Sunday, November 24, 2019

Time Tried, Panic Tested. The Forgotten Story of the First National Bank of Keystone

September 1st, 1999, regulators from the Federal Deposit Insurance Corp, at the behest of the Office of the Comptroller of the Currency, descended on a small coal mining town in Keystone, West Virginia.

The town, already depressed from coal's decline, had a population of 600. Clearly, blue-suit regulators stood out. The bank, First National Bank of Keystone, was $1.1 billion in assets, had 87 full-time equivalent employees, and accounted for two-thirds of the town's tax revenue. 

The blue-suits were not well-received. In fact, during the OCC exam that led to the bank's failure, federal marshals were called in to keep regulators safe. Harassment included a bellicose management team, scowls from the townspeople, and threatening sidewalk art outside of the bank. 

In 2015, nearly sixteen years to the day of the failure, the last defendant, Terry Church, was released from prison

Church, part of "Knox's Foxes", was a Vice President of the bank and President of the mortgage subsidiary, which was at the center of Keystone's problems. She effectively ran the bank and its operations. Because the then-President was Billie Jean Cherry, the former town mayor, and paramour of J. Knox McConnell, the mastermind behind the bank's meteoric growth and the "Knox" behind "Knox's Foxes". McConnell died suddenly two years prior to the bank's failure.

Why Knox's Foxes? Because McConnell hired only women, stating he didn't want any relationship entanglements at the bank. He did not note the irony that he had a relationship with a board member. He was also ok if two women entered a relationship. 

I'm not making this up.

The Bank's Rise

McConnell came to the bank in 1977 from McKeesport, Pennsylvania. Another depressed town due to the general economic malaise that bedraggled the region when the steelmaking industry moved elsewhere. So McConnell was comfortable in a depressed area.

The bank was small when he arrived, it had $17 million in total assets, and grew to a reasonable $85 million in 1990. At the time of the bank's failure in 1999, the bank had $1.1 billion in total assets. Allegedly. One point one billion in total assets from one branch in a depressed town with a population of 600. 

How did McConnell do it? In 1990, the bank ramped up its HUD Title I loan program. These loans were primarily for home improvements, and if over $7,500, required a lien on the home. The government guarantee allowed for a secondary market in these loans. Meaning they could be packaged and sold to investors. And so went the birth of First National Bank of Keystone's meteoric rise.

They purchased these loans from lenders all over the country. How else can you blow your balance sheet up (pardon the pun) from a dying coal town? Nationwide lending! The bank, or more accurately its mortgage subsidiary, eventually run by Church, packaged these loans, securitized them, and sold them on the secondary market. Booking the valuable "gain on sale of loans". They kept some. But sold most. 

Keystone expanded its lending to include high loan-to-value mortgages and home equity loans. So it's balance sheet by the time it failed was chock full of these loans plus the Title I loans they did not sell. Or so we thought. 

How did the bank fund a $1.1 billion balance sheet from a town of 600? Nationwide brokered deposits. 

And the bank was doing fabulously. In 1998, its last full reporting year, it had net income of $69 million. On $1.1 billion in assets. A 7.15% ROA! It had $102 million in interest income! And, due to it's securitization and sale of loans, it had $73.5 million of fee income. All from Keystone, West Virginia.

The Bank's Fall

But oh, its balance sheet was not all it was cracked up to be. I could not uncover if McConnell was complicit in what went down and his "Foxes" just continued the charade, or if the Foxes were the brain child behind it. And by Foxes, I'm not implicating all bank employees. I'm specifically talking about Billie Jean Cherry, and Terry Church. However, it seems unlikely that McConnell didn't orchestrate the fraud. He set the tone for antagonizing regulators. And the bank had over $800 million in assets at the time of his death.

In 1998, the OCC gave the bank a Consent Order. No worries though, because the bank was fabulously profitable and management was in the business of ignoring their aggressive overlords. Cherry and Church kept the loan machine churning, and paid lackluster attention to the OCC. And anyone that has experience with the OCC, knows that ignoring them is like ignoring a crazy boyfriend or girlfriend's texts.

The OCC required Cherry to step down as president, deeming her incompetent for the job. They suggested one of their own to step in. In 1998, Keystone directors appointed Owen Carney as president, who had spent 28 years with the OCC.

Carney started work on February 1st, and lasted two months. Bank officials told him that employees were unhappy with his management style, and they controlled enough stock to keep him off of the Board. In hindsight, Carney said in an interview that he believed bank officials forced him out for reasons that had nothing to do with his management style. They feared he would discover the fraud. 

Ya think?

As a side note, one reason Cherry and Church had enough stock to control the vote was because Cherry gained control of McConnell's estate. She subsequently looted it and went to jail for it, and denied McConnell's will to donate a significant part of his wealth to his alma matar, Waynesburg University in Pennsylvania. Even though Cherry and McConnell had a 30 year relationship, Cherry married someone else one year prior to McConnell's death. 

There really should be a movie.

The OCC's 1999 exam was the final domino. The last straw, The end of the road. During that exam, the OCC decided to verify the loan portfolio. Typically, regulators would rely on the financial audit to verify assets and liabilities, among other things. 

But the OCC had been criticizing the bank's accounting practices for years, issuing exam MRA's and informal memorandum's compelling them to fix it. First McConnell, then the dynamic duo of Cherry and Church, ignored regulator admonishments. 

Until the OCC decided to check things out for themselves.

Where'd the Loans Go?

When the OCC finished looking, they couldn't find $515 million in loans. On a $1.1 billion balance sheet. I'd say that was material. You?

When they started asking bank officials "where are they?", they received nothing but sneers. And that's when the federal marshals were called in. Things weren't going well, and they were about to get worse.

Worse because, knowing the gig was up, Church asked her husband, who was in the construction business, to pull his trucks next to an old school building where the bank stored its documents, so the Foxes could dump boxes of records into them.

And what happened after they ended up in trucks? They were buried in a 100 feet long, 30 feet wide, and 10 feet deep trench dug at Church's house. Dirt was poured over them, and they were seeded so it didn't look like what it was. Nice touch, right?

Still not making this up.

And Now, the End is Near

Nearly half of the bank's assets were MIA. They had been likely sold in the secondary market, and never removed from their books. Meaning the bank was booking interest income on loans it did not own.

Recall that in 1998 the bank recognized $102 million in interest income. But with $515 million of phantom loans, the real number was likely less than half. Making the bank, effectively, insolvent.

In comes the blue suites.

Out goes employees. And to jail goes Church, Cherry, and Michael Graham, another mortgage subsidiary employee. Someone must have loosened the "no men" philosophy of Knox McConnell to let Graham in the door.

Graham flipped and got the lightest sentence because he didn't re-write and forge McConnell's will. That was Church and Cherry. Cherry died in 2008 while still in jail. And Church was released in 2015. I could not find her whereabouts. She's 66 years old now. Other Knox's Foxes involved in the fraud and pleaded guilty were Melizza Quizenbeury, Barbara Nunn, Lora McKinney and Ellen Turpin.

There was one other criminal case that emerged from the bank collapse. Norma Faye Canipe met Church in prison. After her release, Canipe went to Keystone (why would anyone go to Keystone) and attempted to sell off Church's ranch. The infamous ranch with the football field sized trench that once was the final resting place of the bank's mortgage documents. The problem was the government owned the property because it was bought with Church's compensation from the bank... i.e. ill-gotten gains.

Today, Keystone remains depressed. Even more so since it's biggest employer and major taxpayer was mercifully taken over by an out of area financial institution.

And the bank's tagline, "Time Tried, Panic Tested" is now a punchline.

You can't make this stuff up.

~ Jeff

Want to read more?

Pittsburgh Post-Gazette story:

Compliance Alert story:

Bluefield Daily Telegraph on Church's sentence shortened:

Bluefield Daily Telegraph article on Church's release from prison:

Washington Post article on scandal:

Charlestown Gazette on article from 2018 on Keystone decline:

LA Times Oct 1999 article:

Anatomy of a Banking Scandal book:

American Banker article Oct 1999 after Church is jailed:

BankEncyclopedia 1998 financials:

Office of the Inspector General Material Loss Review:

2019 West Virginia University blog post:

Sunday, November 03, 2019

Improve Bank Boards Through A Disciplined Nomination Process

"Rigorous, peer-reviewed studies suggest that companies do not perform better when they have women on the board. Nor do they perform worse." ~ Katherine Klein, University of Pennsylvania

Do you know how difficult my life might become for the above quote? Just yesterday I received a newsletter from a highly regarded executive recruiting firm that said "publicly traded companies with a diverse board of directors generate higher return on investment (ROI) than those that aren't as diverse."

Klein, who did this analysis in 2017, disagrees and says that most citations of gender diversity being either highly correlated or even a causation to better performance are performed by consulting firms and/or information providers... i.e. they are not peer reviewed. And correlation to high performance is not statistically significant.

We're Already Here

That is not the politically correct thing to say. Jill Pursell from my firm wrote a thoughtful newsletter on the subject regarding new and pending legislation compelling gender diversity. We are already deep in this rabbit hole.

So let's make the best of it.

I have observed that the best functioning boards are not dominated by one or two voices, that operate at the level of what a board should operate at, and challenge each other and management. Perhaps I would add community contacts to the list for a community bank board. But I don't think the list speaks to race or gender specifically. 

Larry Fink, CEO of BlackRock, said this of board diversity: "Boards with a diverse mix of genders, ethnicities, career experiences, and ways of thinking have, as a result, a more diverse and aware mindset. They are less likely to succumb to groupthink or miss new threats to a company's business model. And they are better able to identify opportunities that promote long-term growth." Larry's funds are invested in virtually all publicly traded banks. And this is his thinking. 

And it's pretty close to my own thinking regarding reducing the likelihood of groupthink. I have a friend, let's call her Jane. I would guess that Jane and I think similarly about 99% of the time. We are each other's mind doppelganger. I don't think it would be helpful having her and me on a bank board because our backgrounds and world view are too similar. How would we challenge each other? Who was it that said if two people think alike, one of them is unnecessary? 

Back to Fink's thinking. One key challenge I have observed that prevents boards from achieving the level of diversity that he speaks of, and achieving "best functioning board" attributes that I mentioned above, is our nominating process. Most new board members are nominated through a board Governance and Nominating Committee. 

And how they come up with prospects is ad hoc, in my experience. As in, "hey, we need a CPA on the board. Jeff, know anyone? Yeah, I golf with my accountant. Let's see if he's interested." This has led to boards that suffer from groupthink, and lack diversity, in my opinion. To support the point, look at the accompanying picture of me and my friends at a Penn State hockey game. 

Creating A Board That Avoids Groupthink

So let's fix it. Let's be more disciplined in the nominating process. Here is what I suggest...

1.  Do an annual assessment of board needs that includes professional backgrounds, experience strata, customer demographics, and geography. 

2. Use third parties to identify prospects that best fit board needs. This could be chambers of commerce, associations, community organizations (such as Rotary), or even recruiting firms. The key here is you want to develop a diversity of thought, challenging dialogue, at the right level (the level the board should operate at). Do not be limited, or even driven, by who other board members know. That elevates the risk of groupthink, exactly what we are trying to avoid.

3. Get rid of age limits. Wouldn't it be terrible to kick off the 70 year old, thoughtful, and community connected board member for the younger person that barely speaks and opens their board package on board day? Listen to David Baris, CEO of the American Association of Bank Directors, on my firm's podcast regarding this subject. 

4. Perform individual board member assessments that includes the ability to bring in diverse views. CalPers, California's pension fund, estimates that board members get too cozy with one another after 12 years of service. To mitigate this threat, create a fair and disciplined assessment process that gives high scores for bringing diverse views. 

Assigning quotas so bank boards appoint by race and gender does not necessarily deliver the "best functioning board" that I described above. However, implementing the above four suggestions will likely result in a more diverse board. There have been more women than men college graduates since the 1980's. A random walk through Chicago's O'Hare airport shows that there is an increasing diversity of professionals pulling their roller boards. And as our markets become more ethnically diverse, so will our boards if we want our board to better reflect our communities. The end result should be a board that does not suffer groupthink and delivers more positive outcomes.

Any other suggestions on what a "best functioning board" is, and how to achieve it?

~ Jeff