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Board Report:  December 18, 2009

Material Loss Review of Michigan Heritage Bank


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Michigan Heritage Bank (Michigan Heritage) was supervised by the Federal Reserve Bank of Chicago (FRB Chicago), under delegated authority from the Board, and by the Michigan Office of Financial and Insurance Regulation (State). The State closed Michigan Heritage in April 2009, and the FDIC was named receiver. On June 22, 2009, the FDIC IG notified us that Michigan Heritage's failure would result in an estimated loss to the Deposit Insurance Fund (DIF) of $68.3 million, or about 42.5 percent of the bank's $160.9 million in total assets.

Michigan Heritage failed because its Board of Directors and management did not adequately control the risk associated with a high concentration in the construction and land development (CLD) loan component of the bank's commercial real estate (CRE) portfolio. The bank developed a CLD concentration after changing its lending strategy from equipment lease financing to CRE and commercial and industrial loans. The decline in southeast Michigan's economy affected the bank's local real estate market, and the CLD loan portfolio experienced significant losses. In early 2007, the Board of Directors hired new management to strengthen risk management and credit administration, but efforts to improve the deteriorating CLD loan portfolio were unsuccessful. As losses mounted, Michigan Heritage's earnings were eliminated, and capital was severely depleted. The bank was closed on April 24, 2009, after it failed to meet a regulatory deadline to either increase its capital, be acquired by another institution, or take other necessary measures to make the bank adequately capitalized.

With respect to supervision, we believe that the circumstances examiners observed in the late 2007 to early 2008 timeframe, including (1) deteriorating economic conditions, (2) a more than four-fold increase in classified assets, and (3) concerns regarding the bank's future prospects, provided an opportunity for a stronger supervisory response, such as an appropriate enforcement action requiring management to maintain capital commensurate with an increasing risk profile. 

The financial impact of the deteriorating local economy and real estate market was evident during the examination that FRB Chicago began in October 2007. Auto industry lay-offs were increasing, causing what examiners referred to as economic stagnation, particularly in the real estate market. Michigan Heritage's concentration in CLD loans made the bank vulnerable to a downturn in the real estate market. Significant asset quality deterioration was also evident, and classified assets more than quadrupled from $2.7 million to $12.5 million in a 12-month period. Examiners warned that protracted weaknesses in the real estate market could have a significant impact on potential portfolio losses, and they noted that the prospects for improving Michigan Heritage's financial condition and performance were "mixed" because of the Michigan economy and the bank's location in the northern suburbs of Detroit. While we believe that the circumstances FRB Chicago observed during the late 2007 to early 2008 time period provided an opportunity for a more forceful supervisory response, it was not possible to determine whether any such action would have affected Michigan Heritage's subsequent decline or the cost to the DIF. 

Michigan Heritage's failure offered a valuable lesson learned. The bank changed its business strategy from equipment lease financing to CRE and commercial and industrial loans; in doing so, it developed a concentration in CLD loans. Many of the problem loans that eventually led to Michigan Heritage's failure were underwritten during its lending strategy transition to CLD loans when the bank did not have the appropriate leadership, personnel, and infrastructure to support the change. Accordingly, we believe that a bank making a significant change to its business strategy warrants heightened supervisory attention, including an in-depth assessment of management's experience and capability to manage the risks associated with any new lines of business. 

The Director of the Division of Banking Supervision and Regulation agreed with our conclusion and concurred with the lesson learned.