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SARC-99-03 (May 12, 1999)

Your appeal of material supervisory determinations has been decided. The Supervision Appeals Review Committee (“Committee”) of the Federal Deposit Insurance Corporation (“�౦��Ϸ����”) made rulings not in favor of [Bank] (“Bank”) on May 4, 1999. The Committee’s findings on each material supervisory determination appealed by the Bank is presented below along with an explanation of the reason for the decision.

Loan Classifications
The Committee concluded that the adverse classifications assigned to the loans and other real estate properties listed in the Bank’s appeal are appropriate for the reasons noted below.

1. Customer A: Primary weaknesses are the significant continuing operating losses, negative cash flow, and increasing debt of the obligors. While credit is given to management’s market valuation of livestock and the proposed sale of the *** property, the additional collateral held does not adequately protect the remaining balance. The accounts receivable, feed inventory, and machinery, equipment, and remaining real estate collateral are far less liquid that the livestock collateral. Additionally, Bank valuations for this collateral are not supported. The Bank’s references to the perceived noncompliance with the �౦��Ϸ����’s policy on the Analysis and Classification of Agricultural Credits were also reviewed. This policy addresses the need for proper collateral controls and the importance of reviewing all areas that affect repayment. Therefore, in reviewing the credit relationship, the Committee must look at the borrower’s financial condition, as well as collateral. In addition to the collateral weaknesses, the Committee must consider the deteriorating financial trends and the significant increase in the financial leveraging of the family businesses.

2. Customer B: Both the X and the Y are speculative in nature and appear motivated by the potential for future profits on the investments. Given the speculative nature of the transactions, the lack of any debt service requirements, and the extensive marketing periods, the loans and related other real estate parcel are properly classified.

3. Customer C: The adversely classified loans, all which are single-pay loans, originated on December 2, 1996, April 4, 1997, June 30, 1997, October 1, 1997, and February 3, 1998. The notes remain at their original balances, with at least four of the five notes being renewed without any principal reduction. The notes do not have any structured repayment plan. The leveraged financial condition of the company, operating losses being incurred, and Mr. *** illiquid asset composition, detracts from the credit quality of the loan relationship. The Bank’s view that the notes are fully secured is not supported. Generally, collateral is the secondary repayment source and it is potentially hazardous to look only at the margin in the collateral value. Liquidity of the collateral and collateral documentation must also be analyzed. The collateral for these loans is not liquid assets and most likely would bring “fire-sale” prices in a liquidation situation.

4. Customer D: The company’s financial condition does not support the loan amount. The company has a deficit net worth; a current ratio well below 1:1; past due account payables; and the company is incurring operating losses. Personally, Mr. *** is highly leveraged and assets are centered in nonliquid assets with unknown values. If the Bank were given full value for the collateral, despite that the livestock inspection was not completed by an independent third party, a collateral shortfall of $570,000 would still remain. The real estate note receivable, taken as additional collateral, is given little value since it is a single pay note due in the year 2000. Furthermore, taking in consideration, and giving full appraised value for the real estate, coupled with the first lien to another institution, the equity in the real estate is less than the note receivable to the Bank. Nevertheless, if full value of the real estate was realized in a sale and the Bank attained the remaining equity in the sale, the Bank would still have a collateral shortfall of $188,000.

Customer E Other Real Estate Classification
The asset is properly classified, in part, due to marginal and questionable collateral value and significant volatility of the collateral. A high degree of risk exists for a number of reasons. Income to the Bank remains volatile as it is based on the merchandising activities of the lessee, not fixed payments. If the lessee chooses not to renew its lease, it is uncertain whether or not a new lessee could be found, or, if found, whether the same amount of income could be generated. Value is questionable because of a number of deficiencies noted in the appraisal. Even if the $8.7 million appraised value were a fair representation of current market value the margin of protection is insufficient for these properties’ high degree of risk and the marginal rate of return. The Bank has been unable to dispose of the properties for over ten years and there is still apparently no buyer interest. The property is leased on a year-to-year basis and the lessee is apparently not interested in entering into a long-term lease arrangement or in purchasing the properties. Substantial loss exposure is present.

Capital Component Rating
According to the Uniform Financial Institutions Rating System, adopted by the Federal Financial Institutions Examination Council on December 19, 1996, a Capital component rating of “2” indicates a satisfactory capital level relative to the financial institution’s risk profile. A rating of “1” indicates a strong capital level relative to the institution’s risk profile.

Adversely classified assets represent 70 percent of the Bank’s Tier 1 Capital. The adversely classified Customer E property alone represents 40 percent of the Bank’s Tier 1 Capital. Supervisory experience has shown that even a high level of capital can quickly dissipate during times of economic reversal, especially when an institution’s assets and underlying economic base are not diversified. The economy of *** is significantly dependent on agriculture and a local air force base. Giving consideration to these risk factors and the Bank’s continued weak credit underwriting and administration standards, the Committee concludes that a Capital component rating of “2” is appropriate.

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

The Committee concludes a “3” rating is appropriate given the Bank’s high level of adversely classified assets, restructured debt, nonaccrual loans, and deficient credit administration practices, most notably Bank management’s character/collateral based lending philosophy.

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

By contrast, A Management rating of “1” indicates strong performance by management and the board of directors and strong risk management practices relative to the institution’s size, complexity, and risk profile. All significant risks are consistently and effectively identified, measured, monitored, and controlled. Management and the board have demonstrated the ability to promptly and successfully address existing and potential problems and risks.

Management has performed less than satisfactorily with regard to:

• Oversight activities
• Response to risk from changing business conditions
• Accuracy, timeliness, and effectiveness of management information and risk reporting system
• Responsiveness to recommendations from supervisory authorities
• Management depth and succession
• The extent that the board and management is affected by, or susceptible to, dominant influence or concentration of authority
• The overall performance of the institution and its risk profile

Examples of less-than-satisfactory management performance are replete throughout the Report of Examination and include significant credit administration and underwriting deficiencies, the continued reluctance to adopt a formal strategic plan, questionable management depth and succession plans, and lack of adherence to the terms of the outstanding Cease and Desist Order. Given the overall condition of the Bank’s and management’s historical performance, the Committee concludes that the Management rating of “3” is appropriate.

Earnings Component Rating
Under the Uniform Financial Institutions Rating System a rating of “1” indicates earnings that are strong. Earnings are more than sufficient to support operations and maintain adequate capital and allowance levels after consideration is given to asset quality, growth, and other factors affecting the quality, quantity, and trend of earnings.

A rating of “2” indicates earnings that are satisfactory. Earnings are sufficient to support operations and maintain adequate capital and allowance levels after consideration is given to asset quality, growth, and other factors affecting the quality, quantity, and trend of earnings. Earnings that are relatively static, or even experiencing a slight decline, may receive a “2” rating provided the institution’s level of earnings is adequate in view of the assessment factors listed above.

While the Bank’s performance is comparable to its peers, the Bank’s unsatisfactory asset quality and other factors preclude a higher rating. Specifically, there are weaknesses evident such as a less favorable net interest margin caused by a lower than average yield on loans and investments and a lower percentage of earning assets to total assets. Those indices provide support for a “2” Earnings component rating rather than a “1”. The Committee concludes a “2” rating for the Earnings component is appropriate.

Sensitivity to Market Risk Component Rating
Under the Uniform Financial Institutions Rating System a rating of “2” indicates that Market Risk Sensitivity is adequately controlled and that there is only moderate potential that the earnings performance or capital position will be adversely affected. Primarily, market risk results from interest rate, foreign exchange rate, commodity price, and equity price volatility. Like most community banks, your Bank’s principal market risk exposure results from interest rate risk. Interest rate risk management practices are satisfactory for the size, sophistication, and market risk accepted by the institution. The level of earnings and capital provide adequate support for the degree of market risk taken by the Bank. Notwithstanding, over one-third of the Bank’s assets have explicit call options imbedded in their structure. The Committee concludes a “2” rating is appropriate due to the Bank’s level of interest rate risk, especially given the level of option embedded assets.

Composite Rating
According to UFIRS, Composite ratings are based on a careful evaluation of an institution’s managerial, operational, financial, and compliance performance. Comparison of the definitions of a Composite “1”, “2”, and “3” rating are instructive.

Composite 1

Financial institutions in this group are sound in every respect and generally have components rated 1 or 2. Any weaknesses are minor and can be handled in a routine manner by the board of directors and management. These financial institutions are the most capable of withstanding the vagaries of business conditions and are resistant to outside influences such as economic instability in their trade area. These financial institutions are in substantial compliance with laws and regulations. As a result, these financial institutions exhibit the strongest performance and risk management practices relative to the institution’s size, complexity, and risk profile, and give no cause for supervisory concern.

Composite 2

Financial institutions in this group are fundamentally sound. For a financial institution to receive this rating, generally no component rating should be more severe than 3. Only moderate weaknesses are present and are well within the board of directors’ and management’s capabilities and willingness to correct. These financial institutions are stable and are capable of withstanding business fluctuations. These financial institutions are in substantial compliance with laws and regulations. Overall risk management practices are satisfactory relative to the institution’s size, complexity, and risk profile. There are no material supervisory concerns and, as a result, the supervisory response is informal and limited.

Composite 3

Financial institutions in this group exhibit some degree of supervisory concern in one or more of the component areas. These financial institutions exhibit a combination of weaknesses that may range from moderate to severe; however, the magnitude of the deficiencies generally will not cause a component to be rated more severely than 4. Management may lack the ability or willingness to effectively address weaknesses within appropriate time frames. Financial institutions in this group generally are less capable of withstanding business fluctuations and are more vulnerable to outside influences than those institutions rated a composite 1 or 2. Additionally, these financial institutions may be in significant noncompliance with laws and regulations. Risk management practices may be less than satisfactory relative to the institution’s size, complexity, and risk profile. These financial institutions require more than normal supervision, which may include formal or informal enforcement actions. Failure appears unlikely, however, given the overall strength and financial capacity of these institutions.

The ability of management to respond to changing circumstances and to address the risks that may arise from changing business conditions, or the initiation of new activities or products, is an important factor in evaluating a financial institution’s overall risk profile and the level of supervisory attention warranted. For this reason, the management component is given special consideration when assigning a composite rating. Viewed from that perspective, the assigned Composite rating of “3” appears more than amply supported. As noted elsewhere, the Management and Asset Quality components are appropriately rated “3” and greatly influence the assignment of an overall “3" Composite rating. Also, the inability to achieve compliance with the outstanding Cease and Desist Order and the continuing need for an ongoing corrective program are clear indications that the institution requires more than normal supervisory attention. By definition, the Bank is a “3” rated institution.

It is further noted that �౦��Ϸ���� and State of New Mexico bank examiners jointly conducted the contested examination. The Director, Financial Institutions Division for the State of New Mexico (“Director”) concurred in the findings and stated in its transmittal letter to the Bank that “the overall condition of the bank remains less than satisfactory.” The Director also joined in the proposed Memorandum of Understanding (“MOU”). Their agreement with the examination findings and the need for corrective measures lends further support to the appropriateness of the assigned rating.

The Committee concludes that a “3” composite rating is appropriate.

Apparent Violation of Part 362
The Bank petitions the �౦��Ϸ���� for consent to retain its equity investment in two real estate projects. The real estate investment involves an exchange of Other Real Estate Owned (“OREO”) property for other real estate and profit-sharing arrangements with Customer B, ***, Texas. Bank management contends these transactions are analogous to permissible activities for national banks and has accordingly declined to transfer them from the Bank to a subsidiary of the Bank.

Section 24 of the FDI Act provides that no insured state bank or its subsidiaries may engage as principal in any type of activity that is not permissible for a national bank unless the insured state bank meets the applicable capital standards prescribed by the appropriate Federal banking agency and the �౦��Ϸ���� determines that the activity would not pose a significant risk to the deposit insurance fund. Part 362 of the �౦��Ϸ���� Rules and Regulations, which was enacted to implement Section 24 of the FDI Act, sets forth certain restrictions and prohibitions on activities and investments of insured state banks and their subsidiaries.

Section 29 of the United States Code, 12 U.S.C. § 29, represents the authority for a national bank to hold real property. In interpreting Section 29, the Office of the Comptroller of the Currency (“OCC”) has concluded that Section 29 does not authorize a national bank to exchange OREO property for other real estate that it merely deems more marketable. However, national banks may exchange OREO for other property provided the bank is not engaging in real estate speculation and the transaction is undertaken to substantially reduce or avoid potential loss on OREO property. In arriving at this conclusion, the OCC noted that the national bank in question had substantially reduced its exposure on its OREO property in that it received significant amounts of cash in its exchange transactions.

In both of the Bank’s exchange transactions, the Bank is a participant with Customer B in developing real estate. The Bank in the exchange transactions received no cash, and the Bank has provided substantial funds to Customer B to complete development. One borrower, through bankruptcy, has been released from any liability on the loans. Both transactions provide for splitting the profit between the Bank and Customer B upon the properties’ sales. Accordingly, the Bank does not appear to be undertaking the transactions to reduce or avoid potential losses on OREO property, but rather is engaging in real estate development, which is an activity that is impermissible for national banks.

Real estate investment is subject to a high degree of market risk and other specialized risks specific to real estate ownership and may also be of questionable benefit in the diversification of a financial institution’s portfolio of assets. Due to these risks, real estate investment activities appear suitable to a financial institution only on a very limited scale and under restrictions designed to control the various risks posed to the financial institution and the deposit insurance fund. Limitations and restrictions regarding impermissible equity investments, including real estate activities, are set forth in Sections 362.3(a) and 362.4(b).

After review of an appeal of the findings of the 1997 �౦��Ϸ���� examination, including the adverse classification of the properties described herein, the �౦��Ϸ���� determined that the aforementioned transactions constituted real estate activities that are not permissible for a national bank, and that the prior approval of the �౦��Ϸ���� should have been solicited prior to the Bank consummating the swaps. The Committee concurs with these findings and denies the Bank’s request to retain its direct equity investment in the properties. The Bank should forward to the Dallas Regional Office its plans to cure the apparent Part 362 violation within 30 days of receipt of this letter. Bank management is reminded that engagement in impermissible activities makes management susceptible to civil money penalties. Additionally, civil money penalties may not be precluded even if the impermissible activities cease.

Cease and Desist Order (“Order”)
The Bank has achieved compliance with a number of provisions in the outstanding Order. However, the Bank continues to be in noncompliance with the following:

• requirement that the board develop a plan for increasing the directorate so that at least 50 percent of the members are not involved, in any manner, in the Bank’s daily operations
• requirement that loans have repayment understanding (the Customer C working capital loans have no structured repayment plans)
• requirement that loans funded be in conformance with the written loan policy
• requirement to adhere to laws and regulations
• requirement to establish a formal loan review committee
• requirement to establish a formal committee to ensure compliance with the Order

It is particularly troubling that the Bank has been operating under the Order since December 7, 1993, and has still not achieved full compliance. The validity of the Order has been upheld by the administrative court process as the Bank has appealed the issue all the way to the Supreme Court, which the court ruled in favor of the �౦��Ϸ����.

Compliance with the management provisions is necessary to restore the Bank to a sound condition. The Bank’s argument is that it is not possible to attract new board members while operating under a Cease and Desist Order. However, it is not unusual for troubled banks to acquire new directors. Moreover, directors are liable from the day of service going forward only and not for actions prior to their appointment to the Bank’s board. The Bank is not actively seeking independent, outside directors as required by the Order.

Further, the Bank’s contention that the Order’s board membership provision might be in violation of the New Mexico Banking Code is not believed tenable. Bank management claims the provision would require more than five bank directors, which is above the minimum necessary under the banking code. However, the Order does not establish a set number of directors, only a targeted percentage. The Order also makes clear that any plan to reorganize the board would be subject to shareholder approval.

It would be inappropriate to terminate the Order without a corrective program in place to address outstanding and unresolved items. Adoption by the Bank’s board of the proposed MOU prepared by the Dallas Regional Office and the Director would achieve that objective. Once the Bank’s board agrees to adopt and execute the document, the existing Cease and Desist Order could be terminated.

These determinations constitute the final supervisory decision of the �౦��Ϸ����.

By direction of the Supervision Appeals Review Committee of the �౦��Ϸ����.