Fed examiners too lenient with Midwest bank before collapse, report finds

Introduction

Federal Reserve examiners failed several times over five years to take tougher action with Midwest Bank and Trust Co. before it collapsed in May 2010, and did not issue bank soundness ratings consistent with comments in their reports, the Fed’s inspector general says.

In mid-2008, Midwest was given a healthy “2” rating by bank examiners, reflecting its capital strength and liquidity, which later qualified it to receive $84.8 million in Troubled Asset Relief Program funds from the Treasury Department at the end of that year. The eventual collapse of the bank in suburban Chicago cost the federal deposit insurance fund about $200.7 million.

The inspector general blamed the bank’s failure on a series of problems first identified in 2002-03, when Midwest began quickly expanding into commercial real estate and construction loans without adequate credit risk controls. After being marked down for an enforcement action in 2004, the bank replaced its top executives, one of several actions that prompted Fed examiners to give it a higher soundness rating.

But Fed examiners were too quick to drop the 2004 enforcement action and should have waited for management to demonstrate that its new risk controls were effective, the watchdog’s report said. Other opportunities to downgrade the bank’s asset quality and soundness ratings were missed in 2007 and in 2008, it said.

“Examiners identified key weaknesses, such as the bank’s CRE [commercial real estate loans] and CLD [construction loans] concentrations, reliance on non-core funding, and reliance on the holding company’s capital support, that contributed to the bank’s failure, but did not act on multiple subsequent opportunities to take more forceful supervisory action that might have prompted management to resolve these weaknesses,” the watchdog said.

For example, examiners did not “hold bank management accountable for failing to diversify the bank’s loan portfolio and funding sources between 2005 and 2007,” which ultimately led to Midwest’s failure, the report said. And in 2007, with unfortunate market timing, Midwest boosted its preferred securities holdings in Fannie Mae and Freddie Mac just months before their value fell sharply amid the financial markets crisis.

Among the lessons learned is that Fed examiners must issue bank soundness ratings that are “consistent with the narrative comments included in examination reports,” the inspector general said.

FAST FACT: To rate a bank’s health, examiners use criteria known as CAMELS — capital adequacy, asset quality, management capability, earnings quality, liquidity, and sensitivity to market risk. A “1” is given to banks performing well, while a “5” indicates a bank is close to failure.

Following are other new watchdog reports released by the Government Accountability Office (GAO), various federal Offices of Inspector General (OIG), and other government entities:

FINANCE

• The FDIC’s deposit insurance fund will lose about $5.2 billion from the April 30 failure of three Puerto Rico banks. Westernbank, Eurobank, and R-G Premier Bank were closed by regulators because of management’s mishandling of credit risk, a slow down in commercial real estate loans as the island’s economy deteriorated, and improper accounting of mortgage loan transactions. (OIG)

HEALTH

• There is no scientific proof that stricter testing of ground beef purchased by the USDA for the federal school lunch program, food banks, disaster relief agencies and other programs would lead to safer meat. (National Research Council)