Crisis Tales

The financial crisis has had an overwhelming impact on the banking industry. At the end of the first quarter, 775 banks, or more than 10% of all banks in the country, were on the Federal Deposit Insurance Corp.’s problem bank list. The worst may be yet to come.

Less talked about are the stories of literally thousands of bank boards that, under closer than ever scrutiny, have taken on greater workloads and commitment levels to confront the crisis’s effects.

A handful of boards whose institutions have come out of the chaos looking stronger have seized upon the crisis as a once-in-a-lifetime opportunity to bulk up. For most of the rest, however, it’s been a harrowing slide from a once-comfortable gig overseeing a profitable enterprise to a stressful struggle to keep that same business afloat.

“You’re under a lot of outside pressure and are doing everything possible to stay on top of things,” says Richard Claydon, a retired oral surgeon and 17-year director with the Bank of Illinois in Normal, which failed earlier this year. “Collectively, we were putting in three or four times as much work as we used to, easily. And it didn’t matter.”

For those in the mood to learn, the crisis has reinforced basic lessons about the business of banking-the value of good leadership, outside counsel, and capital when times get tough, and the importance of remaining vigilant on credit quality-that some boards apparently never learned or forgot.

Directors who come out on the other side, hardened by the tough policy and operating decisions of the past few years, should be wiser for the experience. That is as likely as anything to prevent a replay of the crisis.

The following three tales-one about a buyer, another describing a survivor, and the third recounting a bust-illustrate some of the extremes bank boards have encountered in the present environment.

While differing circumstances have driven distinctions in those boards’ responses, one striking similarity stands out: The singular importance of capital. Have enough of it, and your bank can survive or even thrive, even with asset-quality problems; don’t have enough, and your days as a bank director are likely numbered.

Associated Banc-Corp:

Back from the brink

The board of Associated Banc-Corp got its wake-up call in April 2009, when regulators came in for a heart-to-heart with the audit committee.

Like so many banks, $23.1 billion Associated gorged on commercial real estate loans-many of them participations in out-of-market deals-during the boom times of 2006 and early 2007, when money was easy and property prices were near their peak.

The Green Bay, Wisconsin-based company had turned a small profit in the first quarter of 2009, but also had seen nonperforming loan levels jump 33%. While management had begun addressing those problem loans, officials from the Office of the Comptroller of the Currency scolded directors that the bank wasn’t monitoring or valuing the portfolio aggressively enough, and would soon be paying the price.

“We were basically unfamiliar with what happens when a bank gets into trouble,” says William Hutchinson, 67, nonexecutive chairman of the company’s board. The meeting “raised a bunch of orange flags for us. … I give the regulators high marks for raising our attention level.”

In the 15 months since, the board has boosted loan-loss provisions, raised fresh capital, cut the bank’s dividend twice, launched a new credit-and-risk committee, endured the wrath of shareholders and regulators, and even replaced the CEO. Board meetings have gone from quarterly to monthly affairs, and barely a day goes by without directors engaging in a bank-related conference call or email exchange.

The hard work has helped assure Associated’s survival. Analysts expect the company, which lost $161.2 million in 2009 and another $33.8 million in the first quarter of 2010, to turn a small quarterly profit by the end of the year.

Almost immediately after the meeting with regulators, Associated’s board swung into action. It appointed Hutchinson as lead director and hired an outside law firm, Chicago-based Winston & Strawn LLP, to advise the 10 independent directors.

Christine Edwards, a partner in Winston’s corporate practice group, talked directors through what to expect from the regulatory process and how to stay a step ahead of the troubles. Her prescription was harsh: better loan assessments, higher provisions, more aggressive reappraisals and chargeoffs, more effort placed on collection efforts.

“She said, ‘Here’s what’s going to happen next, and here’s what you need to do,’” Hutchinson recalls. “It motivated the board to begin pressing management to deal with the issues the OCC was warning about.”

Directors needed to “move with a sense of urgency and have a bias for action,” adds Eileen Kamerick, 51, a three-year director and chief financial officer at Houlihan Lokey, the investment bank. Working with outside experts, such as Edwards, “enabled us to be much more nimble and thoughtful in our responses.”

The board upped its meeting schedule to once-a-month, while a recently formed, three-member risk and credit committee began receiving regular weekly updates-and forging new policies-on credit quality. Directors had little interest in raising capital at the time but did move to preserve what the bank had, slashing the quarterly dividend from 32 cents to 5 cents.

Associated was thrown another curve a month later when President and Chief Operating Officer Lisa Binder abruptly resigned. Directors don’t like to talk about it, but Binder, a retail banking expert who had joined the company from Mellon Financial Corp. two-and-a-half years earlier, reportedly left because of style differences, not the bank’s handling of the crisis.

In the second quarter, Associated added $155 million to its loan-loss provision, sparking a $24.7 million loss-the company’s first of the crisis. For the board, the gravity of the situation was sinking in.

At a tense July board meeting, Chairman and CEO Paul Beideman told the board the worst was likely over, but outside directors were skeptical. Indeed, in a breakout discussion later that day, some said they no longer believed that top executives were being forthcoming enough with bad news. “Our concern was that we hadn’t seen bottom yet,” Kamerick recalls.

After lengthy discussion, board members concluded that the situation had become serious enough that the “line between governance and management necessarily needed to blur,” Kamerick says. “The board had to step out of its comfort zone and get more engaged in the day-to-day management of the company.”

Hand-in-hand with that decision came the realization that the company needed a new CEO-one who would take more aggressive action with the balance sheet and be more blunt with the board about the bank’s condition.

A short while later, Hutchinson met with Beideman, who already was planning to step aside in 2011. The two men mutually agreed to bump up his exit, and announced in August that Beideman would step down as soon as a replacement was found.

The board formed an ad hoc search committee of five independent directors and once again turned to an outside expert, hiring Korn Ferry, the big recruitment firm, to help with a national search.

The recruiters identified 50 potential CEO candidates from around the country. They also helped directors determine what they wanted in a candidate. The consensus: a high-level executive from a larger bank that had dodged serious trouble who could instill similar discipline in Associated; commercial credit experience would be a bonus.

Fifteen executives made the preliminary cut, and the committee interviewed them all-seven more than once. Most interviews were in-person, often in the Chicago offices of either Winston or the recruiters-easier than Green Bay for both candidates and far-flung directors to get to on short notice.

Philip Flynn, 53, had spent his entire career at $85 billion Union Bank in San Francisco, where he was chief operating officer and a director. He stopped in Chicago on his way home from a New York business trip and met with committee members at Korn Ferry’s offices in the Willis (formerly Sears) Tower.

Flynn recalls finding board members who seemed “shocked by the magnitude of the problems that had emerged, fairly quickly.” He was nonetheless intrigued with the prospect of running his own regional bank, and he met with directors four more times over the next several months, including twice in Green Bay, where he spent time reviewing the loan book.

“I wanted to be sure the situation could be fixed, and that once it was fixed, you’d be left with a fundamentally good franchise,” Flynn recalls.

Board members had questions of their own. Did Flynn have the skills and mindset to address Associated’s problems? How would he work with regulators? Could a lifelong Californian find happiness in northern Wisconsin? Could he attract other skilled bankers to the Midwest?

In the end, they were taken by Flynn’s desire for the job and track record. Hutchinson says he was the only person to be offered the job.

Associated has $525 million in capital from the Troubled Asset Relief Program on its balance sheet, which made it tricky to create a good compensation package. The two sides settled on a deal that pays Flynn $1.2 million in base salary, with $2.25 million in option grants and another $1.2 million in restricted shares.

Flynn began work on Dec. 1, just after the OCC had slapped Associated with a Memorandum of Understanding, ordering the board to beef up its risk-management and capital levels. The MOU dovetailed well with the new CEO’s vision of what needed to be done.

Among Flynn’s first moves was to bring in an outside firm to help review the loan portfolio. Aggressive markdowns led to an additional loan-loss provision of $395 million in the fourth quarter. (For the year, Associated set aside $751 million to cover loan losses.)

He also invited investment bankers to help plot what would become a $478 million capital raise. Selling equity at $11.15 per-share, or about a third of its all-time high, was difficult for a board that had recently slashed the quarterly dividend further, to a penny, and directors questioned the move thoroughly. “The board was exercising its fiduciary duty, being concerned about the obvious dilution,” Kamerick says.

Flynn, however, was more worried about market perceptions of Associated’s future: Wall Street was pricing the company as if it might fail-something that, if not addressed, could become a self-fulfilling prophecy. “We needed to take the whole issue of survivability off the table,” he says.

The board was convinced by his arguments. At the end of March, after the capital raise, Associated’s Tier 1 capital ratio was 10.57%, while its tangible common equity ratio stood at 7.73%-both healthy.

Associated isn’t out of the woods yet. At the end of the first quarter, nonperforming assets accounted for 9% of the loan book. Between that, a shaky economy and TARP repayments, it’s likely to be years before shareholders see a dividend increase. “Our profitability isn’t sustainable yet,” Flynn explains.

Even so, Flynn has noted “a certain element of relief [in directors], now that they can see that the worst is over.” The board “should take a lot of pride in hanging in there during the tough times,” he adds. “They’ve put this place back on track.”

Bank of Illinois:

A sense of loss

The black cars and SUVs descended on downtown Normal, Illinois, just before 5 p.m. on the first Friday in March. Dozens of federal and state examiners, some wheeling big black boxes filled with computers and sophisticated accounting gear, moved smartly through the front door of the Bank of Illinois headquarters, and promptly shuttered the 96-year-old institution, transferring its operations to a chief rival.

It’s a scene that’s played out in various forms more than 250 times over the past three years, and doubtless will happen plenty more as the financial crisis unfolds. Being part of a big club doesn’t make the experience any less painful.

“It was very traumatic for everyone-directors, employees and the community,” says Larry Maschhoff, BofI’s chairman and CEO. “There’s nothing you can do to stop it. … You just feel very, very sorry that it’s happening.”

Having an institution fail on your watch is every bank director’s worst nightmare. Overseeing a collapse can be emotionally and physically draining for the directors-a time-draining blur of frustrating capital-raising attempts and other efforts to save the institution. The sense of loss at the end-and the feeling of somehow having let down employees, shareholders, and the community, after months or years of hard work-is palpable.

“The toughest thing about it wasn’t the time and effort we devoted to it,” says director Richard Claydon, 64. “It was running into one wall after another and ultimately losing the battle.”

The failure was “an extreme disappointment, because we couldn’t get the job done,” Claydon adds. “But maybe it was a little bit of relief, too.”

BofI fell victim to zealous regulatory authorities, deadbeat borrowers, and its own outsized taste for commercial real estate loans. Along the way, the bank and board became embroiled in conflict and lawsuits, played out in the local media, that left reputations and relationships tattered. The final blow came when the board couldn’t raise enough capital to satisfy regulator demands.

No one would have predicted things would come to such an ugly end. Back in the 1980s, BofI was a major consumer auto lender. When the big automakers got into the captive financing business, the bank went looking for another niche. CRE was a good fit. Home to two colleges, two big hospitals, and the headquarters of insurance giant State Farm, Bloomington-Normal was a solid, steady-growth community in need of a likeminded bank.

BofI’s assets grew from $39 million when Maschhoff became president in 1987, to $211 million at the end of 2009. It built a shiny new headquarters facility early last decade, while Maschhoff headed up the Community Bankers Association of Illinois and, in 2006, even testified before Congress on the industry’s behalf in opposition to Wal-Mart’s application for a limited banking charter.

That same year, regulatory agencies issued guidance advising banks to limit their CRE exposures to 300% of capital and to 100% of capital on land, development, and construction loans.

Like many community banks, BofI-which had about 70% of its loans tied to CRE-weighed the advisory, concluded it knew its customers well enough to avoid serious trouble, and moved on without much change. “Our history led us to believe that we wouldn’t see much of a downturn here,” Maschhoff says.

The guidance “sounded good in theory,” Claydon adds. “But the reality is that once most banks find a niche to work with, it’s difficult to change.”

Of course, few foresaw the precipitous drop in national real estate values and the recession it would inspire. The local economy held steady for a while. By 2008, however, sales tax collections, a good barometer of economic activity, had fallen 20%.

As the contagion spread, many businesses trimmed their payrolls. Local unemployment rates doubled, to more than 6%. Rents-and appraisal values-declined for most existing commercial properties, while some new projects stalled out. Credit quality became an issue, but directors thought they had enough capital-$18.4 million, against $186 million in loans-to ride things out. Those perceptions soon began to crumble.

The company began 2008 with just over $1 million in reserves, and rode that through most of the year. In September, its balance sheet took a hit when the Bush administration placed Fannie Mae and Freddie Mac into conservatorships, instantly bringing the value of $1.2 million in preferred stock the company had long owned to zero.

In the fourth quarter, BofI booked $4.6 million in chargeoffs, and reported a $5.5 million loss for 2008. Worse, more than 8.6% of BofI’s loan book was either past-due or in nonaccrual, according to figures from SNL Financial in Charlottesville, Virginia.

Directors’ calendars became fuller with bank business. They were now meeting weekly to pore over the loan books and identify assets to shed. They also explored private capital-raising alternatives.

To prep for an expected onslaught, the board added $9.5 million to its loan-loss reserves, according to filings. Equity capital levels dropped to $13.5 million, or less than 7% of assets.

Things might have looked bleak. Still, the board was hard at work now, and felt confident. Indeed, Maschhoff says that when regulators suggested in early 2009 that BofI apply for TARP capital, directors initially turned them down, for fear of the dilution and government interference. After some additional prodding, the bank did apply for the funds-only to have its application rejected.

The wheels began to come off in May, when a team of examiners arrived. They lacked, in Maschhoff’s opinion, an understanding of what made BofI tick, treating it as just another troubled bank that fit into a formula. “They told me the first day they came in, ‘There’s a commercial real estate problem. You going to need to boost reserves to $6 million to withstand the storm,’” Maschhoff recalls.

The examiners ordered reappraisals on most of the bank’s CRE loans-a process Maschhoff estimates cost about $100,000-“and then they went about justifying that [$6 million] number.”

By the end of September, call report data shows, BofI had charged-off another $5.4 million in loans, and the board had bumped reserves to $10.9 million, taking Tier 1 capital levels to $8.1 million, or less than 3% of assets.

The capital situation now had the board’s full attention. In July, the directors kicked in a combined $175,000 in capital, but that was a pittance next to the $12 million required to hit a 13% capital ratio demanded by regulators.

By October, directors’ concern morphed to alarm. State banking authorities issued a cease-and-desist order, citing low capital levels. “We understood what was happening,” Maschhoff says. “If we didn’t raise more capital, the bank wouldn’t be around much longer.”

The board hired an investment banker to explore ways to raise the money. It also weighed a potential sale, and even signed a preliminary purchase agreement with one unnamed bank. But the would-be buyer had compliance issues of its own, and was temporarily barred from doing a deal. That institution eventually emerged from its troubles, but by then, FDIC-assisted deals had become all the rage and the offer was pulled.

In November, examiners visited again. “They were extremely critical of every commercial loan,” Maschhoff says. “It didn’t matter if they were paying on time or not, they were classified… and we had to reserve for them.”

A Prompt Corrective Action notice followed. If BofI didn’t raise the requisite capital within 90 days, the bank would go down. The clock was now ticking, and there was nothing to suggest the money was coming.

Local newspapers latched onto the government releases. Every story began with “the troubled Bank of Illinois,” eroding the confidence of customers.

Perhaps most galling, some troubled clients tried to leverage the situation to their benefit. “They’d say, ‘Do you think we can make a deal with the FDIC to pay 50 cents on the dollar [on their loans]?’” Maschhoff says. “We’d say, ‘What are you talking about? You owe us this money.’”

As the situation got more desperate, so did the tactics. Early in 2010, the bank took a group of local real estate investors to court, trying to collect on $9 million in bad loans. Those clients countersued, accusing BofI officials of forging key loan documents.

As January passed into February, the PCA deadline was approaching. Random groups of bankers came in every couple of days, at the FDIC’s behest, to review the books. “We were 100% sure they would shut us down,” Maschhoff recalls. “We just didn’t know when.”

Final word came to the board three days before the closure. That Friday night, representatives from Heartland Bank & Trust Co. in Bloomington took control. Total cost to the Deposit Insurance Fund: $53.7 million

BofI’s seizure was a grim experience for the board. If he had it to do over, “I would raise more capital well before” the bank’s Tier 1 ratios approached 10%, Maschhoff says. “And I would not do as much commercial real estate lending-not because it’s bad, but because of what the regulators believe about it.

If there was a silver lining for Maschhoff, it was found in the support of friends. When he got home at about 8 p.m. that night, more than 20 well-wishers were waiting for him. “It was like a funeral reception,” he says-in more ways than one.

Stearns Bank:

Window of opportunity

Norm Skalicky has always liked to push the envelope. As chairman, CEO, and majority owner of Stearns Bank in St. Cloud, Minnesota, he’s launched a de novo bank in Arizona and a factoring business in Utah. He’s also made Stearns an active player in SBA lending and Section 42 affordable housing programs around the country.

So it’s perhaps no surprise that Stearns is on that relatively short list of banks-one that includes giants such as U.S. Bancorp, and smaller names like Georgia State Bank & Trust Co.-with the capital, regulatory standing, and guts to embrace the industry’s troubles as a growth opportunity.

The $1.5 billion company has completed five FDIC-assisted deals over the past two years, adding 60% to its asset size and gaining footholds in Florida and Atlanta. It’s also bought a $730 million package of residential and commercial construction loans that the agency seized from a failed Nevada bank.

“It’s a huge job. There are so many bad assets in these banks,” Skalicky, 76, says of managing the purchases. “You have to talk to each borrower, and also change the culture of the bank. … But we know how to take care of distressed assets. That’s our strength.”

On the surface, buying failed banks in faraway places looks like risky business for a small central Minnesota lender. Members of Stearns’ seven-person board insist the deals are merely another expression of the entrepreneurial strategy that has served the company and its shareholders well. Over the past five years, the company has generated an average return on assets of 2.87%.

Stearns has just one office in St. Cloud and isn’t viewed as a retail bank in its hometown. Instead, it makes its money by dipping into-and occasionally out of-niches that offer some profit potential. Earlier this decade, for instance, Stearns was a financier of ethanol plants in the Midwest, but it left the business when other banks arrived.

Ownership concentration-Skalicky owns about 60% of the bank; most of the rest is held by family members, employees, and directors-is a big plus, allowing Stearns to “turn on a dime if we need to,” says Tom Euen, 70, a director who once ran the company’s Phoenix operations. “When you have hundreds of shareholders, you have to move more slowly and carefully.”

That’s not to imply, however, that the board shirks on its oversight responsibilities. “Looking from the outside, I’m sure you’d think we were a gun-slinging operation, but nothing could be further from the truth,” says Tom Williams, 63, a 15-year director and owner of a group of funeral homes in central Minnesota.

“This is a very conservative institution. Our moves have been very well thought out.”

The board’s role, as everywhere, is to provide oversight, ask good questions, and serve as a sounding board for management. But when it comes to strategy, directors are quick to acknowledge their willingness to follow Skalicky’s lead. “We have a lot of confidence in Norm’s leadership and ideas. He’s very hands-on and knows the banking game,” says Williams.

As recently as 2006, more than half of Stearns’ loan portfolio was tied to commercial real estate-the bulk of it in white-hot Arizona. That fall, Skalicky approached his board with what sounded like a radical proposal: Scale back all lending activity. “We knew real estate pricing was way out of whack. It just couldn’t keep accelerating like it had been,” he recalls.

The CRE business had been good to Stearns, so the board chewed on that idea for a while before deciding. Director Don Weeres, owner of a local delivery business, offered his insights. “Things are slowing down a bit,” Williams recalls him saying. “I’m not seeing the traffic I saw a couple years ago.” Chris Coborn, owner of a local grocery store chain, seconded the notion.

For a year, the loan portfolio sat in “neutral,” Skalicky says. In 2007, still well before most bankers had grasped that anything was seriously amiss with the housing market, Stearns quit lending altogether, going so far as to cancel commitments that already had been made to customers.

It also began clamping down on payroll expenses and shedding assets. The bank had $1.4 billion in assets on its books in mid-2007; today, that legacy portfolio stands at about $500 million.

The moves sparked rumors that the bank was in trouble and “really irritated a lot of borrowers,” Skalicky says now. Stearns also boosted Tier 1 capital ratios to about 20%, from about 12%, affording the wherewithal to capitalize on the crisis. “It was profound at the time, but it’s what kept us from being a very troubled bank.”

Having dodged those problems, it wasn’t long before another question emerged: “How were we going to make money?” Euen recalls.

The board considered management’s ability to handle distressed assets a core expertise. And so, in October 2008, Stearns took its first foray into the failed-bank business, when it won the bidding on the leftovers of the failed Alpha Bank & Trust in Alpharetta, Georgia, assuming most of its $346 million in deposits and about $38 million of workable assets.

The deal did not come with a loss-share agreement, and most of the deposits were “very high-priced,” which fled when Stearns reset the rates. Within a year, the whole operation was shuttered.

From the outside, the transaction might have looked questionable. But directors say the opportunity to build a relationship with the FDIC, and to better understand the failed-bank bidding process, made it worthwhile. “We viewed it as a learning opportunity, a way to understand how the FDIC works,” says Euen, who flew to Alpharetta to help with the takeover.

As the crisis deepened, the FDIC began employing loss sharing as a way to liquidate troubled banks. In June 2009, Stearns won the bidding for $87.6 million Horizon Bank in Pine City, Minnesota, paying a 0.75% deposit premium and obtaining a loss-sharing agreement that covered $65.1 million in assets.

Less than two months later, it acquired two Florida banks: First State Bank, Sarasota and Community National Bank of Sarasota County, picking up $545 million in assets (most with loss-share agreements) and $472 million in deposits.

Board members were well aware of Florida’s troubles, but reckoned the deals-which gave Stearns 13 branches in the Sarasota area-would pay off over time.

“Florida is suffering now,” Euen says, “but we all expect it to turn around at some point. We’ll be there for it.”

Two weeks later, Stearns picked up another Georgia institution-ebank, a one-branch operation in Atlanta that came with a loss-share agreement on $111 million in assets and $130 million of deposits.

In all of those transactions, directors asked a series of tough questions that became almost formulaic: How protected was Stearns in the agreement? Would a deal be profitable? “The biggest thing was, if things don’t work out as projected, what’s the downside risk?” Euen explains. “People don’t realize how much homework we put into these transactions.”

The board also worried about stretching the company’s management ranks too thin. Stearns already has closed nine of the 13 branches it acquired in Florida, for instance. It has fired many local bankers, replacing them with new in-market hires or transfers from Minnesota, capable of teaching the Stearns’ culture.

“The lenders who were in place, they’re in love with the borrower,” Skalicky explains. “You need a complete culture change in these banks. That takes time and resources.”

Stearns hasn’t done an FDIC-assisted deal since last August, choosing to digest what it’s acquired. Will it pursue more? Board members won’t rule it out, but note that more banks now view buying failed banks as an attractive way to grow. “We don’t want to be part of the herd,” Williams explains.

If the past is a predictor of the future, that shouldn’t be a big concern.