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Feds come down hard on Westsound Bank

After months of waiting, the other shoe has finally dropped on Bremerton-based WSB Financial Group Inc. and its Westsound Bank subsidiary . Federal regulators have completed their work in untangling the intricately mammoth financial web of questionable lending practices stretching from the Olympic Peninsula to South King County. Regulators have ordered substantial changes that have, in essence, handcuffed management to the federal and state governments in almost every aspect including the day-to-day servicing of checking and savings depositors.

The Federal Deposit Insurance Corp. and Washington Department of Financial Institutions issued a Cease and Desist order on March 10, which will remain in effect until modified or terminated by the FDIC and the DFI. As part of the order, WSB signed an agreement that includes the appointment of former Chief Financial Officer Mark Freeman as interim CEO, replacing Dave Johnson who resigned on March 7. A permanent CEO should be named between now and May 9.

Freeman was formerly the chief financial officer of the bank and took a very unexpected and sudden leave of absence for what was termed “medical reasons” when Westsound’s problems first came to light last September.

WSB had no choice but to agree to the Cease and Desist order with regulators, but according to both a press release from the bank, and a statement from regulators, “…has not admitted or denied any allegations of unsafe or unsound banking practices, or any legal or regulatory violation.”

Former Westsound Bank President and CEO Dave Johnson To read the press release from WSB, one would be led to believe everything was fine, and this is a minor incident of little consequence. Nothing could be further from the truth. Reading the Security and Exchange Commission’s form 8K, which was issued on March 7 — the same day Johnson resigned — and the 30-plus page order from the Feds, it becomes immediately clear that WSB is in serious trouble, both financially and with regulators.

Among previous actions required by regulators was to add $13.9 million to total provisions for loan losses and unfunded commitments in Q3 of 2007, plus increasing Q4 2007 reserves by up to $2.5 million, and a serious tightening of internal controls over loan portfolio review.

However, as a result of this most recent FDIC exam, the Federal Reserve bank of San Francisco has notified WSB that the bank has been designated in a “troubled” condition. The FDIC and the DFI enumerated 17 separate circumstances it must correct in order to remain operational.

After an investigation spanning almost six months, regulators found the bank had a documentable history of unsafe and/or unsound banking practices, had engaged in unsatisfactory lending and collection practices; operated with inadequate management and board supervision; had less than satisfactory capital in relation to its large volume of poor quality loans with an inadequate loan valuation reserve; had inadequate provisions for liquidity, inadequate internal routine and control policies, and was in violation of various banking laws and regulations relating to internal audits and controls, real estate appraisal and lending guidelines, and responsibilities of bank directors and officers.

Under the terms of the FDIC order, the bank can no longer declare dividends without the prior written approval of the FDIC and the DFI. Other material provisions of the order require the bank to:

Review the compensation and effectiveness of Westsound bank’s current executive officers and directors, and the structure of the board and its committees. At a minimum, that will include:

  • An analysis of the management and personnel structure, including a critical assessment of each individual’s background, experience, duties and responsibilities, and an appraisal of each individual’s performance compared to the present level of compensation including incentive compensation;
  • A determination of whether present executive officers are capable of implementing the bank’s board directives and policies, operating within the constraints of laws and regulations, and operating the bank in a prudent manner;
  • A comparison of each officer’s total compensation with compensation received by officers with similar responsibilities in similar institutions;
  • A review of the board members’ qualifications and committee structures.
  • An analysis of staffing adequacy.

WSB also agreed to restore all aspects of the bank to a safe and sound condition, including asset quality, management effectiveness, liquidity, earnings, and capital adequacy. Meanwhile, during the life of the Cease and Desist Order, WSB agreed to notify the Regional Director of the FDIC’s San Francisco Regional Office and the Director of the DFI in writing 30 days in advance when it proposes to add any individual to the bank’s board or employ any individual as a senior executive officer.

Other mandates include:

  • Improving the bank’s internal controls, internal audit function, lending and collection policies and procedures, particularly with respect to the origination and monitoring of construction loans;
  • Maintaining specified capital and liquidity ratios, and;
  • Preparation and submission of progress reports to the FDIC and the DFI.

The bank is allowed to continue serving its customers in all areas including making loans, establishing lines of credit, accepting deposits and processing banking transactions. The FDIC and DFI did not impose or recommend any monetary penalties.

The majority of the problems stem from the bank’s previous residential construction loan program, but sloppy internal controls and what appears to be a somewhat casual approach to regulatory compliance are also at issue.

Among the 17 problem areas WSB agreed to correct in order to remain operational are:

  • Operating with management whose policies and practices are detrimental to the bank and jeopardize the safety of its deposits;
  • Operating with a board of directors which failed to provide adequate supervision over and direction to the active management of the bank;
  • Operating with less than satisfactory capital in relation to the kind and quality of assets held by the bank;
  • Operating with an inadequate loan valuation reserve;
  • Operating with a large volume of poor quality loans;
  • Engaging in unsatisfactory lending and collection practices;
  • Operating in such a manner as to produce operating losses;
  • Operating in such a manner as to produce low earnings;
  • Operating with inadequate provisions for liquidity;
  • Operating with inadequate internal routine and controls policies;
  • Failing to comply with a several other written policies and specific FDIC rules.

As part of the agreement WSB waived its right to defend itself, to a public hearing for the purpose of taking evidence on such alleged charges; to the filing of Proposed Findings of Fact and Conclusions of Law; to accepting the recommended decision of an Administrative Law Judge; and to exceptions and briefs with respect to such a recommended decision.

In other words, WSB essentially admitted to everything the FDIC and DFI accused it of and waived its right to defend itself on any of the charges. That is significantly different than what the press releases the bank has issued say.

WSB says it is actively engaged in responding to the concerns raised in the FDIC order, and believe it has already addressed many of the regulators’ requirements, including the $13.9 million increase in loan loss reserves. WSB claims it is also complying with the terms of the FRB notice, and has exercised its option to start deferring payments of quarterly interest on its trust preferred securities on March 15, 2008, as permitted by the indenture agreement.

The “Troubled Condition” designation also prohibits WSB from making any “golden parachute” payments except under certain circumstances.

WSB must comply with the restrictions on indemnification and severance payments in accordance with the FDIC’s regulations. Any request must detail the proposed payments and demonstrate that WSB is not aware of any evidence at the time the payment is proposed to be made, that the party receiving such a payment has committed any fraud, breach of fiduciary duty, insider abuse, or materially violated any applicable banking law or regulation that had, or is likely to have, a material adverse affect on the bank or its holding company, that the individual is substantially responsible for the institution’s insolvency or troubled condition, and has violated specified banking or criminal laws.

The people most impacted by this are expected to be Johnson and Brett Green, a major stockholder who also headed up the mortgage lending operation before resigning in September, the same day WSB laid off 33 members of its mortgage staff.

WSB was also ordered not to make any payments to any entity unless the company provides 45-day advanced written notice to the regulators for prior approval of such payments. This restriction applies to any proposed dividends and interest payments, director fees, consulting expenses and salaries — and other operating expenses. This may not be good news for the cash flow of local businesses doing business with WSB. However, for handling day-to-day operating expenses, regulators are considering some type of arrangement whereby WSB would not need to seek prior approval for every payment it needs to make.

WSB is required to comply with an extensive and highly detailed list of conditions with very specific 30, 45, 60 and 90-day timelines attached to them. The first set of mandates must be completed by April 9. The complete list of timelines and requirements WSB must comply with to remain operational, along with a detailed explanation of each, can be found in this KPBJ Article.”

At this point, no criminal charges have been filed against anyone, and no mention of any have surfaced in any of the documentation, although early reports from the FDIC seem to support the possibility.

But two things have become abundantly clear — by all measures, WSB is in serious trouble. What will become of it remains to be seen. Will WSB be able to survive, or will it be sold to another bank? One Pierce County-based bank is rumored to be interested, but that could not be confirmed — or denied — by presstime. The second thing is that not one single local bank seems to want to go anywhere near what is undeniably complete and total chaos.

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