The thread should have the following posted to it for posterity.
The Ugly Story of BestBank
By David Tice
The Prudent Bear Fund
July 9, 1999
The mania, unfortunately, was in full-force during this holiday-shortened week, as the breathtaking speculative run continues throughout the high tech sector. For the week, the NASDAQ 100 increased 2%, bringing its year-to-date gain to 30%, and its rise since the lows of last October to 125%. The Morgan Stanley High Tech and semiconductor indices rose 3%, increasing 1999 gains to 39% and 45%. Since October lows, these two indices have gained 168% and 178%. And while The Street.com Internet index was flat for the week, year-to-date this index has gained 65% and since the lows last October, 360%. Inarguably, this has been one of the great speculations of all time. Price-to-earnings ratios for the NASDAQ 100 and Morgan Stanley High Tech index are now 97 and 78. Since many of the semiconductor companies have reported losses, the semiconductor index PE is 1,474. Moreover, the Street.com Internet index has no earnings. Outside of technology, it was a relatively quiet week with the Dow gaining 55 points, while the S&P 500 rose about 1%. The Transports actually declined about 2%, while the Morgan Stanley Cyclical, Morgan Stanley Consumer, and utility indices were little changed. The small cap Russell 2000 gained about ½% and the S&P Bank and Bloomberg Wall Street indices were largely unchanged.
Yesterday, the American Banker reported that the FDIC had raised its estimate to $200 million for the cost of the failed BestBank of Boulder, Colorado. Just last July when regulators closed this bank, the FDIC expected a loss of $28 million. How could a bank with total assets of just over $300 million end up costing the Federal Deposit Insurance fund $200 million?
Well, the culprit was a subprime credit card portfolio. It is our view that the collapse of Bestbank should be a wakeup call for bank regulators, Wall Street investment bankers, investors and, especially, the Federal Reserve. One thing is for sure, it is an ugly story. Interestingly, the general media hasn't reported about the BestBank fiasco but we believe it is certainly something that needs to be told.
BestBank has been under the watchful eyes of bank regulators for years. In fact, as early as 1989, when the CEO acquired 100% ownership, the bank became a concern to regulatory authorities. At that time, FDIC examiners stated that the CEO "is unfamiliar with many aspects of banking." In 1992, when the bank's Board of Directors hired a president who had formerly presided over another bank, the FDIC Field Office Supervisor stated that the new president was "largely responsible for getting the Sioux Falls bank heavily into credit card receivables and related investments that have caused tremendous reversals and significant problems in the bank." Back in 1992, the FDIC examiners also recommended the removal of the CEO from banking because of his "disregard for the safe and sound operation of the bank…" All the same, no regulatory action was taken and the bank proceeded aggressively, rapidly growing assets in a game of high risk lending. Yet, in a 1995 article, American Banker stated that BestBank "is the best performer among U.S. banks" based upon its high return on assets.
Bank assets did grow steadily during the early 1990's but were still only about $10 million at the end of 1994. The company, however, entered a period of very rapid growth, especially during 1996 when it moved aggressively into an unsecured credit card program. At June 30, 1996, total assets were $42 million. By the end of the year, asset had expanded 28% to almost $54 million. By the end of the following year, 1997, total assets had grown exponentially to $190 million. When the bank was closed in July of 1998, assets totaled $314 million. Most of this growth was from its new telemarketing-based subprime credit card program. In a two-year period beginning in mid-1996, BestBank issued more than 500,000 new credit cards and grew assets an astonishing 648%. Obviously, BestBank management knew all too well what many on Wall Street have learned: That about the easiest business to grow, and certainly an area where aggressive accounting can create the illusion of profitability, is lending to those with poor credit histories and limited opportunities to borrow elsewhere – here lies the key to the boom in subprime lending.
And, of course, BestBank management understood clearly that aggressive asset growth in high risk lending initially looks to be quite profitable, with poor credit borrowers willing to accept high interest rates. And while many will never repay the money borrowed, as long as the bank finds new borrowers and lending expands rapidly, the lagging bad-debt write-offs remain relatively insignificant to rapidly growing interest income. For awhile, this type of lending does generate accounting profits and this game can continue (as many lenders are proving today!) as long as new borrowers can be found. And to accomplish the necessary ever-greater growth, Bestbank, as is commonplace throughout our entire financial system, would keep lowering credit standards. And, according to the FDIC, "In late 1997 and early 1998, the credit underwriting standards were reduced to the single requirement that an applicant had no more than one 90-day delinquent account within the prior 6-month period." With assets soaring at BestBank, accounting profits allowed the CEO and president to pay themselves handsome bonuses totaling more than $17 million over a 3-year period. Amazingly, $9.5 million of these bonuses were paid during the first six months of 1998, right before regulators closed the bank in July.
And how was the bank able to raise the funds to pay such egregious bonuses and to finance the rapid expansion of high risk lending? Well, the bank simply offered above-market interest rates on the Internet and the influx of rate-seeking depositors easily provided all the funding the bank needed. The FDIC and State examiners were both aware and critical of BestBank's risky approach to raising funds in 1996 and 1997. Nothing, however, was done to end this practice.
Finally, last July, the FDIC and Colorado Division of Banking detected that losses in the credit card portfolio had made BestBank insolvent and moved to close the doors. At this time, the FDIC estimated that this failure would cost the fund $28 million. The FDIC expected that it could recover considerable funds by selling the $255 million subprime credit card portfolio. Investors, however, had little interest in these accounts with high default rates and allegations of manipulated accounting. When no qualified buyer materialized, the FDIC decided to liquidate the portfolio. According to American Banker, "The agency sent notices to about 350,000 cardholders, asking them to pay 50 cents on the dollar. The FDIC said that in exchange, it would tell credit bureaus the borrower was paid up." Well, that was a great deal that should have been much too good to pass up; the complete forgiveness of half of the outstanding debt. However, only 48,000 of the 350,000, or 14%, accepted the deal, netting the FDIC $5 million, or about 2% of total receivables. The FDIC then "wrote off the balances of the remaining 302,000 accounts."
There are many important lessons to be drawn from BestBank, we will highlight just a few. First, and a key point to recognize in today's most profligate of lending environments, truly staggering losses can develop over relatively short periods of time from aggressive lending practices. Second, the true value of receivables from poor credits is virtually unknowable and certainly much less than face value. BestBank's portfolio had a face value of $255 million, but the FDIC was only able to collect 2%, and this during a period of economic boom. At some point down the road, the holders of asset-backed securities may re-evaluate the economic value of the underlying receivables, especially in the subprime area, and the consequence could be a collapse in this key market. Third, our regulatory system is desperately inadequate and, if such a disaster can occur under the watchful eye of bank regulators, what kind of debacle is developing with the proliferation of non-bank lenders and securitizers? And, why all the complacency today regarding subprime lending when there are hundreds of years of history that clearly prove that lending to poor credits is simply a very bad idea.
Yet, in today's Wild Wild West of financial excess, high risk lending is not only commonplace, it is encouraged by a lack of controls, a cheerleading Wall Street, and an extremely accommodative environment fomented by a lack of discipline and foresight from the Federal Reserve and Washington politicians. If a little bank in Boulder can lose $200 million, someone better start worrying about how much the major lenders are in the process of losing as they continue to expand their aggressive lending programs. And, importantly, what is the ultimate damage to the American financial system and economy? These are the critical questions that should be addressed now but that are so easily ignored with the stock market zooming and the economy booming. |
