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SARC-2003-03 (December 31, 2003)

At a meeting held on December 23, 2003, the Supervision Appeals Review Committee (“Committee”) of the Federal Deposit Insurance Corporation (“�౦��Ϸ����”) considered the appeal filed by [Bank’] (“Bank”). In its appeal, the Bank contested certain material supervisory determinations contained in the safety and soundness examination dated December 30, 2002 (“Report of Examination”) prepared by the �౦��Ϸ����. In accordance with the Guidelines for Appeals of Material Supervisory Determinations, 60 Fed. Reg. 15923 (March 28, 1995), the Committee reviewed the appeal for consistency with the policies, practices and mission of the �౦��Ϸ����, and the overall reasonableness of, and support offered for, the respective positions advanced. The scope of the Committee’s review was limited to the facts and circumstances as they existed at the time of the examination. Although facts or circumstances that occurred after the examination and any subsequent corrective actions were not considered as part of the Committee’s review, they will be reviewed during future on-site supervisory activities

After considering the matter at length, the Committee has concluded that the Bank’s appeal should be denied. The Committee found that the conclusions contained in Report of Examination accurately reflected the condition of the Bank and that these conclusions were adequately supported by facts presented within the Report of Examination. Upon careful consideration of the issues raised in the appeal, the Committee determined that the Asset Quality and Earnings component ratings and the Composite rating assigned at the examination were appropriate. In addition, the Committee agrees that the examination’s securities accounting treatment is in accordance with generally accepted accounting principles (“GAAP”) and �౦��Ϸ���� policies, and that the Bank is therefore required to amend its December 2002, March 2003, June 2003, and September 2003 Consolidated Reports of Condition and Income (“Call Reports”).

The bases for the Committee’s decision are discussed below.

Equity Securities Determined Other Than Temporarily Impaired, Related Adverse Classifications, and Call Report Amendments
The examination identified nine equity investments that were deemed to be “other than temporarily impaired” (“OTTI”) as of September 30, 2002. The Committee has concluded that the OTTI determination is appropriate based on applicable GAAP, the related SEC pronouncement, and generally accepted auditing standards. As a result, the Loss classifications on the nine equity securities listed in the Report of Examination are also appropriate. In addition, the Committee reviewed the materiality of the earnings charges (depreciation) involved and determined that, per Call Report Instructions, the amounts involved are in fact material to the Bank’s earnings as reported on its Call Reports; therefore, amendments to the affected Call Reports are necessary and appropriate.

Technically, under GAAP and in accordance with Call Report Instructions, the required write-downs should be reflected as of September 30, 2002, the examination “as of” review date for the investment portfolio. However, given that the examination did not begin until December 30, 2002, the Regional Office’s decision to require that the write-downs be reflected in the December 31, 2002, Call Report using December pricing rather than in the September 30, 2002, Call Report is reasonable (and is, in fact, more beneficial to the Bank). The total loss to be recognized through the bank’s income statement as of December 31, 2002, equals $667,687.

Asset Quality Component Rating
Three equity securities determined to be of subinvestment quality were adversely classified Substandard at the examination (aggregate market values totaled $85 thousand). The Committee reviewed relevant information pertaining to the three equity securities classified Substandard in the Report of the Examination as well as the examiners’ methodologies in making their determinations. The Committee considers both the examiners’ findings and methodology appropriate and the resultant classifications well supported. The examiners appropriately applied outstanding policy guidance in the examination treatment of the securities. In making a determination that the subject equity securities were subinvestment quality, the examiners conducted individual credit analyses of each issuer, utilizing available financial information, which supports the adverse classifications.

Bank management also contested the adverse classification of the … bond, primarily based upon the Bank’s subsequent sale of the security above its purchase price. The Committee agrees with the classification accorded in the Report of Examination and has determined that the methodology used by the examiners in evaluating this investment was appropriate. The examiners followed relevant guidance in the �౦��Ϸ����’s Manual of Examination Policies, which indicates that depreciation in subinvestment grade debt securities not in default should be classified “Doubtful” with the remaining amortized cost classified “Substandard.” In arriving at the classification decision, the examiners also considered available financial information on the issuer, as well as the concurrent Shared National Credit classification for … bank debt.

The Bank also disagreed with the Substandard classification of the … loan relationship. The Committee agrees with this adverse classification, which is supported by the well-defined weaknesses in the relationship as detailed in the Report of Examination.

Overall, the Committee concurred with the Asset Quality component rating of a “2.” While the volume, level, and trend relating to virtually all of the Bank’s asset quality quantitative measures present minimal concern, especially given the nature of the identified asset problems, the weaknesses present in the credit administration area do warrant supervisory attention, particularly because several of them are repeat in nature. That weaknesses of the nature and type identified are allowed to continue is not indicative of “strong” credit administration practices.

Earnings Component Rating
The Committee agrees that the assigned Earnings component rating of “2” is appropriate. The Bank’s earnings are clearly sufficient to support operations and maintain adequate levels of both capital and loss allowances. However, the questionable sustainability of 2002 earnings levels and the weaknesses relating to the budgeting process and securities analysis do not support an Earnings component rating of “1.” Several analyses of peer group comparisons were utilized by the examiners to support this conclusion.

Sensitivity to Market Risk
In its appeal, the Bank contends that the interest rate risk (“IRR”) analysis was unjustly critical. The Bank suggests that the sole basis for the criticism was the perception that the Bank did not conduct an adequate independent review of the process. Although this issue was not specifically appealed by the Bank, the Committee has reviewed the Bank’s concerns.

The examiners stressed that, although the depth of an independent review may be dependent on the complexity of the institution, all institutions—regardless of size or complexity—are expected to have an independent review that addresses specific items outlined in the “Joint Agency Policy Statement on Interest Rate Risk.” As noted in the Report of Examination, the Bank’s independent reviews do not address three of the five standards identified in the Policy Statement. In addition, the periodic reviews conducted by the Bank’s external auditor are not a sufficient substitute, and do not satisfy the requirement, for annual reporting to the Board of Trustees. Based upon its review, the Committee believes that examiners' analysis of the Bank’s sensitivity to market risk was appropriate.

Composite Rating
The Committee agrees that the assigned Composite rating of “2” is appropriate. As alluded to in the Report of Examination, the downgrade in the Composite rating is primarily attributed to several weaknesses identified in the Report of Examination that have not been appropriately addressed by the Bank’s management. These recommendations related to credit administration, information technology, and internal audit. The asset classifications and earnings adjustments are only two of the factors that were considered in the Composite rating downgrade, with greater weight given to weaknesses identified in credit administration and the institution’s overall risk management program relative to the institution’s size and complexity.

The credit administration weaknesses, as well as the numerous other weaknesses identified within the Report of Examination, are not indicative of a “strong” risk management program. The volume and repeat nature of the policy/program type weaknesses identified at the examination are characterized as presenting only moderate risk, and each weakness appears to be well within management’s capabilities to correct. Accordingly, the Bank’s overall condition is considered only satisfactory.

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

By direction of the Supervision Appeals Review Committee of the �౦��Ϸ���� dated December 31, 2003.