Two Billion Dollars Lost Because the FDIC Ignored United Commercial Bank's Frauds

The good news is that we finally have the second group of indictments of senior bank officers. The prosecution involves officers of United Commercial Bank (UCB), a roughly $10 billion San Francisco bank that originally specialized in lending to Chinese-Americans and became primarily a commercial real estate (CRE) lender. The indictment deals only with the cover up phase of UCB's senior officers' frauds. I will show in future posts that the reported facts on UCB's loans were consistent with accounting control fraud. The UCB case is so rich in lessons that it will take a series of articles to capture what the case reveals about the degradation of regulation and prosecution of elite accounting control frauds. Here are the most essential facts. In 2002, a court found that UCB's senior managers had engaged in fraud to hide losses on a large loan for the purpose of fraudulently inducing another bank to bear the losses. It found the senior officers' conduct so outrageous that it awarded substantial punitive damages. The FDIC, the SEC, and the Department of Justice did nothing in response to the fraud. There is no indication that the FDIC filed a criminal referral. UCB then went on campaign to grow massively (to reach the minimum size, $10 billion, to acquire a Chinese bank) by making CRE loans. UCB made so many CRE loans so rapidly that it showed up as an exceptionally high risk bank under the joint agency guidelines on CRE concentrations. Despite this dangerous concentration, its record of engaging in fraud, and examination reports that found pathetic underwriting on CRE loans, the FDIC rated UCB's managers as “1” or “2” (the top possible ratings). The joint agency guidelines were typical products of the anti-regulators' destruction of effective regulation. The guidelines were designed to be unenforceable and they met their designers' goals. The anti-regulators did not believe it was legitimate to regulate – one could only natter at the frauds and crazies that were destroying the economy. The damage that using guidelines instead of enforceable rules causes to effective supervision and prosecution will be subjects of future postings. Making loans without appropriate underwriting causes banks serious losses. When bad underwriting is compounded with extreme concentrations in high risk assets the resulting losses are commonly fatal. When one adds in accounting control fraud the result is catastrophic losses. The UCB case allows us to form critical insights about the FDIC's examination, supervision, and Inspector General (IG) functions. Each needs to be revamped on an urgent basis. UCB was not a difficult case, yet the FDIC got it spectacularly wrong. One of the future articles will focus on these problems. The FDIC has had less fervently anti-regulatory leaders than its sister agencies, so if the FDIC has fallen this low it bodes poorly for federal financial regulation. On October 22, 2008, the FDIC recommended that UCB be admitted to TARP on the basis that it was a well-run and well-capitalized bank. The FDIC claims, with no critical inquiry from its IG, that this recommendation (which added roughly $300 million to the cost of resolving UCB's failure) was appropriate because UCB's senior managers' misled the FDIC about UCB's true financial condition. Yes, they did deceive the FDIC, but the FDIC should have removed UCB's senior managers in 2002 and it should have known that UCB's purported income and capital were likely false from that date. An anonymous whistleblower wrote to the Treasury Department to warn that UCB's CEO could not be trusted. The FDIC then “considered” the warning by deciding that it should not investigate the warning. Had they taken even the most minimal step that a high school student could employ (a web search) the FDIC would have found that UCB's senior managers had led a major fraud in order to cover up loan losses. It is disturbing that the FDIC did not make criminal referrals against UCB's senior managers in 2002 and did not remove and prohibit them from the industry. It is disturbing that the FDIC did not prevent UCB's massive growth in highly risky assets. It is disturbing that the FDIC failed to recognize the signs of accounting control fraud in UCB's CRE lending. It is disturbing that the FDIC rated UCB's management and asset quality as sound or even exemplary. It is disturbing that the FDIC ignored the whistleblower's warnings about UCB and recommended that it be given TARP funds. But it is inexcusable that the IG report, the function of which is to examine the agency's mistakes so that they can be fixed, never mentions that a court found in 2002 that UCB had defrauded another bank by covering up a huge loss on a major loan.

Bill Black is the author of The Best Way to Rob a Bank is to Own One and an associate professor of economics and law at the University of Missouri-Kansas City. He spent years working on regulatory policy and fraud prevention as Executive Director of the Institute for Fraud Prevention, Litigation Director of the Federal Home Loan Bank Board and Deputy Director of the National Commission on Financial Institution Reform, Recovery and Enforcement, among other positions.

Bill writes a column for Benzinga every Monday. His other academic articles, congressional testimony, and musings about the financial crisis can be found at his Social Science Research Network author page and at the blog New Economic Perspectives. Follow him on Twitter: @WilliamKBlack