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To fathom why one of Utah's oldest financial institutions failed two years ago, look past the mountain of missteps made by its managers to the role of its regulators.

Barnes Bank "exemplifies a situation where examiners detected key risks but failed to take decisive supervisory action" to force directors and managers to reduce the chances that trouble would ensue, the Federal Reserve's independent watchdog said after completing an analysis of 35 Fed-supervised banks that collapsed between December 2008 and February 2011.

The Office of Inspector General called for "stronger supervisory action sooner" of deteriorating banks in the future, although it did not lay out specific steps that might avert another lender's collapse. Barnes was the biggest commercial bank failure in Utah history. Yet little apparently has changed.

Since the Utah Department of Financial Institutions shut the Kaysville-based lender in January 2010, another community bank, SunFirst in St. George, has come to grief. Regulators are considering possible reforms, but nothing has been announced.

Historically, Barnes was a small lender. The bank was founded in 1891 in Kaysville, and for the next century was a single branch office with assets that gradually increased but remained under $100 million. That began to change in the 1990s. At the end of the decade it had assets totaling more than $340 million. By 2005, Barnes had expanded to 10 branches. Most were in places when the housing market, fueled by a booming economy and a rapidly increasing population, was booming.

Like other community banks hammered by fierce competition from credit unions, auto finance companies and bigger rivals, Barnes saw an opportunity in commercial real estate loans. Although they yielded good profits, CRE loans, particularly those classified as construction and land development, or CLD, were risky because a borrower's chances of paying back debts hinged on whether the development projects were a success.

As early as 2006, bank examiners saw that Barnes was loading up on CLD loans. Its concentration of construction and land development loans had doubled since a previous examination a year earlier. The total value of its CLD portfolio was 247 percent more than the bank's risk-based capital cushion. Fed guidelines suggested 100 percent was worrisome. Still, examiners continued to rate the bank's state of health as satisfactory.

Although the bank promised in 2006 to reduce its exposure to what the Fed called "speculative" CLD loans, it continued to make them. From May 2007 to September 2008, Barnes originated $286 million in CLD loans, while almost simultaneously the value of its troubled credit portfolio was exploding. From 2007 to 2008, its value jumped from around $25 million to more than $150 million.

Still, it wasn't until 2009 that regulators became alarmed. The Fed had downgraded Barnes a year earlier to a level that had showed regulators had "some degree of supervisory concern," but failure seemed unlikely at the time, according to the agency's rating guidelines. However, after a four-month review, the Fed in January 2009 cut its view of Barnes further.

Failure was now a distinct possibility.

In May of that year, the Fed ordered Barnes to fix several problems associated with its loan practices. In April, it launched a three-month examination that led to a downgrade of Barnes' condition to where, according to agency's guidelines, examiners believed failure was "highly probable." In October, a state-led examination confirmed that Barnes was on the verge of collapse. And in December, the Fed commanded Barnes to immediately raise fresh capital or agree to sell itself to another financial institution. It set a deadline of Jan. 15, 2010.

The bank was unable to comply. On the day of the deadline, Utah bank regulators closed Barnes and immediately appointed the Federal Deposit Insurance Corp. as receiver. The unprecedented failure cost the FDIC's insurance fund $271 million.

Carol Eckert, a spokeswoman for the Federal Reserve Bank of San Francisco, declined to discuss the Office of Inspector General's conclusion that Barnes' failure made plain the need for close regulatory scrutiny and strong supervisory responses when banks increase their lending exposure in markets that are deteriorating.

"These reports speak for themselves," Eckert said.

Paul Allred, deputy commissioner of the Utah Department of Financial Services, had no comment about whether regulators should have moved sooner against Barnes. However, he pointed out that the Fed's watchdog agency said it wasn't able to predict that an earlier intervention would have prevented the bank's collapse.

"We cannot evaluate the degree to which earlier or more forceful supervisory responses might have affected Barnes' financial deterioration or the ultimate cost to the [Depositors Insurance Fund]," the OIG wrote.

So far, the failures of Barnes and other community banks in the country that binged on real estate development loans hasn't sparked any reforms, although reviews are under way. Fed Chairman Ben Bernanke in February noted that risks arise when banks become too concentrated in a lending area. But, he added, that increased supervision could generate costs that may fall more heavily on community banks than on larger financial institutions. He suggested that more stringent rules could dissuade community banks from making loans to some qualified buyers.

The FDIC is evaluating its examination, rule-making and guidance procedures, but no changes have been announced, spokesman Greg Hernandez said.

George Sutton, a former commissioner of the Utah Department of Financial Institutions, doesn't have direct knowledge of what happened to Barnes. But he believes that OIG had the benefit of hindsight when it said more aggressive supervision of Barnes was warranted.

"Here's sort of the ultimate fact. If the housing markets blow up, they are going to take a lot of community banks with them. That has nothing to do with the mismanagement of the bank," said Sutton, who is the Utah Bankers Association's legal counsel.

"The regulators can go in there and say, 'You've got to diversify,' all they want. But if they can't diversify, and I know for a fact with some other banks that has been the case, then the only hope is that they can ride it out," he said.

The better message that regulators should deliver to a bank's directors and management is that, if there are no lending options other than the ones that got the institution into trouble, "then you need to be talking with them about, OK, maybe you need to go out of business because this is just a little too risky. Or you need to get away from being federally insured, and if you want to, go raise some investments and have investors risking everything to do this kind of business."

But, Sutton said, "That's a hard message to deliver."

Ann Graham, former general counsel to the Texas Department of Banking during the height of that state's savings and loan crisis in the late 1980s, said Barnes' failure wasn't unique. Instead Barnes was only one of many lenders with too many construction and land development loans on their books. That happened because regulators, like bank managers, didn't recognize the housing bubble until it was too late.

"Yes, the regulators were supposed to close [Barnes] quicker than they did, based on objective numbers. But the objective numbers are a lagging indicator of a downward spiral, meaning you don't see it on a balance sheet until it's already pretty far down the road," said Graham, who directs the Business Law Institute at Hamline University in Minnesota.

"The crisis hit the [housing] market first, and the regulators, like everyone else, were sort of caught up in this bubble mentality. They didn't put the brakes on. They didn't come to the conclusion that interest rates would not always remain low and that housing prices would not always go up," she said.

Regulators are often hamstrung by their sometimes contradictory roles. On one hand, even if they spot a bank with unhealthy concentrations of construction and land development loans, it's hard to tell managers to stop making more loans if the bank is making money, Graham said.

On the other hand, it's not the duty of bank examiners to alter the business model of a bank, she said. The right to develop loan strategies, risky or conservative, is a fundamental premise of the U.S. banking system. That means the possibility of failure will always be present in free markets.

"You don't want the regulators telling you exactly what you have to do or not do, or how to do it," Graham said.

Twitter: @sltribpaul The Kaysville bank failed because its board and management did not control the risks that came with its strategy of making lots of risky construction and land development loans. Many of those loans went bad when Utah's housing market stumbled.

The bank's loan portfolio more than doubled from 2003 to 2007. Most of the growth was in construction and land development credit. So-called CLD loans grew from $90 million in 2003 to $480 million in 2007.

CLD loans increased from about 100 percent of total capital in 2003 to 373 percent in 2008. The increase substantially increased the bank's risk profile.

Home prices in Utah grew annually until 2008, when they began to fall. The decline undercut the value of raw land and vacant developed lots. Meanwhile, Utah's unemployment rate began to rise sharply, rising from 2.8 percent in 2007 to 6.6 percent in 2009, shortly before regulators closed Barnes.

Many of the bank's loans began to sour. CLD loans accounted for 81 percent of all loans considered to be in trouble in 2008. Troubled loans increased from $29 million in 2007 to $333 million in 2009. Over the same period, Barnes' troubled assets rose from 24 percent of its capital to 400 percent.

Even so, Barnes continued to make CLD loans. It originated $482 million in commercial and land development loans from May 2007 to September 2008. By the third quarter of 2008, Barnes' loan portfolio included 2,500 vacant development lots. Regulators said the lots constituted a five-year supply.

Barnes was profitable in 2008 and 2009 ­— before accounting for loan losses. In 2008, it set aside $51 million for losses. That created a $22 million loss for the year. In 2009, the bank lost $97 million after reserving $104 million for bad loans.

The combined $155 million provision for bad loans wiped out earnings and eroded the bank's capital, leading the Federal Reserve to demand that Barnes find new capital or submit to a buyout. It gave the bank a deadline of Jan. 15, 2010.

When Barnes missed the deadline, the Utah Department of Financial Institutions closed the bank.

Source: Federal Reserve

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