Friday, May 7, 2010

IG Report: CDOs, C&D Loans, and Eastern Financial Florida CU Failure

NCUA’s Inspector General (IG) released its Material Loss Review on the failure of Eastern Financial Florida Credit Union (EFFCU). NCUA estimates that the failure of EFFCU imposed a loss of $40 million on the National Credit Union Share Insurance Fund.

The IG concluded that the “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.”

Excessive Exposure to Risky CDOs

The report found that EFFCU had significant losses related to large investments in CDOs backed by subprime home equity/auto loans and corporate debt. Management and the Board of EFFCU relied too heavily on rating agencies’ grading of CDO investments; failed to fully evaluate and understand the complexity of the CDO investments; and created a concentration risk by investing a total of eighteen CDOs for $149 million, of which nearly $100 million were backed by home equity loan asset backed securities.

In September 2005, EFFCU wrote the state supervisory authority (SSA) about the permissibility of investing in CDOs. The Florida CU supervisor concluded that it was a permissible activity. The report makes the point that Eastern was the only federally-insured state chartered credit union to invest in CDOs.

In the first half of 2007, Eastern Financial significantly ramped up its investments in CDOs. Between March and June of 2007, it purchased $94.8 million in CDOs, bringing its total investments in CDOs to $149.2 million. However, once purchased, these CDOs rapidly deteriorated in value.

“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,” according to the IG report.

The IG wrote that the “September 2005 CDO letter should have prompted the Florida SSA to require that EFFCU implement strong CDO policies to include prudent limits on initial CDO purchases to ensure EFFCU could properly manage the complex investments.” The planned investment in CDOs should have been viewed as high risk activity requiring greater supervisory oversight, especially since EFFCU was the only natural person credit union to hold these investments. The IG concluded that examiners missed an opportunity in 2006 and early 2007 to review the credit union’s ability to effectively manage the risk its CDO investments.

Concentration in Construction Loans

The IG report also notes that EFFCU had numerous violations associated with its member business loan program and experienced increasing delinquencies and loan losses, especially from two large construction and development (C&D) loans.

Examiners uncovered that EFFCU had not classified land intended for income producing property as C&D loans – understating its exposure by $61 million. Once properly classified, EFFCU had over 40 percent of its net worth in C&D loans (over $90 million), which exceeded the regulatory limit of 15 percent of net worth.

Additionally, the report points out that EFFCU requested waivers from the requirement that borrowers have at least a 25 percent equity stake in projects being financed. Examiners recommended that NCUA regional office deny the waiver request, because it could lead to lead to unsafe and unsound banking practices. However, NCUA and the Florida CU regulator granted several of these waivers.

The IG report noted that EFFCU was experienced increased delinquencies with respect to its member business loan program. The report cites that in 2007 one larger delinquent member business loan ($30 million) was not properly classified – understating the credit union’s delinquent loan ratio. The actual delinquency ratio for the credit union was 2.58 percent, while the credit union’s September 2007 Financial Performance Report stated that delinquency ratio was 0.66 percent. Examiners determined the construction project was cancelled; however, EFFCU continued to accrue interest despite the loan being 5 months delinquent and there being no more funds in the interest reserve.

Other Findings

The IG cites additional factors that demonstrated the lack of effective management and Board oversight of the credit union. These factors include: costly branch expansions, too heavy of a reliance on overdraft privilege fees, lack of management succession plans, and excessive use of outside contractors (three of the largest contracts had exorbitant termination fees).

A final point I would like to make deals with the lack of transparency with regard two enforcement actions. The IG report references two regulatory enforcement actions that were taken against Eastern Financial, however, they do not appear on either the NCUA’s or Florida regulator’s website. First, the IG report states that NCUA and the Florida regulator issued a joint Letter of Understanding and Agreement on January 25, 2008. Second, the state credit union regulator issued a temporary cease and desist order against EFFCU on December 18, 2008. Neither enforcement action is publicly available.


  1. The story about hard to find credit union enforcement orders is reminiscent of this week’s actions against another Florida depository institution, Mercantile Bank. Mercantile is not really “Mercantile” but rather the Florida branches of Carolina First Bank that received serious Consent Order demands on April 29th from FDIC. Which is different than the demands on Mercantile that have come from the Federal Reserve Bank of Richmond via the holding company for these veiled linkages, AKA South Financial Group, which itself has been rendered as a holder of problems institutions, has losses in the tens of millions of dollars per quarter lately and is trading as a penny stock. How bad is it all? No dividends without first getting approval from regulators, no incurring debt obligations, 60 days to have a capital restoration plan, and requiring regulatory approval for even managing the institutions’ cash flow. And much more. Facts disguised from consumers, it could be claimed, beneath complex ownership constructions, different names, and bank holding shells. Like EFFCU the orders were there, but hard to directly find.

    This is Florida, where ratings agencies like Bauer Financial say 50% of all the state’s banks have become problematic. There is not too much publicity about the poor state of banking by bank regulators perhaps for fear of making the state banking system much worse. Nor is it unusual for a regulatory body to withhold publication of an enforcement order or to re-write or redact the public version because the original order wrongfully contained examination report data. The full orders are still there and can be accessed for all involved.

    It is good that you select to reprint the credit union system’s own autopsy on one of its troubled shops. Nice that they went to all that effort on EFFCU so that others may learn. On the bank side FDIC and the Florida state banking regulator may not have enough web space for all the posting of post-mortems needed.

    Yet to better benefit consumers, perhaps you should illustrate the problems of member Florida banks while they are gasping in real time; see the OTS Supervisory Agreement for Home Federal Bank of Hollywood, or the Federal Reserve’s and Florida State bank regulator’s Enforcement Orders for Metro Bank in Miami and Dade County. This could be news; or a teachable moment for bankers and their enabling trade associations.

  2. Keith: Do you know who underwrote or sold them the CDO's? Who's upstream?

  3. The IG report states that the CDOs were a private placement and did not identify who underwrote the CDOs.

    The New York Times had a story on Eastern's failure on May 14th.

    The article states that the CDOs were the most obscure imaginable and said the timing of Eastern's purchase was intriguing.

  4. Keith, why not focus on the bigger bank messes in neighboring parts of FL which are far more scandalous than Eastern. Note that the FL Mercantile Bank example in the first comment was spot-on. Today, 5/17, Mercantile’s foundation is gone, having been purchased with its parent by T-D Bank, for pennies with a taxpayer subsidized TARP dump of Treasury's shares.


    BTW, better questions than "who sold" was "who's worthless loans" made up Eastern's CDOs? Banks?

  5. remember, eastern financial was a credit union using member dollars to invest in these half ass schemes. until the new management took over they were rock solid, i know, i had an account with them for twenty years and never had one iota of trouble with them. greedy, greedy, greedy.



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