Reader opinion by Ralph Hutchinson
As a former Federal Bank Regulator, banker and now bank consultant for nearly 25 years combined, I’ve followed the Sonoma Valley Bank story as it unfolded right here in our beloved Sonoma Valley, right up until August 20, 2010 when the FDIC swarmed in to seize control.
Here’s how I see it.
After extensive research of public records and numerous interviews with sources, it’s clear to me that principles of finance were violated.
Back in the mid-2000’s an incentive program was created to enhance shareholder value and amplify returns in order to set the bank up for merger or acquisition, most likely.
Executives and directors made large bonuses and compensation based on growth of the loan portfolio and potential earnings, without stop-gaps on credit quality. There were also instances of loaning too many dollars to one person, basically putting too many eggs in the same basket. This was counter to standard practices of diversification and risk management.
Compared to Northern California executives at similar community banks this compensation was as much as two-to-three times higher than average. Over time more of the compensation was shifted toward cash and less to equity options.
SVB management and the board, determining there were no viable deals left in Sonoma Valley, approved considerable loans to projects on the Hwy. 101 corridor between Petaluma and Santa Rosa. Most of these loans were to one person, Bijian Madjlessi, who now has been indicted for four counts of insurance fraud, and has defaulted on numerous projects.
It is my opinion that there were telltale signs of concern at the time of underwriting but internal systems were either too weak to identify risks, or they were bypassed in lieu of growth opportunity. Recent investigative reports suggest SVB management intentionally structured loan terms to avoid legal lending limits, and loan even more money to this, its largest borrower.
SVB had been a typical community bank with strong core deposit stability and solid performance. Character lending (focusing more on who they know versus detailed financial analysis and due diligence in background checking) was prevalent. Most all the loans were granted within Sonoma Valley for smaller dollars relatively, in the $250k to $2 million range — versus the tens of millions loaned to Madjlessi — so if there was a loss, no single loan would greatly impact the bank.
The business model proved very successful for nearly two decades. But when assets were concentrated to one borrower (nearly the entire capital base between $35-$40 million), the bank violated a major principal of finance.
With Madjlessi, all the loans were so intermingled and related that once one toppled, they all were in jeopardy and essentially the entire capital base was put at undue risk.
In fact, banking laws are so concerned about this concept of diversification they limit all loans related to one borrower to just 25 percent of capital, which for SVB equaled about $9 million at the high point. The bank exceeded that limit by three-to-four times that limit.
On large loans, community banks sometimes sell pieces (called “participations”) to their peer banks, as SVB did in the case of the Madjlessi relationship. There were participations sold to banks like Charter Oak Bank of Napa which choked on more than $5 million in Madjlessi toxic assets and failed in February of this year, just six months after SVB went under.
Madjlessi is accused of artificially inflating values of projects by arranging sales to his family, friends, and business associates – deals known as “straw-buyer” transactions. The asset values were then inflated, and the figures used to borrow more and more money.
Based on my experience, all this led to problems when bank management realized the projects were failing and the borrower was becoming “bigger” than the bank: weak monitoring, credit administration and underwriting, and unsatisfactory collection efforts.
Furthermore it appears that bank officers and insiders accepted gifts and investments in side business ventures from the borrowers or their affiliates and family members. This created a relationship too close to make objective decisions, and set the bank up for co-mingled interests. Ethically, it’s a poor practice and according to reports it may have influenced decisions.
With all the suspected “straw” activity and concentrations, regulators were left with little choice but to fail the bank. When the SVB Board wrote the letter a week after failure, claiming they were victims of a poor economy, that wasn’t the reason. I believe the negligent mistakes are clear to see.