The Unsound and the Fury

Arkansas National Bank expanded from 2 branches to 10 branches between 1995 and 2000. Then, this small bank from northwest Arkansas changed its name to ANB Financial and went big into commercial real estates loans in Idaho, Utah, and Wyoming. The Office of the Comptroller of the Currency closed ANB Financial in May 2008, when these loans began defaulting in mass. When I related its story, a friend exclaimed, “What were they thinking?” He marveled that community bank executives imagined they had any advantage monitoring mortgages a thousand kilometers away.

Some insight into the strategy of failed banks comes in the Letters to the Shareholder in old annual reports. Irwin Financial, for example, was a holding company owning a small bank and mortgage company. Will Miller, Irwin Financial’s Chair and CEO explained the strategy for the mortgage unit in the 2006 annual report:

We started our home equity segment in 1995 as a high loan-to-value second mortgage lender. Twelve years ago, "high loan-to-value" was considered any mortgage loan with a loan-to-value (LTV) ratio in excess of 80 percent. By hiring the bulk of our initial senior management and staff with experience in both mortgage lending and credit cards, we combined the best of both of those industries and found a profitable niche. Since then, others in the mortgage market recognized the opportunity. Today, first and second mortgage loans at LTV ratios of 100 percent are commonplace. Given our initial experiences, we began testing mortgage products in 1997 with loan-to-value ratios of up to 125 percent. Our theory was that if customers were underwritten as if they were unsecured (analogous to the credit card business), but had an incentive to repay our debt before their credit cards due to our application of a mortgage lien, our credit quality would be better than that of unsecured debt. This has been true, and including a recent increase in delinquencies and losses, still is. We face a number of challenges with this strategy: the discipline of intensive credit evaluation is expensive; our credit systems and resources are a relatively fixed cost; and, as a result, we need a good amount of volume to maintain attractive margins.

In an increasingly competitive mortgage market, Irwin Financial decided that its conventional mortgage operation was doing too little volume to repay fixed costs, so it sold its conventional mortgage business in 2006 and announced “expansion of our high loan-to-value first mortgages, in an effort to increase our share of the market….By doing so, we believe we will meaningfully increase our volumes, improve our costs per funded loans, and improve profitability.”

So stated, the strategy almost seems reasonable. Credit card companies had a long record of profits from unsecured loans to borrowers of questionable repute. Irwin Financial’s loans would be secured and available only to prime or near prime borrowers. The presence of fixed costs explains the all or nothing approach. Of course, one could argue that high loan-to-value mortgages were insanity itself, that any borrower willing to sign one was sufficiently maladroit at personal finance to constitute a default risk, and that Irwin Financial should have learned from the default losses it took on these loans after the recession in 2001. One so arguing could make a good case.

The 2006 letter also contained two sentences that now stand out: “More recently, volume trends have been in the right direction as broker and correspondent production is increasing... Credit quality has slipped a bit, but it is not yet worrisome.” These would make fitting last words, but Irwin Financial survived long enough to release two more annual reports, each with apologetic letters. The 2007 Letter to the Shareholders began:

In 2007, Irwin Financial had a loss of $24.1 million, or $0.90 per diluted share from Continuing Operations with an additional $30.5 million loss from Discontinued Operations for a consolidated loss of $54.7 million for the year.

My colleagues and I are extremely disappointed with these consolidated results. While we have made significant strategic moves over the past several years to lower our risk exposure to mortgage markets - exiting the conforming conventional first mortgage banking business and continuously tightening credit standards on home equity loans -these moves did not come soon enough for us to avoid being hurt by the deterioration of the residential real estate market far beyond what we and most other observers had expected. I am confident we can substantially improve our results in 2008, although not all the way back to satisfactory levels of long-term performance; that will take longer than one year.

The 2008 annual report announced even greater losses and the letter discussed corporate restructuring, plans to recapitalize the banks, and mass layoffs. Regulators seized both bank and holding company in September 2009. ANB Financial and Irwin Financial were being risky, and perhaps even silly, but at the time their leaders, like the protagonists in most tragedies, thought they were being sensible.