. In this case, examiners were concerned about broker-originated loans and appropriately expanded their coverage of that area. The Committee determined that the inclusion of this credit in the examiners’ sample and its Substandard classification were appropriate.

Customer H: Payments on this loan have been delinquent and late fee assessments have increased the principal balance. These facts, coupled with a high LTV ratio, indicate that a distinct possibility of loss exists.

Customer I: The credit report findings and slow payment history on this relatively new loan indicate problems with repayment capacity. This, coupled with a high LTV ratio, indicates that a distinct possibility of loss exists.

Asset Quality Component Rating
The Report identified $3,790,000 in classified assets. After adjusting classifications for the appeals granted by the Acting Director, total classifications are now $3,477,000, or 73.32 percent of Tier 1 capital and the allowance for loan and lease losses (ALLL). This level of classifications is considered high and is a significant increase over prior examination levels. In addition, the Bank’s loan delinquency ratio is excessive at 10.2 percent and has doubled since the last examination.

Also considered in the asset quality component rating are the inadequacy of the ALLL and deficiencies in loan underwriting, loan administration, and the loan policy. The Report indicates that the Bank has raised the acceptable level of LTV ratios for new loans without a commensurate change or tightening in other traditional underwriting criteria. In addition, there is no independent review of the loan portfolio and the loan policy fails to address subprime lending, which represents the majority of the Bank’s loan portfolio. The Committee concurred with the “3” rating assigned to the Asset Quality component.

Liquidity Component Rating
As of the date of the examination, the Bank had $5.8 million in zero-coupon brokered deposits obtained through “Service Company (“SC”). SC was placed in bankruptcy/receivership in July 1998. The receiver of … filed a class action lawsuit against a number of brokers, banks, and associated individuals. The Bank and Chairman of the Board …, were named as defendants in the lawsuit. The suit’s primary purpose was to allow redemption of the certificates of deposit (CDs) long before the maturity without the assessment of early withdrawal penalties. At the time of the examination, there was a tentative settlement agreement proposed that included significantly reduced prepayment penalties. The suit also sought compensation for damages stemming from offering and selling unqualified securities, misrepresentation in securities transactions, breach of fiduciary duties, constructive and actual fraud, negligent misrepresentation, and other sources of damages.

The Report indicated that the issues surrounding the lawsuit placed a severe strain on the Bank’s liquidity position. The potential for negative publicity and the preponderance of large, volatile deposits at the Bank might have generated additional deposit run-off that would have had a negative effect on the bank. Cash and other liquid assets totaled only $887,000, far less than the CDs. While the securities portfolio did total $20 million, it mostly consisted of long-term investments, it was 30 percent pledged, and it contained $1.3 million in unrealized depreciation. Further, although borrowing lines did exist, the Bank’s borrowings already totaled $8.5 million and the availability and cost of further advances in an emergency situation was uncertain.

The Bank’s appeal indicates that the SC deposits were withdrawn subsequent to the examination and that the early withdrawal penalties received roughly offset the losses taken on the sale of its long-term securities, which funded the withdrawals. The Bank suggests that this fact supports its case that the Liquidity component was improperly rated. However, the Committee must consider the facts that existed at the time of the examination. While the Bank was able to extract itself from a potentially critical situation with only minimal losses, as of the date of the examination, the Liquidity component warranted a rating “4.”

Management Component Rating
The Report documents significant management weaknesses that need to be corrected. These include weaknesses and deficiencies involving Bank policies and operations, transactions with affiliates, employee compensation, Call Report filings, internal routines and controls, and internal audit. Numerous apparent violations of federal and state laws and regulations were cited, including Sections 23A and 23B of the Federal Reserve Act. In addition, there were numerous contraventions of FDIC Statements of Policy. These weaknesses, combined with identified deficiencies in asset quality and liquidity, clearly support a rating of “3” for the Management component.

Composite Rating
The Capital, Earnings and Sensitivity to Market Risk components were all assigned a “3” rating within the Report and were not appealed by the Bank. As the Committee has upheld the Report’s rating of the Asset Quality, Liquidity and Management components as “3,” “4,” and “3,” respectively, the Bank’s overall condition is deemed to warrant a “3” composite rating. This conclusion is not reached upon a calculation of a numerical average but is a result of the consideration of the key Report finding relating to each of the components.

In accordance with the Guidelines for Appeals of Material Supervisory Determinations, the scope of this review was limited to the facts and circumstances as they existed at the time of the examination; no consideration was given to any facts or circumstances that occurred after that date or any subsequent corrective action

Before deciding your appeal, the Committee considered your request to appear in person before the Committee. Based upon a review of your comprehensive appeal letter, dated June 1, 2001, the Committee concluded that the information relating to the appeal was complete. Accordingly the Committee determined that no oral presentations, either by the Bank or by the Division of Supervision, were necessary. Please be assured that the Bank’s appeal and all of the facts and circumstances related to it received careful, thorough, and just consideration.

The FDIC’s Office of the Ombudsman will contact you regarding the allegations made by the Bank concerning the conduct of the examiner-in-charge. These allegations are not addressed within this letter, as they do not fall within the scope of the Guidelines for Appeals of Material Supervisory Determinations.

This decision is considered a final supervisory decision of the FDIC.

By direction of the Supervision Appeals Review Committee of the FDIC.