Subprime Behavior

The financial crisis that engulfed the United States in 2008 helped to shine a bright light on the risks associated with lending to borrowers with questionable—“subprime”—credit profiles. There was nothing new about these risks. Indeed, there were a number of high-profile bank failures tied to subprime lending about 10 years prior to the onset of the financial crisis.

The subprime story in the 1990s was not solely about banks failing to recognize their high-risk lending. Another important part of the story also encompasses federal bank regulators, who set capital requirements too low to take account of subprime lending risks.

One prominent bank failure tied to subprime lending involved the inappropriately named BestBank, which had its headquarters in Boulder, Colorado. BestBank had grown rapidly, with its assets rising from $34 million in 1996 to $314 million in 1998. The bank also had pursued a high-risk business strategy that involved subprime lending. In BestBank's case, it worked with another company, Century Financial, to issue credit cards to borrowers with poor credit histories.

Telemarketers working for Century Financial would target potential customers. Their pitch was that the credit cards included a prepaid travel plan. If prospective customers agreed to accept a credit card and paid a $20 application fee, they would be sent a BestBank Visa card with a $600 credit limit.

But there was $543 in up-front charges, including $498 for the travel package and $45 for an annual fee. In other words, the customer only had $57 left on a $600 credit line on the day the card was issued. This was not well received by the bank's new customers. Many of them claimed that they were never told about the travel package and the up-front fees and stopped making their monthly payments once they realized what they had actually signed up for.

Century Financial was contractually obligated to repurchase delinquent loans from BestBank. However, as the number of loan delinquencies grew, Century Financial did not have enough money to purchase them all. The delinquent loans were initially hidden from BestBank's examiners. Century Financial paid just enough to BestBank that it appeared the bank's customers were still making their monthly payments. Of course, misrepresenting the payments in this way was illegal.

BestBank funded its rapid growth with high-cost deposits and showed extremely high profits in its early years; it was once named by American Banker as the best-performing small bank in the country. During its high-profit years, BestBank's senior officials also paid themselves extravagantly. And once problems began to emerge, the bank's senior officials began to hide the unpleasant truth from their bank regulators—in this case, the FDIC and the Colorado State Banking Department.

When the fraud was uncovered and the bank was closed, the losses to the FDIC's bank insurance fund exceeded $170 million. Most of the credit card balances were forgiven since it was difficult to determine who was and was not a victim of fraud.

A number of the bank's and Century Financial's senior officials were sentenced to long prison terms. The person most responsible for the bank's fraudulent behavior, Edward Mattar, was convicted of 90 counts of bank fraud, conspiracy, and other charges. On the day he was to be sentenced, in November 2007, he jumped to his death from the 27th floor of his apartment building in downtown Denver.

“If I were you, kid, I would be a banker. They go to work at 9 A.M. and leave at 2 P.M. and all day long they sit and look at the most wonderful stuff in the world—money.”

Boxing legend Billy Conn reportedly delivered this advice following his military service in World War II. The recipient was a young boy named J. Knox McConnell.¹

McConnell grew up to make quite a mark for himself, although not the kind he likely had hoped for. I never met him, but there was one peculiar incident where our paths did cross. In 1989, American Banker profiled me after my appointment as deputy to the FDIC chairman. Shortly afterward, I received a small package from Keystone, West Virginia. Inside, there was something resembling a passport, with a copy of my picture that had appeared in American Banker.

One side of the “passport” stated, “Welcome to the free state of McDowell, the greatest coal region in the world. You are walking on precious ground owned by the greatest people in the world. Let it be known that you will be given safe conduct in and through our precious free state provided you obey the law at all times.”

On the other side, beneath my name and picture, the text said, “The above individual is known to me and deserves all rights, privileges and courtesies.” Below was Knox McConnell's signature.

In the accompanying letter, McConnell, who by then had become a banker, wrote that he thought very highly of the FDIC and the Federal Reserve, but that he didn't think too much of the other bank regulatory agencies. I never thought too much about the letter and passport, but they were interesting enough that, instead of throwing them out, I filed them away.

Years later, as high-profile problems emerged at the First National Bank of Keystone, I remembered the passport. Sure enough, First National was McConnell's bank.

The First National Bank of Keystone was one of the biggest bank failures connected to subprime lending, and provided the most colorful cast of characters.

Keystone is located deep in the mountains of West Virginia, approximately 125 miles south of the state capital, Charleston. It was a coal-mining town, founded in 1892 by the Keystone Coal & Coke Company. During the first half of the 1900s, the town and the surrounding county prospered.

Keystone National Bank was a local community bank founded in 1904, and it helped the town grow through the peak coal-mining years in the 1930s and 1940s. While the bank itself remained small, it was strong enough to survive the fear and runs of the Depression years. Afterward, a sign posted outside noted that the bank was “Time Tried, Panic Tested.”²

By the 1950s, the boom coal-mining years were over. Without jobs, many people left town. Many of those who remained were elderly and dependent on Social Security and federal disability payments, as black lung disease was fairly common. By the late 1970s, only about 600 residents remained in the city.³

This was the unlikely setting when Knox McConnell arrived from Pittsburgh in 1977. He had been hired to run the bank. McConnell brought two new employees with him, Billie Jean Cherry and Terry Church, who became the senior members of what soon became a virtually all-woman workforce at the bank. Around town they were known as “Knox's Foxes.”⁴ Later, it became clear that Knox was no Charlie and his foxes were no angels.

McConnell was ambitious. He wanted to do much more than run a small community-oriented bank. He became active in politics, serving as the West Virginia finance director for George Bush's presidential campaigns in 1988 and 1992, and often boasted of his connections with Bush. On the business front, he reached across state lines and began offering mortgages to doctors in the Pittsburgh area, where homes were considerably more expensive than in Keystone. But his real goal was to make his mark at the national level. McConnell found his strategy in the early 1990s when he began to buy low-quality or subprime loans from other lenders around the country. He then sold securities by promising investors that the interest and principal payments made on his subprime loans would be used to pay the interest and principal on their securities. (In an interesting twist, Lehman Brothers handled many of the securitizations for Keystone.) Like a few who came before him and many who came after him, McConnell figured that if he earned a little bit more on the interest payments he received from his subprime loans than the interest he paid on the securities, with a large enough volume of business, he would have a sizable, steady, and secure income flow.

Many of the underlying low-quality loans McConnell used to back the securities he sold were subprime home improvement loans. Others were debt consolidation loans. By the mid-1990s, Keystone National Bank was a substantial player in the market for “Title One” loans, which were subprime home improvement loans insured by the Federal Housing Administration (FHA). A Keystone subsidiary, Keystone Mortgage Corporation, bought and sold $725 million worth of Title One loans in 1996, which amounted to about half of the total volume of Title One securitizations that year.

As the bank grew, McConnell's ambitions grew as well. He wanted to raise even more money to support his loan-buying and securitization activities. He was able to raise this additional money by offering to pay prospective customers higher rates of interest for their deposits than anyone else in the country—sometimes as much as two percentage points higher.

These high interest rates allowed Keystone to expand well beyond the size of the quiet, out-of-the-way community where it was located. People from all around the country were willing to deposit money in a bank they weren't familiar with, as long as they were going to earn more than they could get elsewhere, and their money remained federally insured.

There are many ways for depositors to place their money in banks outside of their local communities. McConnell raised money through the Internet and through middlemen known as deposit brokers.

Paying higher interest rates for deposits than everyone else left McConnell with little margin for error. Banks that borrow at high rates of interest have to lend at even higher rates of interest. Often, the only people willing to borrow money at the very highest interest rates are those who can't get loans from other, more conservative bankers. They are the borrowers who are the least likely to pay the money back.

This was the same problem faced by the insolvent savings-and-loans (S&Ls) of the early 1980s. They paid higher interest rates than everyone else as they tried to grow their way out of their troubles. In order to make money, McConnell also needed to grow his bank.

Early on, McConnell's strategy seemed to be working. Three times during the 1990s, the First National Bank of Keystone was recognized by American Banker as one of the best-performing small banks in the country.⁵ The bank also grew from holding $17 million in assets in 1977 to $102 million in 1992, and $1.1 billion in 1999. McConnell looked like a man ahead of his times. But while progressive in some ways he was old-fashioned in other ways. McConnell refused to install ATMs, stating, “This isn't ATM country. If one of those things broke, someone would pull out a gun and shoot it.”⁶

Emblematic of McConnell's risk taking was his decision to keep the riskiest parts of the securities that he otherwise sold. Securities are divided up into different pieces or tranches. Each tranche represents a different level of risk to its buyers. The riskiest tranche is called the residual interest. Also known as residuals, these are the part of a securitization that takes the first loss when the underlying loans don't generate enough in interest payments to pay all of the interest that is owed on the securities. None of the other tranches take any of the losses until the overall losses on the underlying assets are so great that the residual interest is wiped out. Estimating the value of the Keystone's residual interests turned out to be a major source of contention between McConnell and his bank's regulators.

As a national bank, Keystone was regulated and supervised by the Office of the Comptroller of the Currency (OCC). The relationship between Knox, his “foxes,” and the OCC's examiners was anything but cordial. He once told a business newspaper that, “I don't care for examiners at all. I think they ought to do away with them.”⁷

It's easy to see why he thought so. OCC examiners identified shortcomings at Keystone, and in 1995 issued criminal referrals to the local U.S. attorney after identifying falsified bank records and misapplied bank funds. McConnell challenged the examiners on just about everything. He wanted to make their lives as difficult as possible and delay them as much as possible until they left. But the OCC's examiners, who already were concerned about the bank's high-risk business strategy, increasingly were finding other problems related to the bank's weak internal controls, bad record keeping, and overall poor management. They began demanding improvements in the bank's operations.

McConnell did not live long enough to see the ultimate fate that awaited his bank. He died of a heart attack at age 70 in October 1997. Billie Jean Cherry became the new bank president. Later, she would become the mayor of Keystone. Terry Church, who was later described by an FDIC bank-closing specialist as a dogmatic, overbearing, and incompetent manager, took over responsibility for the bank's securitization activities. The relationship grew even more hostile. The examiners began to receive U.S. marshal escorts during their visits. Billie Jean Cherry didn't last long in her job—the OCC recommended replacing her with someone who possessed a better understanding of the financial system, and securitization in particular. Keystone's directors selected an OCC veteran, Owen Carney, and he started as the bank's president in February 1998. He resigned two months later, after clashing with bank officials.

At the FDIC we, too, were becoming increasingly concerned about the condition of Keystone and how its residual interests were being valued. These assets had come to represent nearly half of the bank's total assets. We asked the OCC if our examiners could participate in their next examination in order for us to better ascertain the bank's true condition. The OCC turned down our request. Later, as the bank's problems worsened they acquiesced and allowed us to participate in their examinations.

Once the FDIC's examiners were inside the bank, in mid-1999, our fears were confirmed. The discrepancy between what we thought the residual assets were worth and what the bank and its auditor claimed they were worth was large enough to wipe out all of the bank's capital and render it insolvent. But that wasn't the worst of it.

The bank's examiners had become increasingly suspicious of the condition of the other half of the Keystone's assets. For years, they had been looking at the bank's information on these loans to determine their condition. All had appeared to be in order. But Keystone didn't manage these loans itself. Another firm had been hired to service them. Now the examiners were demanding to see not just the bank's records for these loans, but also the records from the servicing company as well. When they saw the servicer's records the examiners were stunned. Keystone didn't even own the loans. They had sold them, totaling $515 million, but had continued to list them on their financial statements as if they still owned them. The massive fraud meant the bank would have to be closed as soon as possible.

The fact that a bank is about to be closed is kept highly confidential. Rarely does word leak out in advance. But news of Keystone's problems began to spread like wildfire through the community. There was a run on the bank. Merchants stopped honoring the bank's checks. The FDIC had no time to carefully plan for the closing, which needed to happen the following morning—on Wednesday, September 1, 1999.

The FDIC needed to deploy a large number of people to Keystone right away. That was easier said than done. Keystone is not an easy place to get to. Most of the FDIC staffers who closed banks were based in Dallas, Hartford, or Washington, D.C. With some advance notice they could have found their way there, but mobilizing late in the day there were no remaining flights to anywhere near the bank's general vicinity.

Rickey McCullough and David Barr were among the Washington, D.C., and Hartford-based FDIC employees who flew into Charleston, West Virginia, rented cars, and drove over an hour to Bluefield, a town 25 miles and a mountain ridge away from Keystone, where they checked into the Holiday Inn. McCullough and Barr would be responsible for talking with the press and with the bank's customers, to reassure everyone that the bank's insured deposits were safe. The staff in Dallas chartered a plane, leaving near midnight, to get 40-plus FDIC bank-closing specialists into the general Keystone vicinity. They, too, had arranged for vans and hotel rooms to be available upon landing.

Security was a concern. Keystone's residents had a deep mistrust of the federal government. Government workers were bureaucrats who weren't as highly regarded as my passport from McConnell had suggested. State police and U.S. marshals were brought in to provide escort services and security.

The morning the bank was closed, hundreds of people gathered outside the bank building. Everyone was looking for information and answers. McCullough and Barr stood outside, their backs against the wall of the bank building, and began answering questions. Standing near them, unrecognizable to the town's residents, were two plainclothes U.S. marshals, who were there in case the crowd's anger got out of hand. The questions continued throughout the morning, each person wanting to reassure themselves first that their money was safe, and then, when they would have access to it.

The day grew hotter and more humid, with the temperature rising well up into the 90s. At one point, a woman offered McCullough and Barr bottles of cold water. Both accepted, greatly appreciating the kind gesture. After that, it seemed that the tension eased considerably and the crowd became much more accepting of their uninvited visitors.

The town's residents also were concerned about receiving their Social Security and disability payments on time. They were due, in many cases by direct deposit, the next day. But with the bank closed, there was nowhere for those deposits to go. Later that day, the bank-closing staff arranged for the deposits to be sent to the nearest local bank, meaning the 1,300 families waiting for their Social Security and disability payments received them on time.

Each morning during that first week, the FDIC staff would slowly drive along the crooked road from Bluefield to Keystone going up and then down the mountainside into the valley where the bank was located. Once in town most of the FDIC staff would be working inside the small bank building. Others were in the parking lot out back working inside a beat up old trailer from which the bank had conducted some of its mortgage operations.

Initially, communication was an issue. The staff's cellular phones did not work in the mountains. The bank had only a few phone lines, and there were a large number of incoming calls blocking those lines. Additional phone lines were set up, and 1,500 calls came in on the day of the closing. There were over 16,000 calls during the following two weeks.

There was only one restaurant in the nearby area, so for lunch, even though Billy Jean Cherry owned it, it became the place to go. Its specialty was tuna fish and cranberry on fried bread, a new dining experience for many FDIC employees.

On Friday, September 3, the FDIC staff held a town hall meeting to explain what was happening and to continue to reassure everyone that their insured deposits were safe. The meeting was held at nearby Northfolk Middle School. Four hundred fifty residents, most of the town's population, showed up. Many of them took buses from downtown to the junior high school. Initially, the audience was agitated. Then, as the meeting started and their questions were answered, the crowd was reassured that their insured deposits, which represented the vast majority of the money in the bank, were safe.

The most critical task facing the FDIC was getting local depositors access to their insured deposits. This is usually done by selling the closed bank and transferring its insured deposit accounts to another bank, which enables most banking services to be maintained. The buyer of the failed bank will often keep the same branches and employees in place to help serve the customers of the failed bank.

But there had been limited time to sell this bank. The FDIC staff had contacted 350 banks that it viewed as potential bidders to determine their interest in buying the bank. Such conversations are done on a confidential basis so as not to bring attention to an imminent bank closing. In this case, the bank was already closed so secrecy wasn't paramount—speed was. Seventeen banks showed an initial interest. After learning more about the bank, though, only one submitted a bid. It was to purchase some of the local insured deposits and a few of the bank's local assets. That deal was completed, but other arrangements would have to be made for the rest of the bank's insured deposits and for selling most of the failed bank's loans and other assets.

The sale to the lone bidder took place that Friday, September 3. Thirteen thousand insured deposit accounts totaling $135 million were transferred to Ameribank, a bank that 10 years later also would be closed. These depositors were given immediate access to enough of their money to get them through the Labor Day weekend. They had full access to their deposit accounts the following Tuesday. This is a little slower than the FDIC's normal practice, which is to close a bank on a Friday and reopen on Saturday or Monday, with depositors having access to their insured funds at that time. But given the unexpected midweek closing and the bank's antiquated information systems, we considered this to be a good result. The other local insured depositors also had access to some cash for the holiday weekend. Checks for the remaining amount owed were mailed to them at the beginning of the following week.

The community that initially mistrusted the FDIC began to appreciate the staff. When the school's students were outside their building selling T-shirts and hot dogs to raise money for their school supplies, the FDIC's employees on site took up a collection and donated the money to the students. The school principal sent Rickey McCullough a thank-you note for the work the FDIC did in the community. Included with the note was a piece of coal with the state's seal embossed on it.

In addition to the local insured deposits there was over $500 million in brokered deposits at the bank. Returning the insured portion of that money was a more complicated task. The owners of these accounts were not local residents, and unlike other deposit accounts, it is the brokers, not the banks, that keep the information on individual depositor balances that the FDIC uses to determine which accounts are insured. Often, brokers do not have a sense of urgency in providing the relevant information to the FDIC. At Keystone, it took several months to complete the process of paying deposit brokers for their insured amounts.

Despite the protection provided by deposit insurance, there still were local residents who lost most of their life savings. Some individuals, including many of the bank's employees, had purchased stock in the bank and had watched its value grow over the years. Now the stock that once had been valued at $132 million was worthless. Approximately 500 others, perhaps attracted by the bank's high interest rates, had a total of $15 million in deposits above the insurance limits. Only a small portion of that money would be recovered. One person committed suicide.

The bank also had been the major employer in the area. The senior officers of the bank owned most of the other businesses in town, including the hardware store, gas station, and motorcycle repair shop. Two thirds of the tax base of Keystone was directly related to the bank. Now that was gone. Without the temporary and artificial stimulus provided by the bank's activities, the town of Keystone continued its decline. By 2010 only slightly more than 300 residents remained.

McConnell, Cherry, and Church had been viewed as pillars of the community. They bought and developed property in Keystone and other communities in McDowell County, including a Harley-Davidson dealership, a bed-and-breakfast, and a community theater. They had shown a great deal of personal generosity, contributing to a number of worthwhile causes, albeit with other people's money.

McConnell probably didn't start out with the idea of committing fraud. As in most bank fraud situations, the fraud started once the hole already had been dug. The bank wasn't managed well enough to protect itself against the risks it was taking, and it couldn't afford the large salaries and fees that McConnell was paying himself and his senior managers.

After the closing, the FDIC staff found a room at a document storage company owned by Billie Jean Cherry located in an old schoolhouse across the street from the bank building. The door had been nailed shut. When FDIC bank-closing specialist Dan Bell opened the door with a crowbar, he found over 100 boxes of bank records that had never been filed—they had simply been tossed into boxes and set aside.

The bank had completed 18 securitizations in a five-year period and clearly was ill equipped to conduct such sophisticated operations. When buyers began demanding repayment for the poorly documented and badly underwritten loans they had been sold, the bank began sliding into insolvency. Eventually, McConnell began to falsify the bank's records in order to cover up his mistakes. Over the years the fraud grew larger and larger, becoming harder to conceal. After McConnell's death, Cherry and Church, who were willing accomplices, continued to perpetuate the fraud.

By the end, panic set in. A large dump truck pulled up outside the old schoolhouse the bank used as a storage facility. A vice president at Keystone Mortgage joined with some of his colleagues in throwing bank records from a third-floor window into the truck. These records were taken to Terry Church's house, high on a mountainside, and buried in a backyard trench, measuring 10 feet deep, 10 feet wide, and 100 feet long. The trench was covered with sod and grass, but investigators found them six weeks later.

There was little money left to recover. The FDIC's deposit insurance fund paid out $664 million following the bank's collapse. Desperately, Keystone Mayor Billie Jean Cherry claimed that the government was after her and Terry Church because they weren't Ivy Leaguers. During a town council meeting, 75-year-old Cherry made a fist and announced that if anyone tried to remove her from her position as mayor, she would “give ‘‘em some knuckle puddin’.”⁸

Billie Jean Cherry lost her job as mayor and in 2001 was sentenced to 16 years in prison, having been convicted of mail fraud, conspiracy to commit bank embezzlement, and money laundering. Cherry, who died in prison in December 2006 at the age of 82, had engaged in a 30-year relationship with McConnell, who had remained a life-long bachelor. As a result, she felt entitled to, and had taken, his money.⁹ Knox, who never spent money extravagantly, had intended to leave his millions to his alma mater, Waynesburg College.¹⁰ Terry Church, who became the bank's dominant figure after McConnell's death, was sentenced to 27 years in prison on bank fraud charges. Four other bank employees pleaded guilty to crimes connected to their work at the bank.

The scale of the fraud at Keystone National Bank threatened to obscure the larger risk to the financial system, which was the growth of subprime lending and the losses associated with it.

Keystone, BestBank, and a few other banks that failed around the turn of the century, like the $2 billion Chicago-based Superior National Bank, illuminated the risks associated with subprime lending. The losses that resulted from subprime lending at all three of these banks were large enough to warrant their closing.

Keystone and Superior also involved disagreements between the bank regulatory agencies over the use of the FDIC's backup supervisory and enforcement authority. The ability of the FDIC to use this authority was a recurring theme beginning in the 1980s. Each crisis underscored the importance of the FDIC's having the authority to enter any bank when it sees problems. It is not that one agency's bank examiners are better equipped to identify and address problems. Indeed, Keystone, BestBank, and Superior were supervised by three different federal bank regulatory agencies. However, the FDIC does bring a different perspective; it incurs much of the cost of a bank failure. This gives the FDIC the incentive to end hopeless situations before problems escalate. Bank failures are expensive and harmful, so the system of checks and balances provided under the FDIC's backup examination and enforcement authority is important.

The same is true when the FDIC needs to prepare for a bank failure. The bank-closing staff needs information and access in order to prepare properly. The absence of careful advance planning only raises the costs and the disruption associated with bank failures. The Keystone episode shows that even at a fairly small bank, there are myriad issues to address at a bank closing in order to avoid unnecessary costs, disruption, and hardship.

During the late 1990s, the FDIC had grown increasingly concerned about the risks associated with subprime lending. Prior to then, most subprime lending activity took place outside of the banking system. But in the mid to late 1990s, bank holding companies began to acquire subprime lending companies. By the late 1990s, it was clear that subprime borrowers had a much higher default rate than other borrowers. Under Chairman Donna Tanoue, the FDIC attempted to raise capital requirements on subprime lenders to compensate for that higher risk. The agency was only partly successful.

Unsurprisingly, there was strong resistance from the banking industry to higher capital standards for subprime lending activities. What was surprising was that the FDIC's efforts ran into resistance from the other bank regulators, who were not as convinced that higher capital standards were necessary.

The federal bank regulatory agencies always attempt to reach consensus on something as important as capital standards. No regulator should want different standards for banks depending only on which agency regulates them. In the 1980s, there was a point where the bank regulatory agencies were not reaching agreement on appropriate capital standards, and Congress threatened to set the standards itself if the regulators could not agree.

In the case of subprime lending, bank regulators reached a compromise. Banks were required to hold enough extra capital to offset a 100 percent loss on any residual interests they owned. Capital requirements also were raised for banks that had subprime lending programs. However, capital requirements were not raised similarly for the nonbank affiliates of banks.

These actions, while helpful, turned out to be the regulatory equivalent of fighting the last war. Raising capital requirements for subprime lending conducted within banks was a real improvement. However, the predictable result was that banks shifted their subprime lending to their nonbank affiliates, which were not subject to these higher capital requirements. Thus, the broader banking system, particularly within larger financial institutions, remained at risk. These risks became apparent to all in 2008, when the subprime mortgages held by nonbank affiliates of banks became a significant factor contributing to the 2008 financial crisis.