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A bank built on a bubble

Fortune visits the aftermath of the Sunbelt housing bust - and a small bank's struggle to clean up its act.

By David Whitford, editor at large
Last Updated: August 12, 2008: 9:57 AM EDT

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Risky construction and development loans contributed to the Sunbelt's continuing banking crisis.
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A Towne Bank board meeting brings together contractor Mark Carlson, board member Stephen Brophy, and Chairman Ronald Creasman.
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Towne has just one retail location, in Mesa, but it has relied on brokered deposits from all around the U.S. and has lent money in far corners of Arizona for construction projects.
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Patrick F. Patrick was brought in as the new CEO earlier this year to straighten out the bank in response to the FDIC's warning.
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An unfinished residential complex languishes near Phoenix.
Photos
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(Fortune Magazine) -- "I understand why lizards live in sunny Arizona," sings Robert Earl Keen. "Why people do and call it home I'll never understand." Neither will I, but obviously we're in the minority. "People come out here - they like it," insists Tanya Wheeless, CEO of the Arizona Bankers Association.

Especially in winter, but even in high summer, when it's nearly triple digits all through the night, and the rain, when it comes, feels like a hot shower in a steamy bathroom. "Nothing looks rundown," says Wheeless, who's taking me on a driving tour this afternoon (nobody walks here) of Maricopa, 37 miles south of Phoenix. "Streets are wide. Everything is new. You expect everything to be new, you know?"

Just a few years ago Maricopa was a desert crossroads surrounded by cotton fields. Remnants of old Maricopa still exist: a check-cashing business, a rough-looking bar called the Headquarters Lounge, a rustic strip-mall precursor called the Maricopa Business Barn - none of those places look new.

But north and south of the old town center along Route 347 you'll find nothing but clean new subdivisions filled with row after row of identical homes. Mainly stucco with a little bit of rock. No yards to speak of, but playgrounds, swimming pools, walking trails, and a few perfect patches of what could be real grass, I suppose, but looks way too green. "From the $130s," says the sign facing the road.

The pattern repeats all over the valley, evidence at every turn of Phoenix's phenomenal growth in jobs, in housing, and in wealth.

In 2000, Arizona banks held $43 billion in deposits. In 2007 the total was $80 billion, the lion's share controlled by three large national banks. Arizona is third behind Alaska and California in terms of the fewest bank branches per capita. Plenty of room for newcomers, even if all they ever grab is a sliver of market share. Making Phoenix an obvious place to open a bank.

Towne Bank, which sprouted in suburban Mesa just four years ago and still has only one retail location, was one of those opportunistic upstarts, a bank built on a bubble.

For a brief moment at the peak of the real estate boom, little Towne Bank (deposits: $128 million) was a success story. It grew fast, building an impressive loan portfolio, accumulating deposits, and capitalizing on Arizona's construction boom. Then came the sudden collapse of home prices (one-year drop in Phoenix: 26%), which brought closer scrutiny by bank regulators, one directive leading to another with escalating urgency until Towne received a cease-and-desist order (C&D) in March from the Federal Deposit Insurance Corp.

The bank's sins, as catalogued in the ten-page document ordering Towne to change its ways, read like a program guide to the larger banking crisis: " ... unsatisfactory lending and collection practices ... large volume of poor-quality loans ... inadequate provisions for liquidity ... " - and the list goes on. There were consequences: Co-founders Rick Meikle, the former CEO, and Don Fitzpatrick, the former chairman, no longer work at Towne; some depositors have fled; and borrowers, even those with good credit, are finding loans much harder to come by.

The Sunbelt banking crisis is not over yet. Dozens of banks may fail this year, and credit is drying up faster than a Phoenix sidewalk after an afternoon downpour. The tale of Towne Bank illustrates all the ways in which go-go lenders thrived on risk and now aggravate the economic pain as they struggle to survive.

So far, Towne is still standing, with new management and a growing cushion of loan-loss reserves. In this climate, that's saying something. After nearly three years in which there were no bank failures in the United States, ten have gone under since February 2007, including California's IndyMac Bank (branches: 33) and two subsidiaries of Arizona-based First National Bank Holding (branches: 28).

To fortify themselves, banks across the United States have cut back on lending. According to a Federal Reserve survey of senior loan officers conducted in April, 80% of banks had tightened their standards on commercial real estate loans over the previous three months. Goldman Sachs reported in July that commercial bank lending, which typically grows 5% to 10% annually, has stalled over the past four months.

Nowhere has the credit crunch left a bleaker landscape than the suburbs of Phoenix, where half-finished homes and vacant lots testify to the frustrated dreams of developers like Scott MacDougal, who is stuck $10 million short of the financing he needs to finish a project because Towne has cut him off. "They were going to fund all our construction costs," says MacDougal. Then, "they didn't want to do any more real estate loans."

Loaning money against nonexistent assets

All across the Sunbelt - in central Georgia, Southern California, South Florida - new banks were forming at a record pace during the real estate boom: between 100 and 300 a year, beginning in the late 1990s, says Shivan Govindan, president of Resource Financial Institutions Group, a private equity investor. As fast as new banks appeared, others were absorbed, often at astonishing premiums, which led to still more capital flowing into the sector, and still more startups.

For banks intent on rising to the top of an acquirer's wish list, the game was all about ramping up the loan portfolio and getting to profitability as quickly as possible. Construction and development loans, more than home mortgages, were the way to go. Your preferred customers were land flippers and small contractors building a handful of homes or office buildings on spec.

Since you were loaning money against an asset that did not yet exist, these were the riskiest loans in your portfolio. They were also the most profitable, meaning there was room to offer lower terms and still make money, plus an incentive to take on loans that more prudent banks wouldn't touch.

Increasingly, you would find yourself wandering in search of the hottest deals - in terms of risk, in terms of geography. And let's say you're an old-school banker, naturally cautious. You don't have much choice; you almost have to play along or you'll fall too far behind. "The most aggressive behaviors," says Govindan, "become infectious."

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