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Appeal of Composite and Component Ratings, Matter Requiring Attention, Violation of Law, and Compliance With a Formal Enforcement Action (Second Quarter 2015)


A federal savings association (bank) supervised by the Office of the Comptroller of the Currency (OCC) appealed to the Ombudsman the supervisory office’s determinations in the most recent report of examination (ROE). Specifically, the bank appealed the following:

  • Composite rating of 3 and component ratings of 3 for earnings and management.
  • Noncompliance with a cease-and-desist order.
  • Matter requiring attention (MRA) for board and management oversight.
  • Violation of 12 CFR 34.43(b) regarding evaluations.


The appeal contended that the composite rating was unsupported because the ROE acknowledged improvements in credit risk management. The appeal stated that the improvements resulted in closing five MRAs and continued decline in the volume of problem assets. In addition, the bank was not in significant noncompliance with laws and regulations, overall risk management practices were satisfactory, and bank was financially sound and well capitalized. The appeal also stated that the Uniform Financial Institutions Rating System (UFIRS) states that the composite ratings generally bear a close relationship to the component ratings assigned and the bank received four ratings of 2 and two ratings of 3, which were also under appeal.

With respect to the rating for management, the appeal contended that the supervisory office assigned a 3 rating primarily due to noncompliance with one remaining article of the cease-and-desist order and because the board did not hire senior management as requested by the OCC. The appeal also said that the ROE incorrectly stated there were two new MRAs. The appeal stated that there was only one new MRA and the second MRA was a repeat regarding board and management oversight.

With respect to the rating for earnings, the appeal stated that while the bank recognized the need to improve earnings, the 3 rating was unsupported. The bank contended earnings increased 88 percent from 2013 year-end, supported operations, and provided appropriate capital in relation to the bank’s growth and overall condition. In addition, the bank noted improved earnings over 2014. The appeal further stated that earnings that are relatively static or experiencing a slight decline may receive a 2 rating, provided the bank’s level of earnings is adequate.

With respect to noncompliance with the cease-and-desist order, the appeal argued that the bank complied with a business plan article found to be in noncompliance. The bank contended the cease-and-desist order did not require it to meet business plan projections and targets, but to implement the plan and ensure adherence to the plan. The appeal stated that the bank implemented the business plan but it has not met all of the projections and targets. The appeal also argued that the bank took actions to improve core earnings and maintain profitability; however, market conditions changed and the bank did not want to make ill-advised, long-term, low fixed-rate loans increasing the bank’s interest rate risk profile just to meet projections.

With respect to the MRA, the appeal stated that the bank chairman initially committed to recruit a new chief executive officer (CEO) and hire a new chief credit officer (CCO) by June 30, 2013. In October 2013, the bank realigned its lending department and appointed the chief lending officer to serve as the CCO during an interim period. The appeal also stated that the board’s decision to sell the bank, followed by the pending sale and associated delays related to the purchaser, prevented the hiring of a capable CEO. The board also concluded on its own that the notice of change in director and senior executives, required by Financial Institutions Reform, Recovery and Enforcement Act 914, would take longer than closing the merger transaction.

With respect to the violation, the bank argues that it advised the supervisory office that the bank’s evaluation materials for the renewal of a one- to four-family construction loan were consistent with the Interagency Appraisal and Evaluation Guidelines dated December 10, 2010, and in compliance with 12 CFR 34.43(b).


The Ombudsman thoroughly reviewed the information submitted by the bank and the supervisory office. The Ombudsman conducted the review using the standards in effect at the time of the examination including

  • Comptroller’s Handbook, “Bank Supervision Process” booklet, September 2007, updated September 2012 and May 2013.
  • Comptroller’s Handbook, “Duties and Responsibilities of Directors” booklet March 1990 and January 1998.
  • 12 CFR 34.43.
  • OCC Bulletin 2010-42, “Sound Practices for Appraisals and Evaluations: Interagency Appraisal and Evaluation Guidelines,” December 10, 2010.
  • the cease-and-desist order.


Composite Rating

The Ombudsman concurred with the supervisory office assessment of a 3 rating. The supervisory office noted the bank’s quantitative and qualitative improvements in asset quality and capital by upgrading the component ratings for these two areas from 3 to 2. Continuing concerns regarding earnings level and sustainability, noncompliance with the Order, and management oversight remained overriding issues requiring the board’s attention and more than normal supervision. In addition, because of the significant reliance on income from mortgage banking operations, which is subject to high volatility from interest rate changes, the bank was less capable of withstanding business fluctuations and was more vulnerable to outside influences. The UFIRS states, “The composite rating generally bears a close relationship to the component ratings assigned. However, the composite rating is not derived by computing an arithmetic average of the component ratings. Each component rating is based on a qualitative analysis of the factors comprising that component and its interrelationship with the other components. When assigning a composite rating, some components may be given more weight than others depending on the situation at the institution.”

Management Rating

The Ombudsman determined that the supervisory office appropriately weighed the board’s noncompliance with the business plan provisions as well as failure to correct the board and management oversight MRA during three supervisory cycles, as primary considerations for maintaining a 3 rating for this component. Continued failure to correct MRAs and comply with the cease-and-desist order, particularly over several supervisory cycles, were serious concerns that reflected poorly on directors’ and management’s ability or willingness to address critical issues and to operate the bank in a safe and sound manner. The board’s primary responsibility was to ensure competent management; yet, despite the board’s determination in the first quarter 2013 to replace the existing CEO and hire a new CCO, the board failed to execute these decisions. The bank’s merger remains pending and does not preclude it from obtaining the necessary management capability to run the bank. In the ROE, the supervisory office acknowledged improvements in risk management practices, credit risk profile, and capital adequacy by changing the quality of risk management to satisfactory for several categories of the Risk Assessment System. The supervisory office also upgraded the asset quality and capital component ratings from 3 to 2.

The Ombudsman concurred with the bank regarding the number of new MRAs. There was one new MRA and one repeat MRA, as management corrected five previously cited MRAs.

Earnings Rating

The Ombudsman determined that the supervisory office supported the 3 rating given the bank’s lack of stable earnings, earnings subject to interest rate risk from significant mortgage banking activities, and inability to implement a business plan to improve earnings.

Management did not achieve a stable level of earnings at the time of the examination, as demonstrated by the erratic and low return on average assets and net interest margin since at least 2009. While the return on average assets increased by 26 basis points at March 31, 2014, it was only over one quarter, and mortgage banking net income was the primary driver of earnings. As the ROE used financial information as of March 31, 2014, subsequent earnings levels were not available at the time of supervisory decision and did not fall within the scope of this appeal.

The bank’s high reliance on income from mortgage banking activity, reduced on-balance sheet lending, and high overhead expense affected earnings quality. Mortgage banking made up 55 percent of the bank’s total income, subjecting the bank’s financial statements to high volatility from interest rates. Overhead expense remained high, even when viewed without mortgage banking related noninterest expense, and negatively affected earnings due to the high level of assets invested in low-yielding products.

Compliance With the Cease-and-Desist Order

The Ombudsman concurred with the supervisory office that the business plan provisions of the cease-and-desist order require the bank to meet the business plan projections and targets, with the objective of improving earnings. The cease-and-desist order requires the bank to submit a business plan that addresses plans to improve the bank’s core earnings and maintain profitability on a consistent basis. The Ombudsman determined that the narrative section of the business plan may discuss strategies for improving earnings; however, the bank must adhere to detailed financial projections that are part of the business plan.

The Ombudsman also concurred with the supervisory office that the bank did not implement the business plan to improve core earnings and maintain profitability, as evidenced by earnings that need improvement. A comparison of the December 31, 2013 projections to actual performance revealed that the bank’s net income was substantially below projections, primarily due to reduced income from mortgage banking activities and, secondarily from, commercial lending. Despite increases in cash, the bank reduced total assets by reducing commercial lending, while continuing to focus on off-balance sheet mortgage banking activities. Total noninterest income, which was primarily derived from mortgage banking, was also below projections.

Reduced income from mortgage banking and commercial loan portfolios equally contributed to the bank’s first quarter 2014 underperformance. Reduced noninterest expense and a substantial reduction in provision expense, as compared with projections, offset lower-than-projected interest and noninterest income.

Matter Requiring Attention

The Ombudsman determined that the supervisory office accurately cited a repeat MRA on board and management oversight. The board failed to correct practices that deviated from sound governance, internal controls and risk management principles that were first identified in the 2011 ROE. The Ombudsman also determined, however, that the MRA needed enhancement to communicate the corrective actions expected by the OCC when citing a repeat MRA in the ROE. The Ombudsman revised certain sections of the MRA and required that the board immediately ensure competent and capable senior management and hold them accountable for returning the bank to a safe and sound condition. The Ombudsman determined that the bank’s pending merger precluded the escalation of the repeat MRA over several supervisory cycles into an enforcement action.


The Ombudsman determined that the supervisory office appropriately cited a violation for the lack of an evaluation regarding two extensions of a speculative construction loan. Although an appraisal was not required, an evaluation was necessary because this was a subsequent transaction with no new money advanced. The bank did not have documentation addressing the value of collateral securing the one- to four-family speculative construction loan as of the date of the extension, as required by 12 CFR 34.43(b). The bank also did not comply with its lending policies that were in effect during the time of the two extensions.

In addition, a review of the offering memorandum for the most recent extension revealed only a prospective market value of the property. A current market value as of the date of the recent extension was necessary. The residence continued to be in construction after six years, with several extensions and an increase to the loan. Given this, the Ombudsman required the bank to update the recent appraisal to obtain a current market value of the property to ensure collateral protection and accurate risk rating.