Next up in the financial crisis: Scores of community banks face failure after years of gorging on commercial real estate loans

Henderson, Nev. -- Tod Little could see trouble ahead for Silver State Bank when he opened the Las Vegas Review-Journal in June 2006. Five months earlier, Little had left Silver State, the institution he founded and built into a small but profitable business. Now, staring at him in the Journal was a picture of Corey Johnson, his protégé and successor, wearing a broad smile, hands on his waist in a Superman-like pose. The new CEO was vowing to transform the bank into a regional powerhouse and double its assets to $2 billion. High on his agenda: completing purchase of a boutique bank in Arizona and a move into fancy new corporate headquarters.

Little wasn't surprised. Before his departure, Johnson had pressed Little to lend more aggressively in Las Vegas' booming commercial real estate market. Land speculators were approaching community banks like Silver State for loans to build the subdivisions and strip malls that seemed to spring from the desert almost pre-formed. Little had instead exercised caution, capping the amount the bank would lend to buy raw land. He urged his subordinate to resist the blandishments of Wall Street consultants who suggested buying up other banks. And he insisted compensation stay in line with the bank's small profile.

"I was standing in the way of this happening for the last year," he says.

Johnson's strategy delivered explosive growth for a time. But it all came to an equally explosive end in September, when the Federal Deposit Insurance Corporation shuttered the bank. The FDIC -- which oversaw the bank at the federal level -- says Silver State's collapse will cost the insurance fund up to $550 million. The bank's failure also vaporized $20 million in uninsured deposits, including $170,000 belonging to the Las Vegas chapter of the Deaf Seniors of America.

Silver State isn't another casualty of the subprime flameout. The bank made its biggest bets not on home mortgages, but on loans to developers across Nevada and Arizona. Its demise highlights an aspect of the financial crisis that's been overshadowed by the crash of Wall Street and its megabanks: How small banks are suffering from a wave of defaults on construction and development loans that could cause dozens more to succumb in the year ahead.

As with the subprime meltdown, Sun Belt states are likely to be the hardest hit: Georgia, Florida, the southwest and California. In a worst-case scenario, the FDIC insurance fund, which stood at $34.6 billion in the third quarter of 2008, could run out and require a taxpayer bailout. The governmentâs bailout program has so far invested about $230 billion in 290 banks -- the lionâs share of it to large banks -- and there's talk of another round.

"A significant portion of the U.S. banking system is overexposed to commercial real estate," says bank analyst Gerard Cassidy of RBC Capital Markets. Federal Reserve data show commercial real estate loan delinquencies growing nearly fourfold between the first quarter of 2007 and the third quarter of 2008. Smaller banks, like Silver State, are at particular risk. Analysts Oppenheimer and Co. issued a report in November concluding that banks with total assets below $1 billion have, on average, 26 percent of their loans related to commercial real estate. For banks with assets above $1 billion that figure is only 11 percent.

Cassidy has estimated that 200 to 300 more banks are in danger of being closed. If so, it would be the biggest spate of financial institution failures since the savings and loan crisis, when more than 1,000 banks and S&Ls shuttered in 1988 and 1989. Just as today, the inability of developers to repay their commercial development loans played a major role.

Federal and state regulators are supposed to be on the lookout when banks take on too much risk, intervening to protect depositors and other customers. They have a mandate to stop "unsafe" and "unsound" practices. But regulators, particularly the FDIC, failed to act forcefully, relying on guidance letters rather than mandates to goad banks to do better.

Three years ago, federal regulators recognized that banks were amassing big concentrations of commercial development loans and lowering lending standards at the same time. Their response was to issue a mild warning: Take steps to reduce the risk from such loans, or face increased supervision and requirements to raise capital that could serve as a bulwark against potential losses.

Though far from a crackdown, even that mild guidance was too much for banks. Thousands of industry comments poured in objecting to the regulators' intrusion, and the FDIC and other agencies backed off, clarifying that they didn't intend to impose limits.

Donald Isken, a Delaware attorney who specializes in commercial real estate law, said today's rise in defaults on commercial development loans speaks for itself. "Obviously, (the rules) were not strict enough," he said. "It's just a fact."

Hot Money and Desert Scrub

"Better stock up on aspirin: There is a lot of pain coming," Doug French wrote in the January 2008 issue of Liberty Watch, a Nevada Libertarian magazine.

He was in a unique position to know.

French, 51, moonlighted as a columnist when not at his day job as Executive Vice President for Commercial Real Estate Lending at Silver State. The column, titled "Skyscraper Cycles," detailed how the "construction party" under way in Nevada and throughout the world was going to end with "a bad hangover." It was familiar territory for French. In 1992, he earned a master's in Economics from the University of Nevada, Las Vegas. His thesis was on speculative financial bubbles.

Silver State ultimately collapsed under the weight of a portfolio of bad commercial real estate loans. In the past decade, an acre of Las Vegas desert scrub without utilities rose in price from about $40,000 to as much as $1 million, according to French. Silver State loaned into the bubble, financing five- to 30-acre parcels, sometimes based on the estimated value when a project was finished. Much went to subdivisions for a population that grew 14 percent in the first half of the decade.

When the bank cratered, it had more than $225 million in overdue commercial real estate loans, FDIC records say. Loans went to speculators who bet the remarkable jump in raw land values would continue, and to residential construction projects that never were completed. The bank felt secure in giving loans based largely on land values because appraisals had risen so steadily.

"A lot of these people got locked in -- Silver State is an example -- they didn't look at the borrower," says Bill Martin, CEO at a Las Vegas-area bank and a former federal bank regulator. "They looked at the collateral and became an asset lender, believing they were protected."

Real estate in Las Vegas hadn't experienced a down cycle in decades. Surrounded by mountains, with most land outside the city owned by the federal government, it was easy to think property was a finite commodity that would forever appreciate.

"We certainly based our lending on the idea that Vegas would continue to grow," says French.

To fuel that lending, Silver State needed a thriving deposit base. To get it, the bank turned to what are known by insiders as "brokered" deposits. Also called "hot money," brokered deposits are placed in a bank by an intermediary for investors in sums just under $100,000 -- to match the amount FDIC insures. (When the financial crisis hit, the FDIC increased the insured amount to $250,000). Brokered deposits are seen as risky because they are disloyal; unlike deposits painstakingly amassed from the community, brokered depositors are constantly moving to banks that offer the best interest rates. When Silver State closed, it had about $700 million in brokered deposits, about 41 percent of its total deposits.

At the center of Silver State's lending spree stood French. As VP for commercial real estate lending, he brought customers in, receiving commissions on their loans. And as a senior executive, he also played an important role on the six-person committee that approved loans.

Most of the loans French brought the committee were approved, according to two former Silver State loan officials who requested anonymity because they still work in the industry. "Doug pretty much ran the loan committee," says one. "They signed off on everything he did."

French disputes the characterization. "I had one vote out of six, so if I was recommending a loan, I was certainly voting for it," he says. "But I couldn't approve my own loans." Three other senior executives in a position to know about loan committee operations did not return calls.

French specialized in the largest projects and the biggest borrowers, he says. Many had multiple development loans with the bank. One such borrower was developer Thomas Jurbala, who says he received about $100 million in loans from Silver State over a decade. The same month French's "Skyscraper Cycles" appeared, the Silver State vice president approved an application for a $24 million loan to Jurbala. French says he believes the Silver State board voted on the loan.

The Jurbala loan contained what's called an interest reserve, which with loan fees and closing costs amounted to $2.34 million of the total. The use of "interest reserves" is a common practice in construction loans but also one prone to abuse. When a bank makes an interest reserve loan to a developer, it hands the builder both the principal and the interest on the loan. The bank pays itself the interest and books it as revenue. Eventually, if everything goes right, the builder will finish the project, sell or lease the property, and pay back the money. But as the past few years have made clear, things don't always work out so smoothly in real estate.

George Burns, who heads Nevada's Financial Institutions Division, says interest reserves were a significant factor in recent bank failures in his state. (First National Bank of Nevada also failed in 2008.) "You are just creating money," he says. "I call it 'faux income.'"

Interest reserves can remove an important checkpoint on a borrower's project. If a homeowner misses a mortgage payment, the bank knows it has a problem and can come up with strategies to collect -- renegotiating the loan's terms, for example. When a builder gets an interest reserve loan, the bank typically isn't paid anything for 12 months or more. By that time the developer may have folded, leaving the bank on the hook.

"There is nothing wrong with interest reserves as long as management is not lulled to sleep by the lack of payments," says Steve Fritts, the FDIC's associate director of risk management policy.

In theory, lenders guard against problems with interest reserve loans by paying strict attention to loan performance through site visits and attention to unit sales in the development. But FDIC enforcement actions against banks in 2008 that mention interest reserves present a picture of misuse. The FDIC chided banks for practices such as failing to keep track of the loans, rolling the interest payments over into additional loans, or even using them to repay different loans.

Interest-reserve loans are endemic in acquisition and construction lending, which nearly tripled to $600 billion nationwide between 2001 and 2007, according to the FDIC. But it wasnât until June of last year that the agency issued a letter to banks cautioning about the potential for abuse.

In addition to the hefty fees Silver State charged Jurbala, approximately $8.8 million of the $24 million loan was slated to pay down other loans Silver State made to Jurbala for different developments, one of which would fall into bankruptcy two months later.

Jurbala says he still owes Silver State $34 million and is negotiating a payment plan with the FDIC. According to the developer, the FDIC is having difficulty deciphering the loan documents left in Silver State file cabinets, complicating the negotiations.

A Bubble Destined to Burst

Bank founder Tod Little and Doug French agree on one thing: Years before Silver State flopped, the FDIC began warning Nevada banks that the Las Vegas real estate bubble would eventually deflate.

"I started in banking over 20 years ago in Las Vegas, and there was not a year that went by where the FDIC was not a) concerned about Las Vegas, and b) concerned about real estate concentrations," says French.

But warnings and increased monitoring were as far as the agency went with Silver State. "It is one thing to say you warned about the bubble, but it appears they did nothing to ask the bank to tighten their administration, to tighten their assets," says former regulator Martin.

FDIC took no public enforcement actions against Silver State prior to its failure. In June 2007, the agency examined the bank and again expressed concern about its lending, but Silver State never acted on FDIC's critique, according to French. The FDIC refuses to discuss whether it sanctioned the bank privately.

"There was no attempt to say 'Quit -- stop,'" says French. "What they said was 'Track it, slice and dice the numbers, stratify the data, stress test it.'" The agency was "quite complimentary in our tracking of that data."

When the agency returned the following year, Silver State's portfolio had deteriorated. By the time FDIC closed it, regulators determined the bank "exhibited extremely unsafe and unsound practices and conditions; exhibited a critically deficient performance; contained inadequate risk management practices relative to the institution's size, complexity, and risk profile; and is of the greatest supervisory concern," according to the order revoking the bank's charter.

Before the doors shut Sept. 5, depositors had already started to flee. Silver State was the 11th bank to fail that year. By the end of December, total failures had risen to 25; two more have failed this year.

FDIC records show 15 of the banks that collapsed in 2008 were heavily into commercial real estate loans, and all were weighed down with millions in bad loans to developers. At least four were flagged by the FDIC for over-reliance on development loans, an audit by the FDIC's Office of Inspector General indicates.

Although he would not comment on the specifics of Silver State, Nevada Banking Commissioner Burns described the challenge of persuading banks to alter their lending behavior. "It's difficult to sit down and say to directors and executives, 'You need to slow this down,'" says Burns. "It will create political fallout. They will say it's a constraint against business. It's hard to say, 'Be successful -- just don't be too successful.'"

Winners and Losers

It was a simple dream -- create a residential retirement home for deaf seniors in Las Vegas. Members of the Las Vegas Deaf Senior Citizens club didn't have much money. So they raised it through bake sales, picnics and dinners. Some of the money was to host the 10th biennial Deaf Seniors of America national convention in June 2009, which in turn would bring in additional funds. After three-and-a-half years of small-dollar events, they had amassed about $400,000.

In the spring of 2008, they took their money to Silver State Bank.

The association moved about $250,000 from its account at Wells Fargo because, at 4 percent, Silver State offered a better interest rate. The group opened four accounts worth $100,000 or less, believing each would be insured. When they asked repeatedly for a sign-language interpreter to guard against confusion, the bank didn't provide one, according to a lawsuit the group has filed against the FDIC.

When Silver State collapsed, the group learned that some $170,000 wasn't insured. Another 499 other account holders also found themselves with uninsured deposits, for total losses of about $20 million. Now the Deaf Seniors are struggling to pay the hotel that will host their convention. Dreams of the retirement center have been postponed indefinitely.

At least some members of Silver State's board seem also to have been surprised by the bank's demise. Director Alan Knudson joined the board in its early stages and described himself as "a minor player."

"I just lost my life savings, and that was it," he said before hanging up the phone.

Tom Nicholson, another longtime director, purchased $1 million worth of Silver State stock in July 2007 for an average price of $20 per share. When the bank failed, it was worth about 5 cents. Nicholson did not report major sales of stock during its descent. Phone messages left for Nicholson were not returned.

One of the shortest tenures of any board member belonged to Andrew McCain, son of former presidential candidate John McCain. McCain, who was on the Choice Bank board when it was bought by Silver State, resigned after five months following his election as chairman of the Greater Phoenix Chamber of Commerce. McCain did not return a call for comment.

When asked what had happened at Silver State, former board Chairman Bryan Norby says simply, "We are still trying to figure that out."

Some Silver State insiders were also big bank customers. According to FDIC filings, when the bank failed it had $43.5 million in outstanding loans to "executive officers, directors, or primary shareholders." Five of these unnamed insiders received the biggest loans. French says the insider loans were not excessive for Silver State's size.

The board approved comfortable pay packages for top executives the year before the bank collapsed, including bonuses that doubled their pay.

In December 2007, President and CEO Johnson received a $400,000 bonus and a raise that upped his salary to $400,000. According to the American Bankers Association's annual compensation survey, the average CEO salary for a bank with a similar asset size was $354,600. While the majority of banks awarded bonuses based on performance, the average executive bonus across the industry was $25,400. Johnson did not respond to numerous messages requesting comment. He resigned as CEO a month before the bank failed but remained on the board.

Douglas French earned a bonus of $175,000 and a raise that brought his salary to $260,000 in 2007. French also sold stock for a little more than $1.8 million before share prices plummeted. The Silver State vice president says he was forced to sell because the stock was declining and margin calls were coming in.

French didn't stick around to see the end. A little more than three months before the bank went under, a company press release announced that he had resigned for "personal reasons." In truth, French now says, he was fired for "mismanagement of financial real estate."

"The board of directors decided that they would sleep better if I wasn't there," he says.

French is now the executive vice president at the Ludwig von Mises Institute, a Libertarian think tank in Alabama. The job allows him to look back at Silver State with philosophical detachment.

There was no way he could have prevented the bank's fall, French says.

"I was hired to be a real estate lender," French says. "I wasn't in a position to say, 'Hey, we are going to stop this.'"

Researcher Lisa Schwartz contributed to this report.