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Appeals of Material Supervisory Determinations: Guidelines & Decisions

SARC-97-03 (September 19, 1997)

Your appeal of material supervisory determinations has been decided. Rulings not in your favor were made by the Supervision Appeals Review Committee (“Committee”) of the Federal Deposit Insurance Corporation (“FDIC”) on September 16, 1997, and are conveyed in this letter.

The Committee decided against [Bank] (“Bank”) in every appealed matter. The Committee’s reasoning is set forth below.

1. Loan Classifications
The Substandard classification on the six loans listed in the appeal are deemed appropriate. As of the examination, the examiner’s judgement that each loan was inadequately protected by the sound worth and paying capacity of the obligor or of the collateral pledged was correct. Weaknesses that jeopardize liquidation of the debt were supported, and the distinct possibility of some loss was present if the deficiencies are not corrected. Factors leading to this determination regarding each loan are listed below.

a. Customer A—Values and condition of the pledge collateral have not been properly documented, if at all. Payment ability is suspect given the need to advance funds for first mortgage payment, an increase in debt with the Bank, overdraft history and lack of cash flow projection for the 1997 crop year. In addition, the credit is improperly structured, purposes of the debt are difficult to discern, and collateral listings and inspections as well as current financial information are lacking.

b. Customer B—Collateral position is limited to mortgage of $120,000, which supports only a portion of the debt. Overdraft history (218 days in 1996 and 32 days through February 26, 1997) indicates cash flow problems which are more than seasonal in nature.

In addition, no title opinion has been obtained for the real property confirming the Bank’s lien position, and title to the vehicle was not on file.

c. Customer C—At the time of the examination, this property was potential other real estate which President … estimated to be worth $135,000. The actual sale price of $116,000 arranged after the examination marginally covered principal and interest owed the Bank. The sales price indicates collectibility of the loan balance was in question as of the examination date. In addition, the difference between Mr. *** estimated value and the ultimate sales price indicates a potentially optimistic attitude regarding collateral valuations and casts some doubt on other estimates of market value reported in the examination.

d. Customer D—Bank’s mortgage is filed to $55,000, leaving a loan to collateral valuation of approximately 1:1. Past due status at examination and comments contained in the Bank’s letter are indicative of an individual with cash flow difficulties. Collection of the loan in full was not apparent.

e. Customer E—The loan originated in July 1996, to reaffirm debt following bankruptcy. First payment is due July 1997. Collateral consists of a 1996 mortgage on two properties last appraised in 1995 for $70,000 and $10,000, respectively. The marginal collateral position given estimated value at examination date and the questionable payment capacity following bankruptcy support a Substandard classification.

f. Customer F—No information was provided on source of lump-sum payment and collateral support is not indicated.

2. Provision for Loan Losses/Adequacy of the Allowance for Loan Losses
Bank management has not developed an acceptable methodology for determining the adequacy of the loan loss reserve. The examiner recommendation is based upon the risk estimated to be present in the loan portfolio. Percentage criteria applied by the examiner to the various categories of loans appear appropriate at the present time. These percentages could increase or decrease in the future based upon the composition of the loan portfolio and the volume and type of loans adversely classified. Bank management needs to develop a supportable methodology based upon the risk in the loan portfolio rather than application of a set percentage to the entire loan portfolio. Reviewing the Interagency Policy Statement on the Allowance for Loan and Lease Losses dated December 21, 1993, may be helpful as it included a discussion of bank management’s as well as the examiner’s responsibility.

3. CAMELS Rating
The examiner’s component ratings of “3” for asset quality and management and the “3” composite rating were fully supported consistent with the policy statement entitled “Uniform Financial Institutions Rating System” adopted by the Federal Financial Institutions Examination Council. This policy was mailed to your chief executive officer on December 26, 1996 (Financial Institution Letter -105-96). Each of the appealed ratings is discussed below in the context of the Bank’s condition and the criteria set forth in the policy statement.

a. Asset Quality Component
According to the CAMELS guidelines, an asset quality rating of “3” is assigned “when asset quality or credit administration practices are less than satisfactory. Trends may be stable or indicate deterioration in asset quality or an increase in risk exposure. The level and severity of classified assets, other weaknesses, and risks require and elevated level of supervisory concern. There is generally a need to improve credit administration and risk management practices.”

Factors to be considered by the examiner include adequacy of underwriting standards, soundness of credit administration practices, and appropriateness of risk identification practices; adequacy of the loan valuation reserve; adequacy of loan and investment policies, procedures and practices; volume and nature of credit documentation exceptions; and level, distribution, severity, and trend of problem, classified, nonaccrual, restructured, delinquent, and nonperforming assets.

The examination report reflects weak underwriting standards, with loans made largely predicated on the perceived collateral support and character of the borrower. Technical exceptions were noted in 78 percent of loans reviewed (with just 28 percent of the portfolio included in the loan sample). Classifications have increased substantially since the prior examination and are a matter of elevated supervisory concern at 77 percent of capital and reserves. If the disputed adverse classifications were omitted, the level would be 54 percent of capital and reserves. Although improved, the level would remain a matter of supervisory concern. Loan policy deficiencies cited in past examination reports remain uncorrected.

Based upon the foregoing, a “3” rating for asset quality is considered appropriate.

b. Management Component Rating
According to the CAMELS guidelines, a rating of “3” is assigned when management and board performance need improvement or risk management practices are less than satisfactory given the nature of the institution’s activities. The capabilities of management or the board of directors may be insufficient for the type, size or condition of the institution. Problems and significant risks may be inadequately identified, measured, monitored or controlled.

Factors to be considered by the examiner include: adequacy of, and conformance with, appropriate internal policies and controls addressing the operations and risks of significant activities; compliance with laws and regulations; responsiveness to recommendations from auditors and supervisory authorities; depth and succession of management; the extent that the board of directors and management is affected by, or susceptible to, dominant influence or concentration of authority; and, adequacy of audits and internal controls to promote effective operations and reliable financial and regulatory reporting, safeguard assets, and ensure compliance with laws, regulations and internal policies.

Given loan quality problems and inadequate loan administration, the failure of the bank to initiate corrective measures for previously identified weakness in the lending function, and the failure to comply with a variety of policy statements, a “3” rating is deemed appropriate.

c. Uniform Financial Institution Composite Rating
A “3: composite rating, according to the CAMELS guidelines, is defined to include institutions that exhibit supervisory concern in one or more of the component areas. In addition, it has management that “may lack the ability or willingness to effectively address weaknesses within appropriate time frames.” Such institutions “require more than normal supervision [although]…failure appears unlikely, given he overall strength and financial capacity of these institutions.” These comments are compared to those used in describing a “2” composite, which comments include the following: “moderate weaknesses are present and are well within the board of directors and management’s capabilities and willingness to correct…there are no material supervisory concerns.” Peer comparisons of financial ratios are not included in the rating system in order to avoid over reliance on statistical data; rather, examiners consider all relevant factors when assigning a composite rating. Examiners give the management component special consideration when assigning the composite rating.

The overall composite rating of “3” is supported based upon management’s failure to implement previously recommended corrective actions coupled with the increase risk profile presented by the increasing level of classified assets. The failure to implement loan administration improvements recommended at past examinations, the lack of attention to loan documentation details, and the failure to properly structure loan payments are indicative of a less than satisfactory situation. Such failure does not appear to be due to a lack of ability, as evidenced by the success of the Bank in the past, but rather a failure to recognize the need for such changes in the Bank’s operations. Compliance with the Memorandum of Understanding signed following receipt of the examination should result in effecting needed changes and return of the Bank to a satisfactory condition.

The determinations constitute the final decision of the FDIC.