A pair of community banks in eastern Virginia are learning the consequences of trying to keep up with the Joneses.

Commonwealth Bankshares Inc. and Hampton Roads Bankshares Inc., both in Norfolk, are potentially in hot water with federal officials. For some observers, the troubles began when each tried to keep pace with the biggest community bank in their market.

Commonwealth and Hampton Roads face probes from federal grand juries and the Securities and Exchange Commission. The investigations, which do not appear to connect the banks, focus on lending practices and accounting, among other things.

Each bank has also had a chief executive leave in the last 26 months. Regulators have also instructed both banks to boost capital after they posted consistent losses during the last recession.

The situation is one that has repeated itself in other U.S. cities, where smaller banks tried to take on bigger banks in a market, says Philip Smith of consulting firm Gerrish McCreary Smith in Memphis, Tenn.

"I have seen that happen, where smaller organizations have their eyes focused on the largest competitor, and they say, 'Let's be like them,'" Smith says. "Those banks they're targeting didn't get to that size overnight."

Kent Engelke, the chief economic strategist at Capitol Securities Management Inc. in Richmond, Va., agrees that the banks were distracted as they tried to compete with TowneBank in nearby Portsmouth, which has remained profitable, improved capital levels and grown loans.

Engelke said Hampton Roads was especially hurt by an ill-advised acquisition. "Hampton Roads tried to grow too quickly," he says "When they bought Gateway, they tried to be the kingpin challenging TowneBank in the region."

Commonwealth, he says, had too few controls over lending practices. "They were lending money to anyone with a pulse," he says.

Calls to Andy Davies, Hampton Roads' president and chief executive, and G. Robert Aston, TowneBank's chairman and CEO, were not returned. Chris Beisel, Commonwealth's president and chief executive could not be reached for comment.

The Justice Department does not comment on grand jury subpoenas or investigations, says spokeswoman Laura Sweeney. SEC spokeswoman Judith Burns says the agency does not comment on investigations.

TowneBank is the leading community bank in the Tidewater region of Virginia, which includes the cities of Norfolk, Newport News and Virginia Beach. With $2.8 billion in deposits and 14% market share, TowneBank was the third-biggest bank in the Norfolk area, based on June 2010 data from the Federal Deposit Insurance Corp. (Wells Fargo & Co. and SunTrust Banks Inc. had the most market share.)

Commonwealth controls 5% of the market, making it the sixth largest banks, and Hampton Roads is one notch behind, at 3.9%.

Additional numbers bear out the divergent health conditions of the three community banks.

TowneBank had a nonperforming assets ratio of 2.4% at March 31, while Hampton Roads had a 10.6% ratio and Commonwealth had a 15% ratio. The return on equity numbers are horrific for the smaller banks. Commonwealth's was negative 58.35% at March 31, and Hampton Roads' was negative 69.48%. TowneBank's ROE was 6.7%.

Hampton Roads brought trouble on itself when it bought Gateway Financial Holdings Inc., which was based in Virginia Beach, in September 2008, Engelke says. Gateway's capital had been depleted by securities writedowns following the conservatorship of Fannie Mae and Freddie Mac.

In a May 2010 interview with American Banker, Douglas Glenn, the company's general counsel, said that because the bank's growth happened "in the teeth of the economic downturn," it "magnified those challenges."

Hampton Roads was able to attract capital, and in May 2010 it announced multiple capital raises that, totaling $295 million, from private equity firms such as Carlyle Group, Anchorage Advisors and CapGen Capital Group. Hampton Roads completed the capital raises in December.

Other problems surfaced. In September, former CEO, Jack Gibson, sued the company for back pay totaling more than $8 million. Gibson, who claims in court filings that he was terminated without cause, argues that the company owes him from the severance agreement he signed in the wake of his departure. The lawsuit is active in the U.S. District Court for the Eastern District of Virginia, and a trial is set for Dec. 6.

Last November, the company disclosed that the Justice Department's criminal division had issued a subpoena asking for information on its Gateway deal and on loans Gateway made before it was sold. The company also disclosed that the SEC's enforcement division was investigating its accounting practices.

Hampton Roads said in a regulatory filing that it is not a target in the Gateway probe. On the SEC investigation, Hampton Roads said it believes its accounting will be deemed appropriate, though it could face penalties or sanctions. Hampton Roads, in court filings has denied Gibson's claims for back pay.

Meanwhile, Hampton Roads is trying to unload some of the retail banks it inherited from Gateway, in an effort to cut costs. In June, it agreed to sell two Gateway branches in Charlottesville and Richmond.

Engelke says he expects Hampton Roads to make it back to health because its private equity backers "knew of these issues before they put money" into the company and because Hampton Roads was a good bank before it bought Gateway.

Engelke is not as generous in his assessment of Commonwealth, describing it as "an extraordinarily troubled bank right now."

Edward Woodward Jr. quit as Commonwealth's CEO and president on Dec. 3, after serving in those roles since 1973. After ending 2010 with a $51.8 million loss, the company's auditor on April 14 expressed doubt about Commonwealth's ability to continue as a going concern.

The next day, Commonwealth disclosed that a federal grand jury was investigating current and former officers and directors, related to its lending practices, specifically looking at "the manner in which certain loans and loan renewals were considered and approved." Commonwealth also disclosed that the SEC is investigating its accounting controls. Commonwealth said it's cooperating with both investigations.

The bottom line, some observers said, is that shareholders for the banks must wait to see if they can turn their fortunes around

"For some banks, their primary focus was growth — grow, grow, grow — and sometimes at the expense of profitability, with the idea that if you grow your franchise and asset size, the profitability will ultimately catch up," Smith says.

"For the most part that theory might work, provided you don't have the intervening economic event that we had," Smith adds. "What I see more shareholders demanding now is, 'I don't care about my asset size, I want to know where my dividend is.'"

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