The Impact of the Financial Crisis on Community Banks

Introduction

Over the course of the past decade, community banks have become heavily concentrated in construction and development lending as well as commercial real estate lending due to an increase in competition for consumer credit, home mortgages, and credit cards.  Now, two years into the financial crisis, and with the benefit of hindsight, it appears that the increased competition was met with loosening of underwriters standards, and poor management.  As a result, over 150 banks failed in 2010, almost 50 banks have failed thus far in 2011, and we will continue to see high levels of bank failures, particularly among community banks, for the next few years.  In fact, billions of dollars in commercial real estate loans made prior to the financial crisis has still yet to mature, many of which are underwater and will be difficult to refinance.

Not surprisingly, a wave of litigation resulting from the failure of community banks has commenced.  With the economic conditions remaining unsettled, and with the probability of more community bank failures on the horizon, the FDIC will continue to investigate banks and bring additional lawsuits in the coming years.

Insurers that have provided Directors and Officers (“D&O) liability coverage to community banks are concerned over FDIC litigations and their aggregate exposure to financially distressed community banks.  Additionally, many Insurers are reluctant to provide D&O coverage for such risks.  Therefore, some community banks are experiencing displacement issues with regards to the carrier community, and new Insurers are sought to provide D&O programs.

While there has been a considerable increase in cost for D&O coverage, the expected FDIC litigations will not likely affect financially sound financial institutions, including community banks, from procuring D&O coverage.  However, “problem institutions” are struggling to obtain coverage, and will likely continue to struggle until they can shore up their financial viability.

This article examines the causes of the failure of community banks in the wake of the financial crisis, and the resulting investigations and litigation being pursued by the FDIC as well as private investors.  Additionally, the article provides helpful statistics concerning the recent bank failures, and also provides several case studies of banks that have failed during the current financial crisis.

Causes of Community Bank Failures
It is not surprising that many of the community banks that have failed during the recent financial crisis have had similar characteristics.  Many have suffered because of loan losses from construction and development lending as well as commercial real estate.  An analysis of the financial statements of community banks, prior to their failure, demonstrates that the banks had a significant percentage of non-performing loans in the areas in which their lending was heavily concentrated – construction and development, and commercial real estate.  Because the lending at the failed banks were so heavily concentrated in these portfolios, the banks were not prepared to deal with non-performing loans, and the resulting loan losses.

Many companies have shut down during the recession, vacating shopping malls and office buildings financed by the loans, which has resulted in delinquent loan payments and defaults by commercial developers.  While there has already been a significant amount of community bank failures through 2011, because the losses to commercial real estate appear to develop at a later stage, continuing losses to commercial real estate will likely lead to further bank failures in the coming years.  In fact, the Congressional Oversight Panel has suggested that commercial real estate loan losses will significantly increase over the course of the next several years, impacting the stability of community banks, and likely leading to more community bank failures.

While economic conditions have undoubtedly contributed to the recent bank failures, similar to the Savings and Loan (“S&L”) period, we have found that internal problems such as poor management has substantially contributed to bank failures as well.  Our experience demonstrates that high risk business strategies, poor underwriting, which fails to adhere to the bank’s guidelines, including poor documentation, and inadequate management oversight all contributed to the recent failure of many community banks.  In fact, because many directors and officers defend claims by arguing that they could not predict the market collapse, most FDIC lawsuits attempt to develop evidence of dishonest conduct, failure to follow internal policies, and failure to establish and adhere to adequate underwriting policies. 

In light of the foregoing, it is important for community banks to establish strict underwriting guidelines, and to ensure that adequate supervisory guidance remains in place so they do not risk overexposure to a severe risk.

In addition to the above, a report from the St. Louis Fed suggested that similar to the S&L crisis, in the current financial crisis, asset quality issues in the commercial real estate sector are particularly problematic.  The St. Louis Fed examined data on commercial bank failures from 1990 to 2009, paying particular attention to “CAMELS” scores – capital, asset quality, management, earnings, liquidity and sensitivity to risk – to see the point at which each category began to deteriorate for the failed banks.  The findings revealed that failed banks experience deterioration in “asset quality,” and the deterioration first shows in a bank’s “earning level,” as banks begin to provision for potential loan losses. 

The next CAMELS components to deteriorate are “asset quality” and “management,” as both experience deterioration approximately nine fiscal quarters prior to failure.  Furthermore, according to the study, the “management” component rating deteriorates shortly after “earnings,” which reflects ongoing asset quality issues and regulatory initiatives by bank supervisors to communicate with management and hold management accountable for the bank’s condition.

After the management component deteriorates, the study found that “capital” begins to deteriorate, usually seven fiscal quarters before failure.  Generally, “capital” ratios do not fail as quickly as “asset quality” because of the bank’s ability to raise additional capital.  However, “capital” ratios rapidly decline one year before failure, as investors realize that the institution has reached a “point of no return,” and no longer see viability in the bank’s operations.  The study found that the final two CAMELS ratings to fall are “liquidity” (six quarters before failure) and “sensitivity to risk” (two quarters before failure).

Based on the St. Louis Fed study it is also important to review a bank’s financial statements to determine if sufficient risk management has been implemented.  While the study appears to be based on large and small institutions, it is particularly helpful in analyzing small banks as their portfolios are heavily concentrated, and do not have a substantial amount of diversity.

Problem Institutions
The FDIC considers a bank a “problem institution” when it is rated either a 4 or 5 on the FDIC’s one-to-five scale of supervisory concern.  “Problem institutions” are “those institutions with financial, operational or managerial weaknesses that threaten their continued financial viability.”

Currently, one out of every 11 banks is on the FDIC problem list, and the number of “problem institutions” is at its highest level since the S&L crisis 17 years ago.  As of March 31, 2011, the FDIC has designated 888 banks as “problem institutions,” representing more than 11% of all 7,574 insured institutions.  The 888 “problem institutions” represents an increase of 583 “problem institutions” over the last 24 months, or an increase of just under 200%.

The amount of “problem institutions” is at its highest level since March 31, 1993, when there were 928 “problem institutions.”  However, notwithstanding the increase in “problem institutions,” the aggregate assets represented by such institutions has fluctuated over the past year.  Aggregate assets were $379.2 billion in the third quarter of 2010, down from $403.2 billion at the end of the second quarter in 2010, and this was the second consecutive quarter in which the assets of “problem institutions” had declined.  However, aggregate assets of “problem institutions” saw an increase in the fourth quarter of 2010, rising to $390 billion, as well as a continued increase into 2011, as aggregate assets at the end of the first quarter of 2011 were $397 billion. 

“Problem institutions” does not take into account banks that are now closed.  This is especially relevant because, in light of the fact that there are so many “problem institutions,” none of which are failed banks, there is likely to be an even greater amount of bank failures throughout 2011.  In fact, 47 banks have already failed in 2011, and the FDIC’s latest reports suggests that bank closures could be expected to continue well into 2011, and possibly beyond, as banks continue to reel from loan losses on commercial real estate projects, regulatory clampdowns, and a weak U.S. economic recovery.

Statistics
There were 157 bank failures in 2010, up from the 140 bank failures that occurred in 2009, and so far 47 banks have failed in 2011 (as of June 17, 2011).  At this point, 372 banks have failed since the financial crisis began in early 2008.

Since 2008, as well as in 2010 and 2011, Georgia, Florida and Illinois represent the states with the highest amount of failed banks.  In 2010, Florida possessed the most failed banks (28), followed by Georgia (19), Illinois (16) and California (10).  These four states combined for just under 50% of all 2010 bank failures.  In 2010, 39 states, and Puerto Rico, had at least one bank failure.

Thus far in 2011, Georgia has experienced the greatest amount of bank failures (13), followed by Florida (6), Illinois (4) and California (3).  These four states have combined for 55% of all 2011 bank failures, and so far 17 states have had at least one bank failure in 2011.

Georgia has had the most bank failures (65) since 2008, followed by Florida (51), Illinois (32) and California (37).  These four states account for approximately 50% of all bank failures since January 1, 2008.  Other notable states with high failures since January 1, 2008 include Minnesota (16), Washington (16), Missouri (12) and Nevada (11).  While most experts believe that bank failures peaked in 2010, we can expect bank failures to continue at elevated levels for the next several years.

An analysis of the banks that failed in 2010 demonstrates that the failures were largely concentrated among smaller, or community, banks.  In fact, of the 157 bank failures, 131, or about 83%, involved institutions with less than $1 billion in assets.  Of the bank failures that occurred in 2010, 45, or about 29%, involved institutions with less than $100 million in assets.  There are roughly 7,500 “small banks” in the United States, and they have a profound impact on the American economy.  In this regard, community banks provide 64% of the loans to America’s small businesses, which in turn creates 65% of all new jobs, and employ half of the private-sector workforce.

Claims
As the community bank crisis continues to unfold, the FDIC is attempting to limit the damage to its already depleted Deposit Insurance Fund (“DIF”).  In this regard, the weakest community banks remain heavily concentrated in construction and development lending and commercial real estate.  Experts have suggested that in light of the total assets held at these banks, if they were to fail, the DIF could face a 50% increase in losses.  Accordingly, the FDIC has been seeking the least costly way to preserve these community banks, which results in eliminating credit to shaky businesses, firing bank employees and foreclosing on bad loans.

The FDIC is pursuing both civil and criminal proceedings against former directors and officers of failed banks, while investors have already been pursuing their own separate claims.  It is highly probable that claim-related activities will escalate in the months, and years ahead because many recently failed banks are publicly traded, or, if privately held, had outside investors with significant ownership interests who are motivated to sue.  As litigation continues against failed banks, the FDIC and shareholders of the banks will be competing over the proceeds of D&O liability insurance policies, which represents the strongest possibility of recovering funds lost due to a bank’s failure.  Accordingly, directors and officers whose liability coverage could be sought by shareholders and regulators must evaluate whether they have enough limits to address both situations. 

Additionally, more litigation is expected over D&O policy proceeds because FDIC investigations of failed banks are only commencing while shareholder/investor suits involving those same banks have already begun (although some underwriters claim that there are instances where regulators, rather than shareholders, are tapping into existing D&O policy limits).  When shareholders assert rights to D&O policy proceeds in instances where the FDIC is demanding the same, the shareholders must convince courts that they are bringing a direct claim, rather than a derivative claim, because federal law provides that a bank’s available D&O policy limits in derivative claims belong to the FDIC.  However, laws stating that a bank’s D&O policy limits belong to the FDIC may not apply in the event that shareholders are suing the directors and officers of the bank’s holding company.

Generally, the FDIC is first in line to recover assets of a failed bank, such as its directors and officers insurance policy.  The FDIC tends to bring breach of fiduciary duty claims against the directors and officers of the bank, and have the strongest case to claim priority in a breach of fiduciary duty case.  Therefore, so as not to pursue a private action alongside the FDIC, many investors have begun to carefully plead their complaints, and only assert negligence against the directors and officers.  In addition, investors also tend to pursue cases against failed banks and their directors and officers that the FDIC determines are not cost effective to litigate, or in which the directors and officers policy contains regulatory exclusions.  That being said, it appears that, thus far, investors have struggled to prove that their alleged investment losses were caused by misrepresentations of the bank, and not marketwide issues that affected the entire banking industry.  In fact, in early January 2011, the Northern District of Georgia granted the Haven Trust Bank of Duluth, Georgia’s motion to dismiss a securities class action lawsuit filed by investors in the failed bank.  It will be interesting to see if other Courts follow this decision as investor litigation moves forward.

The FDIC is conducting at least 50 criminal investigations of former executives, directors and employees of failed banks in an attempt to punish alleged recklessness, fraud and other criminal behavior.  The probes involve failed banks of all sizes in cities across the United States.  The FDIC is also ramping up civil claims to recover money from former executives at failed institutions.  Hundreds of “demand” letters have been sent to former executives, directors and employees, as well as their professional-liability insurers, putting them on notice of potential claims.  As of June 14, 2011, the FDIC has authorized the filing of lawsuits to recover more than $6.8 billion from approximately 238 directors and officers of failed banks.

Thus far, the FDIC has filed seven civil lawsuits related to bank failures, naming 52 former officers and directors.  Notably, the FDIC is seeking $300 million from four former executives of IndyMac Bancorp, $20 million from 11 former directors of Heritage Community Bank, and more than $70 million from eight former officials of the failed Integrity Bank of Alpharetta, Georgia.  IndyMac, which failed in 2008, cost the FDIC fund an estimated $12.7 billion, and represents one of the largest bank failures in U.S. history.  The lawsuit alleges that the former executives negligently approved loans to homebuilders that had little chance of being repaid.  The lawsuit against Integrity Bank looks to recover losses the FDIC alleges the bank suffered on various commercial and residential acquisition and construction loans.  The FDIC alleges that the bank lacked oversight and took on excessive risk, which led to its failure.

One of the seven lawsuits, which was filed against four former directors and officers of Corn Belt Bank and Trust Company of Pittsfield, Illinois, was settled out of court.  The FDIC obtained a settlement figure of $700,000, though it had sought to recover at least $10.4 million in losses because it claimed that the former directors and officers had “acted recklessly” in approving five high-risk commercial loans. 

There is currently high pressure on regulators to identify and prosecute bankers for wrongdoing that contributed to largest amount of bank failures in 20 years.  To date, no high profile banker has been criminally charged in connection with a financial institution’s failure, but there have been a few low-level criminal prosecutions.  Two former officials of Integrity Bank, which opened in 2000 and was subsequently seized in 2008, were indicted in May 2010 on fraud-related charges.  It often takes at least 18 months for legal action to commence following a bank failure, indicating that the already authorized lawsuits relate to banks that failed during the early days of the financial crisis.  Therefore, the surge in scrutiny is likely to continue through the coming years, and, considering the number of bank failures in 2010 and 2011, many prosecutions are expected to come within the next two years.

Impact of S&L Crisis on Claims
While litigation involving the directors and officers of failed institutions has, at least thus far, been relatively light, despite the high amount of bank failures, many experts anticipate that the FDIC will soon begin to file significant numbers of lawsuits.  The expectation in this regard is not only based on the significant amount of “demand” letters issued by the FDIC, but also on the fact that, during the S&L crisis in the 1980’s and early 1990’s, litigation was an important component of the FDIC’s efforts to recoup its losses.

During the height of the S&L crisis, between 1987 and 1993, there were 1,858 bank and thrift failures, compared to the 372 bank failures that have occurred since January 1, 2008.  While the amount of recent bank failures pales in comparison to the amount of failures that occurred during the S&L crisis, the dollar value of failed bank assets is unparalleled.  Despite the fact that roughly 30% of failed banks are “small banks,” the current crisis has experienced roughly $660 billion of failed bank assets, which is roughly 1.8 times the $360 billion of assets that failed between 1987 and 1993.  As a result of the S&L crisis, between 1990 and 1995, federal agencies collected $4.5 billion in professional liability claims.  Accordingly, many experts predict that there will be a surge of claims by the FDIC against directors and officers of failed banks to recover funds, especially considering that the high amount of failed bank assets.

Furthermore, criminal prosecutions are expected to increase as a result of the current wave of bank failures.  While criminal prosecutions have been minimal thus far, and no high profile banker has yet to be indicted, the FDIC has been investigating many directors and officers of failed banks in its effort to punish alleged recklessness, fraud and other criminal behavior, as U.S. officials did in the wake of the S&L crisis.  Between 1990 and 1995, 1,852 bank executives were prosecuted by federal officials, resulting in the imprisonment of 1,072 directors and officers of failed institutions.  As the FDIC’s investigations continue, it is anticipated that an increased number of prosecutions will result from the current crisis.

Despite the anticipated volume of prosecutions, some experts predict that the FDIC will struggle to obtain convictions.  In this regard, the FDIC will have to overcome the likely defense that bank failures were caused by an unforeseeable real-estate bust, and any civil litigation will call for 20/20 hindsight.  It will be interesting to closely follow the litigation that has commenced to determine its impact on future litigation resulting from the current financial crisis.

Case Studies
While data and statistics are helpful to understand the troubles that community banks have faced, and will continue to face during the financial crisis, case studies based on actual banks that have failed over the course of the past couple of years supports the data and statistics provided above.  Below are several examples of community banks that failed because they were overexposed to construction and development or commercial real estate, and also had many internal problems such as poor underwriting guidelines.

Heritage Community Bank.  Heritage closed in February 2009, and the FDIC, as receiver, recently filed suit against the former directors and officers.  Prior to FDIC filing suit, shareholders sued the Bank’s holding company’s directors and officers, blaming them for the Bank’s loan losses. Heritage’s failure was in large part caused by aggressive real estate practices, as Heritage was “ill equipped” for the commercial real estate lending strategies it pursued.

The FDIC lawsuit is against 11 former executives and comes at a time when few D&O liability insurance markets are available for smaller, financially stressed community banks.  The suit alleges that the executives mismanaged Heritage and its commercial real estate lending program over several years, leaving the bank dangerously overexposed to the volatile CRE market.  It alleges claims of negligence, gross negligence and breach of fiduciary duty.

Community Bank & Trust (“CBT”).  Based in Cornelia, Georgia, CBT was closed by the FDIC on January 29, 2010.  CBT was the 32nd bank to fail in Georgia since the start of the financial crisis in 2008.  The failure of CBT is a prime example of a small town bank getting caught up in the speculative fever caused by rapidly escalating real estate prices, compounded by administrative and procedural shortcomings that led to faulty and improper loans.  The sudden collapse of real estate prices that accompanied the financial crisis left borrowers unable to repay the loans, and CBT was left with a portfolio of bad loans that ultimately caused its failure.  CBT’s practices led to hundreds of residential and commercial foreclosures in and around Cornelia, and may produce thousands more.  Roughly 35 homes and 189 businesses underwritten by CBT were foreclosed on in 2010, 1,500 loans are in serious trouble, and at least 2,700 loans were poorly documented to the extent that it is currently unknown whether or not they should be foreclosed upon.

By 2005, CBT held nearly 50% of the Cornelia’s deposits.  Eventually, property prices on lots adjoining the region’s lakes rose to levels well into the millions.  Initially, the Bank flourished, as bank-backed developers sold second homes to buyers from Atlanta, the closest major city.  However, from 2006 to 2008, the Bank’s loans on development and commercial real estate ballooned from $228 million to $563 million – more than half of all its loans.  By 2009, CBT’s commercial real estate loans were well above FDIC guidelines, totaling 657% of its capital.

CBT was also a victim of poor management, as CBT’s headquarters failed to monitor the loans its officers were authorizing to businesses and homeowners.  Residential mortgages consisted of one-fifth of CBT’s loans, and the Bank renewed interest-only commercial loans every year, causing borrowers to believe the underlying debts would never come due.  CBT kept records that were deficient in several ways, classifying home loans as business loans and vice versa, and losing key data such as collateral-property addresses and historical loan payments.

However, borrowers, bankers and even the FDIC all share responsibility for CBT’s failure.  Borrowers were caught up in the vacation-land boom, and experienced builders, as well as amateurs, borrowed money to buy lots and build spec homes, taking on loans that they could not re-pay.  Some bankers crossed the line from “dangerously sloppy” to “potentially criminally fraudulent” behavior, as they lent to one another and favored friends while concealing lines of credit.  All the while, the FDIC suspected no wrongdoing, noting in a 2007 report that CBT was “well-capitalized.”  However, amidst the financial crisis, in October 2008, the FDIC finally discovered that credit officers had been writing and renewing troubled loans with little or no oversight, as the FDIC found that at least $2 million of unpaid interest had been rolled over into new loans.

Subsequent to the October 2008 examination, on May 1, 2009, the FDIC issued a cease and desist order requiring that the CBT build up its capital.  This constrained lending, as loans that had been rolled over for multiple years were not renewed due to a deficiency in capital, and resulted in cleared subdivisions of lots with unfinished homes that no longer signaled future profits.  Lots with unfinished homes signified tanking real estate valuations and loans that could not be repaid.  By the end of 2009, 26.3% of all CBT loans, worth roughly $300 million, were past due, and more than $100 million of other assets were classified by the FDIC as fraudulent.

New Frontier Bank (“New Frontier”).  New Frontier was a community bank based in Greely Colorado.  The bank was taken over by regulators in April 2009, and on December 15, 2009, approximately 60 investors filed suit against the Bank’s former directors and officers.  Prior to its closing, the Bank’s assets exceeded $2 billion.

New Frontier was particularly dependent on “hot money,” or brokered deposits on behalf of investors seeking higher rates of return on their deposits.  While the flood of “hot money” facilitated the Bank’s business lending, which led to rapid growth, New Frontier’s credit requirements were significantly more flexible than virtually all neighboring banks.  Other community banks in Greely’s surrounding area reportedly used New Frontier as a safety valve by urging their own customers that had fallen behind on  payments to refinance their loans at New Frontier.

One factor that proved particularly dangerous was the Bank’s heavy concentration in agricultural loans, particularly with regards to local dairies.  A number of borrowers became delinquent or defaulted after prices for milk and other products declined, causing significant damage to New Frontier, as well as the defaulting borrowers themselves.

The investors’ lawsuit alleges that New Frontier’s senior officials engaged in a host of improprieties, including reckless lending activities without regard to loan quality, insider deals that improperly benefited board members, and many instances of conflicts of interest among board members.  Among other things, the complaint alleges that insiders received huge loans on preferred terms, and that the Bank’s headquarter building was built by the construction company owned by other board members, on terms that were heavily favorable to the leasing company.

The three case studies above highlight many of the issues suffered by community banks during the financial crisis which has led to the collapse of a significant number of banks.  While we are not involved in the above matters, we do have a significant amount of experience working on community bank programs.  Over the course of the past few years, we have been involved in upwards of 20 community banks claims where the bank has failed or the FDIC has commenced an investigation of the bank.  In the overwhelming majority of the banks that have failed, we have seen an overexposure to construction and lending or commercial real estate, poor underwriting oversight, and aggressive growth fueled by competition.  It appears that the FDIC’s investigations focus on these areas as well in an effort to determine whether it should pursue litigation against the bank.  As the economy continues to struggle to recover, it is important for these problematic community banks to reduce its commercial real estate concentration, and to adhere to strict underwriting and internal controls.

Conclusion
The financial crisis has had a significant impact on community banks.  Many community banks have failed, and many more are in danger of failing as their commercial real estate loans mature over the course of the next few years.  Litigation has commenced and will also continue for years to come.  The FDIC and private investors will continue to litigate in anticipation of recovering funds through the failed banks D&O insurance policy.

The FDIC continues to review the institutions and has increased the amount of “problem institutions” by almost 200% over the past two years.  In the wake of this financial crisis, it has been important for the viable banks to tighten its underwriting guidelines and to increase its management oversight.  While internal changes have been made within many banks, until the economy makes a full recovery, many community banks will find difficulty in procuring D&O coverage.