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Appeals of Material Supervisory Determinations: Guidelines & Decisions

SARC-97-01 (September 15, 1997)

Your appeal of material supervisory determinations has been decided. Rulings not in favor of your institution were made by the Supervision Appeals Review Committee (Committee) of the Federal Deposit Insurance Corporation (FDIC) on September 4, 1997, and are conveyed in this letter.

Before deciding your appeal of supervisory determinations, the Committee considered your request to appear in person. Based on the comprehensive nature of the July 25, 1997, submission to Director Nicholas J. Ketcha Jr., the Committee concluded that the record relating to your appeal was sufficiently complete and that an oral presentation would not be productive.

The Committee gave careful consideration to the issues you raise in your letter of July 25, 1997. Although the Committee decided against the [Bank] (the Bank), in every appealed matter, certain positive steps you appear to have taken since the examination are appropriate and are recognized. Hopefully, your efforts to address the criticisms enumerated in the January 9, 1997, Report of Examination (Report) will serve to strengthen areas of identified weakness and will be reflected in improved ratings at subsequent examinations.

The Committee’s findings on each material supervisory determination appealed by the Bank are presented below along with an explanation of the reason for the decision.

Loan Classifications
The Committee concluded that the Substandard classifications assigned to the six loans listed in the Bank’s appeal are appropriate. The interagency joint statement on classification of bank assets and appraisal of securities in bank examinations provides that:

“Substandard loans are inadequately protected by the current sound worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified must have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the bank will sustain some loss if the deficiencies are not corrected.”

The examiner’s judgment that each loan was inadequately protected by the sound worth and paying capacity of the obligor or of the collateral pledged is supported by the facts existing at the time of the examination. The Bank’s position that the collateral securing these loans sufficiently mitigates the greater than normal degree of risk present is not supported. In each case, the Bank ignored the uncertainty of the current sound worth of collateral, particularly in regard to accounts receivable and inventory, and thus failed to recognize the risk of loss to the Bank.

1. Customer A— The company is highly leveraged, with debt-to-equity of 4-to-1.The company exhibits poor operating performance with net income of only $7,000 on sales of $4,000,000 for the fiscal year ending May 31, 1996. The $1,500,000 revolving line of credit has not been reduced to under $1,000,000 since December 1994. Collateral, which includes two second deeds of trust on personal residences, accounts receivable (AR), and inventory, provides insufficient protection given borrower’s strained financial position. AR turnover is slow and delinquency is high; inventory is possibly stale. As of December 31, 1996, estimated collateral value, using appropriate margins, approximated $1,487,000; indebtedness totaled $1,485,000.

2.Customer B— Borrowers’ financial statement indicates significant financial strain, with annual gross income of $139,200 and mortgage payments and real estate taxes of $100,100. Primary collateral is a restaurant with an appraised value of $810,000, securing an outstanding loan balance of $832,000. Additional collateral consists of a second deed of trust on the borrowers’ personal residence, which is heavily encumbered by a prior lien. Collateral value of the real estate remains uncertain, as appraisal provided indicates improvements are not complete.

3. Customer C— These loans are classified in accordance with Interagency Troubled Commercial Real Estate Loan Classification Guidelines. The loans were past due and foreclosure had been initiated during examination. In addition, public records show the property was sold for $322,000 and the amount of the outstanding debt, including accrued interest, was $369,477. In addition to this implied loss of $47,477, the Bank no doubt incurred additional legal and filing costs related to this credit. The $322,000 sales price further calls into question the most recent appraisal, which must have been grossly overstated given the estimated appraised value was $850,000.

4. Customer D— Borrower lacks sufficient capacity and is in a strained financial position. Net losses of $1,500,000 and $170,000 reflected in financial statements for December 31, 1995, and the ten months ending October 31, 1996, respectively. The company required capital infusion of $1,700,000 in early 1996 to sustain operations. Collateral consists of AR, inventory, and junior liens on guarantors’ residences. At the time of examination, reported collateral value was insufficient in relation to the outstanding loan balance. Collateral support is uncertain given the noted deficiencies relating to control of AR and inventory, as well as the volume of payables reported by the borrower. Additionally, a significant portion of AR are 90+ days past due. Real estate is subject to significant prior liens and equity is limited. There is not sufficient supportable collateral value to preclude a Substandard classification.

5. Customer E— It is recognized that the borrower has paid as agreed; however, there is a high level of risk present given the company is potentially insolvent. The reliability of the financial information is questionable, as the most recent financial statement could not be reconciled to prior reporting periods. The reported equity change in the business would have required a $1,900,000 capital injection (allowing for reported current earnings of $300,000); however, no explanation was provided by the borrower or the Bank. The Bank’s position that collateral protection should preclude classification is not supported. The Bank maintains it has $287,000 of AR and inventory, a $100,000 note, a first deed of trust with an aggregate estimated value of $184,000, and a second deed of trust with limited equity of $35,000. AR and inventory are appropriately excluded from consideration, as financial information provided cannot be considered reliable. It is noted that the $100,000 note is matured. There is not sufficient supportable collateral value to preclude a Substandard classification.

In regard to the appraisal issue, the Bank is correct that appraisals would not have been required for real estate collateral; however, the “Interagency Guidelines on Real Estate Appraisals and Evaluations,” adopted October 27, 1994 (Financial Institutions Letter 74-94), indicate that real estate evaluations should have been prepared for each property to appropriately document collateral values. Although this deficiency was not highlighted in the Report, the guidance therein may be instructive to management.

6. Customer F— At the time of the examination, the company’s interim financial statement reflected an insolvent financial condition and poor operating performance. Collateral consists of a first and second lien on real estate owned by guarantors of the company and a second lien on business assets with little or no value. Adjusted by Bank management for foreclosure and selling costs, the aggregate value of real estate collateral totaled $2,290,000 against an outstanding loan balance of $2,280,000.

In regard to the Bank’s contention that the examiners made an error in the Report, we note that the Report clearly reflects only $2,280,000 of this line as being classified Substandard. A $209,000 line the Bank claims the examiners failed to notice as being paid is clearly not classified. Each individual credit classified is distinctly identified on page 3b.4 of the Report and the sum of the three credits is $2,280,000.

Customer G, Special Mention Listing
The Customer G loan possessed characteristics which, at the time of the examination, fully supported the examiner’s decision to list the loan as Special Mention. Contrary to Bank’s understanding, a bank’s underwriting is specifically an issue in listing a loan for Special Mention. In discussing the use of a Special Mention designation, the Division of Supervision’s Manual of Examination Policies provides, in part:

“…Often the bank’s weak origination and/or servicing policies are the cause for the Special Mention designation….”

Underwriting and credit administration deficiencies discussed in commentary on page 3c.4 of the Report include an aggregate loan commitment in excess of the Bank’s legal lending limit, the lack of a conforming appraisal to support the credit extended (a violation and policy contravention), several misrepresentations made by the originating officer in the credit presentation, the lack of an objective marketing and feasibility analysis, and the use of short-term commitments from loan participants on a long-term project. The question of collateral protection was not a primary concern, as the loan was not adversely classified.

Capital Adequacy Rating
According to the Uniform Financial Institutions Rating System, adopted by the Federal Financial Institutions Examination Council on December 19, 1996, a Capital component rating of “2” indicates “a satisfactory capital level relative to the financial institution’s risk profile. A rating of “1” indicates a strong capital level relative to the institution’s risk profile [emphasis added].”

The Committee concludes that a Capital component rating of “2” is appropriate given adversely classified assets currently represent 79% of the Bank’s Tier 1 capital plus the allowance for loan and lease losses; the underwriting weaknesses identified; and the noted management deficiencies in identifying, monitoring, and reporting risks in the loan portfolio.

Asset Quality Rating
Under the Uniform Financial Institutions Rating System, an Asset Quality component rating of ”4” is assigned to “financial institutions with deficient asset quality or credit administration practices. The levels of risk and problem assets are significant, inadequately controlled, and subject the financial institution to potential losses that, if left unchecked, may threaten its viability.”

The Committee believes a “4” rating to be appropriate given the Bank’s high level of adversely classified assets and deficient credit administration practices.

Management Rating
The Uniform Financial Institutions Rating System provides the following guidance on the Management component rating:

“The capability of the board of directors and management, in their respective roles, to identify, measure, monitor, and control the risks of an institution’s activities and to ensure a financial institution’s safe, sound, and efficient operation in compliance with applicable laws and regulations is reflected in this rating….Sound management practices are demonstrated by: active oversight by the board of directors and management; competent personnel; adequate policies, processes, and controls taking into consideration the size and sophistication of the institution; maintenance of an appropriate audit program and internal control environment; and effective risk monitoring and management information systems.”

The Uniform Financial Institutions Rating System provides that a rating of “4” indicates “deficient management and board performance or risk management practices that are inadequate considering the nature of an institution’s activities. The level of problems and risk exposure is excessive. Problems and significant risks are inadequately identified, measured, monitored, or controlled and require immediate action by the board and management to preserve the soundness of the institution. Replacing or strengthening management or the board may be necessary.”

The Management component rating in this case, or in any other case, is not premised on any individual incident or isolated factor, nor is there a conditional, this–leads-to-that type of relationship to the other rating components. That is not to say that component ratings are assigned in isolation from each other. In this case, the assigned rating of “4” is based upon the numerous deficiencies apparent in the management and administration of the Bank, with the examiner appropriately influenced by asset quality considerations. The following responds to the specific issues raised by the bank.

1. Competence of Mr.… The rating of “4” assigned to the Management component does not necessarily imply Mr…. is incompetent. It does imply that the Bank’s board and Mr.… as CEO of the Bank, need to take corrective action to address the numerous management-related deficiencies highlighted in the Report of Examination.

2. Customer G—The Committee is not persuaded that the examiner-in-charge, in assigning the Management component was distracted by a single error committed by Senior Credit Officer. In fact, the examiner identified numerous other weaknesses, as discussed fully on page 8 of the Report of Examination.

3. Other Management Deficiencies—

Bank Secrecy Act: Customer H—Bank Secrecy Act (BSA) violation discussed in the appeal request was, as noted by the Bank, reversed by the Regional Office on July 1, 1997. The disputed violation of BSA regulations relating to the centralized exemption list and customer exemption limits are viewed as technical violations, but are nonetheless violations. Of more serious concern is the poor implementation of the Bank’s BSA program, as discussed on page 8.3 of the Report.

Appraisal Violations: As discussed above under the heading of “Customer G Incident,” the appraisal violations cited, as well as the lack of an adequate loan review function and internal lending controls, is viewed as a serious management weakness. The Bank’s contention that management’s essentially correct views as to the value of real estate should be taken into account in the Management component rating is without merit. The relevant fact is that management had to make estimates for property values for which appraisal were, by regulation, required.

Poor Supervision: The Bank indicates the Report fails to provide specifics relating to the poor supervision of the junior loan staff. While admittedly this point is not fully developed, the Report does indirectly address this issue. Specifically, senior management provided inadequate oversight of junior lending staff by setting a poor example for them through disregard for the Bank’s loan policy, failing to familiarize themselves and staff with federal appraisal regulations, allowing lax monitoring of loans, and inadequately reviewing credit presentations.

Liquidity Rating
The Uniform Financial Institutions Rating System defines a “2” rating of Liquidity as indicating “satisfactory liquidity levels and funds management practices. The institution has access to sufficient sources of funds on acceptable terms to meet present and anticipated liquidity needs. Modest weaknesses may be evident in funds management practices.”

The Bank’s appeal position regarding the Liquidity component rating is focused narrowly on the ratio of liquid assets-to-total liabilities. The Bank’s appeal, however, does not take into account the degree of reliance by the Bank on short-term, potentially volatile sources of funds, including large certificates of deposit and out-of-area deposits. The examiner properly commented on this issue in the Report.

Composite rating
The Uniform Financial Institutions Rating System provides the following definition of a Composite “3” rating:

“Financial institutions in this group exhibit some degree of supervisory concern in one or more of the component areas. These financial institutions exhibit a combination of weaknesses that may range from moderate to severe; however, the magnitude of the deficiencies generally will not cause a component to be rated more severely than 4. Management may lack the ability or willingness to effectively address weaknesses within appropriate time frames. Financial institutions in this group generally are less capable of withstanding business fluctuations and are more vulnerable to outside influences than those institutions rated a composite 1 or 2. Additionally, these financial institutions may be in significant noncompliance with laws and regulations. Risk management practices may be less than satisfactory relative to the institution’s size, complexity, and risk profile. These financial institutions require more than normal supervision, which may include formal or informal enforcements actions. Failure appears unlikely, however, given the overall strength and financial capacity of these institutions.”

The Uniform Financial Institutions Rating System also provides:

“…Each component rating is based on a qualitative analysis of the factors comprising that component and its interrelationship with the other components. When assigning a composite rating, some components may be given more weight than others depending on the situation at the institution….The ability of management to respond to changing circumstances and to address the risks that may arise from changing business conditions, or the initiation of new activities or products, is an important factor in evaluating a financial institution’s overall risk profile and the level of supervisory attention warranted. For this reason, the management component is given special consideration when assigning a composite rating. The ability of management to identify, measure, monitor, and control the risks of its operations is also taken into account when assigning each component rating.”

The Report identifies asset quality as being unsatisfactory and credit administration practices as being deficient. Risk management practices are, as the Report indicates, less than satisfactory. The Committee believes the composite rating assigned by the examiner reflects the appropriate level of supervisory concern.

The Bank’s charge of “bias” by Regional Director George J. Masa was not considered by the Committee, although the findings on which the Bank premises its belief were considered and are addressed above. The FDIC’s Office of the Ombudsman is available to individuals or institutions who believe that FDIC policy or procedure has been unfairly or erroneously applied or that the policy or procedure itself is unfair. The institution may also file a complaint with the Office of the Ombudsman if it believes or has any evidence that it has been subject to examiner retaliation, abuse, or retribution because of its appeal of a material supervisory determination. You may contact FDIC’s Irvine Office of the Ombudsman by calling (714) 263-7600.

The Scope of this review was limited to the facts and circumstances that existed at the time of the examination and no consideration was afforded any changes occurring after that date or to any subsequent corrective action. In any proposed supervisory response to the Report of Examination, the FDIC’s San Francisco Regional Office will address the Bank’s actions since the examination.

This determination is considered the Federal Deposit Insurance Corporation’s final supervisory decision.

By direction of the Supervision Appeals Review Committee of the Federal Deposit Insurance Corporation.