Popular in Course
verified elite notetaker
Popular in Business
This 36 page Document was uploaded by an elite notetaker on Monday December 21, 2015. The Document belongs to a course at a university taught by a professor in Fall. Since its upload, it has received 10 views.
Reviews for Material-Loss-Review-of-Eastern-Financial-Florida-Credit-Union
Report this Material
What is Karma?
Karma is the currency of StudySoup.
You can buy or earn more Karma at anytime and redeem it for class notes, study guides, flashcards, and more!
Date Created: 12/21/15
NATIONAL CREDIT UNION ADMINISTRATION OFFICE OF INSPECTOR GENERAL MATERIAL LOSS REVIEW OF EASTERN FINANCIAL FLORIDACREDIT UNION Report #OIG-10-04 May 5, 2010 PREPARED FOR THE NATIONAL CREDIT UNION ADMINISTRATION OFFICE OF INSPECTOR GENERAL BY CROWE HORWATH LLP CONTENTS Section Page EXECUTIVE SUMMARY 1 INTRODUCTION AND BACKGROUND 4 OBJECTIVES, SCOPE AND METHODOLOGY 6 RESULTS IN DETAIL 8 Why Eastern Financial Credit Union Failed 8 Florida State Supervisory Authority and NCUA Supervision of Eastern Financial Florida Credit 22ion Findings and Suggestions 29 APPENDICES 32 A NCUA Management Comments 32 B Acronyms 34 i Material Loss Review of Eastern Financial Florida CreditUnion OIG-10-04 EXECUTIVE SUMMARY The National Credit Union Administration (NCUA) Office of Inspector General (O IG) contracted with Crowe Horwath LLP (Crowe) to conduct a Material Loss Review (MLR) of Eastern Financial Florida Credit Union (Eastern Financial or EFFCU), a federally insured state-chartered credit union (FISCU). The material loss review objectives were to (1) determine the cause(s) of EFFCU’s failure and the resulting loss to the National Credit Union Share Insurance Fund (NCUSIF), and (2) assess supervision of the credit union. To achieve these objectives, we analyzed NCUA and Florida State Supervisory Authority (Florida SSA) examination and supervision reports and related correspondence; interviewed management and staff from NCUA Region III and the Florida SSA; and reviewed NCUA and Florida SSA guides, policies and proced1res, NCUA Call Reports, and NCUA Financial Performance Reports (FPRs). This report does not make recommendations but provides observations and suggestions. As major causes, trends, and common characteristics of financial institution failures are identified in OIG MLR reviews, the OIG will communicate those to management for its consideration. As resources allow, the OIG may also conduct more in- depth reviews of specific aspects of the NCUA’s supervision program and make recommendations, as warranted. Florida SSA and NCUA examiners determined and we agree that EFFCU’s Board and management ignored sound risk management principles by: • Exposing the credit union’s net worth to a significant amount of risk due to investments in complex Collateralized Debt Obligations (CDOs) without management and the Board having sufficient expertise to understand and manage the risk of the CDOs. • Implementing a growth strategy that was unsustainable in the current market environment. • Not adjusting the Board and management’s ability to handle the growth and sophistication of the Credit Union’s activities, including complex CDO investments and construction and development (C&D) lending. • Not implementing adequate steps to address the regulatory actions nor address the deterioration of the CAMEL ratings. • Operating inefficiently with excessive operating expenses and a reliance on contracts for third-party providers. 1Section III of Crowe’s report provides further details on the Objectives, Scope , and Methodologies utilized. 1 Material Loss Review of Eastern Financial Florida CreditUnion OIG-10-04 Eastern Financial’s management and Board did not practice sound risk management and created an environment of excessive spending, rapid expansion, increased concentration risk, and a flawed overall strategic plan that put increasing pressure on the credit union to produce higher levels of revenue. As EFFCU’s profitability lagged its asset growth, management and the board approved a leverage strategy to make significant investments in CDOs funded by short term borrowings without fully understanding the interest rate and credit risks associated with such complex investments and exposed EFFCU’s net worth. Management allowed the CDO investment exposure to represent a significant concentration compared to net worth over a short period of time and failed to impose practical limits in the complex and risky investments. Once the investments deteriorated in value, EFFCU management had no course of action for proper divestiture of the assets, even when the investment grades fell below permissible levels per Florida statutes. Eastern Financial suffered substantial losses in the CDO investments during 2007 and 2008 that, coupled with increasing loan losses and other contributing operating factors, quickly eroded the credit union’s net worth and lead to its insolvency. Eastern Financial purchased $94.8 million in CDOs from March 2007 to June 2007 funded by short term borrowings, which brought the total investments in CDOs to $149.2 million. Most of these CDOs deteriorated rapidly in value once purchased. Unrealized losses, eventually recognized through earnings as of September 30, 2007, were $63.4 million. By early 2009, twelve CDOs were completely written off for a $106 million loss the remaining CDOs had a $43.2 million book value with unrealized losses totaling $37.9 million. In the end, EFFCU essentially charged off all eighteen CDO investments, resulting in losses of $149.2 million between June 2007 and June 2009, when EFFCU was merged into Space Coast Credit Union by the NCUA. Management also allowed numerous regulatory violations in the area of member business loan (MBL) limits, with C&D loans representing over 40 percent of net worth. Management failed to properly classify two large loans as C&D loans on quarterly call reports. The credit union experienced increasing delinquencies and loan losses, suffering especially large losses on two larger C&D loans. Eastern Financial’s participation in a Centrix participation program also contributed to overall deteriorating credit quality and increased loan losses. Eastern Financial management had allowed several years of rapidly increasing operating expenses and inefficient operations. During the 3 year period from June 2004 through June 2007, EFFCU grew its assets by $400 million, for a 25 percent increase during that period. By February 2008, the Chief Executive Officer had resigned and the Board’s inability to find a suitable replacement left 2Centrix Financial, LLP loan participation program where Centrix acted as marketer, underwriter, and servicer for EFFCU in an indirect automobile loan program designed for credit-impaired and sub-prime borrowers. 2 Material Loss Review of Eastern Financial Florida CreditUnion OIG-10-04 the institution without qualified leadership until being placed into conservatorship by the Florida SSA in April 2009. NCUA and Florida SSA Supervision of Eastern Financial Stronger supervisory action earlier in the institution’s aggressive growth st rategy and CDO investment strategy may have influenced EFFCU’s Board and management to limit the significant level of risk assumed during the institution’s rapid growth period. It may also have established a more appropriate supervisory tone and prompted the Board and management to take more timely and adequate action to address examiner concerns, thereby mitigating, to some extent, the losses incurred by the NCUSIF. Observations made as a result of our review of EFFCU’s failure include: • We believe examiners should have deemed the planned CDO investment activity as a higher risk warranting greater supervisory efforts, especially given that the CDOs were not typical investments held by natural person credit unions. Eastern Financial was the only FISCU to invest in CDOs. We further believe that the Florida SSA could have benefited from seeking additional expertise, possibly utilizing outside consultants, to help evaluate the complex securities in which EFFCU planned to invest. • Florida SSA and NCUA examiners and officials did not appear to fully understand the severity of the risks associated with thepurchases of the 18 CDO investments, nor does it appear that examiners performed further evaluation of CDO investments as would have been required under the NCUA Examiner’s Guide. • Eastern Financial’s management and Board exposed the credit union to excessive risks by not placing prudent limits on CDO sectors. Furthermore, the lack of reasonable limits on the CDO exposure was found to be the major factore lading to the large mark-to-market losses in the investment portfolio and continued write downs of the CDOs. Reasonable measures would have included lower limits for the CDO sector and further limits on underlying collateral exposure as % of net worth. • We believe the NCUA and Florida SSA could have benefited from more active dialogue and more detailed workpapers during the supervision of this FISCU due to its size and complexity. Of particular focus should be encouraging or requiring more communication and analysis of credit union requests to purchase complex investments that are not typical of natural person credit unions. We appreciate the courtesies and cooperation NCUA and Florida SSA management and staff provided to us during this engagement. 3 Material Loss Review of Eastern Financial Florida CreditUnion OIG-10-04 INTRODUCTION AND BACKGROUND The National Credit Union Administration (NCUA) Office of Inspector General (OIG) authorized Crowe Horwath LLP (Crowe) to conduct a Material Loss Review (MLR) for the Eastern Financial Florida Credit Union (Eastern Financial or EFFCU), as required by Section 216 of the Federal Credit Union Act (FCU Act), 12 U.S.C. 1790d(j). Eastern Financial was chartered as a federal credit union in 1937 to serve the employees of Eastern Airline Transport Company working in or out of Miami, Florida, and their immediate family members. In November 2001, EFFCU converted to a federally insured state-chartered credit union (FISCU) serving Eastern Airlines and numerous other select employee groups. Eastern Financial added several Florida counties to their field of membership between 2002 and 2006. As of March 21, 2009, EFFCU served approximately 208,000 members. Eastern Financial received a composite CAMEL 3 composite rating of 2 4 for annual 5 examinations and insurance reviews performed by the Florida State Supervisory Authority (Florida SSA) and NCUA from June 2003 through March 2007. During the September 30, 2007 annual joint examination and insurance review, the composite 6 CAMEL was downgraded to a CAMEL 3 , with a management component rating of 4. EFFCU’s net worth ratio declined from over 11 percent in 2004 to 9.7 per cent as of September 30, 2007, with examiners citing the decline being caused by high operating expenses and marginal earnings. The insurance review noted concerns with the CDO investment portfolio, which was severely distressed and illiquid due to adverse market conditions. The commercial loan portfolio was also noted as a growing concern with 40 percent of member business loans in construction and development (C&D) loans. Th e weakening economy in Florida and the decline in value of real estate securing the C&D loans were noted as additional threats to EFFCU’s net worth. Delinquency and loan 3 The acronym CAMEL is derived from the following components: [C]apital Adequacy, [A]sset Quality, [ M]anagement, [E]arnings, and Asset/[L]iability Management. See 61 Federal Register 67021 (12/19/1996) – Federal Financial 4nstitutions Examination Council-Uniform Financial Institutions Rating System (UFIRS). 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 5imited. During an insurance review in a FISCU, NCUA examiners limit their role to the review and analysis of existing or 6otential risks to the NCUSIF only, rather than to complete an examination of the FISCU. 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 CAMEL 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 composi te 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. 4 Material Loss Review of Eastern Financial Florida CreditUnion OIG-10-04 losses were increasing and expected to continue rising due to the weakened economy , coupled with expected uncertainty on further declines in the CDO portfolio. Table 1 (below) provides a timeline of significant events related to EFFCU. Table 1 Timeline of Significant Events September 2005 EFFCU management and Board approved investments in CDOs March 2007 EFFCU management and Board approved expansion of CDO investment strategy to include CDOs backed by HEL ABS May 2007 (Effective NCUA performed ALM and Investment contact, which Date - March 2007) identified significant planned purchases of CDOs September 30, 2007 EFFCU CAMEL composite rating downgraded to “3” December 2007 EFFCU was assigned to NCUA Division of Special Actions January 25, 2008 Joint Letter of Understanding & Agreement Issued February 2008 EFFCU CEO permitted to resign December 18, 2008 Florida SSA Issued Temporary Cease & Desist March 19, 2009 Florida SSA Issued Permanent Cease & Desist April 24, 2009 EFFCU Placed into conservatorship June 30, 2009 NCUA merges EFFCU into Space Coast Credit Union As a result of the significant findings and numerous outstanding issues related to the DOR issued during the September 30, 2007 examination and insurance review, a joint Letter of Understanding and Agreement was signed on January 25, 2008. At the September 30, 2008 insurance review, EFFCU was further downgraded to a CAMEL composite 4, 7with examiners citing EFFCU’s continued declining financial trends associated with large losses on the CDO investments, deteriorating asset quality, Bank 8 Secrecy Act and Office of Foreign Assets Control violations, and their inability to hire a permanent CEO. 7CAMEL composite rating “4” under UFIRS - Financial institutions in this group generally exhibit unsafe and unsound practices or conditions. There are serious financial or managerial deficiencies that result in unsatisfactory performance. The problems range from severe to critically deficient. The weaknesses and problems are not being satisfactorily addressed or resolved by the board of directors and management. Financial institutions in this group generally are not capable of withstanding business fluctuations. There may be significantnoncompliance with laws and regulations. Risk management practices are generally unacceptable relative to the institution's size, complexity, and risk profile. Close supervisory attention is required, which means, in most cases, formal enforcement action is necessary to address the problems. Institutions in this group pose a risk to the deposit insurance fund. Failure is a 8istinct possibility if the problems and weaknesses are not satisfactorily addressed and resolved. The Office of Foreign Assets Control (OFAC) is an agency of the United States Department of the Treasury under the auspices of the Under Secretary of the Treasury for Terrorism and FinanOFAC administers and foreign states, organizations, and individuals.U.S. foreign policy and national security goals against targeted 5 Material Loss Review of Eastern Financial Florida CreditUnion OIG-10-04 On March 19, 2009, the Florida SSA issued a permanent and published Cease and Desist Order, Board Resolution, and Stipulation due to the expiration of the effective date of the previously issued temporary Cease and Desist and the existence of many other issues not addressed in the temporary Cease and Desist. The permanent Cease and Desist addressed severe deficiencies in board and management oversight, inadequate maintenance of capital, deterioration of asset quality, inadequate liquidity, and excessive levels of concentrations in the member business loan portfolio. On April 24, 2009, the Florida SSA placed EFFCU into conservatorship as they were determined to be significantly undercapitalized with no reasonable prospect of becoming adequatelycapitalized. The Florida SSA immediately appointed NCUA as agent for the conservator. The Florida SSA cited the following reasons for the conservatorship action: • The credit union does not have sufficient earnings, and has no effective capital maintenance plan to halt the rapid depletion of net worth; • The credit union is operating without adequate core deposits to ensure it can meet financial obligations as they become due without the mandatory use of borrower funds. • The credit union is operating without effective leadership, oversight, executive management supervision, and direction from the Board of Directors. The NCUA merged EFFCU into Space Coast Credit Union effective June 30, 2009. The estimated loss to the National Credit Union Share Insurance Fund (NCUSIF) was approximately $40 million. OBJECTIVES, SCOPE, AND METHODOLOGY We performed this material loss review to satisfy the requirements of the FCU Act which requires the NCUA OIG 9o conduct a material loss review if the loss to the NCUSIF exceeds $10 million. NCUA notified the OIG of a loss reserve for EFFCU of approximately $41 million. Consequently, in accordance with the FCU Act and Chapter 3 of the NCUA Special Assistance Manual, NCUA OIG contracted with Crowe to conduct a material loss review of EFFCU. Our material loss review objectives were to (1) determine the cause(s) of EFFCU’s failure and the resulting loss to the NCUSIF, and (2) assess NCUA’s supervision of the cr edit union. We conducted this review from November 2009 to April 2010 in accordance with generally accepted government auditing standards. Those standards require that we plan and perform the review to obtain sufficient, appropriate evidence to provide a 9The FCU Act, 12 U.S.C. § 1790d, §216(j) requires that the OIG conduct a review when the NCUSIF has incurred a material loss with respect to a credit union. A material loss is defined as (1) exceeding the sum of $10 million and (2) an amount equal to 10 percent of the total assets of the credit union at the time at which the Board initiated assistance or was appointed liquidating agent. 6 Material Loss Review of Eastern Financial Florida CreditUnion OIG-10-04 reasonable basis for our findings and conclusions based on our review objectives. We believe that the evidence obtained as described in the Scope and Methodology section, provides a reasonable basis for our findings and conclusions based on our review objectives. The scope of this review included an analysis of EFFCU from June 30, 2004 until it was placed in conservatorship on April 24, 2009. Our review also included an assessment of Florida SSA and NCUA regulatory supervision of the institution during the same period. To achieve the objectives, we performed the following procedures and utilized the following techniques: • We analyzed NCUA and Florida State Supervisory Authority (SSA) examination and supervision contact reports and related correspondence (workpapers contained within the AIRES 10 system). • Interviewed management and staff from NCUA Region III and the Florida SSA; and reviewed NCUA and SSA guides, policies and procedures, NCUA Call Reports, and NCUA Financial Performance Reports (FPRs). • Reviewed EFFCU data and correspondence maintained at the NCUA Region III office in Atlanta, GA as provided to Crowe by NCUA. Crowe relied primarily upon the materials provided by the NCUA OIG and NCUA Region III officials and examiners, including information and other data collected during interviews. Crowe did not perform specific review procedures to ensure the information and data were complete and accurate. Interviews were conducted to gain a better understanding of decisions made regarding the activities of the credit union management and the supervisory approach and to clarify information and conclusions contained in reports of examination and other relevant supervisory correspondence between the NCUA, Florida SSA and EFFCU. Crowe relied on the information provided in the interviews without conducting additional specific review procedures to test such information. 10 NCUA’s Automated Integrated Regulatory Examination Software. 7 Material Loss Review of Eastern Financial Florida CreditUnion OIG-10-04 RESULTS IN DETAIL Why Eastern Financial Florida Credit Union Failed Eastern Financial’s failure can be attributed to inadequate management and Board of Directors (Board) oversight that exposed the credit union to excessive amounts of risk due to investments in complex private-placement Collateralized Debt Obligations (CDOs), weak business loan underwriting and credit administration, poor earnings resulting from an aggressive growth strategy, and an inadequate strategic plan. The most significant losses suffered as a consequence to EFFCU’s inadequate management oversight were related to large investments made in CDOs backed by subprime home equity/auto loans and corporate debt. Eastern Financial’s management and Board performed limited analysis prior to approving the investments in CDOs and ongoing monitoring also appeared weak. Examiners determined that EFFCU management and Board relied too heavily on the ratings assigned to the CDOs by the 11 Nationally Recognized Statistical Rating Organization (NRSRO) . The credit union also had rapid growth in Construction and Development (C&D) loans through an EFFCU majority-owned Credit Union Service Organization (CUSO) in which CUSO and EFFCU management had limited expertise, as evidenced by significant losses and rapidly increasing delinquencies. These factors and others led to increased exposure to high risk investments and loans secured by subprime assets and commercial real estate property. Eastern Financial’s concentration of CDO investments and C&D member business loans left the credit union vulnerable to downturns in national and local economic conditions and the real estate market. Eastern Financial’s Board and management failed to adequately diversify the investment and loan portfolios. Moreover, the use of short-term borrowings to fund the CDOs, as well as an unusually high reliance on overdraft privilege (ODP) fees for earnings and inefficient operations, compounded the risks of the credit union. Table 2 (below) summarizes selected financial information for EFFCU. 11NRSRO is a credit rating agency which issues credit ratingsthat the U.S. Securities and Exchange Commission (SEC) permits other financial firms to use for certain regulatory purposes. 8 Material Loss Review of Eastern Financial Florida CreditUnion OIG-10-04 Table 2 Key Financial Data and Ratios (000's) Dec-05 Dec-06 Dec-07 Dec-08 Total Assets 1,908,465 2,348,141 1,832,050 1,638,660 Net Worth/Total Assets 10.62% 8.97% 8.21% 2.25% Impaired Assets/Net Worth 5.51% 5.43% 10.70% 123.76% Return on Average Assets (ROAA) 12 (Loss) 0.91% 0.38% (3.3%) (6.54%) Net Income (Loss) 16,309 8,107 (68,907) (113,463) CDO Leverage Strategy Summary Florida SSA and NCUA examiners determined, and we agree, that EFFCU management and Board failed to perform adequate due diligence and establish appropriate limits and controls on investments in CDOs backed by home equity loan (HEL) asset-backed securities (ABS) and other subprime collateral. Specifically, examiners noted that EFFCU management and Board: • Relied too heavily on rating agencies’ grading of CDO investments , • Failed to fully evaluate and understand the complexity of the CDO investm ents, and • Created a concentration risk by investinga total of eighteen CDOs for $149 million, of which nearly $100 million were backed by HEL ABS. Eastern Financial failed to fully understand the complexities of the structured finance CDOs and appeared to rely too heavily on the historical performance of the underlying collateral, as was determined by the rating agencies. Furthermore, once the investments began deteriorating in value, EFFCU policy did not incorporate di vestiture based on value declines. Rather, the policy focused on investment grade decreases to prompt divestiture. This resulted in EFFCU holding the CDOs and taking enormous 12 The Return on Average Assets ratio is annualized net income divided by average assets for the period. 9 Material Loss Review of Eastern Financial Florida CreditUnion OIG-10-04 write downs. By the time the investments were downgraded, there was little or no opportunity for the credit union to divest the illiquid assets. CDO Investments Examiners determined that EFFCU’s investment in CDOs initially began in December 2005. Eastern Financial had requested the Florida SSA approve whether CDOs would be permissible investments during September 2005. The Florida SSA provided a response letter, dated September 13,2005, to EFFCU statingthat CDOs collateralized by loans such as motor vehicle, credit card, home equity or other bank loans were permissible investments. A copy of the letter was provided to NCUA in September 2005. In their response letter, the Florida SSA concluded that “since CDOs have characteristics similar to corporate bonds, which are permitted under Section 657.042(7)(b), it appears the investment in CDOs would be permissible.” The Florida SSA also stated in the letter that Section 657.042 (7)(a) requires appropriate policies, as follows: • The Board of Directors must establish comprehensive policies on investments in CDOs. The policies should dictate limits on CDOs, limits on the underlying collateral in the CDOs, and appropriate documentation to substantiate the legality, credit and investment risk; • The CDOs must meet the credit quality ratings specified in Section 657.042(7)(a), Florida Statutes; • Credit union must maintain a current credit file for each CDO, containing sufficient information to determine whether the investment complies with the credit quality section of Section 657.042(7)(b), Florida Statutes. If the investment fails to comply with the credit quality requirements, the credit union must divest itself of the investment; and • Total investment in CDOs would be limited to the percentage limits of Section 657.042(3)(b), Florida Statutes. The Florida SSA’s letter concluded with language that it was approving the legality of the investment pursuant to governing regulations and didnot express opinion of the quality or acceptability of the investment. The SSA also stated it: “neither endorses nor recommends investment in Trust CDOs” and that the “credit union must know what it is acquiring, its ramifications, impact on liquidity, and the risk associated with this particular investment.” 10 Material Loss Review of Eastern Financial Florida CreditUnion OIG-10-04 The letter also stated that the SSA would: “expect due diligence on each CDO to ensure the Board of Directors and management thoroughly understand the intended security and that the investment’s risk characteristics are consistent with the credit union’s overall investment objectives, policies, and business goals.” We believe the Florida SSA’s letter should have prompted EFFCU’s Board to perform stronger due diligence on each CDO security purchased. However, EFFCU’s investment committee did not perform adequate due diligence on the CDO purchases, as recommended by the SSA’s letter, nor did EFFCU’s CDO investment policy reflect prudentlimitsonunderlyingcollateral. CDO Purchase Activity In November 2006, the EFFCU Board approved a change to the credit union’s investment policy to allow investment in private label mortgage backed securities (MBS). Expanding the acquisition of HEL ABS CDOs was further approved at EFFCU’s March 3, 2007 Board Investment Committee Meeting. All acquisitions were to be AA or A rated by the rating agencies, as required by EFFCU’s investment policy. Purchases in CDOs were at relatively modest levels until early 2007, when EFFCU dramatically expanded their planned CDO investment strategy. From March 2007 to June 2007, EFFCU purchased an additional $94.8 million in CDOs. Chart 1 (below) illustrates EFFCU’s CDO investment growth through June 2007, when new purchases were suspended. Chart 1: CDO Investment Growth Thousands $160,000 $140,000 $120,000 $100,000 $80,000 Exposure $60,000 $40,000 $20,000 $- 11 Material Loss Review of Eastern Financial Florida CreditUnion OIG-10-04 In respect to the CDO strategy, examiners determined that EFFCU management and Board: • Failed to place reasonable or prudent limits on CDOs or the types of underlying collateral; • Had weak investment policy and committee oversight regarding CDOs; • Lacked Board/investment committee expertise; • Allowed large purchases of CDOs over a short period of time, putting net worth at risk to a large concentration of CDOs, and • Failed to account for large risks in monitoring investment decisions (like a nationwide collapse of housing values). NCUA examiners reported that EFFCU sold $301 million of fixed-rate CMOs and MBS during March 2007 at a net gain of $1.7 million. The sales proceeds were used to payoff short-term borrowings and reduce balance sheet leverage and market risk. From that point forward, the credit union’s investment/leverage strategy shifted to a focus on purchasing CDOs funded by short-term borrowings. Several CDO purchases early in the strategy were backed by corporate bonds. Examiners considered the corporate bond CDOs were not exposed to sub-prime residential mortgage loans that experienced much less market value losses than the 2007 CDO purchases backed by HEL ABS. Initial purchases of CDOs backed by HEL ABS had also initially performed better as the underlying loans were originated in 2005. During the March –June 2007 timeframewhen EFFCU purchased $94.8 million in CDOs, examiners reported that spreads realized over 3 month LIBOR 13 widened considerably. The examiner noted that A-rated CDO spreads ranged from 325-450 basis points and AA-rated CDO spreads realized 130-300 basis points. As such, most of these CDOs deteriorated rapidly in value once purchased. However, we believe that readilyavailable market data existed that should have prompted EFFCU management and Board to further evaluate planned CDO purchases during early 2007, or at least to have limited exposure to types of underlying collateral. In industry circles, it is reasonable to expect prudent management would have reviewed such readily available market data. Since CDOs historically paid higher yields than corporate bonds, EFFCU management and the Board should have understood that higher yields came from taking greater risk associated with uncertainties and risks associated with the CDOs. 13The London Interbank Offered Rate (LIBOR) is a daily reference rate based on the interest rates at which banks borrow unsecured funds from other banks in the London wholesale money market. 12 Material Loss Review of Eastern Financial Florida CreditUnion OIG-10-04 Additional CDO purchases were eventually suspended on June 22, 2007, but EFFCU had already purchased $149.2 million. The August 28, 2007 Internal Investment Committee Minutes stated that the market began to turn in mid-June when news came out indicating Bear Stearns’ hedge funds with sub-prime exposure were being seriously impacted by margin calls. Market conditions for CDOs with sub-prime exposure became increasingly distressed and illiquid and remained so in 2008 and beyond. The estimated market values for EFFCU’s CDOs at September 30, 2007 reflected unrealized market value losses on CDOs of $63.4 million, which amounted to 42 percent of the CDOs’ book value at that point in time. Even before the crash of the CDO market, it was apparent that there were real risks and difficulties in valuing CDOs. We believe management and the Board should have recognized that even though they purchased eighteen different securities, the CDOs were quite similar and provided little diversification. Management and Board oversight of CDO Investment Strategy Based on reviews of EFFCU’s Investment Committee minutes and discussions with examiners, little evidence exists to indicate that management and the inv estment committee performed extensive analysis regarding the decisions to approve CDO investments for purchase. Furthermore, the Board and management allowed EFFCU to purchase large amounts of CDOs within a short period of time without prudent limits being in place. Credit Union management and the Board looked at CDOs as an opportunity to increase earnings (yields) without fully understanding the dramatic market decreases that could occur given the riskiness of the underlying collateral of the CDOswhich consisted of home equity lines of credit (HELOCs) and other subprime loan products. We believe additional readily available market intelligence existed that management could have used as part of performing proper due diligence and addressing the issues raised in the Florida SSA letter on CDO permissibility. A CDO Primer published in 2004 by Bond Market Association (now the Securities Industry and Financial Management Association), described the benefits of investing in CDO’s and their risks. (Note: This was published before the CDO market collapsed.) The following are risks specifically cited as associated with CDO’s: • Systemic or modeling risk: Investors should complete a thorough review with respect to: o the appropriateness of the statistical models employed by the rating agencies and; o the accuracy and reasonableness of the default and recovery data. • Collateral credit risk: Investors should assess the collateral risk of the pool. 13 Material Loss Review of Eastern Financial Florida CreditUnion OIG-10-04 • Structural risk: Investors should perform a breakeven analysis to d14ermine the amount of collateral net losses that can occur before a tranche becomes cash flow impaired. Since CDOs represented a unique and new investment decision for EFFCU in 2005, we believe management and the board should have been able to consider readily available information such as the Bond Market Primer and other sources as part of the due diligence process on CDOs. Eastern Financial invested in private placement CDOs which provided less readily available market data to perform analysis and provide better understanding of underlying assets and grading system, tranches, etc. While EFFCU’s CDOs deteriorated rapidly in late 2007, management and the Board would have benefited from more extensive research prior to purchasing the CDOs. Such research and due diligence would have allowed EFFCU management and Board to understand the risk of loss due to subprime assets that were backing the securities. In August 2007, EFFCU’s Investment Committee minutes reflected a discussion by a portfolio manager who provided the Board with an update on issues in the CDO sector and the impact on their portfolio. The portfolio manager noted the following: “…intense analysis of the portfolio has taken place within the last two months. The 2006 vintage has not performed to historical norms because in late 2005 loan standards declined and individuals who did not qualify were being approved for loans, and as a result, hedge funds that were highly leveraged in these securities were forced to liquidate…” The portfolio manager further indicated that the “no liquidity” environment was expected to last through the end of 2007. He noted an approximate $50 million total (10 percent) drop in mark–to-market was expected in August2007, before a bottom-out was expected. Also during the August 2007 meeting, the investment committee, at the request of the CFO, reviewed and approved a significant expenditure to purchase Standard and Poor’s software to provide an additional tool to monitor and evaluate the CDO investments. We believe these are all steps that the credit union should have taken in the due diligence process prior to approving investment in the CDOs. Also, we believe that the Florida SSA and NCUA could have taken steps to ensure EFFCU management possessed the expertise and tools to evaluate CDOs when EFFCU initially requested whether CDOs would be permissible investments in 2005. 14Tranches are different "classes" of notes within a security that together make up what is referred to as the deal's capital structure or liability structure. Tranches are generally paid sequentially from the most senior to most subordinate (and generally unsecured). The more senior rated tranches generally have higher ratings than the lower rated tranches. For example, senior tranches may be rated AAA, AA or A, while a junior, unsecured tranche may be rated BB. However, ratings can fluctuate after the debt is issued and even senior tranches could be rated below investment grade (less than BBB). 14 Material Loss Review of Eastern Financial Florida CreditUnion OIG-10-04 Examiners reported that EFFCU relied heavily on a modeling program produced by Western Corporate Federal Credit Union (WesCorp) in evaluating its asset/liability management (ALM) and more importantly, its CDO activity. Eastern Financial Investment Committee minutes noted that an August 31, 2007 WesCorp report highlighted the continuing “Headline” risk associated with the CDOs. The report stated that further declines in price were possible, which could contribute to an increase in interest rate risk. The minutes further stated the WesCorp report : “…does not address the underlying credit risk of the CDOs, and that interest rate risk would be impacted if their prices were to decline because of “credit” related issues…” We believe this suggests that EFFCU did not perform the required due diligence on CDO investments when they first expanded their investment policy and planned the investments, thus they failed to understand the significant credit risk and interest rate risk that the CDOs posed to EFFCU capital and net worth. Although addressed by EFFCU’s Investment Policy as required by the Florida SSA, NCUA examiners determined the CDO sector limits appeared to be imprudent , which allowed EFFCU to take excessive risk. Furthermore, the lack of reasonable limits on the CDO exposure was found to be the major factor leading to the large mark -to-market losses in the investment portfolio and continued write downs of the CDOs. NCUA examiners suggested, and we agree, that reasonable limits would have included lower limits for the CDO sector and further limits on underlying collateral exposure. Eastern Financial’s CDOs first started showing problems in June 2007 ($8 million charge off) but no formal risk management actions were put in place to evaluate potential further losses and mitigate continuing exposure. Eastern Financial’s July 21, 2007 Board minutes reflect a review of CDO investment activity and the portfolio for June 2007. The minutes of the Investment Committee meeting of June 16, 2007, were accepted as submitted, with notation that there was a CDO mark-to-market adjustment of $8 million in June. It was also noted that an analysis of securities was underway to look at the credit union’s possible exposure. Based on our review of these minutes and discussions held with examiners, we determined there was no further action taken or exploration by management or the Board to prevent further exposure to losses in the CDO portfolio. Examiner Review and Significant Deterioration of CDOs Examiners determined at the September 30, 2007 examination that management allowed the CDO investment exposure to represent a significant concentration compared to net worth over a short period of time. Additionally, examiners determined that EFFCU had increasing exposure to C&D loans that, once properly classified on Call Reports, represented over 40 percent of net worth in violation of Section 723.3 of NCUA Rules and Regulations. Substantial losses on the CDOs and MBLs, coupled 15 Material Loss Review of Eastern Financial Florida CreditUnion OIG-10-04 with extremely high operating expenses and other contributing factors, quickly eroded the credit union’s net worth in 2007 and 2008 that eventually lead to its insolvency. In February 2009, the NCUA Regional Capital Markets Specialist (RCMS) reported on EFFCU’s CDO activityand determined that initial purchases of CDO investments began in December 2005. The report identified a total of eighteen CDOs purchased through June 2007, totaling $149.2 million. All CDOs were assigned an AA or A- rating as required by EFFCU’s investment policy and Florida statute. Sixteen were residential mortgage backed CDOs, collateralized by HEL ABS. The remaining two CDOs were backed by corporate bonds. The RCMS report also confirmed the Florida SSA’s ruling from September 2005, which as previously noted, had provided a letter of approval for the permissibility of CDOs under Section 657.042(7)(b) of Florida Statutes. NCUA examiners determined, and we agreed, that EFFCU did not appear to be in compliance with the requirement to establish limits on underlying collateral in the CDOs. The only limits EFFCU included in their investment policy on CDOs was with regards to a maximum investment between $10 and $20 million per security depending on the investment grades ranging from A to AAA. Management Exposed Eastern Financial to Significant Credit Risk Background on Lending Activity In 2004 and 2005, the credit union generated significant loan growth (i n excess of 20 percent annually) through real estate lending, indirect and direct consumer loans, and member business lending. Over this same period, the credit union continued to maintain a high loan to share ratio as loan yields over this period steadily increased though the credit union’s overall net income did not. Credit Union Business Capital (CUBC) During 2005, EFFCU transferred all member business loan underwriting to CUBC a CUSO, which EFFCU initially wholly-owned. Our review of EFFCU Board minutes and the regulatory review of the CUSO from 2006 to 2007 indicated that the CUSO struggled to add new Credit Union members and EFFCU remained the majority owner. NCUA and Florida SSA examiner’s initial reviews of CUBC suggested strong underwriting, but it became apparent that underwriting was not as robust given the substantial losses on two larger MBLs underwritten by CUBC that became severely delinquent and lead to foreclosures and eventual charge-offs on loans to construction projects where the properties provided insufficient protection. Eastern Financial’s June 16, 2007 Board minutes indicated that CUBC continued to be behind budget and attributed this mostly to staffing issues and delays with loan 16 Material Loss Review of Eastern Financial Florida CreditUnion OIG-10-04 production. NCUA ’s Asset Management & Assistance Center and the Florida SSA performed a review of CUBC as of September 30, 2006. During this review, examiners found that CUBC estimated itwould have 130 credit union clients bySeptember 2007, but only had 13. The CUBC also had projected it would be profitable by mid-year 2006, but they continued to revise projections to suggest positive earnings would not be achieved until sometime beyond 2007. Based on interviews with NCUA examiners, CUBC did not produce a profit prior to EFFCU being placed into conservatorship. Examiners determined during the September 30, 2007 examination that part of the increase in yields was due to an increased loan to share ratio and emphasis of higher risk loans. Along with loan growth, EFFCU experienced a significant increase in overall loan delinquencies and loan charge-offs which translated into an increased provision for loan losses. Also at September 30, 2007, examiners determined that EFFCU’s commercial loan portfolio exceeded three of the maximum limitations set by Federal Regulations. Of more concern was the fact that 40 percent of the commercial loan portfolio (over $90 million) was C&D loans. Examiners cited the weakened real es tate market in Florida which amplified the threat to net worth and increased the credit union’s overall credit risk exposure. As the real estate market deteriorated and the economic environment weakened in Florida, management anticipated continued increases in delinquenc ies beyond September 2007. Despite this fact, examiners determined that management was still in the process of adding to the credit risk by decentralizing the lending function and increasing unsecured lower grade paper (“C”, “D” and “E”) loans. Eastern Financial had a large volume of mortgage products with high loan to value (LTV) ratios, which added to its increased credit risk profile during 2007. As of September 30, 2007, over 34 percent of the total mortgage loan portfolio represented loans with a LTV ratio exceeding 90 percent. Approximately8 percent of these were HELOC related loans (line of credit and credit card) where the credit union did not have a first lien. Examiners determined that the climate at September 30, 2007 reflected a real estate market slump that was not expected to recover any time soon. As a result, examiners recommended management obtain updated valuations of the properties securing loans issued over 12 months prior where loan to value ratios exceeded 90 percent at the time the loan was granted; especially if the credit union had a second lien on the property. Examiners further urged management to perform an analysis to determine the risk exposure of these loans and set up a specific reserve for this portfolio segmentation, if warranted. Regulatory Violations At the September 30, 2007 examination, examiners discovered that by not classifying land intended to be developed for income producing property as a C&D loan, EFFCU 17 Material Loss Review of Eastern Financial Florida CreditUnion OIG-10-04 understated total C&D loans resulting in a violation of federal regulations. Therefore, C&D loans were understated by approximately $61 million. Onceproperlyclassified, C&D loans totaled $91 million and represented 40.66 percent of net worth which exceed the 15 percent limitation by $57.4 million. Examiners determined two large MBLs became delinquent in late 2007. Although EFFCU management worked to foreclose on the properties, the ability of the credit union to obtain ownership was hindered by the overall volume foreclosures in the state of Florida and legal complexities with one of the properties. Approximately $51 million of the MBL balances remained on the delinquency report for the first three C all Report cycles in 2008. One of the larger MBLs in delinquent status was not properly classified in EFFCU’s Call Report resulting in an understated delinquent loan ratio. Specifically, the credit union’s September 30, 2007 FPR identified the credit union’s delinquent loan ratio at0.66 percent when it actually was 2.58 percent. Examiners determined the construction project was cancelled on the delinquent $30 million MBL. However, EFFCU continued to accrue interest at November 2007, despite the loan being 5 months delinquent and there being no more funds in the interest reserve. The NCUA examiner concluded that there was still sufficient equity in the property to cover principal and interest, but EFFCU was required to classify the loan as substandard and evaluate if there was a potential loss under FAS 114 and set-up a reserve if it was determined necessary. Examiners subsequently reported that this loan went to summary judgment in December 2008 and the loan in the amount of $30 million was transferred to Foreclosed and Repossessed Assets. The second loan for $19 million was in the process of foreclosure with summary judgment expected in the second quarter of 2009. Prior to merging EFFCU into Space Coast credit union, approximately $33million was charged off for both loans. There was no information on whether there were any recoveries related to those charged off loans. MBL Waiver Limit Requests Eastern Financial requested the Florida SSA and NCUA for several waivers from NCUA limits for MBLs set forth in Section 723.3(b) of NCUA Rules and Regulations, which require a borrower to have a minimum of 25 percent equity interest in the project being financed. One re quest was for a C&D loan where the borrower’s equity interest in the project was as low as 5percent. Through our review of examinerworkpapers (contained in AIRES) as well as discussions with examiners, we determined that NCUA examiners recommended that NCUA regional office deny the EFFCU MBL waiver requests. The examiner stated that approving this or other loan waivers that significantly depart from the requirements of the MBL regulations could establish an unsafe and unsound precedent. Nonetheless, several of the waivers were granted by NCUA and Florida SSA, allowing EFFCU to make MBLs to borrowers with less than the regulatory mandated 25 percent equity in the project. 18 Material Loss Review of Eastern Financial Florida CreditUnion OIG-10-04 A review of the March 30, 2007 EFFCU Board minutes also reflected a discussion by management and the Board to request approval from the Florida SSA to increase their business lending ceiling cap to 20 percent of total assets. We believe these types of waiver requests exemplify management and the Board’s willingness to circumvent regulatory limits in order to expand business lending activity, at the expense of putting the credit union’s financial stability and sound net worth position at risk. Centrix Participation Program Examiners reported that EFFCU management and the Board approved the participation up to 5 percent of assets or $70 million in a Centrix Financial, LLP loan participation program where Centrix acted as marketer, underwriter, and servicer for an indirect automobile loan program designed for credit-impaired and sub-prime borrowers. Florida SSA reviewed the program at the June 30, 2004 report. Loans under the Centrix program totaled $29.8 million by August 2004. Examiners noted that the Centrix Sub Prime Auto Loan Program was a high-risk program that required an increased level of monitoring by management and that borrowers were marginal, loan terms did not correspond with the age of collateral (e.g. 66 month loan for a 3 year old car) and interest rates were high. Examiners determined such loans would require constant m onitoring and verification of the reports and information provided by Centrix. Eastern Financial August 2007 Board minutes indicated the CFO made the Board aware of $3 million in charge offs expected in 2007 on the Centrix portfolio. The September 20, 2007 examiner informal discussion items included comments on the bankruptcy of Centrix, LLC in October 2006 that caused charge offs to more than double from September 2006 to September 2007, close to $2 million in that time period. Forgery and Loss on Member Business Loan During the September 30, 2007 examination, examiners noted a past due $22 million balloon loan that matured in October 2007. Examiners noted the borrowers were in the process of refinancing this loan through another credit union. Asof the exam, the borrowers were attempting to obtain a three-month extension from EFFCU. However, the following required documents had not been received to complete the extension: • Three month extension agreement (received November 15, 2007), • Executed contract (joint venture between borrower and new investor), • Commitment Letter from the take-out institution. Only a Letter of Interest was received, • $30,000 extension fee, and • $510,000 interest reserve to be deposited at the credit union. 19 Material Loss Review of Eastern Financial Florida CreditUnion OIG-10-04 On February 12, 2008, EFFCU was made aware of an alleged forgery in their $22 million loan for South Florida Properties. The loan was for the refinance of an existing mortgage held by Florida Community Bank, and to provide funds for closing costs and interest reserve. In legal documents presented to EFFCU, the managing member of South Florida Properties stated that all signatures on the loan were forged. He was seeking to rescind on the personal guaranty and mortgage. Some of the documents were notarized in Florida despite proof the borrower was at home in Connecticut. Additional Issues Providing Evidence of Poor Management and Board Oversight Outside of the large losses associated with CDOs and MBL activity, there were additional factors that raised EFFCU’s risk profile that further demonstrate the lack of effective management and Board oversight: • Costly Branch Expansions - Examiners noted EFFCU’s rapid branch expansion strategy dated back to 2004 with continuous branch expansions costing EFFCU significantly more than originally budgeted. For example, the very costly opening of EFFCU’s Sunrise branch and other planned expansions continued even as the credit union’s financial condition deteriorated. The June 16, 2007 Board minutes focused on the credit union’s need to control expenses, while the Board approved additional overruns on the Sunrise branch. Ultimately, the Sunrise branch opening cost EFFCU approximately $3.4 million, which represented $1 million to $1.5 million more than initially budgeted. • Reliance on Overdraft Privilege Fees - Examiners indicated that as EFFCU’s operating expenses were increasing significantly as early as 2001, EFFCU decided to offer overdraft privilege (ODP) as a member service and a profit center at the end of the first quarter in 2002. The resulting increase of fee income enabled management to increase operating expenses to such a high level that by 2007, EFFCU became significantly dependent on ODP as a source of income, which produced a positive return on average assets. As of September 30, 2007, ODP fee income represented an annualized 1.43 percent of average assets compared with the total return on average assets of 0.26 percent. ODP income accounted for roughly $20.2 million, or 65 percent of total fee income at September 30, 2007. • Lack of Management Succession Plan - A review of the March 30, 2007 Board minutes includes a discussion on a Succession Plan presentation that disclosed ten out of 36 key positions within EFFFCU did not have a named successor. There was no evidence of further discussion at the board level or what corrective actions were taken. This is of particular importance because EFFCU became subject to regulatory actions in late 2007 as the financial condition deteriorated, the CEO resigned after the Board signed an LUA in February 2008. However, EFFCU management and the Board were unable to fill the vacant CEO position. The position was offered to three individuals during 2008; however, all three 20 Material Loss Review of Eastern Financial Florida CreditUnion OIG-10-04 declined to take the position. The CEO position was never filled until EFFCU was placed into conservatorship, at which point EFFCU was being managed by officials from Space Coast Credit Union. • Service Contracts - Through the review of the due diligence process as part of the planned acquisition of EFFCU, NCUA officials determined Space Coast Credit Union had discovered that EFFCU had over 400 contracts in place with outside service providers. Further review of Space Coast and NCUA documentation on the planned acquisition determined that three of the largest contrac ts in place would cost roughly $8.5 million to terminate, since EFFCU had signed 5-year agreements with all of these providers. 21 Material Loss Review of Eastern Financial Florida CreditUnion OIG-10-04 Florida State Supervisory Authority and NCUA Supervision of Eastern Financial Florida Credit Union Supervisory Background Florida SSA and NCUA examiners had few criticisms of EFFCU operations or its management in examination reports leading up to September 30, 2007. Prior to September 2007, EFFCU consistently received composite CAMEL ratings of 1 or 2, with examiners generally citing a traditional business plan (prior to 2005) and EFFCU maintaining a consistently strong net worth position. Eastern Financial’s earnings component rating dropped to a 3 during the June 30, 2006 examination, the remaining components were rated 1 or 2, with a composite of 2. Examiners concluded that the ROAA of 0.53 percent could have initiated Administrative Action in the form of a DOR which would have outlined a course for corrective action. However, Florida SSA decided against issuing a DOR as examiners felt it would not substantially add anything to management’s ongoing efforts. Examiners determined that management was being proactive and that earnings would improve as “strategies change, services expand, and lending products are enhanced.” Eastern Financial’s component and composite ratings were substantially downgraded as a result of the September 30, 2007 examination, based largely on the losses associated with the substantial write-downs being required in the CDO investments. Eastern Financial’s composite rating was downgraded to a 3. The financial condition continued to deteriorate in 2008 and the credit union was downgraded further to a CAMEL composite 4 following the September 30, 2008 insurance review. With the seriously distressed CDO portfolio, concerns with the member business loan portfolio, and impact of the overall economic issues on the state of Florida, the Florida SSA issued a temporary Cease and Desist in December 2008 and a permanent Cease and Desist on March 19, 2009. The asset and liability account records of EFFCU as of March 31, 2009 showed assets of approximately $1.62 billion and liabilities of approximately $100 million. Since EFFCU’s shares of $1.53 billion exceeded the cash value of assets less liabilities, the credit union was found to be insolvent with a Problem Asset/ Share ratio of 99.77 percent. The Florida SSA placed EFFCU into conservatorship and appointed the NCUA conservator on April 24, 2009. Table 3 (below) provides an overview of significant contacts by the Florida SSA and NCUA Region III. 22 Material Loss Review of Eastern Financial Florida CreditUnion OIG-10-04 Table 3 Exam Report Date Exam / Insurance Performed by C-A-M-E-L / Review Type Composite 6/30/04 Annual SSA lead / joint 1-2-2-3-2 / 2 6/30/05 Annual NCUA lead / joint 1-2-1-2-2 / 2 6/30/06 Annual SSA lead / joint 1-2-2-3-2 / 2 9/30/07* Annual NCUA lead / joint 3-3-4-3-3 / 3 9/30/08 Annual Joint (Special Actions) 4-4-4-5-3 / 4 4/24/09 On-site Contact NCUA 5-5-5-5-4 / 5 * NCUA placed Eastern Financial into Special Actions after the September 2007 annual exam. Supervisory Efforts to Key Risks Were Not Adequate or Timely We determined NCUA and Florida SSA examiners could have identified key risk areas such as planned purchases of substantial amounts of CDO investmentsin early 2007 and the extension of larger member busi
Are you sure you want to buy this material for
You're already Subscribed!
Looks like you've already subscribed to StudySoup, you won't need to purchase another subscription to get this material. To access this material simply click 'View Full Document'