How big gambles took down small banks

— -- Last year, the Bank of Clark County in Washington state was riding high.

In January, it was named "Business of the Year" by the Better Business Bureau of Oregon and Southwest Washington. In February, it won a "Better Workplace Award" from the Association of Washington Business. And in July, it received Portland Business Journal's "Lighthouse Award" for being one of the region's fastest-growing companies. The bank — a 9-year-old institution with about 90 employees — seemed a model for business in the Pacific Northwest.

This year, on Jan. 16, federal regulators seized the Bank of Clark County (BCC), making it the first bank to fail in Washington state since 1993. The Federal Deposit Insurance Corp. said the failure would cost it up to $145 million.

BCC's story isn't unique. It provides a glimpse of the pockets of vulnerability within smaller banks across the U.S. financial system, which already is strained by massive losses at large banks that are draining the nation's resources.

BCC, like several other recently failed banks, chased growth using unreliable sources of funding to finance the real estate bubble. It proved to be a toxic, unsustainable combination that led to the bank's demise.

"Banks were swept by the 'get big fast' fever, and very basic fundamentals of risk management went by the wayside," says Ali Tarhouni, professor at the Michael G. Foster School of Business in Seattle.

While BCC's problems were mirrored elsewhere, some other banks took it further, opening out-of-state loan offices in hot real estate markets such as California and Florida and even Idaho and Utah, scouring for growth.

"The majority of the failed banks were either migrating their books into high-risk loans such as construction and home equity, or moving to places outside of their comfort zone," says Joshua Siegel, managing principal of New York-based private equity firm StoneCastle Partners, which invests in community banks.

The list of casualties is growing.

During the first three months of 2009, 21 banks failed, compared with just two bank failures during the first quarter of last year and one during that period in 2007. In its latest quarterly report, the FDIC's list of problem institutions included 252 banks at the end of 2008, compared with 76 at the end of 2007.

Mike Worthy, BCC's CEO until it failed, said in an interview that he was "as proud as I could possibly be" of the bank he founded in 1999. He declined to discuss circumstances or reasons behind the failure, other than to say, "It's beyond my worst nightmare."

Perils of 'hot money'

Federal filings show BCC grew quickly to $441 million in assets — loans, deposits and investments — at the end of 2008, from $40 million at the end of 1999.

Outwardly, BCC appeared to be another success story in community banks, a locally focused institution that drew on deposits from the surrounding area in Vancouver, Wash., and lent that money to nearby businesses.

However, that was only partly the case. Although it had just one branch for much of its existence, more than one-third of BCC's deposits came from out of state in the form of brokered deposits.

These deposits are called "hot money" in the banking industry because they're directed through brokerage firms that chase the highest yields on certificates of deposit at federally insured institutions. The money often stays at the bank only until the CDs mature, so banks that depend heavily on such deposits to fund their lending can be vulnerable to cash shortfalls.

Many bankers, who were desperate to grow and couldn't gather deposits from their branches as fast as they wanted to write loans, found brokered deposits an easy well to turn to.

"Funding with hot money is a dead end — because when those deposits are pulled, you get into a liquidity crisis like the Bank of Clark County, where the FDIC had to step in overnight to close it down," says Ray Davis, CEO of Umpqua Bank in Portland, Ore., which took over BCC's two branches in February.

The other problem was that BCC also had made a big bet on real estate, making its loan portfolio extremely risky.

At the end of 2008, 33% of its loans were tied to real estate construction. By comparison, overall at U.S. commercial banks, construction loans make up 8% of their total loans. And at banks that have less than $1 billion, construction loans make up about 15% of the total.

A market's sudden fall

Vancouver, the Clark County city where the bank was based, is on the north bank of the Columbia River, the boundary between Oregon and Washington.

As a bedroom community to Portland, the area is one of the country's fastest-growing in recent years. Clark County's population swelled to 1.9 million in 2008 from 345,200 in 1990, driving a boom in residential and commercial construction.

However, what BCC's executives missed was that Clark County's economy and real estate market started to sour ahead of the rest of the country. Building permits — often a good leading indicator for the real estate market — didn't post an annual decline nationwide until 2006, and posted gains of 8.7% in 2004 and 6.1% in 2005, according to the U.S. Census Bureau.

But in Clark County, building permits starting falling in 2004 with a 6.5% decline, followed by a 2.2% drop in 2005. In 2008, when permits fell 35.3% nationwide, Clark County's drop was 42.7%.

Unemployment also outpaced the U.S. rate, accelerating from 6.4% in 2005 to 8.6% at the end of 2008, vs. the rise from 5.1% to 6.6% nationwide in that period.

Meanwhile, BCC continued to lend heavily, and soon, serious signs of strain started to show in its loan portfolio.

In early 2005, BCC had $186 million in loans, and just $956,000 of those, 1% of the portfolio, were bad, or at least 30 days behind on payments.

However, by the end of 2008, BCC's loan portfolio had jumped to $403 million, and borrowers were behind on payments totaling $74 million — nearly 18% of the portfolio — with $48 million of that more than 90 days past due, at which point most banks consider them uncollectible.

Growth fuels problems

Several banks across the USA followed a similar path to failure, sharing the common thread of hunger for growth. Among them:

•ANB Financial, Rogers, Ark. In the mid-1990s, northwest Arkansas was being reshaped by Wal-Mart, now the No. 1 retailer. "Our original office was across the street from Wal-Mart's headquarters," says Victor Evans, ANB's former chairman.

From just $5 million in assets in 1994, the bank grew quickly, catering to employees of Wal-Mart suppliers. However, ANB's growth soon plateaued and deposits slowed, so it began relying on out-of-town brokered deposits. By the time the FDIC seized ANB on May 9, 2008, ANB's brokered deposits totaled $1.58 billion, or 87% of total deposits.

ANB also opened loan offices in Wyoming, Idaho and Utah, scouring for growth, and started writing riskier construction and development loans. The bank's assets surged from $500 million in 2004 to $2 billion in 2008.

By March 31, 2008, just months before ANB failed, 77% of its loans were in construction and land development. That compares with 15% for a bank of its size nationwide. Of those loans, more than half were in Utah, Idaho, Nevada and California.

"When you go out to unfamiliar territory, there are information gaps, and you are bound to make loans based on poor information," says Tim Yeager, an associate professor of finance at the University of Arkansas.

•Franklin Bank, Houston. When Lewis Ranieri decided to invest in this little Texas bank in April 2002, financial trade publications called it a bank to watch. Ranieri is a Wall Street legend and widely credited with having founded the market for mortgage-backed securities.

At the time Ranieri became its chairman, Franklin had barely $50 million in assets. Originally based in Austin, Franklin was dubbed "Austin's hometown bank." It proclaimed in a press release its ambition to "become one of the strongest community banks with local ownership."

That's not what happened. Franklin did buy a few Texas banks, but within two years, it also set up offices to sell mortgages in California, Florida and Arizona, three of the states that today have the highest foreclosure rates. The bank's assets soared to $5.1 billion, but in 2007, it saw its loans defaulting at a high rate.

In February 2008, the bank conducted an internal audit investigation, and in May said it had found several accounting errors, including various mortgage-related defaults that it didn't write down on its books.

Franklin's past-due loans ballooned from $100 million at the end of 2006 to $740 million at the end of September 2008, before it was taken over by the FDIC in November. Ranieri, who is CEO of private investment adviser Ranieri & Co., declined to comment.

•Riverside Bank of the Gulf Coast, Cape Coral, Fla. On the Gulf Coast in southwest Florida, Cape Coral was named one of the 10 best places to live by Money magazine in 2006. The median price of a home had soared 168%, to $281,000, from 2000 to 2005.

Riverside Bank boomed; assets rose from $100 million in 2000 to $527 million in 2005. Its loan portfolio grew from $79 million to $375 million; 97% of its loans were in residential and commercial real estate.

However, local deposits were not rising as fast as loan demand, so Riverside started accessing brokered deposits. At first, it was just a little — $34 million, or 8% of its total deposits in 2005, compared with none in 2000. But its reliance on "hot money" grew, and at the end of 2006, brokered deposits were $56 million, 13% of total deposits. By the end of 2008, these deposits were $142 million, or 33% of the total.

When the real estate bubble burst, Florida led the nation in foreclosures. In Cape Coral, median home prices flattened in 2006 and have since fallen 24%, to about $212,000.

Riverside followed the decline. In 2005, loans delinquent for more than 30 days made up $1 million of the bank's $375 million loans. By 2007, delinquent loans ballooned to $26.2 million out of $405 million. As losses mounted, the bank closed four of its 13 branches and fired its CEO in June 2008. At the end of 2008, delinquent loans had grown to $86 million; total loans had fallen to $373 million.

On Feb. 13, the FDIC seized Riverside Bank's nine branches and gave the keys to TIB Bank of Naples, Fla. The cost to the FDIC: $201.5 million.

Analysts expect bank failures to escalate the rest of this year. Research firm Foresight Analytics expects more than 100 failures in 2009. "With the economic meltdown in full swing, many small banks will go by the wayside," says Seattle professor Tarhouni.