A bank built on a bubble

None of this is possible, of course, without money in the bank, which creates a ferocious appetite for deposits. Traditionally, the way little banks have competed against big banks for our savings dollars is by giving away toasters and sponsoring the Little League team.

But there's a new way. It costs a lot less upfront than opening new branches or expanding your network of ATMs, and it's faster. You do it with so-called brokered deposits, gathered through wholesale channels - brokers, mutual fund companies, and specialists who run ads in the business pages of local newspapers advertising the highest rates in the country. And while you'll have to pay more interest to get those deposits and will end up with a lot of fickle customers whose only loyalty is to the best rate, you'll get your money and can make your loans. It's a tradeoff many banks have been willing to make.

That whole way of doing business - fueling a far-flung, rapidly expanding portfolio of inherently risky real estate loans with hot money from brokered deposits - describes scores of small banks that popped up during the past several years, but none more accurately than Towne Bank of Arizona. Co-founder Rick Meikle was building a home in Gold Canyon, Ariz. He had sold a bank that he had founded in Washington State and was looking for the next deal.

"Real estate was booming, but everything was booming there," says his friend Don Fitzpatrick, who had worked with Meikle before and agreed to join him in his new venture. "Nice economic climate, a lot of people moving into the state. It looked like a perfect opportunity. Plus there were a lot of banks that in Rick's opinion weren't doing a good job." (Meikle declined to talk to Fortune.)

Cattleman Stephen Brophy, the second-largest landowner in Arizona and chairman of the advisory council of the San Francisco Federal Reserve, says he accepted Meikle's invitation to join Towne's board because he, too, saw an unmet need. He envisioned a traditional community bank that would loan money in its own backyard and whose officers would serve on the boards of local charities.

However it was not some cozy little community where Towne set itself up, but on busy Baseline Road in the Phoenix suburb of Mesa, which ranks as America's largest suburban town, bigger in population than such cities as Cleveland or Minneapolis and pushing farther into the desert every day. Yet Towne Bank ranged even farther afield. From the beginning, its loan territory tracked the ever expanding tide of Arizona development, from Casa Grande, 55 miles south of Phoenix, all the way north to Bullhead City on the Nevada border.

To feed the beast, Towne perfected the art of gathering brokered deposits. As recently as the first quarter of 2008, Towne had the second-highest percentage of brokered deposits of any publicly traded bank in the country - 59.5%, down from a peak of almost 78% in June 2007. "We were common," says the new CEO, Patrick F. Patrick, a professional turnaround executive who was brought in earlier this year to restore some sanity to Towne's balance sheet, "but we were aggressively common."

Probably the board should have asked more questions. Then again, it's hard to argue with success. "We had an enormous net interest margin," says Brophy. "We were making hundreds of thousands of dollars a month pretax. We were growing at a very rapid rate. The stock was going up. And our management, who were professional bankers - and who I believed knew what you could and couldn't do - said what we were doing was the right thing."

When its holding company, Towne Bancorp (TWNE), did a secondary stock offering in August 2005 through FIG Partners in Atlanta, the response was overwhelming. Towne gave itself three weeks to raise $25 million; within a week the offering was oversubscribed. A year later the stock was up nearly 60%, partly in response to soaring profits in what would prove to be the final stages of Arizona's real estate boom.

"I thought our excess profitability was a sign of success," says Brophy. "But it was a sign that adjustments had to be made."

In hindsight, Towne's success was as fragile as it was illusory, born of a business plan better suited to a rip-roaring entrepreneurial startup than a community bank backed by the full faith and credit of the federal government.

Regulators don't like it when you play fast and loose with guaranteed money. By early spring 2007, they were telling Towne's board with growing concern that the bank was on a dangerous path, that it needed to cut back on real estate loans, especially as the market was softening, and that it could not continue to rely so heavily on brokered deposits.

The regulators turned up the heat considerably last summer, even as the board was growing more skeptical of Meikle's capacities to address their concerns.

"He would tell us that 'the things they've asked me to do are 90% complete,'" says Towne board member Ron Creasman, who was elected chairman in October 2007. "When we would dive deeper, we would find they were not."

NEXT: A bank built on a bubble

1 2 3