Sept. 23 (Bloomberg) -- New Frontier Bank, the largest lender in northern Colorado, had a lot to be proud of in early 2007. Assets had grown by 66 percent the previous year and profits by 53 percent. American Banker rated the bank the ninth- most efficient in the country.

Regulators knew the reality was different. In mid-2007, the Federal Deposit Insurance Corp., citing weak management, a rise in soured loans and an increased reliance on volatile funding, told executives to slow growth and add capital, according to board minutes of the privately held bank obtained under the Freedom of Information Act.

While Greeley, Colorado-based New Frontier’s loan losses rose, it took almost two years for state and federal regulators to shut the bank -- a delay that may have made the closing more costly. On April 10, the lender, whose assets had grown to $2 billion under Chief Executive Officer Larry Seastrom, became the 10th-most expensive failure of 2009, costing the FDIC $670 million. No other bank could be found to take over, and the FDIC had to charter a new one to assume the liabilities.

“The examiners should have seen a lot of this coming,” said Gerard Cassidy, an analyst with Portland, Maine-based RBC Capital Markets, an investment bank owned by Royal Bank of Canada. “I shake my head when I look at some of these failures and ask, ‘Where were the regulators?’ We’re paying a lot more than we would if they had acted sooner.”

FDIC Criticized

New Frontier is one of 94 banks that have been shut this year at the fastest pace in almost two decades. The FDIC’s inspector general criticized the agency in 20 reports this year examining banks that failed in 2009 or 2008 for acting too slowly or not assertively enough to correct or close lenders.

The most recent report, released yesterday, said the agency failed to understand risks posed by IndyMac Bancorp Inc. until 11 months before the Pasadena, California-based lender was seized last year in the most expensive U.S. bank collapse, costing the FDIC’s insurance fund $10.7 billion. IndyMac’s primary regulator was the Office of Thrift Supervision, or OTS.

Steven Fritts, associate director for risk management policy at the FDIC, defended the agency’s overall handling of troubled banks and said the size of the losses was the result of an “unprecedented decline” in real estate values.

“Of course there are cases when we could have acted more swiftly,” Fritts said. “We’ve reacted reasonably well.”

He said the agency has taken steps in recent months to tighten its oversight by lowering the amount of real estate loans banks can make relative to their capital.

‘Well-Capitalized’

Banks supervised by other regulators, including the OTS, the Office of the Comptroller of the Currency and the Federal Reserve, have also failed. The Fed came under fire from its inspector general, who issued two reports on Sept. 9 saying the central bank didn’t rein in excessive real estate lending at banks in California and Florida that later closed.

A review of New Frontier is set to be released by Oct. 23, according to the FDIC inspector general’s office.

FDIC spokesman Andrew Gray wouldn’t comment on discussions with the Colorado lender. He said the bank was “well- capitalized” in 2007, meaning it had a risk-based capital ratio of 10 percent or more, and “adequately capitalized” in 2008, with a ratio of between 8 percent and 10 percent.

“As a matter of policy, the FDIC and other agencies typically do not require formal corrective programs without corroborating evidence of a safety-and-soundness weakness at the institution that would be subject to such an order,” Gray said.

Mounting Losses

Delays can raise the cost of closing banks. From 1980 to 1994, during the savings-and-loan and regional banking crises, the government adopted a policy of quickly shutting troubled institutions and selling them or liquidating their assets.

The losses to the FDIC insurance fund during that period averaged 12 percent of the assets of failed banks, reaching a peak of 25.3 percent in 1986, according to agency data. This year losses are 24.6 percent of assets on average, which Cassidy said was a sign of lax supervision. At New Frontier, the fund’s losses were 33.5 percent of the bank’s assets.

The FDIC said that its insurance fund’s assets fell to $10.4 billion at the end of June from $13 billion at the end of March, the lowest since the savings-and-loan crisis in 1993. In its Aug. 5 report on the 2008 failure of Duluth, Georgia-based Haven Trust Bank, the agency’s inspector general said FDIC supervision “was not effective in identifying and addressing problems early enough to prevent a material loss” to the fund.

‘Balancing Act’

New Frontier grew to $2 billion in assets when it failed in April from $795 million at the end of 2005. The bank used its swelling deposit base to increase lending to developers and dairy farmers in states as far away as Texas and Florida. It also made loans in Greeley, a city 60 miles north of Denver with a population of about 90,000 whose largest employer is meatpacker JBS USA, a subsidiary of JBS SA, the world’s largest beef producer.

Fred Joseph, Colorado’s acting bank commissioner, questioned whether regulators, including state officials, were tough enough with New Frontier. The state agency was the bank’s primary regulator.

“With 20-20 hindsight, perhaps we could have done more,” said Joseph, head of the state’s division of securities and acting banking commissioner since November. “As a regulator, you want to take measured steps because you want the institution to do better. You want to give them every opportunity to correct. It’s a balancing act.”

‘Unstable’ Deposits

Joseph said New Frontier’s growth was fueled by excessive amounts of “hot money,” deposits brought in by brokers that can disappear quickly if someone else offers higher rates.

The over-reliance on such deposits was evident to state and federal regulators for years. Brokered deposits rose almost fivefold to $121 million in 2005, or 19 percent of New Frontier’s total, from $26 million, or 6 percent, at the end of 2004. By March 31, 2008, they accounted for 41 percent. By comparison, brokered deposits made up 8.4 percent of the deposits at similarly sized banks nationwide in March 2008, according to FDIC reports.

“Any time a bank gets up into double digits with brokered deposits you’ve potentially got a problem,” said Christopher Whalen, managing director of Institutional Risk Analytics, a Torrance, California, firm that evaluates banks for investors. “These deposits are unstable. You can wake up one morning, and 5 percent of your deposits have left.”

‘Not Bankable’

Joseph said the need to earn high returns to pay for the brokered deposits “led to lax underwriting” at New Frontier. The bank paid 4.62 percent in interest for every dollar of earning assets as of June 30, 2008, compared with 2.71 percent at similarly sized lenders, according to FDIC figures.

Robert Brunner, a founder and director of New Frontier and owner of Northern Feed and Bean, an animal-feed supplier in Lucerne, Colorado, defended the high level of brokered deposits, saying the local deposit base wasn’t large enough to support rapid growth.

“We brought into this area capital that wouldn’t have been here otherwise,” Brunner, 69, said in an interview.

Some rival bankers said New Frontier expanded by offering loans they wouldn’t have made.

“We have seen a substantial number of their loans, and they are not bankable,” said Leroy Leavitt, chairman of New West Bank in Greeley, which has $147 million in assets. “We would never have made those loans in the first place.”

‘Problem Assets’

Leavitt said he was puzzled that regulators hadn’t acted sooner.

“We had the same bank examiners they had, and I can tell you the examiners that wear the boots, the guys on the ground, were very competent, very thorough, very knowledgeable,” Leavitt said in an interview. “But somewhere the regulatory process failed.”

Brunner said accusations that the bank had engaged in reckless lending were “unjustified.”

“It wasn’t like all of a sudden we put on all these bad loans,” Brunner said. “They saw what we were doing all along, and they hadn’t criticized any of those loans before 2007.”

Gray of the FDIC said the agency’s mid-2007 examination “noted an increased level of problem assets, an over-reliance on volatile funding, declining earnings and capital, unsatisfactory management and a myriad of other issues.”

Camels Ratings

Regulators use a system known as Camels, an acronym for capital adequacy, asset quality, management, earnings, liquidity and sensitivity to market risk. Banks are rated in each category, with 1 the best and 5 the worst. Banks with ratings of 1 or 2 are considered safe. A rating of 4 or 5 usually brings a formal order for corrective action, while a rating of 3 can lead to either a formal or informal call for improvement.

FDIC examiners gave New Frontier ratings of 3 for capital adequacy, management and liquidity in June 2007, according to the bank’s board minutes from November 2007. The bank received ratings of 1 or 2 in the other categories.

Brunner said New Frontier’s directors were “upset” by the downgrade in ratings. The board passed a resolution on Nov. 13, 2007, authorizing the bank to “take appropriate action to contest the preliminary ratings,” according to minutes of the meeting.

New Frontier’s adversely classified assets -- loans overdue 30 days or more or at risk of loss -- rose to 42 percent of Tier I capital in October 2007 from 25 percent in January 2007, according to board minutes.

Red Flag

If the percentage approaches 50 percent, or rises rapidly, it should be a red flag calling for quick regulatory action, said Nicholas Ketcha, head of the FDIC’s division of supervision until 1999 and now a managing director at FinPro Inc., a bank consulting company in Liberty Corner, New Jersey.

“We had rapid growth in real estate loans that started falling rapidly, and loans to dairy farms increased as milk prices collapsed,” said Seastrom, 54, a founder of New Frontier and its CEO until shortly before the bank was closed. “There was a snowballing effect.”

Seastrom said he couldn’t comment further because of continuing investigations.

The FDIC issued a memorandum of understanding on Feb. 28, 2008, requiring that New Frontier raise capital, reduce brokered deposits, slow asset growth and improve or replace management, according to board minutes.

The confidential document, an indication that a bank is being given a last chance to meet regulators’ requirements on its own, almost assured New Frontier’s failure, according to Brunner.

“When we had to back away from the brokered deposits, we couldn’t replace them,” he said.

Looking for Capital

Brunner said the bank tried and failed to raise capital from outside investors and sell some of its loans after the memorandum of understanding. By then, it was too late. New Frontier’s adversely classified assets grew to 134 percent of Tier I capital on Sept. 22, 2008, according to FDIC records. It would reach 265 percent on March 3, 2009.

Cassidy of RBC Capital Markets said the slow response by bank regulators over the last year was partly the result of insufficient staffing. The FDIC and the organization created for cleaning up after the savings-and-loan crisis, the Resolution Trust Corp., had 22,549 employees in 1992. By the end of 2006, there were 4,476.

Gray, the FDIC spokesman, said that the reductions were in line with the reduction in the number of FDIC-supervised banks, and that the decline has been reversed since mid-2006, when Sheila Bair became chairman. The agency now has more than 6,000 employees, Gray said.

Cease and Desist

The FDIC issued a cease-and-desist order in December 2008, demanding that New Frontier find capital, replace management and halt unsafe practices. The order wasn’t released publicly until Jan. 31, 2009. In the three days after the news got out, the bank lost $16.3 million of deposits, according to board minutes.

In order to raise fresh capital, New Frontier tried to sell a majority stake to investors Gary Jacobs and Mark Wong. The two began combing the bank’s books in January, before the order was made public, and what they found scared them away, according to Jacobs, a partner at J2 Partners, a private-equity firm in Boulder, Colorado.

“We knew there were problems buried there, but we were naive with respect to the extent,” Jacobs said. “Once we delved into it, it was 100 percent clear that the bank was substantially more troubled than had been purported or from what we had found in the regulatory filings.”

Johnson Dairy

Jacobs said he was particularly troubled by loans totaling about $50 million to Johnson Dairy LLC, the largest dairy farm in Colorado, which had filed for bankruptcy on Jan. 8.

The owner, John D. Johnson, claimed in a lawsuit against New Frontier, filed in Federal bankruptcy court in Denver, that bank officials had structured complex loans and leases involving their relatives and friends to conceal that the bank had exceeded regulatory loan limits, and had forced Johnson to use some of the borrowings to purchase New Frontier shares.

While New Frontier denied the allegations, Jacobs said the pattern of behavior suggested lax policies.

“The bank grew too fast to be in control,” Jacobs said.

Jacobs said he and Wong, CEO of Agrivida, a Medford, Massachusetts-based biotechnology company, withdrew their offer in March.

On March 25, New Frontier’s directors were informed that the bank would have to make a loan-loss allowance of $143 million, which would reduce its capital to about 2 percent, according to board minutes. Sixteen days later, almost two years after it first found fault with the bank, the FDIC took it over.

“There were many bad actors in the meltdown, but it wasn’t just the bankers,” Cassidy said. “The regulators played a role, and the size of the losses tells you the banks were not being monitored closely enough.”

To contact the reporter on this story: James Sterngold in New York at jsterngold2@bloomberg.net

Last Updated: September 23, 2009 10:56 EDT