Park National Bank was known for caring deeply about its local community. The flagship bank of FBOP Corp. donated 28 percent of its profits to Chicago's West side communities, made zero-interest loans to schools and, at the height of the housing crisis, committed $20 million to a foreclosure rescue plan. On a rainy, unseasonably warm Friday last October, Treasury Secretary Timothy Geithner himself came to town and awarded the bank $50 million in tax credits to expand its nonprofit community development agency.

Later that same day, FBOP's nine subsidiary banks - including the $4.7 billion-asset Park National - were seized by regulators and sold to U.S. Bancorp at a steep discount.

The bank failures, estimated to cost the Deposit Insurance Fund $2.5 billion, set off a controversy in Chicago, where FBOP founder and chief executive Michael Kelly worked closely with local leaders on all sorts of community-development projects. David Pope, president of Oak Park, Ill., FBOP's hometown, has called the firesale of the local franchise to a regional giant headquartered 400 miles away "the largest bank robbery in the history of the United States."

The Chicago press, playing to failure fatigue in its market-through the end of March, 25 Illinois banks had collapsed-glommed onto the story, typically casting Kelly as George Bailey from "It's a Wonderful Life" and the government as the evil Henry Potter.

The $18.3 billion-asset FBOP had more than half of its balance sheet invested in the preferred stock of Fannie Mae and Freddie Mac-a capital strategy that was approved, some would even say encouraged, by federal regulators. When the Treasury Department abruptly placed the government-sponsored mortgage giants into conservatorship in September 2008, FBOP's capital levels plunged.

The company tried to obtain additional capital, first from the capital markets and later the Troubled Asset Relief Program. But it was thwarted multiple times by government actions as it pursued TARP. "The rules kept changing," recalls Daniel Watts, Park National's former president. "We thought early on we'd get the money, and we didn't. Then we thought we had it a second time, but didn't. ... The ring just kept getting moved a little further from our grasp until we ran out of time."

What galls Watts and other observers most is an apparent lack of flexibility on the government's part. FBOP's franchise included seven banks in California, Arizona and Texas that were undercapitalized. Under the so-called cross-guarantee provision of FIRREA, the Federal Deposit Insurance Corp. is required to seize all banks in a holding company if that appears to be the most cost-effective solution for the Deposit Insurance Fund.

But it's a subjective exercise. Park National itself had a 9 percent capital ratio, considered "adequate," according to Watts. Moreover, community leaders and some members of Chicago's congressional delegation argued that this relative health, combined with a mission of supporting underserved neighborhoods, earned the bank some additional time to find capital.

The FDIC didn't agree.

"They didn't seem to take the components apart and ask, 'What will this do to our local community?'" says Steven McCullough, president of Bethel New Life, a Chicago community-development organization that worked closely with Park National. "Our question is, why was a financially successful, model community-based bank not only allowed to die, but prevented from saving itself?"

While FBOP was bigger than the typical community bank, its tale has emerged as exhibit A in a growing national debate over Washington's handling of troubled small banks. In January, a congressional subcommittee used its collapse as the centerpiece of a hearing-subtitled "examining the failure and seizure of an American bank"-that brought testimony from Kelly, several regulatory officials and West Side community development leaders, some of whom bussed all the way from Chicago.

The gist of the critics' arguments: Treasury and the regulators seem more than willing to contort the rules to prop up giant institutions, including several that helped cause the crisis, because their failures might jolt the system. When it comes to community banks, the approach is more like "callous disregard," says former FDIC Chairman William Isaac.

Most community banks didn't make risky loans or play around with exotic instruments, but many now find themselves on the ropes because of an "erosion of capital reserves due to the current economic climate," Kelly told congressmen. At the end of 2009, 702 banks and thrifts-most of them small ones-were on the FDIC's problem bank list, up from 552 in the third quarter.

"I'm very concerned that small banks are getting the short end of the stick," says Isaac, now the chairman of consultant LECG Global Financial Services. "There clearly is a double standard at play: We have a lot of rules that seem to apply to the smaller institutions, but very few that apply to the bigger banks."

The bias is apparent in the way TARP capital was literally forced on some of the biggest banks, even those that didn't want it, while many community banks with mid-range CAMELS 3 ratings and in need of capital have been denied the money if they were unable to raise matching private equity first. "The test they've used for the smaller guys was, you had to prove you are viable without TARP," Isaac says. "The test should have been, you've got to prove you can be viable with TARP."

Worse, some institutions unable to secure the money have been slapped with ratings downgrades that exacerbate the situation-part of what some say is an overly rigid approach to examinations and enforcement that seems rooted more in fear of getting burned than a desire to help the economy and banks improve.

"The regulators have overreacted to the crisis," says Chris Cole, senior regulatory counsel for the Independent Community Bankers of America. "They've become too conservative and cautious, too strict with their policies, and it's killing our banks."

Another point of contention was the Bush administration's decision to seize Fannie and Freddie - a move former Treasury Secretary Henry Paulson has since admitted was meant primarily to placate Chinese bondholders, and "basically killed" holders of the preferred shares.

No large banks had enough Fannie and Freddie paper to make much of a difference in their capital standings. But Isaac notes that some 2,700 smaller banks had relatively "major investments" in thesecurities of the government-sponsored enterprises. "Those banks were encouraged to buy that paper by the low-risk ratings" regulators assigned to the paper, Isaac says. "It was an ambush, and it caused a number of banks to fail."

Indeed, some bankers have a sneaking suspicion that the regulators are using extra-tough enforcement to spur along the pace of the clean-up, and hasten the recovery, at their expense.

Regulators have acknowledged the role of the GSE conservatorships in the failures of FBOP and some other institutions, but say rules are rules, and the FDIC's primary mandate is clear: maintain the system's stability, while minimizing the costs to the Deposit Insurance Fund.

"The determinations to place the FBOP banks into receivership were consistent with, or required by, the statutory scheme Congress put in place to resolve banks ... at the least cost to the Deposit Insurance Fund," Senior Deputy Comptroller of the Currency Jennifer Kelly testified during the January hearing.

Some outside consultants, and even some bankers, don't have much sympathy for FBOP's position, or the bigger argument that smaller banks aren't getting a fair shake. "I don't understand what the gripe is," says Bert Ely, a regulatory analyst in Alexandria, Va. "If you're insolvent, you're insolvent. ... Just because some companies are too-big-to-fail and no one can figure out what to do with them doesn't mean that you compound the problem by bailing out community banks."

Ely also is unmoved by the capital woes of FBOP and other banks snared by collapses of Fannie and Freddie. While the regulators had approved the holdings, the GSEs' potential demise had been rumored for months. "The question should be, 'Why were they so heavily invested in the stocks of those two companies?'" he asks. "You can't let the regulators make decisions for you."

Dan Blanton, the CEO of Georgia Bank & Trust Co. in Augusta, sits on the FDIC Advisory Committee on Community Banking. He hears a lot of complaints and says the regulators aren't perfect, but also has come to appreciate the difficult decisions with which they are confronted.

"You've got to realize, they're approaching all of this from a very high-level perspective," Blanton says. While some individual decisions might be debatable, "there's no intention I can see from them to damage community banks."

Whether FBOP is a good choice for the role of industry martyr is another matter of debate. The company made its share of strategic mistakes, before and during the crisis, and got some help from nongovernmental sources. An ongoing lawsuit, for instance, accuses JPMorgan Chase & Co. of sabotaging the company's capital-raising efforts last May by calling a $246 million loan prematurely.

There's more than a little irony that Kelly, the grandson of a banker who committed suicide during the Great Depression, found himself in this predicament. A workout specialist who honed his skills in the 1970s with Wells Fargo & Co. predecessor Minneapolis-based Northwestern National Bank, Kelly bought the faltering First Bank of Oak Park in 1981, and within a decade transformed it into one of the top-performing banks in the country.

The company acquired nearly 30 troubled institutions at bargain prices over the years. Those rehabilitation projects gave Kelly three small banks in Texas and one in Arizona, and a $12.5 billion-asset, three-bank California franchise to complement Park National.

FBOP didn't get involved in subprime mortgage lending, but did have a knack for turnaround situations and working out troubled loans. Attempts to reach Kelly for this story were unsuccessful, but in his congressional testimony he noted that the company posted record profits for 25 straight years, and had historical net loan losses that were about one-quarter the industry averages. In their 2008 examinations, all nine FBOP banks were well-capitalized with solid regulatory ratings, he added.

Along the way, FBOP distinguished itself by doing good. Nearly one-third of its 150 branches were in low-to-moderate income areas. Six of the banks, including all of the big ones, received "outstanding" CRA designations. In 2007 and 2008, FBOP banks made $55 million in "community donations and investments," Kelly testified.

A reclusive billionaire to the rest of world, Kelly earned a reputation in Chicago for thoughtful engagement. He'd meet frequently with community leaders, helping to plot the latest church or school project. Kelly "is the smartest guy I've ever worked for and the most honorable person you'd ever want to meet," Watts says.

All of the banks, especially Park National, were reflections of Kelly's values, and he clearly liked calling the strategic shots. He owned 100 percent of FBOP, and sold only debt-mostly trust-preferred securities-but never equity, to maintain control. He also ran at a very low tangible equity ratio, providing relatively less room for error.

FBOP's troubles began in late 2007, as the crisis was gaining traction. In her congressional testimony, Jennifer Kelly described a series of "strategic decisions that, in retrospect, diminished the company's financial flexibility and exposed the banks in the company to failure."

The company grew its loan portfolio 35 percent during the year ended in the third quarter of 2008, filling a gap in a commercial real estate market that other banks thought too risky. It also bumped up loan participations among its various banks. In hindsight, such moves "limited FBOP's financial flexibility and ability to absorb losses,"the OCC's Jennifer Kelly testified.

Those close to Michael Kelly say he viewed the financial crisis as another opportunity to buy distressed banks. Most of his previous deals came during bad times for struggling institutions that could be had on the cheap. "M&A was part of our history, and there was a feeling that acquisition opportunities would be coming our way," says Watts, now president of $180 million-asset Forest Park Bank in suburban Chicago.

With that in mind, FBOP began shifting its capital into a more "safe, liquid form," that could be sold quickly if the right chances emerged, Watts says. That turned out to be Fannie and Freddie preferred shares, which had a better yield than Treasury securities and were rated AAA-minus by the ratings agencies.

By 2008, FBOP's three California banks - California National Bank in Los Angeles, Pacific National Bank in San Francisco and San Diego National Bank - had almost $700 million of Fannie and Freddie stock on their balance sheets; Park National's tally was about $100 million, Watts recalls.

"It was the safest investment we had," he adds, noting that management split the investments 50-50 between the two GSEs to limit the risks. "The regulators encouraged it to help support community lending-you got a [Community Reinvestment Act] benefit. Because they were GSEs, there was no limitation on how much you could hold."

Kelly also sought additional capital in the summer of 2008, but his appetite for control got in the way, observers say. At the time, debt-financing alternatives were slim, while private equity was hot. The ink was still drying on Corsair Capital's $7 billion equity injection into National City Corp. and a similar amount invested by a TPG-led group into Washington Mutual Inc. Financial advisers tried to persuade Kelly to go that route too, "but he just didn't want shareholders with a say," explains one of the advisers.

FBOP was still in good shape as the second quarter of 2008 ended. Just over a month later, Fannie and Freddie were seized, reducing the value of some $885 million in securities to zero overnight. Several weeks later, FBOP lost another $100 million when Wamu failed. FBOP had purchased Wamu paper when it was rated investment grade. In less than a month, FBOP had lost 63 percent of its Tier 1 capital.

Kelly and his team immediately committed to raising enough money to get FBOP's individual banks back to well-capitalized status. At the time, the company's credit quality still looked relatively good, and there was serious investor interest in the company.

Just when it was looking like the company would raise the money, however, TARP's Capital Purchase Program was announced. The CPP created confusion in the market, and ground most capital-raising efforts to a halt. Most agree that FBOP would have been a strong candidate for early TARP funding that October. But Treasury didn't have an option for private companies, because warrants were a big part of the equation.

When a private-company option became available in mid-November, the Office of the Comptroller of the Currency recommended to the interagency council overseeing applications that FBOP be approved. But that council requested additional information. In the interim, the company's loan quality began to deteriorate precipitously, and the OCC withdrew its support.

In July 2009, the agency notified the FDIC of its intent to close seven of the nine banks. Park National and the $120 million-asset Citizens National Bank of Teague in Texas were not included on the list, but Park National was cited as a "deteriorating problem institution with financial and managerial weaknesses," Mitchell Glassman, director of the FDIC's division of resolutions and receiverships, testified to Congress.

In early September, the FDIC began marketing the seven banks on a standalone basis and in combination with each other. To test the waters, Park National and Citizens were offered, without a loss-share agreement, but no takers were found. On October 20, the agency received 41 bids from 18 bidders for some or all of FBOP. The best deal for the seven banks in immediate danger would have cost the DIF $1.85 billion.

By the FDIC's calculations, if Park National and Citizens failed later-a distinct likelihood, given the volume of loan participations among the banks-the total cost would be $2.91 billion; applying the cross-guarantee provision and seizing Park National earlier lowered the cost to $2.54 billion, saving the fund $316 million. And so Park National joined a list of failed institutions that now numbers more than 200 since the fall of 2007, and still has a ways to grow.

Was the seizure justified? By the numbers, yes. Even so, the sense of loss on Chicago's West Side is real.

While U.S. Bancorp has pledged to meet most of Kelly's commitments in the short-run, it also has shareholders to answer to and runs an efficiency-based banking model-not better or worse than FBOP's, just different. It has announced plans to shutter some branches and likely won't be making zero-interest loans to schools or waiving fees for nonprofits. In the end, saving the deposit insurance fund money comes at a cost, too.

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