Material Loss Review of 1st Centennial Bank, Redlands, California
As required by section 38(k) of the Federal Deposit Insurance Act (FDI Act), the Office of Inspector General (OIG) conducted a material loss1 review of the failure of 1st Centennial Bank (1st Centennial). On January 23, 2009, the California Department of Financial Institutions (CDFI) closed the institution and named the FDIC as receiver. On February 11, 2009, the FDIC notified the OIG that 1st Centennialís total assets at closing were $783.5 million with an estimated loss to the Deposit Insurance Fund (DIF) of $226.6 million. As of July 17, 2009, the estimated loss to the DIF had decreased to $215.4 million.
When the DIF incurs a material loss with respect to an insured depository institution for which the FDIC is appointed receiver, the FDI Act states that the Inspector General of the appropriate federal banking agency shall make a written report to that agency which reviews the agencyís supervision of the institution, including the agencyís implementation of FDI Act section 38, Prompt Corrective Action (PCA); ascertains why the institutionís problems resulted in a material loss to the DIF; and makes recommendations to prevent future losses.
The audit objectives were to: (1) determine the causes of the financial institutionís failure and resulting material loss to the DIF and (2) evaluate the FDICís supervision2 of the institution, including implementation of the PCA provisions of section 38 of the FDI Act. Appendix 1 contains details on our objectives, scope, and methodology; Appendix 2 contains a glossary of
terms; Appendix 3 contains the FDICís comments to the report; Appendix 4 contains a chronology of significant events; and Appendix 5 contains a list of acronyms used in the report.
This report presents the FDIC OIGís analysis of 1st Centennialís failure and the FDICís efforts to ensure 1st Centennialís management operated the bank in a safe and sound manner. The FDIC OIG plans to issue a series of summary reports on our observations on the major causes, trends, and common characteristics of financial institution failures resulting in a material loss to the DIF. Recommendations in the summary reports will address the FDICís supervision of the institutions, including implementation of the PCA provisions of section 38.
1st Centennial, insured by the FDIC on August 1, 1990, was a state, nonmember bank with six branches and was headquartered in Redlands, California. 1st Centennial provided traditional banking activities within the Southern California area and focused extensively on commercial real estate (CRE) loans, including acquisition, development, and construction (ADC) loans in single-family residence (SFR) tract construction. The bank was fully owned by 1st Centennial Bancorp, a bank holding company, but did not have any affiliates or subsidiaries.
DSCís Los Angeles North Field Office and CDFI performed regular safety and soundness examinations of 1st Centennial, conducting five examinations from May 2004 through April 2008. The FDIC performed examinations in 2004, 2006, and 2008,3 while Californiaís CDFI performed examinations in 2005 and 2007. In addition, the FDIC and CDFI conducted a visitation in November 2008 that focused solely on a review of the bankís CRE/ADC construction loan portfolio.4
1st Centennial specialized in CRE/ADC loans for SFR tract construction, which was significantly concentrated in the Inland Empire (Riverside, California-San Bernardino, California, metropolitan area) of Southern California. 1st Centennial experienced record profitability in 2007. On October 12, 2007, 1st Centennial issued a press release stating that the bank had record third-quarter earnings of $2.2 million and $6.2 million for the year to date. However, the bank suffered significant losses in 2008, and on August 7, 2008, 1st Centennial issued a press release stating that the bank had posted a $2.8 million quarterly loss. By December 31, 2008, 1st Centennialís losses exceeded $50 million.
Details on 1st Centennialís financial condition for the calendar years 2005 through 2008, and March 31, 2008 follow in Table 1.Table 1: Financial Condition of 1st Centennial
b Financial institution regulators and examiners use the Uniform Financial Institutions Rating System (UFIRS) to evaluate a bankís performance in six components represented by the CAMELS acronym: Capital adequacy, Asset quality, Management practices, Earnings performance, Liquidity position, and Sensitivity to market risk. Each component, and an overall composite score, is assigned a rating of 1 through 5, with 1 having the least regulatory concern and 5 having the greatest concern.
The growth in adverse classifications in 2008 from 1st Centennialís deteriorating CRE/ADC loan portfolio reduced earnings (causing a $50 million loss), due in part to a large increase ($32 million) in the allowance for loan and lease losses (ALLL), and decreased capital. The growth in the adverse classifications also affected 1st Centennialís liquidity because
past-due loan payments increased. 1st Centennial bought approximately $300 million in brokered deposits during the second half of 2008, thereby increasing total deposits and total assets for 2008.
CAUSES OF FAILURE AND MATERIAL LOSS
The failure of 1st Centennial and resulting material loss to the DIF was due to bank managementís pursuit of rapid asset growth concentrated in high-risk CRE/ADC loans without adequate risk management controls and loan underwriting and credit administration practices. The fact that those CRE/ADC loans were concentrated in SFR construction and in one geographic area increased the risk in the bankís loan portfolio. Losses in the CRE/ADC loan portfolio, driven by a downturn in the economy, severely eroded earnings, capital, and liquidity, and the bank increased its dependence on wholesale funding sources. The bank failed due to a lack of capital as a result of these loan losses. The resulting loss to the FDICís DIF was estimated at $226.6 million but decreased to $215.4 million, as of July 17, 2009.Local Economic Impact
The Inland Empire and other areas in California experienced some of the highest rates of home price appreciation in the first half of the decade.5 Rapid population growth in this area spurred higher-than-average rates of home construction. According to Moodyís, the Riverside economy contracted amid weakened house construction activity and the United States and global downturns in industrial production. As indicated in Table 2, which follows, certain indicators showed that the economic conditions in California, and particularly the Inland Empire, were slowing considerably during 2007 and 2008.
Table 2: Indicators of Economic Downturn in California
Examiners concluded that the market downturn and the declining housing market in the Inland Empire were partially responsible for 1st Centennialís financial deterioration. However, examiners also indicated that, while the distressed housing market negatively impacted asset quality, inadequate credit administration and internal controls caused further erosion of the loan portfolio. 1st Centennialís bank management stated that the housing market was deteriorating at such an accelerated pace that it was difficult for them to properly evaluate the bankís loan portfolio.Deficient Asset Quality and Inadequate Risk Management Controls
Examiners found 1st Centennialís asset quality to be seriously deficient during the FDICís April 2008 examination, primarily due to deterioration in the bankís CRE/ADC loan portfolio. The examiners also found that bank management failed to implement adequate risk management controls to effectively recognize loan portfolio risk, ensure the proper use of interest reserves, institute a sound loan approval process, and appropriately fund the ALLL. In addition, at the 2008 examination, examiners noted that (1) internal control weaknesses in underwriting and credit administration in the bankís Construction Loan Department appeared to have gone uncorrected by management for many years, and (2) the internal loan review function was inadequate. Examiners also concluded that the CRE/ADC concentration, coupled with inadequate internal controls, resulted in extremely high levels of adversely classified assets, significant provisions to the ALLL, negative earnings, capital erosion, and a tightened liquidity position. Further, examiners reported that the deterioration in the bankís asset quality would not have been as severe had bank management implemented strong internal controls before the economic downturn, when the bankís financial condition was better.
1st Centennialís asset quality received a 2 (satisfactory) rating during the 2004, 2006, and 2007 examinations; and a 1 (strong) rating during the 2005 examination. The April 2008 examination and November 2008 visitation progressively downgraded asset quality to 4 and 5, respectively. The downgrades indicated that the bankís level of risk and problem assets were significant and inadequately controlled, subjecting the bank to high levels of actual and potential losses. During the November 2008 visitation, examiners concluded that 1st Centennialís asset quality had become critically deficient and presented an imminent threat to the bankís viability.Excessive CRE/ADC Loan Concentrations
Examiners identified substantial loan losses, payment delinquencies, and management deficiencies during 2008 that were centered in 1st Centennialís CRE/ADC loan concentrations. 1st Centennial had implemented a high-growth strategy in CRE/ADC loans, beginning in 2004. In addition to concentrating in high-risk CRE/ADC loans, the bank had two further concentrations of its loan portfolio. Specifically, the portfolio was significantly concentrated in SFR tract construction loans and was geographically concentrated within the bankís local market area in the Inland Empire.
1st Centennialís high CRE/ADC loan concentrations are shown in Figure 1, which follows. The bankís CRE/ADC concentration ranged from 37 percent to 42.9 percent of average total loans between 2003 and 2008. The bank was consistently in the 93rd to 98th percentile of its peer group for this measure. In contrast, the peer groupís CRE/ADC concentration measure ranged from 9.16 percent to 16.31 percent during the same period.
Figure 1: ADC Loans as a Percentage of Average LoansSource: UBPRs for 1st Centennial. [ D ]
As part of their examinations, examiners identified and measured the extent of 1st Centennialís CRE/ADC loan concentrations as a percentage of the bankís Tier 1 Capital. The examinersí review of the CRE/ADC loan concentrations during the 2004, 2006, 2007, and 2008 examinations and 2008 visitation determined that the concentrations represented the following levels of Tier 1 Capital:
The bankís CRE/ADC loans were further concentrated in SFR tract construction loans. Examiners determined that SFR tract construction loans represented high percentages of the bankís CRE/ADC portfolio as follows:
A geographic distribution summary performed during the 2007 examination showed that the CRE/ADC loan portfolio was also geographically concentrated with almost 90 percent of the CRE/ADC construction projects located in the Inland Empire (Riverside and San Bernardino counties), as indicated below.
1st Centennialís ADC loans increased from 292 percent to 383 percent of total capital between December 31, 2006 and December 31, 2007, exceeding the regulatory threshold of 100 percent for this measure. The percentage of ADC loans to total capital on December 31, 2008, was 1,264 percent. However, the December 31, 2008 percentage was high, due, in part, to the bankís extensive losses resulting in a reduced capital level. Regarding the level of ADC loans to total capital, 1st Centennial was consistently in the 90th to 96th percentile of its peer group.Loan Losses and Classifications
According to the April 2008 ROE and the November 2008 draft visitation report, a high level of CRE/ADC loan losses had accrued due to a combination of external and internal factors during 2008. In addition, the bankís internal loan grading system was considered inadequate and was not effectively classifying loans, leading to the untimely recognition of problem assets, an inaccurate ALLL, and a misrepresentation of the bankís capital and earnings. During the examination and visitation, examinersí recognition of problem assets and the subsequent downgrade of numerous loans resulted in adversely classified assets, including Other Real Estate Owned (OREO), which severely affected the ALLL and significantly eroded the bankís capital.
External factors, in large part, caused the bank to suffer increased loan losses, which affected the viability of the institution. Most significantly, reductions in land and residential home values, a significant increase in the unemployment rates, and poor single-family home sales in the Inland Empire caused a substantial number of the bankís CRE/ADC borrowers to stop developing their projects, cease making payments, or refuse to invest additional funds into a project.
Additional problems within the institution affected the bankís ability to weather the economic downturn. Internal control inadequacies and poor bank management oversight identified by examiners in 2008 included inappropriate use of interest reserves and an inadequate interest reserve policy, an ineffective loan grading system, a weak loan approval process, and a lack of current borrower financial statements to assess the borrowerís and/or guarantorís ability to repay the loan in light of declining collateral valueóall of which contributed to the bankís loan losses. Examiners found several loans where the bank either had not placed the loan into a non-accrual status or had delayed placing the loans into a non-accrual status when payments were 100 to 160 days past due.
Delays in placing loans in a non-accrual status postponed accrued interest reversals, where needed, and prevented timely recognition of the problem status of loans so that the bank could initiate appropriate collection or other activities.Problems Related to the Allowance for Loan and Lease Losses
Although the loan portfolio grew steadily, the ALLL remained relatively constant without significant increases, and adverse classifications actually declined between the 2006 and 2007 examinations (as noted in Table 3 below). However, as previously discussed, during the FDICís April 2008 examination and November 2008 visitation, examiners identified a substantial amount of loan downgrades. The loan downgrades identified in the April 2008 examination resulted in the need for an additional $6.0 million provision for 1st Centennialís ALLL. Table 3, which follows, presents the amount of assets that were adversely classified during examinations and the visitation conducted between 2004 through 2008, the ALLL funding level that 1st Centennial computed, and the increases needed to the ALLL that examiners computed. The examiners performing the November 2008 visitation did not recompute the bankís ALLL based on the additional loan downgrades identified.
Table 3: 1st Centennial's Adversely Classified Assets and ALLL
*Although the FDIC reviewed the ALLL during this visitation, the draft visitation report did not include information related to a computed increase to the ALLL. Amounts are as of October 31, 2008.
In the April 2008 and prior examinations, the FDIC and CDFI examiners consistently concluded that the bankís ALLL methodology was adequate. The FDICís November 2008 draft visitation report stated that loan deterioration necessitated large provisions to the ALLL, and thus reduced the bankís capital position but did not specifically conclude on the adequacy of the ALLL methodology. The bankís external auditors did not identify deficiencies in either the bankís methodology or provisions to the ALLL during the annual financial statement audits performed for the years ending December 31, 2005, December 31, 2006, and December 31, 2007.
Table 4, below, shows 1st Centennialís net income (loss) and ALLL as of year-end for 2004 through 2008. As indicated in Table 4, the need for a substantial increase in the ALLL during 2008, coupled with actual losses that year was a primary cause of the net loss for the year.
Table 4: 1st Centennialís Net Income (Loss) and ALLL (Dollars in Thousands)
Significant loan underwriting and credit administration problems were identified during the April 2008 examination and November 2008 visitation. According to DSC, prior examinations did not identify similar problems because the bank either did not have problem assets, such as OREO, or problem assets were small in number. The ROEs for 2004 through 2007 described loan underwriting and credit administration in terms such as adequate, satisfactory, and prudent. The ROEs for the 2004 and 2006 FDIC examinations also included examiner recommendations for improvement in various aspects of the bankís loan underwriting and credit administration controls. For example, in the 2004 ROE, examiners recommended that 1st Centennialís BOD and management (1) continue to closely monitor the bankís real estate and construction loan concentrations; (2) implement a construction loan software program for detailed reports on the loan portfolio; (3) consider analyzing a sample of construction loans on a periodic basis, comparing actual performance of a project to the planned performance; and (4) present the results of such analysis to the bankís loan committee. In its response to the FDIC, 1st Centennial stated that the bank had initiated a process to address the 2004 recommendation. In addition, the 2006 ROE included minor recommendations to enhance concentration monitoring and reporting.
Loan underwriting and credit administration problems that were identified during the April 2008 examination and reported in the ROE included, but were not limited to, the following:
High-Risk Owner-Occupied Single-Family Home Construction. In 2008, examiners also identified risks in the owner-occupied SFR construction portfolio due to liberal loan
underwriting standards and incomplete borrower information. The bank allowed borrowers to qualify for loans without verifying the borrowerís income or assets. Additionally, 1st Centennial made these loans at 80 percent loan-to-value at origination in a declining real estate market. Further, 1st Centennial did not require loans under $1 million to be reviewed and approved by the bankís loan committee. The examinersí review of these loans showed that information on the borrowerís ability to repay the loan was incomplete.
Inappropriate Interest Reserve Payments. According to the April 2008 ROE, 1st Centennial used interest reserves to make interest payments totaling $781,000 for seven loans. Those loans had a total outstanding balance of $30.3 million. All seven loans were construction loans for which either construction progress had stopped or the units developed could not be sold. Instead of requiring the debtors and/or investors to make the interest payments, the bank improperly made the interest payments from the interest reserve portion of the loan funding. A total of $244,314 in improper loan interest payment entries were made during 2007 and $536,708 during 2008.
The $781,000 in inappropriate interest payments improperly increased the bankís capital and earnings, delayed the recognition of the non-accrual status of these seven loans, and delayed activities to minimize losses attributable to these loans. In addition, examiners identified weak internal controls associated with the use of interest reserves that included (1) a lack of segregation of duties, (2) a lack of senior management monitoring and oversight of troubled and criticized loans with interest reserves, and (3) weak policies and procedures for the use of interest reserves.
November 2008 Visitation Results. The FDIC November 2008 visitation also identified many of the same loan underwriting and credit administration problems (the FDIC did not issue a final report on the visitation results) identified in the April 2008 examination. According to examiners, these underwriting and credit administration problems further exacerbated the bankís losses due to construction loans continuing to falter since the April 2008 examination as a result of the continuing decline in sales and market values. Many of the bankís loan files were incomplete and included only stale financial statements for the borrowers and guarantors, making it more difficult for the bank to determine a borrowerís and guarantorís financial capability and seek repayment from the borrowerís and guarantorís assets. These deficiencies increased the bankís reliance on the propertyís collateral value for repayment of the loan, which is risky in a declining real estate market. In addition, examiners stated that 1st Centennialís credit administration was weak due to understaffing and unqualified staff.Wholesale Funding
Examiners found that 1st Centennial had relied on varying amounts of brokered deposits and FHLB borrowings during the examinations performed between May 2004 and February 2007 (as shown in Table 5 which follows), and that 1st Centennialís reliance on those funds was generally in line with other banks in the bankís peer group. However, during the April 2008
examination, examiners found that 1st Centennial had (1) shifted to a high-risk wholesale funding strategy during 2007 due to competition for local deposits, (2) experienced a deficient core liquidity position since September 2007, and (3) increased its reliance on brokered deposits to maintain liquidity. In addition, examiners determined that the bankís shift to a liability funding strategy in 2007, combined with deteriorating loans and liquidity, created a high-risk environment for which bank management had not established adequate controls. Further, 1st Centennial needed to (1) implement additional controls and reporting to improve its management of liquidity operations and (2) develop a more detailed contingency liquidity plan (CLP) to provide guidance for anticipated liquidity problems.
Table 5: 1st Centennialís Funding Sources by Examination Date
* In addition to the non-core funding sources listed above, 1st Centennial also had other sources of funding, such as lines of credit with other financial institutions. Access to non-core funding may have been restricted as the bankís financial condition deteriorated.
A key metric of the risks related to a bankís liquidity management is the net non-core funding dependence ratio. This ratio is an indication of the degree to which the bank relies on non-core volatile liabilities, such as brokered deposits; FHLB borrowings to fund long-term earning assets; and certificates of deposit over $100,000. Generally, the lower the ratio, the less risk exposure there is for the bank, whereas higher ratios reflect a reliance on funding sources that may not be available in times of financial stress or adverse changes in market conditions. As noted in Figure 2, which follows, although 1st Centennialís reliance on non-core/volatile liabilities was higher than the bankís peer group at the May 2004 examination, the January 2005 and April 2006 examinations determined that the bank was generally in line with its peer group. However, the bankís net non-core funding dependence ratios of 28.60 and 44.12 percent were higher than the bankís peer group as of the February 2007 and April 2008 examinations, respectively. In addition, during the November 2008 visitation, the bankís dependence ratio had increased to 68.39 percent. According to DSC officials, the increase in 1st Centennialís brokered deposits and overall net non-core funding dependence during 2008 was in anticipation of liquidity events related to increasing levels of core deposit withdrawals. DSC officials also stated that 1st Centennial anticipated those substantial deposit withdrawals due to expected negative press associated with the firing of the bankís Chief Executive Officer and Chief Credit Officer, and with other bank failures that had occurred in 1st Centennialís local market area.
Figure 2: Net Non-Core Funding Dependence
[ D ]
After the FDIC meeting with the bankís BOD on June 20, 2008 to discuss examination results, 1st Centennialís BOD reported that depositors withdrew over $130 million in deposits during July and August 2008. During this same period, 1st Centennial purchased $224 million in brokered deposits to provide the liquidity needed to address its actual and potential core deposit withdrawals. By the end of October 2008, the bank had purchased $303 million in brokered deposits. The bank used excess funds primarily to purchase negotiable securities. As the bankís financial condition became critical, the FDIC monitored 1st Centennialís liquidity. On October 31, 2008, regulatory restrictions prohibited the bankís further use of brokered deposits as a funding source without first obtaining a waiver from the FDIC.
ASSESSMENT OF FDIC SUPERVISION
The FDIC and CDFI conducted timely examinations of 1st Centennial from 2004 until the bank closed in 2009. Examiners identified and reported on 1st Centennialís concentrations and the risks that those concentrations presented. In addition, examiners made recommendations related to the need for adequate monitoring and reporting. However, there were two areas where the FDICís supervisory activities regarding 1st Centennial could have been improved. These two areas related to supervisory actions needed to address the bankís high CRE/ADC concentration and the implementation of a formal enforcement action after the bankís condition had deteriorated. (See the Chronology of Significant Events in Appendix 4 of this report for additional details.)
At the April 2008 examination, examiners downgraded 1st Centennialís composite rating from 2 to 4, indicating unsafe and unsound practices or conditions and an imminent threat to the bankís viability. The transmittal letter for the April 2008 ROE stated that the FDIC considered 1st Centennial to be ďtroubledĒ for purposes of section 32 of the FDI Act, which would require 1st Centennial to notify the FDIC of any management changes, and Part 359 of the FDIC Rules
and Regulations, which placed certain restrictions on payments to institution-affiliated parties. In December 2008, examiners further downgraded 1st Centennialís composite rating to 5, indicating extremely unsafe and unsound practices or conditions that pose a significant risk to the DIF and that the bank had a high probability of failure.
1st Centennial attempted to raise $30 million in capital by August 1, 2008 but was unsuccessful. To address examination concerns, including those related to concentrations, inadequate risk management controls, and other safety and soundness issues, the FDIC and CDFI jointly sent the bank a draft Cease and Desist Order (C&D) on October 8, 2008.
Negotiations ensued between the bank and the FDIC and CDFI over C&D language until November 12, 2008, when 1st Centennial broke off further negotiations and stated that it would not stipulate to the proposed C&D. On November 14, 2008, the FDIC issued 1st Centennial a Notice of Charges (NOC) that contained provisions similar to those in the C&D. The NOC was still pending an administrative hearing when the bank failed on January 23, 2009.
The CDFI and FDIC performed a joint visitation of the bank in November 2008 that identified further losses and deterioration in 1st Centennialís CRE/ADC loan portfolio. The bank was issued a capital demand letter, PCA notification letter, and letter notifying 1st Centennial of downgrades to the bankís CAMELS ratings on December 19, 2008. The Capital Demand Letter required the bank to raise $78 million in additional capital within 60 days ($60 million within 30 days, followed by an additional $18 million) to replenish the losses in the bankís capital. Unfortunately, 1st Centennial was unable to raise the needed capital and was closed by the CDFI on January 23, 2009.Supervision Related to the CRE/ADC Concentration
Based on our review, the FDIC could have increased supervisory efforts concerning the risk inherent in the bankís CRE/ADC loan concentration. The FDIC had identified 1st Centennialís CRE/ADC loan concentrations in each of its examinations, starting in 2004, but determined that the risk was mitigated based on the bankís policies, controls, and monitoring activities. As noted below, examinations prior to 2008 noted significant concentrations and made recommendations to 1st Centennial to improve issues, including, but not limited to, monitoring and reporting practices.
The 2004 ROE reported that the high concentration of real estate loans, and more specifically, construction loans, remained an added risk to the bank that required managementís continued close attention. Regarding the 2004 examination, the FDIC concluded that the bank had a strong capital level, which mitigated some of the risk associated with the concentration. Further, the 2005 ROE stated that asset quality was
strong, and the 2006 ROE noted that although the bank was operating with a concentration in construction lending, management was effectively monitoring and managing this risk.
According to the December 2006 joint guidance entitled, Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices, CRE lending, in general, and construction lending, in particular, may require a greater level of supervisory oversight. Although the guidance was not intended to limit financial institutionsí CRE lending, the guidance states that an institution may be identified for further supervisory analysis of the level and nature of risk if it has experienced rapid growth in CRE lending, has notable exposure to a specific type of CRE, or is approaching or exceeds the following supervisory criteria:
The 2007 ROE noted that the bank continued to have substantial land and development concentrations but that management had effectively controlled the bankís credit risks. Given that the CRE/ADC loan concentrations (shown on page 6 of this report) far exceeded the supervisory criteria in the 2006 CRE guidance, additional examiner attention to the associated risks was warranted. For example, the CRE lending guidance emphasized that financial institutions should hold capital commensurate with the level and nature of the risk presented by CRE concentrations. An assessment of capital adequacy by the institution may have been warranted under these circumstances. In addition, the guidance reminds institutions that strong risk management practices are essential elements of a sound CRE lending program, particularly when an institution has a concentration in CRE/ADC loans. FDIC officials stated that examiners cautioned 1st Centennialís BOD and management in various ROEs regarding the risks associated with the bankís large CRE/ADC concentration.
By the April 2008 examination, FDIC examiners had determined that 1st Centennialís asset quality was deficient and had seriously deteriorated as of March 31, 2008 when adversely classified assets totaled $109.6 million and the ALLL needed to be increased by $6.0 million. Examiners determined that while the market negatively affected the institution, 1st Centennialís BOD and managementís lack of controls and oversight of the CRE portfolio played an important part in the significant losses. Examiners determined that adversely classified assets were centered in the CRE/ADC loan portfolio with loan classifications comprising $101.9 million (93 percent) of the $109.6 million and OREO asset classifications comprising the remaining 7 percent. The $109.6 million of adversely classified assets represented 177.6 percent of 1st Centennialís Tier 1 Capital plus reserves ($61.7 million). The 2008 examination findings stand in sharp contrast to the 2007 and prior examination results.
The April 2008 ROE stated that the bankís capital had deteriorated to a level insufficient for the bankís high-risk profile. The Risk Management Manual of Examination Policies (Examination Manual) states that the ďFDIC is not precluded from requiring an institution to maintain a higher capital level based on the institutions particular risk profile.Ē We found no evidence prior to the 2008 examination that the FDIC had considered the deterioration of capital or the need to increase capital to support the bankís increased risk profile and the significant CRE/ADC and geographic concentration. In 2008, 1st Centennial responded to the capital insufficiency by stating that the bank planned to raise $30 million in capital by August 1, 2008 through an investment banking firm but was ultimately unsuccessful in generating the needed capital.
Although examiners identified and reported 1st Centennialís CRE/ADC loan concentration, including the types and extent; inadequate risk management controls; and inadequate loan underwriting and credit administration practices; additional supervisory action related to those risks was not taken until October 2008, as discussed in detail later in this section of this report.Formal Enforcement Action Implementation
The FDIC pursued formal enforcement action after the June 20, 2008 meeting with 1st Centennialís BOD regarding the April 2008 examination because of the bankís deteriorated condition and composite 4 rating. However, the final ROE was not formally transmitted to the bank until August 13, 2008. San Francisco Regional Office (SFRO) officials explained that the delay in issuing the final ROE occurred because of staff assignments but that the SFRO had been in contact with 1st Centennial management during that period to discuss the examination findings and recommendations. For example, 1st Centennial senior management submitted a Criticized Assets Action Plan to the SFRO in response to the April 2008 examination findings and recommendations.
The FDIC and CDFI jointly pursued a Section 8(b) C&D and formally transmitted the proposed C&D to the bank on October 8, 2008. The proposed C&D required the bank, among other things, to:
After conducting 5 weeks of negotiations with 1st Centennial management over the terms of the proposed C&D, bank management notified the FDIC on November 12, 2008 that it would
not stipulate to the C&D. The FDIC then issued an NOC on November 14, 2008 that required a judicial hearing with a Federal Administrative Law Judge prior to becoming effective. The NOC contained a broad range of supervisory restrictions on bank operations that were similar to those contained in the proposed C&D. The NOC was still pending judicial review and adjudication when the bank failed on January 23, 2009.Additional Supervisory Action
The CDFI started an independent examination of the bank on November 17, 2008 to review and assess 1st Centennialís construction loan portfolio to obtain up-to-date information needed to issue a C&D that would become effective on issuance. The FDIC joined the CDFI examination loan review and began a visitation on November 24, 2008, which was later to become a joint FDIC/CDFI visitation. The visitation reviewed the construction loan portfolio as of October 31, 2008 and resulted in examiners classifying $115.4 million in construction loans, which represented 55.4 percent of the bankís construction loan portfolio.
The SFRO staff met with 1st Centennial management along with CDFI and officials from the Board of Governors of the Federal Reserve System7 on December 19, 2008 when bank management received a letter notifying the bank of downgrades in the CAMELS ratings, a PCA deficiency letter, and a capital demand letter. The downgrade letter downgraded the bankís composite and all component ratings to a 5 (critically deficient). The PCA deficiency letter notified bank management that 1st Centennialís capital category was Critically Undercapitalized. The capital demand letter informed the bank that $60 million in capital was required within 30 days and that an additional $18 million in capital was required within 60 days for a combined total of $78 million in additional capital.Actions Taken Subsequent to 1st Centennialís Failure
The SFRO established a 2009 regional operational goal to ensure that enforcement actions are presented to the financial institution within 30 days of the examination completion date. The SFRO has also streamlined the process used to shorten the time needed to coordinate and issue a C&D with CDFI. Additionally, DSC has begun issuing an examination exit letter to 4 or 5 composite-rated institutions that they must notify the FDIC prior to any material change in their balance sheet to include large brokered deposit acquisitions. The SFRO has also taken steps to strengthen offsite monitoring of financial data by enhancing current offsite monitoring with reports that identify and rank institutions with characteristics that include concentrations and high levels of wholesale funding.
IMPLEMENTATION OF PCA
Enforcement actions addressing 1st Centennialís capital deficiencies were taken in accordance with PCA capital-related provisions. Based on the supervisory actions taken, the FDIC properly implemented applicable PCA provisions of section 38 in a timely manner.
The purpose of PCA is to resolve problems of insured depository institutions at the least possible long-term cost to the DIF. PCA establishes a system of restrictions and mandatory and discretionary supervisory actions that are to be triggered depending on an institutionís capital levels. Part 325 of the FDICís Rules and Regulations implements PCA requirements by establishing a framework for taking prompt corrective action against insured nonmember banks that are not adequately capitalized.
The FDIC evaluated 1st Centennialís capital position and assigned a capital component rating of 2 in the 2006 and 2007 examinations, indicating a satisfactory capital level. Subsequently, the 2008 examination downgraded the bankís capital rating to a 4, indicating an insufficient level of capital for the bankís high-risk profile. Bank management indicated to examiners that it would raise $30 million in capital by August 1, 2008, but that effort never materialized. As a result, the FDIC proposed a C&D in October 2008 that contained several capital-related provisions even though the bankís reported PCA capital ratios had been in the Well Capitalized range. These provisions included:
As discussed earlier, the FDICís attempt to issue a C&D to 1st Centennial was not timely, and the C&D was ultimately not issued. The bank was subsequently deemed Adequately Capitalized with the filing of the bankís September 30, 2008 Report of Condition and Income (Call Report). Accordingly, upon the bankís filing of its Call Report, the availability of brokered deposits became restricted.
Examiners concluded that the bankís capital was critically deficient based on information as of November 30, 2008. The FDIC submitted an interim downgrade letter to the bank, downgrading the capital rating to a 5 and categorizing the bank as Critically Undercapitalized. The FDIC formally notified the bank of this categorization in a PCA Notification Letter, dated December 19, 2008. The letter stated that the bank was subject to the mandatory requirements of section 38 of the FDI Act including, but not limited to, submission of a written capital restoration plan, restrictions on asset growth, and payments of dividends. Some of these requirements reiterated provisions included in the proposed C&D. On December 19, 2008, CDFI informed 1st Centennial that CDFI may take ďextreme action against the bankĒ unless the bank merged with another institution, sold its business to another depository
institution, or increased capital by $78 million. The bank was unsuccessful in accomplishing any of those actions and was subsequently closed January 23, 2009.
PCAís focus is on capital, and capital can be a trailing indicator of an institutionís financial health. In addition, the use of PCA Directives can depend on the accuracy of capital ratios in a financial institutionís Call Reports. 1st Centennialís reported capital ratios remained in the Well Capitalized to Adequately Capitalized range long after its operations had begun to deteriorate as noted in the April 2008 ROE.
CORPORATION COMMENTS AND OIG EVALUATION
On August 4, 2009, the Director, DSC, provided a written response to the draft report. DSCís response is provided in its entirety as Appendix 3 of this report. In its response, DSC noted that 1st Centennialís asset growth and concentration of CRE/ADC loans began in 2004 as a result of the expanding population in Southern Californiaís Inland Empire where the bankís branch offices were located. DSC noted that when the bank began its concentration of CRE/ADC loans, it had strong capital levels and was well above the minimum levels of Well Capitalized for PCA purposes. The response further noted that FDIC examinations made specific recommendations to 1st Centennialís management for improving, monitoring, and analyzing the bankís loan concentrations.
DSC stated that 1st Centennial failed due to the risk embedded in its loan concentrations and funding strategies and due to a decline in the bankís local real estate market. The response further noted that the bankís recovery efforts from the loan losses were negatively affected by other market events that caused a large volume of deposit withdrawals and an upheaval in the secondary mortgage market. Further, DSC acknowledged that 1st Centennialís management had delayed the implementation of the C&D in 2008 through protracted negotiations and refusal to stipulate to the action. The OIG takes no exception to these comments.
The Director also stated that subsequent to 1st Centennialís failure, DSC (1) conducted an internal analysis, (2) has taken specific steps to limit growth that is funded by volatile non-core deposits, and (3) recognizes the threat that institutions with high-risk profiles, such as 1st Centennialís pose to the DIF.
OBJECTIVES, SCOPE, AND METHODOLOGY
Our ability to evaluate the adequacy of DSC supervisory efforts was restricted by the lack of FDIC examination work papers for the 2006 FDIC examination which resulted in a 2 composite rating for the bank. We were informed that the 2006 examination work papers had been destroyed prior to the commencement of our review. According to DSC, it was a common practice to destroy work papers for examinations that resulted in a 1 or 2 composite rating after a subsequent examination had been completed. Regional Directors Memorandum 01-039, Guidelines for Examination Workpapers and Discretionary Use of Examination Documentation Modules, dated September 25, 2001, and the Examination Manual notes that, with some exceptions, the retention of work papers beyond one examination is generally discouraged.Internal Control, Reliance on Computer-processed Information, Performance Measurement, and Compliance With Laws and Regulations
Due to the limited nature of the audit objectives, we did not assess DSCís overall internal control or management control structure. We performed a limited review of 1st Centennialís management controls pertaining to its operations as discussed in the body of this report.
For purposes of the audit, we did not rely on computer-processed data to support our significant findings and conclusions. Our review centered on interviews, ROEs and correspondence, and other evidence to support our audit.
The Government Performance and Results Act of 1993 (the Results Act) directs Executive Branch agencies to develop a customer-focused strategic plan, align agency programs and activities with concrete missions and goals, and prepare and report on annual performance plans. For this material loss review, we did not assess the strengths and weaknesses of DSCís annual performance plan in meeting the requirements of the Results Act because
such an assessment is not part of the audit objectives. DSCís compliance with the Results Act is reviewed in program audits of DSC operations.
Regarding compliance with laws and regulations, we performed tests to determine whether the FDIC had complied with provisions of PCA and limited tests to determine compliance with certain aspects of the FDI Act. The results of our tests were discussed, where appropriate, in the report. Additionally, we assessed the risk of fraud and abuse related to our objectives in the course of evaluating audit evidence.
GLOSSARY OF TERMS
|Adversely Classified Assets||Assets subject to criticism and/or comment in an examination report. Adversely classified assets are allocated on the basis of risk (lowest to highest) into three categories: Substandard, Doubtful, and Loss.|
|Allowance for Loan and Lease Losses (ALLL)||Federally insured depository institutions must maintain an ALLL that is adequate to absorb the estimated loan losses associated with the loan and lease portfolio (including all binding commitments to lend). To the extent not provided for in a separate liability account, the ALLL should also be sufficient to absorb estimated loan losses associated with off-balance sheet loan instruments such as standby letters of loan.|
|Cease and Desist Order (C&D)||A C&D is a formal enforcement action issued by a financial institution regulator to a bank or affiliated party to stop an unsafe or unsound practice or a violation of laws and regulations. A C&D may be terminated when the bankís condition has significantly improved and the action is no longer needed or the bank has materially complied with its terms.|
|Concentration||A concentration is a significantly large volume of economically related assets that an institution has advanced or committed to a certain industry, person, entity, or affiliated group. These assets may, in the aggregate, present a substantial risk to the safety and soundness of the institution.|
|Prompt Corrective Action (PCA)||
The purpose of PCA is to resolve the problems of insured depository institutions at the least possible long-term cost to the DIF. Part 325 of the FDIC Rules and Regulations, 12 Code of Federal Regulations, section 325.101, et. seq., implements section 38, Prompt Corrective Action, of the FDI Act, 12 United States Code section 1831o, by establishing a framework for taking prompt supervisory actions against insured nonmember banks that are less than adequately capitalized. The following terms are used to describe capital adequacy: (1) Well Capitalized, (2) Adequately Capitalized, (3) Undercapitalized, (4) Significantly Undercapitalized, and (5) Critically Undercapitalized.
A PCA Directive is a formal enforcement action seeking corrective action or compliance with the PCA statute with respect to an institution that falls within any of the three categories of undercapitalized institutions.
|Uniform Bank Performance Report (UBPR)||The UBPR is an individual analysis of financial institution financial data and ratios that includes extensive comparisons to peer group performance. The report is produced by the Federal Financial Institutions Examination Council for the use of banking supervisors, bankers, and the general public and is produced quarterly from Call Report data submitted by banks.|
August 4, 2009
Pursuant to Section 38(k) of the Federal Deposit Insurance Act (FDI Act), the Federal Deposit Insurance Corporationís Office of Inspector General (OIG) conducted a material loss review of 1st Centennial Bank (1st Centennial), which failed on January 23, 2009. This memorandum is the response of the Division of Supervision and Consumer Protection (DSC) to the OIGís Draft Audit Report received on July 20, 2009.
Beginning in 2004 1st Centennial pursued asset growth concentrated in commercial real estate/acquisition, development, and construction (CRE/ADC) loans, primarily as a result of expanding population in Southern Californiaís Inland Empire. 1st Centennialís branches were located in the Inland Empire. Thus, its lending was concentrated in that geographic area. When 1st Centennial began holding notable CRE/ADC concentrations in 2004, its capital levels were strong and well above minimum levels to be ďWell CapitalizedĒ for Prompt Corrective Action purposes. FDIC examinations in 2004, 2006, and 2008 made specific recommendations to the Board for improving, monitoring and performing internal analyses of its concentrations, with a formal enforcement action recommended after the April 2008 examination. After protracted negotiations, 1st Centennialís Board refused to stipulate to the Cease and Desist Order, and the FDIC filed a Notice of Charges.
1st Centennial failed due to the risk embedded in its loan concentrations and funding strategies and due to a decline in its local real estate market. Recovery efforts were also significantly hampered by other market events that led to a large volume of deposit withdrawals and secondary mortgage market upheaval. DSC conducted an internal analysis following the failure of 1st Centennial and has taken specific steps to limit growth that is funded by volatile non-core deposits. We recognize the threat that institutions with high-risk profiles, such as 1st Centennial, pose to the Deposit Insurance Fund; and we continue to look for and implement improvements to our supervisory program.
Thank you for the opportunity to review and comment on the Draft Audit Report.
CHRONOLOGY OF SIGNIFICANT EVENTS
|5-24-2004||Full-scope FDIC examination - UFIRS ratings were 2-2-2-2-2-2/2. 1st Centennialís overall financial condition was satisfactory.|
|1-31-2005||Full-scope CDFI examination - UFIRS ratings were 2-1-2-2-3-2/2. 1st Centennial was stated to be fundamentally sound.|
|4-24-2006||Full-scope FDIC examination - UFIRS ratings were 2-2-1-1-2-1/2. 1st Centennialís overall financial condition continued to be satisfactory. The bank used a limited amount of brokered deposits as a funding source.|
|2-26-2007||Full-scope CDFI examination - UFIRS ratings were 2-2-1-1-2-2/2. The condition of the bank was satisfactory.|
|4-7-2008||Full-scope FDIC examination - UFIRS ratings were 4-4-4-4-4-3/4. 1st Centennial needed to raise $30 million in capital by August 1, 2008.|
|5-22-2008||FDIC completed fieldwork on examination.|
|6-11-2008||FDIC held an exit meeting with 1st Centennialís management.|
|6-20-2008||FDIC held a meeting with 1st Centennialís BOD to discuss the ROE and that the FDIC/CDFI would propose a joint C&D based upon the weaknesses identified in the ROE.|
|8-8-2008||FDIC started daily liquidity monitoring.|
|8-13-2008||FDIC sent the April 2008 final ROE to 1st Centennialís BOD.|
|9-16-2008||Proposed C&D sent to CDFI for review.|
|9-30-2008||CDFI discussed C&D changes with the FDIC; 1st Centennial letter sent to the FDIC discussed setting up a meeting to discuss the bankís capital plan, loan portfolio, ALLL, and brokered deposits.|
|10-8-2008||Joint C&D sent to 1st Centennial.|
|10-28-2008||Proposed C&D language was negotiated between the FDIC and 1st Centennial.|
|10-31-2008||1st Centennial notified the FDIC that the bankís capital category would decline from Well Capitalized to Adequately Capitalized based on the filing of the September 30, 2008 Call Report.|
|11-12-2008||1st Centennialís management notified the FDIC that they would not stipulate to the proposed C&D; the FDIC commenced onsite liquidity monitoring.|
|11-14-2008||The FDIC issued the NOC to 1st Centennial.|
|11-17-2008||The CDFI began a full-scope examination of 1st Centennial which was later changed to a visitation.|
|11-24-2008||The FDIC started a visitation of 1st Centennial.|
|12-19-2008||Joint FDIC/CDFI interim downgrade letter sent to 1st Centennial based on November 30, 2008 financial data Ė UFIRS ratings were 5-5-5-5-5-5/5. The CDFI Capital Demand letter required the bank to raise $78 million in capital. The FDIC issued a Critically Undercapitalized PCA notification letter to the bank.|
|01-08-2009||1st Centennial forwarded the Capital Restoration Plan to the FDIC and CDFI.|
|01-23-2009||The CDFI closed 1st Centennial and appointed the FDIC as receiver.|
ACRONYMS IN THE REPORT
|ADC||Acquisition, Development, and Construction|
|ALLL||Allowance for Loan and Lease Losses|
|BOD||Board of Directors|
|C&D||Cease and Desist Order|
|CAMELS||Capital, Asset Quality, Management, Earnings, Liquidity, and Sensitivity to Market Risk|
|CDFI||California Department of Financial Institutio|
|CLP||Contingency Liquidity Plan|
|CRE||Commercial Real Estate|
|DIF||Deposit Insurance Fund|
|DRR||Division of Resolutions and Receiverships|
|DSC||Division of Supervision and Consumer Protection|
|FDI||Federal Deposit Insurance|
|FHLB||Federal Home Loan Bank|
|MERIT||Maximum Efficiency, Risk Focused, Institution Targeted Guidelines|
|NOC||Notice of Charges|
|OIG||Office of Inspector General|
|OREO||Other Real Estate Owned|
|PCA||Prompt Corrective Action|
|ROE||Report of Examination|
|SFRO||San Francisco Regional Office|
|UBPR||Uniform Bank Performance Report|
|UFIRS||Uniform Financial Institution Rating System|
|Last updated 10/7/2009|