The Impact of the Financial Crisis on Community Banks 6/21/2011 Courtesy of Mendes and Mount, LLP Introduction Over the course of the past decade, community banks have become heavily concentrated in construction and development lending as well as commercial real estate lending due to an increase in competition for consumer credit, home mortgages, and credit cards. Now, two years into the financial crisis, and with the benefit of hindsight, it appears that the increased competition was met with loosening of underwriters standards, and poor management. As a result, over 150 banks failed in 2010, almost 50 banks have failed thus far in 2011, and we will continue to see high levels of bank failures, particularly among community banks, for the next few years. In fact, billions of dollars in commercial real estate loans made prior to the financial crisis has still yet to mature, many of which are underwater and will be difficult to refinance. Not surprisingly, a wave of litigation resulting from the failure of community banks has commenced. With the economic conditions remaining unsettled, and with the probability of more community bank failures on the horizon, the FDIC will continue to investigate banks and bring additional lawsuits in the coming years. Insurers that have provided Directors and Officers (“D&O) liability coverage to community banks are concerned over FDIC litigations and their aggregate exposure to financially distressed community banks. Additionally, many Insurers are reluctant to provide D&O coverage for such risks. Therefore, some community banks are experiencing displacement issues with regards to the carrier community, and new Insurers are sought to provide D&O programs. While there has been a considerable increase in cost for D&O coverage, the expected FDIC litigations will not likely affect financially sound financial institutions, including community banks, from procuring D&O coverage. However, “problem institutions” are struggling to obtain coverage, and will likely continue to struggle until they can shore up their financial viability. This article examines the causes of the failure of community banks in the wake of the financial crisis, and the resulting investigations and litigation being pursued by the FDIC as well as private investors. Additionally, the article provides helpful statistics concerning the recent bank failures, and also provides several case studies of banks that have failed during the current financial crisis. Causes of Community Bank Failures It is not surprising that many of the community banks that have failed during the recent financial crisis have had similar characteristics. Many have suffered because of loan losses from construction and development lending as well as commercial real estate. An analysis of the financial statements of community banks, prior to their failure, demonstrates that the banks had a significant percentage of non-performing loans in the areas in which their lending was heavily concentrated – construction and development, and commercial real estate. Because the lending at the failed banks were so heavily concentrated in these portfolios, the banks were not prepared to deal with non-performing loans, and the resulting loan losses.

Many companies have shut down during the recession, vacating shopping malls and office buildings financed by the loans, which has resulted in delinquent loan payments and defaults by commercial developers. While there has already been a significant amount of community bank failures through 2011, because the losses to commercial real estate appear to develop at a later stage, continuing losses to commercial real estate will likely lead to further bank failures in the coming years. In fact, the Congressional Oversight Panel has suggested that commercial real estate loan losses will significantly increase over the course of the next several years, impacting the stability of community banks, and likely leading to more community bank failures. While economic conditions have undoubtedly contributed to the recent bank failures, similar to the Savings and Loan (“S&L”) period, we have found that internal problems such as poor management has substantially contributed to bank failures as well. Our experience demonstrates that high risk business strategies, poor underwriting, which fails to adhere to the bank’s guidelines, including poor documentation, and inadequate management oversight all contributed to the recent failure of many community banks. In fact, because many directors and officers defend claims by arguing that they could not predict the market collapse, most FDIC lawsuits attempt to develop evidence of dishonest conduct, failure to follow internal policies, and failure to establish and adhere to adequate underwriting policies. Continue Reading Full Article at Company Website