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SARC- 2007-01 (September 5, 2007)

I. Background

This appeal arises from contested component and composite ratings assigned to *** (“X,” or the “Bank”) in the Joint Report of Examination dated March 27, 2006 (“Examination Report”) of the Dallas Regional Office (“Regional Office”) and the *** State Banking Department (the “State”). Specifically, X disputes each of these material supervisory determinations made by the Regional Office and the State. In its appeal, X requests that the Capital Adequacy, Management, and Liquidity component ratings and the Composite rating be upgraded from “3” to “1”; the Asset Quality and Earnings ratings be upgraded from “2” to “1”; and the Sensitivity to Market Risk component rating be upgraded from “3” to “2.”

On December 1, 2006, X filed its request for review with the Director of the Division of Supervision and Consumer Protection (“DSC”). On March 15, 2007, the Director affirmed the decisions of the Regional Office and determined that the ratings were consistent with �౦��Ϸ���� policy and existing examination guidance and appropriate, given the facts available at the time of the examination. X had also requested that the outstanding Memorandum of Understanding (“MOU”) dated November 23, 2004, be rescinded. The Director declined to rescind the MOU, stating in part that under the Guidelines for Appeals of Material Supervisory Determinations decisions to initiate informal enforcement actions such as memoranda of understanding are not material supervisory determinations and are, therefore, not subject to appeal before the Supervision Appeals Review Committee (the “Committee”). The Bank timely filed an appeal with the Committee by letter dated April 12, 2007.

X disputes each of its component ratings, as well as its Composite rating, but does not press its request for rescission of the MOU before the Committee. The Bank bases its request of the Committee to upgrade each of its ratings on what it argues is the proven strength and viability of its investment strategy. X states that it has demonstrated over the past few years its ability to identify, measure, monitor, and control present and potential risks. It further contends that its models have accurately projected the Bank’s earnings performance and that Management has demonstrated the willingness and the ability to develop and continually refine the Bank’s risk measurement tools, and, using those tools, to monitor market risk accurately.

DSC responds that the Bank’s strategy of investing short-term funding sources into longer term assets is excessively risky. The key deficiencies that DSC identifies include the consistently inadequate capture by X’s risk measuring models of the unique risks inherent in its collateralized mortgage obligation investment portfolio. Moreover, the risk models that X uses are burdened by unsupported interest rate risk assumptions. Finally, the Asset/Liability Policy limits of X’s investment strategy allow increased risk levels without a commensurate increase in capital.

In accordance with the Guidelines for Appeals of Material Supervisory Determinations,¹ the Committee reviews the appeal for consistency with the policies, practices, and mission of �౦��Ϸ����, as well as the reasonableness of and support for the respective positions of the parties. The Committee granted X’s request to appear, and a hearing was held on June 26, 2007. Appearing on behalf of the Bank were *** (“A”), outside counsel for X, as well as *** (“B”), Investment Officer for X, and ***, X’s Advisory Board Member. The Committee has carefully considered the written submissions made by the Bank and by DSC, as well as the oral presentations at the June 26 meeting. Under the Guidelines, the scope of the Committee’s review is limited to facts and circumstances as they exist at the time of the examination (March 27, 2006). No consideration has been given to facts or circumstances that developed after the examination.

II.Analysis.

A. X’s Leverage Program
X is a state-chartered bank with total assets of $571 million as of September 30, 2006. X operates a single office in *** (“City”), with approximately 25 employees. The Bank was insured on April 14, 1975, and is wholly owned by *** (“C”), and his 1989 Revocable Family Trust. C is chairman of the Bank’s board of directors and chief executive officer of X. Before 2002, X engaged in traditional banking activities, with average assets in the $30 million to $43 million range. Beginning in 2002, the Bank initiated an investment program designed to maximize its return on equity by leveraging capital (the “Leverage Program”).

Under the Leverage Program, X purchases longer-term collateralized mortgage obligations (“CMOs”) using shorter term, lower-cost funding sources. The Leverage Program is directed by C and was implemented at a time when short-term rates were at historically low levels and the yield curve was steep. The Bank’s Investment Management Policy sets forth investments that are permissible for use as shorter term, lower cost funding sources. Specifically, these “permissible investments” include Federal funds and repurchase agreements; securities issued by government-sponsored enterprises (“GSEs”), such as Federal Farm Credit Banks (“FFCB”), Federal Home Loan Banks (“FHLB”), Federal Home Loan Mortgage Corp. (“FHLMC”), Federal National Mortgage Association (“Fannie Mae”), Government National Mortgage Association (“Ginnie Mae”), and Small Business Administration [not a GSE] (“SBA”); mortgage-backed securities, including pass-through securities issued by Ginnie Mae, Fannie Mae, or FHLMC; and CMOs issued or guaranteed by Ginnie Mae, Fannie Mae, or FHLMC. The stated purpose of the Leverage Program is to mismatch investment and funding durations and yields (assets to liabilities) to enhance earnings and capital.

As of December 31, 2005, the investment portfolio represented 83 percent of total assets. Ninety-four percent of the portfolio were GSE-sponsored CMOs, and six percent were GSE debentures.² X’s liability structure places significant reliance on wholesale funding. The Bank has a notably low percentage of deposits, particularly core deposits relative to its peer group. While core deposits have increased, deposit concentrations are similarly noteworthy. Five large depositors control $226.8 million, or, nearly 80 percent of total deposits.

Regulatory concerns over the Bank’s Leverage Program and its impact on earnings, liquidity, and sensitivity to market risk were first raised in the March 17, 2003 State examination. Repeat and uncorrected deficiencies were reported in the February 2, 2004 �౦��Ϸ���� Examination. As a result, a Memorandum of Understanding was imposed on November 23, 2004, which remains in effect. The MOU addresses capital maintenance and asset growth; liquidity and earnings; development of an acceptable asset/liability management policy, of an interest risk rate model appropriate to the Bank’s activities, of an acceptable investment policy, and of plans to improve liquidity and reduce reliance on volatile liabilities; and correction of regulatory violations and adoption of procedures to prevent future violations of law and regulatory mandates.

B.The Safety and Soundness Material Supervisory Determinations
X disputes its Composite rating and its component ratings for Management, Sensitivity to Market Risk, Capital Adequacy, and Liquidity of “3,” and its component ratings for Asset Quality and Earnings of “2.” The Bank seeks a “2” for Sensitivity to Market Risk, and a “1” rating for all other components and for its Composite rating.

1. Management
Under the Federal Financial Institutions Examination Council’s Uniform Financial Institutions Rating System (the “FFIEC Rating System,”), sound management is demonstrated by active oversight by the board and management; competent personnel; adequate policies, processes, and controls; maintenance of an appropriate audit program and internal control environment; and effective risk monitoring and management information systems. A “3” rating signals the need for improved management and board performance and possible inadequate identification, measurement, monitoring, and control of risk.

X’s Board of Directors (the “Board”) believes that Management’s performance and oversight are satisfactory for the Bank’s size, complexity, and risk profile. To monitor the Leverage Program, the Board uses three risk-measuring models it views as adequate to measure X’s risk exposure. In addition, the Board has approved an Asset/Liability Management Policy and an Investment Policy that the Board considers effectively limit risk tolerances and set up a foundation to operate the Bank’s investment strategy in a safe and sound manner. According to the Bank, any deviations from these Policies have been carefully evaluated and considered before receiving Board approval. The Asset/Liability Committee (“ALCO”) and the Board undertake reviews at monthly meetings, of a detailed set of minutes measuring the Bank’s performance against the limits set by the Asset/Liability Management and Investment Policies. These reviews provide critical commentary on market information crucial to investment decisions derived from analysis of the three risk-measuring models.

X uses two interest rate risk (“IRR”) models provided by vendors *** Consulting (“Consultant 1”) and *** Financial Corporation (“Financial Corporation”). The third IRR model is a Fixed Base Earnings at Risk Model (“Earnings Model”) developed for the Bank by a Financial Corporation sales representative. Each of the three models analyzes IRR from both a balance sheet, or economic perspective, and an income statement perspective. On a quarterly basis, the ALCO and Board review model results, as well as a third-party review of the Earnings Model conducted by outside consultant *** (“Consultant 2”). Consultant 2 also conducts a quarterly audit of the accuracy and validity of the internal ALCO reports. X argues that it effectively uses the expertise of Consultant 1, Financial Corporation, and Consultant 2 to maintain models and policies that effectively measure, monitor, and manage the Bank’s risk exposure by posting strong profits in the midst of some of the narrowest spreads and the most volatile interest rate environments in the last twenty years. The Bank asserts that it has remained profitable during an extended yield curve inversion, which poses the highest potential risk to earnings from an IRR standpoint.

DSC responds that Management’s tolerance for risk is not commensurate with the level of capital held. DSC points out that the three models have similar weaknesses so that each is of limited value. A primary weakness of each is its limited ability to model the most significant risk assumed by the Bank: variability in CMO prepayment speeds. Typically, banks with significant prepayment exposure use models that have much more detailed and supported cash flow assumptions. The results from X’s models, on the other hand, are flawed and provide misleading conclusions about the Bank’s IRR exposure. For example, the Consultant 1 model, on which the Bank relies as its primary risk-measuring model, uses data obtained from the Bank’s quarterly Call Report. Call Report data do not contain sufficient detail, nor do they capture the underlying risk characteristics needed to model and measure the risk of complex and high-risk CMOs. The repricing data derived from Call Reports are not dynamic and will not capture the significant extension risk embedded in X’s CMO portfolio. Banks with elevated IRR generally use models that use general ledger data, which are much more detailed and can be generated more frequently.

In reply to X’s assertion of profitability, DSC acknowledges that, while the Bank has remained profitable during the recent yield curve inversion, for the relevant period of the March 2006 Examination, X’s net interest income has trended sharply downward as funding costs have risen significantly and yields on the CMO portfolio have remained relatively static. Since December 31, 2003, the Bank’s net interest margin (“NIM”) has declined over 30 percent as funding costs have increased. During the same period, the average margin of the Bank’s peer group actually increased somewhat, as those banks exercised pricing flexibility with core deposits. As of December 31, 2005, the Bank’s NIM was 2.52 percent, compared to 4.24 percent for the peer group. This declining margin indicates IRR higher than similarly sized institutions.

DSC observes that compliance with laws and regulations is also a factor in assessing Management, pointing to X’s deficiencies in the administration of the Bank Secrecy Act (“BSA”) and related regulations. Violations of section 326.8 of �౦��Ϸ����’s Rules and Regulations covering BSA include inadequate independent testing and training for BSA compliance. X was also cited for violations of section 103 of Treasury’s financial recordkeeping regulations covering Currency Transaction Reports (“CTRs”).³ Additionally, the Bank continues to operate under an MOU issued as a result of findings of the February 2004 examination. As of March 27, 2006, X had not complied with a number of the provisions in the MOU; the Bank: had not established an acceptable asset/liability management policy; had not developed an adequate IRR measurement model nor a satisfactory investment policy; had not developed a viable overall liquidity strategy or plans and procedures to improve liquidity and reduce reliance on volatile liabilities to fund long-term assets; and had not adopted adequate procedures to prevent recurrence of violations of laws and regulations.

DSC notes that for the third consecutive examination, X’s operations are in conflict with the Joint Agency Policy Statement on Interest Rate Risk.⁴ Similarly, for the third consecutive examination, X is not complying with the provisions of the Supervisory Policy Statement on Investment Securities and End-Use Derivatives Activities.⁵ X’s investment policy permits a portfolio with a high level of market risk and the potential for extended duration that is not commensurate with the level of its capital.

The record thoroughly documents that deficient procedures covering BSA, IRR, and investment securities have led to violations of law and regulations and contraventions of statements of policy. A key factor in assessing Management is the existence of appropriate policies and the accuracy and effectiveness of management information and risk monitoring systems that are appropriate for the institution’s size, complexity, and risk profile. Thus, deficiencies in X’s IRR and liquidity policies, Management’s failure to comply with �౦��Ϸ���� Policy Statements as well as its less than satisfactory risk management practices concerning the Leverage Program stand as a further adverse reflection of Management’s capabilities. Given these deficiencies, it is clear that Management and Board performance need improvement and that risk management practices are less than satisfactory. The Committee finds that these facts fully support a Management rating of “3.”

2. Sensitivity to Market Risk
Under the FFIEC Rating System, the sensitivity to market risk component reflects the degree to which changes in interest rate, foreign exchange rates, commodity prices, or equity prices can adversely affect an institution’s earning or economic capital. The rating is based in part on the ability of Management to identify, measure, monitor, and control exposure to market risk given the institution’s size, complexity, and risk profile. A “3” rating indicates that control of market risk sensitivity needs improvement or that there is significant potential that the earnings performance or capital position will be adversely affected.

X’s Board states that the Bank’s level of market risk sensitivity is only moderate and that there is a very low potential that earnings or capital will be adversely affected. X relies on its models, arguing that they demonstrate that the Bank will remain profitable even in the face of further rate hikes. Although cash flow slowed in early 2006, X still received more than adequate cash to meet immediate needs. The Bank contends that its Asset/Liability and Investment Management Policies provide adequate and sound limits and procedures, and that the strategies that Management sets in its monthly ALCO meetings, while they may deviate from its internal policies, are designed specifically for its investment program. X asserts that “since Management concentrates the investment portfolio on CMOs, factors such as portfolio composition and portfolio sectors are irrelevant to Management’s strategies” and therefore need not be addressed. X further asserts that use of Bloomberg median prepayment estimates to calculate the average life of CMOs is inappropriate and that examiners should focus on “internally generated average life estimate[s].” Finally, regarding the inaccuracies of the Bank’s IRR models, the Bank argues that the use of market median prepayment estimates provided by Bloomberg in the Consultant 1 model produces erroneous results.

DSC responds that Bank Management has not implemented satisfactory risk management practices. The Bank has chosen not to upgrade its risk measurement systems so that they are capable of quantifying the risk inherent in the investment portfolio and its leveraging strategy. In analyzing IRR, the Bank uses a Call Report-based model, which, according to DSC, is incapable of adequately measuring its risk exposure due to both its quarterly schedule and the less detailed, more general nature of the information it produces. DSC asserts that use of historical prepayments in estimating future prepayments is unsound, and, consequently, it does not support the Bank’s argument that the level of risk in its strategy is acceptable. DSC argues that using historical prepayment levels is especially problematic, given the recent trends in mortgage rates and prepayment levels as of March 2006. X rejects the use of prepayment projections derived from models based on market sources. It uses its Call Report data instead, as noted, and generally assumes that the predictive ability of prepayments in the recent past is adequate to make accurate predictions of future prepayments. Thus, if mortgage rates have not changed in the last few months, this method predicts that mortgage rates will not change in the upcoming month. The use of such data is not predictive in a changing rate environment, a necessity for sound risk management.

X’s belief with respect to the concentration of its investment portfolio in CMOs relieving it from any concern over portfolio composition is contrary to established guidance and implies that Management has developed a strategy that ignores sound risk management practices to maximize financial results. Although the Bank’s investment portfolio of CMOs has limited credit risk, market risk must be carefully monitored and controlled as well. The Bank’s quality and trend of earnings are jeopardized by the IRR exposure inherent in the Bank’s Leverage Program. The narrowing of the Bank’s NIM has been driven by an increasing cost of funding. Further, the Bank’s capital does not fully support the high risk profile. A two percent change in interest rates using market median prepayment speeds as reported by Bloomberg would be expected to decrease the value of the investment portfolio by $58.7 million, nearly twice the amount of X’s Tier 1 Capital. Finally, X’s IRR models do not accurately measure the impact of IRR on either earnings or capital.

The DSC Examination Manual specifically discusses risk limits, stating that they should be consistent with the bank’s strategic plans and overall asset/liability management objectives. Limits should be placed on market risk; in other words, limits should at least quantify maximum permissible portfolio or individual instrument price sensitivity as a percentage of capital or earnings. Similarly, limits should be placed on asset types – that is, concentrations in specific issuers should be limited. So, too, does the Manual counsel for limits on maturities, stating that longer term securities have greater IRR, price risk, and cash flow uncertainty than shorter term instruments. Thus, maturity limits should complement market risk limits, liquidity risk limits, and the Board’s investment goals.

The FFIEC Rating System defines a “3” Sensitivity to Market Risk rating, in part, as one in which “. . . control of market risk sensitivity needs improvement or that there is significant potential that the earnings performance or capital position will be adversely affected.” The Bank’s Asset/Liability Management Policy fails to establish prudent market risk limits, asset type limits, or maturity risk limits. Based on a careful evaluation of X’s level and management of market risk, the Committee determines that the record establishes that the “3” rating assigned to Sensitivity to Market Risk is justified.

3. Capital Adequacy
A financial institution is expected to maintain capital commensurate with the nature and extent of risks to the institution and the ability of Management to identify, measure, monitor, and control these risks. Under the FFIEC Rating System, a “3” indicates a less than satisfactory level of capital not fully supportive of the institution’s risk profile. The rating indicates a need for improvement, even if the institution’s capital level exceeds general minimum regulatory and statutory requirements.

X contends that it maintains a strong level of capital and one that is adequate to support its risk profile. The Bank believes that Management and the Board have demonstrated an ability and willingness to meet and exceed the Regional Office’s MOU requirement of a 7 percent Tier 1 Capital ratio, adding that its “shareholder has shown a consistent willingness and capacity to augment the Bank’s capital.” X further states that its risk-based capital ratios exceed 23 percent because the investment portfolio is almost entirely composed of GSE-sponsored securities, which pose no credit risk. The Bank’s Board and Management also argue that it is not meaningful to measure the investment portfolio’s unrealized loss to Tier 1 Capital because the Bank intends to hold the securities to maturity, reasoning that danger to capital is only realized on sale of securities with losses and that the only true risk as a result of the portfolio’s depreciation would be the requisite reduction in the value of the securities as collateral for the Bank’s obligations to FHLB, Bankers Bank and/or Financial Corporation. To address this risk, the Bank maintains sufficient collateral in unpledged securities, well above its current collateralized debt. X complains that �౦��Ϸ���� “continues to express its displeasure at the Bank’s current level of capital without providing guidance as to a level of capital acceptable to the �౦��Ϸ����.” In sum, X maintains that the claim that its risk profile suggests a need for a much higher capital level is “completely subjective and unsupported.”

DSC observes that the Bank’s balance sheet composition is markedly different from that of its peer group: net loans and core deposits are well below peer banks, and investment securities, Federal Home Loan Bank borrowings, and short-term, non-core funding are well above peer. The Bank’s Tier 1 Leverage Capital ratio is also well below peer. However, risk-based capital ratios exceed peer due to the volume of GSE-sponsored CMOs, which are reported in a lower risk-weight category because of the status of the securities’ sponsor. Thus, these higher risk-based capital ratios are reflective of low credit risk in the Bank’s assets but do not take into account the high IRR. DSC believes that, as the Examination Manual makes clear, risk limits are important with respect, not only to credit risk but also market and liquidity risks. Risk limits should be consistent with a bank’s strategic plans and overall asset/liability management objectives. The Bank’s capital position does not fully support the risk profile associated with the Leverage Program. CMOs are highly interest rate sensitive, and changes in rates affect their value and cash flow, which in turn affect capital and earnings. The Bank’s investment portfolio analysis as of December 31, 2005, indicates that the value of the portfolio would decrease $58.7 million, if rates increased 200 basis points.⁶ This anticipated investment portfolio depreciation represented approximately 194 percent of equity capital at that time. The Bank’s capital position was evaluated based on its overall unique risk profile, including its Leverage Program. Therefore, the effects of market and other risks on the institution’s financial condition were considered in evaluating the adequacy of capital.

Finally, in response to the Bank’s complaint that �౦��Ϸ���� has not provided sufficient guidance in establishing an acceptable level of capital, DSC states that �౦��Ϸ���� provided the Bank with a minimum capital level as specified in the November 2004 MOU, based on the condition of the Bank at the time. However, as of December 31, 2005, the Bank’s total assets grew 23 percent, which outpaced Tier 1 Capital growth of 17 percent, including a $1.3 million capital injection by the Bank’s shareholder. The risk exposure to capital is identified through the market and extension risk in the investment portfolio. The March 2006 ALCO meeting minutes indicate that the weighted average life of the investment portfolio increased from 2.3 years at December 2004 to 5.1 years at December 2005. Additionally, internal reports indicate $11.1 million in securities depreciation as of March 31, 2006. The Board approved a Capital Plan in April 2005, stating that the Tier 1 Leverage Capital Ratio would be maintained at 7 percent. However, in December 2005, the $1.3 million capital injection was needed to maintain the required capital level. The Bank is expected to maintain capital commensurate with the nature and extent of risk to the institution and with the ability of Management to identify, measure, monitor, and control these risks. The portfolio’s market risk and the Bank’s overall IRR profile suggest a higher Tier 1 Leverage Capital Ratio is warranted. During that growth period, the Examination Report noted that the Board “failed to implement policies, procedures, and systems to adequately identify, measure, monitor, and control the Bank’s interest rate risk exposure and the related impact on capital protection, earnings performance and the investment portfolio.”

In consideration of the relevant information, X’s capital is clearly not “strong,” but “less than satisfactory,” given the significant level of IRR combined with the material weaknesses identified in X’s IRR management practices. Accordingly, the Committee deems the Capital Adequacy component rating of “3” appropriate.

4. Liquidity
In evaluating the adequacy of an institution’s liquidity position, consideration is given under the FFIEC Rating System to the current level and prospective sources of liquidity compared to funding needs, as well as to the adequacy of funds management practices relative to the bank’s size, complexity, and risk profile. The rating is based on a number of factors, including the degree of reliance on short-term, volatile sources of funds, including borrowings and brokered deposits, to fund longer term assets. A “3” rating denotes liquidity levels or funds management practices in need of improvement. Institutions rated “3” may lack ready access to funds on reasonable terms or may manifest significant weaknesses in funds management practices.

X asserts that its liquidity level and funds management process are strong for its risk profile and investment strategy. According to the Bank, Management maintains access to sufficient sources of additional funding through FHLB and Bankers Bank, and maintains adequate collateral to pledge. Although five depositors control nearly 80 percent of total deposits, the Board does not believe the level of deposit concentrations presents a high level of risk to the Bank. Further, the Bank considers its brokered deposits stable as they are structured over a one- to five-year timeframe and can only be prematurely withdrawn in special circumstances. The State’s deposits are also considered stable because the State imposes a pledging obligation to secure the funds. Finally, it considers the deposits of Chairman C and Director *** (“D”) to be stable, core deposits that evince their commitment to the Bank’s strategy.

DSC counters that under a number of traditional liquidity measures, X remains decidedly remote from its peer group. The following figures reflect the Bank’s balance sheet liquidity ratios as a percentage of average assets. X uses significantly fewer deposits, particularly core deposits, to fund their assets – (12/2005, 17.40 percent for X; 66.19 percent for peer) (12/2004, 13.16 percent for X; 67.54 percent for peer). X places significantly more reliance on wholesale funding and large time deposits than their peer group – (12/2005, Total FLHB borrowings for X, 34.91 percent; 4.91 percent for peer) (12/2004, Total FLHB borrowings for X, 35.17 percent; 5.00 percent for peer); (12/2005, Time Deposits of $100M or more for X, 26.36 percent; 14.49 percent for peer). Each of these traditional liquidity measures is indicative of liquidity concerns or pressures.

Deposit concentrations are significant at X – five large depositors control $226.8 million, or nearly 80 percent of deposits. Two of the large depositors, Chairman C and D, are directors of the Bank. Together, C and D control nearly 45 percent of total deposits. Although a certain degree of deference can be given to a director’s relationship with the bank when assessing the stability of deposits,⁷ X’s degree of reliance on insider deposits, DSC states, is highly unusual and warrants extended review. DSC explains that, although it is fair to assume that the directors have the willingness to hold deposits at the Bank as long as they are needed, their ability to maintain such balances must be assessed as well. X has performed no analysis of the deposit levels of each insider in relation to his net worth, nor of any correlation between their individual financial conditions and the Bank’s. Moreover, DSC points out, the three other large depositors each have volatility concerns. Public funds and individual large depositors are sensitive to reputation risk and the financial condition of the Bank. Such depositors are more likely to withdraw funds at institutions facing bad publicity or in financial distress. General economic conditions can also be a factor in assessing the volatility of these deposits because each may experience revenue shortfalls in times of economic decline and feel a need to withdraw their funds.

X’s reliance on volatile funds is addressed in the MOU, which requires the Bank to review liquidity objectives and develop plans and procedures to reduce reliance on volatile liabilities to fund longer term assets. Bank Management has failed to adopt such procedures.

X’s liquidity risks are heightened by the high degree of leverage in its portfolio, the price volatility of the assets purchased, and the extensive use of non-core funding. While the Bank may have sufficient liquidity during best-case scenarios, there remains a concern that the Bank’s funding sources may evaporate under certain market conditions. To continue to access wholesale funds, the Bank must be able to provide eligible collateral to secure advances. Because the portfolio consists of CMOs with a high degree of market and extension risk, increasing interest rates could result in additional depreciation and reduced available collateral. The same market condition would also likely impair the Bank’s earnings and restrict its access to funding sources that would be sensitive to the financial condition of the Bank. In addition, deterioration in the Bank’s finances could lead to restriction under Part 337 on the Bank’s ability to accept brokered deposits, which form another key funding source.

The Bank has failed to adopt policies and procedures to improve liquidity and continues to place significant reliance on short-term, volatile funds to fund longer term assets. The Committee finds that these facts support a Liquidity component rating of “3.”

5. Asset Quality
The asset quality rating under the FFIEC Rating System reflects the quantity of existing and potential credit risk associated with the loan and the investment portfolios. Asset quality is rated based on a number of factors, including the adequacy of underwriting standards; soundness of credit administration practices; appropriateness of risk identification practices; the adequacy of asset valuation reserves; the diversification and quality of the loan and investment portfolios; and the adequacy of loan and investment policies, procedures, and practices. A rating of “2” is a sign of satisfactory asset quality and credit administration practices. The level and severity of classifications and other weaknesses warrant a limited level of supervisory attention. Risk exposure is commensurate with capital protection and Management’s abilities.

X requests an Asset Quality rating of “1,” arguing that it had received a “1” for its Asset Quality component rating for the previous two examinations and that no changes had occurred since the last exam that warranted a downgrade to “2.” In particular, adversely classified assets totaled only $590,000, or 0.12 percent of total assets and 1.66 percent of Tier 1 Capital. Stating that the reason for the “2” rating was the “high degree of market risk” in the portfolio, X argues that the Board and Management believe that degree of market risk “is not an asset quality issue.” The Bank asserts that, as 100 percent of the Bank’s portfolio is comprised of GSE-sponsored securities, all with the (implied) guarantee of the U.S. government, the principal is protected and risk-free. See n. 2, supra. Any risk in the portfolio would relate to the Sensitivity to the Market Risk component and not to Asset Quality.

DSC acknowledges that the Bank’s assets present nominal credit risk and that credit risk is of minimal supervisory concern. However, existing and potential credit risk is only one type of risk associated with asset quality. The Examination Manual specifically states that in addition to credit risk, the Asset Quality rating is extended to include “[a]ll other risks that may affect the value or marketability of an institution’s assets, including, but not limited to, operating, market, reputation, strategic, or compliance risks . . . .” DSC explains that at most banks, the loan portfolio serves as the primary source of earnings; however, at X, the asset mix is different from its peer group and X’s investment portfolio is its primary earnings component. Accordingly, DSC looked at other risks that affect value or marketability of the Bank’s assets and at the bank’s ability to identify, measure, monitor, and control those risks. Market risk and extension risk associated with the CMO portfolio were assessed in reviewing the Asset Quality component.

As of December 31, 2005, X’s investment portfolio represented 83 percent of total assets and consisted entirely of GSE-sponsored securities. Market risk (that is, interest rate risk) rather than credit risk is the primary risk facing investors in CMOs. Market risk is exemplified by potential volatility in the portfolio. To note, a 2 percent change in mortgage rates could decrease the value of the portfolio by $58.7 million, or, nearly twice the amount of equity capital. DSC goes on to point out that associated with market risk is significant extension risk in the portfolio. One characteristic of a CMO is the embedded option of early prepayment of the underlying pools of mortgage loans. The prepayment feature of the mortgage creates cash flow uncertainty and affects the average life of the CMO. In other words, as prepayments begin to decrease due to rising interest rates, the effective maturity of the CMO will extend. The Bank’s ALCO minutes include an average-life analysis of the CMO portfolio based on several different average life estimates, including the Bloomberg Default Average Life and the Bloomberg Default Average Life with a 2 percent shock. As of December 2005, these estimates were 5.03 years and 12.28 years, respectively, indicating that potential extension risk is significant in a rising rate environment. During 2005 (a rising rate environment with decreasing prepayments) the Bloomberg Default Average Life estimate more than doubled from its December 2004 estimate of 2.30 years. In addition, the Examination Report noted that an independent review had not been conducted of the Investment Management Policy, investment procedures, limitations, or exceptions to policy.

The Bank’s investment policy allows Management to undertake a high level of risk and permits extended duration in the investment portfolio despite comments in previous examination reports about the high level of market risk. Even though credit risk is of minimal supervisory concern and credit administration practices are sound relative to the Bank’s size, complexity, and risk profile, the Bank is exposed to market and extension risk in its CMO portfolio, the asset that is X’s primary earnings component. When this risk exposure and the Bank’s ability to identify, measure, monitor, and control it are considered, Asset Quality is not “strong,” but “satisfactory,” given the Bank’s asset mix and risk profile. Accordingly, the Committee believes an Asset Quality rating of “2” is justified.

6. Earnings
The FFIEC Rating System’s earnings rating reflects not only the quantity and trend of earnings, but also factors that may affect its sustainability or quality. The quantity as well as the quality of earnings can be affected by high levels of market risk that may unduly expose an institution’s earnings to volatility in interest rates. Future earnings may be adversely affected by an inability to forecast or control funding and operating expenses, improperly executed or ill-advised business strategies, or poorly managed or uncontrolled exposure to other risks. A “2” rating connotes satisfactory earnings – that earnings are sufficient to support operations and maintain adequate capital and allowance levels after consideration given to asset quality, growth, and other factors affecting the quality, quantity, and trend of earnings.

X’s Board states that its earnings are strong and more than sufficient to support operations and maintain adequate capital. The Bank asserts that its internal earnings model demonstrates that the Bank would return a “healthy profit if the current rate environment continued,” and that, even if Director C’s low-interest deposits were priced to market, the Bank would still maintain a “healthy and sustainable profit.” Finally, X contends that “despite adverse conditions for a leverage strategy’s success, the Bank has continued to post earnings at or above its peer group, and well above its benchmark of 15 percent.”

DSC observes that the Bank’s earnings have steadily declined due to the substantial IRR that is the hallmark of its leverage strategy. Net income declined from $10 million in December 2004 to $7.7 million in December 2005. The Bank’s NIM has declined substantially and is well below peer. As of December 2005, the NIM was 2.52 percent in comparison to a NIM of 3.22 in December 2004. The narrowing of the NIM is largely driven by the increasing cost of funding compared to yields on CMO investments. Between 2003 and 2005, the costs of Federal funds purchased and borrowed funds increased by 167 basis points and 212 basis points, respectively. During the same period, the yields on U.S. Treasury and GSE securities and CMOs increased by 8 basis points and 126 basis points, respectively. X’s leverage strategy exposes earnings to substantial IRR and net interest income volatility.

The Bank’s profitability was well above average in past years because of the risk undertaken during a steep yield curve. As interest rates have moderated, earnings have reduced measurably, again demonstrating the high IRR held by the Bank. Further, one reason that the Bank remained profitable in 2005 was that X’s majority shareholder placed $99 million of deposits at below-market interest rates. These funds largely replaced more expensive wholesale funding. The lower rate on the shareholder’s deposit reduced interest expense by an estimated $3 million annually. Had this transaction not occurred, the Bank’s earnings performance would have been drastically lower than current levels. DSC calculates that a $3 million increase in interest expense would have reduced the Bank’s NIM from 2.52 percent to about 1.79 percent, and the Return on Average Assets (“ROAA”) from 1.83 percent to 1.12 percent, all else being equal. By comparison, the peer group’s NIM and ROAA were 4.24 percent and 1.27 percent, respectively.

Although the quality and trend of earnings are satisfactory in light of X’s risk profile, they do not merit a rating of “1,” which would be indicative of earnings that are more than sufficient to support operations and maintain adequate capital and allowance levels. Accordingly, the Committee finds that X’s Earnings component rating was properly assigned as “2.”

7. The Composite Rating
Composite ratings are based on a careful evaluation of an institution’s managerial, operational, financial, and compliance performance, as measured by the six key CAMELS components. Institutions with a “3” rating exhibit a combination of weaknesses that may range from moderate to severe. Such institutions are less capable of withstanding business fluctuations and are more vulnerable to outside influences than those rated “1” or “2.” Risk management practices may be less than satisfactory relative to the institution’s size, complexity, and risk profile.

X believes the ALCO and IRR reports demonstrate that the Bank’s capital, liquidity, asset quality, earnings, sensitivity to market risk and management are all strong to satisfactory, and that the Composite rating should therefore be revised to a “1.”

DSC cites the FFIEC Rating System’s definition for a Composite rating of “1”: 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. . . . [T]hese 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.” DSC argues that the Bank’s overall financial condition clearly remains less than satisfactory, and that the nature and severity of IRR, liquidity, and management-related deficiencies at the Bank are material.

The record demonstrates: that Management lacks the ability or has been unwilling to address effectively weaknesses identified over several examination cycles; that risk management practices are less than satisfactory in relation to the institution’s size, complexity, and risk profile; and that material non-compliance with laws, regulations, and policy initiatives has been identified in three examination cycles. These facts are not demonstrative of strong performance in every respect nor indicative of risk management practices that give no cause for supervisory concern. The evidence on this record is not descriptive of an institution with a few minor weaknesses. The Committee finds that these facts fully support a Composite rating of “3.”

III. Conclusion

For the reasons set forth above, X’s appeal is denied. This decision is considered a final supervisory decision by �౦��Ϸ����.

By direction of the Supervision Appeals Review Committee, dated September 5, 2007.

Valerie J. Best
Assistant Executive Secretary

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¹ The Guidelines are set out at 69 Fed. Reg. 41,479 (July 9, 2004) and in �౦��Ϸ���� Financial Institution Letter (“FIL”) 113-2004 (Oct. 13, 2004).
² Congress established government-sponsored enterprises to facilitate the development of mortgage and agricultural lending in the U.S. Although the Federal government does not explicitly guarantee the approximately $4.4 trillion in financial obligations of GSEs, the potential exists that the government would provide financial assistance in an emergency as it has done in the past. Government-Sponsored Enterprises: A Framework for Strengthening GSE Governance and Oversight - PDF, 108^th Cong. (2004) (statement of David M. Walker, Comptroller General of the U.S., in testimony before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate, Open Session Hearing on Proposals to Improve the Regulatory Regime of GSEs), reprinted in GAO-04-269T.
³ 31 C.F.R. §103.
⁴ The Joint Agency Policy Statement, which was issued by �౦��Ϸ����, the Board of Governors of the Federal Reserve System (“FRB”), and the Office of the Comptroller of the Currency (“OCC”), under the auspices of the Federal Financial institutions Examination Council (“FFIEC”) in June 1996, provides guidance to banks on prudent interest rate risk management principles. 61 Fed. Reg. 33,166 (June 26, 1996). This Policy Statement augments the action taken by the agencies in August 1995 to implement section 305 of the Federal Deposit Insurance Corporation Improvement Act of 1991 (“�౦��Ϸ����IA”), Pub. L. 102-242 (12 U.S.C. §1818 note), which requires the agencies to revise their risk-based capital guidelines to take adequate account of interest rate risk. On August 2, 1995, the agencies published a final rule implementing section 305 that amended their risk-based capital standards to specify that the agencies would include, in their evaluations of a bank’s capital adequacy, an assessment of the exposure to declines in the economic value of the bank’s capital due to changes in interest rate risk. The final rule, which became effective on September 1, 1995, adopted a “risk assessment” approach under which capital for interest rate risk is evaluated on a case-by-case basis, considering both quantitative and qualitative factors.
⁵ The Supervisory Policy Statement, which was issued by �౦��Ϸ����, the FRB, the OCC, and the Office of Thrift Supervision (“OTS”), under the auspices of FFIEC in April 1998, provides guidance on sound practices for managing risks of investment activities. 63 Fed. Reg. 20-191 (April 23, 1998).
⁶ Prudent IRR management requires considering extreme scenarios that might not be within a given risk model’s structure. In this practice, commonly referred to as stress-testing, the underlying model and IRR management system are “stressed” by examining uncommon, although not implausible, scenarios. The scenarios should incorporate a sufficiently wide change in market interest rates (e.g., +/- 200 basis points over a one-year horizon). See e.g., Joint Agency Policy Statement on Interest Rate Risk, supra at n.3.
⁷ The Examination Manual defines deposit concentrations as “deposits under one control, or payable to one entity, which aggregate 2 percent or more of the bank’s total deposits. By virtue of their size, such deposits are considered to be potentially volatile liabilities; . . . [however] a board member might maintain sizable deposit accounts in the institution because of his or her relationship with the institution. These deposits in aggregate might be considered large deposits, but are not volatile funds due to the stability of the relationship.”