Ordered by regulators to boost capital levels immediately, Frontier State Bank in Oklahoma City has sold a chunk of its securities portfolio, returning it to well capitalized status.

It remains to be seen whether the bank — whose assets shrank 19%, to $583 million, as a result of the sales — will win a fight to preserve its business model of investing heavily in collateralized mortgage obligations. The Federal Deposit Insurance Corp., which calls this model risky, took Frontier State to court over the matter this month; both sides rested their cases last week.

Some observers said the sales, which also let the bank repay some of its Federal Home Loan bank borrowings, could make Frontier's unusual strategy more palatable to regulators.

On May 1, a month before the trial began in U.S. District Court for the Western District of Oklahoma in Oklahoma City, the FDIC issued a "prompt corrective action" letter against the bank. It said the bank had not properly risk-weighted some of its CMOs under standards that regulators had issued to all banks the day before. The FDIC told Frontier to rectify the situation.

Joseph D. McKean Jr., Frontier State's chairman and owner, wrote in an e-mail to American Banker that by June 5 it had sold the CMOs in question, at a profit of $4.6 million. As a result, the bank's total risk-based capital ratio rose to 11.66% on June 1, from 4.64% on March 31, he said. (A bank is generally considered well capitalized if this ratio is above 10% and undercapitalized if it is below 8%.)

But McKean was clearly unhappy that Frontier was forced to liquidate what he called "well-performing, private-label CMOs." He wrote that the bank will miss out on $30 million of future earnings, plus interest.

Frontier State's total risk-based capital stood at a healthy 18.71% at yearend but plunged in the first quarter because its CMOs were downgraded by a rating agency.

Joshua Bock, an attorney at Bracewell & Giuliani LLP representing Frontier, said that since the end of the first quarter, the bank has reduced its outstanding Home Loan bank advances by $103 million, to $167 million.

Christopher Whalen, the managing director at Lord, Whalen LLC's Institutional Risk Analytics, said less reliance on Federal Home Loan bank advances could significantly improve the bank's ability to handle risk.

"It may be the sale of that big chunk of securities will be enough to get them into good graces" with regulators, Whalen said.

Other observers were dubious.

Jeffrey C. Gerrish, a partner at Gerrish McCreary Smith PC in Memphis, said that, because Frontier's portfolio is still largely made up of CMOs, he is not sure that selling some of them would help Frontier's case.

Regulators "are complaining about the business model of investing in securities, and it seems they are still heavily invested with them," said Gerrish, who left the FDIC 25 years ago after being a regional counsel. "So I don't know if that will help them with the regulators or not, but it couldn't hurt." (Gerrish, who has worked on almost a dozen administrative hearings in his career on both sides of the courtroom, said he represented the agency in its first administrative hearing, in 1978.)

The next step in the federal case is for Administrative Law Judge C. Richard Miserendino to make a recommendation to the FDIC's board of directors.

Bock, the Frontier attorney, said the recommendation is expected to be made in the third quarter, with the board making its decision before yearend.

If the board rules in the FDIC's favor, Bock said, Frontier will most likely appeal.

The FDIC had wanted Frontier to sign a cease-and-desist order because the regulator asserts that the bank's model of short-term funding for investments in long-term securities exposes it to risk from rate swings.

Frontier refused to sign the order and argued in court that nothing it is doing is illegal. It also said it has proven it operates safely by continuing to make money despite large interest rate swings in recent years.

Industry watchers said the case is drawing a lot of interest because Frontier's model has not proven to be problematic despite one of the worst banking climates in decades and that bad communication between bank and regulator may be what drove the issue into a courtroom conflict.

A spokesman for the FDIC said it does not discuss pending litigation.

Randall James, a consultant and former Texas banking commissioner, said Frontier's case is unusual because the bank is profitable and most of the risk appears to be borne by McKean.

Because of that, James said, it seems as though the difference of opinion on the bank's business model could have been resolved before an administrative hearing.

"They have been able to keep making money through the downslide," James said. "The operation of the bank does not fit in a box that the FDIC has to work with. So nobody is getting along with anybody. … Anything that is out of the ordinary, out of the box, or out of the standard community banking model is quite difficult for most regulators to deal with. It might have assisted in finding a good resolution if the FDIC sought another solution to its own risk mitigation early on. There might have been another way around these problems."

The FDIC said that a test of Frontier's portfolio in the April 2008 exam found that the risks of the current asset and liability concentrations would be detrimental to the bank at its current capital levels.

One problem with the strategy of using short-term funding to invest in long-term CMOs is that a rate increase would reprice the funding faster than the assets, which would then lose market value because CMOs would be paying below-market rates and the repayment rate for the mortgages would slow. The bank would be forced to dig into capital, the FDIC said.

In its complaint, the agency said that a 200-basis-point jump in interest rates would cause the weighted average life of the portfolio to extend to 11.28 years, from 3.33 years, and that such a jump would cause the portfolio to drop in value by $82 million — or more than one-and-a-half-times Frontier's Tier 1 capital.

But McKean told American Banker that the FDIC is assuming "a parallel shift in interest rates, meaning all rates on the yield curve, from the Fed rate for overnight funds to the 30-year Treasury rate, simultaneously jumping 2% overnight and staying precisely at that level for 11.28 years.

"Expert testimony in court stated that this scenario has never happened," he wrote.

Frontier has outperformed peers since it adopted the CMO strategy in 2002, earning $7.6 million in the first quarter, for a return on equity of 44% and a return on assets of 4.18%. By comparison, Oklahoma banks with $500 million to $1 billion of assets returned 1.23% on assets in the quarter, and the national average for banks of that size was 0.32%. The average return on equity in Oklahoma was 11.64%, and the national average was 3.36%.

Frontier is heavily concentrated in collateralized mortgage obligations, with roughly 71% of its total assets in the securities.

By comparison, the average portfolio allocation for banks in Oklahoma with $500 million to $1 billion of assets at March 31 was 21%, and peers nationally allocated 17.4% of their portfolios to securities, according to FDIC data.

Further separating Frontier's model from a typical bank's is that the bulk of its core deposits belong to two people, McKean and John Stuemky, a director. For other funding, the bank relies heavily on Federal Home Loan bank advances, federal funds, brokered deposits and large certificates of deposit.

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