SAN FRANCISCO -- Just three years ago, Financial Center Bank ranked among California's most profitable financial institutions. But earlier this month, regulators seized the $195 million-asset bank after losses virtually wiped out its capital.

How could a bank fall apart so quickly?

Financial Center's top managers admit they have no one to blame but themselves. "We felt we could build a better mousetrap," said Stephen H. Brinck, who was chief financial officer. "If we had stuck with what we knew, we would have done fine."

The eight-year-old bank's meltdown serves as a textbook example of the what can go wrong when management strays from its areas of expertise. While Financial Center succeeded at lending to small and medium-size companies, an aggressive push into mortgage banking and other unfamiliar businesses led to its demise.

The mortgage unit delivered hefty profits when California's economy was thriving, but it produced huge losses when the recession hit.

"The strategic plan was to marry a [lending] business with a fee business," said James M. Sherman, 55, the bank's former president and chief executive. But, he admitted, "We didn't do a good job tactically."

A Low-Key Presence

Make no mistake, Financial Center was not a go-go bank. In its first few years, it operated out of a modest and aging downtown office building. "It was one of the most unpretentious banking offices you've ever seen," recalled Van Kasper & Co. analyst Philip L. Hage.

And Mr. Sherman, who was ousted last year, was hardly the high-rolling type. He was the chief credit officer at San Francisco's Hibernia Bank and founded Financial Center with a group of fellow executives after Hibernia was acquired.

His 3% share of the holding company's stock tied up much of his personal wealth. And no one could accuse him of being overpaid: In 1990, when the bank was still profitable, Mr. Sherman's received just $122,500 in cash compensation.

"He was an honest, loyal and capable guy who was in over his head," said Mr. Brinck.

Financial Center got off to a modest start, booking about $72 million in assets in its first three years of operation. But in its quest for fees, Financial Center in 1987 made two major acquisitions: First Capital Corp., which made commercial loans insured by the Small Business Administration; and ILS Mortgage Corp.

Profitable Operation

First Capital proved to be a solid moneymaker. But the mortgage company was largely responsible for Financial Center's eventual collapse.

ILS specialized in so-called nonconforming mortgages - risky high-interest-rate loans that didn't meet the standards of mortgage-backed security issuers such as the Federal National Mortgage Association. To get the loans off its books, ILS sold them to junk-bond laden Imperial Federal Savings Association of San Diego.

Financial Center pumped considerable money and resources into the mortgage unit. Between 1987 and 1989, the number of offices increased to 20 from 12, while mortgage originations more than doubled to $513 million. By yearned 1989, 72% of the bank's 365 full-time employees worked for the mortgage company.

The bank provided volume incentives to mortgage lenders, in effect encouraging them to make loans with little regard for quality.

ILS president D. Fred Baldwin, kept on as head of the mortgage company after the acquisition, had a contract giving him 1% of loan origination fees over a certain target. The unit's lending spree allowed him to collect cash pay of $709,000 in 1989, according to Financial Center's proxy.

An Untamed Banker

Mr. Baldwin ran the business with very little interference. "Fred was an alley fighter," commented an investment banker. "Jim didn't lasso Fred in."

Meanwhile, the mortgage unit's heavy lending strained Financial Center's funding capacity, forcing it to chase hot money. By the end of 1989, brokered deposits and high-interest certificates sold through a money desk totaled $47.1 million, or 22.9% of total deposits.

In the first two years after the acquisition, the mortgage company performed spectacularly, thanks to the extra-wide margins and hefty fees its high-risk loans produced. Financial Center's return on assets exceeded 1.5% during that period.

Sharp Drop in Originations

But when California's economy began to slump in 1990 and mortgage demand dried up, the unit's monthly originations fell from a high of more than $50 million to less than $15 million.

At the same time, the company was unable to find buyers for its loans because the market for low-quality mortgage paper dried up. Financial Center was forced to keep mortgages in its portfolio, many of which went sour.

Compounding its woes, the mortgage company had sold its $619 million servicing portfolio in 1989, depriving it of a major income stream.

The high overhead, low origination volume, loss of servicing income, sharp drop in fees and rising burden of delinquencies were a murderous combination.

Runaway Losses

"We sustained incredibly big losses" in the mortgage unit, said Mr. Brinck. The bank as a whole reported a $498,000 loss in the fourth quarter of 1990 and trouble snowballed from there.

Mr. Sherman tried to come to grips with the mortgage unit's problems by rapidly slashing staff and overhead. But troubles popped up elsewhere, symptoms of the bank's weak credit procedures.

The trade finance unit charged off $4 million in poorly secured import-export loans in 1991. Among them was a $1.3 million credit to Yee Nor Kong, owner of a San Francisco sweatshop, who fled the country.

Meanwhile, losses mounted on a portfolio of loans to real estate developers made by the bank's Walnut Creek office in the San Francisco suburbs.

New Chief Recruited

As things spiraled out of control, Financial Center sought a new chief executive. The "lack of turnaround in the mortgage company" prompted the board to replace Mr. Sherman, a director said.

As its new CEO, Financial Center hired Gordon R. Taubenheim, chief executive of a small bank in the San Francisco suburbs. Mr. Taubenheim also became chairman, replacing James J. Funsten, the executive of a floor coverings company who had headed Financial Center's board.

Arriving last September, Mr. Taubenheim put into effect an emergency plan to rescue Financial Center. To show his commitment, he invested more than $250,000 of his own money in the holding company, Financial Center Bancorp, becoming its second-largest shareholder.

Mr. Taubenheim stopped making higher-risk mortgages, turning instead to home loans that met the standards set by issuers of mortgage-backed securities. He dramatically shrunk assets and added millions to loanloss reserves.

"Gordy did a valiant job, but he got there too late," said an investment banker.

Financial Center had pledged to regulators to raise total capital by the end of 1991 to 9% from 7.59% of risk-adjusted assets. But losses in the second half reduced Financial Center's regulatory capital to a razor-thin 0.38% of assets.

Meanwhile, nonperforming assets reached $23.5 million by yearend, or 13.4% of loans plus foreclosed property.

As the bank's woes deepened, hot money climbed over $100 million, or nearly 50% of deposits.

Dependency on hot deposits was a gun to Financial Center's head. Under a federal banking rule scheduled to take effect in June, troubled and undercapitalized banks such as Financial Center faced a complete ban on use of such funds.

In a last-ditch effort to raise capital, Financial Center in March sold its First Capital unit to a subsidiary of Tokyo-based Fuji Bank Ltd. But time had run out.

Earlier this month, federal regulators declared Financial Center insolvent and put it into receivership.

For their part, Financial Center insiders remain convinced that the bank could have been saved if the government had engineered a sale through the government's open-bank assistance program. Under that procedure, a troubled bank remains open while the government provides a buyer protection against losses.

While industry sources said one potential buyer, Detroit-based Comerica Inc., had talked about a deal, it had no serious interest in buying the bank as a going concern.

Said Bailey S. Barnard, who headed the bank's First Capital unit: "It was too far gone to interest anybody."

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