Lessons Learned from FDIC Lawsuits


As bank failures went on the rise after the crisis of 2008, so did lawsuits from the Federal Deposit Insurance Corp. The target of many of these lawsuits has been both the management of banks, but also independent directors, which can be a scary thought for anyone serving on a bank board today. So what can we learn from this moving forward? Based on the responses Bank Director received from lawyers across the country, the “best practices” today can still be summarized by the same timeless instructions: make sure your board is engaged, get a good directors and officers (D&O) insurance policy, and document, document, document!  

What is the most important lesson that bank boards should learn from the surge in FDIC lawsuits, and how should this be institutionalized in the form of a best practice?

William-Stern.jpgSome things never change, and it’s never too late to re-learn old lessons. Directors must remain independent, informed and involved in their institution’s affairs. It’s not enough to simply attend board meetings. Directors need to read materials provided by management, ask questions and actively participate in board discussions. And they should make sure their participation is accurately reflected in the minutes. Special care should be taken when considering transactions with insiders and affiliates, and directors should always require detailed presentations from management regarding steps to address regulatory criticisms raised in examinations or otherwise. In addition, professional advice and expertise should be sought when addressing complex issues or other out of the ordinary course matters, and fully documented when appropriate. 

—William Stern, Goodwin Procter

Gregory-Lyons.jpgGiven that the FDIC  has authorized lawsuits in a significant number of failed bank cases, directors are appropriately concerned about liability.  I continue to believe that ensuring fulfillment of the two underpinnings of the business judgment rule—the duty of loyalty and the duty of care—remain a director’s best defense against such actions.  The bank can help institutionalize that as a best practice by providing full board packages in a timely manner, strongly encouraging attendance at meetings, and making internal and external experts and counsel available to board members.

—Gregory Lyons, Debevoise & Plimpton

John-Gorman.jpgThere has been a surge in FDIC lawsuits because there has been a surge in bank failures and FDIC losses due to the financial market meltdown and the great recession. Perhaps the most important lessons for bank boards are that 1) capital is KING and 2) process is KING. Moreover, a board has to be diligent and honest in terms of assessing management performance and replacing management as needed. Finally, and as discussed above, a board’s fiduciary obligations require that adequate systems be in place to monitor compliance with laws, regulations and policies and that boards be informed and engaged and take action as necessary when red flags indicate issues or problems in certain areas. A cardinal sin in banking, which mirrors this fiduciary obligation, is to have regulatory violations repeated, i.e., uncorrected. Uncorrected violations are probably the single most cause of civil money penalties against banks and their boards.

—John Gorman, Luse Gorman

Douglas-McClintock.jpgFrom a legal standpoint, a best practice is threefold. First, maintain capital levels substantially higher than the minimum levels necessary to qualify as well-capitalized, even if it causes the bank’s return on equity (ROE) to suffer. Second, make sure that the bank’s charter and by-laws provide the maximum legal indemnification protection permitted under the applicable law, including providing for advancement of funds during litigation to defend the directors. And third, be sure to maintain an adequate directors and officers liability policy with no regulatory exclusion, so the insurance company has an obligation to defend FDIC claims. The only good protection from a storm surge such as this is a good wall of defenses and a plan of retreat!

—Doug McClintock, Alston + Bird

Victor-Cangelosi.jpgExcessive concentration of credit risk is a recurring theme in FDIC lawsuits.  Boards need to monitor on an ongoing basis significant credit risk concentrations, whether it be in type of loan, type of borrower, geographical concentration, etc.  Management reports to the board should address these and other concentration risks inherent in the institution’s loan portfolio.

—Victor Cangelosi, Kilpatrick Townsend

Mark-Nuccio.jpgDirectors should pay attention to their D&O insurance. All policies are not equal and the insurance markets are constantly evolving. Banks and their boards should consider involving experts in the negotiation of the policy terms and cost. Independent directors may want special counsel to be involved. Beyond paying attention to D&O insurance, directors need to pay more attention—pure and simple. The recent case brought by the FDIC against directors of Chicago-based defunct Broadway Bank criticizes the directors for not digging into lending policies or the details of lending relationships and deferring entirely to management. Documenting involvement is almost as important as the involvement itself.

—Mark Nuccio, Ropes & Gray

Twist This


america-money.jpgYour country needs you. Your country needs you to go into debt, that is.

Hoping to jumpstart a lackluster lending environment, the Federal Reserve recently announced “Operation Twist” to drive down long-term interest rates such as the 30-year fixed-rate mortgage while increasing short-term interest rates.

The idea, a much bigger replay of a 50-year economic program of the Federal Reserve during the Kennedy administration, is that the move will make long-term borrowing more attractive, which could encourage home buyers to buy homes and businesses to invest in job creation.  But will it?

Scott Brown, the chief economist and senior vice president for Raymond James & Associates, says the Federal Reserve’s $400 billion program of buying and selling U.S. Treasury securities is trying to get banks to lend more, possibly by squeezing the interest margins that banks depend on. This interest margin is the difference between the interest banks charge on loans and the interest they pay out for deposits. As their profits get squeezed, the banks could increase lending to make more money.

But will they?

“With banks in a much better position than they were three years ago, the Fed is betting that a flatter curve, and margin compression, will not cause undo strain, but instead lead them to make up the difference in loan volumes,’’ Brown writes in his weekly commentary. “We’ll see.”

The problem with such an approach is that there are few high-quality borrowers out there wanting to get loans, and the banks have worked hard to improve the credit quality of the assets on their books. The idea that they would stretch their underwriting guidelines to offer more loans is doubtful, and whether their regulators would even allow it is also doubtful.

What could really spur lending is for more high-quality borrowers to somehow come out of the woodwork looking for loans at record low interest rates. But many potential homebuyers can’t sell the homes they do have or take advantage of low rates to refinance as home values continue to decline. Freddie Mac announced this week that the average 30-year fixed-rate mortgage fell to a record low of 4.01 percent as of Sept. 29.

In contrast, the short-term, five-year adjustable -rate mortgage rate ticked up after the Sept. 21 announcement by the Federal Reserve from 2.99 percent to 3.01 percent. It has remained flat since then, according to Freddie Mac.

Whether all this will spur lending is another matter.

“We question whether this program can be successful because we believe the lack of borrowing and lending activity has more to do with other fundamental economic and regulatory conditions than it does with interest rates,’’ writes G. David MacEwen, chief investment officer of fixed income for American Century Investments.

He goes on to describe the Federal Reserve’s toolbox as “nearly empty.”

It may be that the Federal Reserve is in the same boat as the Obama administration: there’s not that much more it can do to incentivize a reluctant and hobbled private sector. The government would like you to borrow, but will you?

 

Why bank stocks are performing so badly


You can almost hear the wind come out of the recovery.

John Duffy, the chairman and CEO of investment bank Keefe, Bruyette & Woods gave his update on the state of the banking industry at Bank Director’s Bank Audit Committee conference in Chicago June 14, and it wasn’t a pretty picture.

As of early June, the recovery in bank stocks has stalled. This, despite the fact that 63 percent of bank stocks tracked by KBW beat analyst expectations in the first quarter.

kbw-recovery.png

That’s quite a change from the depths of the recession, when 73 percent of banks missed analyst expectations, back in the fourth quarter of 2008.

“I think there is some credibility being established between analysts and bank management, but unfortunately, the economic news is not always good,’’ Duffy said.

Credit quality has improved but non-performing assets still are high. Deposit growth has slowed dramatically. And even the biggest banks, which were more aggressive than the regional banks in terms of provisioning for bad loans, don’t have much room for growth.

“As you shrink the balance sheet, it’s hard to replace those assets,’’ Duffy said. “I think a lot of the optimists have now gone to the sidelines and are less convinced that the economic recovery is going to continue and that obviously has implications for loan volume in the banking industry as well as credit quality.”

Duffy said bank stock analysts are probably going to be focused on the fact that net new non-accruing loans (non-performing loans whose repayment is doubtful) rose in the first quarter for the first time in six quarters.

With all the loan problems and regulatory pressure, investment bankers such as John Duffy, who depend on M&A as their bread and butter, having been predicting a coming wave of consolidation.  It hasn’t happened yet.

With just 60 traditional, non-FDIC-assisted acquisitions this year through June 3, valued at about $3 billion in total, Duffy said he thinks it’s been difficult to raise capital, especially for banks below $1 billion in assets. Plus, there’s a lack of potentially healthy buyers in regions with a lot of hard-hit banks.

“We should think there are at least a couple hundred banks that are not going to make it,’’ he said. “For the banks that are healthy, we continue to think this remains a real opportunity.”

What Falling Home Prices Mean for Banks


skydive.jpgThe most recent S&P/Case-Shiller Home Price Indices declined 4.2 percent in the first quarter of 2011 on top of an earlier 3.6 percent drop in the fourth quarter of 2010. “Nationally, home prices are back to their mid-2002 levels,” according to the report.

If you are a connoisseur of home price data—and the countless expert predictions since the market’s collapse in 2007—you know that the housing market should have bottomed out by now and been well into its long awaited recovery. There was a slight rebound in housing prices in 2009 and 2010 due to the Federal Housing Tax Credit for first-time homebuyers, but that rally pretty much died when the program expired on Dec. 31, 2009. Now, housing prices are falling again like a skydiver without a parachute.

Recently I called Ed Seifried, Ph.D., who is professor emeritus of economics and business at Lafayette College and a partner in the consulting firm Seifried & Brew LLC in Allentown, Pennsylvania, to talk about the depressed housing market and its impact on the banking industry. Seifried is well known in banking circles and was a keynote speaker a few years ago at our Acquire or Be Acquired conference.

“We’re pretty close to a structural change in housing,” Seifried says. You, me and just about everyone else (including, apparently, former Federal Reserve Chairman Alan Greenspan) was taught that home prices always go up—sometimes by the rate of inflation, sometimes more—which made it a pretty safe investment. “That dream has pretty much been shattered,” Seifried continues. “The Twitter generation is looking at the European (housing) model, which is smaller and more efficient. Your home shouldn’t be a statement of your wealth.”

A broad shift in housing preferences could have important long-term implications for the U.S. economy, since housing has been one of our economy’s engines of growth for decades. What is absolutely certain today is that a depressed housing market is hurting the economy’s recovery after the Great Recession, and that has broad implications for the banking industry.

A depressed housing market translates into a depressed mortgage origination industry, which has significant implications for the country’s four largest banks—Bank of America, J.P. Morgan Chase, Citigroup and Wells Fargo—which have built giant origination platforms that might never again churn out the outsized profits they once did. In fact, I wouldn’t be surprised to eventually see one or two of them get out of the home mortgage business if Seifried’s structural change thesis is correct.

Community banks that lent heavily to the home construction industry during the housing boom are either out of business or linger on life support. But even those institutions that did not originate a lot of home mortgages, or lent heavily to home builders or bought lots of mortgage-backed securities are being hurt because housing’s problems have become the economy’s problems.

In a recent article, Seifried points out that for the last 50 years housing has contributed between 4 and 5 percent of the nation’s GNP. In the 2004-2006 period, that contribution rose to 6.1 percent.  In 2010, housing accounted for just 2.2 percent of GDP—and dropped to 2.2 percent in the early part of 2011. Seifried also estimates that the housing market accounts for 15-20 percent of all U.S. jobs when “construction and its peripheral impacts are weighed.”

“It’s difficult to imagine an overall economic recovery that can generate sufficient jobs to return the U.S. economy to full employment without a return of housing to its historical share of GDP,” he writes.

In our interview, Seifried told me of a recent conversation he had with a bank CEO who thought his institution was reasonably well insulated from the housing market’s collapse because it had made relatively few construction loans. But that bank still experienced higher than expected loan losses because of all the other businesses it had lent to that ended by being hurt by the housing downturn.

Indeed, virtually no bank in the country is immune to the housing woes because banks—even very good and very careful ones—require a healthy economy to thrive. The U.S. economy needs a strong and growing housing market to thrive, and that doesn’t seem to be anywhere on the horizon.

 

Bankers Are Starting to See the Glass Half Full


Things are looking up. The tide of optimism has definitely turned since the first quarter of this year. In our recent survey of bank executives, 45% say they believe the U.S. economy will improve within the next six months. This demonstrates a sizeable increase from the 24% who were similarly optimistic in our first quarter 2010 survey. While the bulk of respondents are still in the camp that believe the economy will likely remain the same over the near term, (44%), we noted a drop by nearly half among those who believe that harder times are still ahead (11%, compared to 20% six months earlier).

Moreover, among those who were asked how well their local economies are faring, a similar strain of optimism is found. Thirty-five percent (compared to 22% in the first quarter) believe their local economy is poised to improve, and only 9% (compared to 18%) believe things will get worse within the next six months.

Compliance concerns remain high. Among the concerns that bank executives have over the next 12 months, regulatory concerns overwhelmingly stand out above the rest. Fully 87% of bank executives ranked regulatory burden as a major concern over the next 12 months—nearly 30 points higher than the next, most pressing concern: exposure to commercial real estate losses (58% ranked it as a major concern.) In third place, but much lower than either of the first two, was a concern over retaining quality talent (37% ranked as a major concern.)

Watch out for commercial real estate. The largest percentage of bank executives surveyed (35%) believe the shoe will drop on commercial real estate values sometime within the next 12 months, but that opinion is far from unanimous. Another quarter of the surveyed group (25%) believes commercial real estate values already have bottomed out; and another 24% believe it will happen in the next six months. Not surprisingly, perspectives on this question have a lot to do with one’s region. Forty-two percent of the central region think their values have already bottomed out, compared to only 10% of bankers in the southern region and 18% of those in the western region who think so.

Who is raising capital? With the regulatory scrutiny placed on capital standards in the wake of the financial crisis, we asked bank executives to tell us their anticipated plans with regard to capital raises in the next 12 months. Less than a quarter of the total surveyed (22%) say it is very likely they’ll go to the market to raise capital, but a higher percentage of those from the still-troubled Southeast (37%) say they’ll do so. The majority (67%) say such action is not likely in the next 12 months. Finally, a small group (11%) said they had already successfully undergone a capital raise.

For the complete survey results and graphic analysis, watch for Bank Director’s third quarter issue mailing later this month.